Lecture04c - FINM2401 Financial Management What is a share...

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FINM2401 Financial Management Share Valuation Lecture 4 2 What is a share? Financial asset – a claim to a series of cash flows (dividends) against some economic unit (corporation) Limited liability – the maximum loss of a shareholder is limited to their share investment A residual claim – to part of what’s left in the event of liquidation Ownership – shareholders own company, and elect board of directors to oversee management 3 Trading Shares Buy Expect shares to rise in value Long position Sell Expect shares to fall in value Short Sell Sell shares not already owned Short position 4 Dividend Payments On announcement an “ex-dividend” date is set Shares purchased before the ex-dividend date will receive the dividend Shares purchased on or after the ex-dividend date will not receive the dividend Share price will drop by value of dividend on the ex-dividend date
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5 Cash flows are the key… Key concept Value of share = present value of future cash flows from equity Cash flows stemming from shares Dividends (d 1 …d n ) Price it will be sold for (P n ) ( ) ( ) ( ) ( ) ( ) = + + + + + + + + + + 3 1 2 0 1 2 3 ... 1 1 1 1 1 n n n n e e e e e d d d d P P r r r r r 6 Valuing debt was easy! ( ) ( ) - - + = + + 1 1 1 n per n per per r FV PV A r r The coupon payment is known The market yield can be observed Face value is known Maturity date is known 7 Valuing equity is harder! Future dividends are not known Required rate of return is difficult to observe Future share sale proceeds are not known ( ) ( ) ( ) ( ) ( ) = + + + + + + + + + + 3 1 2 0 1 2 3 ... 1 1 1 1 1 n n n n e e e e e d d d d P P r r r r r 8 Share Valuation (E) Cash flows stemming from shares Dividends (d 1 ) Share price once sold (P 1 ) + = = + 1 1 0 1 e d P E P r Today’s Price
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9 Share Valuation Since future investors will simply value future dividends, the price next year is given by: Which means the price now is: ( ) + + + + = = + + + + 2 2 1 1 2 2 0 2 1 1 1 1 e e e e d P d r d d P P r r r + = + 2 2 1 1 e d P P r 10 How do we handle the infinite sum?
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