Lecture 8 - Share Capital

PREFERENCE SHARES (PREFERRED STOCK)
A hybrid security, having characteristics of both bonds

(i.e. Debt) and ordinary shares (i.e. common stock or
Equity) – financial analysts often classify it as Debt.
• Advantages
 Dividend not obligatory (like ordinary shares)
 Usually no maturity date (like ordinary shares)
 No voting rights, so no dilution of ownership and control
(like debt)
 Preference dividend is fixed (like interest on debt), so no
dilution of earnings
• Disadvantages
 Costlier than debt (higher cost of capital, no tax shield)
 Increases financial risk for equity shareholders
 If preference dividend is cumulative, it can mount up
VALUE OF A PREFERENCE SHARE
Preference shares usually pay a fixed dividend, and
have no maturity date. So the preference dividend is
effectively a perpetuity, and the value of a preference
share is the present value of a perpetuity:
So the value of a preference share (Vps) is the perpetual

dividend (D) discounted at the required rate of return of
preference share holders:
Cost of Preference Share Capital
The value of preference share capital is thus the result of
the interplay of two factors – the perpetual dividend and
the expected rate of return of preference share holders:
The expected rate of return of preference shareholders

(kps) is the cost of preference share capital. Given the
value at which preference share capital is trading in the
stock market, the implied cost of capital (kps) is:
ORDINARY SHARES (COMMON STOCK)
An ordinary share is a certificate that indicates part ownership
of a company. Ordinary share capital therefore represents the
owners’ stake in a company, and is referred to as Equity.
• Sources of Equity Capital:
– Retained earnings
• Undistributed profits carried in the company
– Public issue of shares
• Public offering of new ordinary shares
– Private placing of shares
• Placement of ordinary shares by private agreement,
usually with an institutional investor
– Rights issue of shares
• Offering existing shareholders the pre-emptive right to
buy a new issue of ordinary shares
Valuation
Valuation of
of Ordinary
Ordinary Share
Share Capital
Capital
(Common
(Common Stock)
Stock)
 Difference between ordinary shares & bonds:
 Principal
 Bonds - repaid after a fixed maturity
 Ordinary Share - no fixed maturity (i.e. it is like a
perpetual bond)
 Income
 Bonds – Interest at fixed rate must be paid
 Ordinary Share - Dividend may or may not be paid;
rate of dividend is uncertain
BASIC
BASIC DIVIDEND
DIVIDEND VALUATION
VALUATION MODEL
MODEL
(“ZERO
(“ZERO GROWTH”)
GROWTH”)
Assume a constant dividend D is paid forever - i.e. the
dividend D is a perpetuity :
Present value of common stock (Vcs) will then be
determined in the same way as preferred stock:
This is the “constant dividend” or “zero growth” model -

kcs is the expected rate of return of equity investors:
Suppose dividend is not constant? Then
the general dividend valuation model is:
The main problem is how to estimate D1, D2, etc.

up to infinity? The model does not assume any specific pattern for
future cash dividends + we need to estimate an infinitive number of
dividend in the future
Only the current dividend (i.e. the last dividend
paid) is known - this is referred to as D0. When
we only know D0, and dividend is variable, how
can we estimate D1, D2, etc?
CONSTANT
CONSTANT GROWTH
GROWTH MODEL
MODEL
Companies always try to avoid reducing the
dividend payment - so dividend payouts
generally tend to grow fairly steadily.
Assume a constant growth rate “g”
If D0 = 20p and g = 10%, then
D1 = 20(1 + .10)1 = 22p,
D2 = 20(1 + .10)2 = 24.2p, and so on
Thus, D1 = D0(1 + g)1 and
Dt = D0(1 + g)t
This is a geometric progression which simplifies to:
Note that the zero growth model is a special

case of the constant growth model: i.e. when g is
zero:
Given the share price, the expected rate of return
of equity investors (“kcs”) can be determined:
With zero growth:
With constant growth:

How to estimate “g”? Two ways:
Dividend Growth Method

 Use average growth of last few years.
 Assumes past can be used as a proxy for future.
 Gordon Method
 Assuming
• Constant Return on Equity (ROE); and
• Constant Retention Ratio (r)
 Dividend growth rate g =
Rate of return on reinvested earnings x Retention ratio
i.e. g = ROE x r
Equity Valuation
The Relationship between R and g
 Constant-growth dividend model yields
solutions that are invalid whenever dividend
growth rate equals or exceeds discount rate
(g ≥ kcs).
 If g = kcs, the value of the denominator is

zero and the value of the share is infinite–
which makes no sense.
12
Equity Valuation
The Relationship between kcs and g
 If g> kcs the present value of the share is

negative, which makes no sense
 If g < kcs, the present value of the
dividend gets bigger and bigger rather
than smaller and smaller as it should.
This implies that a firm that is growing at
a very fast rate does so forever.
13
SHARE Valuation
Some Simplifying Assumptions
 Three different assumptions can cover most
growth patterns.
1) Dividend payments remain constant over
time; i.e., they have growth rate of Zero.
2) Dividends have constant growth rate.
3) Dividends have mixed growth rate pattern; i.e.,
they have one payment pattern then switch to
another.
14
Assumptions
Assumptions when
when using
using Dividend
Dividend
Valuation
Valuation Model
Model to
to estimate
estimate cost
cost of
of
equity
equity
• Value of share is discounted stream of future
dividends - this creates practical problems in using
the model for firms that are not paying dividends.
• Future dividend growth can be accurately measured,
and continues indefinitely at a constant rate - this is
unlikely in practice.
• Share price is in equilibrium - a questionable
assumption in volatile capital markets.
• Assumes that the relevant risk of a share is
encapsulated in the existing share price - it does not
attempt to specifically measure the risk of the share.

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PREFERENCE SHARES (PREFERRED STOCK)

A hybrid security, having characteristics of both bonds

So the value of a preference share (Vps) is the perpetual

The expected rate of return of preference shareholders

This is the “constant dividend” or “zero growth” model -

The main problem is how to estimate D1, D2, etc.

Note that the zero growth model is a special

With constant growth:

Dividend Growth Method

 If g = kcs, the value of the denominator is

 If g> kcs the present value of the share is

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