FIN11108 Global

Finance

Unit 7
Equity Financing
Links between the Lecture Slides and Videos:

 Lecture Slides No. 1 – No. 8 are linking to

Video 1

 Lecture Slides No. 9 – No. 18 are linking to Video

2

 Lecture Slides No. 19 – No. 24 are linking to

Video 3

 Lecture Slides No. 25 – No. 33 are linking to

Video 4
 Learning Goals
1. Explain what equities are
2. Explain the differences and associated
advantages/disadvantages between debt and equity
financing
3. Understand and apply the various techniques/models
for the valuation of stock
4. Explain the generic structure and trading
arrangements of equity markets
5. Introduce the major and emerging stock markets
6. Discuss and evaluate the cross-listing shares in the
international equity market.
7. Critically assess the impacts of COVID-19 on global
stock market.
 Recommended Reading
 Chowdhury, E. K., Khan, I. I. and Dhar, B. K., 2020, Catastrophic
impact of Covid-19 on the global stock markets and economic
activities, Business and Society Review.

 Eun, C. S. and Resnick, B. G., 2018, International Financial

Management (8th ed), Ch 13.

 Jones, H., 2020, The winners and losers of the Covid-19 stock
market crash, available at
https://www.thenationalnews.com/business/money/the-winners-an
d-losers-of-the-covid-19-stock-market-crash-1.1004792
Equity: Definition and Basic Characteristics
 What Are Equities?
• market intermediated financial claim
• represent an ownership stake in the issuing
company
• enable financial funds to be reallocated from the
surplus sector to the deficit sector.

Two types of most common equities:

1. ordinary shares (common stock)
2. preference shares (preferred stock)
 1. Ordinary Shares (OS)
• give their holders claims to variable future
streams of income dividends
1) dividends are NOT guaranteed
2) depend upon the level of profits
3) discretionary
4) rank of payment --- only AFTER all the
creditors
• a limited liability
• never have to be repaid
• voting rights
• preemptive rights
 2. Preference Shares (PS)
• offer their owners certain preferences over ordinary
shareholders

• PS v.s. OS
1. PS --- a fixed dividend payment; paid before any
dividends are distributed to OS
2. the price of PS --- relatively stable
3. PS holders --- NOT part of the owners; NO voting rights
4. PS holders --- claim on assets before OS but after
creditors and bondholders

OS Holders Get a Vote while PS Holders Get Paid First

Stock Valuations
 Key Indicators: Dividend Yield (DY)
• a financial ratio shows how much a company pays out
in dividends each year relative to its share price

• the return on investment for a stock (in the absence of

any capital gains)

• a way to measure how much cash flow investors are getting for
each pound invested in an equity position

• Dividend yield = (distributed profit/number of shares)/market price per share

Or
= annual dividends per share/market price per share
 Continue…

 if the share market price dividends

then the dividend yield
Or vice versa.

 Therefore investors cannot just judge whether a share to

be ‘cheap’ or ‘dear’ solely by share price.
 Key Indicators: Price/Earning Ratio (P/E)
Dividends
• Profits
Retained earnings
 Retained earning ? share prices
 a valuation ratio of a company's current share price compared to its
per-share earnings
 Price/Earning ratio = market capitalisation per share/earnings per share
(EPS)
 more useful to compare the P/E of one company to other companies
in the same industry
 or against the company's own historical P/E
 Example:
Company ABC and Company XYZ are both IT companies. Company ABC
trades at 15 times P/E and Company XYZ’s P/E ratio is 22. Only think of
P/E ratios. Which company do you prefer to invest in?
Return on Preferred Stock
DP = Dividends of PS
NP = Net Proceeds of Issuing PS

Craiglockhart Corporation is contemplating the issuance

of a 10% preferred stock that is expected to sell for its
£87-per share value.
The cost of issuing and selling the stock is expected to be
£5 per share.
The dividend is £8.70 (10% x £87). The net proceeds
price (Np) is £82 (£87 - £5).

rP = DP/Np = £8.70/£82 = 10.6%

Return on Common Stock:
Gordon Growth Model (GGM)
Assumption:
dividend grows continuously at the constant rate forever

: The most recent dividend paid

: The required return on investment equity

: The expected constant growth rate in dividends
: The dividend paid at the end of year 1
GGM (con’t)
Constant Dividend Growth Model

ke = +g

For example, assume a firm has just paid a dividend of

£2.50 per share, expects dividends to grow at 10%
indefinitely, and is currently selling for £50.00 per share.
First, D1 = £2.50 * (1+.10) = £2.75, and

ke = (£2.75/£50.00) + .10 = 15.5%.

Return on Common Stock:
Capital Asset Pricing Model (CAPM)

: The required/expected return on the asset

: The risk-free rate of return

: The sensitivity of the asset returns to market return
: The expected return of the market
: The expected market risk premium
CAPM (con’t)
Systematic Risk
 ‘undiversifiable risk’
 affects the overall market, not just a particular stock or
industry.
 e.g., Interest rate changes, inflation, recessions and
wars

Unsystematic Risk
 ‘diversifiable risk’
 Company- or industry-specific hazard
 e.g., a new competitor, a regulatory change, a
management change and a product recall

CAPM eliminates unsystematic risk and only considers

systematic risk
CAPM (con’t)

For example, if the 3-month Government

security rate is currently 5%, the expected
return of the market is 14%, and the firm’s beta
is 1.20, the return on the common stock will be:

ke = 5.0% + 1.2 * (14.0% - 5%) = 15.8%.

Stock Market Structure and Trading Systems
 Stock Market Structure
1. Primary Market
 market where new issues of shares are made
 market where companies actually raise new finance
The principal methods of issuing new shares
(i) Initial Public Offering (IPO)
company (issuer) offering its shares enters into a
contract with a major investment bank to sell its
shares to the public.
(ii) Placement
the company’s sponsor, a bank or broker will contact
major investment institutions asking them to buy
some of the shares.
Primary Market (con’t)

(iii) Rights Issue

used by a company which has previously issued

shares on the market but now wishes to raise
additional finance.
shares are first offered to existing shareholders
the number of offered shares depends upon how
many shares they already hold
offer price is at a discount to their current price –
usually between 20% and 40%.
Stock Market Structure
2. Secondary Market
 a market where investors purchase securities
or assets from other investors, rather than
from issuing companies themselves.
 it provides two essential services:
(i) Liquidity
the ease and speed which an asset can be
converted back into cash
(ii) Share Valuation
• a ‘fair’ market price
• Indicator of company performance
Secondary Market Trading Systems
 Before…
(i) ‘exchanges’, real physical buildings with trading floors
(ii) OTC (over-the-counter) markets

 Today
electronic trading systems called Electronic Communications
Networks (ECNs)

• What are the advantages of ECNs over OTC and exchanges?

1) Flexible hour trading
2) Transparency
3) Time saving
4) Cost saving
Can you think of any disadvantages of using ECNs?
 Secondary Market Trading Systems (con’t)
Two Basic Types of ECN Trading Systems
 Dealer Markets (‘quote-book’ markets) --- an electronic version of
the old exchange type of market
e.g. The London Stock Exchange’s quote driven market : SEAQ system
(Stock Exchange Automated Quotation).
 Auction Markets (‘order-book’ markets) --- The exchange has a
central computer which operates an electronic order book.
e.g. The London Stock Exchange’s electronic order-book system called
SETS (Stock-exchange Electronic Trading Service)
Example:
4 buyers want to buy a share of XYZ and make the following bids: £10.00,
10.02, 10.03 and 10.06. Conversely, there are 4 sellers that desire to sell
XYZ and they submitted offers to sell their shares at the following prices:
£10.06, 10.09, 10.12 and 10.13. In this scenario, the individuals that made
bids/offers for XYZ at £10.06 will have their orders executed.
International Equity Market
Major Stock Markets
 The biggest developed stock markets

 USA: NYSE and NASDAQ

 UK: LSE
 China: SHSE and SZSE

 Access guides to various national stock markets via the

following link:
http://www.world-exchanges.org/
Emerging Stock Markets
 Standard & Poor’s Emerging Markets Data Base classifies
a stock market as “emerging” if it meets at least one of two
general criteria:
(1) it is located in a low- or middle-income economy as defined by the
World Bank, and/or
(2) its investable market capitalization is low relative to its most recent
Gross National Income (GNI) figures.
 Late 1980s
capital market liberalisation
European, Asian, Latin American and African continents
 In the 1990’s
capital flows to emerging markets increase dramatically,
and also their composition changed substantially
 Capital Market Liberalisation
 Table 7.1 Percentage of world stock market capitalisation

Source: Bespoke Investment Group, 2014

Cross-Listing of Shares

Cross-Listing refers to a firm having its equity

shares listed on one or more foreign exchanges.

The number of firms doing this has exploded in

recent decades.
Table 7.2 Total, Domestic, and Foreign Company Listings
on Major National Stock Exchanges for 2003

Source: World Federation of Exchanges, 2003

Advantages of Cross-Listing

It expands the investor base for a firm.

 Very important reason for firms from emerging market countries with
limited capital markets.

Establishes name recognition for the firm in new

capital markets, paving the way for new issues.

May offer marketing advantages.

May mitigate possibility of hostile takeovers.

 Impacts of COVID-19 on Global
Stock Markets
Huge amount of wealth had been washed out from
the global stock market
 Al-Awadhi et al. (2020) – Base upon the Data of the Chinese Stock Market, the day
to day growth rate of confirmed cases and deaths both hurt the stock returns of
different organisations.

 Ozili and Arun (2020) - 6 trillion USD in wealth was washed out from the global stock
market in the week of 24th February.

 Fernandes (2020) - the stock market performance of the United Kingdom and
Germany were even worse than the performance of the US stock market. It also
showed the two industries that performed worst are Oil, Gas, and Coal sector, and
Travel and Leisure industry.

 Chowdhury et al. (2020) - the pandemic affected all the countries severely especially
European countries.
 Impacts of COVID-19 on Global
Stock Markets (Con’t)
Result in a dramatic increase in the market’s
volatility

 Baker et al. (2020) - from February 24 to March 24, 2020 in 22

trading days, there were 18 market jumps, which is the highest
number of jumps In the history of the United States.

 Zhang et al. (2020) - the pandemic had a strong influence on

the stock market as the risk level of all the sample countries
has increased.

 Fernandes (2020) - the global stock market volatility was above

or similar to the 2008–09 level of volatility.
Appendices
Largest stock exchanges worldwide as of March 2020, by market
capitalisation of listed companies (in trillion U.S. dollars)

Source: Statista, 2020