Financial Lecture Notes PDF

Topic 3 Capital raising & evaluation of securities Lectures 5 & 6 1 Lecture outline 1. 2. 3. 4. 5. Ways of raising capital IPO & Issue methods Bond feature and price Bond yields Examples of bonds: government gilts, corporate bonds 6. Share valuation using dividend discount models 2 Why raise capital...

Topic 3 Capital raising & evaluation of securities Lectures 5 & 6 1 Lecture outline 1. 2. 3. 4. 5. Ways of raising capital IPO & Issue methods Bond feature and price Bond yields Examples of bonds: government gilts, corporate bonds 6. Share valuation using dividend discount models 2 Why raise capital? Growth Pay off debts Mergers and Acquisitions 3 How to raise capital? Many options Angel finance Non - securities debt Venture Capital Listing on the stock market 4 Listing on the stock exchange The process of listing on a stock exchange is called an Initial Public Offering (IPO). Through an IPO, a firm sells its shares to new investors. Some well known examples of IPOs: Facebook, Royal Mail, Spotify, Just Eat, Air China, Alibaba, Saudi Aramco. The process involves hiring a number of advisors and choosing a method to conduct an IPO. 5 Methods of conducting an IPO on LSE Offer for sale Placing Offer for subscription Intermediaries offer Introduction 6 Introduction to Bonds and Shares Bonds—governments, local authorities, companies Other names: gilts, stocks, debentures https://www.youtube.com/watch?v=qwCXhumCe1g Shares—companies (shareholders own the company) Other names: stocks, equity shares, ordinary shares https://www.youtube.com/watch?v=JrGp4ofULzQ 7 Bond features and prices Feature Face value Coupon or coupon rate Maturity yield Normally UK bonds have a face value of £100 Face value  principal, nominal value, par value Coupon rate: the % of the face value that the bond pays in interest each year Coupon: the amount of interest Maturity: the date when the issuer repays the face value 8 Example: A 9%, 10-Year Bond A company issues 5,000 bonds, each with a face value of £100, carrying a coupon of 9% and maturity in 10 years.  each bond pays interest, or coupon of 0.09 x £100 = £9 each year for 10 years, plus £100 after 10 years year t = 1 t = 2 … t = 9 t = 10 cash flow 9 9 … 9 109 9 Value/price of the bond depends on market interest rates Assume market interest rates are a constant 9% (same as coupon rate)  ten-year annuity of £9 plus £100 in year 10 PV = 9 x [ 1-{1/(1.09)10 }] + __100__ = 100.09 (1.09)10  bond value = face value  selling at par 10 Example: Bond value at other interest rates 1. r = 10% PV = 9 x [ 1-{1/(1.1)10 }] + __100__ = 93.86 0.1 (1.1)10  bond priced at a discount to its par value (a) coupon rate  interest rate  price  par (b) interest rates rise  bond prices fall 2. r = 8% PV = 9 x [ 1-{1/(1.08)10 }] + __100__ = 106.71.08 (1.08)10  bond priced at a premium to its par value (a) coupon rate  interest rate  price  par (b) interest rates fall  bond prices rise 11 Interest rate risk How sensitive are bond prices to changes in interest rates? Volatility measures the percentage change in bond price for a small (say 1%) change in interest rates. 1. prices of bonds with longer maturities are affected more by changes in interest rates 2. prices of bonds with lower coupons are affected more by changes in interest rates 12 Bond yields Yield to redemption: constant rate of interest that discounts the bond’s future payments to it current price P c F t Y = = = = = the bond’s price the bond’s coupon payment the bond’s face value the bond’s maturity the bond’s yield  the yield is the return on the bond if you buy it and hold it until maturity Solving for Y? If t  2  trial and error 13 Example: Solving for bond yield when t = 2 A 6% bond, currently priced at 98, is due for redemption in 2 years. What is the yield? Letting x = 1/(1 + Y)  106x2 + 6x – 98 = 0 If ax2 + bx + c = 0 then 2 − 4ac − b  b X= 2a = − 6 203.93 212 − 6  62 + 4(106)(98) x= 2(106) x = 1/ (1 + Y) = 0.93364 and Y = 7.108% 14 Example: Solving for bond yields A 10%, 5-year bond with £100 face value is currently priced at £95. What is the yield? Bond is priced at a discount  Y  coupon rate. Try Y = 11%      5} 1 − { 1 / ( 1. 11 ) 100 = 96.3 P = 10 x  + .11 (1.11)5  Try Y = 11.5%      5} 1 − { 1 / ( 1. 115 ) 100 = 94.53 P = 10 x  + .115 (1.115)5  15 PV of bond’s future cash flows 96.3 95 94.53 11% ? 11.5% Interest rate 96.3-95 = 1.3, 96.3-94.53=1.77, 11.5%-11%=0.5%, P =11 + [ 1.3 x(11.5-11.0)]= 11 + 0.367Y ~ 11.367% 1.77      5} 1 − { 1 / ( 1. 11367 ) 100 P = 10 x + = 94.99  .11367 (1.11367)5  16 Government gilts, corporate bonds Semi-annual coupons  a 10% bond (selling at 95) pays £5 after every 6 months In the UK, by convention, we calculate the yield as a flat rate of interest, 95 = 5  Y   1 +     2   + + + 5           2 5      9      + 105 10   Y  1+  2   1+ Y 1+Y 2 2  Y = 11.3374%  nominal yield  flat rate of interest       Effective yield EAR= 1+ 0.113374  2  2 - 1=11.659% 17 Financial Times 1. Government gilts – UK Gilts Prices short: < 5 years medium: 5-15 years long:> 15 years + others Prices are per £100 and given to two decimal places Eg: 98.90 interest yield = annual coupon as % of current price 2. Corporate bonds- International Bond Service yields are effective yields 95= 5 0.5 1+Y     + 105 Y = 11.659% 5 5 +…+ +     5 1+Y  1+Y 4.5     1 +Y       18 Summary 1. bond features are face value, coupon, maturity, and yield 2. bond value equals the discounted value of coupons plus face value 3. bonds sell at par, at a premium, or at a discount 4. bond volatility measure sensitivity of bond value to interest rates 5. a bond’s yield is the interest rate that discounts future payments to the current value. 6. if a bond pays coupon more than once a year, its effective yield exceeds its nominal yield. 19 Valuing Shares Dividend discount models: discount expected future dividends at the rate of return investors require P0 = an estimate of the current price or value of the share, also called the intrinsic value of the share; dt = the dividend per share expected in year t: r = the return that investors require, assumed constant. P0 = The first dividend, +…= occurs in 1 year’s time 20 Rationale for (1): You buy the share intending to sell after 1 year  d1 , P1 What is P1 ? +P 2 2 d + d P d 1 1 + r 2 2 1 P = = 1+ r + + 0 1+ r (1 + r )2 (1 + r )2 d What is P2 ? 21 Zero dividend growth: dt = d at any time  d d d Po =  = + +..., t 2 t 1 + r (1 + r ) t =1 (1 + r ) This is the PV of a perpetuity of d. So we can use the formula Example: Nevergrow plc will pay an annual dividend per share of 24p forever. Investors require a return of 15%. 22 Constant dividend growth: If dividends are growing at a constant rate of g% every year, the current intrinsic price of a share is 𝑃𝑜 = 𝑑1 𝑟−𝑔 This model only makes sense if g < r Example: Evergrow plc has just paid a dividend of 20p and we forecast the dividend will grow at 6% forever. Investors require a 16% return on Evergrow. What is Evergrow’s intrinsic value? What is Evergrow’s price after 4 years? 20(1.06) 21.2 Po = = = 212 p 0.16 − 0.06 0.16 − 0.06 d (1 + g )4 P = 5 = 1 = Po ((1 + g )4 = P (1 + g ) 4 = 267.6 4 r−g 0 r−g d 23 Supernormal dividend growth: Example: Supergrow plc has just paid a dividend of 10p. We forecast dividend growth at 35% for 5 years followed by 8% growth forever. Investors require a return of 20% on Supergrow. P0 = =72.2+162.2=234.4p General formula Where d0 is the current dividend, s is the supernormal dividend growth rate, t1 is the time for which supernormal growth happens, r is the investors’ required rate of return, g is the normal growth rate of dividends 24 Summary 1. Share value equals the discounted value of future dividends 2. Special cases assume constant dividends, constant dividend growth, supernormal growth followed by constant normal growth 25