A comprehensive summary of lecture content, textbook chapters and a few of the essential readings. This all-in-one document includes all the explanations you will need for Finance IIA.
Price: what a share is trading at (objective)
Value: what you think the firm is worth (subjective)
When the price is above the value, it would be beneficial to sell the shares. This is because
the share is then overvalued, and value theory states that the price will eventually return
to the level of value and potentially drop below it (therefore, if you were to keep the
shares, you would make capital losses).
When the price is below the value, it would be beneficial to buy shares. This is because
the share is then undervalued and is estimated to return to its value level or higher
(therefore, there is potential to make capital gains by holding onto the share or buying
more shares).
FRICTION
However, we must take note of some friction that affects our estimation of value.
A MARGIN OF SAFETY
A margin of safety is the difference between price and value that signals to investors
whether or not to invest.
,The price needs to be above/below the value by more than the margin of safety in order
to sell/buy. This is because the margin of safety accounts for any uncertainty in our
estimation of the value.
TRANSACTION COSTS
These affect the price at which we will sell or buy. This means that if our transaction costs
are higher than our return, it is an unwise transaction to make, because you will profit from
the transaction but make larger losses in paying for the transaction.
EXTERNAL EVENTS
External events can affect the price in many unexpected ways. It may cause the price to
take a longer time to return to value or perhaps even affect the value itself.
MICROSTRUCTURE OF THE MARKET
The microstructure of the market can also affect the movements in price.
EXAMPLE: When China banned the short sales of shares, the short sellers could not drive
the prices back down.
REAL ASSETS V FINANCIAL ASSETS
REAL ASSETS
Real assets determine the productive capacity and the net income of the economy. It is
something that produces income.
EXAMPLE: Land, buildings, machines and knowledge/patents used to produce goods and
services.
FINANCIAL ASSETS
Financial assets are claims to the income generated by real assets.
There are 3 types of financial assets:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities
FIXED INCOME/DEBT
EXAMPLE: bonds
These are payments that are fixed or determined by a formula.
,Money market debt: short term debt (less than a year to maturity)
Capital market debt: long terms bonds (can be safe or risky)
COMMON STOCK
EXAMPLE: shares that pay dividends
This is equity or ownership in a corporation. However, there is much debate as to whether
a share equates to ownership. This is because of a few of the following reasons:
- Voting at shareholder meetings only appoints directors and does not mean
shareholders have control of the company.
- Shareholders can receive a dividend, but only once it is declared. There is no right
to a dividend.
These rights are a far cry from actual ownership, particularly if it is only a minority
shareholding.
Payments to stockholders are not fixed but depend on the success of the firm.
DERIVATIVES
The value of derivatives derives from the process of other securities, such as stocks and
bonds.
These can be used to transfer risk (to hedge against risk).
They can also be used to gear returns.
FINANCIAL MARKETS AND THE ECONOMY
Historically, financial markets used to be purely a method of raising capital for firms and
entities. Now, there are many more functions of the financial markets. Namely:
- The informational role of financial markets
- Consumption timing
- The allocation of risk
- The separation of ownership and management
- Corporate governance and corporate ethics
THE INFORMATIONAL ROLE OF FINANCIAL MARKETS
Financial markets play an essential role in the allocation of capital resources. If a
corporation seem to have good prospects for future profitability, investors will bid up its
stock price. Capital therefore flows to companies with good prospects.
- Some companies may be “hot” for a short period of time, attracting a large flow of
investor capital, and then fail after only a few years.
- No-one knows with certainty what will happen. Stock markets encourage the
allocation of capital to those firms who appear at the time to have the best prospects.
, CONSUMPTION TIMING
Individuals may earn more than they currently wish to spend. They can “store” their
wealth in financial assets. Investment in financial assets allows individuals to postpone
consumption for the future.
ALLOCATION OF RISK
Investors can select securities consistent with their tastes for risk.
This also benefits the firms that need to raise capital to finance their investments because
each security is being sold for the best possible price because investors are selecting
security types which best suit their risk-return preferences.
SEPARATION OF OWNERSHIP AND MANAGEMENT
This gives a firm stability (as ownership can be continuously changing).
Firm’s management should pursue strategies that enhance the value of the shares.
However, there can be agency problems involved as management may choose to pursue
their own interests instead of those of the shareholder. This can be combatted using
various methods:
- Compensation plans that tie the income of managers to the success of the firm.
- The board of directors can force out management teams that are underperforming.
- Outsiders, such as security analysis, monitor the firm closely to make the life of
poor performers uncomfortable.
- Bad performers are subject to the threat of takeover.
CORPORATE GOVERNANCE AND CORPORATE ETHICS
For markets to effectively serve their purpose, there must be an acceptable level of
transparency that allows investors to make well-informed decisions.
In South Africa, we have King III, which is implemented in the JSE, which ensures a certain
level of governance within the listed companies.
THE INVESTMENT PROCESS
Investors take two types of decisions in constructing their portfolios:
1. Asset Allocation: the choice among broad asset classes
2. Security Selection: the choice of what securities to hold within asset classes.
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