- August 10, 2021 at 1:03 pm #631040
Sir, you said in your lectures that once the company has raised money from the shareholders or debtholders (in case of traded debt) it is over for the company.
However, the shares or tradeable debt can be traded in the stock market where people buy & sell shares or debts of a company.
1) In case of shares how do people earn profit by buying & selling of shares?
If there is higher prices for a share we simply sell the shares to others; However, if there is lower prices for a share we simply buy the shares at lower price?
2) BUT in case of a tradeable debt how do the people buy & sell?
If there is higher price for a debt we simply sell the debt to others; However, if there is lower price for a debt we simply buy the debt at lower price?
3) In exam when we calculate redeemable & irredeemable debts so what do we assume whether this is the debt borrowed from bank or it is a debt issued to debtholders?
4) Is it also true that when the debt is borrowed from bank, it is non-tradeable debt & therefore, calculated by interest x (1 – tax)
However, if the debt is issued to debtholders then it is calculated either from formulae depending whether it is redeemable or irredeemable debt.
Is that all correct SIR? Thanks for your answer 🙂August 10, 2021 at 4:51 pm #631076
For (1) and (2), both shares and bonds (i.e. traded debt) are both traded on the stock exchange. The market value changes from day to day depending on how many people are buying and how many people are selling – the dealers fix the prices so as to get as many people wanting to sell as people wanting to buy. (Just as the price of vegetables on the market goes up and down depending on the supply and the demand. Dealers on the stock exchange are just like vendors on a market.
If a person wants to deal in shares (as opposed to simply buying shares and keeping them so as to keep getting the dividend) then they buy and later they sell. They make a profit or a loss of the difference between the price they paid and the price at which they sold.
(3) Redeemable and irredeemable debt always refers to traded debt i.e. bonds/loan stock – they are different names for the same things.
The cost to the company of a bank load is indeed the interest x (1 – T).
The cost of debt is calculated as I explain in my lectures, depending whether ir is redeemable or irredeemable.August 10, 2021 at 5:29 pm #631082
Thanks for your answer 🙂
As regards to profit or loss when the shares are sold.
If somebody bought shares in a company with a share price of $3 (two years ago) BUT the market price of shares is $5 currently then if anybody wants to sell the shares they can only sell them for $5.
That means the price we paid is $3 (which was two years ago) and the price at which we sold the shares is $5 which simply gets a $2 gain on the sale of shares. And this gain or loss goes to whoever owns the shares. If we have 1000 shares that we sold where a gain of $2 / each share but in total it will be $2000 (1000 x $2).
Secondly, is it true that shares are overvalued if the market value of a share is the present value of the future expected dividends (calculated by DVM formula). If the current share price in the market is actually more than the PV of future dividends then the share is currently overvalued. And if current share price is lower then it is undervalued.
Can you please give me an example of overvalued & undervalued stock? Since we can use DVM or Perpetuity formulae to calculate the PV of the future expected dividends (Is that correct too?)August 11, 2021 at 7:51 am #631122
What you write about the gain of $2 is correct.
As far as shares being over or under valued is concerned, in theory the share price should be the PV of future expected dividends discounted at the required rate of return as determined by the riskiness of the share measured by its beta. In a perfect world this would be the case but in the real world the share price is not always what it should be for several reasons – investors do not have perfect information about future dividends, the beta is never certain, and when expectations change then although the share price will change it does not happen instantly and therefore in the meantime the MV may be higher of lower than it should be.
To continue this discussion may be of interest but to say more is not of relevance for Paper FM.August 11, 2021 at 10:42 am #631187
Is it also true that to calculate share price which is PV of future expected dividends discounted at the required rate of return; we have only DVM and Perpetuity formulae to calculate share price in paper FM?
If the share price calculated from these formulae is lesser than the current market price of a share then the share price is overvalued. However, if it is greater than the current market price of a share then the share price is undervalued.
BUT in real life, whether only these two formulae are used to calculated Share Price or there are any other ways to calculate the share price?August 11, 2021 at 3:22 pm #631219
In exams you can be expected to value shares using the dividend valuation model (which is the same as discounting a perpetuity), or using PE ratios, or (occasionally) using the asset valuation.
In real life prices are determined by supply and demand as I explained before and many factors influence what investors are prepared to pay (including rumours). The dividend valuation model is not used. PE ratios are often used by some investors as are asset valuations on specific occasions (as I explain in my lectures).
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