Extra critical thinking and challenging question:

Q1: Why are investors and managers concerned about market efficiency?

The role of secondary markets is to bring buyers and sellers together. Ideally, we
would like security markets to be as efficient as possible. Markets are efficient when
current market prices of securities traded reflect all available information relevant to
the security. If this is the case, security prices will be near or at their equilibrium price
(true value). The more efficient the market, the more likely this is to happen. This
makes it easier for managers to price the securities close to the equilibrium price.
What investors are most concerned about is having complete information regarding a
security’s current price and where that price information can be obtained. Efficient
markets allow them to trade at prices that are closer to the true equilibrium price than
otherwise possible.
Thus, both investors who provide funds and managers (companies) who raise money
are concerned when high transaction costs lead to inefficient markets.

Q2: What does it mean when a company has a very high P/E ratio? Give examples of
industries in which you believe high P/E ratios are justified.

A high P/E ratio implies that investors believe that the company has good prospects
for earnings growth in the future. In fact, they believe that the company will have
higher growth potential than companies with lower P/E ratios. Companies in
industries that are fast growing like biotech or any hi-tech industry have high P/E
ratios. In the past, companies like Cochlear and CSL had very high P/E ratios. As
these companies matured and settled to annual growth rates of 20 per cent or less,
their P/E ratios have declined.

Q3: Why are ordinary shareholders considered to be more at risk than the holders of other
types of securities?

In the hierarchy of lenders (suppliers) of funds to a company, ordinary shareholders

have the most to lose. In the event of a company becoming bankrupt, the law requires
that creditors of different types, including bondholders, be paid off first. Next,
preference shareholders are paid off. Finally, ordinary shareholders receive their
investment if any funds are still available. Thus, ordinary shareholders receive their
money back last and are placed at most risk. This feature of ordinary equity is referred
to as residual claim.
Q3: Trentham Estate Pty Ltd expects to grow at a rate of 22 per cent for the next 5 years and
then settle to a constant-growth rate of 6 per cent. The company’s most recent
dividend was $2.35. The required rate of return is 15 per cent.
a. Find the present value of the dividends during the rapid growth period.
b. What is the price of the share at the end of year 5?
c. What is the price of the share today?

Solution:

g1-5 = 22%; g = 6%; D0 = $2.35; R = 15%

D1  D0 (1  g 1 )  $2.35(1.22)  $2.867
D2  D1 (1  g 2 )  $2.867(1.22)  $3.498
D3  D2 (1  g3 )  $3.498(1.22)  $4.268
D4  D3 (1  g 4 )  $4.268(1.22)  $5.207
D5  D4 (1  g )  $5.207(1.22)  $6.353

D1 D2 D3 D4 D5
PV ( Dividends )     
(1  R ) (1  R ) 2
(1  R ) 3
(1  R ) 4
(1  R )5
$2.867 $3.498 $4.268 $5.207 6.353
    
1.15 (1.15) 2 (1.15)3 (1.15) 4 (1.15)5
 $2.49  $2.64  $2.81  $2.98  $3.16
a.  $14.08

D6  D5 (1  g )  $6.353(1.06)  $6.734
D6 $6.734
P5    $74.82
b. R  g 0.15  0.06

$74.82
PV ( P5 )   $37.20
(1.15)5
P0  PV ( Dividends )  PV ( P5 )
 $14.08  $37.20
c.  $51.28