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International Corporate

Finance

International Capital Markets &


Securities

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Financial Markets (1)


A financial market can be defined as the
participants, commentators and facilitators which
contribute to setting the price of a financial asset
Participants
Investors
Traders

Commentators
Equity analysts and credit rating agencies

Facilitators
Stock exchanges and investment banks
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Financial Markets (2)


Capital markets
Long-term securities (> 1 year from issue to maturity)

Money markets
Short-term securities (< 1 year from issue to maturity)

Derivative markets
Futures and options

Foreign exchange markets


Currencies and forwards
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Long-term Securities
Long-term securities are issued to investors for
cash in the primary capital market by:
Companies issue equities and bonds to finance growth
Governments issue bonds to make up tax shortfall

The investor has legal rights to receive future cash


flows from the issuer:
Equities dividends and liquidation proceeds
Bonds interest and redemption proceeds

Previously issued securities trade (are bought and


sold) in the secondary capital market
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Global Companies
Listed companies ranked by equity market capitalisation:
Country

Sector

Market
capitalisation

Apple

USA

Technology

$725bn

Exxon Mobil

USA

Oil & Gas

$356bn

Petrochina

China

Oil & Gas

$330bn

Switzerland

Pharmaceuticals

$268bn

UK

Oil & Gas

$192bn

Company

10 Novartis
14 Royal Dutch

Source: Financial Times Global 500 at 31st March 2015


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Importance of Security Prices


Company directors are concerned about security
prices in the secondary market:
Financial efficiency share price and bond price
Shareholder wealth creation share price
Remuneration share price

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Security Pricing
The secondary market price of a security is set by
the interaction of participants when they trade:
Price rises when more buyers than sellers
Price falls when more sellers than buyers

Participants trade a security because they have


different opinions on its intrinsic value
The intrinsic value of a security is:
Determined by the amount, timing and certainty of its
expected future cash flows
Subjective and not (necessarily) the same as its price
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Intrinsic Value - Equities


Expected future equity cash flows depend upon
the performance of the issuer:
Dividend payments amount and timing uncertain but
typically rise over time
Disposal proceeds amount uncertain as will depend
upon market price when shareholder sells
Liquidation proceeds amount and timing uncertain
although typically zero if issuer fails

Equity analysts advise on future corporate


performance
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Intrinsic Value - Bonds


Expected future bond cash flows depend upon
the survival of the issuer:
Interest payments amount and timing known with
certainty and fixed unless issuer fails
Redemption proceeds amount and timing known
with certainty and fixed unless issuer fails
Disposal proceeds uncertain as will depend upon
market price when bondholder sells

Credit rating agencies advise on likelihood of


future failure of issuer
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Share Prices (1)


Opinions on the intrinsic value of a company (and
its share price) are likely to change when new
information is made public by:
The issuing company
Financial results and trading updates
Management changes
Mergers and acquisitions

Third parties
Close competitors
Economic data
Equity analysts forecast upgrades / downgrades
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Share Prices (2)


Share price performance can be stated in absolute terms
and/or in relative terms to i.e. an equity index
Index
value
Index change -2%
Share
price
Absolute change -15%

Relative performance of share price: -15% + 2% = -13%


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Share Prices (3)


Reasons for relative underperformance of the share price
Index value

Share price

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Equity Indices
Indices reflect share prices of constituent companies
Country

UK
USA
Japan
Germany

Main stock
exchange

Main index

London

FTSE 100

100

+1%

New York

Standard &
Poors 500

500

+6%

Tokyo

Nikkei

225

+19%

Frankfurt

Xetra Dax

30

+15%

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Constituent
12 month
companies performance

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Market Efficiency
In an efficient market, security prices are fair and
can be trusted to:
Reflect the markets consensus opinion on its intrinsic
value at a point in time
React fully, rapidly and rationally to any new
information which is relevant to its intrinsic value

Hence, directors can be confident that actions


which create or destroy shareholder wealth will
be reflected in the share price
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Efficient Market Hypothesis (1)


Fama (1970) distinguished three levels of
informational efficiency in the equity market:
1.Weak efficiency:
Prices fully, rapidly and rationally reflect all information contained
in past prices
Not possible to make consistent abnormal returns by predicting
future price movements based on past price movements
Possible to make consistent abnormal returns by using publicly
available and/or privately available (inside) information
Strongly supported by tests of empirical evidence
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Efficient Market Hypothesis (2)


2. Semi-strong efficiency:
Prices fully, rapidly and rationally reflect all information contained
in past prices and all relevant publicly available information
Not possible to make consistent abnormal returns by using past
prices or publicly available information
Possible to make consistent abnormal returns by using inside
information
Fairly well supported by tests of empirical evidence despite
anomalies i.e.:
Existence of star investors
Earnings announcement effect
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Efficient Market Hypothesis (3)


3. Strong efficiency:
Prices fully, rapidly and rationally reflect all information contained
in past prices and all relevant publicly available information and
all relevant inside information
Not possible to make consistent abnormal returns with any
information
Not well supported by tests of empirical evidence i.e.:
Abnormal returns by directors dealing in their companys
shares
Abnormal returns made by (prosecuted) insider dealers

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Efficient Market Hypothesis (4)


What would be the immediate impact on the
share price of a company which trades in a
market which is weak to semi-strong efficient if it:
Announces financial results which are in line with
expectations?
Announces better than expected financial results?
Issues a profits warning?
Wins a major new contract?
Announces that the chief executive officer has
resigned?
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Equity Valuation
The academic theory:
The intrinsic value of a company is the present value of its
expected future cash flows discounted at an appropriate,
risk-adjusted, rate

The reality:
Future company cash flows are inherently uncertain
Many and varying factors affect the discount rate
Non cash flow methodologies to estimate equity value are
used in practice:
Price Earnings Ratio (PER)
Dividend Yield (DY)
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Price Earnings Ratio (1)


Formula
PER = share price prospective annual earnings per
share

Calculation guidance
Prospective annual earnings per share is the
consensus equity analyst forecast (a.k.a. broker
estimate) for the next financial year end which can be
found in financial databases
The earnings per share forecast should be on an
underlying and fully diluted basis
PER is a multiple i.e. 18.5x
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Price Earnings Ratio (2)


Considerations
Cannot use if company is loss-making
Forward looking but inherent uncertainty in forecasts
Earnings per share is partly subjective (accounting
profits)
Measure of relative (not absolute) value

Current UK Index PERs


FTSE 100 - 17.8x
FTSE 250 - 18.9x
(source: www.ft.com)
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Price Earnings Ratio (3)


Inferences
PER = market average +/- 2 (?) suggests shares are
fairly valued but is this justified?
PER < market average - 2 suggests shares are
undervalued but this may be justified by i.e. poor
profit growth outlook
PER > market average + 2 suggests shares are
overvalued but this may be justified by i.e. strong
profit growth outlook

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Dividend Yield (1)


Formula
DY = prospective annual dividend per share share
price

Calculation guidance
Prospective annual dividend per share is the
consensus equity analyst forecast (a.k.a. broker
estimates) for the next financial year end which can
be found in financial databases
DY is a percentage i.e. 3.5%

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Dividend Yield (2)


Considerations

Cannot use if company has a zero dividend policy


Forward looking
Dividends per share are objective
Measure of relative and absolute value

Current UK Index DYs


FTSE 100 - 3.8%
FTSE 250 - 2.5%
(source: www.ft.com)
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Dividend Yield (3)


Inferences
DY = market average +/- 1% (?) suggests shares are
fairly valued
DY > market average +1% suggests shares are
undervalued but this may be justified by i.e. poor
dividend growth prospects or possible dividend cut
DY < market average -1% suggests shares are
overvalued but this may be justified by i.e. fast
dividend growth prospects

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Key Points
The main corporate securities are shares & bonds
Companies issue securities in primary capital
markets to raise finance for growth
Major secondary capital markets are semi-strong
efficient
The price of a security is not necessarily the same
as its value
Equity valuation methodologies can only provide
estimates of value
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Review & Preparation


Review:
Read chapter 2 of the key text (Watson & Head 6th ed.)
Self-test questions 2 & 3 (answers provided)

Preparation:
Seminar questions
Equity indices
Equity valuation
Efficient market hypothesis

Next lecture
International Trade and Foreign Exchange
Read chapter 12 of the key text
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