Stock Markets and Corporate Finance: A Primer, 2nd Edition
Michael Dempsey
Contents
Preface v
About the Author vii
Welcome to the Revised and Amended Stock Markets and
The Important Formulas xxi
Part A 1
Introduction: Stock Markets, Investments and
Corporate Financial Decision-Making 3
Financial Institutions and a History of Stock Markets 11
2.1 The supporting cast for financial markets . . . . . . . . 12
2.2 Prologue: The early background economy . . . . . . . . 23
2.2.1 Act I: The 1980s bull market and
BlackMonday . . . . . . . . . . . . . . . . . . 25
2.2.2 Act II: The dot.com bubble and
Black Friday . . . . . . . . . . . . . . . . . . . 32
2.2.3 Act III: Securitisation and the global
financial crisis . . . . . . . . . . . . . . . . . . 38
2.2.4 Act IV: Market recovery, COVID-19 and
cash injections: From here to eternity . . . . . 47
The Time Value of Money and Financial Planning 61
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 62
3.2 The time-value of money: Discrete returns,
compounding, and discounting . . . . . . . . . . . . . . 63
3.2.1 Percentages as fractions . . . . . . . . . . . . . 63
3.2.2 Single period growth . . . . . . . . . . . . . . . 64
3.2.3 Multiple period growth . . . . . . . . . . . . . 65
3.2.4 Discounting . . . . . . . . . . . . . . . . . . . . 66
3.3 Perpetuities and annuities . . . . . . . . . . . . . . . . 67
3.3.1 A growing perpetuity . . . . . . . . . . . . . . 67
3.3.2 A perpetuity . . . . . . . . . . . . . . . . . . . 68
3.3.3 Present value of an annuity . . . . . . . . . . . 69
3.3.4 Future value of an annuity . . . . . . . . . . . 70
3.4 Quarterly (and semi-annual, etc.) payments . . . . . . 72
3.5 Life policies . . . . . . . . . . . . . . . . . . . . . . . . 74
3.6 Planning for retirement . . . . . . . . . . . . . . . . . . 76
3.7 Real rates of return . . . . . . . . . . . . . . . . . . . . 79
3.8 Planning for retirement allowing for money purchasing
power . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.9 Repayment of a mortgage . . . . . . . . . . . . . . . . 83
3.10 Time for reflection: What have we learned? . . . . . . . 85
Market Debt, Interest Rates, and Bond Valuation 91
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 92
4.2 Short-term financing: The money markets . . . . . . . 93
4.2.1 Finance companies . . . . . . . . . . . . . . . . 96
4.3 The role of a central bank in determining
interest rates . . . . . . . . . . . . . . . . . . . . . . . . 97
4.4 Long-termdebt . . . . . . . . . . . . . . . . . . . . . . 98
4.5 Valuation of bonds . . . . . . . . . . . . . . . . . . . . 100
4.6 Required discount rate and risk of default . . . . . . . 104
4.7 Interrogating bonds . . . . . . . . . . . . . . . . . . . . 106
4.8 Time for reflection: What have we learned? . . . . . . . 112
The Valuation of Equity Shares 119
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 120
5.2 Share price response to new equity issues . . . . . . . . 121
5.3 The discounting of dividends model of share
valuation . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.4 A firmwith a fixed growth . . . . . . . . . . . . . . . . 130
5.5 A firmwith zero (real) growth . . . . . . . . . . . . . . 132
5.6 Motivation for dividends . . . . . . . . . . . . . . . . . 134
5.7 Self-sustaining growth . . . . . . . . . . . . . . . . . . 136
5.8 The P/E ratio . . . . . . . . . . . . . . . . . . . . . . . 141
5.9 Share price determination in practice . . . . . . . . . . 146
5.10 Time for reflection: What have we learned? . . . . . . . 147
Shareholders’ Required Rate of Return
(The Cost of Equity Capital) 157
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 159
6.2 The CAPM as a determination of the
discount rate . . . . . . . . . . . . . . . . . . . . . . . . 159
6.3 Empirical issues with the CAPM . . . . . . . . . . . . 165
6.4 Empirical tests of the CAPM . . . . . . . . . . . . . . 168
6.5 The tournament nature of investing as an explanation
for the ineffectiveness of the CAPM . . . . . . . . . . . 170
6.6 The Fama and French three-factor (FF-3F) model . . . 171
6.7 Time for reflection: What have we learned? . . . . . . . 173
Statistical Patterns of Stock Market Returns 179
7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 180
7.2 Building amodel of risk and return . . . . . . . . . . . 181
7.3 Empirical observations of stock market outcomes
and the investment time horizon . . . . . . . . . . . . . 184
7.4 The “behavioural” nature of the market: Bull and
bearmarkets . . . . . . . . . . . . . . . . . . . . . . . . 187
7.5 Time for reflection: What have we learned? . . . . . . . 190
Part B 193
Financial Leverage 195
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 196
8.2 Leverage of the firm’s capital structure . . . . . . . . . 197
8.3 Debt and the economy . . . . . . . . . . . . . . . . . . 200
xii Stock Markets and Corporate Finance: A Primer
8.4 Derivation of Modigliani and Miller’s Propositions I
and II . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
8.5 The Modigliani and Miller propositions and
the CAPM . . . . . . . . . . . . . . . . . . . . . . . . . 204
8.6 Consistency of the discounting of dividends model with
leverage and the CAPM and MM propositions . . . . . 208
8.7 TheMMpropositions challenged . . . . . . . . . . . . 213
8.8 An optimal debt leverage . . . . . . . . . . . . . . . . . 214
8.9 Time for reflection: What have we learned? . . . . . . . 217
Valuation of Cash Flows 227
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 228
9.2 Methods of discounting: The CFE (kE) and FCF
(WACC) approaches . . . . . . . . . . . . . . . . . . . 231
9.2.1 The cash flow to equity (CFE) approach . . . . 231
9.2.2 The operating free cash flow (FCF) discounted
by theWACC approach . . . . . . . . . . . . . 234
9.3 Additional examples demonstrating consistency
of the discountingmethods . . . . . . . . . . . . . . . . 237
9.4 The WACC as industry-favoured approach . . . . . . . 243
9.5 Key elements of the cash flow . . . . . . . . . . . . . . 244
9.6 Time for reflection: What have we learned? . . . . . . . 247
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
Investment Decision-Making: Theory and Practice 259
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 260
10.2 Investment decision-making . . . . . . . . . . . . . . . 261
10.3 Time for reflection: What have we learned? . . . . . . . 268
Financial Planning and Working Capital: The Firm’s
Financial Statements 271
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 273
11.2 The statements . . . . . . . . . . . . . . . . . . . . . . 275
11.2.1 The Income Statement (Table 11.1) . . . . . . 275
11.2.2 The Balance Sheet (Table 11.2) . . . . . . . . . 278
11.2.3 The self-locking nature of the Income
Statement and Balance Sheet . . . . . . . . . . 282
11.2.4 The Statement of Cash Flows (Table 11.3) . . 283
Contents xiii
11.3 Ratio analysis (Table 11.4) . . . . . . . . . . . . . . . . 286
11.4 Du Pont ratio analysis . . . . . . . . . . . . . . . . . . 298
11.4.1 The Du Pont analysis of Return on Assets
(ROA) ≡ Net income
Total assets . . . . . . . . . . . . . . . 298
11.4.2 The Du Pont analysis of Return on Equity
(ROE) ≡ Net income
Shareholders equity . . . . . . . . . . . 299
11.5 Time for reflection: What have we learned? . . . . . . . 301
Ethical Behaviour 307
12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 308
12.2 The meaning of ethical behaviour . . . . . . . . . . . . 309
12.3 Time for reflection: What have we learned? . . . . . . . 312
SOLUTIONS to Multiple Choice Questions and Illustrative
Examples 313
Index 345