Tutorial 4 Investors in the Share Market

Question 2
a) Ms Brown has an investment portfolio comprising Australian
shares. At a meeting with her investment advisor she
requests explanations of systematic risk and unsystematic
risk, and an explanation of factors that are responsible for
the two types of risk.

Systematic risks are those risk exposures that will have an impact on
share prices generally in the market; that is, the majority of shares listed
on a particular stock exchange will be affected to a lesser or greater
degree. Examples of systematic risk exposures include:

Changes in interest rates

Changes in exchange rates
Contraction or expansion in economic activity
Introduction of new legislation
Political stability
Changes in market confidence and perception

Unsystematic risks are those risk exposures that affect a single

corporation or a small group of companies. Examples of unsystematic risk
exposures include:

The resignation of an executive manager

A change in future performance forecasts
The possibility of a merger
The failure of technology or communication systems
Dissent within the board of directors
Rumour or evidence of financial difficulty

In its basic form, risk comprises components of probability, variance,

volatility and uncertainty. Probability is a statistical estimate of a variance
in an expected outcome. Volatility relates to the degrees of change that
historically have occurred in outcomes over time. Uncertainty is the
possibility that an unexpected outcome might occur.

b) Why should an investor not expect to be rewarded for the

unsystematic risk element in a share portfolio?

An investor should not expect to be rewarded for the unsystematic risk

element in a share portfolio because they are able to minimise
unsystematic risk by holding a diversified investment portfolio; for
example, a portfolio of shares, property and fixed interest investments.
Within the share portfolio, the investor can hold shares in a number of
companies, a range of industry sectors and across different countries.
Therefore, prices will not incorporate a significant risk component for
unsystematic risk.

Question 3
An investor holds the following shares in an investment portfolio:

JB Hi-Hi $6500 beta 1.20

Telstra $8600 beta 0.95
ANZ Bank $7900 beta 1.05
a) What does each beta coefficient imply about the volatility of
each companys shares relative to the overall market?

The beta coefficient, or beta, is the amount of systematic risk that is

present in a particular share relative to an average share listed on a stock
exchange. The market has a beta of 1.0.

JB Hi-Fi and ANZ have betas greater than 1.00, therefore they are more
volatile than the market. When the S&P/ASX 200 increases (decreases) by
1.20 times as much or 10%, JB Hi-Fis price will increase (decrease) by
12% and ANZ shares will increase (decrease) in price by 1.05 times as
much or 1.50%. Because Telstra has a beta of 0.95, it will move less
proportionally with the market.

b) What is the portfolios beta?

P =w JBHi Fi JB HiFI + wTelstra Telstra +w ANZ Bank ANZ Bank
6500 8600 7900
( 6500+8600+7900 ) (
( 1.2 ) +
6500+ 8600+7900 ) (
( 0.95 ) + )
6500+ 8600+ 7900
(1.05 )
1.055

c) If the investor added to the portfolio with the purchase of

$5000 worth of shares on Myer (beta 1.60), what impact
would that purchase have on the risk structure of the
portfolio?
B P =w JB Hi Fi JB HiFI + wTelstra Telstra + w ANZ Bank ANZ Bank + w Myer Myer
6500 8600 7900
( 6500+8600+7900+5000 ) (
( 1.2 ) +
6500+ 8600+7900+5000 ) (( 0.95 ) + )
6500+ 8600+7900+5000 (
( 1.05 ) +
6
1.1523

By adding the risky investment in Myer, the investor has increased the
volatility of the portfolio. This is reflected in the increased systematic risk.
Therefore, the average weighted beta is now quite a bit higher than the
market beta.

Question 4
As an investment adviser for a managed fund that invests in
Australian resources shares, you must advise clients on the
funds strategy of passive investment. Analyse and explain the
concept of passive investment to your client, and describe how
the fund manager uses an index fund to achieve a specific
performance outcome.

Passive investment involves building an investment portfolio based on

shares incorporated in a share-market index. A share-market index is a
grouping shares listed on a stock exchange that shows changes in the
overall prices of those shares day by day. Each stock exchange has its own
set of indices. Well-known international indices include the Dow Jones
Industrial Average (USA), the FTSE (UK), the Nikkei 225 (Japan) and the
Hang Seng (Hong Kong). A passive investor who wishes to obtain returns
on a share portfolio equal to the return achieved by the Dow Jones will
purchase the 30 stocks included in that index. Another investor may
replicate a sector index, such as the telecommunications sector of the
industrials sector.

A number of managed funds are index funds. Index funds use a range of
sophisticated techniques to replicate or track the share market, including
full or partial replication of a specified share-market index. Full replication
occurs when a funds manager purchases all the stocks included in an
index. However, with a large index, such as the S&P 500, the funds
manager may hold only a percentage of the stocks, so long as sufficient
stocks are held to ensure that the portfolio closely tracks the index.

The funds manager buys and sells shares in order to maintain the
replication of the index over time.

Question 5
Jack and Jill have recently married and have decided to start
buying shares or an investment portfolio.

a) Explain the role of a stockbroker in the direct investment

approach to share investments.
A stockbroker acts as the agent for an investor in the buying and selling of
stock-market securities. They have access to the trading and settlement
systems of a stock exchange.

Stockbrokers add to the efficiency and integrity of the stock markets in

that they must gain minimum education and training standards, and abide
by the rules of the stock exchange and the nation-states Corporation Law.

The development of electronic trading and settlements systems, plus

great access to the Internet, has radically changed the way stockbrokers
function. Other important factors included an increase in investor
knowledge, more affluent investors and an ageing population preparing
for retirement. Further, globalisation of the investment markets, investor
demand for high performance outcomes and significantly increased
competition for the provision of broker services have also changed the
structure of the stockbroking sector.
 b) Within the context of services provided by a stockbroker,
discuss the two main types of stockbrokers that an investor
may choose to use. Differentiate between the services
provided by these brokers.

Stockbrokers can be categorised as discount non-advisory brokers or full-

service advisory brokers.

A discount non-advisory broker accepts buy or sell orders from clients, but
provides no advice or recommendations to the client in relation to
investment alternatives or opportunities. The majority of orders to buy or
sell are initiated by the client entering an instruction to the stockbroker
via the Internet. Discount brokers fees in Australia range between $25
and $40 per transaction for smaller-value transactions, but increase to a
percentage of the transaction value for large-value transactions, for
example 1% of transactions over $50 000.

A full-service advisory broker offers advice and recommendations to

clients on investment choices and strategies. The range of services
provided includes:

Buying and selling shares on the instruction of clients

Providing investment advice on securities listed on a stock
exchange, including shares, fixed-interest securities, derivatives and
listed trusts
Giving advice on other investment opportunities such as cash
management trusts, property trusts and equity trusts
Making recommendations and establishing and monitoring personal
financial plans for clients
Conducting investment research, forecasting and disseminating
information to clients

A full-service advisory broker typically charges a flat fee ranging up to

$120 or a percentage of the transaction, ranging from 2.5% for smaller
value transactions, usually less than $5 000, down to 1.0% for larger
transactions over $50 000.

Question 6
Condor Limited in listed on the ASX, and earns part of its income
in Australia and part overseas, where it is required to pay tax.
The Australian company tax rate is 30%. Condor Limited can
provide dividend imputation to Australian shareholders from
Australian tax paid. Assume the shareholders marginal tax rate
is 37%, plus Medicare levy of 2%. The investor receives a 70%
partly franked dividend of $12 700.00.

a) Explain the dividend imputation process.

Under the current dividend imputation system, dividends on which the

company already paid company tax are referred to as franked dividends.
For personal taxation purposes, the franked dividend received by the
shareholder is grossed-up by the franking credit and the total amount is
included in assessable income. The individual shareholder is entitled to
receive a tax rebate up to the amount of the franking credit. The franking
credit is calculated as follows:
Company Tax Rate
Franking Credit =Franked Dividend
1Company Tax Rate

b) Why might a dividend by only partly franked?

A dividend might be only partly franked if a company generate part of

their income overseas, and do not pay Australian tax on that income, as it
is unable to pass on a tax credit on associated dividend payments. In this
situation, the company may allocate a partly franked dividend based on
Australian tax paid.

c) Calculate the income tax payable by the investor.

Company Tax Rate 0.3

Franking Credit =Franked Dividend 12700
1Company Tax Rate 0.7
5442.86

Income Tax Payable=( Dividend Received+ Franking Credit ) Tax LiabilityFranking Credit Paid By Comp
( 12700+5442.86 ) ( 0.37+0.02 )( 1200 )( 0.3 ) $ 2628.9

Question 7
a) Explain what is meant by the liquidity of a company. Define
two common accounting measures of liquidity.

The companys level of liquidity is its ability to continue to meet its short-
term financial obligations and thus to continue trading.

One ratio used to measure the level of liquidity available to a company is

the current ratio, that is, the ratio of current assets, being assets maturing
within one year, to current liabilities, being liabilities due within one year.

Current Assets ( Maturing Within 1Year )

Current Ratio =
Current Liabilities ( Due Within1 Year )

A second, more specific, ratio is the liquid ratio, that is the ratio of Current
Assets less stock, to current liabilities less the companys bank overdraft.

Current AssetsInventory ( Stock on Hand )

Liquid Ratio=
Current LiabilitiesBank Overdraft

Of the two ratios, the liquid ratio provides a more realistic view of a
companys liquidity position. The reason for excluding inventory from
current assets is that the liquidation of inventory may be quite difficult to
achieve if the company is experiencing a liquidity crisis. Overdrafts are
deducted from current liabilities because an overdraft facility with a bank
is typically an ongoing financial arrangement and is less likely to be
required to be repaid.

b) Why is liquidity an important indicator that an investor

should consider when analysing share investment
opportunities?

Liquidity is an important indicator that an investor should consider when

analysing share investment opportunities because a company with a
higher liquid ratio or current ratio is in a healthier position than one with
lower ratios. Liquidity ratios are an indicator of whether a company has
the capacity to meet its on-going commitments and take advantage of
trading opportunities. Understanding the liquidity of a company is one
measure of the level of risk associated with an investment in that
company.

Question 8
Define the commonly used measures of profitability of a firm.
Which measure do you consider to be most informative in
comparing the profitability of firms across different industry
sectors?

A companys profitability may be represented by a range of different

accounting ratios.

A ratio that allows for comparisons to be made between companies with

different capital structures is the ratio of earnings between interest and
tax (EBIT) to total funds employed:
EBIT
EBIT Total Funds Ratio=
Total Funds Employed ( Shareholder s' FundsBorrowings )

A variation of this ratio is to exclude short-term funding. This eliminates

the effects of seasonal fluctuations in the amount of short-term debt
employed by some companies. This ratio is referred to as the EBIT to long-
term funds ratio:
EBIT
EBIT LongTerm Funds Ratio=
LongTermTotal Funds ( i .e .Total Funds Less Short Term Debt )

A further measure of profitability is the return on equity. It is given by:

Operating Profit After Tax
Return on Equity=
Equity ( Shareholder s ' Funds )

Another ratio considered by shareholders is earnings per share (EPS). The

EPS ratio measures the earnings that are attributable to each ordinary
share after abnormal items.

Each measure of profitability provides valuable information on company

performance. It is important to compare the current performance measure
with the past equivalent measure for that company. There is a need to
consider the performance of other companies in the same industries.
Variations of earnings on shareholders funds between industry sectors
indicate that other factors, other than profitability, must be considered,
including level of risk, cycle of an industry sector and timing of an
investment opportunity.

Question 9
a) Define two measures of a companys debt-servicing
capacity.

The amount and timing of cash flows available to a company are of critical
importance to its ability to meet its short-term financing requirements and
to ensure its solvency.

One ratio used to measure a firms solvency is the debt to gross cash-flow
ratio, which compares the amount of debt outstanding with the firms
gross cash flow. This ratio provides an indication of the number of years
required for the cash flow to repay the total debt of the company.

A further measure of a firms capacity to service debt is the interest cover

ratio. This ratio represents the number of times the businesss finance
lease and interest charges are covered by its earnings before lease
charges, interest and tax. The higher the ratio, the greater is the ability of
the business to cover its interest commitments.
Earnings Before Finance Lease Charges, InterestTax
Interest Cover =
Fiance Lease ChargesInterest
b) Explain why it is not appropriate to compare, on the basis of
the identified measures, companies in different industry
classifications.

It is not appropriate to compare ratios between companies in different

industry classifications without analysing the debt-servicing practices and
capital structures adopted within various industries. For example, some
industries will normally maintain higher levels of debt-to-equity ratios
which in turn will impact upon their debt-servicing ratios. Other industries
may normally hold lower levels of debt, while others may hold mainly
short-term debt. Depreciation levels may also vary substantially between
industry sectors.

Question 10
A corporations price to earnings ratio (P/E) is a commonly used
measure in the analysis of share investments. An investor who is
analysing two retail sector corporations notes their P/E ratios for
the past three years:

2012 2013 2014

JB Hi-Fi 8.37 14.37 16.95
Woolworths 12.00 17.38 18.56
a) Define the calculation and discuss the meaning and purpose
of a P/E ratio.

The price to earnings ratio (P/E) is the market price of a companys shares
divided by its earnings per share. This ratio is an indicator of investors
evaluation of the future earnings prospects of a firm, rather than an
indicator the firms current or past performance. Where good earnings
growth is expected, the P/E ratio will rise and be relatively high. Where
there is less optimism about the future prospects, the P/E ratio will
generally fall. Variations are evident between companies within the same
industry sectors. This implies that the prices of company shares do, to
some extent, already reflect anticipated changes in future earnings.

While the P/E ratio is generally used and is conceptually quite simple, it is
often difficult to calculate and interpret. The P/E ratio for a particular
company can vary from one published source to another, depending on
the earnings figure used in the calculation and on the estimation of the
projected earnings growth rate. The ratio should be based on expected
future earnings. However, there are likely to be as many numbers put on
the future earnings figure as there are analysts who are constructing P/E
ratios for specific firms. When interpreting P/E ratios published in the
financial press, keep in mind that they will have been calculated using the
immediate past earnings figures.

b) Analyse and interpret the data in the table.

The P/E ratios of both companies increased between 2012 and 2014. This
could indicate either an increase in the price of the shares relative to
earnings or a decline in earnings relative to the share price.

Question 11
Gazal Limited pays a constant dividend of $0.18 per share. A fund
manager is considering purchasing the shares as part of an
investment portfolio. The fund manager requires a return of 14%
on the investment. Calculate the price that the funds manager
would be willing to pay for the shares.

D0 0.18
P 0= $ 1.29
rs 0.14

Question 12
The last dividend paid to shareholders by AMP Limited was $0.23
per share. Assume that the board of directors of the company
plans to maintain a constant dividend growth policy of 4%. An
investor, in evaluating an investment in the company, has
determined that she would require a 17% rate of return from this
type of investment. If the current share price of AMP shares in
the stock market is $5.22, should the investor purchase the
shares? (Show your calculations.)

D 0 (1+ g ) 0.23 ( 1.04 )

P 0= $ 1.41
r sg 0.17

At a current market price of $5.22, the investor should not consider buying
the shares. Rather, to justify a purchase at $5.22, the required rate of
return must be lower or the growth of the dividends must be higher.

Question 13
AGL Energy Limited has declared a $0.33 per share dividend,
payable in one month. At the same time the company has decided
to capitalise reserves through a one-for-three bonus issue. The
current share price at the close of business on the final cum-
dividend date is $16.15.

a) Explain the strategy adopted by the company. In your

answer define the terms cum-dividend and ex-dividend.

A cum-dividend refers to the situation when a share price includes an

entitlement to receive a declared dividend.

An ex-dividend refers to the date at which a share price is theoretically

expected to fall by the amount of the declared dividend.

The company wishes to restructure its balance sheet by converting

reserves into ordinary shares through the provision of bonus shares to
existing shareholders.

b) Calculate the theoretical price of the share after the bonus

issue and the dividend payment have occurred.

Ex Dividend Price=Share Price Cum DividendDividend Paid 16.150.33

15.82

Market Valueof 3 Cum Bonus Shares=3 Ex Dividend Price 3 15.82 47.46

Theoretical Value of 4 Ex Bonus Shares=Market Value of 3 Cum Bonus Shares 47.46

Theoretical Value of 4 Ex Bonus Shares 47.46

Theoretical Value of 1 Ex Bonus Share=
4 4
$ 11.87

Question 14
Myer Holdings Limited has a share price of $2.82. The company
has made a renounceable rights issue offer to shareholders. The
offer is a three-for-ten pro-rata issue of ordinary shares at $2.60
per share.
 a) Explain the effect of the offer being renounceable.

A renounceable rights issue refers to when the right is listed on the stock
exchange and the shareholder is entitled to sell the right to a third part
rather than accepting the offer.

b) What is the price of the right?

10
( 2.822.6 )
N ( Cum Rights PriceSubscription Price ) 3
Value of = $ 0.17
N +1 10
+1
3
c) Calculate the theoretic ex-rights share price. Explain why an
actual ex-rights price of a share may at times differ from the
calculated theoretical price.

M arket Value of 10 Cum Rights Shares=10 Cum R ights Price 10 2.82 28.2

New Funds Raised Thru TakeUp of 3 For 10 Issue=3 Subscription Price 3 2.6
7.8

Market Value of 13 Ex R ights Shares=M arket Value of 10 Cum Rights Shares+ New Funds Raised Thru Ta
28.2+ 7.8 36

Market Value of 13 Ex Rights Shares 36

Theoretical Ex Rights Share Price=
13 13
$ 2.77