6127BUEG: VALUATION THEORY &

INVESTMENT

Lecture 1 (WK 3)
An Introduction to Investment

Structure of lecture
An explanation of investment
Sources of funds for investment
Gearing
Investment options/vehicles

An explanation of investment
Investment is a term used in business management,
finance and economics to refer to saving or deferring
consumption
It is a sacrifice an individual or a firm makes regarding
consumption for the receipt of some returns in the future
An example is the purchase or acquisition of
assets/property with the object of making gains in the
future
The benefits could be in the form of income or capital
receipts or any other benefits
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Sources of funds for investment

Retained profit or surplus
It refers to the excess of income over expenditure and it is
a most significant source of new capital for most UK
companies

Sale of old assets/property

The sale of scrap or redundant assets and substantial
assets like landed property

Grants/selective assistance
Normally, government financial support for specific
projects
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Sources of funds for investment (cont)

Depreciation
Whilst included as an expense in the profit and loss
account along with other expenses, depreciation is
different in that it does not actually lead to a cash outflow
It can be regarded as a form of retained profit for the
specific purpose or replacing worn-out assets

Personal and family savings

Capital for investment can be raised from past personal
savings or from family members
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Sources of funds for investment (cont)

Aid from friends
It is also possible to raise money from friends for business

Borrowing from financial institutions

Financial institutions is a major source capital for investment
This form of financing is referred to as debt capital

Bonds and debentures

A bond is a debt instrument issued for a period of usually more
than one year with the purpose of raising capital by borrowing
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Sources of funds for investment (cont)

It is a promise to repay the principal amount borrowed normally
with interest on a specified date - governments, corporations and
other types of institutions sell bonds
When an investor buys a bond, he/she becomes a creditor of the
issuer - thus, the buyer does not gain any kind of ownership
rights to the issuer
When governments issue bonds, they are known as gilts
A debenture is an unsecured debt backed only by the integrity of
the borrower
An unsecured bond is an example of a debenture
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Sources of funds for investment (cont)

Private finance initiative (PFI)
PFI was introduced in 1992 to encourage private investment
in major public building projects, like schools, hospitals and
roads
Private investment implies that the level of government
borrowing falls and that risk is transferred from the public to
the private sector
A private sector consortium [usually consisting of a
construction company, a bank or financier, a facilities
management contractor and consultants] pays for a new
project
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Sources of funds for investment (cont)

A state organisation then pays the consortium a regular
fee for the use of the building
The fee normally covers construction costs, the rent of
the building, the cost of support services and the risks
transferred to the private sector

Thus, in essence the new building will be designed,

built, owned and run by a consortium or grouping of
companies
The state organisation will rent the building and other
facilities from the consortium for at least 25 years
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Sources of funds for investment (cont)

The deal is constructed in such a way that the
consortium is guaranteed a full return on costs
including interest on the capital borrowed, plus an
element of profit
The benefits of PFI include:
The cost of a project does not appear as an
immediate lump sum payment in public
expenditure
Leads to more projects being completed on time
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Sources of funds for investment (cont)

The major demerit of PFI is the fact that high
costs are associated with it
Average increase in estimated cost is 72%
Total costs in a sample of hospitals built under the
PFI are 18-60% higher than construction costs
alone
The costs of PFI contract negotiation have been
estimated to be seven times higher than for
traditional tendering
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Gearing
Most companies or firms mainly use a mix of borrowed
capital [debt] and shareholders capital [equity]
The relationship between the two is known as gearing
or leverage
A company is said to be highly geared when it has a
large amount of borrowed capital relative to
shareholders funds

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Gearing (cont)

A company is lowly geared when debt is smaller

than shareholders capital
Gearing is, thus, the ratio of debt to equity but the
relationship between the two sources can
alternatively be expressed as a proportion of the
total capital instead of one another

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Gearing (cont)
It is possible to find firms with no borrowed capital
at all
Such firms eliminate the risks either of defaulting on
the loan/interest payments or of having to reduce
dividends as much when profits fall
But un-geared firms may miss the opportunity of
increasing the return to shareholders achieved by
investing borrowed capital so as to earn more than
the cost of interest
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Investment vehicles (IVs)

Investment vehicles refer to the various investment
options/media a potential investor can decide to put his
resources into
Each investment vehicle has its attributes and it is these
characteristics that attract potential investors
Whichever investment vehicle the potential investor
ultimately chooses is the one he feels approximates to his
ideal investment vehicle
Examples of investment vehicles are as follows:
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IVs(cont): Purchase of shares (stocks)

It is the purchase of part ownership of a firm or company
They are thus basically ownership certificates and
represent part ownership of a company or firm
Share holders risk the loss of their money and at the same
time gain the right to share in the companys profits
They have a limited liability and unlimited returns prospect
Ownership conveys the right to information & to vote on
matters affecting the firms operations
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IVs(cont): Purchase of shares (stocks)

Shareholders choose who runs a company or firm and are
involved in making key decisions, such as whether a
business should be sold or not
Profits that are paid to shareholders are called dividends
The size of ownership acquired is indicated by the
proportion of the acquired shares/stocks to the total in the
company that have been sold
The merit of holding shares is the direct benefit from any
increases in in the company's profitability and equity value
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IVs(cont): Purchase of shares (stocks)

The demerit of owning equities rather than debt is that
an equity holder is the residual claimant [the company
has to pay all its debts before it pays its shareholders]
Shares are most obviously traded on the stock market
or exchange, but the majority of small businesses won't
go anywhere near a stock market in their lifetime
They are more likely to sell the shares in their firms to, for
example, friends, family members and some specific
members of the public
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IVs(cont): Purchase of shares (stocks)

The merit of raising money via floatation of shares is
that companies that have sold shares do not have to
pay the money back or pay interest to purchasers of
the shares
Floating shares in a company or firm on the stock
market, for example, can provide:
New finance (equity) for companies but which at the
same time is a form of investment for the purchasers
of the shares
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IVs(cont): Purchase of shares (stocks)

An exit for founding investors who want to realise

their investment in a particular company
A mechanism for investors to trade shares
A market valuation for a company & a way to
raise the business profile of a company or firm

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IVs(cont): Purchase of shares (stocks)

Methods of issue
There are 2 markets in which shares are traded:
primary and secondary markets
In the primary market new issues of a security are
sold to initial buyers
It is in the secondary market, that existing
securities are traded
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IVs(cont): Purchase of shares (stocks)

Methods of issue
A market for shares can be organized in two ways:
Exchange: buyers and sellers meet in one
central location, e.g. London Stock Exchange
Over the counter market (OTC): dealers at
different locations buy & sell securities via
computer contacts

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IVs(cont): Purchase of shares (stocks)

Dividend yield
Dividends on UK company shares are normally paid twice
yearly in the form of an interim and final dividend
The value of these dividends is determined by the Board
The dividend yield normally given in the FT refers to last
years known dividends (interim and final)
Dividend yields are quoted gross for comparison purposes
since interest and redemption rates on gilts are quoted as
gross [before tax]
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IVs(cont): Purchase of shares (stocks)

Dividend yield is a shares dividend expressed as a % of the
share price:

D0
DY
x100
Pt

Where
Do = Annual dividend per share
Pt = Current share price

Example 1: If Mr A owns 1,000 shares of Company B which pays 0.50

per share in annual dividends, and the current share price is 10.00,
the

0.5
DY
x100 5%
10

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IVs(cont): Purchase of shares (stocks)

There is an inverse relationship between yield and share price
If for instance, the share price rises to 15.00, the yield would be:

0. 5
DY
x100 3%
15would be worth 15,000.00 [as
The 1,000 share investment
opposed to 10,000.00 originally] but the yield on the investment
would fall from 5% to 3%.
The dividend stays the same, implying that though the share
price falls or rises, the same dividend per share [0.50] is earned
unless the company changes the dividend

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IVs(cont): Purchase of shares (stocks)

What purpose does DY serve?
DY is a measure of an investments productivity and it is
also viewed as the interest rate earned on an investment
DY can also be a sign of the stability of a company and
often supports a companys share price
Normally, only profitable companies pay out dividends
Investors often view companies that have paid out
significant dividends for a long period of time as safer
investments
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IVs(cont): Purchase of shares (stocks)

Exercise:

Mr C owns 800 shares in a Firm called Toto Plc

which pays 0.20 per share in annual dividends.
If the current share price is 8.00, compute the
DY.
In the above also compute the DY if the share
price falls to 5.00 and comments on your results

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IVs(cont): Purchase of shares (stocks)

Price -earnings ratio (PE ratio)
The PE ratio is calculated as the ratio of the current share
price [Pt ] to the company's earnings [e0].
Pt = current share price
e0 =last years earnings per share

Pt
P/E
e0

For instance , if a firm is currently trading at 20 a share and

earnings over the last 12 months were 0.80 per share, the
P/E ratio for the share would be 25 [20/0.80]
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IVs(cont): Purchase of shares (stocks)

Generally, a firm with high P/E ratio suggests that
investors are expecting higher earnings growth in the
future compared to firms with a lower P/E ration
A low P/E ratio could be interpreted in two ways:
The share is undervalued
Thus, it is a good buy as the market will adjust and the
price should rise

Poor firm performance

The share is not worth buying unless the market
assessment is wrong and further analysis is required
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IVs(cont): Purchase of shares (stocks)

Types of shares
Shares issued by companies are of different forms with
different conditions and rights for the purchasers, the main
types of which are:
Ordinary shares
Standard shares with no special rights or restrictions
Have the potential to give the highest financial gains and
highest risk
Ordinary shareholders are the last to be paid if the company
winds up
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IVs(cont): Purchase of shares (stocks)

Preference shares
Typically carries a right that gives holders preferential
treatment when annual dividends are to be distributed
Shares have a fixed value, which means that a shareholder
would not benefit from an increase in the business profits
They usually have rights to dividend ahead of ordinary
shareholders if the business is in trouble
Where a business winds up, they are likely to be repaid
ahead of ordinary shareholders
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IVs(cont): Purchase of shares (stocks)

Cumulative preference shares
Shareholders have the right that if a dividend cannot be paid
in one year, it will be carried forward to successive years
Dividends must be paid, irrespective of the earning levels of
the business

Redeemable shares
They come with an agreement that the company can buy
them back at a future date which can be at a fixed date or at
the choice of the firm
A company cannot issue only redeemable shares
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IVs(cont): Purchase of Govt. securities

Govt. securities are loan stock or debt instruments issued by a
govt. as a method of raising money to fund its activities
A promise to repay principal amount borrowed normally with
interest on a specified date
Govt. pays a certain annual rate of return and repays the original
capital at a future date
They are the bonds (gilts) govt. issues out; an example is a
treasury bill
There are instances where the bond can be undated so that there
is no promise to repay the capital at a specific time
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IVs(cont): Purchase of debentures

A debenture is a loan stock issued by companies
Firms that need to raise money could, instead of floating shares issue
debenture stocks at an interest rate in return for loans from private
investors
A promise to pay interest periodically and to repay the principal amount at
a stated time in the future called the redemption date; it is a type of bond
The quantum of interest rate on the debenture determines the
attractiveness of the investment
Holders of debentures are the companys creditors and do not have any
ownership rights over the firm
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IVs(cont): Savings with financial institutions &

insurance policy
Savings with financial institutions
This is where funds are deposited in a banking
institution over which interest is paid in a given period

Insurance policy
It is an investment undertaken to provide cover against
loss on the occurrence of unlikely and unwanted event
A premium is paid to the insurer who in turn agrees to
pay certain sums of money on the occurrence of the
event insured against
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IVs(cont): Unit or investment trusts

Unit or investment trusts are similar forms of investment
vehicles
Money is paid to buy shares in a Trust, which in turn reinvests
the money in, for instance, shares of other companies
An example is real estate investment trust (REIT)
Through this system small investors are able to spread their
limited resources thereby spreading the risks
Investing money in Trusts reduces the risk of investors losing all
their money when there is a problem
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IVs(cont): Real estate

Real estate [real property or landed property]
encompasses land and anything affixed to it like buildings
and structures
Real estate as an investment vehicle can take various
forms:
Purchase or development of real estate for holding
Real estate can be purchased or developed for the sole
purpose of holding or occupying it [owner occupation]
It is a form of investment
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IVs(cont): Real estate

Purchase or development of real estate for sale
This is where the real estate is developed or purchased
for sale or re-sale sometime in the future [rather than
occupying it] in order to make a monetary gain

Purchase or development of real estate for letting

[buy-to-let]
Real estate can also be bought or developed for the
purposes of renting it out to tenants instead of occupying or
with the intent of selling it
Buy-to-let is very popular in the UK
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IVs(cont): Real estate

The preceding forms of real estate investment are
normally distinct from other forms of economic or
financial investment due to the following reasons:
Real estate investment is usually long term in
nature
Normally, considerable amount of time elapses
before the resources invested in real estate may be
fully regained or paid back and any profit made

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IVs(cont): Real estate

Huge capital is normally required to develop or
purchase real estate
Colossal sums of money are required to develop or
purchase real estate as an investment
Thus, financing is often required
The UK Office of National Statistics (ONS) estimates
that 75% of home purchases in the UK are funded by
mortgage loan facilities and the percentage for
commercial properties is higher
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IVs(cont): Real estate

High transaction costs
The sale and purchase of real estate, most of the
times, is done by professionals on behalf of the
purchaser or seller and the costs involved in such
arrangements can be considerable
Also, there are other incidental costs associated
with the purchase of real estate like stamp duty land
tax (SDLT), solicitors fees and land registration
fees
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IVs(cont): Real estate

Lengthy sale or purchase periods

Real estate as an economic commodity is
different from other commodities in that
considerable amount of that is often required for
its sale and purchase
Due to its huge capital requirements, a
reasonable amount of time and planning is
required for its purchase
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IVs(cont): Real estate

Proof of ownership, especially, where the real
estate is not registered can be difficult and
lengthy sometimes
In England and Wales, where real estate is
unregistered, the law requires that the root of title
has to be investigated 15 years back [used to be
30 years before 1970] when purchasing it

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IVs(cont): Real estate

Legal and institutional interference
The ownership of real estate is one area that
governments intervene in a big way
From planning to conservation laws, planning and
building regulations to fire regulations, through to
regulation of tenancies, taxation, etc., governments
intervene in how private individuals use their real
estate more than many other economic
commodities
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IVs(cont): Real estate

High costs of management
Due to the nature of the commodity, real estate,
most of the times, has to be managed by
professionals and that entails costs

Prestige in real estate ownership

In many countries, the ownership of real estate
measures the wealth of a person and is a source
of prestige and respect
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IVs(cont): Real estate

Real estate as a good hedge against inflation
Real estate is normally regarded as a commodity that its value
can appreciate over time
But is this always the case??

Real estate usually has high yields

Normally high returns are expected from real estate as an
investment over time
But is this always the case??

Real estate as collateral

Real estate is normally accepted as collateral by financial
institutions for investment loans

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Seminar Question for WK 4

The quality of any good investment option is

normally assessed based on various factors.
Identify and discuss any five of such factors

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Summary of lecture

Explanation of investment
Sources of funds for investment
Gearing
Investment vehicles

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