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CP1 - Chpater 13

D

Darragh Kelly

Ton up Member
Hi,

Just have a few questions from chapter 13 of the CP1 notes.

1. Section 2.2
Over the long term equity dividened growth might be expected to be close to growth in GDP, assuming the that the share of GDP taken by 'capital' remains constant
is this because equitiys are shares, and shares genreally in an ecomony grow as a result in growth in land and labour? And then no further injection of 'capital' into ecomony?

2. Section 2.2 Equities
The diluiton effect also depends on the extent to which economic growth is generated by start-up companies. If the earnings of unquoated companies grow more quickly than those of quoated companies, then the share of profits attributable to quoated companies must decline. I'm just struggling to connect the these two statemetns in relation to dilution of shares.

3. Section 2.5 Cash
Just struggling with this section in general. Why would returns on cash be expected to exceed inflation except in peroids where inflation is rising rapdily? I also struggled to find where it outlined this earlier in chapter.

Thanks for the help in advance.

Cheers,

Darragh
 
Hi Darragh

Regarding your first query, I think you've got the idea. To make things simpler, imagine a country consisted of just one company financed by shareholders only. As long as the number of equity shares remains the same (and all else was equal), each share would increase in value in line with the company's profits, which increase in line with the size of the company and its workforce (land and labour). However, if further shares were issued (capital increasing), the performance of each share would be diluted as profits would then be shared between more shares, so each share would not increase in value as fast when the number of shares is increasing (capital growth).

Regarding your second query, as for the first query, if the amount of capital invested is increasing, the returns on that capital won't increase as fast as profits as these will be divided up more. To continue my previous example, if a second company was added to our one-company country, total output and profit in the country would be increased dramatically by the introduction of the new company, but the shares in the original company would not increase in value as a result of this increase.

Regarding your third query, this reflects the fact that investors predominantly have real liabilities and so would generally require a real return from any asset they purchase or invest in - as is explained in Section 1 of this chapter, investors will then require that their investments don't increase in real terms (inflation growth) and that they have additional compensation on top of this in return for giving up the use of their cash. Of course, that doesn't mean that cash returns will always exceed inflation - as we have seen in recent years.

I hope this helps.
 
James Nunn said:
Hi Darragh

Regarding your first query, I think you've got the idea. To make things simpler, imagine a country consisted of just one company financed by shareholders only. As long as the number of equity shares remains the same (and all else was equal), each share would increase in value in line with the company's profits, which increase in line with the size of the company and its workforce (land and labour). However, if further shares were issued (capital increasing), the performance of each share would be diluted as profits would then be shared between more shares, so each share would not increase in value as fast when the number of shares is increasing (capital growth).

Regarding your second query, as for the first query, if the amount of capital invested is increasing, the returns on that capital won't increase as fast as profits as these will be divided up more. To continue my previous example, if a second company was added to our one-company country, total output and profit in the country would be increased dramatically by the introduction of the new company, but the shares in the original company would not increase in value as a result of this increase.

Regarding your third query, this reflects the fact that investors predominantly have real liabilities and so would generally require a real return from any asset they purchase or invest in - as is explained in Section 1 of this chapter, investors will then require that their investments don't increase in real terms (inflation growth) and that they have additional compensation on top of this in return for giving up the use of their cash. Of course, that doesn't mean that cash returns will always exceed inflation - as we have seen in recent years.

I hope this helps.
Click to expand...
Hi James,

All clear on first point now thanks. So basically shares increase in line with GDP but if more shares are issued (ie capital raised), then equity growth will no longer be the same as GPD growth (diluted)?

Just on the second point. So introducing more companies in effect means that 2 companies will have to share the ecomonies resources (land and labour), and so profits will lower. So now when GPD increases (as we have 2 companies now) the growth of equities for the 1st company will no longer increase at the same rate as profits have been reduced/shared?

There was one more question I had on that section:
There is however, a dilution effect due to the need for companies to raise new equity capital from time to time if dividend yields are high
I guess there is a need to raise capital when divident yields are high because money is leaving the firm right?

On the last point so basically cash is an asset (just like bonds and equities) and investiors want the risk free-return + expected inflation + risk prem? Why did you say investors will then require that their investments don't increase in real terms? Though the 'expected inflation' component means they do?

Thanks for your help on this,

Darragh
 
Hi Darragh

Regarding your first paragraph, yes that’s correct.

Regarding the second, the GDP in the theoretical two-company country will increase massively due to addition of the new company. However, the original company’s growth, and hence the growth in its dividends, will not mirror this huge increase in GDP (and will grow much less). It’s likely that Land and labour resources for the country in question will not have risen as much as output either – this would be explained by these resources being utilised to a greater extent (ie less space left in the country and less unemployment). Obviously, this is a very extreme example, just to illustrate the point.

Regarding the need to raise capital when dividend yields are high, a company's dividend yield can be high due to a falling share price (dividend yield being dividend divided by share price). This could be due to investors thinking that the company is doing less well (and so demanding the shares less, reducing price). If the company is doing less well, it’s more likely it will need further capital support and hence it would be more likely to raise new equity capital.

Regarding your last point, my apologies but the word ‘don’t’ shouldn’t have been there.
 
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