Equity Part 1

Quick reference

• 00:04 Yay, we finally got past tax.
• 00:07 You thought this was just a tax course.
• 00:09 But you're wrong, we've actually got past it and we're on to equity apparently.
• 00:14 Why, let me explain.
• 00:18 Just for change, lets put up this graphic.
• 00:21 So we're going from a to b with our efficient model again.
• 00:24 We're building our checks.
• 00:25 Yes, we've completed the operational.
• 00:27 Yes, we've completed the working capital adjustments.
• 00:29 Yes, we've completed the assets.
• 00:31 We've still got some financing to go, more on that in a minute.
• 00:34 We've done tax, feeding it into the financial statement and
• 00:38 any other key applets that we need.
• 00:40 So why are we back in financing?
• 00:42 So let me explain, we finish the income statement, we actually
• 00:47 finished it when we completed tax expense, everything's now grayed out, done.
• 00:51 The smallest of the three financial statements conceptually is now completed
• 00:55 and we can move on to the second smallest,
• 00:57 which is the cash flow statement, which is why its highlighted.
• 00:59 But why are the dividends higher, well,
• 01:01 lets all look at the cash flow statement and see.
• 01:05 This is the cash flow statement in general.
• 01:07 We've already covered off a lot of these when we were actually building the model.
• 01:11 What haven't we done?
• 01:13 We haven't done ordinary equity issuance, ordinary equity buybacks, or
• 01:18 dividends paid.
• 01:19 This is what we got to model, and that's why equity and dividends are highlighted.
• 01:23 So let's plow back into financing, do a recap, and get equity sorted out.
• 01:30 You may remember when referring to modeling,
• 01:32 capital refers to all external forms of funding used by an entity,
• 01:36 ranging from Ordinary Equity right through to Senior Debt.
• 01:39 And the provision of this capital to an entity, is a risk return proposition for
• 01:44 each capital provider.
• 01:45 Now, importantly for the modeller, the risk is going to be an important number,
• 01:50 it's gonna be a percentage, so your return on debt, return on equity, etc.
• 01:54 That's going to be easy to calculate.
• 01:56 But we've gotta think more about what the return itself is and separate that out.
• 02:01 Because there's two elements as far as a model is concerned.
• 02:04 We've got the return on capital and the return of capital.
• 02:08 From a shareholder's point of view,
• 02:11 a return on capital is the income on gain earned on money invested in entity.
• 02:15 That would be a dividend or an increasing share price.
• 02:18 Whereas, a return of capital will be a return from an investment that is not
• 02:21 considered income.
• 02:23 Well you don't get repayments of share.
• 02:24 What you do is you get a compulsory buyback, or something like that, and
• 02:27 that would be what a return on capital is in that case.
• 02:30 To find out how it would actually work, you'd need to look at the prospectus and
• 02:34 that will be your contractual entity, which would help you model it up.
• 02:38 So, let's look at equity then.
• 02:41 Ordinary equity is the owner's interests in entity's assets
• 02:44 in the form of common shares or stock which pays a dividend.
• 02:47 It's the most basic form of capital, and the risk is high,
• 02:51 because a lot of businesses will start up and never make a profit.
• 02:55 The returns, though, can be high, because if it does come off, well, it's all yours.
• 03:00 But the ranking's low.
• 03:01 You have to pay everybody else off first.
• 03:04 So the dividends come at the end.
• 03:06 Now we need to model the dividends, so I want to try and explain how to derive,
• 03:10 that formula through an example.
• 03:12 Let's do a walk through, now I wanna be clear in most jurisdictions, you
• 03:15 cannot pay out a dividend which makes you insolvent, IE and net assets go negative.
• 03:21 Further, you can only pay dividends out of what we call distributable reserves,
• 03:26 which typically are just retained profits and net profit after tax.
• 03:30 Retained profits are the profits for all periods, but
• 03:33 the current one after previous period's dividends have been paid.
• 03:37 Whereas net profit after tax is for
• 03:39 the current period before the dividends been paid.
• 03:42 So, in this scenario, I've got $100 of retained profit and
• 03:45 40 of net profit after tax.
• 03:47 What would the maximum dividend be?
• 03:49 Well, it's not rocket science, it'd be 140, just add the two together.
• 03:54 What about instead, my net profit after tax is negative.
• 03:57 What would it be then?
• 03:58 Well, it's 60, 100 less the 40.
• 04:02 What about in this case?
• 04:04 Retained profits are minus 100.
• 04:05 But net profit after tax is 40.
• 04:08 Now, this one might surprise you.
• 04:10 It's not zero, it can be 40, if certain criteria are met.
• 04:15 That is, if the auditors say, yep, the company's still a going concern, and
• 04:19 the shareholders vote for it.
• 04:21 Now when I explain why this is, it becomes a bit clearer why that's the case.
• 04:26 Imagine retained profits were in fact minus 1000 and
• 04:29 net profit after tax were 50.
• 04:31 It would take, if this happened each year,
• 04:33 20 years to get the retained profits paid off and get back into the black.
• 04:38 But this is precisely what happens with startup companies often.
• 04:41 They have a lot of write-offs and provisions to pay.
• 04:44 When in fact, it might have very little effect on their cash flow at all.
• 04:47 And so they're stockpiling.
• 04:49 This way, you wouldn't actually be able to get investors in.
• 04:51 Because they'll say, well it's gonna be 20 years before you can pay me a dividend,
• 04:54 why would I come on board?
• 04:56 So what happens is they make this special allowance that you can pay out of current
• 05:00 period profits.
• 05:01 Provided you don't go insolvent, shareholders vote on it, and
• 05:05 the auditors are happy.
• 05:08 In this situation though, it's zero, there's no way around that.
• 05:12 So let's go back to this then.
• 05:14 I think we've got a formula, don't we, that the max div is going to be equal to
• 05:17 the maximum of retained profits plus net profit after tax and net profit after tax.
• 05:22 So let's just check it through.
• 05:24 So 100 plus 40 is 140.
• 05:29 Net profit is 40, so the maximum division is the maximum of 140 and 40.
• 05:33 Is 140 correct?
• 05:36 In this case, the maximum in retained profits plus NPAT is 60 and
• 05:41 minus 40 is 60, that works.
• 05:44 Next one, is a maximum of -60 and 40 is 40, that works.
• 05:50 In this one, It's the maximum of -140 and -40, no, that one's not worked.
• 05:56 We're actually asking, shareholders, we'd like 40,000 off you, doesn't really work.
• 06:02 So we have to put in there a third element,
• 06:04 we have to make it the maximum of ten profits plus their profit after tax.
• 06:08 Their profit after tax and zero, now it seems to work, cool.
• 06:13 Okay, next, up, let's have another limitation.
• 06:16 The most cash we have available is 30.
• 06:19 Well then, we've actually got to restrict it.
• 06:21 So we may have a maximum dividend we can pay out of 60, but
• 06:24 we've only got cash for 30.
• 06:26 So let's change the formula.
• 06:27 It's gonna be the minimum of the maximum of retained profits
• 06:31 plus net profit after tax, net profit after tax is 0 and max cash.
• 06:34 So that's going to be the minimum of 60 and 30 is 30.
• 06:40 Okay, seems to work.
• 06:43 I've gone overdrawn.
• 06:45 Now we're going to have the minimum of 60 and -30 is -30.
• 06:50 Hi, I'd like 30,000 off you.
• 06:53 Not gonna do it, are they?
• 06:54 No good, so we need another restriction.
• 06:58 We've actually got to put a maximum around on all this.
• 07:01 I've put it subject to 0 so it can't go negative.
• 07:04 And then we can take 0 out of the inner MAX.
• 07:07 So we've got a Max, MIN, MAX formula here.
• 07:10 Isn't that wonderful?
• 07:11 And this is the formula we're gonna use in modeling.
• 07:15 Talking of which, let's go do some modeling.

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