FINS1612 – SUMMARIES

Week 3 Equity Markets 1 Part 1 The Share Market and The Corporation

1/3 – The Nature of a Corporation :

Corporation:

A business organisation legally registered as an entity (person) that is owned by one or more individuals or entities and has many rights and duties of a person – borrowing money, owning property (or other Corporations)

Separate and distinct from owners

Forming involves preparing articles of association (or charter), that sets out the name, life expectancy, purpose etc and bylaws, outlaying how the company is to be run, that are submitted to the state in which the firm will be incorporated (making it a resident)

Advantages (Result from separation of management and ownership) :

Ownership is represented by shares, >>>Greater effectiveness in strategic planning and implementation through specialised and expert management teams.

¥ Hence can be transferred easily - Hence unlimited life

¥ Liquidity of securities facilitates investor diversification and encourages investment in corporate securities.

¥ Large number of owners lowers risk of problems with few owners

Corporation can borrow money in its own name

¥ Hence Limited liability

o Shareholder liability Limited to issue price of shares of a limited liability company and any partly paid portion of shares in a no-liability company

Easy to raise larger sums of capital by selling more shares.

Disadvantages:

o Earnings are liable for corporate taxation

Though since 1987, the double-taxing of shares has been removed due to Australia’s dividend-imputation taxation system

o Formalities of forming and running are complicated and take time and money

In the 1990s the companies law was changed so

people could form one-share-

one-director companies so

individuals could take advantage of

limited liability afforded to

corporations.

Principal – Agent Problems – Shareholders and Managers :

The Agency Relationship is where a principal (stockholders) hires an agent (managers) to represent his/her interest (running a company)

The agency problem is when problems arise because of conflicts of interest between principal and agent.

This is because the agency relationship has a separation of ownership and control where the owners are not the people who manage the firm on a daily basis.

Hence there are agency costs which are the costs of different parties (managers) acting in a manner that is inconsistent with maximising shareholder value.

Direct Agency Costs: Managers act in their own self interest (reducing firm value to shareholders)

Managers hence need to be monitored to ensure actions are in the owner’s best interests – Monitoring costs

Money is spent setting up contracts to control managers – Bonding costs

Indirect agency costs: Arise when value maximising investment opportunities are rejected.

Mechanisms to solve this agency problem :

Internally: Board of directors (executive and non-executive directors on the board), Shareholder meetings (major shareholders can exert considerable influence on the company)Managerial compensation (compensation to incentivise managers to act in the best interest of the shareholders)Shareholder activism

Externally: >>Public opinion & Political pressures>>Managerial labour market (managers who act in line with principal objectives command higher demand and hence higher salaries)>>Debt and legal constraints – debt as a monitoring mechanism. (The Companies Acts also covers directors)Mergers and acquisitions market – mass selling of shares to another entity

The Primary goal of (financial mgmt of) any (for-profit) business :

>>>Maximise the value of the firm to shareholders<<<(Maximising the market value of the existing owner’s equity)

Note: Sometimes simplified (in efficient markets where shares don’t change hands often and are difficult to value) as maximising a firm’s current market share price.

2/3 – The Stock Exchange:

General Roles (Provision of):

Markets for a range of financial securities

Securities trading system

Clearing and settlement system

Regulation and monitoring of market integrity

Well-informed market

Specific Roles (7) :

Primary Market Role

A stock exchange facilitates the efficient and orderly sale of new financial securities

IPO – Initial issue of shares to the public for cash. Listing on stock exchange.

Rights Issue – Issue of additional new shares to existing shareholders on a proportional basis to their existing holding. (pro-rate)

Private placement – Exclusive issue of shares to a select investor/group of investors who may not be currently investors in the firm.

Dividend reinvestment plans – Reinvestment of dividends into corporation for additional shares..

Secondary Market Role

The stock exchange facilitates trading in existing shares

No new funds are raised by the issuing company – funds flow to owners of shares.

An active, liquid, well-organised secondary market increases the appeal of buying new shares in the primary market.

¥ Market liquidity – Ratio of share turnover to market capitalisation

¥ Market Turnover – Number of shares on issue X current share price

Derivative market role

The Stock exchange provides a market for trading equity-related derivative products(Provides a Risk-management tool for share traders)

Derivative – A financial security that derives its price from an underlying commodity (eg. Gold) or financial instrument (eg. Shares)

¥ Exchange-traded; Standardised financial contracts traded on a formal exchange

¥ Over-the-counter; Personalised contracts negotiated between writer and buyer.

These serve as a speculative instrument and a risk management tool (hedge)

Futures: A standardised contract that is traded on an exchange and hence has clearing houses that guarantee the transactions – significantly lowering the probability of default (unlike the private forward contracts) to almost never.

¥ >>>Possess only one settlement date

o >>>Marked-to-market daily (daily changes are settled day by day in cash payments from an initial margin put up by both parties) and thus settled at the settlement price (whether that is higher or lower than at the time of entering the contract)

Option: (OTC or EX) This is a contract between two parties for a future transaction on an asset at a reference price – the buyer has the right but no obligation to engage in the transaction whilst the seller has the obligation to fulfil if acted upon.>>>The price of an option derives from the difference between the reference price (decided) and the value of the underlying asset plus a premium based on the proximity of timing to the expiration of the option.

Warrants

Interest rate market role

The listing, quotation and trading of typically longer term debt instruments on a stock exchange.

Straight corporate bonds (fixed interest security with face value repaid at maturity)

Floating rate notes (same as above just with variable interest)

Convertible notes (hybrid fixed interest security with option to turn into a note)

Preference shares (hybrid share with more preference in bankruptcy than ordinary shares and a fixed dividend but reduced/no voting rights)

Adds to value of debt issue due to

¥ Transparency – Information about price, yield, maturity, credit rating of debt instruments.

¥ Allowing Ease of entry – Electronic trading system facilitates buy and sell orders at minimum cost and time delay at current market prices.

¥ Enhancing Liquidity – quotation on a stock exchange provides access to a wider market.

Trading and settlement roles

The ASX uses CLICK XT, an integrated computer-based trading system to trade all listed securities.

Client’s orders are executed via computer from the broker’s office.

Orders are executed in order of;

¥ Price > time > Order volume

CHESS (Clearing House Electronic Sub-register System)

¥ Facilitates the settlement of transactions conducted through CLICK XT

¥ Settlement of transactions within 3 days (T + 3)

¥ Provides an electronic sub-register that records the ownership of listed securities.

o CHESS Sponsor – Market participant with access to CHESS (stockbroker etc)

o CDI (chess depository interest) – developed to overcome the issue of countries that do not accept uncertified holdings or electronic transfers of titles.

Information role

Investor confidence in the ASX relies on informational efficiency.

Current share price should reflect all information available in the market, determined by;

¥ The speed at which new information flows to the market

¥ The speed at which that information is absorbed and reflected in share prices.

Corporations Act 2001 (Cwlth) requires information materially affecting the share price of a listed company to be immediately given to the ASX.

Listing Rules – stock exchange rules by which a listed entity must comply

¥ Change in company’s financial forecasts

¥ Appointment of a liquidator

¥ Declaration of a dividend

¥ Notice of a takeover bid

¥ Disclosure of director’s interests

o Corporations are also required to give the ASX their financial statements.

Regulatory role;

Regulation aims to ensure market participants have confidence in the integrity of market operations.

ASX - Ensures companies meet specified limited levels of performance and standards of information disclosure so investors can make informed decisions.

o CONTINUOUS DISCLOSURE

¥ Prescribes appropriate behaviour of broker participants (not just companies) on the exchange.

o Penalties, license revocation

¥ Utilises electronic surveillance system to monitor trading behaviour;

o Trades that fall outside certain limits

o Cross-references all trades against information on company, directors and associated parties

¥ NGF (national guarantee fund) compensates investors for failure or misconduct by a stockbroker.

ASIC - Responsible for the supervision of Corporations Law and markets in Australia.>> Corporations Act 2001 (Cwlth)

¥ Market integrity and consumer protection across the financial system, covering investment, insurance and superannuation products.

¥ Supervises ASX addressing potential conflicts of interest as the ASX is a publicly listed corporation – ASX is listed on the ASX.

3/3 – The Private Equity Market:

Alternate funding source for companies unable (or not wanting to) access equity capital through a public issue.

Source of funds;

Superannuation funds, Life insurance offices

Uses of funds;

Startups, business expansion, recovery finance, management buyouts

Aim:

Improve profitability sufficiently to realise value through an IPO

Break up business to achieve return on investment.

Week 3 Equity Markets 1 Part 2 Corporations Issuing Equity in the Share Market

FOUR (5 really) Financial Management Decisions:

1) The investment decision:

Capital Budgeting – The process of planning and managing a firm’s long term investments. Analysing the size, timing and risk of the cash flow for potential long term investments.

2) The Financing decision:

Capital Structure – How the firm obtains financing to support long-term investments, the mix of long-term debt and equity. Analysing magnitude of borrowing and borrowing sources and types.

Working Capital Management – Managing the working capital (short-term assets and liabilities) of a firm and deciding amounts, sources etc.

3) The Dividend Decision

Distribution of returns to shareholders (how much, how often, etc)

4) The Restructuring Decision:

Corporate actions that will benefit the firm

Intermediate Objectives of financial management :

Social and ethical responsibilities such as OH&S, Adhering to letter and spirit of laws, environmental responsibility, charity.

1/5 P2 – The investment Decision: Decisions in depth - The investment decision:

The Primary goal of (financial mgmt of) any (for-profit) business :

>>>Maximise the value of the firm to shareholders<<<(Maximising the market value of the existing owner’s equity)

Note: Sometimes simplified (in efficient markets where shares don’t change hands often and are difficult to value) as maximising a firm’s current market share price.

Capital Budgeting – The process of planning and managing a firm’s long term investments. Analysing the size, type timing and risk of the cash flow for potential long term investments.

The four types of project:

Replacement

o Maintenance of existing business

o Cost reduction

Expansion

o Existing markets or products

o New markets or products

Safety and Environmental

o Mandatory investments to ensure compliance with government legislation on safety or environmental issues.

o The investment may or may not result in any positive cash flows for the firm.

Are there fines for non-compliance? Are these worth it (morally and financially)

o These require analysis of how the firm will fund the investment and impact on the firm.

Other Projects

o Infrastructure etc that does not fall under the previous categories.

Type - Real vs. Financial Assets:

Real Assets:

Assets that can be put to productive use to generate a return (machinery and equipment for example)

Financial Assets:

Assets that represent a claim to a series of cash flows against an economic unit such as shares (claim against a company, cash flows = dividends and sale price), bonds (claim against bond issuer, CF = interest and principal), bank accounts (claim against bank, CF = interest and principal)

5 Steps in the Capital Budgeting Process;

Generate Project Proposals:

Does the project fit with the firm’s long-term goals

Screening

How will the project affect the firm?o Typeo Different options

Evaluation:

Quantitative analysis (worth > cost, Return > required return?)o Forecast cash flows (Initial cost, expected cash flows, salvage value)o Determine risk of cash flows (discount rate based on risk, alternative cash flow

forecasts generated perhaps)o Apply evaluation method (or more than one)

Qualitative Analysiso Values, morals, ethics etc

Implementation and Control

Monitoring actual cash flows relative to forecasts

Post-implementation Audit

Project follow up and review

A note on Project Relationships ;

One project simply has options of reject or accept

Multiple projects can be;

o Independent (no impact on each other’s cash flows) – analyse independently and accept one or more or reject all as decision to accept or reject doesn’t affect others.

o Mutually exclusive (accepting of one requires rejection of all others usually because of resource constraints) - analyse projects independently but rank relative to determine which to undertake.

o Contingent (Acceptance of rejection of a project is dependent on the decision to accept or reject a related project)- analyse cash flow interactions of projects as well

Can be Complementary projects or substitute projects

Decisions in depth - QUANTIFYING investment decision – NPV

Value of a project, accounting for initial outlay and discounted value of all FCF(Influenced by accuracy of forecasted CF and R-ROR)

- Measures increase in firm value (wealth of shareholders) from undertaking a project above what shareholders could obtain by investing in capital market themselves

Decision Rule Independent Projects:

Accept if NPV > 0 (or = 0 and have personal preference over giving cash to shareholders to invest themselves)

Decision Rule Mutually exclusive Projects:

Accept if Highest positive NPV

To calculate: Treat as bond (which can be annuity if payments are equal)

Discount rate represents ROR that could be earned on an investment in the capital market with equivalent characteristics.

o NPV > 0 indicates project yields greater wealth than equivalent capital market investment. The opposite for NPV < 0 and NPV = 0 means equivalent to capital market investment.

Advantages;-Clear decision rule (& easy to interpret result)- Doesn’t ignore time value - Considers all cash flows generated by a project- Correctly ranks projects on shareholder wealth maximisation- Incorporates risk of project

Disadvantages:- Need extensive forecasts of future cash flows- Can be difficult to choose appropriate discount rate- NPV is hard for non-finance-trained managers to understand

Decisions in depth - QUANTIFYING investment decision – IRR

MINUS Initial Outlay

Working out IRR without trial and error;

1. For UNIFORM CF firstly divide the initial outlay by the CF

o This therefore gives the PVIF

2. Look on table A2, under the number of periods in the question, for this PVIF.

3. Then simply see the percentage listed (that is IRR)

o Note that if it is between one – Trial and error or %-of-Difference techniques may need to be utilised

NPV Profile:

This is a useful graph of the NPV against the discount rate which should have a relationship such that;

o The higher the discount rate, the lower the NPV

Hence the IRR for a project is the point at which the profile crosses the discount rate axis (NPV = 0)

Note the Multiple IRR’s from non-normal cash flows

Normal cash flows

Remember TABLE A2 for IRR range!

Comparing IRR and NPV :

Considering if these two projects (A and B) are independent, we now look at both IRR and NPV and how they would handle decisions on these two projects.

o IRR would suggest that we could accept A,B or both depending on the hurdle rate. If it is <18.49% then both would be undertaken.

o NPV would suggest, once again, both projects if the discount rate were less than 18% because NPV > 0.

o Hence, when they are independent, NPV and IRR give the same answer

Considering these projects as Mutually exclusive – we once again evaluate the responses of IRR and NPV

o IRR would suggest the highest IRR which is A (A > B = 21.22% > 18.49%)

o NPV would depend on if the discount rate </> the crossover rate.

Higher than crossover, A >B

Lower than crossover, B > A

Comparing IRR and NPV – Reinvestment of Funds problem

The NPV approach assumes that funds generated by the project can be reinvested at the discount rate (R-ROR)

o This is the more realistic assumption of the two

The IRR approach assumes that funds generated by the project can be reinvested at the IRR rate.

Comparing IRR and NPV – Scale Problem

Consider NPV and IRR for incremental cash flows

Comparing IRR and NPV – Timing Problem

MIRR example

2/5 P2 – The Financing Decision:

Capital Structure – How the firm obtains financing to support long-term investments, the mix of long-term debt and equity. Analysing magnitude of borrowing and borrowing sources and types.

o The objective is to maximise return, subject to an acceptable level of risk, which is divided into;

Business risk (which depends on);

¥ The type of operations of the business (due to level of fixed vs. variable operating costs), Sectoral growth rates, Market share, Aggressiveness of competitors, Competence of management and workforce

Financial Risk>>Exposure to factors that impact on the value of assets, liabilities and cash flows.

¥ Level of financial risk is borne by the security holders (debt and equity)

¥ Categories (6) ;

o Interest rate risk – Adverse movements in interest rates

o Foreign exchange Risk – Adverse movements in exchange rates

o Liquidity Risk – Insufficient cash in the short term

o Credit risk – Default or untimely payments by debtors

o Capital risk – Insufficient shareholder funds to meet capital growth needs OR absorb abnormal losses

o Country risk – Financial loss owing to currency devaluation or inconvertibility.

¥ D/E Ratio – Ratio of funds borrowed (debt) to funds contributed by shareholders (equity).

o Indicates risk of being unable to meet interest due and principal repayments associated with use of debt (risk of insolvency)

o Influenced by industry norms, historical firm ratios, lender’s limits (loan covenants), management’s assessment of capacity to service debt.

¥ EPS – Net return on company’s shares express in CPS (cents per share)

o If cost of debt is less than return achieved, more debt will benefit shareholders because of higher EPS

o HOWEVER, more debt raises financial risk and insolvency risk

3/5 P2 – Initial Public Offering (IPO):

Issuing New Shares:

Publicly listed corporation – Has its shares listed and quoted on a stock exchange

This is a complex alternative to retained earnings for raising capital for investment.

Types of issuance:

o IPO – Initial issue of shares to the public for cash

o Rights Issue – Issue of new shares to existing shareholders on a proportional basis to their existing holding.

o Private placement – Exclusive issue of shares to a select investor/group of investors who may not be currently investors in the firm.

Ordinary Shares and company type:

¥ Limited Liability Companies;

o Shares are major source of equity funding

o Shareholders have voting rights at general meetings (can be transferred to proxy)

o Shares usually sold fully paid but can be partly paid (contributing basis) or paid by instalment receipt

Instalment receipt:

Issued upon payment of the first instalment on a share issue in lieu of the ordinary share.

On payment of a specified amount at a future date, a full paid share is issued in place of an instalment receipt

o Shareholder liability is limited to the price of fully paid shares

Partly paid shareholders have a contractual obligation to pay the remaining amount when it is called or due.

¥ NO-Liability Companies;

o Used for highly speculative ventures

o Shares issued as partly paid

o Shareholders may decide not to meet future calls BUT they forfeit the partly paid shares in that case.

4/5 P2 – Listing a Business on a Stock Exchange:

Procedure for issuance:

1. Get approval from BOD

2. Obtain expert opinion on financing options, pricing, marketing and level of interest/support for the issue

Must meet listing requirements (Or can be suspended or delisted)(These are in addition to a corporations’ legislated obligations)

o These principles embrace the interests of listed entities, maintain investor protection and maintain regulation and integrity of market.

Minimum standards on quality, size, operations and disclosure

Sufficient investor interest required to warrant listing

Security issues must be fair to both new and existing holders

¥ Rights and obligations attached to securities must be fair to both new and existing shareholders.

Prescribed information must be provided to the exchange on a timely basis

Material information that may affect security prices or investment decisions must be disclosed immediately to the exchange

¥ Disclosure of information of a sufficiently high standard to investors

Highest standards of behaviour on the part of company officers.

3. Hire an investment bank to assist with the sale

4. Write a prospectus and register it with the appropriate authorities

Out-Clause - Specific conditions precluding full enforcement of an underwriting agreement

5. Conduct a marketing road-show

6. Receive applications

7. Allocate and distribute shares

8. Trading begins

Standby Underwriting

¥ At the end of the issue, the issuer buys any shares not bought by the public

¥ Underwriter bears the risk of not being able to sell the entire issue to the public

¥ Underwriter charges a fee for this service

o Most common type of underwriting in Australia

Best Efforts Underwriting

¥ Underwriter makes “Best Effort” to sell securities at agreed offering price

¥ Company bears the risk of the issue not being sold

¥ Offer may be pulled if there is not enough interest at the offer price and the company does not get the capital and have still incurred substantial flotation costs

o Not as common as it used to be

Issuing New Shares – Cost of issuing new shares:

¥ Costs of issuing new shares (and other forms of capital) are called flotation costs.

¥ Includes;

o Direct;

Management and/or underwriting fee

Filing, listing, legal, printing fees and taxes

o Indirect;

Management time

o Underpricing

o Abnormal returns and green shoe options

5/5 P2 – Equity Funding for Listed Companies:

¥ There are several forms of equity finance available to established corporations;

o Additional ordinary shares;

Rights issue - Issue of ordinary shares to existing shareholders on a pro-rate basis (1 :5 or 1 for every 5 owned)

Renounceable – Shareholder may sell their right

o Non-renounceable; Right may not be sold.

Issue price (discount to current price) is influenced by;

o Company’s CF requirements

o Projected earnings flows from the new investments funded by the rights issue

o Cost of alternative funding sources (opportunity cost)

Placement – Additional new ordinary shares issued directly to selected investors (institutions and individuals) deemed to be clients of brokers.

No prospectus needed but do need a memorandum of information

Minimum subscription to $500,000 to not more than 20 participants

Market price discount CANNOT be excessive

o Allows smaller discount and shorter time frame than rights issue

Dilutes the holding of non-participating shareholders.

Takeover Issues – The Acquiring company issues additional ordinary shares to owners of the target company in settlement of the transaction.

Alleviates need for owners of acquiring company to inject cash for the purchase of the company.

Dividend Reinvestment Schemes – Shareholders have the option of reinvesting dividends into additional ordinary shares.

Usually discounted between 0 and 5%

No brokerage or stamp duty payable

In growth periods this allows companies to pay dividends and pass on tax credits, whilst increasing equity

o The scheme may be suspended in low growth periods

o Preference Shares;

Classed as hybrid securities (characteristics of both debt and equity)

Fixed dividend rates are set at issue date

Rank ahead of ordinary shareholders in the payment of dividends AND in the event of liquidation.

Can have the following characteristics;

Cumulative (/not), = dividends can rolled over to be paid next year.

Redeemable (/not), = Shares can be redeemed into something else

Convertible (/not), = shares can be converted back to original shares

Participating (/not), = shareholders able to participate in bigger profits than would be allowed with fixed dividend issues.

Issued with different rankings = different rankings of entitlements to dividends/shares.

Advantages:

Fixed interest borrowings but they are an equity finance instrument

Assist in maintaining D/E ratio

Widen a company’s equity base (allowing further debt to be raised)

Dividends may be deferred on cumulative shares and not paid on non-cumulative shares>>>Unlike Debt interest which MUST be paid

o Convertible notes (Quasi-equity) -

Classed as a hybrid instrument, issued for a fixed term at a stated rate of interest, either by direct placement or pro-rata to shareholders.

Holder has right to convert the note into ordinary shares at a specified future date and at predetermined price

The option to convert to equity has value

Gain is made on share prices subsequently rising.

If share price falls, holder may not exercise conversion option and take the note’s cash value.

Interest paid on notes is usually lower than straight debt interest.

o The interest is tax deductible

Notes are often issued for longer periods than is possible with straight debt borrowings.

o Company-issued Options

Provide the right, BUT NOT THE OBLIGATION, to purchase shares at a stated price and date.

Allows companies to raise further equity funds at planned future dates.

Providing holders exercise the option.

Typically offered in conjunction with a rights issue or placement.

Generally have value and can be traded

Option will be exercised if the exercise price is less than the market price of the share at the exercise date

o Company-issued Equity warrants

Generally attach to corporate bond issues but may be issued unattached

Warrants may be detachable from the bond and traded separately

Holder has option to convert warrant into ordinary shares at specified price over a given period.

No dividends but holders benefit from capital gains if share price rises above conversion price.