fins1612 w4 lecture

8/18/2019 FINS1612 W4 Lecture

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Lecture 4

Chapter 5

Corporations Issuing Equity in the Share Market


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Learning Objectives

Understand capital budgeting issues

Examine issues relevant to the choice between debt and equityunding ! Capital structure

"utline the lotation and listing #I$"% process

&escribe equity funding alternatives available to newly listedand established corporations

&emonstrate share pricing methods


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Chapter Organisation

5'( )he Investment &ecision

5'* )he +inancing &ecision

5', Initial $ublic "ering

5'- .isting a /usiness on a Stock Exchange

5'5 Equity0unding or .isted Companies

5'1 Summary


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5.1 The Investent !ecision

)he ob2ective o inancial management is to a"iise shareholder value Corporate managers ace important decisions in their attempt to maximise

shareholder wealth' +our main aspects o management

! Investent decision #capital budgeting%

3Invest in which assets4 ! #inancing decision #capital structure%

3 ow to und the purchase o these assets

! Liquidity #working capital% management

3 ow to best manage current assets and current liabilities

! !ividend policy decision3 ow to retain and6or distribute proits

)his lecture ocuses on the investment and inancing decisions


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5.1 The Investent !ecision $cont.%

7 corporation irst determines the assets in which it will investunds according to organisational ob2ectives

! 8eal assets9 e'g' plant and equipment

! +inancial assets9 e'g' equities9 bonds

Competing investment alternatives should be evaluated on thebasis o shareholder wealth maximisation


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)wo important measures used to quantiy the contribution o aninvestment to shareholder wealth

! :et present value #:$;%

! Internal rate o return #I88%


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&ricing a 'ecurity

&einition o +inancial 7sset

$rice is present value of e"pected future cash flo(s

$resent value < C+6 #(=i%n

$rice < >C+i6 #(=i%n

C+ < expected uture cashlows

i < required 8ate o return

n < number o periods

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:$;

)he dierence between the present value o cash flo(sassociated with an investment and the cost o the investment

)he :$; decision rule

! 7ccept an investment that has a positive :$;9 i'e' re2ect aninvestment with a negative :$;

:$; #and I88% inluences

! )he accuracy o the orecasted cash lows

! )he discount rate #required rate o return%


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)"aple of *&+

7 company is currently considering whether it should outlay?5@@9@@@ or a machine that will have a useul lie o ive years')he orecast net cash lows rom using the machine are?(5@9@@@ each year or the next ive years with no residual value

at the end' Ahat is the :$; o this pro2ect9 given the requiredrate o return is (@B

5-10


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I88

! )he required rate o return resulting in :$; < @

! )he I88 acceptance rule

3 7ccept the investment i its I88 is greater than the irms required rate

o return


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5'1 Summary


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5., The #inancing !ecision

8elates to the question o how a business investment is to beunded

)he inancing decision concerns the capital structure used tound the irms business activities

)he most important inancing decision is choosing between debtand equity

)he inancial ob2ective o a corporation is to maximise return- sub2ect to an acceptable level o ris


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5., The #inancing !ecision $cont.%

8eturns are generated rom the net cash lows o the business

8isk is the uncertainty or variability o expected cash lowsderived rom

! /usiness risk

! +inancial risk


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/usiness risk

! )he level o business risk depends upon the type o operations othe business9 i'e'

3 Industry sector that inluences the level o ixed versus variableoperating costs

! Exposures that a irm might have that could impact the day to dayoperations o the organisation

3 +ailure o computer system

3 Industrial actions o personnel

3 Sectoral growth rates3 Market share

3 7ggressiveness o competitors

3 Competence o management and workorce


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+inancial risk

! )he exposure to actors that impact the value o assets9 liabilitiesand cash flo(s

! )he level o inancial risk o a company is borne by the security

holders #debt and equity% ! +inancial risk categories

Interest rate risk

! 8isk o adverse movements in interest rates

#oreign e"change risk ! 8isk o adverse movements in exchange rates


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+inancial risk categories #cont'%

Liquidity risk

! 8isk o insuicient cash in the short term

Credit risk

! 8isk o deault or untimely payments by debtors

Capital risk

! 8isk o insuicient shareholder unds to meet capital growth needsor absorb abnormal losses

Country risk ! 8isk o inancial loss due to currency devaluation or inconvertibility


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+inancial risk and the debt to equity ratio #&6E%

&6E is the ratio o unds contributed by shareholders #equity% tounds borrowed #debt%

&6E indicates the risk o being unable to meet interest due and

principal repayments associated with use o debt9 i'e' risk oinsolvency

! Earnings per share #E$S% is the net return on a companys sharesexpressed in cents per share

3 I the cost o debt is less than the return achieved9 then issuing more

debt will beneit shareholders3 owever9 high debt levels increase a companys level o inancial risk

and9 thus9 the risk o insolvency


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Ahat is the appropriate &6E ratio4 7lthough there is no agreed ideal &6E ratio9 actors inluencing the

&6E ratio in practice areD

! Industry norms

!/istoric levels o irms ratio

! .imit imposed by lenders through loan covenants9 i'e' restrictionsplaced on a borrower speciied in a loan contract

! Managements assessment o the irms capacity to service debt

earing ratio < the percentage o a irms total unding provided by

debt .oan covenants < conditions or restrictions placed on a borrower

and speciied in a loan contract


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5'1 Summary


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5.0 Initial &ublic Offering

Initial public oering #I$"% is an oer to investors o ordinaryshares in a newly listed company on a stock exchange

! :ew share issuer must meet 7SF listing requirements

! )he promoter appoints advisers #stockbroker9 merchant bank9

other specialists% and possibly underwriters


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5.0 Initial &ublic Offering $cont.%

Underwriters3 Ensure a company raises the full amount o the issue

3 7ssist with advice on the structure9 price9 timing and marketing o theissue and allocation o securities

$rospectus lodged with 7SIC3 &ocument prepared by a company stating the terms and conditions o

an issue o securities to the public

"ut0clause3 Speciic conditions precluding ull enorcement o an underwriting

agreement

$ublicly listed corporation3 as its shares listed and quoted on a stock exchange


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"rdinary sharesD liited liability companies

! Ma2or source o equity unding

! Shareholders have voting rights at general meetings

! Shares usually sold fully paid9 or can be partly paid #contributing

basis% or paid by instalment receipt

! Shareholders liability is limited to the price o ully paid shares

! $artly paid shareholders have a contractual obligation to pay theremaining amount when it is called or due


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"rdinary sharesD no liability companies

! Used or highly speculative ventures

! Shares issued as partly paid

! Shareholders may decide not to meet uture calls9 in which case

they oreit the partly paid shares


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5'1 Summary


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5.4 Listing a usiness on a 'toc )"change

7 company seeking to have its securities quoted on a stockexchange #i'e' to 2oin the oicial list% must comply with listingrules9 which are additional to the corporations legislationobligations

7 non0complying listed company can be suspended romquotation or delisted

.isting rule principles embrace the interests o listed entities9aintain investor protection9 and maintain the reputation andintegrity of the aret

Main principles o a stock exchanges listing rules include ! Minimum standards on quality9 siGe9 operations and disclosure

! Suicient investor interest required to warrant listing


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5.4 Listing a usiness on a 'toc )"change $cont.%

Main principles o a stock exchanges listing rules include #cont'%

! Security issues must be air to both ne( and e"isting holders

! 8ights and obligations attached to securities must be air to bothnew and existing holders

! $rescribed inormation must be provided to the exchange in atimely basis

! 2aterial inormation that may aect security prices or investmentdecisions must be disclosed immediately to the exchange

! &isclosure o relevant inormation o a suiciently high standard to

investors

! ighest standards o behaviour o company oicers


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5'1 Summary


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5.5 )quity3funding for Listed Copanies

&ierent orms o equity inance are available to establishedcompanies

! 7dditional ordinary shares

3 8ights issue9 placements9 takeover issues9 dividend reinvestment

schemes ! $reerence shares

! Huasi0equity

3 Convertible notes9 options9 warrants


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5.5 )quity3funding for Listed Copanies $cont.%

8ights issue ! Issue o ordinary shares to e"isting shareholders

! Issued pro0rata9 e'g' (D5 or ( or 5

! +actors inluencing the issue price

3 Companys cash low requirements

3 $ro2ected earnings lows rom the new investments unded by the rights issue

3 Cost o alternative unding sources

! 8ights issued at a discount to current share price

! )wo types

3 8enounceableshareholder may sell their right

3 :on0renounceableright may not be sold


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$lacements

! 7dditional new ordinary shares issued directly to selectedinvestors #institutions and individuals% deemed to be clients obrokers

! :ot required to register a prospectus but a memorandum oinormation must be prepared

! Minimum subscription ?5@@ @@@ to not more than *@ participants

! Market price discount cannot be excessive

! 7llows smaller discount and shorter time rame than rights issue

! &ilutes holding o non0participating shareholders


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)akeover issues

! 7cquiring company issues additional ordinary shares to owners otarget company in settlement o the transaction

! 7lleviates need or owners o acquiring company to in2ect cash or

the purchase o the company


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&ividend reinvestment schemes

! Shareholders have the option o reinvesting dividends inadditional ordinary shares

! Usually issued at a discount between @B and 5B

! :o brokerage or stamp duty payable


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$reerence shares

! 7re hybrid securities9 i'e' they have characteristics o both debtand equity

! +ixed dividend rates are set at issue date

! 8ank ahead o ordinary shareholders in the payment o dividendsand liquidation

! Include combinations o the ollowing eatures

3 Cumulative or non0cumulative

3 $articipating or non0participating

3 Issued with dierent rankings


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$reerence shares #cont'%

7dvantages o preerence shares

! +ixed interest borrowings but they are an equity inanceinstrument

! 7ssist in maintaining debt to equity ratio ! iden a companys equity base9 which allows urther debt to be

raised also

! &ividends may be deerred on cumulative shares and not paid onnon0cumulative shares9 while interest on debt must be paid


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Convertible notes

7re a hybrid instrument9 issued or a ixed term at a stated rateo interest or the term o the note

older has right to convert the note into ordinary shares at a

speciied uture date and at a predetermined price )he option to convert to equity has value

)he notes are usually issued at a price close to the market priceo the shares at the time o issue and the rate o interest oeredon the notes is usually lower than that oered on straight debt

instruments' It is usually lower because o the explicit option value embedded

in the security #option to convert to ordinary shares%'I share pricesubsequently rises a gain is made


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Convertible notes #cont'%

I share price alls9 holder may not exercise conversion optionand take the notes cash value

Interest payments are tax deductible to the company

:otes are oten issued or longer periods than is possible withstraight debt borrowings


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.5 &ricing of 'hares

Share price is mainly a unction o supply and demand or ashare

! Supply and demand are inluenced mainly by inormation

! Share price is considered to be the present value o uturedividend payments to shareholders

! :ew inormation that changes investors expectations about uturedividends will result in a change in the share price


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.5 &ricing of 'hares $cont.%

Estimating the price o a share

! eneral dividend valuation model

( )

returno raterequiredr

tperiodinshareper dividendexpected&

pricesharecurrent$

tsr (

(t &$

s

t

@

t

@

=

=

=

+

∑∞

==

AhereD$.6%


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Estimating the price o a share #cont'%

! ;aluing a share with a constant dividend #&@%

! ;aluing a share with constant dividend growth #g%

sr &

$ @@=

$.7%

−

+=

gr

g(&$

s

@@

$.1,%


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8uestion

The last dividend paid to shareholders by 2ega anLiited (as 91.6: per share. The board of directors of theban plans to aintain a constant dividend gro(th policy of6.5 per cent. ;n investor- in evaluating an investent in theban- has deterined that she (ould require a ,: per centrate of return fro this type of investent. If the currentprice of 2ega an shares in the stoc aret is 915.5:-should the investor purchase the shares< $'ho( yourcalculations.%


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;ns(er

Mega bank is planning to maintain constant dividend growth')hereore9 the next dividend paid will be the last dividendmultiplied by the growth rateD

$@ < &@ #( = g % 6 #r s ! g %< ('J@ #('@J5% 6 #@'*@ ! @'@J5%

< ?(1'KJ

at a current market price o ?(5'5@ the investor should consider

buying the shares


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Cum0dividend and ex0dividend

! &ividends are payments made to shareholders9 expressed as

cents per share

! &ividends are declared at one date and paid at a later9 speciieddate

! &uring the period between the two dates9 the shares have theuture dividend entitlement attached9 i'e' cum0dividend


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Cum0dividend and ex0dividend #cont'%

! "nce the dividend is paid the shares are traded ex0dividend

! )heoretically9 the share price will all on the ex0dividend date bythe siGe o the dividend

3ExampleD

Share price cum0dividend ?('@@

&ividend paid @'@L

)heoretical ex0dividend price @'K,


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/onus share issues

! Ahere a company has accumulated reserves9 it may distribute

these to existing shareholders by making a bonus issue oadditional shares

! 7s with dividends9 there will be a downward ad2ustment in shareprice when shares go ex0bonus


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/onus share issues #cont'%

! 7s no new capital is raised9 there is no change in the assets or

expected earnings o the company

3 ExampleI a bonus (D- issue is madeD

Cum0bonus price ?5'@@

Market value o - cum0bonus shares ?*@'@@

)heoretical value o 5 ex0bonus shares ?*@'@@

)heoretical value o ( ex0bonus share ?-'@@


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Share splits

! Involves division o the number o shares on issue

! Involves no undamental change in the structure or asset value othe company

! )heoretically9 the share price will all in the proportion o the split

3 Example5 or ( splitD

$re0split share price ?5@'@@

)heoretical ex0split share price ?(@'@@


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$ro0rata rights issue

! Involves an increase in the companys issued capital

! )ypically issued at a discount to market price

! )heoretically9 the market price will all by an amount dependent on

theD3 number o shares issued

3 siGe o the discount


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$ro0rata rights issue #cont'%

! Examplemarket price cum0rights ?('@@9 with (D5 rights issue

priced at ?@'JJD

Cum0rights share price ?('@@

Market value o 5 cum0rights shares 5'@@

$lus new unds rom (D5 issue @'JJ

Market value o 1 ex0rights shares 5'JJ

)heoretical ex0rights share price #5'JJ61% @'KJ


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$ro0rata rights issue #cont'%

! 7 renounceable right is a right that can be sold beore it is

exercised3 )he value o the right is determined by Equation 1'(*

share'additionaltheo pricediscountedtheispriceonsubscriptitheandshare9issuerightstheobtainto

requiredshareso number theisAhere

(price%onsubscripti0pricerights#cum righto ;alue

N

N

N

+= $.1,%


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8uestion

igandbold Liited has a current share price of 915.5:. Thecopany has ade a renounceable rights issue offer toshareholders. The offer is a three3for3ten pro3rata issue ofordinary shares at 915.05.

hat is the price of the right<

Calculate the theoretical e"3rights share price.


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;ns(er

where N is the number o shares required to obtain the rightsissue share9 and the subscription price is the discounted price o

the additional share' )hereoreD


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;ns(er

cum0rights share price ? (5'5@

Market value o (@ cum0rights shares ?(55'@@

plusD

new cash introduced through take0up o , or (@ issue ? -1'@5

givesD

market value o (, ex0rights shares ?*@('@5

thereoreD

theoretical ex0rights share price ? (5'-L


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True=#alse questions

7 company announces the payment o an interim dividend o?@'*@ per share' )he cum dividend shares are trading at ?5'-@')he theoretical ex0dividend price will be ?5'1@

In a one0or nine bonus issue9 i the cum bonus price o the sharewas ?(@9 then the theoretical ex0bonus price would be ?K

7 pro0rata rights issue that has a (@@ percent take up rate simplyincreases the number o shares issued and has no eect on thecompanys capital


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5. 'uary

"b2ective o inancial management is to maximise shareholdervalue

+our key inancial management decisions involve investment9inancing9 liquidity #working capital% and dividend

7ppropriate investment decision techniques are :$; and I88 )he inancing decision concerns the choice o capital structure

#&6E% and inluences a irms inancial risk

7dmission to the 7SF broadens inancing opportunities or theirm and is achieved by satisying listing requirements

7dditional equity can be raised through ordinary shares9preerence shares9 convertible notes and other quasi0equity

fins1612 w4 lecture

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