Topic 4 - Corporations Issuing Equity in the Share Market (Equity Markets)

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 174-205.

Required Reading

Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL. Pages [1]

Financial Management Objectives

Objective of financial management is to maximise shareholder wealth/value. There are 4 key decisions to make:

  • Investment - Capital Budgeting, what investments do we make?
  • Financing - Capital Structure, how do we fund the purchase of these assets
  • Liquidity - Working Capital Management, how to best manage current assets & liabilities
  • Dividend - Retain or distribute profits

The Investment Decision

[2] Corporations must first determine the assets in which it will invest funds into (according to objectives). These can be real or financial assets. Competing investment alternatives must be evaluated on the basis of shareholder wealth maximisation.[3]

  • Net Present Value (NPV)
    • Difference between Cash Outlay & Present Value of expected future cash flows
    • NPV > 0 - Accept Investment, NPV < 0 - Decline Investment
    • Subjected to inaccuracy of forecasted cash flows (particularly in dynamic industries)& changes in the discount rate
  • Internal Rate of Return
    • The required rate of return for NPV = 0
    • Accept - IRR > firms required rate of return (discount rate), issues with non normal cash flows & M.E projects

The Financing Decision

[4] This related to the capital structure used to fund the firm’s business activities. It must choose between debt & equity in order to maximise return (net cash flows from the firm) subject to an acceptable level of risk (uncertain/variability of exp. cash flow).

  • Business Risk - Depends on the type of operations (fixed/variable costs, contracts, commoditised, mining or diversified)
    • Computer system failure (tech firms), industrial action, industry growth, competitors, management competence
    • SWOT Analysis
  • Financial Risk - exposure to factors that impact the value of assets, liabilities & cash flows
    • Interest Rates, FOREX & Liquidity (insufficient funds to meet short term liabilities)
    • Credit – risk of debtors defaulting
    • Capital – insufficient shareholder funds to meet capital growth needs or absorb abnormal losses
    • Country – risk of currency devaluation or inconvertibility + political events, regulations & policies (asset freeze)

Debt To Equity Ratio

The Debt to Equity Ratio is the ratio of shareholder funds to borrowings. It indicates the risk of being unable to meet interest or principal repayments (insolvency risk - higher if high D/E (all things being equal) due to contractual obligation to repay debt repayments). If Returns > Cost of Debt, leverage will benefit shareholders via higher EPS, but will harm EPS if Cost of Debt > Returns. No ideal D/E ratio, it is influenced by: industry norms, historic level of firm’s ratio, loan covenants (imposed by lenders), and management’s assessment of the firm’s capacity to service debt. Gearing ratio = Debt/Assets.

Initial Public Offering

[5] An IPO occurs when a corporation (promoter) first lists/floats on the SX to become a publically listed corporation. The firm must meet the ASX’s minimum listing requirements. The process of issuing newly created securities involves:

  • Underwriters - Ensure company raises the full amount of the issue (+ often market/promote the issue)
    • Advise on the structure, price, timing & marketing of the issue & allocation of securities
    • Out – Clause - Specific conditions to escape the full enforcement of an underwriting agreement
      • E.g. If the index drops below a certain level – indicating a change in market conditions for the worse
  • Prospectus - Terms & Conditions of an issue of securities to the public (document)[6]
  • Costs - advisory fees (structuring, documentation, legal, taxation, financial & specialists e.g. geologist) + cost of listing

Most publicly listed corporations are Limited Liability with the majority of equity funding being ordinary shares, representing a residual ownership claim on the firm’s assets. Shares are usually fully paid (contributing basis, contractual obligations to pay the remaining amount when due) & liability is limited to the price of fully paid shares. Holders have voting rights (proxy – party authorised to vote on behalf of a shareholder at a GM).

Ordinary shares of No Liability companies are used for speculative ventures & are issued partly paid. Shareholders can decide not to meet future calls but they forfeit the partly paid shares.

Listing a Business on the Stock Exchange

The corporation must comply with listing rules & corporate laws & obligations - burdensome. Non compliance can result in suspension or delisting. Listing rules embrace interests of listed entities; maintain investor protection & market integrity. Main Principles of SX listing include (fair & orderly price discovery)

  • Minimum standards on quality, size & disclosure + sufficient investor interest to warrant listing.
  • Security issues (& attached rights & obligations) must be fair to both new & existing holders
  • Continuous disclosure requirements (high standards, material/relevant/prescribed information disclosed immediately)
  • Highest standards of behaviour of company officers

Equity Funding for Listed Companies

[7]

Additional Ordinary Shares

[8]

  • RIGHTS ISSUES - issue of ordinary shares to existing shareholders on a pro rata basis (proportional to holding offer, 1 for 5)
    • Factors influencing price (discount to market price to attract funding)
      • Urgency of cash flow requirements
      • Projected earnings flow from new investments funded by rights issue (more attractive = less discount)
      • Cost of alternative funding sources
    • Renounceable – shareholders may sell the right (instrument providing a future right has value)
    • Non Renounceable – rights may not be sold
    • Pro’s - Right for non dilution of ownership
    • Con’s - Admin burden, 2 month process + mightn’t get full amount
  • PLACEMENTS - Issue of ordinary shares to selected investors (institutions/individuals) deemed to be clients of brokers
    • Minimum subscription 500,000 to not more than 20 participants + require memorandum of information
    • Discount cannot be excessive (ASIC), can’t ‘place’ > 15% of issued shares in less than 12 months (without ratification from the shareholders)
    • Pro’s - Quick response (days), no prospectus, small discount,
    • Con’s - Dilution of ownership (non participants)
  • TAKEOVER ISSUES - Acquiring firm issues additional ordinary shares to owners of target firm in settlement of the transaction
    • Pro’s - No need for cash injection to takeover,
    • Con’s - may overpay (i.e. payments of undervalued shares)
  • DIVIDEND REINVESTMENT SCHEMES - Option of reinvesting dividends in additional ordinary shares
    • Pro’s - Minor owners can reinvest dividends easily, no friction costs, small discount,
    • Con’s - negative dilution if there are no growth opportunities

Preference Shares

PREFERENCE SHARES are hybrid securities (characteristics of debt & equity). Fixed dividend rates are set at the issue date & ranks ahead of ordinary shareholders in the payment of dividends & liquidation.

  • Cumulative/non Cumulative – payments not met are carried forward to the next period, must be paid before ordinary dividends
  • Redeemable/non Redeemable – redeem preference share for a specified cash payment at a predetermined or expiry date
  • Convertible/non Convertible – may be converted to ordinary shares at a future date & a specified price. Usually is.
  • Participating/non Participating – receive a higher dividend if ordinary shareholders receive a dividend higher than a specified rate.

The advantages from the firm’s point of view include:

  • Fixed interest borrowings classified as equity finance + No Voting Rights
  • Maintains Debt/Equity ratio
  • Widening equity base allows further debt financing
  • Dividends may be deferred on cumulative shares & not paid on non cumulative, while interest on debt must be paid

Quasi-Equity

  • CONVERTIBLE NOTES - Hybrid instrument issued for a fixed term at a stated rate of fixed interest with a right to convert
    • Right to convert the note into ordinary shares at predetermined price at a future date (value to attract surplus)
      • Convert if share price rises, otherwise take the notes cash value (if falls)
      • Able to issue for longer periods than with straight borrowings
    • Lower tax deductible interest payments due to convertible option value (compared to bond issues)
  • COMPANY ISSUED OPTIONS - Right, but not the obligation to purchase shares at a predetermined price & date
    • Raises equity funds if holders exercise the option right (depends on exercise & market prices)
    • Typically offered with a rights issue or placement OR issued free OR sold at a price
      • Have value & may be traded
      • Option will be exercised if exercise price < market price at the date
  • COMPANY ISSUED EQUITY-WARRANTS - Option to convert warrant into ord. shares at a specified price over a given period
    • Often attached to corporate bond issues (can be detachable & traded separately)
    • No dividends but can benefit from capital gains if price > conversion price

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 176-179
  3. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  4. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 180-183
  5. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 183-188
  6. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  7. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 188-193
  8. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
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