13 Financial Instruments and Financial Markets Flashcards
Sources of equity finance
Name them
Retained Earnings
Rights issues
New issues
What are the implications of rights issues?
Legally a rights issue must be offered to existing shareholders before a new issue to the public. Existing
shareholders have rights of first refusal (pre-emption rights) on the new shares and can, by taking
them up, maintain their existing percentage holding in the company.
However, shareholders can, and
often do, waive these rights by selling them to others
What factors need to be considered when making rights issues?
Companies need to consider the following factors when making rights issues:
Issue costs
Shareholder reactions
Potential dilution of control
Existing shareholders may not have enough funds (especially if unlisted)
What are the implications of new issues?
New issues to the public account for around 10% of new equity finance. When they occur they are
often large in terms of the amount raised. They are often used at the time a firm obtains a listing on
the Stock Exchange, wants to raise a very large amount and therefore needs a high profile issue
There are two methods of making a public share offer, what are they?
Which is more common?
Offer for sale
- X plc sells shares to an issuing house (investment bank)
- issuing house offers shares for sale to general public
Direct offer or offer for subscription
X plc - shares directly to the general public.
In practice the offer for sale is far more common; in either method the issue is likely to be underwritten. There is no restriction on the amount of capital raised by this method.
Accounting issues
(share issue)
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities.
Under IAS 32, Financial Instruments: Presentation, whether a financial instrument is classified as an equity instrument should be in accordance with the substance of the contractual terms and not with factors outside the terms.
Hence preference shares are generally treated as debt.
Equity markets
Name them
London Stock Exchange
Alternative Investment Market (AIM)
London Stock Exchange
What is it?
The London Stock Exchange (LSE) is, above all else, a business. Its primary objective is to establish and run a marketplace in securities. In any economy there are savers and borrowers. The exchange acts as
a place in which they can meet.
London stock exchange -
criteria for listing?
The expected market value of shares to be listed by the company must be at least £700,000. If
the company is to issue debt, the expected market value of any such debt is to be at least £200,000
All securities issued must be freely transferable
The company must have a trading record of at least three years. Its main business activity must have been continuous over the whole three-year period. In addition, there should be three
years of audited accounts. This requirement is waived for innovative high-growth companies,
investment companies and certain other situations.
The shares must be sufficiently marketable. A minimum of 25% of the company’s share capital being made available for public purchase (known as the free float) is normally seen to satisfy this requirement.
Alternative Investment Market (AIM)
What is it?
What are the criteria?
The LSE introduced the second-tier AIM in 1995. This forum for trading a company’s shares enables
companies to have their shares traded through the LSE in a lightly regulated regime. Thus smaller, fast growing companies may obtain access to the market at a lower cost and with less regulatory burden.
For AIM companies, there is no minimum level of free float (shares available for purchase by the
public), no minimum market value for their securities and no minimum trading history. However, they
must produce a prospectus, which is considerably less detailed than for a full listing and is known as an Admission Document
Sources of debt finance
Name them
Bank loans
Bonds/Debentures
Convertible bonds
(Leases?)
Bank loans - when might they be used? What are their features?
A bank loan may be the only long-term source of debt available for some companies, particularly if they are not listed and cannot issue bonds.
Bank loans may have fixed or variable rates of interest.
Bonds/Debentures
What are they and what’s the difference?
A written acknowledgement of a debt by a company, normally containing provisions as to payment of interest and the terms of repayment of principal. A bond may be secured on some or all of the assets
of the company or its subsidiaries. A debenture is usually unsecured.
What are the more common forms of bond?
Irredeemable – bonds with no redemption date, whose interest will continue to be paid into the foreseeable future.
Redeemable – bonds which will mature at the end of a specified period, with a redemption payment being made to the investor.
Zero coupon – bonds that are issued at a discount to their redemption value, but no interest is paid on them. The investor gains from the difference between the issue price and the redemption value.
Convertible bond – A liability that gives the holder the right to convert into another instrument, normally ordinary shares, at a predetermined price/rate and time.
Fixed coupon – where the coupon is at a set level for the entire life of the bond.
Floating coupon – where the coupon varies as the yield on a benchmark interest rate varies
Convertible bonds
What are they and when / why are they used?
Convertible bonds give the holder the right, but not the obligation, to convert the bond into a pre-determined number of shares on a pre-determined date.
This should reduce the required yield on the bond.
If a company has convertible bonds in issue, you may be required to calculate its diluted earnings per share (EPS) for disclosure under IAS 33
How is this done?
EPS = earnings / number of ordinary shares in issue
Where earnings = profits after tax – preference dividends
Diluted EPS is calculated in the same way, but assuming that all convertible bonds have been
converted (and any share options have been exercised)
Charges
Bonds may have fixed or floating charges over the assets of a company.
What’s the difference?
A fixed charge gives security over a specific asset or group of assets, typically land and buildings.
A floating charge gives security over the general assets of the business
Summary of volatility
Features that lead to high volatility?
Long dated
Low coupon
Low yields
Summary of volatility
Features that lead to low volatility?
Short dated
High coupon
High yields
Duration
What is it?
This calculation gives each bond an overall risk weighting that allows two bonds to be compared. In
simple terms, it is a composite measure of the risk expressed in years.
In simple terms, duration is the weighted average length of time to the receipt of a bond’s benefits (coupon and redemption value)
The basic features of sensitivity to interest rate risk will all be mirrored in duration.
Longer-dated bonds will have longer durations.
Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero-coupon bond where the duration will be the maturity.
Lower yields will give longer durations. In this case, the present value of flows in the future will
rise if the yield falls, extending the point of balance, therefore lengthening the duration
Credit risk (also referred to as default risk)
What is it?
The risk undertaken by the lender that the borrower will default either on interest payments or on the
repayment of principal on the due date, or on both. The credit risk of an individual loan or bond is determined by the following two factors:
The probability of default
The recovery rate (the fraction of the face value of an obligation that can be recovered once the
borrower has defaulted)
Covenants
Bank loans and bonds may have covenants attached to them. These are legally enforceable conditions
agreed to by the borrower and the lender. Some typical covenants include
The borrower must maintain certain types of insurance
Quarterly or monthly financial statements must be submitted to the lender and may need to be audited
The borrower may need to maintain certain financial ratios above or below specified levels
Choice of finance
If a company is trying to decide which source of finance is most appropriate for a planned expansion or acquisition, the following factors may be considered:
Issue costs
Annual cost (Ke, Kd, or Kp)
Liquidity (required cash flows)
Duration
Covenants
Security required
Availability
Dilution of control
Currency
Effect on financial statements and financial ratios
Leasing
Rather than buying an asset outright, using either available cash resources or borrowed funds, a
business may lease an asset
Advantages for the lessee:
No need to find cash up front
May be cheaper than a bank loan.
Tax Relief on payments
Lease or buy
In order to decide whether to lease or buy an asset, a business should compare the cash flows of purchasing against those of leasing or hire purchase arrangements, discounted at an after-tax cost of borrowing.
There’s an example question
