2 - The Share Market

Question 1

What is Limited liability?

Answer 1

The liability of the shareholders of a company is limited to the share’s fully-paid price. Where partly-paid shares are issued, the shareholder is liable to pay the company the balance of the share’s paid-up value.

Question 2

What are Partly-paid shares?

Answer 2

Shares that have been issued for part of their paid-up amount only, with the balance being payable at a later date.

Question 3

What are Ordinary Shares?

Answer 3

Ordinary shares are the securities issued to the owners of a company in return for providing equity finance.

Question 4

How do shares earn a return?

Answer 4

Ordinary shares earn a return from dividend payments and earn capital gains when their market price increases. These returns potentially have an ‘unlimited upside’ – that is, a firm may increase the amount of its future dividend payments and there is no fixed upper limit to a share price.

Question 5

How are Dividends Usually Paid?

Answer 5

Dividends are usually paid semi-annually. The dividends are denoted as being either an interim dividend, which is paid during a company’s financial year, or a final dividend, which is paid after the end of the financial year.

Question 6

What are Preference Shares?

Answer 6

Shares that promise a stated dividend payment, which ranks before dividend payments to ordinary shareholders. They do not usually entail any voting rights.

Question 7

What two factors need to be considered when comparing the yield represented by dividends (the dividend as a percentage of the share price) with the market yield for debt securities?

Answer 7

1. The payment of interest by a firm has priority over its payment of a dividend to ordinary shareholders (and so is less risky) 2. Share prices have greater opportunities for capital gains, which enhances the returns to the shareholder. The returns to equity were shown to be higher but more volatile than the returns on debt.

Question 8

What characteristics are held by most preference shares?

Answer 8

They are non-participating, cumulative, non-converting and irredeemable.

Question 9

Explain non-participating as it pertains to preference shares?

Answer 9

This means the shareholders would not receive bonuses such as special dividends or issues of bonus shares (free additional shares issued by a company).

Question 10

Explain cumulative as it pertains to preference shares?

Answer 10

When the company promises to subsequently make up any missed dividend payments (should subsequent profits permit).

Question 11

Explain converting as it pertains to preference shares?

Answer 11

Converting preference shares convert to ordinary shares on a specified date at a specified ratio.

Question 12

Explain Redeemable as it pertains to preference shares?

Answer 12

Companies issue redeemable preference shares on the terms that they are liable to be redeemed. They are redeemable at: • a fixed time or on the happening of a particular event. • the company’s option; or • the shareholder’s option.

Question 13

What is the P/E ratio?

Answer 13

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).

Question 14

What is the formula for the P/E ratio?

Answer 14

P/E Ratio = Market Value Per Share/Earnings Per Share.

Question 15

What could a high P/E Ratio Mean?

Answer 15

A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future.

Question 16

What formula allows P/E ratios to be used in conjunction with estimated earnings to provide estimates of share-price changes?

Answer 16

P₁ = (P/E)₀ x E₁

Where:

P₁ = The predicted share price next period

(P/E)₀ = The existing P/E ratio

E₁ = The estimate of the next period’s EPS.

Question 17

What is the formula to work out EPS using the P/E Ratio?

Answer 17

EPS = (Share Price) / (P/E Ratio)

Question 18

What is Gordon’s dividend growth model?

Answer 18

A model for estimating a share’s price based on the present value of its expected future dividends, which are assumed to grow at a constant rate.

Question 19

What is a Perpetuity?

Answer 19

A series of regular cash flows that continue indefinitely.

Question 20

What is the formula for Gordon’s dividend growth model?

Answer 20

P₀ = D₀ (1 + g) / r - g

Where D₀ = Current annual dividend payment

g = Assumed dividend growth rate

r = The interest rate to discount future payments

Question 21

What is the formula for calculating a dividends annual growth rate?

Answer 21

g = (D_n/D₀) ^(1/n) -1

D_n = Last Annual Dividend

D₀ = The first annual dividend

n = Number of years

Question 22

What is Systematic risk?

Answer 22

Risk that is common to all securities of the same class; also known as market risk. It cannot be reduced by diversification through holding more securities of the same class.

Question 23

What is Beta?

Answer 23

The measure of an asset’s systematic risk; it is a measure of the variation in the returns on an individual investment relative to the market portfolio’s returns.

Question 24

What does CAPM stand for?

Answer 24

Capital Asset Pricing Model

Question 25

What is the CAPM formula?

Answer 25

r_Firm= r_riskfree + b_Firm (r_market –r_riskfree)

Where:

r_Firm= Required rate of return

r_riskfree = Riskfree Rate

b_Firm = The stocks beta

r_market = The Market Rate

Question 26

What is an IPO?

Answer 26

Initial public offering (IPO) The initial sale of shares in a company that is seeking listing on the stock exchange.

Done on the Primary Market.

Question 27

What is Privatisation?

Answer 27

The sale of a public enterprise by the government through an IPO.

Question 28

What are Carve-outs?

Answer 28

The sale of part of a large business through an IPO for the new company.

Question 29

What is Demutualisation?

Answer 29

The conversion of a mutual organisation into a company.

Question 30

What are two main reasons are company would go public?

Answer 30

1. to raise additional equity capital that will finance the company’s planned growth
2. to allow some (or all) of the owners to sell all or part of their interest in the company.

Question 31

What is the Dilution effect?

Answer 31

Also known as equity dilution, is the decrease in existing shareholders’ ownership percentage of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders.

Question 32

What is some of the information included in a prospectus?

Answer 32

A prospectus includes some of the following information:
A brief summary of the company’s background and financial information
The name of the company issuing the stock
The number of shares
Type of securities being offered
Whether an offering is public or private
Names of the company’s principals
Names of the banks or financial companies performing the underwriting

Question 33

What is one of the main reasons the pricing for an IPO is negotiated?

Answer 33

prior to the IPO there can be no secondary
market for the shares to discover their fair value (except for IPOs that are spun out of an already listed company).

Question 34

What is Market capitalisation?

Question 35

When can we tell if an IPO was under or overpriced?

Answer 35

The price at which the shares trade on the first day after listing (on the secondary market) indicates whether the shares were under-or overpriced. If the market price were higher than the IPO price, the issuer would raise less capital than its market capitalisation, with the difference referred to as ‘money left on the table’.

Question 36

What are some possible causes of the The underpricing phenomenon?

Answer 36

• the desire of the seller in the primary market to achieve a successful float (which is more likely if the shares are offered at a relatively low price)
• providing the buyers of shares in the IPO with an initial capital gain, to create goodwill that the issuer can draw on in subsequent share offers
• the risk accepted by the buyers of shares in the IPO given that underpricing is not guaranteed
• the superior negotiating power over the seller of the investment bank handling the process (especially in small IPOs)
• that the original owners who have retained a substantial holding of shares in the new company benefit from the underpricing, even though the company could have raised a greater amount through the IPO

Question 37

What are 4 ways a company can raise additional equity?

Answer 37

• Internally through retained earnings
• rights issues
• private placements
• dividend reinvestment schemes

Question 38

What are retained earnings?

Answer 38

The earnings (profits) of a firm that are not paid out to shareholders as dividends.

Question 39

What is a share buy-back scheme?

Answer 39

A process whereby a company purchases shares from existing shareholders.

Question 40

What are 3 reasons a company would initiate a share buy-back?

Answer 40

1. It increases the firm’s EPS, since the number of shares is reduced.
2. To return funds to shareholders when the company does not have any identified projects with a sufficiently large return to justify the investment risk.
3. A more cynical view is that share buy-backs are often initiated by a company’s top management in order to put upward pressure on the share price, thus making it more likely that they will achieve share-price growth targets and hence realise their bonus performance targets.

Question 41

What is a Seasoned Offering?

Answer 41

When firms require a substantial increase in their equity capital they will generally issue additional shares, This term is used because the company’s shares are trading in the share market, and thus investors know their value.

Question 42

What is a rights Issue?

Answer 42

a rights issue involves the issue to all of a company’s shareholders of ‘rights’ to buy new shares at a stated ‘subscription’ price on the scheduled subscription date. The subscription price is set at a discount to the current share price to encourage the use of rights as vehicles for selling the new shares. A rights issue has the potential to raise a substantial amount of equity capital, and is the method used when this is the company’s aim.

Question 43

What does Renounceable mean as it pertains to a rights issue?

Answer 43

In most cases these rights are renounceable, meaning they become temporary securities that can be traded prior to their expiry date.

Question 44

What are four of the key things that will be specified by a rights issue?

Answer 44

A rights issue will specify:

• the ex-rights date (when the rights are assigned to shareholders)
• the terms of the issue (such as ‘one-for-five’, where shareholders receive one right for every five shares they own)
• the subscription price and subscription date
• whether the rights can be traded.

Question 45

What is the main risk that may cause a rights issue to fail?

Answer 45

The main risk is posed by volatility in the company’s share price during the period over which the rights issue is conducted. Specifically, events external to the company (or within the company) could trigger a fall in the share price that makes the subscription price unattractive as at the subscription date, and so the rights would not be exercised.

Question 46

What does trading cum-rights mean as it pertains to a rights issue?

Answer 46

Once a company has decided to make a rights issue, it will advise the share market and its shareholders of this. Following this announcement (and prior to the assignment of the rights), the company’s shares will trade on the basis that shareholders will receive the rights. During this period the share price is referred to as a cum-rights price (signifying that whoever owns the shares will be entitled to the rights).

Question 47

What does trading ex-rights mean as it pertains to a rights-issue?

Answer 47

The announcement of a rights issue will indicate the date on which the shares go ex-rights, as well as the subscription date for the issue. The ex-rights date serves to identify who owns the shares when the rights are allocated and indicates when the rights can be traded in the market as a distinct security. Hence, from the ex-rights date the shares and the rights will trade during the ex-rights period (up to the subscription date) as separate instruments.

Question 48

Why does a rights issue cause a drop in share price?

Answer 48

On the ex-rights date the share price can be expected to fall, because the rights then exist as separate instruments and no longer form part of the value of the shares. The extent of the fall in share price is related to the value of the rights. The rights can be traded until their expiry date – namely, the subscription date.

Question 49

What is the formula to calculate the value of the right to subscripe to a rights issue.

Answer 49

R = n(P - S) / n + 1

Where:

R = the value of the right to subscribe to one new share

n = the number of shares that attract the right to subscribe to a new share

P = the cum-rights share price in the share market

S = the subscription price for the new shares.

Question 50

What is the formula to calculate the ex-rights price of a share?

Answer 50

P_ex-rights = P - (R/n)

Where:

R is the value of the right to subscribe to one new share

n is the number of shares that attract the right to subscribe to a new share

P is the cum-rights share price in the share market.

Question 51

Describe the three general functions performed by secondary markets for equities?

Answer 51

• It carries out price discovery.
• The share market generates liquidity for listed shares.
• The market facilitates the flow of funds by pooling investments from many investors, who each supply relatively small amounts, into the large amounts of equity required by large companies.

Question 52

What is price discovery?

Answer 52

Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs.

Question 53

What types of shares trade on the ASX?

Answer 53

1. Ordinary Shares
2. Preference Shares
3. Partly-Paid Shares

Question 54

What are dividends?

Answer 54

A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business.

Question 55

What is a private placement?

Answer 55

The sale of large parcels of securities to one or more investors .

Question 56

What are 3 advantages of private placement over rights issues?

Answer 56

1. The placement can be made much more quickly than through a rights issue (private placements can be achieved in a few days, whereas rights issues usually take several months), because the issue is not based on an offering document such as a prospectus.
2. The price the company receives for the new shares is generally higher than that received through a rights issue (the latter being less than the current share price).
3. The shares can be placed with an institutional investor that supports the current management of the company, thereby reducing the risk of a takeover.

Question 57

What is the main disadvantage of a private placement?

Answer 57

they dilute the proportionate claims of existing shareholders to the company’s future profits. Because of ASX rules, private placements usually represent less than 10 per cent of the number of shares (and equivalent securities) of a company. Larger private placements can be made, but they require shareholder approval, which would increase the time involved in arranging the placement.

Question 58

What is a Dividend reinvestment plan?

Answer 58

An arrangement that allows shareholders to reinvest their dividends in further shares in the company. Dividend reinvestment plans are an important source of raising equity capital in Australia. They are equivalent to retained earnings, since they enable the company to retain the profits they would have paid out in dividends.

Question 59

What purposes of Price discovery by the share market serve?

Answer 59

It determines the entry and exit values for equity investors.

It values the equity capital of listed companies, and so reveals part of the wealth of the economy as well as the value of individual companies. It also helps to determine the price for newly issued securities. When expressed by indices, share prices reveal the general movements in equity values.

Question 60

Explain the term market discipline?

Answer 60

The term market discipline refers to the influence that movements in share prices have on the behaviour of a company’s senior managers. Share price increases that are attributed to new management policies would signal market approval, whereas falls in a company’s share price attributed to management policies would signal market disapproval. Should management respond to these signals, it will have influenced the firm’s corporate governance.

Question 61

What is corporate governence?

Answer 61

The decision-making processes used by a company’s top management and the processes through which management is held accountable.

Question 62

What is the risk ransfer function?

Answer 62

The third function ofthe financial system is to meet the need for managing risks, whether they are faced by traders in financial markets, clients of financial institutions or financial institutions themselves. The risk-transfer function is so named because risk cannot be made to disappear by the financial system. The risk one trader faces can be eliminated for that trader only by exchanging it (with another trader) for another risk, with the risk being thus transferred for a less onerous risk.

Question 63

From where do the two most important sources of risk in the financial system arise?

Answer 63

1. from the possibility of default (such as loan payment defaults).
2. from unexpected movements in financial variables.

Question 64

What is market risk?

Answer 64

The risk of loss from unexpected changes in market variables. The fundamental causes of market risk are that the future cannot be predicted with certainty, and that many financial variables (such as share prices, exchange rates and interest rates) vary over time in what appears to be a random fashion, especially when one is trying to predict future values.

Question 65

What is a Derivative?

Answer 65

A contract whose value is linked to the value of another financial instrument, market variable or index. There are a wide range of derivatives, but the basic feature of most of them is that they provide financial protection against unexpected future changes in a variable, or from specified adverse future events. These instruments are contracts, and they are known as ‘derivatives’ because their value is based on the value of their contract’s item.

Question 66

What is a Forward contract?

Answer 66

An agreement to trade a specified amount of a specified item at a future date at the price in the forward contract.

It is a type of derivative Commonly used to transfer risk.

Question 67

What is Interest Rate risk?

Answer 67

The chance of loss arising from an unexpected movement in interest rates.

Question 68

What is Foreign-exchange risk?

Answer 68

The chance of loss arising from an unexpected movement in exchange rates.

Question 69

What are Forward interest rates?

Answer 69

Interest rates that apply for a specified future period (or periods) on a specified sum.

Question 70

What is a Forward FX contract?

Answer 70

A contract that commits the buyer and seller of a specified amount of a foreign currency to the exchange rate that will be used at the specified future date when the currency will be exchanged.

Question 71

What are share price indices?

Answer 71

A Share indice, or index, measures a share market, or a subset of the share market, that helps investors compare current price levels with past prices to calculate market performance.

Question 72

How can investors invest in a share indice?

Answer 72

Investors can invest in a share market index by buying an index fund, which are structured as either a mutual fund or an exchange-traded fund, and “track” an index. The difference between an index fund’s performance and the index, if any, is called tracking error.

Question 73

What is the ASX?

Answer 73

The Australian Securities Exchange. It is Australia’s primary securities exchange. It is owned by the Australian Securities Exchange Ltd, or ASX Limited, an Australian public company

Question 74

What are some of the rules and requirements for a company to be listed on the ASX?

Answer 74

• The listed entity must have a constitution that is consistent with the listing rules.
• Securities must be issued in circumstances that are fair to existing security-holders.
• A prospectus (or product disclosure statement or information memorandum) must be lodged with the Australian Securities and Investments Commission (ASIC).
• The listed entity must have a minimum number of shareholders.
• If the entity is a trust, it must be a registered managed investment scheme.
• The entity must satisfy either the profits test or the assets test and have adequate working capital.

Question 75

What is ASIC?

Answer 75

The Australian Securities and Investments Commission.

ASIC is an independent Australian government body that acts as Australia’s corporate regulator.

ASIC’s role is to enforce and regulate company and financial services laws to protect Australian consumers, investors and creditors.

ASIC’s authority and scope is determined by the Australian Securities and Investments Commission Act, 2001

ASIC is responsible for the administration of all or parts of the following legislation:

Corporations Act 2001

Insurance Contracts Act, 1984

National Consumer Credit Protection Act, 2009

Question 76

What is the ASX’s continuous disclosure policy?

Answer 76

firms must immediately advise the ASX of any new price-sensitive information.

Question 77

What is Liquidity?

Answer 77

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.

Question 78

What are 3 indicators of a markets liquidity?

Answer 78

the daily turnover, the bid–ask spread and price resilience.

Question 79

What is daily turnover?

Answer 79

Daily turnover is a measure of stock liquidity calculated by dividing the total number of shares traded over a daily period by the average number of shares outstanding for the daily period. The higher the share turnover, the more liquid company shares are.

Question 80

What is the bid-ask spread?

Answer 80

The bid–ask spread, is the difference between the prices quoted for an immediate sale and an immediate purchase for stocks, futures contracts, options, or currency pairs. The size of the bid–ask spread in a security is one measure of the liquidity of the market and of the size of the transaction cost.

Question 81

What is price resilience?

Answer 81

One of the measures of a market’s liquidity. It can describe how quickly prices in a particular market return to normal following a large order. A large order can cause temporary price disruption in a market. For example, the sale of a large block of shares in a relatively small company may lead to a drop in their price. Resiliency gauges how quickly a market responds to prices that are temporarily incorrect.

Question 82

What is Market capitalization?

Answer 82

Market capitalization, commonly called market cap, is the market value of a publicly traded company’s outstanding shares.

Question 83

What Is a Capitalization-Weighted Index?

Answer 83

A capitalization-weighted index is a type of market index with individual components, or securities, weighted according to their total market capitalization. The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index.

Question 84

How do you find the value of a cap-weighted index?

Answer 84

To find the value of a cap-weighted index, we can multiply each component’s market price by its total outstanding shares to arrive at the total market value. The proportion of the stock’s value to the overall total market value of the index components provides the weighting of the company in the index.

Question 85

What does it mean for an index to be float adjusted?

Answer 85

The original market cap-weighted indexes included all of a company’s outstanding shares. This method is problematic in cases where companies have shares that are not fully available for trade on the open market, such as government-held shares or large privately-controlled holdings. Float adjusting an index means that only shares that are readily available to the public are represented in the index.

Question 86

What sort of index is the S&P ASX 200?

Answer 86

The S&P/ASX 200 index is a market-capitalization weighted and float-adjusted stock market index of stocks listed on the Australian Securities Exchange (ASX).

Question 87

How are index values derived?

Answer 87

When an index is first created, a starting (base) value is chosen.

The next step is to determine the index divisor by dividing the total market value of the index by the base index value.

Each day, as the market values of the stocks in the index fluctuate based on changes to their prices, the new total market value of the index is divided by the same divisor to produce a new index value.

The divisor remains constant until the index constituency changes. For example, if a stock is delisted or a stock split occurs, the divisor will be recalculated to be reflective of the new index membership.

Question 88

What is the formula for deriving index values?

Answer 88

Index_t = Σ P_i,t x Q_i,t / Divisor

Where: P_i,t is the share price of company i on day t and Q_i,t is the number of issued shares for company i on day t.

Question 89

How can we find an index’s divisor?

Answer 89

We can find the divisor’s value at any time by dividing the index’s current market capitalisation by the current index.

Question 90

What is Holding Period Return (HPR)?

Answer 90

Holding period return is the total return received from holding an asset or portfolio of assets over a period of time, known as the holding period, generally expressed as a percentage. Holding period return is calculated on the basis of total returns from the asset or portfolio (income plus changes in value). It is particularly useful for comparing returns between investments held for different periods of time.

Question 91

What is the formula for working out HPR?

Answer 91

Holding Period Return = Income + (End Of Period Value − Initial Value)​​ / Initial Value

Question 92

What Is Return on Investment (ROI)?

Answer 92

Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

Question 93

What is the formula for ROI?

Answer 93

ROI = Current Value of Investment − Cost of Investment / Cost of Investment​​

Question 94

What Is Mean Return?