5.) Raising Capital through Equity

Question 1

Briefly describe how response to supply and demand may cause share prices to fluctuate

Answer 1

An increase in demand, and a reduction in supply will drive prices up, versus a decrease in demand and an increase in supply will drive prices down

Question 2

Define why shares are seen as volatile investments

Answer 2

Their price can fluctuate

Question 3

Define the reasons why share prices fluctuate

Answer 3

Response to supply and demand. An increase in demand, and a reduction in supply will drive prices up, versus a decrease in demand and an increase in supply will drive prices down

Poor/favourable company results or unexpected results

Takeover bid rumours/speculation

Poor/good management

Political climate

Economic climate including interest rates, exchange rates, inflation rate

Price movements on other major stock markets

Actions taken by speculators

Confidence in the markets

Note that share prices are deemed as volatile investments due to the fact that their price can fluctuate

Further note that equity investments (stocks) can provide income and capital growth to the investor, but holders face various risks including:

The risk of an adverse price movement

The risk of potential difficulty in selling the shares

The risk that the profit the company makes won’t be adequate to pay a dividend return.

Question 4

Define ordinary shares

Answer 4

Ordinary shares represent the portion of a company’s capital that’s owned by the ordinary shareholder.

The number of shares issued by a company is determined by the amount of share capital to be raised and the par value or nominal value of the shares.

E.g. ABC Company may seek to raise £500,000 by issuing 500,000 ordinary shares with a par value of £1 or by issuing 1,000,000 ordinary shares with a par value of £0.50p

Question 5

Define and briefly describe examples of shareholders rights

Answer 5

Ordinary shareholders have an ownership stake in the company, which attach to it a number of rights:

Right to a dividend, a variable share in the profits of the company (note that investors will also stand to lose money if the company underperforms or goes into liquidation)

Right to attend, speak, vote and appoint a proxy in the company’s AGM (Annual General Meeting)

Right to a surplus on liquidation (other liabilities and creditors will have to be repaid before the ordinary shareholders receive anything)

Right to statutory protection for minority shareholders, provided by the Companies Act 1985 and 1989

Right to receive the company’s annual reports and accounts

Right to subscribe for any new share capital or loan stock in proportion to existing holdings

Right to receive bonus issues in proportion to existing holdings

Right to transfer their shares freely (unless restrictions apply in the Articles of Association)

Question 6

Define dividend

Answer 6

A variable share in the profits of a company, payable to shareholders

Question 7

Define the acronym AGM

Answer 7

Annual General Meeting

Question 8

Define the different types of ordinary shares

Answer 8

Ordinary shares

‘A’ Ordinary shares

‘B’ Ordinary shares

Deferred Dividend shares

Deferred Ordinary shares

Redeemable shares

Question 9

Define the key characteristics of Ordinary shares

Answer 9

Holders have full voting rights and are entitled to dividends

Question 10

Define the key characteristics of ‘A’ Ordinary shares, as a type of ordinary shares

Answer 10

Holders won’t have voting rights, but will be entitled to dividends. Market price will normally be lower due to the lack of voting rights

Question 11

Define the key characteristics of ‘B’ Ordinary shares, as a type of ordinary shares

Answer 11

Shares rank equally with ordinary shares except that instead of a cash dividend, shareholders receive a free issue of shares to the equivalent value

Question 12

Define the key characteristics of Deffered Dividend shares, as a type of ordinary shares

Answer 12

Shares rank equally with ordinary shares, but the payment of dividends is deferred until a specified date.

Market price will normally be lower and are more attractive to investors seeking capital growth rather than income

Question 13

Define the key characteristics of Deffered Ordinary shares, as a type of ordinary shares

Answer 13

Also referred to as founder shares - holders aren’t entitled to any dividend until the rest of the ordinary shares have reached a minimum level

Question 14

What are Deffered Ordinary shares also referred to as?

Answer 14

Founder shares

Question 15

Define the key characteristics of Redeemable shares, as a type of ordinary shares

Answer 15

Shares are redeemable at the company’s option at some time in the future for a sum of money

Question 16

Define Preference shares

Answer 16

All companies that are quoted on the stock exchange must have ordinary shares, but they need not have preference shares.

Preference shares give superior rights to their holders over and above ordinary shares.

They are not equity capital so technically cannot be referred to as equities

Preference shares do not normally carry the right to vote in general meetings, but to compensate dividends are constant and are expressed as a percentage of the nominal value of the shares.

Although there is a fixed dividend payable, this is not guaranteed.

Preference shares can only be paid from available profits, and at the discretion of the directors.

Therefore, if no profits exist to cover the dividend payment, the preference dividend may not be made

Question 17

Define and describe the rights of a shareholder of a preference share

Answer 17

Preference share values are constant, and are expressed as a percentage of the nominal value of the shares

Preference shareholders have priority of dividend payment over ordinary shareholders; no ordinary dividend can be paid unless the preference shareholders have received their dividend

Preference shareholder dividends are usually cumulative, unless otherwise stated, thereby giving the preference shareholders rights to receive any arrears of dividend from the company

Preference shareholders will usually have priority of repayment over the ordinary shareholders should the company go into liquidation. The repayment will only be the nominal amount of the shares, the preference shareholder will not be entitled to participate in any surplus

Question 18

Define and briefly describe the various types of preference shares

Answer 18

Cumulative - if the company is unable to pay a dividend, the unpaid dividend is accumulated and will be paid once the company had earned sufficient profits

Non-cumulative - any unpaid dividend is NOT accumulated and is NOT paid to the preference shareholder

Participating - a fixed dividend is received plus a right to participate in surplus profits of the company along with ordinary shareholders

Redeemable - the company has the right to redeem the shares at some point in the future

Convertible - the preference shareholder had the right to covert at some future date to a specified quantity of ordinary shares

Question 19

Define shareholders

Answer 19

Shareholders are owners of a limited company, and as owners of fully paid shares, do not have legal responsibility for the company’s debts. This ownership cannot make the shareholder personally liable.

Should the company go into liquidation, the shareholder will be entitled to receive any surplus only after payment of all external liabilities

Question 20

Define directors

Answer 20

Directors manage the day-to-day business and operational activities on the shareholders behalf.

Executive directors are appointed and removed by the shareholders of the company, usually at the Annual General Meeting (AGM).

Executive directors have a legal obligation to run a company in the best interests of the shareholders and are usually appointed due to their business acumen, experience, knowledge and skills

Question 21

Compare the roles of shareholders and directors in a limited company

Answer 21

Shareholders are owners of a limited company, and as owners of fully paid shares, do not have legal responsibility for the company’s debts. This ownership cannot make the shareholder personally liable.

Should the company go into liquidation, the shareholder will be entitled to receive any surplus only after payment of all external liabilities

Directors manage the day-to-day business and operational activities on the shareholders behalf.

Executive directors are appointed and removed by the shareholders of the company, usually at the Annual General Meeting (AGM).

Executive directors have a legal obligation to run a company in the best interests of the shareholders and are usually appointed due to their business acumen, experience, knowledge and skills

Question 22

Define dividends

Answer 22

Dividends represent an ordinary shareholder’s share of the company’s profits in proportion to their share holding. From any profits earned, companies will pay dividends to its shareholders, but will also retain a substantial part of its profits in order to provide for maintenance and expansion of the business.

This element of ‘retained profits’ is critical as it provides reserves to the company should it require cash in future years. It is also fully attributable to the ordinary shareholder

Question 23

Define retained profits

Answer 23

Retained profits is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to pay debt.

Question 24

Define who in a company declares dividends, and how they may be declared

Answer 24

Dividends are declared by the directors of the company, and may include ‘interim’ and a ‘final’ dividend:

The interim dividend may be declared at some point during the trading year

The final dividend is declared and approved at the company’s AGM

Question 25

Define why the amount of dividend that a shareholder receives may vary, and what forms dividends can take

Answer 25

The amount of dividend received by the ordinary shareholder isn’t a fixed amount, and will vary according to the dividend policy and profits earned by the company during that trading year.

A company may choose to pay a dividend using:

A cash sum

By a ‘scrip’ - issuing new shares instead of cash

By a ‘special dividend’ - an additional, one-off dividend

Question 26

When will the amount of a dividend to be paid out, the dividend payment date and the record date of a dividend be announced?

Answer 26

On the declaration date

Question 27

Define how a shareholder is seen to be eligible to receive a dividend

Answer 27

To be eligible to receive a dividend, a shareholder must be a registered member of the shares as at the record date.

The ‘record date’ is the cut-off date selected by the company to determine which shareholders will receive the dividend payment

Question 28

Define the ‘record date’, in terms of dividends to be paid to shareholders

Answer 28

The ‘record date’ is the cut-off date selected by the company to determine which shareholders will receive the dividend payment

Question 29

Describe why there must be a cut-off time before the record date, for investors who are willing to buy and sell shares?

Answer 29

This gives the registrars time to compile an accurate list of eligible shareholders.

This ex-dividend date is determined by the stock exchange.

The share price will be quoted with the letters ‘xd’ after it. This advises investors that during this period (around 5 working days), the buyer of shares won’t receive the next dividend, which will be retained by the seller. The price of shares will fall to reflect this. The opposite of ‘xd’ is cum dividend

Question 30

Define the advantages of holding shares as an asset

Answer 30

Benefit from capital gains if share prices rise over a period of time

Benefit from income if the company pays a dividend from profits

Diversify risk by buying shares in different companies, sectors, geographic locations

Owner in the company therefore have various rights

Easily transferable, therefore able to buy and sell the investment

Information on popular shares are easily available, and investor can keep a track on his investment

Question 31

Define the disadvantages of holding shares as an asset

Answer 31

Exposed to capital risk if share prices fall over a period of time

Income is only available if the company has made a profit - there’s no guarantee that it will have

Cannot vote to increase the dividend, as this is at the discretion of the directors

The asset is unsecured, therefore in the event of a company’s liquidation, you may not receive your capital investment if there isn’t enough funds to pay other creditors

Any capital gains is subject to CGT

Despite diversification, investments will still be subject to systemic (market) risks which affect all portfolios (interest rate risk, economic risk, foreign exchange risk, etc)