CEMAP 1 Topic 7- Other direct investments Flashcards
What are equities?
Equities, AKA ordinary shares, are the most important type of security that are issued by UK companies. They can be bought by private investors, but most transactions in equities are made by institutions and by life and pension funds.
Holders of ordinary shares (shareholders) are in effect the owners of the company. The two main rights that they have are to:
- receive a share of the distributed profits of the company as income in the form of dividends; and
- participate in decisions about how the company is run, by voting at shareholders’ meetings.
The rights attaching to shares of the same class can sometimes differ. These rights are set out in the company’s articles of association; this is a public document and can be examined at the
registered office of the company or at Companies House.
Direct investment in shares is higher risk because the failure of the company can result in the loss of all the capital invested. This risk can be mitigated by investing across a range of shares in different companies operating in different sectors. There are several products to enable investors to do this, such as unit
trusts.
Factors affecting share prices:
- Company profitability
- Strength of the market sector
- Supply and Demand for shares and other investments
- Strength of the UK and Global economy
KEY TERMS
SECURITIES
Financial assets that can be traded. They can be divided into two broad classes: those that represent ownership (equities) and those that
represent debt (such as gilts and corporate bonds).
DIVIDEND
A portion of a company’s profits that is distributed to shareholders. The level of dividend available is dependent on the profitability of the company and strategic decisions such as the need to reinvest profits to
expand the business.
How are shares bought and sold?
The Stock Exchange is London’s market for stocks and shares.
Shares, gilts, corporate bonds and options are all traded on this market. There are two
markets for shares: the main market and the
Alternative Investment Market.
The main market
To be listed on the main market, companies must conform to the stringent requirements of the Listing Rules laid down by the FCA, acting in its capacity as the UK Listing Authority (UKLA).
For a full listing, a considerable amount of accurate financial and other information must be disclosed. In addition:
- the applicant company must have been trading for at least three years;
- at least 25 per cent of its issued share capital must be in the hands of the public.
The London Stock Exchange, like most stock markets, is both a primary and secondary market.
The primary market is where companies and financial organisations can raise finance by selling securities to investors. They will either be coming to the market for the first time, through the process of ‘going public’ or ‘flotation’, or issuing more shares to the market. The main advantages of listing include greater ease with which shares can be bought or sold, and
the greater ease with which companies can raise additional funds.
The secondary market is where investors buy and sell existing securities. It is much bigger than the primary market in terms of the number of securities traded each day.
Alternative Investment Market
The Alternative Investment Market (AIM) is mainly intended for new, small companies with the potential for growth.
Its purpose is to enable suitable companies to raise capital by issuing shares, and it allows those shares to be traded. In addition to the benefit of access to public finance, companies will enjoy a wider public audience and enhance
their profiles by joining the AIM.
Rules for joining the AIM are fewer and less rigorous than those for joining the main market and were designed with smaller companies
in mind.
Returns from shares
Shareholders in a limited liability company do not have a liability for the debts of the company. The company is, legally, a separate entity from its owners and is liable for its own debts. Shareholders do run the risk that the value of their investment in the company could go down; if the company goes into liquidation they could lose their investment altogether.
EX‑DIVIDEND SHARES
Dividends are usually paid half‑yearly. Once the date has passed when the administrative process of paying the dividend starts, the shares are said to be ex‑dividend (or xd). The share price would normally be expected to fall by approximately the dividend amount on the day it becomes xd. Alternatively, a share may be paid cum‑dividend, which means that it is purchased before it goes xd, and the purchaser receives the next dividend payment.
The financial returns that shareholders hope to receive from their shares take two forms:
- The growth in the share price (capital growth); and
- The dividends they receive as their share of the company’s distributable profits (income).
Measures that can be used to assess the success of investment:
Earnings per share
This is equal to the company’s post‑tax net profit divided by the number of shares, but it is not normally the amount of dividend to which shareholders are entitled on each of their shares. This is because a company may choose not to distribute all of its profits: some profits might be retained in the business to finance expansion. This in turn leads to the concept of dividend cover.
Dividend cover
This factor indicates how much of a company’s profits are paid out as dividends in a particular distribution. If, for example, 50 per cent of the profits are paid in dividends, the dividend is said to be covered twice. Cover of 2.0 or more is considered to be acceptable by investors, whereas a figure below 1.0 indicates that a company is paying part of its dividend out of retained surpluses from previous years.
Price/earnings ratio
The price/earnings (P/E) ratio is calculated as the share price divided by the earnings per share.
Earnings per share (EPS) = post‑tax net profit ÷ number of shares
Dividend cover = how much of company profits are paid as dividends
P/E ratio = share price ÷ earnings per share
Taxation of Dividends
Dividends are paid without deduction of tax but are subject to income tax. Everyone is entitled to a dividend allowance (DA). If an individual’s aggregate dividend income in a tax year falls within the DA, no tax is payable. If dividend income exceeds the DA, it is taxed at different rates depending on the tax band into which it falls.
Gains realised on the sale of shares are subject to capital gains tax (CGT), although investors may be able to offset the gain against their annual CGT exemption.
Other ways of investing in companies
Rights issues
Stock Exchange rules require that, when an existing company that already has shareholders wishes to raise further capital by issuing more shares, those shares must first be offered to the existing shareholders. This is done by means of a rights issue offering, for example, one new share per three shares already held, generally at a discount to the price at which the new shares are expected to commence trading. Shareholders who do not wish to take up this
right can sell the right to someone else, in which case the sale proceeds from selling the rights compensate for any fall in value of their existing shares (due to the dilution of their holding as a proportion of the total shareholding).
Scrip issues
Scrip issue, also known as a bonus issue or a capitalisation issue, is an issue of additional shares, free of charge, to existing shareholders. No additional capital is raised by this action – it is achieved by transferring reserves into the
company’s share account. The effect is to increase the number of shares and to reduce the share price proportionately
.
Preference shares
As with ordinary shares, holders of preference shares are entitled to dividends payable from the company’s profits. They differ from ordinary shares in that they are generally paid at a fixed rate, and holders of preference shares are eligible for any dividend pay-out ahead of ordinary shareholders. Many preference shares are cumulative preference shares, which means that if dividends are not paid, entitlement to dividends is accumulated until such a time as they can be paid.
Preference shares do not normally carry voting rights, although in some cases holders may acquire voting rights if their dividends have been delayed. If a company has to be wound up, there would generally be only a limited amount of money available to repay debts and shareholders. In this situation, the claims of creditors are repaid in a set order of priority. Shareholders rank lowest in the order of priority and are therefore most at risk of receiving
nothing at all; however, holders of preference shares have a higher claim than holders of ordinary shares.
Convertible preference shares
Convertibles are securities that carry the right to be converted at some later date to ordinary shares of the issuing company. Traditionally they were issued as corporate bonds (with a lower rate of interest than conventional corporate bonds because of the right to convert to equity). In recent years, they have been increasingly issued as convertible preference shares.
Warrants
Warrants give the holder the right to buy shares at a fixed price at an agreed future date. The attraction is that they give the holder rights at a fraction of the cost of the shares themselves. At the date when the warrant can be exercised, it will be exercised if the share price is above the price at which the shares can be bought
under the terms of the warrant. If the share price is at or below the terms offered by the warrant, it will not be worth exercising the warrant and it will lapse.
Residential property
Property investment has a number of benefits and advantages, including the following:
- Property is a very acceptable form of security for borrowing purposes.
- The UK property market is highly developed and operates efficiently and professionally
On the other hand, there are a number of pitfalls and disadvantages:
- Location is of paramount importance and a badly sited development may prove a problem.
- The property market is affected by overall economic conditions – in times of recession, letting properties may be difficult and property prices may fall.
- Property is a less liquid form of investment than most others
The purchase of property is subject to stamp duty land tax and a premium applies where the property is not the only one owned.
Income from property, after deduction of allowable expenses, is subject to income tax. It is treated as non‑savings income for tax purposes. On the disposal of investment property, any gain is liable to CGT, but any capital expenditure on enhancement of the property’s value can be offset against
taxable gains.
Buy to Let Property
Recent tax crackdowns have had a significant impact on the BTL market in the UK, although a number of landlords hold portfolios of BTL properties.
Benefits offered by BTL investment:
- Regular and increasing income stream can
provide a hedge against inflation
- Well-developed market
- Easy access to ancillary services, eg letting and
property management agents
- Easy access to BTL mortgages
There are also a number of risks:
- Accessing the market can be difficult, as investment and associated costs are high- mortgage, legal fees and SDLT.
- Property is an illiquid investment
- There may be void periods when the property is untenanted, meaning that income is reduced or ceases.
- There is the risk that tenants may damage the property, leading to additional costs.
- Legal fees may be incurred to remove unsatisfactory tenants.
- The property will require ongoing management and maintenance; these services can be outsourced but the costs would reduce overall yield.
A number of measures were put in place
that reduced the attractiveness of BTL as an investment by the UK Gov:
Tax relief – Changes were phased in from April 2017–20, which mean that tax relief is limited to a tax credit at the basic rate only.
- Wear and tear – furniture replacement relief that only allows the actual cost of replacing furnishings to be offset against profits.
- Stamp duty land tax – Second properties are
now subject to an SDLT surcharge purchase
Commercial Property
Investment in commercial property covers almost anything that is not defined
as wholly residential- e.g:
- Individual retail units
- Shopping arcades and shopping centres
- Offices
- Industrial units, eg workshops, factories, storage units
- Hotels and leisure facilities
- Mixed-use property (shops/offices with some
residential property)
Commercial property provides reasonably high rental income together with steady growth in capital value. The main advantages are:
- regular rent reviews, with typically no more than five years between each;
- longer leases than for residential property;
- more stable and longer‑term tenants;
- typically lower initial refurbishment costs.
Drawbacks may include the following:
- the higher average value means that spreading the risk is more difficult;
- commercial property does not generally show the growth in value that can be achieved in residential property;
- if the investment is to be funded by borrowing, interest rates may be higher than for residential loans.
Lenders often carry out detailed investigations before lending for the purchase
of commercial property, checking on the:
- quality of the land and property;
- reputation of builders, architects and other professionals involved;
- suitability of likely tenants.
Money‑market instruments
‘Money‑market instruments’ is a generic term used to describe forms of short‑term debt. Interest is not normally paid during the term of the transaction, the rate of interest being determined by the difference between the
amount invested/borrowed and the amount repaid.
Three money-making instruments:
Treasury bills, certificates of deposit, and commercial paper.
Treasury bills
Treasury bills are short‑term redeemable securities issued by the Debt Management Office (DMO) of the Treasury. Like gilts, they are fundraising instruments used by the UK government, but they differ from gilts in a number of ways.
Two major differences are:
- Treasury bills are short term, normally being issued for a period of 91 days, whereas gilts can be long term or even undated;
- Treasury bills are zero‑coupon securities, ie they do not pay interest.
Instead, they are issued at a discount to their face value or par value (the amount that will be repaid on their redemption date).
As with gilts, Treasury bills are considered to be very low‑risk securities.
Throughout their term, Treasury bills can be bought and sold. The price tends to rise steadily from the issue price to the redemption value
over the 91‑day period, but prices can be affected by significant interest rate changes, or by supply and demand.
Treasury bills are purchased in large amounts, and they are not of interest to small, private investors. They are held in the main by large organisations seeking secure short‑term investment for cash that is temporarily surplus to requirements.
Certificates of deposit
Certificates of deposits (CDs) are issued by banks and building societies.
They are a receipt to confirm that a deposit has been made with the institution for a specified period at a fixed rate of interest. The amounts deposited are typically £50,000 or more.
There are significant penalties for withdrawals before the end of the term.
However, because certificates of deposit are bearer securities, they can be sold to a third party if the depositor needs the funds before the end of the term.
Banks may also hold CDs issued by other banks, and they can issue and hold CDs to balance their liquidity positions. For example, a bank would issue CDs maturing at a time of expected liquidity surplus, and hold CDs maturing at a
time of expected deficit.
Commercial paper
When businesses wish to borrow for working capital purposes they can issue commercial paper. The transactions are for very large amounts, with most purchasers being institutions such as pension funds and insurance companies. Commercial paper can be placed directly with the investors, or through intermediaries.
The commercial paper market offers cheaper borrowing opportunities for companies that have good credit ratings, but even companies with lower credit ratings can issue commercial paper if it is backed by a letter of credit from a
bank that guarantees (for a fee) to make repayment if the issuer defaults.
Most commercial paper is issued for periods of between 5 and 45 days, Firms that need to retain funds for longer than this regularly roll over their commercial paper – the advantages of this are:
- flexibility; and
- the fact that the rate of interest is not fixed for a long period
CERTIFICATE OF DEPOSIT
A ‘receipt’ confirming that a (substantial) deposit has been made with a bank or building society for a fixed period at a fixed rate of interest.
BEARER SECURITIES
Securities that are deemed to be owned by whoever physically possesses the document that confers ownership, rather than ownership being determined by an entry on a register, etc.
COMMERCIAL PAPER
An unsecured promissory note – ie a promise to repay the funds that have been received in exchange for the paper.
WORKING CAPITAL
Funds available for the day‑to‑day running of the business, calculated as current assets minus current liabilities
