CFA 48: Overview of Equity Securities

Question 1

common shares

Types and Characteristics of Equity Securities

Answer 1

Represent an ownership interest in a company and are the predominant type of equity security. As a result, investors share in the operating performance of the company, participate in the governance process through voting rights, and have a claim on the company’s net assets in the case of liquidation. Companies may choose to pay out some, or all, of their net income in the form of cash dividends to common shareholders, but are not contractually obligated to.

Question 2

vote by proxy

Types and Characteristics of Equity Securities

Answer 2

Allows a designated pary, such as another shareholder, a shareholder representative, or management, to vote on the shareholder’s behalf.

Question 3

statutory voting

Types and Characteristics of Equity Securities

Answer 3

Regular shareholder voting, where each share represents one vote.

Question 4

cumulative voting

Types and Characteristics of Equity Securities

Answer 4

Allows shareholders to direct their total voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates. Total voting rights are based on the number of shares owned multiplied by the number of board directors being elected. The key benefit to cumulative voting is that it allows shareholders with a small number of shares to apply all of their votes to one candidate, thus providing the opportunity for a higher level of representation on the board than would be allowed under statutory voting.

Question 5

callable common shares

Types and Characteristics of Equity Securities

Answer 5

Give the issuing company the option, but not the obligation, to buy back shares from investors at a call price that is specified when the shares are originally issued.

Question 6

putable common shares

Types and Characteristics of Equity Securities

Answer 6

Give investors the option or right to sell their shares back to the issuing company at a price that is specified when the shares are originally issued.

Question 7

preference shares (preferred stock)
Types and Characteristics of Equity Securities

Answer 7

Rank above common shares with respect to the payment of dividends and the distribution of the company’s net assets upon liquidation. Preference shareholders do not share in the operating performance of the company and generally do not have any voting rights, unless explicitly allowed for at issuance. Preference shares have characteristics of both debt securities and common shares. Similar to the interest payments on debt securities, the dividends on preferred shares are fixed and are generally higher than the dividends on common shares. However, unlike interest payments, preferred shares are not contractual obligations of the company. Similar to common shares, preference shares can be perpetual (no fixed maturity date), can pay dividends infinitely, and can be callable or putable.

Question 8

cumulative preference shares

Types and Characteristics of Equity Securities

Answer 8

Dividends accrue so that if the company decides not to pay a dividend in one or more periods, the unpaid dividends accrue and must be paid in full before dividends on common shares can be paid.

Question 9

non-cumulative preference shares

Types and Characteristics of Equity Securities

Answer 9

Any dividends that are not paid in the current or subsequent periods are foreited permanently and are not accrued over time.

Question 10

non-participating preference shares

Types and Characteristics of Equity Securities

Answer 10

Do not allow shareholders to share in the profits of the company. Instead, shareholders are entitled to receive only a fixed dividend payment and the par value of the shares in the event of liquidation.

Question 11

participating preference shares

Types and Characteristics of Equity Securities

Answer 11

Entitle the shareholders to receive the standard preferred dividend plus the opportunity to receive an additional dividend if the company’s profits exceed a pre-specified level. In addition, participating preference shares can also contain provisions that entitle shareholders to an additional distribution of the company’s assets upon liquidation, above the par (or face) value of the preference shares.

Question 12

convertible preference shares

Types and Characteristics of Equity Securities

Answer 12

Entitle shareholders to convert their shares into a specified number of common shares. The conversion ratio is determined at issuance. Convertible preference shares have the following advantages:
-They allow investors to earn a higher dividend than if they invested in the company’s common shares
-They allow investors the opportunity to share in the profits of the company
The allow the investors to benefits from a rise in the price of the common shares through the conversion option
-Their price is less volatile than the underlying common shares because the dividend payments are known and more stable.
A popular financing option in venture capital and private equity transactions in which the issuing companies are considered to be of higher risk and when it may be years before the issuing company goes public.

Question 13

private equity securities

Private Versus Public Equity Securities

Answer 13

Issued primarily to institutional investors via non-public offerings, such as private placements. Because they are not listed on public exchanges, there is no active secondary market for these securities. As a result, private equity securities do not “market determined” quoted prices, are highly illiquid, and require negotiations between investors in order to be traded.

Question 14

venture capital

Private Versus Public Equity Securities

Answer 14

Provide seed, or start-up, capital, early-stage financing, or mezzanine financing to companies that are in the early stages of development and require additional capital for expansipon. Usually a 3-10 year investment horizon.

Question 15

leverage buyout (LBO)
Private Versus Public Equity Securities

Answer 15

Occurs when a group of investors (such as the company’s management or a private equity partnership) uses a large amount of debt to purchase all of the outsanding common shares of a publicly traded company.

Question 16

management buyout (MBO)
Private Versus Public Equity Securities

Answer 16

A case where the leveraged buyout of a firm is mostly the company’s existing management.

Question 17

private investment in public equity (PIPE)

Private Versus Public Equity Securities

Answer 17

Type of investment generally sought by a public company that is in need of additional capital quickly and is willing to sell a sizeable ownership position to a priate investor or investor group. It can be at a significant discount to the market-quoted price.

Question 18

depository receipt (DR)
Investing in Non-Domestic Equity Securities

Answer 18

A security that trades like an ordinary share on a local exchange and represents an economic interest in a foreign company. It allows the publicly listed shares of a foreign company to be traded on an exchange outside its domestic market. A depository receipt is created when the equity shares of a foreign company are deposited in a bank in the country on whose exchange the shares will trade. The depository then issues receipts that represent the shares that were deposited. The number of receipts issued and the price of each DR is based on a ratio, which specifies the number of depository receipts to the underlying shares. A depository receipt can represent one share, many shares, or a fractional share of the underlying stock.

Question 19

depository bank

Investing in Non-Domestic Equity Securities

Answer 19

Issues the receipts and acts as the custodian and registrar. Handles dividend payments, other taxable events, stock splits, and serves as the transfer agent for the foreign company whose securities the DR reqpresents.

Question 20

sponsored/ unsponsored DR

Investing in Non-Domestic Equity Securities

Answer 20

Sponsored when the foreign company whose shares are held by the depository has a direct involvement in the issuence of the receipts. Investors in sponsored DRs have the same rights as the direct owners of the common shares. With unsponsored DRs, the underlying foreign company has no involvement with e issuance of the receipts. Instead, the depository purchases the foreign company’s shares in its domestic market and then issues the receipts through brokerage firms in the depository’s local market. In this case, the depository bank, not the investors, retains the voting rights.

Question 21

global depository receipt (GDR)

Investing in Non-Domestic Equity Securities

Answer 21

A depository receipt issued outside of the company’s home country and outside of the Unite dStates. A key advantage of GDRs is that they are not subject to the foreign ownership and capital flow restrictions that may be imposed by the issuing company’s home country because they are sold outside of that country. Usually denominated in US dollars. Although they cannot be listed on US exchanges, they can be privately placed with institutional investors based in the United States.

Question 22

American depository receipt (ADR)
American depository share (ADS)
Investing in Non-Domestic Equity Securities

Answer 22

A US dollar-denominated security that trades like a common share on US exchanges. They enable foreign investors to raise capital from US investors. The term American depository share is often used in tandem with the term ADR. A depository share is asecurity that is actually traded in the in the issuing companys domestic market. In other words, while ADRs are the certificates that are traded on US markets, ADSs are the underlying shares on which these receipts are based.
NOTE: 4 primary types of ADRs, and each have different levels of orporate governance and filing requirements.

Question 23

global registered share (GRS)

Investing in Non-Domestic Equity Securities

Answer 23

A common share that is traded on different stock exchanges around the world in different currencies. Currency conversions are not needed to purchase or sell them, because identical shares are quoted and traded in different currencies.

Question 24

basket of listed depository receipts (BLDR)

Investing in Non-Domestic Equity Securities

Answer 24

A global security which is an exchange-traded fund that represents a portfolio of depository receipts. An ETF is a security that tracks an index but trades like an individual share on an exchange.

Question 25

foreign exchange gains (or losses)

Risk and Return Characteristics of Equity Securities

Answer 25

There are two main sources of equity securities’ total return: price change and dividend income. For investors who purchase depository receipts or foreign shares directly, there is a third source of return: foreign exchange gains/losses. Foreign exchange gains arise because of the change in exchange rate between the investor’s currency and the currency that the foreign shares are denominated in.

Question 26

Return on Equity (ROE) concept

Risk and Return Characteristics of Equity Securities

Answer 26

Primary measure that equity investors use to determine whether the mangement of a company is effectively and efficiently using the capital they have provided to generate profits. It measures the total amount of net income available to common shareholders generated by the total equity capital invested in the company. It is computed as net income available to oridinary shareholders divided by the average total book value of equity (BVE).

Question 27

Level 1 ADR

Investing in Non-Domestic Equity Securities

Answer 27

Trade in OTC markets and do not require full registration with the SEC.

Question 28

Level 2 and 3 ADR

Investing in Non-Domestic Equity Securities

Answer 28

Can trade on NYSE NASDAQ and AMEX. Allow companies to raise capital and make acquisitions using these securities. However, the issuing companies must fulfill all SEC requirements.

Question 29

Level 4 ADR (SEC Rule 144A or Regulation S DR)

Investing in Non-Domestic Equity Securities

Answer 29

Does not require SEC registration. Instead, foreign companies are able to raise capital by PRIVATELY placing these depository receipts with qualified institutional investors or to offshore non-US investors.