Chapter 11 Flashcards
What is most common type of share capital
Ordinary shares
What does authorised share capital do
In theory, it acts as a ceiling on the amount of share capital the directors can issue
Initial payment in a fiscal year for a equity is called
Interim dividend
In advance of an ipo,the company usually works with IBs to advise on
Type of security to issue
Best price that can be expected
Number of shares to be issued
When to bring the ipo to market
What must also be provided for when doing ipo
Prospectus filed to sec containing risks and info about deal
Issues with ipo
Dilutes existing shareholders ownership
Risky as their is little history on what to base their share price off, new shares usually underpriced to increase attractiveness
Two types of secondary share offering
Seasoned equity offering, offering after doing an ipo
Secondary offering involves sale of shares held by directors at company for example
What is. A dilutive secondary offering and what is non dilutive secondary offering
Seasoned equity offering is dilutive
Secondary offering is non dilutive as no new shares are issued p, shares just transferred
Preference shares
Pay investors a fixed dividend as a percentage of face value of the share.
How can preferred stocks dividends be affected
Ordinary shareholders can defer dividends paid to preference shareholders if it is appropriate, ie poor earnings
Characteristics of preference shares
No voting right s
Dividends paid out before div to ordinary shares
Preference shares higher in cap structure compared to ordinary stock holders
Why do firms like preference shares
Act as a bond security but classed as equity so helps with financing but less affect on d/e ratio
American depository receipt
Stock that trades in the USA but represents an investment in a specified number of shares of a non us company
What are ADRs useful for
Helping us investors invest in non us companies, simpler
Lower admin costs and avoids paying foreign taxes
Why do foreign countries issue ADRs
Helps them increase exposure to wealthy North American market
What does a primary issue require
Firm must ensure they have financial stability and managerial competence to obtain stock exchange quotation
Underwrite a capital issue meaning
Investment bank will garentee they will buy up any unbought shares or arrange for the unbought to be bought by other institutions
Placing
A firm may issue equity by placing new securities with an IB. So issuing house (IB) buys all the shares and resells them to other investors
When is placing used and why is tit good
Used by smaller issues, less costly
Firm is garenteed to raise full amount of capital
When is placing used and why is it good
Used by smaller issues, less costly
Firm is garenteed to raise full amount of capital
book building
Investment banks go out and find investors who are interested in buying shares and create an actual book of them
Accelerated book building
Refers to short period of time when investor interest is shown and established by IB
IB may garentee a minimum price and sales revenue to issuing firm
Intermediaries offer
Number of brokers placing an issue with their own clients, thus widening the investor base
Offer for sale issuance and why’s it good
Issuing house purchase all of the shares from the firm and instead of offering to other investment houses, they issue to the general public instead. The issuing firm garentees the sale of share and IB acts as undersitier
Offer for sale by tender
Firms issue capital by inviting public to to bid for an issue, once the subscription deadline is reached, the firm establish a strike price, which is calculated to ensure whole issue is fully subscribed
All shares above strike price are allotted shares at the strike price
Problem with offer for sale by tender
Will not know full raised amount until offers have been received
Offer for sale by subscription
Offer shares to general public directly with no issuing house in the middle, only done really by large corporations
Introduction issuance and benefits of it
Firms may float on stocks exchange using introduction, the company can join market without raising capital
No underwriting fees and little advertising
Equity crowdfunding
People invest in early stage unlisted company in exchange for shares of that company
Rights issue primary or secondary and meaning
Secondary share issue
Shareholders can buy a certain number of shares usually at below market value. Not an obligation to buy though
Rights can also be sold to others who wish to take advantage e
How can a firm try and avoid using an underwriter in rights issue
If the shares are so deeply discounted
How do you value the sale of a rights issue to someone who wants to exercise the right but you don’t want to
Rights price = ex rights price - subscription price
Scrip dividend and why done
Do scrip issue instead of pay dividend and done to reduce investors income tax liability, investors then sell scrip issue and only have to pay capital gains
How is a share repurchase done
Through tender offer where shareholders tender a portion of their shares within a certain time frame
Holding period return formula
Pt - Pt-1 +D1
/
Pt-1
Price of a stock should represent….
Present value of a stream of expected future cash flows
Dividend yield equation
D0/P0
Dividend cover =
EPS0/DPS0
DPS EQUAL TO DIVIDEND PER SHARE
Dividend cover of 1 indicates what and what happens if earnings fall
That it pays out all their earnings in the form of dividends so if earnings fall then dividends will be cut
How is dividend decision affected
Signal to investors
Clientele effect - attract certain investors
Tax implications
Stability of firm
Limitations of distributing dividends
Companies may have to dip into previous year profits to maintain constant dividend
Does it have the cash, as not all profits are cash
Dividend discount model
P0 = D1/1+r + D1(1+g)/(1+r)^2 + D1(1+g)^2/(1+r)^3 ….
Gordon growth model
P0 = D1/r-g
What can a stocks higher expected return represent
Greater riskiness
How to estimate growth rate of dividend
Look at historical rates
Look at analyst forecasts
If dividends are a constant proportion of earnings
Growth rate of dividends formula
Retention ratio x ROE
What is retention ratio formula
Retained earnings / earnings
Two ways of valuation processes for equities
Discount techniques ( absolute value)
Market multiples (relative value)
Relative value equity valuation formula
Earnings power x market price multiple
Current earnings =
2 formulas
Profits after interest tax and preference shares dividends
Or
Equity dividends + retained earnings
Why is eps not always ideal
Not useful for inter company comparisons ( double the eps does not mean double the profits)
Earnings is an accounting measure and can be distorted easily by certain accounting tricks
Diluted eps
Figure that shoes eps if all stock options had been exercised and this figure is shown with the eps figure
Historic pre ratio and prospective P/E ratio
P0/EPS0
P0/ EPS1
High P/E ratio indicates
Investors believe future earnings will be high
Or
The stock is overvalued
twelve month trailing P/E ratio
Uses aggreagatiom of past years earnings and gives the ernings for this type of pe ratio
What values does forward P/E ratio use
Current share price divided by forecasted earnings
Peg ratio (pe to earnings growth ratio) =
And what does low peg mean
PE/annual EPS growth
Low peg means stock undervalued given its earnings
What is. A desirebale peg ratio
Less than 1
Two problems of P/E ratio
What if company has negative earnings = pe becomes negative and useless, negative earnings could be due to cyclical nature of economy
Ratio based on accounting figures which can get distorted from, accounting standrds
Different companies adopt different accounting rules and standrds
Price to book ratio, why good
Book value (net assets) more stable than earnings
Company may have negative earnings but unlikely to have negative book value
How does market value and book value of asset differ
Market value depends on earning power and expected future cash flows
Book value is derived by original cost
What sector may not be ideal for price book ratio analysis
Service sector which has limited significant assets
What does higher price book ratio mean
Market believes company as a whole will use assets more efficiently to create more value in the future
Price to sales why is it good
Cannot become negative
Less subject to accounting distortions
Issues with price to sales ratio
Sales do not always mean profits for shareholders
Sales are generated by equity and debt capital, price to sales ignores gearing
What is a good price to sales ratio
Low ps is good
High ps could be bad
Enterprise value =
Debt + equity - cash
What does enterprise value to sales ratio do
Eliminate accounting and financing decisions in comparing companies profitability
What does a high enterprise value/ sales ratio mean
Sign that investors believe future sales will increase
Low value mean investors believe future sales will be slow
Why is ebitda to enterprise value ratio a good measure
Standardises between companies for differences in taxation, capital structure and fixed asset accounting.
Using EV normalises companies with different cap structures
Price to cash flow ratio advantages
Harder to manipulate cash flows
More reliable indicator
Price to cash flow limitations
Different types of free cash flow
Neglects non cash components
Simplistic
What does a high price to cash flow ratio mean and is high or low ratio preferred
Firm is trading at high price and may not be generating enough cash flow to support multiple
Low ratio preferred
Free cash flow meaning y
Cahs flows available for distribution to investor in firm
Free cash flow to the firm equation
Revenues - operating cost - gross interest - taxes + non cash charges - investment in fixed capital - investment in working capital + net interest
=net income + non cash charges - investment in fixed capital - investment in working capital + net interest
Free cash flow to equity equation
= Free cash flow to the firm - net interest +net borrowing
What does residual mean in residual income
Income in excess of any opportunity costs measured relative to the book value of shareholders equity
What does residual mean in residual income
Income in excess of any opportunity costs measured relative to the book value of shareholders equity
Residual income formula
Net income - equity charge
Equity charge = equity capital x cost of equity
How is cost of equity usually generated
CAPM
Intrinsic fair value of share equation
Book value per share + present value of future residual income per share
What valuation method is most suitable for non dividend paying firms
Residual income method
Gearing
Level of company debt relative to equity capital (debt to equity ratios)
Total long term debt/total equity
What does equity include in debt to equity ratio
Book value of ordinary shares, preferred stock and retained earnings
What happens as I rate changes for firms with low and high gearing
Only small increase in risk as I rate changes for low gearing
High gearing means more volatile returns and increased risk of I rate changes
What happens as I rate changes for firms with low gearing
Only small increase in risk as I rate changes for low gearing
Implications of high gearing
Returns more volatile and genuine risk of bankruptcy so investors demand higher return s for the increased risk they are taking p, so overall cost of capital rises
Loan agreements can affect what
Dividend level
Amount of additional debt taken on
Disposal of fixed assets
How does higher gearing affect dividend discount model
Increase shearing means increased cost of capital so future expected cash flows are discounted at higher rate leading to lower share prices e
Equity finance or debt finance require higher returns
Return required by equity financing is higher than that of debt financing since debt holders higher in the cap structure than equity
Equity finance or debt finance require higher returns
Return required by equity financing is higher than that of debt financing since debt holders higher in the cap structure than equity
Which sector has the highest and lowest debt equity ratio
Utility highest
Shoes lowest
