Chapter 3 - Equities

Question 1

What 2 documents are required to form a company

Answer 1

1 memorandum of association
2 articles of association

Question 2

What is memorandum of association

Answer 2

Confirms subscribers intention to form a company under companies act 2006
Legal statement signed by all initial shareholders agreeing to form a company

Question 3

What are the articles of association

Answer 3

Detail relationship between company and its key sources of finance (its owners)
Agree shareholder rights, frequency of company meetings and borrowing powers

Question 4

For quoted companies, what is needed?

Answer 4

A shareholder resolution needs to be passed that meets standards of uk listing authority (UKLA)

Question 5

Private companies vs public companies

Answer 5

Private can have one shareholder but public has to have more than one
Only PLCs can issue shares to public
All listed companies are public (PLCs), not all PLC are listed

Question 6

“Limited” means…

Answer 6

The liability of shareholders for the debts is limited to the amount they agree to pay on initial subscription

Question 7

Company meetings - public companies must…

Answer 7

Hold AGMs at which shareholders are given opportunity to question directors
Must be held 6 months within financial year end
Shareholders have the right to attend, speak, vote or appoint proxy
Matters of major importance require special resolution, and 75% or more, vote in favour
Can vote electronically in proxy voting form
Can hold extraordinary meetings which are important issues such as takeover or capital raising

Question 8

The capital of a company is made up of

Answer 8

Borrowing and money invested by its owners

Question 9

Ordinary shares

Answer 9

Carry the full risk and reward of investing in a company
Can vote on each resolution
Share of profits by receiving dividends declared by the company
If company does badly it’s these shareholders that will suffer
If the company closes ‘wound up’ shareholders are paid last

Question 10

Preference shares

Answer 10

The company’s internal rules (arts of associations) sets out the ways in which they differ
Technically equity investment but hybrid with both debt and equity
Characteristics of debt, they pay a fixed income
Preference have legal priority in respect of earnings in event of bankruptcy
Non voting (unless there are exceptions)
Pay a fixed dividend each year (before ordinary shares dividends are paid)
Rank ahead of ordinary (in terms of being paid back if company wound up)
Preference shares may be cumulative, non cumulative and/or participating
If no profits, no dividend received however, if they were cumulative then dividend accumulated. Assuming sufficient profits, the cumulative shareholders will have the arrears of dividend paid in subsequent year
If shares non cumulative dividend from first year is lost
Preference shareholders can participate in bumper profits
These types of shares may be convertible and redeemable

Question 11

Convertible preference shares

Answer 11

Can convert to ordinary shares

Question 12

Redeemable

Answer 12

Have a date on which they can be redeemed. The nominal value of the shares will be paid back and shares cancelled

Question 13

Benefits of owning shares

Answer 13

Dividends
Dividend yield
Capital gains
Shareholder benefits

Question 14

Dividends

Answer 14

Is a return that investors get for providing risk capital for a business
Company pays dividends out of their profits which form part of their distributable reserves
Companies seek to pay steadily growing dividends. A fall in the dividend can lead to negative reaction

Question 15

Distributable reserves

Answer 15

These are the post tax profits made over the life of the company, in excess of dividends paid

Question 16

Dividend yield

Answer 16

Potential shareholders will compare dividends paid on a company’s, with the return on other investments
A comparison of returns is facilitated by calculating a dividend yield ie do fine as a percentage of the current share price

Question 17

Dividend yield calc

Answer 17

Dividend/market cap x 100

Question 18

Some companies have a higher than average dividend yield which may be for the following reasons CHECK THIS CARD

Answer 18

Company is mature but limited potential so high dividends
Company has a low share price so high dividend not expected to rise

Question 19

Why do some companies have a low yield

Answer 19

Share price is high, so potential for growth
Large proportion of profit is put back into the business rather than paid out

Question 20

Capital gains

Answer 20

Can be made on the shares if their prices increase over time
Needs to be sold to realise the gain
Unsold shares are “unrealised” gains

Question 21

Shareholder benefits

Answer 21

Free goods, deals on products
Not a factor for investment decisions

Question 22

Shareholder rights

Answer 22

Rights issue is one method by which a company can raise additional capital. Existing shareholders have the right to subscribe to new shares
If a company were to issue new shares to anyone the existing shareholders could lose control of company or at least see ownership dilution. Under uk legislation existing shareholders in the uk companies are given pre-emptive rights to subscribe for any new share offering

Question 23

Right to vote

Answer 23

Ordinary shareholders have the right to vote on matters presented to them at company meetings
The votes are normally allocated on the basis of one share = one vote
Votes are cast one of two ways:
- shareholders attends the meeting
- shareholders can appoint someone else to vote on their behalf
Most shares held in electronic form by nominees
These are used solely for holding and administering shares.
If the shareholder wishes to vote, they will need to arrange for the operator to vote on their behalf

Question 24

The risk of owning shares

Answer 24

Market and price risk
Liquidity risk
Issuer risk
Foreign exchange risk

Question 25

Market price risk

Answer 25

Risk is the risk that share price in general might fall
Market wide falls in price

Question 26

Liquidity risk

Answer 26

Shares may be difficult to sell at a reasonable price

Question 27

Issuer risk

Answer 27

Issuing company collapses and ordinary shares become worthless
Unlikely with larger firms but collapse of Northern Rock shows it’s possible

Question 28

Foreign exchange risk

Answer 28

Indirect relates to investing in a firm that has earnings/operations overseas. Company will engage in hedging to reduce currency risk
Direct relates to investing in shares in a currency

Question 29

Corporate actions

Answer 29

Occurs when a company does something that affects its shareholders

Question 30

Mandatory corporate action

Answer 30

No intervention required from shareholders eg payment of dividends

Question 31

Mandatory corporate action with options

Answer 31

Option that has some sort of default that will occur if shareholder doesn’t intervene

Question 32

Voluntary corporate action

Answer 32

Requires a shareholder to make a decision

Question 33

3 types of corporate action

Answer 33

Mandatory corporate action
Mandatory corporate action with options
Voluntary corporate action

Question 34

In the US there are only 2 types of corporate action

Answer 34

Mandatory corporate action
Voluntary corporate action

Question 35

Security ratios

Answer 35

When a corporate action is announced the terms of the event will specify what’s to happen
For some events the terms will announce how many new shares the owner is entitled to. The bonus issue may be expressed as 1:4 which means they’ll receive one new share for every 4 shares
In the US the first number indicates the final holding after the event. Eg 5:4.

Question 36

Rights issue example

Answer 36

Company may approach its existing shareholders with a cash call
Uk law gives protections to existing shares holders. They have a pre-emptive rights
Is an offer to existing shareholders of new shares pro rata. Shareholder has a choice
Is an example of a mandatory with options corp actions
If it is to finance expansion and the strategy makes sense to investors, the share price may rise
If investors have a negative view, the price may fall
If the price at which the shares are offered are too high, the cash call might flop. Embarrassing and costly for underwriters (they will agree for a fee to buy any position not taken up. They will sell these shares and may make the gain or loss)

Question 37

A rights issue arises. The investor can:

Answer 37

take the rights
Sell the rights onto another investor (transferable and renounceable)
Do nothing

Question 38

TERP (theoretical ex rights price)

Answer 38

If an investor takes up the rights, their share price will fall, to account for the new, lower priced shares

The rights can be sold and the price is the premium. If ex rights price is £3.60 and new share is £2. The premium would be £1.60 although the actual price would depend on demand and supply.

Question 39

Bonus issues

Answer 39

Also known as scrip or capitalisation issue

Question 40

Bonus issues

Answer 40

Is a corporation action when a company gives existing share holders extra shares without having to subscribe further funds
The company is increasing number of shares held and capitalises earnings by transfer to shareholder funds

Eg £15 shares each. Bonus issue is 1:2. Giving one more share per every 2. Shareholders with 2 shares worth £30, now has 3 worth £10

Question 41

Reason for bonus shares

Answer 41

To increase the liquidity of company shares in market to bring lower share price. Logic if price is too high, it may be unattractive to investors

Question 42

Stock splits and reverse stock splits

Answer 42

Similarly to bonus issue, this corporate action doesn’t raise extra cash
Involves division of existing shares, making share capital more marketable

Eg shares may be split £1/5 = 20p, nominal is one and market value is £5. The market value then becomes £1, the reverse may be appropriate where market value is low.

Question 43

Dividends

Answer 43

Mandatory corporate action. Represents part of company profit
Usually 2 a year, second is usually paid after approval at AGM
Will receive by cheque, money into their accounts or CREST
Shares bought and sold with the right to receive the next dividend to which they are entitled

Question 44

Right to receive dividend up to date shortly before payment is made. At this point the shares are described as

Answer 44

Cum dividend

Question 45

At the point between declaration date and payment date, the shares will go…

Answer 45

Ex dividend

Question 46

Are buyers of shares when they are ex dividend entitled to shares?

Answer 46

No

Question 47

Takeover

Answer 47

The predator seeks to acquire another company (the target)
When they acquire shares, they are under obligation to report share purchases once they reach a certain percentage
In a successful takeover the predator will buy more than 50% of shares of target
When predator holds more than half it’s described that it gained control. Usually they’ll look to buy all shares

Question 48

Merger

Answer 48

A similar transaction when the two companies are of similar size and agree to merge their interests

It is usual for one to exchange new shares for the shares of the other