Chapter 3: Public Markets Flashcards
Explain how the public market context introduces new stakeholders that a public company must consider, Explain the process of raising capital through public markets, Differentiate between various types and classes of shares, Understand the financing options available to public companies
what are stakeholders
Parties that have an interest in a company because they can affect or be affected by the business
who are internal stakeholders
- directly affect the business
- Have access to internal information that is not publicly available
- May be involved in the management of the organization
- Drive the business decisions that move a company forward
who would internal stakeholders include
- Executives (CEO, CFO, COO, etc.)
- Management team (directors, managers, etc)
- Board of Directors
- Private investors
- Employees
who are external stakeholders
- are affected by the business
- Do not have knowledge of internal information
- Information is not publicly available
- Impacts company decisions to a degree (depending on the type of stakeholder)
who does external stakeholders include
- Lending institutions (banks, credit unions, etc)
- Governments (federal, provincial, and municipal)
- Regulatory bodies
- Vendors / suppliers
- Competitors
who are public shareholders
- Entities (people or corporations) that have an ownership stake in the business resulting from the purchase of company shares through public markets
- Can own an extremely small piece of the company (ex. 0.00001%) or a big chunk (ex. 25%)
who are market analysts
Generally are individuals who work for financial firms that make predictions about future public company performance
how do market analysts affect a company
- Predictions are publicly available
- Often indirectly affects the market value of the companies they make predictions about
what is usually a top priority for public companies
- Satisfying shareholders
- Always think of them when making strategic business decisions
what are public/capital markets
Facilitate a mutually beneficial exchange between those who have capital and those who want or need capital
why do public/capital markets exist
- Companies want/need money
- investors have money
- Each party will get what they want and benefit in the process
who are investors in capital markets
- investors
- They represent those with available capital that gives to those who want/need it (ex. Public companies), and receive shares to represent their ownership in the company
what are the ways investors expect a return from when investing
- share price appreciation
- dividends
what is share price appreciation (simple explaination)
When the price of the shares in the capital markets increase over time, and can be sold for higher than it was bought for (for a profit)
what are dividends
When the company chooses to return profits they make to the shareholders through consistent payment
how does share price of a company change
- Earning potential of a company = their ability to generate future earnings
- Public companies are judged by their earning potential
- Company value is determined by the present value of a company’s future cash flows
- Investors try to predict the future earnings of a company & determine their worth today
- The predictions drive the company’s share price
how could investors opinion change the share price of a company
- If investors think the company has a strong positive future, the share price could rise
- If the investors think the company will face hardships in the near future, the share price could fall
how can market analysts affect the share price of a company
- Market analysts affect this process, making public predictions about a company’s earnings every quarter
- Since public companies report their earnings quarterly, analysts can compare their expectations to the actual results
- If company results > analyst expectations = share price increases
- If company results < analyst expectations = share price decreases
what is the Market Value (of company shares)
The price of shares based on what the market believes the company is worth
are changes in the market value of shares recorded on the balance sheet
no
what is the Book Value (of company shares)
- Net asset value (total assets - total liabilities) on a per-share basis, that is recorded on the equity section of the statement of financial position (also total equity available to shareholders / number of shares outstanding)
- The actual line items of the shares show the initial cost of the shares
- The market value is almost always different from the book value
what is the journal entry to record the sale of shares
DR cash
CR common shares/share capital/stock
how does dividends impact whether an investor invests in a company
- Investors invest if they think they would earn consistent or even increasing dividends
- Investors might invest if they would get dividends or if they would get dividends and think that there would be share price appreciation
- Depends on investor preference
if a company chooses to pay dividends, when is it usually done
- quarterly
- sometimes monthly or semi-annually
can a company decide to stop giving out dividends if they gave it out before
they can decide to stop mid-way, but it wouldn’t look good on the public markets
what is the journal entry to record dividends
DR Dividends (SE)
CR Dividends Payable (L)
what is the journal entry for when dividends are paid
DR Dividends Payable (L)
CR Cash (A)/Common Shares/Share Capital (SE)
- Credit common shares/share capital when stock dividends are given instead of cash
- Stock dividends are just additional shares of the company given instead of cash
when does an IPO happen
after:
- seed investments (from friends and family)
- angel investment
- venture capitalists
- private equity investments
- bank financing
or simply if a company wants to go public
how are shares divided when a company is just starting (as private)
- owners inject capital (cash) into the organization for shares
- They deposit money into the corporate bank account & receive a share certificate for their portion of the total shareholding
- If no new/additional shares were issued & no shares were bought back, the common share line item on the balance sheet will always = the amount of cash injected to start the company
how are changes in common share balance shown & where
- on a note to the financial statements
Rows: - As at end of previous period
- additional shares issued
- shares repurchased
- as at end of period
Columns:
- number of shares
- value ($)
what is an IPO
Represents the first time a company’s newly issued shares are sold in the public markets
what is it like to issue an IPO
- Process is lengthy and complex
- Time extensive & expensive to go public
which parties are involved when a company decides to go public
- Investment banks
- Lawyers
- Auditors & Securities exchange experts
- Regulators
what do investment banks do when a company decides to go public
- Play a critical role in pre-marketing the IPO to large authorized private & institutional investors
- Influence the demand and initial price of the shares at the time of the IPO
what do lawyers do when a company decides to go public
Help facilitate the transactions
what do auditors & securities exchange experts do when a company decides to go public
Ensure all accounting records & paperwork are appropriate based on the requirements
what is a common misconception about IPOs
That retail investors (like you) can buy IPO shares (can happen, but really rare)
what is the process of purchasing shares from a company (starting from IPO shares)
- Large private & institutional investors buy the IPO shares directly from the company in large quantities (primary market)
- Retail investors can only buy IPO shares if an investment broker is an institutional investor & decides to sell their shares to the public
- Then retail investors buy it from the private & institutional investors (secondary market)
- Price is usually higher than the IPO price (private & institutional investors want to make a return)
what is the difference between IPO share issuance and share issuance in a private company
that the price is determined by the primary market
how is the common share balance on the balance sheet calculated
of shares sold x price
what happens to the common share balance on the balance sheet when all IPO shares are sold
- the balance does not change (even when the market price of the shares change)
- only changes if more shares are sold
- or if the company repurchases previously issued shares
what is it called if a company decides to give out more shares after their IPO
- Seasoned equity offering
- follow-on public offering
what are the different types of shares
- common shares
- preferred shares
what are the characteristics of common shares
- commons
- all companies have them
- Issued when a company is first established + at IPO time
- Usually 1 vote per share
what are the characteristics of preferred shares
- preferreds
- Typically, no voting rights
- Guaranteed indefinite dividends
- Closer to the front of the line upon company liquidation
what are cumulative preferred shares
- a class of preferred shares with special dividend rights
- Legally entitled to receive dividends every year (arrears)
- The company may not pay you every year, it just becomes a liability for them
- If you didn’t get paid dividends from before, they will give you the total amount they missed
- Also ahead of any dividends being paid to common shareholders
what are non-cumulative preferred shares
- another class of preferred shares without special dividend rights to receive dividends in arrears
- Company has no legal obligation to pay them dividends every year
- Can choose to pay dividends or not (if they operated on a loss that year, they might not)
what can companies do with different classes of stocks
- Common & preferred stock can have multiple classes issued
- Ex. Class A common shares, Class B common shares, Class A preferred shares, etc.
- Company can decide on rights & limitations of each class of shares
what is a common reason why different classes of shares are created & issued
- companies want voting power to remain with a particular group
- Issuing multiple classes of shares can structure voting rights to ensure other parties don’t accumulate too much voting power or even potentially take over the company
what are examples of classes of shares
can be common or preferred
- Redeemable shares
- Callable shares
- Convertible shares
what are dividends (definition)
The distribution of a company’s earnings to its shareholders
how are dividends distributed
- Often distributed quarterly (sometimes annually)
- Can be paid as cash (cash dividends) or by issuing more shares to the company’s shareholders (stock dividends)
what is a requirement if a company is paying dividends
- Company must have enough retained earnings and cash to pay cash dividends
- If they don’t have enough cash but want to give out dividends, they can give stock dividends
what are the steps/dates for if a company wants to pay a cash dividend
- declaration date
- record date
- payment date
what happens on the declaration date
- BOD approve & declare a dividend
- Dividend becomes a legal liability on this date
what is the journal entry for when a dividend is declared
DR retained earnings
CR dividends payable
what happens on the record date
- Company prepares a list of current shareholders
- Only those that own shares on the declaration date
- No journal entry
what happens on the payment date
Payment of dividends is recognized
what is the journal entry for when dividends are paid
DR dividends payable
CR cash
what are dividends like on preferred shares
are usually an annual dollar figure (per share) or annual dividend % (dividend yield)
what is dividend yield
A financial ratio that shows how much a company pays out dividends each year as a % of its stock price
how is preferred share dividends calculated if it is communicated as an annual dollar figure (per share) if it is 200,000 shares of $4 cumulative preferred shares outstanding
- Every shareholder gets $4 per share they hold annually
- If paid quarterly: $4 / 4 quarters = $1 per share quarterly
- If cumulative, they get paid prior period dividends if were not declared/missed in prior periods
how is preferred share dividends calculated if it is communicated as a dividend yield if it is 200,000 shares of non-cumulative preferred shares outstanding & issued at a par value of $50 per share & dividend yield is 6%
- $50 x 6% = $3 per share annually
- If paid quarterly: $3 / 4 quarters = $0.75 per share quarterly
- If not cumulative, will not get paid prior periods
what are dividends in arrears
When a company with cumulative preferred shares has missed dividend payments that will be paid next time dividends are declared
how dividends are divided & allocated to preferred and common shareholders
- Calculate the dividend to be paid to preferred shareholders (including any preferred dividends in arrears)
- Assign remaining dividends to common shareholders
what are the options for a company if they need more capital (after an IPO)
- seasoned equity offering
- debt
- equity
what are the pros of a company taking on more debt to finance their operations
- No dilution of ownership
- Once debt is paid off, no further commitment to lender required
- Tax savings, as interest is an expense that reduces taxable income
what are the cons of a company taking on more debt to finance their operations
- Requires continuous repayment (principal & interest)
- Rising interest rates can increase cost of borrowing
- Assets can be seized if business cannot pay back the loan
- Company might need to meet certain bank covenants
what are the pros of a company taking on more equity to finance their operations
- No legal requirement of continuous repayment
- Less restrictive on the use of funds
what are the cons of a company taking on more equity to finance their operations
- Dilution of ownership/control
- Higher pressure to achieve results as shareholders expect continuous share appreciation/dividend payments
- Difficult & costly to raise equity
- Will require new governance, reporting, processes, regulatory requirements, etc.
what does a company also need to consider when getting more financing
weighted-average cost of capital
what is Weighted-Average Cost of Capital (WACC)
- The cost to acquire additional financing, fluctuating depending on the level of debt vs. equity a company holds
- Expressed as a %
- Changes based on how the proportion of debt to capital changes
what do companies try to do with WACC
try to minimize it
how do companies try to minimize their WACC
- they calculate how WACC changes if they take on more debt vs more equity
- Outcome affects their financial decisions along with qualitative factors
what is another form of debt corporations can have
- Corporations can issue bonds as a form of debt
- Bond markets exists to exchange debt
- Global bond markets are much larger than global stock markets
- Corporations can sell bonds on bond markets in exchange for cash with the promise to repay with interest (instead of ownership in the company)
how to calculate WACC if you have debt for $10M @ 10%, equity for $10M at 15%
- total amount of financing = $20M
= (50% x 10%) + (50% x 15%) = 12.5% -> means you need to make at return of at least this amount, otherwise, you would be operating on a loss - ^ 50% because debt and equity both make up half of the total $20M
