Chapter 4 – Equities

Question 1

What are the 4 main types of company?

Answer 1

A private company limited by shares
Private (i.e. you can’t trade the shares on a public exchange), has a share capital and the shareholders have a limited liability.

A private company limited by guarantee
Has no shareholders per se. Members agree to contribute an amount of capital if the company is wound up, and their liability is limited to that amount. Again, because it is private, it cannot offer shares to the public.

A private unlimited company
You can’t trade their shares on a public stock exchange and your liability is NOT limited to the amount initially paid by buying shares or contributing capital. Potentially more liability

A public limited company or plc
most well-known. It is public because its shares are traded on a stock exchange, and limited because the shareholders liability is limited to the price paid for the shares. It follows that all companies that are listed on the stock exchange must be a plc.

Of the above, The most common types of companies are public limited companies and private companies limited by shares.

Question 2

4.1.1: What are the Requirements for forming a company

The formation of a new limited company is known as incorporation.

Answer 2

The process involves the completion of two documents: the memorandum of association and the articles of association along with various other application forms.

These documents are submitted to Companies House who issue the company with a certificate of incorporation once they have vetted all proposed directors and checked that the company name is acceptable. The documents are then kept on record and open for public inspection.

Question 3

How many directors must a PLC have?

Answer 3

Public companies must have a minimum of 2 directors and a company secretary

There are certain requirements for directors that must be met, such as they must be over 16, not been previously disqualified from being a director or be an undischarged bankrupt, whilst the company secretary must be qualified to undertake the role.

Question 4

Public limited companies must obtain a trading certificate from Companies House, as it is an offence to trade without one. True or false

Answer 4

True

Question 5

4.1.2: Memorandum of Association

What is this for?

Answer 5

This is a relatively short document and forms the legal agreement by all the initial shareholders or subscribers that they are agreeing to form a company.

Once a company is registered, then the memorandum cannot be changed or updated.

Question 6

4.1.3: Articles of Association

What is this for

Answer 6

The articles of association is a big document

It contains written rules agreed by the shareholders, directors and company secretary about how the company is to be run and how decisions will be taken by the shareholders and directors.

The articles can be changed but only with the agreement of the shareholders and must then be resubmitted to Companies House.

Firms can choose to write their own or to adopt the model articles.

The model articles are made up of 5 different areas:
Defined terms & Limited Liability
Directors
Shares & distributions
Decision making by shareholders
Administrative arrangements

Question 7

How often must directors in PLCs be held up for election?

Answer 7

Directors in PLCs are required to submit themselves for re-election at intervals of no more than 3 years,

They must do it annually if they are director in a FTSE 350 companies.

Question 8

Companies must hold Annual General meetings (AGM) where shareholders can exercise their vote on proposals made by the directors known as resolutions. True or false

Answer 8

True

Occasionally, the company may need to present exceptional matters (such as takeovers and mergers or a substantial change to the business) to the shareholders for their approval.

In these cases, an Extraordinary General Meeting or EGM will be called.

Question 9

What are Partly paid shares?

Answer 9

At incorporation, the subscribers don’t provide all the capital. normally, all capital is provided. Instead, they pay for just a part of each share. These are known as partly paid shares.

The company can call on the shareholders to pay the balance at any time. At that point, the shareholders have a legal obligation to pay up!.

Question 10

Ordinary shareholders are entitled to company profits after tax and ‘preference shareholders’ dividend payments

Question 11

How do shareholders know about meetings?

Answer 11

Notices of AGMs must be sent to shareholders at least 21 clear days before the AGM.

14 days if a special resolution allowing it has been passed by members.

The voting record date determines who is entitled to vote at the meeting. If your name is on the share register on the voting record date, which must be no more than 48 hours before the proposed meeting, then you will be able to vote at the AGM

Question 12

Under the Companies Act 2006, shareholders also have some statutory rights:

Answer 12

Companies must hold AGMs at least once a year.

Shareholders with more than 10% of the voting rights have the right to call an extraordinary general meeting (EGM), and those with more than 5% of voting rights can propose resolutions.

A shareholder can also petition the court if they feel that the affairs of the company are unfairly prejudicial to the interests of some or all of the shareholders.

Question 13

4.2.2: Preference shares

Answer 13

Preference shares rank above ordinary shares in the event of liquidation.

Preference dividends are also paid ahead of ordinary dividends.

Pay dividends every 6 months, however the dividend will only be paid if profit is made (not guaranteed)

No voting rights normally, but if dividend payments are missed, voting rights are given

Question 14

4.2.2: Preference shares

What are the different types of preference share?

Answer 14

Cumulative = missed dividends are made up in future years

Non cumulative = any missed dividend does not have to be made up and investor loses right to missed dividend after end of financial year

Participating = pay a fixed dividend. Also pays an extra dividend depending on profits (like with ordinary shares) so with participating the owner is entitled to some of the profits of the company. This combines ordinary and preference shares

Redeemable = Undated and dividends are payable until shares are repurchased by the company. Act as a source of temporary finance for the company

It’s worth pointing out that the features can be combined, so ‘cumulative non-participating’, ‘non-cumulative non-participating’, ‘cumulative participating’ …

Question 15

4.2

What are Convertible preference shares?

DO NOT CONFUSE WITH CONVERTIBLE CORPORATE BONDS ALTOUGH THEY DO WORK SIMILARLY IN TERMS OF CONVERSION RATIO ETC

Answer 15

Convertible preference shares allow the holder to convert the preference share into ordinary shares on pre-determined dates.

The conversion ratio will set out how many preference shares are needed to buy 1 ordinary share.

extra:

Just as we did with convertible bonds, we can calculate the premium or discount to find whether it is cheaper to buy the ordinary shares in the market or buy them through the convertible preference share.

The formula is slightly different (because the conversion ratio is quoted differently) so make sure you don’t get them mixed up!

Question 16

4.3: Holding Title

When we buy shares, we need to have some record of proof of ownership of the shares.

How is this achieved?

Answer 16

Holding title is the method by which this ownership is recorded. There are two methods of holding title;

Registered shares
Ownership of the shares are recorded on the share register which is maintained by the company registrar.

Bearer shares.
Issuing shares in bearer form involves issuing a certificate, but unlike registered shares there is no name on it. The company only records the certificate and not who owns it. That means that whoever holds the certificate owns the shares (a bit like a £10 note).

Question 17

A share certificate can be issued by companies which details the number of shares owned

Can a shareholder use this as proof of ownership?

Answer 17

No, their record on the companies share register shows ownership.

Question 18

In relation to the systems used, what happens when someone sells their shares and how does this differ from the past?

Answer 18

In the past, if you wanted to sell your shares then you would need to send the certificate along with a stock transfer form to the registrar who would then update the share register with the new owner’s details.

This was a drawn-out process and very inefficient, so these days most shares have been dematerialised (i.e. share certificates are not issued) and are held electronically. Transfer of the shares from the seller to the buyer happens very easily by amending the electronic record in a process that is known as book-entry transfer.

Nowadays = book-entry transfer

Question 19

4.4: Ranking In Liquidation

If a company winds up, its assets will be liquidated and used to pay the company’s creditors.

As owners of the company, the shareholders are last in line.

The order of priority is: WHAT

Answer 19

1st - Secured creditors with fixed charge
2nd - Insolvency practistior fees
3rd - Preferential Creditors (employees wages, holiday pay etc)
4th - Secured creditor with a floating charge
5th -Unsecured creditors (also includes unpaid HRMC tax
6th - preference shareholders
7th - Ordinary Shareholders

Question 20

4.5: Tax Treatment of Divided Income

LOOK AT R03 calc book for refresher of this

Answer 20

Dividends are paid gross

Pay 0% on the first £500 of dividends received in a tax year (dividend allowance).

After this allowance, the tax paid depends on which of the investor’s income tax bands the dividends fall in.

What about the dividend allowance (DA)?

Question 21

4.6: Depositary Receipts

Outline and explain the two types

American Depository Receipt (ADRs)
Global Depository Receipt (GDRs)

(this is a favourite question in the J12 exam so make sure you remember this).

Answer 21

Depositary receipts help investors mitigate some of the costs and issues associated with buying foreign equities.

4.6.1: American Depositary Receipts (ADRs)

ADRs enable US investors to hold shares in foreign companies without the associated hassle of overseas equity transactions. They represent shares in foreign companies but are denominated in US dollars and trade on a number of stock exchanges including NYSE and NASDAQ. Holders get voting rights and receive dividends.

THEY CANNOT be included in a rights issue, instead the rights are sold and proceeds distributed.

4.6.2: Global Depositary Receipts (GDRs)

Question 22

American Depositary Receipts (ADRs) ADRs enable US investors to hold shares in foreign companies without the associated hassle of overseas equity transactions. They represent shares in foreign companies but are denominated in US dollars and trade on a number of stock exchanges including NYSE and NASDAQ. ADRs settle in exactly the same way as domestic shares, which makes the whole process of buying shares in overseas companies much simpler and cheaper than buying the foreign shares directly

What rights do holders of ADRs get then in relation to company because they do own the shares through the ADR? Is it the same as investors who directly hold the shares domestically, for example, can they take part in AGMs etc?

Answer 22

they get the same rights as if they had bought the shares directly i.e. they receive dividends (in US dollars instead).

they can vote at shareholder meetings via a proxy.

However, they CANNOT, partake in rights issues. instead the rights are sold and the proceeds are distributed (this is a favourite question in the J12 exam so make sure you remember this).

Question 23

Holders of ADRs cannot partake in rights issues

Answer 23

they CANNOT, partake in rights issues. instead the rights are sold and the proceeds are distributed. This is one right they do miss out on compared to those who hold the shares directly (this is a favourite question in the J12 exam so make sure you remember this).

Question 24

Depositary receipts (DRs) issued outside of the US are known as Global Depositary Receipts.

For example, European Depositary Receipts (EDRs) are issued by non-European companies, are denominated in euros and trade on European stock exchanges.

GDR issues are particularly popular with Asian and emerging market issuers

Question 25

Is there stamp duty or SDRT on the purchase of depositary receipts?

Answer 25

No

Question 26

The main risks associated with shares include:

Price risk
Market risk
Liquidity risk
Issuer risk
Share dividend volatility
Currency risk
Counterparty risk

Answer 26

The main risks associated with shares include:

Price risk: The risk that individual share prices fall.
Market risk: The risk that share prices in general fall.
Liquidity risk: The ability to sell at a given time.
Issuer risk: The risk that the company goes under and the shares become worthless.
Share dividend volatility: Dividends are uncertain.
Currency risk: Exchange rate movements, if dealing in overseas equities.
Counterparty risk: The risk that a counterparty will not pay what it is obliged to. (the collective scheme fails for example)

Question 27

Company formation

Limited liability means that shareholders cannot lose any more than they paid for the shares.
Companies can be one of four types: private company limited by shares, private company limited by guarantee, private unlimited company, and public limited company.
To form a company, the memorandum of association and the articles of association must be submitted to Companies House and a certificate of incorporation issued.
Companies are obliged to hold an Annual General Meeting where shareholders vote on resolutions.
Share Capital

Companies can issue 2 types of shares: ordinary shares and preference shares.
Ordinary shares give shareholders the right to vote and the right to receive discretionary dividends.
o Ordinary shareholders can also benefit from capital gains if the price of the shares rise.

Preference shares pay a fixed dividend and usually do not have any voting rights.
o They rank ahead of ordinary shares both in terms of dividend payment and in the event of a liquidation.

o The come in a wide range, including; cumulative or non-cumulative, redeemable, participating and convertible preference shares.

o The conversion premium or discount for convertible preference shares represents how much more expensive / cheaper it would be to buy the ordinary shares by buying the preference shares.

Companies can also issue redeemable shares, deferred shares, partly paid shares, ‘A’ or non-voting shares, and other share classes that may give certain shareholders more rights.
Holding Title

Shares can be registered where the shareholders’ details are recorded on the share register.
Investors may or may not receive a share certificate giving details of their holdings, but this is not proof of ownership.
Bearer shares are certificates that represent the number of shares owned, but no name appears on it.
Bearer shares are usually immobilised in a central securities depository.
Ranking in company liquidation

Fixed charge secured creditors come first, followed by insolvency practitioner fees, staff wages, floating charge secured creditors, unsecured creditors, preference shareholders and then ordinary shareholders.
Tax treatment of dividends

There is currently a tax-free dividend allowance of £500 per person, regardless of tax status.
Above this, dividends are taxed at 8.75% for basic rate tax-payers, 33.75% for higher rate tax-payers and 39.35% for additional rate tax-payers.
Depositary Receipts

Depositary Receipts represent ownership in foreign shares without the associated costs of dealing directly in foreign shares.
There are two types: American Depositary Receipts and Global Depositary Receipts.
They enable investors to trade the shares in overseas countries but pay for them in US dollars (ADRs) or their domestic currency (GDRs).
Dividends are also received in US dollars / domestic currency.
The DR ratio refers to the number of shares that the DR represents.
They are issued by a depositary bank who hold the shares in trust; with the investors as the beneficial owners.
They retain most of the rights of share ownership, with the exception of rights issues.
Risks associated with equities

The main risks are price risk, liquidity risk and issuer risk.
Price risk is the risk that share prices fall, either due to specific problems with the issuer or because of a general fall in market prices (market risk).
Liquidity risk is the risk that investors are not able to sell their shares quickly. This is higher for smaller companies than larger companies.
Issuer risk is the risk that the company collapses, and the shares become worthless.
Other share-specific risks include currency risk, dividend volatility, and counterparty risk.
Factors that affect share prices include external economic factors, investor sentiment, profit expectations, dividend expectations, takeover activity, and quality of management.

Question 28

The market price for ‘A’ shares will usually be lower than the price of ordinary shares because:

they do not entitle holders to dividends.

they only pay a dividend after ordinary dividends have been paid.

they pay a lower dividend than ordinary shares.

they do not have any voting rights.

Answer 28

they do not have any voting rights.

‘A’ shares generally do not have any voting rights attached.

Question 29

A convertible preference share is priced at 75p and can be converted into the company’s ordinary shares at a conversion ratio of 5:1. If the ordinary shares are priced at 300p, what is the conversion or discount premium?

25% premium.

25% discount.

20% premium.

20% discount.

Answer 29

The conversion premium or discount is

((conversion ratio x price of convertible preference share ÷ ordinary share price) -1) x 100

= ((5 x 75 ÷ 300)-1) x 100 = 25%. It is positive, so it’s a premium.

Question 30

A share which pays a fixed dividend and ranks ahead of ordinary shares is:

a convertible share.

a partly paid share.

a deferred share.

a preference share.

Answer 30

a preference share.

There is no such thing as a convertible share.

Partly paid shares are where only a part of the full amount of the shares has been paid for.

A deferred share is one where the dividend will only be paid once certain conditions have been met.

A preference share pays a fixed dividend and ranks ahead of ordinary shares.

Question 31

Which of the following has the highest payment priority in the event of a liquidation?

HMRC.

Preference shareholders.

Staff wages.

Fixed charge secured debt.

Answer 31

Fixed charge secured debt.

Fixed charge secured debt is the highest in the priority claim, then staff wages, then HMRC and then preference shareholders. Ordinary shareholders would then come after the preference shares.

1st - Secured creditors with fixed charge
2nd - Insolvency practistior fees
3rd - Preferential Creditors (wages, holiday pay etc)
4th - Secured creditor with a floating charge
5th -Unsecured creditors (also includes unpaid HRMC tax
6th - preference shareholders
7th - Ordinary Shareholders

Question 32

Brandon receives £5,000 in dividend during the tax year. He is a basic rate tax-payer and has not used any of his dividend allowance. How much tax would he need to pay?

£393.75

£900.00

£1,350.00

£1,518.75

Answer 32

£393.75

Subtract the £1,000 dividend allowance from the total dividend to give £4,000 taxable dividends.

Basic rate tax-payers pay 8.75% tax on dividends.

Tax liability = £4,500 x 0.0875 = £393.75

Question 33

A company is formed where each member contributes an amount of capital, but do not purchase shares. This type of company is:

a private company limited by shares.

a private company limited by guarantee.

a private unlimited company.

a public limited company.

Answer 33

a private company limited by guarantee.

Private company limited by shares issue shares, private unlimited shares are unlimited and public limited companies also issue shares.

Question 34

How are shares in an American Depositary Receipt held for investors?

They are held by investors and registered in their name.

They are registered in the name of the investor and held by the issuing company.

They are held on behalf of the investor by a custodian who is appointed by the issuing company.

They are registered in the investor’s name and held by a depositary bank.

Answer 34

They are held on behalf of the investor by a custodian who is appointed by the issuing company.

ADRs are not registered in the individual’s name. They are registered and held by either the depositary bank or a custodian appointed by the issuer.

Question 35

A major difference between GDRs and regular equities is that:

GDRs do not confer holders with voting rights.

GDRs holders cannot participate in rights issues.

GDRs do not pay dividends.

GDRs are not settled in the same way as regular equities.

Answer 35

GDRs holders cannot participate in rights issues.

GDRs give investors the same rights as regular shares except they cannot partake in a rights issue.

Question 36

Issuer risk refers to the risk that:

the issuer collapses and the shares are worthless.

the price may fall due to profits falling.

the company may not pay any dividends.

the investor is unable to sell their holding quickly

Answer 36

the issuer collapses and the shares are worthless.

The risk that the price may fall either due to profits falling or that the company may not pay dividends would be price risk. The risk that the investor cannot sell their holding quickly is liquidity risk.

Question 37

Aaron has a share certificate that details the number of shares it represents but does not have his name on it. This is an example of:

a registered share.

a dematerialised share.

an uncertificated share.

a bearer share.

Answer 37

a bearer share.

Registered shares may or may not issue a certificate. If they do, they will bear the holders name on them. Dematerialised and uncertificated are other names for registered shares where no certificate is issued. Bearer shares do not have the holder’s name on them.

Question 38

4.6.2: Global Depositary Receipts (GDRs)

Answer 38

If the depositary bank is a member of the local CSD:

the shares will be registered in the name of the depositary bank and not the individual investors.
the investors will be the beneficial owners.

If the depositary bank is not a member of the local CSD:

the shares will be registered in the name of a custodian in the local market.
the custodian will hold the shares on behalf of the depositary bank.
the depositary bank will hold the shares as trustee (usually on ‘bare trust’) unless a custodian has been appointed.

Basically, GDRs are either held on behalf of the depositary bank by a custodian or if no custodian, it is held by the depository bank in trust on behalf of the investors

Never held in name of investors

Question 39

Global Depositary Receipts (GDRs) = NO SDRT OR STAMP DUTY