Chapter 4 - Equity Finance

Question 1

Preference Shares

Answer 1

• Fixed rate dividends
• Preference shareholders have prior claim to profits available for distribution and capital in the event of winding up
• Participating preference shares = pay extra dividend as fixed percentage of ordinary divided (very rare)
• Mainly issued by banks to strengthen their balance sheets and also used to fund specific projects such as a takeover

Question 2

Advantages of preference shares – compared to debt:

Answer 2

• More flexible than debt – if losses are made, dividends are not paid

Question 3

Disadvantages of preference shares – compared to debt

Answer 3

• No tax relief on dividends
• Higher return expected due to riskier investment (preference shareholders rank third after creditors in the event of winding up)

Question 4

Advantages of preference shares – compared to ordinary shares:

Answer 4

• No dilution of control – carry no voting rights except in exceptional circumstances such as liquidation

Question 5

Disadvantages of preference shares – compared to ordinary shares:

Answer 5

• Creates extra risk for ordinary shareholders due to preference dividend being paid first
• Less discretion over whether to pay the dividend

Question 6

Ordinary Shares:

Answer 6

• Right to vote on director’s appointments & any other important matters
• Receive dividends that are agreed by the board
• Equity capital refers to capital invested by ordinary shareholders (owners of business) although non-cumulative, irredeemable preference shares are also treated as equity)
• Timing of dividend payment is flexible

Question 7

Purpose of capital markets:

Answer 7

• Primary markets = enable org’s to raise new finance which is easier than to contact investors individually
• Secondary markets = enable existing investors to sell investments if they wish to
• Enable investors to buy securities that have already been issued
• Marketability of securities is important since investors are more willing to buy investments if they know that they could sell them easily
• Realisation of value = owners of company can realise some of the value of their shares in cash when floating shares
• Takeover by means of share exchange = issue shares to finance the takeover & only feasible if shares are readily traded on a stock market and therefore have an identifiable market value

Question 8

Obtaining a Stock Market Listing - Main requirements:

Answer 8

• Three years of successful trading history
• Compliance with corporate governance rules of the Combined Code
• Minimum 25% of shares in public hands

Question 9

Advantages of a stock market listing:

Answer 9

• Access to a wider pool of finance
• Easier to seek growth by acquisition
• Original owners selling holding to obtain funds for other projects
• Original owners realising holding
• Enhanced public image
• Improved marketability of shares

Question 10

Disadvantages of a stock market listing:

Answer 10

• Significant greater public regulation, accountability and scrutiny – greater legal requirements and will have to comply with stock exchange rules where listed
• Wider circle of investors with more exacting requirements – pressure to deliver short-term benefits or certain levels of dividends
• Additional costs involved = Brokerage commissions, Underwriting fees , Ongoing stock exchange membership fees
• Listing may make company target for takeover

Question 11

Why do companies retain cash within the business:

Answer 11

• Companies retain cash in the business to fund investment needs and this cash represents equity finance since it could have been paid out to shareholders

Question 12

Three main ways of issuing new shares:

Answer 12

• Initial public offering
• Placing
• Rights issue

Question 13

Initial public offer (IPO):

Answer 13

• An offer for sale to the public with subsequent issues being through placing or rights issues
• Entails the acquisition of a large block of share by an issuing house (investment bank) with a view to offering them for sale to the public
• Could be via a direct allotment or by purchase from existing members
• The issuing house publishes an invitation to the public to apply for shares at either a fixed price or on a tender basis

Question 14

IPO - Offer for sale at a fixed price:

Answer 14

• A prospectus is produced outlining the company’s future plans & past performance and advertised in the national press
• Normally underwritten
• Normally for larger issue of shares

Question 15

IPO - Offer for sale by tender:

Answer 15

• A minimum price will be fixed and subscribers will be invited to tender for shares at prices equal or above the minimum
• Shares will then be allotted at the highest price at which they all be taken up (strike price)

Question 16

IPO Lock-up period:

Answer 16

• Prevent directors from selling shares for a specified period after the listing – usually 6 months
• Designed to prevent directors from selling significant holdings immediately after a listing and making the share price fall sharply as a result

Question 17

Placing:

Answer 17

Method of raising share capital in which there is no public issue of shares, but instead a sponsoring market maker arranges for most of the share to be bought by a small number of institutional investors (pension funds) for a predetermined price

Question 18

Choice between an offer for sale and a placing:

Answer 18

• Placings are much cheaper – used for smaller issues
• Placings are likely to be quicker
• Placings involve less disclosure of information
• Most of shares will be placed with small number of institutional investors which means most of shares are unlikely to be available for trading after floatation & shareholders will have control

Question 19

Rights Issue:

Answer 19

• Raise new capital by giving existing shareholders the option to subscribe to new shares in proportion to their existing holding
• Shares are usually issued at a discount to market price
• A shareholder not wishing to take up a rights issue may sell their rights

Question 20

What happens after a rights issue has been announced?

Answer 20

• After the announcement of a rights issue, share prices will usually fall due to uncertainty about the consequences of the issue, with respect to future profits, earnings and dividends
• After the actual issue the market price will fall because there are more shares in issue and the new shares were issued at a discount price
• The issue price should be low enough to secure the acceptance of shareholders but not so low as to excessively dilute the share price (discount is commonly between 20 – 30% of market price)

Question 21

Theoretical ex-rights price (TERP)

Answer 21

• The new market price will be the consequence of an adjustment to allow for the discount price of the new issue and a TERP can be calculated
• Cum-rights price = shares are sold after the announcement of a rights issue but before it is completed, which means the purchaser of new share can also gets the right to participate in the rights issue
• Ex-rights = without rights attached, first day after dealing the rights no longer exists

Question 22

The value of rights

Answer 22

• Value of a right = (TERP - issue price) / N
• N = number of rights required to buy one share
• Value of rights is the theoretical gain a shareholder would make by exercising their rights

Question 23

Yield adjusted TERP formula:

Answer 23

• Yield adjusted TERP =
  1 / (N+1) x
  [(n ×cum-rights price) + (Issue price × {Y new ÷ Y old})]

Question 24

Why have a yield adjusted ex-rights price?

Answer 24

• It is assumed that the additional funds from a rights issue will generate the same rate of return as existing funds
• If the company expects that new funds will earn a different return then a yield adjusted TERP should be calculated

Question 25

Advantages of a rights issue:

Answer 25

• Cheaper than offers for sale - no prospectus required, simpler admin and cost of underwriting is less
• Voting rights are unaffected if all shareholders take up their rights
• Reduce gearing in book value terms by increasing share capital and/or to pay off long-term debt which would reduce gearing in market value terms

Question 26

Disadvantages of a rights issue:

Answer 26

• Amount of finance to be raised is limited by the funds available to existing shareholders
• Choosing the best issue price may be problematic
• During the time between announcement of rights issue and date of subscription, the market price of shares may fall
• Rights issues can’t be used to widen the base of shareholders
• Equity is seen as the most expensive finance as ordinary shareholders are last to be paid in the event of liquidation, dividends are not guaranteed and share prices are volatile

Question 27

Methods to calculate the cost of equity:

Answer 27

1. Dividend Growth Model

2. Capital Asset Pricing Model (CAPM)

Question 28

Dividend Growth Model formula:

Answer 28

Ke = (D1 ) / (P0) + g

• D1 = dividends at end of year 1 (D x [1 + g])
• P0 = share price
• If dividend is about to be paid and the share price is cum div, the share price needs to be adjusted by stripping the dividend out of the share price
• If company fails to provide this return to shareholders, the share price will fall

Question 29

Assumptions of dividend growth model:

Answer 29

• Dividend growth can be estimated and is constant

* Dividends are paid and the company has a share price

Question 30

Estimating g:

Answer 30

1. Historic growth
   g= n √(Latest dividend)/(Earliest dividend) - 1
2. Current reinvestment levels
   g = return on equity x balance reinvested

Question 31

Capital Asset Pricing Model (CAPM):

Answer 31

CAPM looks at ways in which risk can be measured and then examines the extra return investors are looking for to compensate for the extra risk

Question 32

What is unsystematic risk?

Answer 32

• investors diversify investments in suitably wide portfolio, so that bad performing investments are cancelled out by those that perform well
• Risk is therefore diversified away
• It has been estimated that 90% of unsystematic risk can be eliminated by holding a portfolio in more than 15 securities and therefore it is assumed that investors are only exposed to systematic risk

Question 33

What is systematic risk (or market risk)?

Answer 33

• Risk that cannot be diversified away
• In return for accepting systematic risk, a risk averse investor will expect to earn a return higher than the return of a risk-free investment
• Systematic risk is measured using a beta factor

Question 34

What is a Beta factor?

Answer 34

Beta factor = historic data is used to calculate the average fall in the return on a share each time there is a 1% fall in the stock market as a whole

Question 35

What given Beta factors mean:

Answer 35

Beta < 1.0

• Share < average risk
• Ke < average

Beta = 1.0

• Share = average risk
• Ke = average

Beta > 1.0

• Share > average risk
• Ke > average

Question 36

CAPM formula:

Answer 36

Ke = Rf + (Rm – Rf) x B

• Rm = market return
• Rf = risk free rate of interest
• B = beta of investment
• (Rm – Rf) = market premium

Question 37

Assumptions of CAPM:

Answer 37

• Single period model = same Ke used regardless of the length of the project
• Unstable estimates of Rf and Rm
• Based on past data = assumes that firm’s historic beta will not change
• Simplistic = ignores the higher risk premium expected by investors for small companies
• Assumes only systematic risk is relevant = only true if shareholders have a diversified portfolio