CHAPTER 4: Overview of Equity Securities Flashcards
OVERVIEW OF EQUITY SECURITIES
2008 CRISIS: SUBPRIME MORTGAGES
- World Markets Fell By ___
- Ireland Markets Fell By ___
World Markets Fell by 53%
Irish Markets Fell by 70%
COMMON SHs can vote on CORP GOVERNANCE issues viz:
Election of BOD
M&A Decisions
Selection of Auditors
If SH can’t attend the annual meeting in person, he can “vote by proxy” i.e. have someone else to vote on his behalf
ORDER OF LIQUIDATION
Debt
Subordinate Debt
Mezzanine Financing (Debt+Equity)
Preference Shares
Common Shares
Different Classes of Shares (Class A and Class B)
Class A: More voting rights, higher influence.
Class B: Fewer voting rights, lower influence.
Priority in Liquidation: Can vary between classes. A»B
STATUTORY VS CUMULATIVE VOTING RIGHTS
Statutory Voting: One vote per share for each position.
Cumulative Voting: Total votes can be allocated to one candidate.
Example: With 100 shares and 3 positions:
- Statutory: 100 votes per position.
- Cumulative: 300 votes to one candidate. Can accumulate voting rights and then vote
Benefit: Cumulative voting favors minority shareholders.
PREFERENCE SHARES
EQUITY OWNERSHIP
1ST RIGHT TO DIVIDENDS (Fixed as a % to the par value)
FIRST RIGHT IN LIQUIDATION
TYPES OF PREFERENCE SHARES
Cumulative: Unpaid dividends accumulate. Dividends Carry Forward.
Non-cumulative: Unpaid dividends do not accumulate. Dividends Lapse. (Higher Risk & Returns)
Participating: Participate in PROFITS. More dividends when profits are higher + more asserts on liquidation
Non-participating: Fixed dividends, only % of par value at liquidation.
Convertible: Embedded Call Options. Can convert to common stock, lower risk. Lower Yield.
KEY CHARACTERISTICS OF PRIVATE EQUITY
- Less Liquidity
- Price Discovery maybe BIASED because of less coverage
- Long-Term Value Creation because it doesn’t have to worry about reporting results to market
- Lower Reporting Costs
- Potential for high returns when Investment is Exited
- Exit: SELL OR IPO
Require a commitment of funds for a relatively long period of time (3-10 years)
LBO
LEVERAGED BUYOUT
- Large amount of debt relative to equity is used to buy out a firm
- The large proportion of debt AMPLIFIES RETURNS if the buyout turns out to be successful.
- Leveraged buyout performed by management is termed as MANAGEMENT BUYOUT (MBO).
- The firm acquired either has to generate the adequate cash flows or sell assets to service the debt.
PIPE?
Private Investment in Public Equity
A Public Company, when needs additional capital immediately sells equity to Pvt. Investors
NON-DOMESTIC EQUITY SECURITIES
A Market is said to be INTEGRATED when
INTEGRATED: Capital flows freely across borders
SEGMENTED: Capital restrictions
WHY CAPITAL RESTRICTIONS?
* Prevent foreign control/dominance over domestic companies
* Decrease volatility due to FII inflows/outflows
* Domestic Investors get advantage to make higher returns
2 WAYS TO INVEST IN EQUITY OF COMPANIES IN A FOREIGN MARKET ARE:
- DIRECT INVESTING
- DEPOSITORY RECEIPTS
PROBLEMS WITH DIRECT INVESTING:
- Along with stock performance, returns are exposed to CURRENCY RISK as the trade is made in foreign currency
- Investors must be aware of INVESTMENT CLIMATE + LAWS of foreign land
- Disclosure requirement of foreign country might be low, impeding the analysis process
DEPOSITORY RECEIPTS & TYPES
Shares DEPOSITED to Foreign Bank
DRs trade on Foreign Exchanges
DR is a security that trades like an ordinary share on the local exchange & represents an economic interest in a foreign company.
TYPES:
- SPONSORED: Exchange-Traded; Foreign company involved in issuance; Holders given Voting Rights
- UNSPONSORED: OTC; Foreign Company not involved in issuance; Bank Retains Voting Rights
- GDRS: outside home country & outside USA
- ADR: American Depository Receipts eg: DRs of TCS & INFY traded in US exchanges
GDRs & ADRs are NOT SUBJECT TO FOREIGN OWNERSHIP & CAPITAL FLOW RESTRICTIONS IMPOSED BY THE COMPANY’S HOME COUNTRY
- GRS: GLOBAL REGISTERED SHARES:
Shares traded in DIFFERENT STOCK EXCHANGES IN DIFFERENT CURRENCIES
- BLDR: BASKET OF LISTED DRs: An ETF representing collection of DRs
Process of Creating a DR (Depository Receipt)
- Deposit: Foreign company’s shares are deposited in a local bank.
- Issue Receipts: Bank issues receipts representing ownership of these shares.
- Trade: Receipts trade on a local exchange in local currency.
Example: Japanese firm’s shares held by a UK bank, DR issued to UK citizens.
Bank Duties: Depository bank manages dividends, stock splits, and other events.
TYPES OF ADRs
Level I: Unlisted, OTC, low fees, no capital raising, F6-SEC
Level II: Listed, major exchanges, high fees, no capital raising, F6-SEC
Level III: Listed, major exchanges, high fees, can raise capital, F1+F6-SEC
Rule 144A: Unlisted, for QIBs or PIPE, low fees, private placements, SEC Registrations not required
WHY DO COMPANIES ISSUE EQUITY?
- RAISE CAPITAL
- INCREASE LIQUIDITY
Reasons:
1. ORGANIC GROWTH: Finance Revenue-Generating Activities
2. INORGANIC GROWTH: M&A
3. Stock-based & Option-based incentives to Employees (ESOPS & Sweat Equity)
4. If cash-strapped, it needs capital to keep it a going-concern, fulfill debt requirements & maintain key ratios
SOURCES OF TOTAL RETURN FOR EQUITIES
- CAPITAL GAINS (Price Appreciation)
- DIVIDEND INCOME
- FOREX GAINS/LOSSES due to CURRENCY CONVERSION
WHAT IS RISK?
UNCERTAINTY OF FUTURE CASH FLOWS
EXPECTATIONS (X) - OUTCOMES (X BAR)
WHAT IS THE MANAGEMENT’S GOAL?
- Increase Book Value (A-L)
- Maximize Market Value of Equity (SH Returns)
Management
Directly Impacts= Book Value
Indirectly Impacts= Market Value
HOW CAN MANAGEMENT INCREASE BOOK VALUE?
- Increase Net Income
- Sell (New Issue)/Buy Back Own Shares
- Hold Back Dividends to Increase Retained Earnings (RE0-Net Income-Dividends)
Book Value & Market Value are seldom same (Same in Efficient Markets)
RISK CHARACTERISTICS OF DIFF. TYPES OF EQUITIES
- COMMON vs PREFERENCE
- CUMULATIVE vs NON-CUMULATIVE
- CALLABLE vs NON-CALLABLE
- PUTTABLE vs NON-PUTTABLE
MORE RISKY? MORE RETURNS?
- COMMON: no priority in liquidation + no first right to dividends (dividends not fixed as a % to par value)
- NON-CUMULATIVE: dividends lapse: year 3 dividends is simply year 3’s dividends standalone, not Y1+Y2+Y3
- CALLABLLE: company can CALL to BUYBACK shares
- PUTTABLE: investor can’t give shares back to the company
BOOK VALUE VS MARKET VALUE
BOOK VALUE= HISTORIC (based on current value of assets & liabilities)
MARKET VALUE= INTRINSIC VALUE (based on what investors expect will happen in the future)
P/B RATIO= good ratio to understand this: PERCEPTIONS:BOOK OR PRICE:BOOK
PPS/BVPS OR MCAP/BV
RETURN ON EQUITY
NET PROFIT/EQUITY
OR
NET PROFIT/AVG. BV OF EQUITY
If ROIC is closer to ROE
Lots of Free Money (Accounts Payables)
DU PONT ANALYSIS
PIERRE DUPONT= GENERAL MOTORS
INVENTED BY DU PONT EXPLOSIVES SALESMAN DONALDSON BROWN
ROE= NET PROFIT/EQUITY
ROE= NET PROFIT/BV OF EQUITY
NP/EQ * SALES/SALES * ASSETS/ASSETS
REARRANGING
NP/SALES * SALES/ASSETS * ASSETS/EQUITY
PROFITABILITY–EFFICIENCY–LEVERAGE
NET PROFIT MARGIN – ASSET TURNOVER – EQUITY MULTIPLIER
Excessive Debt can Inflate ROE by INCREASING Net Profit
ROE INCREASES WHEN??
ROE= Net Income/Equity
Thus, ROE INCREASES when NET INCOME increases at a faster rate than EQUITY
IS INCREASE IN ROE ALWAYS GOOD??
DEPENDS.
ROE= Net Income/Equity
If Net Income is decreasing & Equity is decreasing at a FASTER RATE. Then ROE is INCREASING. THIS IS NOT GOOD.
ROE also increases if company ISSUES DEBT TO BUY-BACK EQUITY. But, the riskiness of the company will also go up. Du-Pont Leverage Equity Multiplier.
3 REASONS FOR INCREASE:
1. NP Increases
2. BV or EQUITY Declines FASTER than NP
3. More Leverage for Buybacks
ONLY 1st case is DESIRABLE.
INVESTOR’S REQUIRED RATES OF RETURN
When Investors purchase company shares, their minimum required rate of return is based on the future cash flows they expect to receive
COST OF EQUITY & CAPM MODEL
CAPM MODEL: Sharpe & Treynor
Rf+B(Rm-Rf)
COE: Minimum expected rate of return that a company must offer its investors to purchase its shares
- COE may be DIFFERENT from the investor’s required rate of return
- Because companies try to raise capital @ lowest possible cost, COE is a PROXY for investor’s MINIMUM REQUIRED RATE OF RETURN
- If the expected rate of return is NOT maintained, share price FALLS.
WHY IS COST OF EQUITY A PROXY FOR INVESTOR’S MINIMUM REQUIRED RATE OF RETURN
Because companies try to RAISE CAPITAL at LOWEST POSSIBLE COST
RISK: Uncertainty, Sensitivity & Loss
- UNCERTAINTY (x-xbar)
- SENSITIVITY (B: systematic risk, Duration, Delta: options)
- Loss (VAR, EAR, EAR)
- value at risk
- earnings at risk
- equity at risk
RISK-ADJUSTED RETURN RATIOS
ST SC
Return (excess)/Risk
SHARPE= (Rpf-Rf)/sigma
TREYNOR= (Rpf-Rf)/BETA
SORTINO= (Rpf-Rf)/downside sigma
CALAMAR= (Rpf-Rf)/max. drawdown
downside sigma because Standard Deviation doesn’t differentiate UPSIDE or DOWNSIDE risk. In long term investing, upside risk isn’t really a risk
JENSEN’S ALPHA= Rpf-Ke
= Rpf-Rf+(Rm-Rf)B
METHODS/MODELS TO ESTIMATE COST OF EQUITY
- CAPM
Rf+B(Rm-Rf) - DDM
DDM= D1/r-g
DDM = D0(1+g)/r-g
r= constant COE
g= constant growth rate in perpetuity (TGR)
Which of the following is not a characteristic of common equity?
A. It represents an ownership interest in the company.
B. Shareholders participate in the decision-making process.
C. The company is obligated to make periodic dividend payments
Answer: C
The company is not obligated to make dividend payments. It is at
the discretion of the company whether or not it chooses to pay
dividends.
Eg: Google never paid dividends till June 2024
All of the following are characteristics of preference shares except:
A. They are either callable or putable.
B. They generally do not have voting rights.
C. They do not share in the operating performance of the company.
Answer: A
Preference shares do not have to be either callable or putable.
The type of equity voting right that grants one vote for each share of equity owned is referred to as:
A. proxy voting.
B. statutory voting.
C. cumulative voting.
Answer: B
Statutory voting is the type of equity voting right that grants one vote per share owned.
Participating preference shares entitle shareholders to:
A. participate in the decision-making process of the company.
B. convert their shares into a specified number of common shares.
C. receive an additional dividend if the company’s profits exceed a
pre-determined level.
Answer: C
Participating preference shares entitle shareholders to receive an additional dividend if the company’s profits exceed a predetermined
level.
Which of the following statements about private equity securities is incorrect?
A. They cannot be sold on secondary markets.
B. They have market-determined quoted prices.
C. They are primarily issued to institutional investors.
Answer: B
Private equity securities do not have market-determined quoted
prices.
Venture capital investments:
A. can be publicly traded.
B. do not require a long-term commitment of funds.
C. provide mezzanine financing to early-stage companies.
Answer: C
Venture capital investments can be used to provide mezzanine financing (mix of debt & equity) to companies in their early stage of development.
Which of the following statements most accurately describes one difference between private and public equity firms?
A. Private equity firms are focused more on short-term results than public firms.
B. Private equity firms’ regulatory and investor relations operations are less costly than those of public firms.
C. Private equity firms are incentivized to be more open with investors about governance and compensation than public firms.
Answer: B
Regulatory and investor relations costs are lower for private equity firms than for public firms. There are no stock exchange, regulatory, or shareholder involvements with private equity, whereas for public firms these costs can be high.
Emerging markets have benefited from recent trends in international markets.
Which of the following has not been a benefit of these trends?
A. Emerging market companies do not have to worry about a lack of liquidity in their home equity markets.
B. Emerging market companies have found it easier to raise capital in the markets of developed countries.
C. Emerging market companies have benefited from the stability of foreign exchange markets.
Answer: C
The trends in emerging markets have not led to the stability of foreign exchange markets
When investing in unsponsored depository receipts, the voting rights to the shares in the trust belong to:
A. the depository bank.
B. the investors in the depository receipts.
C. the issuer of the shares held in the trust.
Answer: A
In an unsponsored DR, the depository bank owns the voting rights to the shares. The bank purchases the shares, places them into a trust, and then sells shares in the trust—not the underlying shares—in other markets.
With respect to Level III sponsored ADRs, which of the following is least likely to be accurate? They:
A. have low listing fees.
B. are traded on the NYSE, NASDAQ, and AMEX.
C. are used to raise equity capital in US markets.
Answer: A
The listing fees on Level III sponsored ADRs are high.
A basket of listed depository receipts, or an exchange-traded fund, would most likely be used for:
A. gaining exposure to a single equity.
B. hedging exposure to a single equity.
C. gaining exposure to multiple equities.
Answer: C
An ETF is used to gain exposure to a basket of securities (equity, fixed income, commodity futures, etc.).
Calculate the total return on a share of equity using the following data:
Purchase price: $50
Sale price: $42
Dividend paid during holding period: $2
A. –12.0%
B. –14.3%
C. –16.0%
Answer: A
Total return=(42-50+2)/50=-12.0%
If a US-based investor purchases a euro-denominated ETF and the euro subsequently depreciates in value relative to the dollar, the investor will have a total return that is:
A. lower than the ETF’s total return.
B. higher than the ETF’s total return.
C. the same as the ETF’s total return.
Answer: A
The depreciated value of the euro will create an additional loss in the form of currency return that is lower than the ETF’s return.
- Exchange Rate Impact: Depreciation of the euro means fewer dollars when converted back.
- ETF Return: The ETF’s performance is measured in euros.
- Total Return in USD: When the euro value drops, the same ETF return in euros translates to a lower return in dollars.
Which of the following is incorrect about the risk of an equity security?
The risk of an equity security is:
A. based on the uncertainty of its cash flows.
B. based on the uncertainty of its future price.
C. measured using the standard deviation of its dividends.
Answer: C
Some equity securities do not pay dividends, and therefore the
standard deviation of dividends cannot be used to measure the risk of all equity securities.
From an investor’s point of view, which of the following equity securities is the least risky?
A. Puttable preference shares.
B. Callable preference shares.
C. Non-callable preference shares.
Answer: A
Puttable shares, whether common or preference, give the investor the option to sell the shares back to the issuer at a pre-determined price.
This pre determined price creates a floor for the share’s price that reduces the uncertainty of future cash flows for the investor (i.e., lowers risk relative to the other two types of shares listed).
Which of the following is least likely to be a reason for a company to issue equity securities on the primary market?
A. To raise capital.
B. To increase liquidity.
C. To increase return on equity.
Answer: C
Issuing shares in the primary (and secondary) market reduces a company’s return on equity because it increases the total amount of equity capital invested in the company (i.e., the denominator in the ROE formula).
Which of the following is not a primary goal of raising equity capital?
A. To finance the purchase of long-lived assets.
B. To finance the company’s revenue-generating activities.
C. To ensure that the company continues as a going concern.
Answer: C
Capital is raised to ensure the company’s existence only when it is required. It is not a typical goal of raising capital.
Which of the following statements is most accurate in describing a company’s book value?
A. Book value increases when a company retains its net income.
B. Book value is usually equal to the company’s market value.
C. The ultimate goal of management is to maximize book value.
Answer: A
A company’s book value increases when a company retains its net income or dividends as retained earnings.
Which of the following statements is least accurate in describing a company’s market value?
A. Management’s decisions do not influence the company’s market value.
B. Increases in book value may not be reflected in the company’s market value.
C. Market value reflects the collective and differing expectations of
investors.
Answer: A
A company’s market value is affected by management’s decisions.
Management’s decisions can directly affect the company’s book value, which can then affect its market value.
Calculate the return on equity (ROE) of a stable company using the following
data:
Total sales £2,500,000
Net income £2,000,000
Beginning of year total assets £50,000,000
Beginning of year total liabilities £35,000,000
Number of shares outstanding at the end of the year 1,000,000
Price per share at the end of the year £20
A. 10.0%.
B. 13.3%.
C. 16.7%.
ROE= NP/AVG. SH EQ
AVG SH EQ= BOP ASSETS-BOP LIABILITIES/2
NI= 2,000,000
EQ= A-L= 50-35= 15,000,000
2,000,000/15,000,000= 13.33%
B.
Answer: B
For 2009, the BVEt–1 is equal to the beginning total assets minus
the beginning total liabilities, which equals
£50,000,000-£35,000,000=£15,000,000
Therefore, ROE=£2,000,000/£15,000,000=13.3%
Calculate the book value of a company using the following information:
Number of shares outstanding 100,000
Price per share €52
Total assets €12,000,000
Total liabilities €7,500,000
Net Income €2,000,000
A. €4,500,000.
B. €5,200,000.
C. €6,500,000.
A-L
120-75= 45
A.
Answer: A
The book value of the company is equal to total assets minus total liabilities, which is
€12,000,000-€7,500,000= €4,500,000
Which of the following measures is the most difficult to estimate?
A. The cost of debt.
B. The cost of equity.
C. Investors’ required rate of return on debt.
Answer: B
The cost of equity is not easily determined.
It is dependent on
investors’ required rate of return on equity, which reflects the
different risk levels of investors and their expectations about the
company’s future cash flows.
Holding all other factors constant, which of the following situations will most likely lead to an increase in a company’s return on equity?
A. The market price of the company’s shares increases.
B. Net income increases at a slower rate than shareholders’ equity.
C. The company issues debt to repurchase outstanding shares of equity.
Answer: C
A company’s ROE will increase if it issues debt to repurchase outstanding shares of equity.
A= not related
B= SH equity growing faster than NI, this is not a necessary implication
Thus,
“most likely”= C
A company’s cost of equity is often used as a proxy for investors’:
A. average required rate of return.
B. minimum required rate of return.
C. maximum required rate of return.
Answer: B
Companies try to raise funds at the lowest possible cost.
Therefore,
cost of equity is used as a proxy for the minimum required rate of return.
