Chapter 6 Capital Adjustments

Question 1

Difference between income events and capital events

Answer 1

Income event:
-Coupons from bonds (fixed and floating rate)

• Dividends from equities (ordinary and preference)

Capital event:
- Redemption of bonds (callable/putable, bullet issue, sinking issue)

• Shares (rights issues, bonus issue, splits and consolidation)

Question 2

What is a bullet issue

Answer 2

Fixed repayment of capital at end

Alternatively, non-bullet issues would
repay the principal over a series of payments, rather than in a lump sum

Question 3

What is a sinking fund

Answer 3

A sinking fund involves the issuer setting
aside a certain amount of funds toward the maturity repayment each year. The money is often paid to a
separate trustee, who will either hold the money until the scheduled maturity date, or buy back bonds
in the open market if they are trading below par. The sinking fund reduces the risk that the issuer will
not have sufficient funds to repay the entire principal on the maturity date.

Question 4

What are putable and callable bonds

Answer 4

Callable bonds can be redeemed earlier at discretion of company

Putable bonds can be redeemed earlier at discretion of investor

Question 5

What is cum and ex dividend period

Answer 5

Cum-div- The buyer of the security will be entitled to next dividend payment

Ex div- Entitlement of next dividend payment remains with seller- buyer not entitled

Question 6

What is record date

Answer 6

Date which company inspects the register of members in order to establish which shareholders will be sent div

Question 7

What is special ex-date trade

Answer 7

Takes place in cum div period but bought/sold without div. Permitted for up to 10 business days before ex div date

Question 8

What is special cum-div trade

Answer 8

Takes place in ex div period but bought/sold with div. Permitted up to the day before the dividend payment date

Question 9

Why would an investor want to trade special ex

Answer 9

To avoid income tax

Question 10

What is claim generation

Answer 10

In such situations, if the dividend was paid to the wrong person in a special cum-trade, then it is the broker acting for the buyers that should make a claim for the dividend.

In contrast, when the dividend
has been paid to the wrong person, following a special ex trade, it is the seller’s broker who will have tomake the claim for their client to receive their rightful dividend payment.

Question 11

Features of rights issue

Answer 11

A follow on issue of shares giving existing shareholders the right to subscribe to more shares in proportion to their existing holding

• Mitigates risk of diluting ownership
• Shares offered at discount to current market price
• Issues generally underwritten

Question 12

Theoretical Ex Rights Calculation

Answer 12

eg 1:4 rights issue. 1 IS NEW SHARE AND 4 IS EXISTING SHARE ALWAYS

TERP=

(Existing share number * existing share price) +(New share number * New share price)/

(number of shares altogether new one and old)

Question 13

What is an open offer

Answer 13

Rights issue but investor not permitted to sell rights nil-paid. Can either take rights or allow rights to lapse

Question 14

What are pre-emptive rights

Answer 14

A pre-emption right is the right of the shareholder to be able to buy shares to maintain their existing percentage shareholding.

Possible for shareholders to waive pre-emptive rights through special resolution. Anyway should limit such issuance to 5% each year

Shares issued pro-rata to existing shareholdings

Question 15

Theoretical nil paid price calculation

Answer 15

= TERP - Subscription price

Question 16

Maximum nil-paid rights calculation

Answer 16

Number of rights sold = number of RIGHTS available*subscription price/ TERP

Minus this number from total number of rights available

Question 17

What is a capitalization issue

Answer 17

Issue of new shares to existing shareholders in proportion to existing shareholding. Shareholders dont have to pay for the new shares

Question 18

What is scrips/bonus issue

Answer 18

Follow on issue of shares to existing shareholders in proportion to existing holding

• Shares issued free of charge
• Dilutes share price alot

Question 19

Theoretical ex-scrip price calculation

Answer 19

Current share price * existing holding/ number of shares held after scrip/bonus issue

Question 20

Who is approval required from for share buy-backs

Answer 20

Shareholders

Question 21

Reasons for buy backs

Answer 21

1. When the company has reduced its activities (perhaps having sold a major part of its business) and
   has surplus cash to return to shareholders.
2. When the company wants to reorganise its capital structure to include more debt and less equity (RATIONALISE CAPITAL STRUCTURE). In
   these circumstances the company can borrow money (by issuing bonds or from banks), and use it to
   buy back and therefore reduce the number of shares it has in issue.

Question 22

Methods of buybacks

Answer 22

• Block trade
• Accelerated book building
• Best efforts with back stop price
• Bought deal

Question 23

What is a block trade

Answer 23

Like placing in reverse

when an investment bank acting for the company will seek to do a small number of
large trades with investors, perhaps through an exchange.

Question 24

What is a bought deal

Answer 24

IB guarantee you will receive number of shares you want to buy back (like underwritten)

underwriter(s) actually purchase
the shares themselves and then attempt to resell them to clients. The investment bank(s) that
provide the guarantee will retain the inventory that is not sold on.

Question 25

What is accelerated book building

Answer 25

The correct answer is: A - An investment bank contacts larger institutional investors in the company to see if they would be willing to sell their shares at a certain price

Question 26

What is FCA disclosure and transparency rules

Answer 26

Notifiable interest= 3% or more of shares triggers obligation to inform company. Once above 3%, notification required if holding rises or falls through a whole % point

Question 27

At what % acquired is takeover successful

Answer 27

Above 50%

Question 28

Acquire X% or more of a company then takeover/merger proceedings will be announced to market

Answer 28

30%

Question 29

How does bonus issue affect EPS and DPS

Answer 29

eps and dps decrease as more shares

Question 30

Look at table showing what happnes in split, consolidation etc

Question 31

What capital event raises capital

Answer 31

Rights issue

Question 32

Options when offered rights issue

Answer 32

Will receive provisional allotment letter then 4 choices:

• Take up rights
• Sell rights
• Split the rights
• Allow rights to lapse

Question 33

How does rights issue affect net assets

Answer 33

Net assets increase by the amount raised

Question 34

What is a dawn raid

Answer 34

Acquirer instructs brokers to purchase shares in target company as soon as market open to take legal control before public disclosures need to be made

Question 35

Examples of indirect stakebuilding

Answer 35

Another possibility for keeping stakebuilding more secretive is to build a stake in an ‘indirect’ way.
Instead of buying shares in another entity directly, the stake could be established by acquiring contracts
for difference (CFDs). A CFD on a share is an agreement between the buyer and seller to exchange the
difference in the current value of the share and its value at the end of the contract. If the difference is
positive, the seller pays the buyer; if it is negative, the buyer pays the seller. CFDs enable participants to get
the economic exposure of owning a stake in another entity in a less visible and potentially leveraged way.

Question 36

Examples of direct stake building

Answer 36

• Buying shares

Question 37

What is purpose of stake building

Answer 37

• build strategic link
• acquire target company

Question 38

Which of the following corporate actions would a company take in order to convert its reserves into new ordinary share capital?

Answer 38

A company converts its reserves, which may have arisen from issuing new shares in the past at a premium to their nominal value, or from the accumulation of undistributed past profits, into new ordinary shares.

These shares rank pari passu with those already in issue and are distributed to ordinary shareholders in proportion to their existing shareholdings free of charge.

Question 39

Which of the following would result in an issuer of shares receiving cash?

Answer 39

The pre-emptive rights issue is the only one to raise capital. In a capitalisation issue the company issues shares for free. No new shares are issued in either a secondary market sale or an introduction.

Question 40

How is the net asset per share affected following a 1:3 scrip?

Answer 40

Decreased by 1/4

Question 41

What best describes the effect on the balance sheet of a 1:1 bonus issue?

Answer 41

Share capital increases; reserves decrease

Question 42

What would the theoretical ex-rights price be, given the following?
A stock is priced 155p cum dividend. It will trade ex-dividend of 10p next week. There is a 3:5 rights issue at 110p.
The new shares rank pari passu except for the dividend.

Answer 42

Ex-div price = 155p - 10p = 145p 3 shares x 110p = 330p 5 shares x 145p = 725p 330p + 725p = 1,055p 1,055p / 8 shares = 131.9p

The question specifically states that ‘It will trade ex-dividend of 10p next week’. This is why the 10p dividend is stripped out of the cum-div price

Question 43

What is a purpose of the rules contained in relevant legislation relating to a company buying back its own shares? It is there to:

Answer 43

To protect the interests of creditors

Question 44

The cum-price of a share before a 5:1 capitalisation issue was 300p. What is the theoretical ‘ex’ price?

Answer 44

Before the scrip issue: 1 share @ 300p.
During the scrip issue: 5 shares were issued at no cost.
After the rights issue: 6 shares @ 300p.
Therefore, the theoretical ‘ex’ price = 300p/6 shares = 50p.

Question 45

An individual holds 2,100 shares in X plc. The cum-rights share price is £6 when the company performs a 1:3 rights issue. The subscription price is £5. What is the maximum subscription at nil cost?

Answer 45

2100 SHARES, NOT RIGHTS

2,100 shares will give the shareholder 700 rights as it is 1:3 rights issue. The formula to calculate the number of rights that need to be sold is the no. of rights x Subscription price / Theoretical ex-rights price
TERP = ((£6x3)+£5)/4 shares = £5.75
700 x £5 / £5.75 =609
These rights are then deducted from the rights available to give the maximum subscription at nil cost.
700 - 609 = 91 shares

Question 46

Which one of the following statements best reflects what happens with respect to the merger of two companies?

Answer 46

One company will exchange new shares for the shares of the other company

Question 47

A firm makes a 1:10 scrip issue; you have a client whose portfolio contains 15,000 shares and was worth £50,000 before the scrip issue. Your client wants to know what his portfolio will be worth after the issue. It will be worth:

Answer 47

A scrip issue will not change the overall value of the portfolio. Rather than having 15,000 shares worth £50,000, the investor will have 16,500 {15,000 + (15,000 / 10) } shares worth £50,000.