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EFB201 Financial Markets > Equity Markets > Flashcards

Equity Markets Flashcards

1
Q

What is a corporation?

A

A company that is a legal entity established under the corporations law of a nation-state

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2
Q

What are the 3 features that distinguish a publicly listed corporation?

A
  1. Ownership is generally widely dispersed among a number of shareholders
  2. The objectives and policies of the corporation are determined by a board of directors, whom are elected at general meetings by shareholders & report to them
  3. The liability of shareholders for the debts of the business is limited to the issue price of the share
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3
Q

What are the rights, roles and responsibilities of the shareholders, board of directors and executive management?

A

Shareholders - Has the right to vote in the affairs of the corporation, elect the board of directors of a corporation, do nor do not directly participate in the day-to-day operations,
Board of directors - elected by shareholders & report to them, determines the objectives and policies of the corporation
Executive management - appointed by the board of directors, achieve the objectives and policies determined by the BoD through the management of day-to-day financial and operational affairs

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4
Q

What are the 6 advantages of a publicly listed company?

A
  1. In a deep and liquid share market, large amounts of money can normally be raised through a wide range of investors
  2. Shareholders can reduce the risk of share ownership by holding a diversified portfolio & being able to trade their shares in the share market
  3. Separation of ownership (Shareholders) and control (managers) means the corporation can appoint specialized and skilled personnel to run a business
  4. The corporation as a legal entity allows for the continuation of the business (perpetual succession)
  5. The corporate form is almost essential for large-scale undertakings
  6. Separation of ownership and control allows for the planning and implementation of strategic decisions to be more effective over both the short-term and longer-term planning periods
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5
Q

What are the disadvantages of a publicly listed company?

A

Separation of ownership and control creates potential disadvantages as the managers may not act in the best interest of the shareholders, and instead act in their own best interests. This is known as the agency problem.

Theoretically, an efficient share market should minimize this conflict as owners can express their dissatisfaction with management through the sale of shares causing the share price to fall. Falling share prices will signal shareholders’ dissatisfaction with management’s performance

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6
Q

What are some remedies for agency problem?

A

Incorporate performance incentives into the management compensation package - share option scheme

Boards of directors and regulators have moved towards corporate governance requirements, relating to the relationship between the shareholders, board of directors and management. Policies and procedures are put in place to ensure that accountability and transparency become an integral part of the corporate culture

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7
Q

Why might a business want to be publicly listed?

A

Publicly listed corporations are legal entities formed under the provision of the corporations law and can be listed on the stock market

Shares can be readily bought & sold on the stock market without directly affecting the continuing existence of the business

Large amounts of equity funding can be obtained through selling shares on the stock market

Investors are willing to purchase shares on the stock exchange as they provide secondary markets for the future sales of those shares

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8
Q

What are Initial Public Offerings (IPOs?)

A

The initial offering of shares by a new publicly listed corporation is an IPO, described as a flotation of a business

The method terms, conditions & timing of an IPO are usually decided after consultation between the business and its financial advisers (stockbrokers, investment banks & other specialist advisers)

Advisers also assist with the preparation of the prospectus (the public offer document) and its lodgement with the corporate regulator

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9
Q

What are IPO advisers?

A

Advisers also ensure the business meets the stock exchange’s listing requirements. The preparation of the prospectus is a critical component of the listing process

A prospectus provides detailed information on the past and forecasted performances of the organisation, and includes reports from the board of directors and specialist experts, as well as financial statements

All information in the prospectus must be verified for accuracy through a process of due diligence

The IPO advisers normally take an active role in the promoting of the issue to potential shareholders

They may also arrange an underwriting group who, for a specific fee, agree to purchase any shares not taken up by investors

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10
Q

What are IPO underwriters?

A

Underwriters, in consultation with the advisers, will provide advice on the structure of the issue, pricing of the issue, timing of the issue, marketing of the issue and allocation of securities

Underwriters may include an out-clause in the underwriting agreement to protect themselves if market conditions change adversely between the initial agreement and timing of the issue and the actual float. The out-clause specifies conditions that preclude the underwriting agreement from being enforced

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11
Q

What are the two types of corporate structures in Australia?

A
  1. Limited Liability - Ordinary shares principal source of equity funding, represents a residual ownership claim on the assets of the firm, shareholders are entitled to some control over management by exercising the voting rights. Shares are sold on a fully paid basis, however sometimes can be issued on partly paid or contributing basis.
  2. No-liability Company - To attract shareholders, this type of venture could form a no-liability company where shares are issued on a partly paid basis
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12
Q

What are some equity funding alternatives?

A

Companies that are listed on the SX and have a problem track record of sound management, good profitability growth and a strong share price performance, provide attractive opportunities for shareholders

These companies can raise additional equity by issuing additional ordinary shares, preference shares, convertible notes and other forms of quasi-equity

Additional equity can also be raised in the form of several methods, such as rights issue, share purchase plans (SPP), placements and dividend reinvestment schemes

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13
Q

What are rights issues?

A

Under a rights issue a company will offer existing shareholders the right to participate in an additional issue of ordinary shares

To ensure that all shareholders receive an equal opportunity to participate, a pro-rate offer is made on the basis of a fixed ratio of new shares to the number of shares already held. e.g a 1:5 offers shareholders the chance to purchase 1 new share for every 5 owned

The terms of the share issue will be determined by the board of directors in consultation with financial advisers and, if applicable, the underwriters of the issue

The board of directors will consider the following when determine the rights offer price:

  • The company’s cash flow requirements - the offer price will be lower the greater the need for raising funds to increase the take-up rate
  • The projected return on assets funded by the rights issue - the higher the return the more attractive the issue will be to shareholders and the higher the offer price can be
  • The cost of alternative funding sources

Under a renounceable rights rights issue, shareholders are able to sell the rights to a third party during the period the right is on offer

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14
Q

How are rights issue valued?

A

Using the equation

N*Cum rights price + S)/(N+1

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15
Q

What is the rights issue value if a company that has cum-rights share price of $2 made a 1:4 rights issue with a subscription price of $1.80

A

Ex-rights price = (NCum rights price + S)/(N+1)
= (42+1.80)/(4+1)=9.80/5=$1.96

Under a renounceable rights issue, the rights to the new shares can be sold:
Value of right = Ex-rights price - S = 1.96 - 1.80 = $0.16

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16
Q

What is a Share Purchase Plan (SPP)?

A

A share purchase plan is an offer to existing shareholders to buy a set dollar amount of additional shares regardless of the number of shares already held

As the company will meet all costs associated with the issue, the shareholder does not incur brokerage or any other fees

The board of directors does not expect all shareholders to take up the offer. The company may raise more money than it currently needs if all shareholders take up the offer so the board might insert a condition in the prospectus that the offer may be scaled back

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17
Q

What are placements?

A

A placement is where additional shares are sold to selected institutional investors, such as fund managers

Some advantages of using a placement are:

  • It can be arranged and finalised more quickly than a rights issue
  • The discount to current market price may be smaller for a rights issue
  • The board of directors can ensure the shares are sold to investors who will support the development of the company

Some disadvantages of using placement are:

  • A placement has to consist of subscriptions of at least $500,000
  • There must be no more than 20 participants
  • The placement cannot be for more than 15% of the company’s issued shares
  • The discount from the current market price cannot be excessive

A prospectus does not need to be lodged if the institutional investors are deemed to be clients of brokers, however an information memorandum detailing activities must be sent to all participants

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18
Q

What is a dividend reinvestment scheme?

A

A company can return a percentage of its profits to shareholders in the form of dividends

One method of encouraging shareholders to put further equity funds back into the company is through the use of a dividend reinvestment scheme

Under the scheme shareholders are allowed to reinvest their periodic dividends by purchasing additional ordinary shares in the company

The company will meet all the transaction costs that the shareholder would have to pay if they had sought independent advice on how to reinvest their dividend

19
Q

How do you calculate the return on a share?

A

Using 1 of the following 3 equations:
Total Return = (End price + Dividend - Beginning price)/Beginning price
Total Return = (End price - Beg price)/Beg price + Dividend/Beg price
Total Return = Capital Gain + Dividend Yield

20
Q

What is the return on a share that was bought for $10, a year later it pays a dividend of $0.5 and then you sell the share for $11

A

Total Return = (End price - Beg price)/Beg price + Dividend/Beg price
= (11-10)/10+0.50/10
= 0.10+0.05=0.15=15%

21
Q

How do you value dividends? [General]

A 
PV=D1/(1+Re)+D2/(1+Re)^2+...+Dn(1+Re)^n
Where 
D is dividend
Re is required return on equity
Re= riskfree return + risk premium
22
Q

How do you value dividends? [Constant dividend for a finite time]

A

Price = D1*[1-(1+Re)^-n]/Re

23
Q

How do you value dividends? [Constant dividend in perpetuity]

A

Price=D1/Re

24
Q

How do you value dividends? [Constant growth in dividends in perpetuity]

A

Price=D0(1+g)/(Re-g)= D1/(Re-g)
Where
g = growth on dividends

25
Q

What are the principal functions of a modern and efficient stock exchange?

A
  1. Establishment of markets in a range of financial securities
  2. Provision of a securities trading system
  3. Operation of a clearing and settlements system
  4. Regulation and monitoring of the integrity of the exchange’s markets
  5. Provision of a well-informed market, to secure the confidence of participants
26
Q

What was the development of the stock exchange necessary for?

A
  • Facilitate the formation of publicly listed corporations and the creation of a deep and liquid market for the issue, buying and selling of shares of listed corporations
  • A stock exchange facilitates the rapid flow of information to all market participants
  • Market confidence in the integrity of a stock market is essential and must be maintained
  • The stock exchange, in conjunction with the corporate regulator, plays a very important role in prescribing and monitoring the activities of market participants
27
Q

What is the difference between primary and secondary markets?

A

Primary: Ensure the efficient and orderly sale of new-issue securities (they also list debt instruments and units in listed trusts)

Secondary: Where shareholders can buy & sell their existing financial securities.

  • A shareholder will normally issue a sell order to a stockbroker
  • The stockbroker will then enter the order into the stock exchange securities trading system.
  • Another broker will enter a buy order on behalf of another client
  • The stock exchange securities trading system will match the orders and facilitate the sale of shares, transfer of ownership and payment for the purchase
28
Q

What is the role of information?

A
  • Information must be given immediately to the ASX if the information is deemed to have a material effect on the price or value of the entity’s security
    e. g. A change in the corporation’s financial forecasts or expectations
29
Q

How does the ASIC supervise the share market?

A
  • The regulatory body responsible for the supervision of the Corporations Act in Australia
  • Market integrity and consumer protection across the financial system, covering investment, insurnace and superannuation products
  • Supervises the real-time trading on Aus’ domestic licensed markets (ASX)
30
Q

How does the ASX supervise the share market?

A
  • Ensures listed companies continue to meet the rules after being listed. A company that fails to do this can have trading in its securities suspended or it can be de-listed
  • Ensures listed entities comply with continuous disclosure obligations so that the market is fully informed at all times
  • Admit new market participants, including companies seeking listing on the exchange and stockbrokers trading operations, including the securities trading system
  • Supervise clearing and settlement participants, including Clearing House Electronic Sub-register System (CHESS), stockbrokers and financial institutions
31
Q

How does a company become listed on the stock exchange?

A
  • A company must apply to a stock exchange to have its shares quoted if it wishes to become a publicly listed corporation and raise equity funds
  • The application must be accompanied by documents outlining the company’s activities and performance: this information will be provided directly to the exchange and will be contained in a prospectus that supports the share offer to the public
  • The company will need to comply with the stock exchange’s listing rules . These rules aim to embrace the interests of listed entities, maintain investors protection and maintain the reputation and integrity of the market
32
Q

What are the main principles that form the basis of a stock exchange’s listing rules?

A
  1. Minimum standards of quality, size, operations and disclosure must be adhered to
  2. Sufficient investor interest must be demonstrated to warrant an entity’s participation in the market
  3. Securities must be issues to new and existing security holders in circumstances that are fair
  4. Securities must have rights and obligations attached to them that are fair to new and existing security holders
  5. Prescribed information must be provided to the exchange in a timely manner
  6. Material information that may affect security values or influence investment decisions must be disclosed immediately to the stock exchange
  7. Information must be produced according to the highest standards and, where appropriate, enable ready comparison with similar entities
  8. The highest standards of integrity, accountability and responsibility of entities and their officers must be maintained
  9. Practices must be adopted and pursued that protect the interests of security holders, including ownership interests and the right to vote
  10. Security holders must be consulted on matters of significance
  11. Market transactions must be commercially certain
33
Q

What is dividend imputation?

A

Dividends are taxed on the system, dividends which a company has already paid company tax are referred to as franked dividends.

Franking credit = Franked dividend * (company tax rate/1-company tax rate)

Franking credit = (5000.7)(0.3/1-0.3)

Tax payable = tax liability - franking credit

Tax payable = (650*0.4) - 150

34
Q

What is a stock market indices and what do they do?

A
  • Provides a measure of the performance of a share market or industry sectors within the overall market
  • A bull market is said to occur when stock market indices are continually rising while a bear market is occurring when the indices are steadily falling
  • A number of stock exchanges have rules in place to suspend trading on the exchange if, on any day of trading, the overall market index moves by more than a specified percentage
  • The rationale behind this rule is that large rises and falls in a single day may cause panic and generate a stampede to sell or buy. Time allows rationality to return to the market
35
Q

How do stock exchanges use specialist index providers?

A

3 types of share market indices:

  1. Performance benchmark indices which measures the performance and risk of a combination of companies with a high level of market capitalisation
  2. Tradeable benchmark indices which is a narrower index than a performance benchmark index and used to price certain derivative contracts
  3. Market indicator indices which measure performance of an overall market or a selected group of stocks that indicate the performance of the overall market
36
Q

What are the types of risk?

A
  1. Systematic risk - risk exposure that impacts the prices of the majority of shares listed on a stock exchange (changes in interest rates, new legislation, changes in market confidence)
  2. Unsystematic risk - risk exposure that significantly impacts the price of a particular corporation (resignation of an executive manager, changes in future performance forecasts)
37
Q

What is investment theory?

A

By holding a diversified portfolio an investor minimizes the risk exposure associated with investing in a single share (somewhere between 10 and 25 stocks)

38
Q

What is portfolio return?

A

The expected return on a portfolio is measures as the weighted average of the expected returns of each share held in a portfolio

39
Q

What is portfolio risk?

A

Often measures using variance or standard deviation of return on the portfolio. This reflects both the individual risks of the shares and the correlation of pairs of securities within an investment portfolio

40
Q

What is asset allocation?

A
  • Asset allocation within an investor’s portfolio needs to be taken into account
  • Risk versus return: this includes systematic and unsystematic risk and diversification
  • Investment time horizon: generally, higher returns are achieved over longer investment term
  • Income versus capital growth: investors have different liquidity needs
  • Domestic and international share investments
  • Other constraints
41
Q

What is ethical investing?

A

Following an ethical approach to your portfolio construction (avoiding companies perceived to trade in unethical products or participate in unethical practices)

Advantages

  • Feel better about making the world a better place
  • Avoiding companies that may face loses due to public backlash

Disadvantages

  • Possible lower return and liquidity
  • Loss of diversification benefits
42
Q

What are the two types of asset allocation?

A
  1. Strategic - structuring a portfolio to meet an investor’s personal risk return preferences (long term)
  2. Tactical - structuring a portfolio to reflect the changing investment environment (short term)
43
Q

What is fundamental analysis?

A

Top down:

  • broad country and asset class allocations
  • sector allocation decisions
  • individual securities selection

Bottom up:

  • Emphasizes the selection of securities without any initial market or sector analysis
  • Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth
44
Q

What is technical analysis?

A
  • Alternative approach to forecasting the movement of share prices for individual companies, and forecasting the performance of particular sectors and the overall stock market
  • This approach seeks to explain and forecast share price movements on the basis of the past behaviour of share prices
  • One underlying assumption of technical analysis is that markets are dominated at certain times by a mass psychology, and that over time regular share price patterns emerge
  • It assumes that the historical pattern will re-emerge in full as it did in the past.

EFB201 Financial Markets (4 decks)

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