Topic 11 Equity Capital Markets and Payout Policy

Question 1

What are primary markets?

Answer 1

Markets in which corporations raise funds through new issues of shares

Question 2

What are secondary markets?

Answer 2

markets that trades financial instruments once they are issued

Question 3

What are the two types of shares issued?

Answer 3

1. Initial Public Offering (IPO)
2. Seasoned Equity Offering (SEO)

Question 4

What are Initial Public Offerings (IPO)?

Answer 4

Firms initially going public and list their shares to be publicly traded on stock market for the first time.

Question 5

What are seasoned equity offerings?

Answer 5

new equity issued by an already publicly traded company.

Question 6

How are share prices determined in the primary market?

Answer 6

• Share prices are determined by underwriters or investment banks in the primary market  depending on the underwriting process, the pricing is determined by the investment bank

Question 7

How are share prices determined in the secondary market?

Answer 7

Pricing in secondary market is completely determined by investors

Question 8

Why are IPOS administered by underwriters?

Answer 8

IPOs are usually administered by underwriters as they have easy access to investors and a client base so they can buy a new issue shares otherwise they have no other ways to distribute it

Question 9

How do companies raise funds in equity capital markets?

Answer 9

• Companies only raise funds and receive cash in the primary market  they don’t receive cash in the secondary market  it is very active but has nothing to do with the company themselves

Question 10

How are shares circulated?

Answer 10

1. Company
2. Asset
3. Primary market
4. Investors
5. Asset
6. Organised exchanges and over-the-counter
7. Secondary market

Question 11

What is a price driven trading system?

Answer 11

It only displays the bid and asks offers for a security from designated market makers, dealers, or specialists. These market makers will post the bid and ask price that they are willing to accept at that time.

Question 12

What are some features of a price driven trading system?

Answer 12

1. Market makers quote the bid and ask price
2. Guarantee the execution of order
3. Execution is fast

Question 13

What is an order driven trading system?

Answer 13

One in which all of the orders of both buyers and sellers are displayed, detailing the price at which they are willing to buy or sell a security, and the amount of the security that they are willing to buy or sell at that price.

Question 14

What are some features of an order driven trading system?

Answer 14

1. More Transparent
2. Orders are matched by market makers according to rules (price, time and order priority)
3. No guarantee that all orders will be executed –> no dealers in this market may be carrying the stock that is desired, may not be able to execute the trade

Question 15

What is a hybrid system?

Answer 15

• Mix of price driven and order driven systems

Question 16

What is the process of trading shares?

Answer 16

1. Investor contacts a stockbroker, who opens an account for the investor to deposits funds into
2. Investor places an order with the stockbroker by phone or internet (or trade initiated by an algorithm)
3. The stockbroker attempts to execute the order via a counterparty
4. Settlement takes place, where the ownership of shares is transferred in exchange for a transfer of cash

Question 17

What are the two main type of orders in equity markets?

Answer 17

a. Limit orders
b. Market orders

Question 18

What are limit orders?

Answer 18

limit orders are an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.

Question 19

What are market orders?

Answer 19

an order to buy or sell a stock at the market’s current best available price. Market order typically ensures an execution but it does not guarantee a specified price.

Question 20

Who are the major parties involved in share trading?

Answer 20

a. The buying and selling parties, who could be individuals, institutions or fund managers
b. The stockbroker, who provides trading services
c. The securities exchange, which provides the facilities for trading and acts as a self regulatory body

Question 21

What are some features of a security exchange?

Answer 21

• Place where companies are listed
• They charge a listing fee and a trading fee
• Some of the brokage fee may cover the trading fee
• Exchange likes the idea of high frequency traders as they bring large volumes to the market which the exchange can charge a lot of fees to

Question 22

What is a stockbroker?

Answer 22

A stockbroker may be either a conduit to the market or they may act as the client’s agent

Question 23

What types of trading do brokers carry out?

Answer 23

a. Agency trading business transacted on behalf of clients
b. Principal trading business transacted on the broker’s own account

Question 24

What is a fund manager?

Answer 24

an organisation that invests funds on behalf of investors (their clients)

Question 25

What is house trading?

Answer 25

House trading is when fund managers get money from the company (proprietary trading) to get profit for the company

Question 26

What is an open fund?

Answer 26

Open end funds are ready to buy the shares or they have an underlying basket of shares they can deliver. An open-end fund is a diversified portfolio of pooled investor money that can issue an unlimited number of shares. The fund sponsor sells shares directly to investors and redeems them as well.

Question 27

What are the two types of open end funds?

Answer 27

1. Mutual Funds
2. Exchange rate funds

Question 28

What are mutual funds?

Answer 28

A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. They post their Net asset value at the end of the day, not traded on exchange.

Question 29

What are exchange rate funds?

Answer 29

An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does.
ETF share prices fluctuate all day as the ETF is bought and sold

Question 30

What is the difference between exchange rate funds and mutual funds?

Answer 30

A major difference between the two is that ETFs can be traded intra-day like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price known as the net asset value.

Question 31

What are close end funds?

Answer 31

A closed-end fund is a type of mutual fund that issues a fixed number of shares through a single initial public offering (IPO) to raise capital for its initial investments. Its shares can then be bought and sold on a stock exchange but no new shares will be created and no new money will flow into the fund.

Question 32

What are passive funds?

Answer 32

Passive funds are used to earn a return similar to the market index

Question 33

What are active funds?

Answer 33

Active funds are used to outperform the market index
* Actively select stocks to outperform the market
* Hedge fund managers are also active but they are not open to the market and raise funds easily  limited to the number of investors

Question 34

What is dividend policy?

Answer 34

Dividend policy refers to the decision by corporations to pay out net profits as dividends or alternatively, to reinvest, or retain the profits.

Question 35

What is the dividend payout ratio?

Answer 35

The dividend payout ratio quantifies the dividend policy decision by measuring the proportion of profits after tax paid out as dividends.

Question 36

How do companies decide the amount of dividends paid?

Answer 36

a. Set long run target payout ratios
b. Focus on the change in dividends
c. Base dividends on long run forecast profits and are consequently reluctant to change dividends
d. Are reluctant to cut dividends

Question 37

What is the theory about the impact of dividend policy on shareholder wealth?

Answer 37

dividend policy has no impact on shareholder wealth, given a number of assumptions
Their work should not be seen as proving that dividend policy is irrelevant to shareholder wealth; rather it should be seen as setting the conditions (assumptions) under which it is irrelevant, and by implication, suggesting why it may be relevant to shareholder wealth.

Question 38

What are the main assumptions underlying the M&M dividend irrelevance proof?

Answer 38

1. There are no costs of issuing shares
   * Not true as investment bank when they underwrite shares for the company, they issue fee so it takes some shareholder values
2. There are no costs of trading shares
   * No arbitrage examples
3. All market participants (e.g. management and shareholders) have the same information
4. There are no personal or corporate taxes

Question 39

What is the logic behind the M&M irrelevance proposition?

Answer 39

The M&M irrelevance proposition can be explained using the example of a company that pays out all of its free cash flows as dividends
If the company cuts back on existing projects –> Its future cash flows, and hence the share price, will fall
If the company issues new shares –> The existing value of the company will be spread across a greater number of shares, and the value of each share will fall
Either way, the increase in dividends will be offset by a decline in the price of shares, leaving shareholders no better or worse off

Question 40

What are special dividends?

Answer 40

A special dividend is a non-recurring distribution of company assets, usually in the form of cash, to shareholders. Most special dividends are larger than the normal dividends paid to shareholders and are tied to a certain event.