Topic 8 – Capital Markets: Corporations and Investors in the Share Markets Flashcards
The objective of financial management is to
maximize shareholder value
Four main aspects of financial management are
Investment decision (capital budgeting)
Financing decision (capital structure)
Liquidity (working capital) management
Dividend policy decision
Investment decision (capital budgeting)
What assets to obtain or invest in.
Financing decision (capital structure)
How to fund the purchase of these assets.
Liquidity (working capital) management
How to best manage working capital – liquidity.
Dividend policy decision
What proportion of profits should be distributed/retained.
The financing decision
the capital structure used to fund the firm’s business activities.
The financial objective of a corporation
maximise return, subject to an acceptable level of risk.
Two sources of risk
Business Risk
Financial Risk
Business Risk
Exposure to factors that have an impact on a firm’s activities and operations
Financial Risk
Exposure to factors that affect value of assets, liabilities and cash flows
Business risk is affected by
- Sectoral growth rates
- Market share
- Aggressiveness of competitors
- Competence of management and workforce
Categories of financial risk
Interest Rate Risk Foreign Exchange Risk Liquidity Risk Credit Risk Capital Risk Country Risk
Interest Rate Risk
Risk of adverse movements in interest rates
Foreign Exchange Risk
Risk of adverse movements in exchange rates
Liquidity Risk
Risk of insufficient cash in the short term
Credit Risk
Risk of default or untimely payments by debtors
Capital Risk
Risk of insufficient shareholder funds to meet capital growth needs or absorb abnormal losses
Country Risk
Risk of financial loss due to currency devaluation or inconvertability
debt to equity ratio (D/E)
indicates the risk of being unable to meet interest due and principal repayments associated with the use of debt, i.e. risk of insolvency
Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in practice are:
- Industry norms
- Historic levels of firm’s ratio
- Limit imposed by lenders through loan covenants, i.e. restrictions placed on a borrower specified in a loan contract
- Management’s assessment of the firm’s capacity to service debt
Initial Public Offering (IPO)
an offer to investors of ordinary shares in a newly listed company on a stock exchange.
Underwriters
A contactual undertaking to purchase securities that are not subscribed to by investors
An IPO is described as
Flotation of a business
Flotation of a business
the public listing and quotation of a corporation on a stock exchange
Underwriters will provide advice on
- Structure of issue
- Debt to Equity Ratio
- Pricing of issue
- Timing of the issue
- marketing of issue
- allocation of securities
Prospectus lodged with ASIC
Document prepared by a company stating the terms and conditions of an issue of securities to the public
Out-clause
Specific conditions precluding full enforcement of an underwriting agreement
Publicly listed corporation
Has its shares listed and quoted on a stock exchange
2 common types of corporate structures
A limited liability company
A no liability company
Limited Liability Company
the claim of creditors against shareholders are limited to the issue price of their fully paid shares
Proxy
is someone who is authorised to vote on a shareholders behalf.
Limited liability shares are usually sold
fully paid, or can be partly paid (contributing basis) or paid by instalment receipt
Installment Receipt
Issued upon payment of the first instalment on a new share issue; ordinary share issued when final installment paid
listing rules
Rules that must be met by an entity seeking to be quoted on a stock exchange
Delisted
removal from quotation of the securities of an entity that breaches stock exchange listing rules
Listing rule principles
- embrace the interests of listed entities
- maintain investor protection, and
- maintain the reputation and integrity of the market.
A non-complying listed company can be
suspended from quotation or delisted.
Main principles of a stock exchange’s listing rules include:
- Sufficient investor interest must be demonstrated
- Timely disclosure must be made of information which may affect security values.
Different Forms of equity finance are available to established companies
Additional ordinary shares
Preference Shares
Quasi-Equity
Ways to raise equity funds through issuing additional ordinary shares
Rights Issue
Placements
Takeover Issues
Dividend Reinvestment Schemes
Ways to raise equity funds through issuing quasi-equity
convertible notes
company-issued options
company-issued equity warrants
Rights Issue
Issue of ordinary shares to existing shareholders
Factors affecting the rights issue price
- Company’s cash flow requirements
- Projected earnings flows from the new investments funded by the rights issue
- Cost of alternative funding sources
Two types of rights issue
Renounceable
Non-renounceable
Renouncable
Shareholder may sell their right issue
Non-Renouncable
Right issue may not be sold
Placements
Additional new ordinary shares issued directly to selected investors (institutions and individuals) deemed to be clients of brokers
Minimum subscription $500 000 to not more than 20 participants
Takeover issues
- Acquiring company issues additional ordinary shares to owners of target company in settlement of the transaction.
- Alleviates need for owners of acquiring company to inject cash for the purchase of the company.
Dividend reinvestment schemes
Shareholders have the option of reinvesting dividends in additional ordinary shares;
Preference Shares
- Are hybrid securities, i.e. they have characteristics of both debt and equity
- pay fixed dividend
- offer the right to convert to ordinary shares at a future date
Features of Preference Shares
- Cumulative or non-cumulative;
- Redeemable or non-redeemable;
- Convertible or non-convertible;
- Participating or non-participating.
Cumulative preference Shares
Fixed dividends not paid in one period carry forward untill paid
Redeemable Preference Shares
May be redeemed for cash or convert to ordinary shares at the expiry date
Non-redeemable preference shares
Only convertible to ordinary shares at expiry date
Convertible Preference Shares
May be convertible to ordinary shares at a future date at a specified price
Participating Preference Shares
Holders will receive a higher dividend if ordinary shareholders receive a dividend above a specified amount
Advantages of preference shares
- Fixed interest but an equity finance instrument
- Assist in maintaining debt to equity ratio
- Widen a company’s equity base, which allows further debt to be raised also
- Dividends may be deferred on cumulative shares and not paid on non-cumulative shares, while interest on debt must be paid
Convertible Notes
- hybrid instrument, issued for a fixed term at a stated rate of interest, either by direct placement or pro-rata to shareholders.
- Holder has right to convert the note into ordinary shares at a specified future date and at a predetermined price.
- If share price subsequently rises a gain is made.
- If share price falls, holder may not exercise conversion option and take the notes’ cash value.
Company-issued options
- Bestows a right, but not an obligation, on the holder to buy new ordinary shares in the company
- Typically offered in conjunction with a rights issue or placement
- The option will be exercised if the exercise price is less than the market price of the share at the exercise date
Company-issued equity warrants
- An option to buy additional shares that is orginally attached to a debt issue
- Generally attach to corporate bond issues but may be issued unattached
- option to convert warrant into ordinary shares at specified price over a given period
- Warrants may be detachable from the bond and traded separately
Pre-dividend imputation (prior to 1987)
Dividends were taxed twice—first at company level (as profits) and then at the investor’s marginal rate.
Dividend imputation (since 1987)
Removed the double taxation of dividends
Investors receive franking credit for the tax a company pays on a franked dividend
Share Pricing
mainly a function of supply and demand for a share
- influenced mainly by information
- present value of future dividend payments to shareholders
- New information that changes investors’ expectations about future dividends will result in a change in the share price.
But when dividends are not expected to grow at a constant rate:
the investor must evaluate each year’s dividends separately
- However, the multistage growth model does assume that dividend growth eventually becomes constant
Cum-dividend share prices
A share price includes an entitlement to receive a declared dividend
Ex-Dividend Share Price
Date at which a share is theoretically expected to fall by the amount of declared dividend
Cum-Dividend v Ex-Dividend
- Beforethe ex-dividenddate the shares are said to be cum-dividend. If you buy shares whilst they are cum-dividend you are entitled to the recently announced dividend.
- Once the dividend is paid the shares are traded ex-dividend
- Theoretically the share price will fall on the ex-dividend date by the size of the dividend.
Bonus share issues
- Where a company has accumulated reserves, it may distribute these to existing shareholders by making a bonus issue of additional shares
- As with dividends, there will be a downward adjustment in share price when shares go ex-bonus
Share Splits
- Involves division of the number of shares on issue
- no fundamental change in the structure or asset value of the company
- Theoretically the share price will fall in the proportion of the split
Pro-rata rights issue
- Involves an increase in the company’s issued capital
- Typically issued at a discount to market price
- Theoretically, the market price will fall by an amount dependent on The number of shares issued and
The size of the discount
