Ways of buying shares Flashcards
How are shares in listed companies initially issued?
Shares in listed companies are initially issued via an IPO – Initial Public Offering – and are then traded on the market.
what are the attractions of an initial public offering?
► The price of the share is often set at a ‘reasonable’ level to ensure that all the available shares are taken up
► This price attracts corporate investors who may find they are unable to get as many shares as they would like due to the limited supply.
► In the short term, once issued, this can have an upward pressure on prices and can lead to short term gains for the investor.
There are, however, potential downsides to investing via an IPO:
► The short-term price movements mentioned above aren’t always in an upward direction! (Remember the US housing bubble of the mid 2000s)
► The company is an unknown entity at first IPO. There is an element of ‘leap of faith’ in making the investment – the trading history and track record aren’t visible
► The timing of the IPO is set by the original owners, who will try to time things to suit them. Consider the government’s timing in selling its shares in Lloyds Banking Group… the sale was delayed more than once, waiting for the optimum conditions
► Once listed, there are many regulatory checks and balances which may not have been applied as rigorously pre-listing.
what is a rights issue?
A rights issue is an offer of shares to existing shareholders at a special price, in relation to their existing holding of shares. For instance, look at the below:
Share: ABC Ltd
Holding :13,600
Price: £1.75
Rights: £1.10
If this investor was offered a 1 for 9 rights issue, ABC Ltd would allow him to buy 1511 shares (13,600 / 9) at a price of only £1.10. This right could be given now, or at a future date. Where the date is in the future, the
right could be traded on the stock market freely.
Why might a firm offer a rights issue?
► Desire to raise capital to pay down debt
► Seeking to invest in expansion plans
► Planned acquisition of another company requiring further funds
Often, larger companies will have such rights issues underwritten by an investment bank to give them security that they will be able to raise the necessary capital.
What are the options available when a company issues a rights issue?
► Exercise their rights in full
► Ignore the right and let it lapse
► Sell it on in the market where this is permitted – not all rights can be transferred.
How do we consider if a rights issue is worth exercising or not?
In working out whether the deal is a good one, you would need to consider the effect of the new shares on the share price as a whole. The price is going to be diluted by the new shares, meaning that the overall price will fall on the issue date. To work out if the deal is worth exercising, we need to calculate what is known as the ex-rights price. To do this, we work out an average price for our investor, assuming that all
the rights are exercised. In the above example, this would mean:
13,600 x £1.75 = £23,800
1511 x £1.10 = £1662.10
Total value = £25,462.10
Divided by total holding of 15,111 (13,600 + 1511) Gives ex-rights price of £1.69
This is still significantly more than the £1.10 offer price meaning that the deal looks to be a good one for the investor.
What is a scrip / bonus issue?
A scrip or bonus issue is similar to a rights issue but without the requirement to buy shares. Here, the company’s reserves are converted into additional shares and issued to existing investors in proportion to their current holding. So, a bonus issue might offer 1 for 15 meaning that one additional share will be given for each 15 currently being held. These are usually issued in lieu of a dividend and are therefore known as ‘scrip dividends’. Importantly, they are still taxed in the same way as a normal dividend and must be declared on the tax return, even though no cash is actually paid out. Since the issue of shares comes from existing holdings, the company does not actually increase in value when new shares are issued in this way. This means that the overall share price will be slightly diluted by the scrip issue. Offering a scrip dividend may be attractive to companies with tight cash flow but who still want to pay a dividend (the investor could sell the additional shares for income) or who want to reorganise their capital
structure.
