Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared

Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis

Slides prepared by Kaye Watson

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney

Slides prepared by Anthony Stanger1

Chapter 5Corporations

Issuing Equity in the

Share Market

Website:

http://www.asx.gov.au





Learning Objectives• Examine issues relevant to the choice

between debt and equity funding• Outline ASX floatation and listing rules• Describe the equity-funding

alternatives available to newly listed and established corporations

• Distinguish between equity and quasi-equity securities





Chapter Organisation5.1 Introduction5.2 The Investment Decision5.3 The Financing Decision5.4 Initial Public Offering (IPO)5.5 Listing a Business on the Stock

Exchange5.6 Equity-funding Alternatives for

Listed Companies5.7 Summary





5.1 Introduction• The objective of financial

management is to maximise shareholder value

• There are four main aspects of financial management– Investment decision (capital budgeting)

In which assets to invest?

– Financing decision (capital structure) How to fund the purchase of these assets?





5.1 Introduction (cont.)– Liquidity (working capital) management

How to best manage current assets and current liabilities?

– Dividend policy decision How to retain and/or distribute profits?

• This chapter focuses on the financing (funding) decision












5.2 The Investment Decision• A corporation first determines the

assets in which it will invest funds according to organisational objectives– Real assets e.g. plant and equipment– Financial assets e.g. equities, bonds

• Competing investment alternatives should be evaluated on the basis of shareholder wealth maximisation





5.2 The Investment Decision (cont.)• Two important measures used to

quantify the contribution of an investment to shareholder wealth are– Net present value (NPV)– Internal rate of return (IRR)





5.2 The Investment Decision (cont.)• NPV

– The difference between the present value of cash flows associated with an investment, and the cost of the investment

• The NPV decision rule– Accept an investment that has a positive

NPV i.e. reject an investment with a negative NPV





5.2 The Investment Decision (cont.)• NPV (and IRR) are influenced by

– The accuracy of the forecasted cash flows– The discount rate (required rate of return)





5.2 The Investment Decision (cont.)• IRR

– The required rate of return that results in a NPV of zero

• The IRR acceptance rule– Accept the investment if its IRR is greater

that the firm’s required rate of return





5.2 The Investment Decision (cont.)• Limitations of IRR

– Non-conventional cash flows Can result in multiple IRRs

– Mutually exclusive projects A situation where, from a choice of two or more

projects, only one project can be chosen












5.3 The Financing Decision• The financing decision concerns the

capital structure used to fund the firm’s business activities

• The financial objective of a corporation is to maximise return, subject to an acceptable level of risk





5.3 The Financing Decision (cont.)• Returns are generated from the net

cash flows of the business• Risk is the uncertainty or variability of

expected cash flows, caused by either– Business risk– Financial risk





5.3 The Financing Decision (cont.)• Business risk

– The level of business risk depends upon the type of operations of the business i.e.

Industry sector which influences the level of fixed versus variable operating costs

– Also affected by Sectoral growth rates Market share Aggressiveness of competitors Competence of management and workforce





5.3 The Financing Decision (cont.)• Financial risk

– The exposure to factors that impact the value of assets, liabilities and cash flows

– The level of financial risk of a company is borne by the security holders (debt and equity)

– Financial risk categories Interest rate risk

• Risk of adverse movements in interest rates





5.3 The Financing Decision (cont.)

– Financial risk categories (cont.) 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






– Financial risk categories (cont.) Country risk

• Risk of financial loss due to currency devaluation or inconvertibility

Debt to equity ratio (D/E) i.e. the ratio of funds contributed by shareholders (equity) to funds borrowed (debt)

• Risk of being unable to meet interest due and principal repayments associated with use of debt i.e. risk of insolvency






– Earnings per share (EPS) is the net return on a company’s shares expressed in cents per share

If the cost of debt is less than the return achieved, then issuing more debt will benefit shareholders due to higher EPS

However, high debt levels increase the company’s level of financial risk and, thus, the risk of insolvency





5.3 The Financing Decision (cont.)• Is there an optimal debt to equity

ratio?– No optimal debt to equity ratio– Optimal D/E for a company depends on

Industry norms Historic levels of a firm’s ratio Limits imposed through loan covenants Firm’s capacity to service debt












5.4 Initial Public Offering (IPO)• IPO is an offer to investors of ordinary

shares in a newly listed company on a stock exchange– New share issuer must meet ASX listing

requirements– The promoter appoints advisors

(stockbroker, merchant bank, other specialists) and possibly underwriters





5.4 Initial Public Offering (IPO) (cont.)

– Underwriters Ensure companies raise full amount of the issue Assist with advice on the structure, price,

timing and marketing of the issue and allocation of securities

– Prospectus lodged with ASIC





5.4 Initial Public Offering (IPO) (cont.)• Ordinary shares: limited liability

companies– Major source of equity funding– Shareholders have voting rights at

general meetings– Shareholders may transfer voting rights to

a proxy





5.4 Initial Public Offering (IPO) (cont.)

– Shares usually sold fully paid, or can be partly paid or by instalment receipt

– Shareholder’s liability is limited to the extent of the fully paid shares

– Partly paid shareholders have a contractual obligation to pay the remaining amount (the call) to the company





5.4 Initial Public Offering (IPO) (cont.)• Ordinary shares: no liability

companies– Used for highly speculative ventures– Shares issued as partly paid– Shareholders may decide not to meet

future calls, in which case they forfeit the partly paid shares












5.5 Listing a Business on the Stock Exchange• Listing rule principles• Admission to a stock exchange• Quotation of securities• Cost of listing• Continuing listing requirements





Listing rule principles

• A company seeking to have its securities quoted on a stock exchange (i.e. join the official list) must comply with listing rules which are additional to the corporations legislation obligations

• Listing rule principles have been established to maintain market integrity and protect investors





Listing rule principles (cont.)

• Listing rule principles are specific criteria that must be met and include– Minimum standards on quality, size,

operations and disclosure– Sufficient investor interest required to

warrant listing– New issues permitted if equitable





Listing rule principles (cont.)

• Listing rule principles are specific criteria that must be met and include (cont.)– Disclosure of relevant information of a

sufficiently high standard to investors– Rules on the behaviour of company

officers





Admission to a stock exchange

• Companies admitted to the ASX official list are characterised as either– General– Debt issuer– Exempt foreign entity





Admission to a stock exchange (cont.)

• General admission requirements include– Satisfying either profit test or assets test

requirements





Quotation of securities

• A general admission entity seeking quotation of its main class of securities on the official list must satisfy conditions including– Compliance with listing rules– Quoted securities must have an issue

price of at least 20 cents– Calls to be made by the entity must be set

out





Costs of listing

• Significant costs are involved with listing including– Underwriting fees– Float management fees– Legal fees– Accounting and taxation fees– ASX listing fees and annual fees





Continuing listing requirements

• Listed companies must satisfy continuous disclosure requirements by notifying the ASX of any information expected to have a material effect on the share price





Continuing listing requirements (cont.)

• Additionally, routine disclosure requirements include the provision of– Half-yearly reports to the ASX– Yearly reports to both shareholders and

the ASX












5.6 Equity-funding Alternatives for Listed Companies• Different forms of equity finance are

available to established companies– Additional ordinary shares

Rights issue, placements, takeover issues, dividend reinvestment schemes

– Preference shares– Quasi-equity

Convertible notes, options, warrants





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Rights issue

– Issue of ordinary shares to existing shareholders

– Issued pro-rata (e.g. 1:5—1 for 5)





5.6 Equity-funding Alternatives for Listed Companies (cont.)

• Rights issue (cont.)– Two types

Renounceable—shareholder may sell their right Non-renounceable—right may not be sold

– Rights issue made at a discount to current share price





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Placements

– Additional new ordinary shares issued to selected investors (typically institutions)

– Not required to register a prospectus– Minimum subscription $500,000 to not

more than 20 participants






• Placements (cont.)– Market price discount cannot be excessive– Allows smaller discount and shorter time

frame than rights issue– Dilutes holding of non-participating

shareholders






• Takeover issues– The acquiring company issues additional

ordinary shares to the owners of the target company in settlement of the transaction

– Alleviates the need for owners of the acquiring company to inject further equity for the purchase of the company





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Dividend reinvestment schemes

– Shareholders have the option of reinvesting dividends in additional ordinary shares

– Generally issued at a discount– No brokerage or stamp duty payable






• Dividend reinvestment schemes (cont.)– In growth periods it allows companies to

pay dividends and pass on tax credits, while increasing equity

– Schemes may be suspended in low growth periods






• Preference shares– Are hybrid securities (i.e. they have

characteristics of both debt and equity)– Fixed dividend rates are set at issue date– Rank ahead of ordinary shareholders in

the payment of dividends and liquidation





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Preference shares (cont.)

– Include combinations of the following features

Cumulative or non-cumulative Redeemable or non-redeemable Convertible or non-convertible Participating or non-participating Issued with different rankings






– Advantages of preference shares In effect preference shares are fixed interest

borrowings, but are an equity finance instrument

Assists in maintaining debt to equity ratio Widens a company’s equity base, which allows

further debt to also be raised






– Advantages of preference shares (cont.) Dividends may be deferred on cumulative

shares, and not paid on non-cumulative shares, while interest on debt must be paid






• Convertible notes– Are a hybrid instrument—initially as a

debt instrument issued for a fixed term– Interest payments are specified in the

note– Bestows the right to convert the note into

ordinary shares at a specified future date at a predetermined price





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Convertible notes (cont.)

– The option to convert to equity has value– The conversion price is nominated at note

issue—a gain is made if share price rises subsequently

– If share price falls, holder may not exercise conversion option, and take the notes cash value





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Convertible notes (cont.)

– Interest paid on notes is usually lower than straight debt interest

– Interest payments are tax deductible to the company

– Notes are often issued for longer periods than is possible with straight debt borrowings





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Company-issued options

– Provide the right but not the obligation to purchase shares, at a stated price and date

– Issued for a period of up to 5 years– Allows companies to raise further equity

funds at planned future dates (providing holders exercise the option)






• Company-issued options (cont.)– Generally have value and may be traded– The option will be exercised if the exercise

price is less than the market price of the share at the exercise date





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Company-issued equity warrants

– Generally attach to corporate bond issues; however, may be issued unattached

– Holder has the option to convert the warrant into ordinary shares at a specified price over a given period





5.6 Equity-funding Alternatives for Listed Companies (cont.)• Company-issued equity warrants

(cont.)– Warrants may be detachable from the

bond and traded separately– Holder does not receive dividends, but

may benefit from capital gains if the share price rises above the conversion price












5.7 Summary• Objective of financial management is

to maximise shareholder value• Four key financial management

decisions involve investment, financing, liquidity (working capital) and dividend

• Appropriate investment decision techniques are NPV and IRR





5.7 Summary (cont.)• The financing decision concerns the

choice of capital structure (D/E) and influences a firm’s financial risk

• Admission to the ASX broadens financing opportunities for firm, and is achievable by satisfying listing requirements

• Additional equity can be raised through ordinary shares, preference shares, convertible notes and other quasi-equity

Documents

Copyright 2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared