Tài chính doanh nghiệp - Chapter 10: Sources of long - Term finance: Equity

Chapter 10Sources of Long-Term Finance: EquityLearning ObjectivesOutline the characteristics of ordinary shares.Explain the advantages and disadvantages of equity as a source of finance.Outline the main characteristics of preference shares.Outline the main sources of private equity in the Australian market.Learning Objectives (cont.)Be familiar with the information that must be disclosed when issuing securities.Outline the process of floating a public company.Discuss alternative explanations for the underpricing of initial public offerings.Explain how companies raise capital through rights issues, placements, share purchase plans and share options.Learning Objectives (cont.)Outline the different types of employee share plans.Outline the advantages of internal equity as a source of finance.Outline the effects of bonus issues, share splits and share consolidations.The Characteristics of Ordinary SharesOrdinary shares represent an ownership interest in a business.Residual claimThe holder has a claim to the profits of the business (through dividends). In the event of failure, the holder has a claim to the residual value of the assets after claims of all other entitled parties are met.The Characteristics of Ordinary Shares (cont.)Residual claim (cont.)Due to this residual claim, shareholders are more likely to lose their investment if the company fails (shareholders are said to provide the company’s risk capital).To compensate for this risk, shareholders expect a return that is greater than that received by lending.Fully and partly paid sharesWhen new shares are created they will have a stated issue price which may be paid in full at issue.The Characteristics of Ordinary Shares (cont.)Fully and partly paid shares (cont.)Alternatively, shares may be issued for part payment, with the balance paid in subsequent instalments, often referred to as ‘calls’.The size and timing of calls may be specified at the outset or determined at some date after issue.If the issue price has not been paid in full, shares are called ‘partly paid’ or ‘contributing’ shares.‘Instalment receipts’ are marketable securities for which only part of the issue price has been paid.The Characteristics of Ordinary Shares (cont.)Fully and partly paid shares (cont.)The balance of an instalment receipt is payable in a final instalment on or before a specified date.A well-known example is the Australian government’s sale of Telstra shares, which was executed through the issue of instalment receipts.Main differences from partly paid shares is timing and size of instalments specified up front, instalments payable to vendor of shares rather than issuing company and holders of instalment receipts entitled to same dividends as ordinary shareholders.The Characteristics of Ordinary Shares (cont.)Limited liabilityA legal concept which protects shareholders whose liability to meet a company’s debts is limited to any amount unpaid on the shares they hold.No liability (NL) companiesNL companies are restricted to operating in the mining industry.Holders of partly paid shares are no obliged to pay calls made by the company — though shares are forfeited if calls are not paid.The Characteristics of Ordinary Shares (cont.)Rights of shareholdersEntitled to proportional share of any dividend declared.Right to exert a degree of control over management through use of voting rights attached to ordinary shares — in practice difficult to execute (typically need at least 50% of shares).The right to sell their shares.Advantages and Disadvantages of Equity as a Source of FinanceAdvantagesDividends are discretionary.No maturity date.The higher the proportion of capital structure made up by equity, the lower the cost of debt.DisadvantagesIssuing more shares can dilute existing shareholders’ ownership and control.Returns to shareholders can be subject to double taxation (non-residents).Transaction costs of issuing shares.Preference SharesPreference shares give the holder preference over ordinary shareholders with respect to dividends, and capital in the event of liquidation.Dividend is typically fixed, though it can vary (reset preference share) and can be fully franked, partly franked or unfranked.Preference shareholders rank after lenders and other creditors.Preference Shares (cont.)Cumulative or non-cumulativeA company that issues cumulative preference shares is required to pay any accumulated preference dividends before a distribution may be made to ordinary shareholders.Non-cumulative preference shares do not oblige the company to pay any past accumulation of unpaid preference dividends.Preference Shares (cont.)Redeemable or irredeemableRedeemable preference shares are similar to debentures, but dividends are not deductible for income tax purposes.Irredeemable preference shares are similar to ordinary shares.Convertible or non-convertibleConvertible preference shares can be converted to ordinary shares at the option of the holder.Converting preference shares automatically convert to ordinary shares at some specified time in the future.Preference Shares (cont.)Participating or non-participatingA company may issue participating preference shares that allow the holders to share in any profit earned in excess of a certain amount.These participating preference shareholders can obtain a dividend in excess of the preference dividend rate.Non-participating preference shareholders are not entitled to a dividend in excess of the stated dividend rate.Preference Shares (cont.)Voting or non-votingPreference shareholders have voting rights, but these are restricted relative to ordinary shareholders (e.g. News Corp. has two classes of shares).May be able to vote at preference shareholder meetings but not at general meetings, unless payment of preference dividends is in arrears and there is a proposal to wind up the company.Preference Shares (cont.)Classification as debt or equityLegally, equity, but some characteristics of debt lead them to be regarded as hybrid debt and equity.Classification according to economic substance of rights and obligations of parties to a financing arrangement.An interest providing non-contingent returns is treated as debt for tax purposes.Contingent returns means the interest is equity.A perpetual non-cumulative preference share is classed as equity, as dividends do not need to be paid (contingency).The classification is important as to the tax deductibility of the dividend payments.Private EquityWhat is private equity?Securities issued to investors are not publicly traded.Sources can include family members, friends and business angels, but a more formal source is a private equity fund.Private equity is sometimes called ‘venture capital’ but it is not only for new ventures.Four categoriesStart-up financing — for companies less than 30 months’ old, funds to develop firms products.Private Equity (cont.)Four categories (cont.)Expansion financing — additional funds required to manufacture and sell products commercially.Turnaround financing — to assist a company in financial difficulty.Management buy-out (MBO) — where a business is purchased by its management team with the assistance of a private equity partner or fund.Illiquid market and investors must be willing to hold on for 5 –10 years.Information Problems and New VenturesThree important information problems with new ventures:(i) Information on value of venture is likely to be  incomplete and uncertain.(ii) Information asymmetry — either party, the entrepreneur or investor, may have more information than the other.(iii) Idea may be stolen by potential investors who have been shown the idea.Private Equity (cont.)Private Equity (cont.)Information Problems and New Ventures (cont.)New ventures are typically financed in stages to overcome these problems.Each stage of funding is linked to achievement of milestones.These stages help to overcome uncertainty and information asymmetry.Information Problems and New Ventures (cont.)Entrepreneur may require confidentiality agreements with potential investors in order to prevent them stealing the idea.Venture capitalists usually do not sign such agreements.Instead, they focus on establishing and protecting a reputation for honesty and integrity.Private Equity (cont.)Sources of Finance for New VenturesSources include personal funds, bank loans, private equity funds and funds from IPOs.Stages of a venture include:R&D phase.Start-up phase, equipment and personnel assembled.Rapid growth, if product is successful.Slower growth, followed by maturity and possible decline.Sources of Finance for New Ventures (cont.)Different sources of finance are appropriate at different stages.Personal savings, personal loans, home mortgages are most likely at R&D stage.Business angel may enter the R&D stage if these other sources are exhausted.Finance from Business AngelsBusiness angels — investors in the early stages of new ventures.Bring useful expertise as well as funds to a new venture.Attempt to help develop a project to a point where outside finance from private equity funds and other financial institutions can be attracted.Investment horizon is medium to long term (5–10 years).Finance from Private Equity FundsABS estimates $7.5b committed to private equity market at 30 June 2003.As at June 2003, 174 private equity funds operated in Australia by 133 fund managers, investing in 850 companies.According to ABS, these 133 managers reviewed 9512 potential investments in 2002/03, of which only 132 have been successful.Investments range from $0.5 to $20m over 3–7 years.Finance from Private Equity Funds(cont.)Looking for projects with high-growth prospects.Private equity investments are relatively risky — higher rates of return are typically required.Seed and start-up capital may require a return of 30–40% p.a.Once past R&D stages, expansion capital may require returns of 20–30% p.a.To obtain private equity, require a well-structured and convincing business plan.Private equity fund managers usually require a seat on the board of the company.These managers specialise in new, fast-growing companies. They can offer specialised expertise to help the venture succeed.Finance from Private Equity Funds(cont.)Private equity fund managers seek capital gains rather than dividends and will plan to divest within 3–7 years.High level of risk reflected by fact that more than 1/3 of disposals in 2002/03 resulted in losses: see Bivell (2004).Larger sources of private equity include superannuation funds, fund managers and banks.Government has encouraged private equity with incentives like the Pooled Development Funds Program and the Innovations Investment Fund Program.Finance from Private Equity Funds(cont.)Information DisclosureCorporations Act 2001 has provisions that protect investors in public companies by disclosure of information requirements.Specific requirements apply to offers of securities.Typically, the provision of a disclosure document with details of the issuer and securities being offered.Offers of Unlisted SecuritiesOffers of unlisted securities include IPOs of shares and offers of new classes of securities by listed companies.In these cases, securities do not have an obvious market price and information can help determine the appropriate price.Offer cannot proceed until disclosure document has been lodged with ASIC.Offers of Unlisted Securities (cont.)ProspectusMost comprehensive disclosure document.Contains details of the issue, capital sought, price, use of funds etc.Non-financial information on issuer — description of business and reports from directors and/or industry experts.Risks associated with business.Offers of Unlisted Securities (cont.)Prospectus (cont.)Financial information on issuer — most recent audited financial statements.Most expensive disclosure document to prepare.Contributors to prospectus are liable for prosecution by investors over losses resulting from misstatements in, or omissions from, disclosure documents.Offers of Unlisted Securities (cont.)Offer Information Statements (OIS)An OIS may be used instead of a prospectus in the case of smaller capital raisings.Total raisings must amount to less than $5m.OIS is less costly to prepare, less information to disclose.Offers of Listed SecuritiesDisclosure requirements for offers of listed securities are less onerous.Listed entity is subject to continuous disclosure requirements.Much of the relevant information is publicly available anyway.Market provides a guide on price.Offers that do not Need DisclosureVarious offerings may not require a disclosure document:Small-scale offerings.Offers to sophisticated investors.Offers to executive officers and associates.Offers to existing security holders.These exemptions assume the participants have relevant skills or information to judge the merits of an offer. Floating a Public CompanyA ‘float’ is the term given to the company’s first invitation for the public to subscribe for shares — an initial public offering (IPO).For stock exchange listing, the company needs to satisfy the listing requirements of the exchange.A prospectus is required — a legal document that provides details of the company and the terms of the issue of shares.Companies unable to meet ASX listing requirements may list on Bendigo or Newcastle Stock Exchanges — aimed at smaller firms.Public Versus Private OwnershipA company undertaking a float may be a new company or an existing private company.Two reasons for a private company to float:Better access to capital markets.Allows private owners to cash in on the success of their business (creates a market for otherwise non-traded shares).Costs of going public include loss of control, listing fees, shareholder servicing costs, information disclosure requirements.Pricing a New IssueDifficult if there is no earnings record, as historic earnings are commonly used as the basis for estimating future earnings.Advisers consider price–earnings ratios of existing companies in the same industry.Fixed price offer versus open pricing.Fixed price offer is open for several weeks, depends on demand for shares and offer may close early and oversubscribed.Pricing a New Issue (cont.)Alternative approach is a book build (open pricing or constrained open pricing).Trying to get investors to reveal their willingness to pay for new shares.Open pricing mechanisms are less likely to generate abnormal returns to investors, so constrained open pricing is preferred to attract investors — set a lower and upper bound on issue price.Available evidence suggests ‘underpricing’ of IPOs, on average.Underwriting and Managing a New IssueService provided by a stockbroker or investment bank.For a fee, the underwriter contracts to purchase all shares for which applications have not been received by the closing date of the issue.If book building process is used to issue shares, there is no need for underwriting but an institution needs to manage the issue.Underwriter can limit exposure by sub-underwriting.Selling a New IssueIf a stockbroker is underwriter or lead manager, it will usually act as selling agent for the issue.Promotion reduces the need to purchase underwritten shares and will generate brokerage fees.Even without underwriting, a broker is engaged to assist in distribution of shares.Brokerage depends on size of issue but range between 1% and 2% of funds raised.Costs of Floating a CompanyCosts fall into three main categories:ASX listing fees, prospectus costs (legal, accounting, expert opinions and printing and distribution).Underwriters’ fees and brokers’ commissions (for 143 floats on ASX during 2003/04, listing costs averaged 5.1% of funds raised — see KPMG (2004)).These costs depend on size of float and if it is underwritten, which in turn depends on market conditions and on the size and quality of the broker engaged and of the underlying business.Costs of Floating a Company (cont.)Costs fall into three main categories (cont.):Shares sold in an IPO are usually underpriced — on average, there is an immediate abnormal return to IPOs.This represents a cost to owners of business, they are selling for less than it is really worth.Ibbotson, Sindelar and Ritter (1994) find an average initial return of 15.3% for IPOs in US.Loughran and Ritter find an average initial return of 18.7% for a later sample of US IPOs.Lee, Taylor and Walter (1996) find an 11.9% initial abnormal return for Australian IPOs.Gong and Shekhar (2001) find an 11% initial abnormal return to government-sector IPOs in Australia.Costs of Floating a Company (cont.)UnderpricingWell-documented underpricing of IPOs.Possible reasons for underpricing:Underpricing is necessary to attract investors who have difficulty estimating the future market price of the shares being offered (winner’s curse).Underpricing is necessary to induce some potential investors to buy, which may set off a cascade in which other investors are willing to subscribe. Underpricing leaves a good taste with investors, raising the price at which subsequent share issues by the company can be sold.Subsequent Ordinary Share Issues: Rights IssuesAn issue of new shares to existing shareholders in proportion to their current shareholding.Requires a prospectus.The right of existing shareholders to take up some of the new shares may be sold to another party via trading on a stock exchange: renounceable issue.Where the right is exercisable only by the existing shareholders, the issue is non-renounceable. Rights IssueSubscription pricePrice that must be paid to obtain new shares.Ex-rights dateThe date on which a share begins trading ex-rights. After this date, a share does not have attached to it the right to purchase additional shares on the subscription date.Cum-rights — when shares are traded cum-rights, the buyer is entitled to participate in the forthcoming rights issue.Valuation of RightsAs the subscription price is at a discount to market price, theoretically there should be a downward adjustment in the share price when it is traded ex-rights compared to cum-rights. The ex-rights price should fall by the value of the right attached to each share.Valuation of Rights (cont.)The theoretical value of a right (R) is given by:Rights ValueThe theoretical value of a share ex-rights (X) is given by: Theoretically, a rights issue has no value to shareholders — should not get anything for free otherwise, market must be inefficient.However, the announcement can have an impact on shareholders’ wealth — information content, rights issues are usually bad news, with information about expected future cash flows.Private Issues (Placements)Equity can be placed directly with institutions and individual investors without the need for a disclosure document.Placements can be underwritten and they can be a very inexpensive way of accessing equity, as low as 1.25% of funds raised.Book build is an increasingly popular mechanism for private placement — less likely to be underpriced.Due to large sums of money in hands of fund managers and speed of private placements, they have grown in popularity relative to rights issues with more placements than rights issues in 2003/04.Advantages:Can be quickly arranged and finalised.Lower issue costs than a rights issue.Board can direct the placement to ‘friendly parties’.Private Issues (Placements)Pros and ConsDisadvantages:Dilution of proportion of the ownership of the company for non-participating shareholders.However, existing shareholders are protected by the ASX listing rule that a company can only place up to 15% of the issued shares in any 12-month period without the need for shareholder approval.Placements at a discount to market will reduce the value of existing shareholders’ investments.Private Issues (Placements)Pros and Cons (cont.)However, placements at a premium to market have the opposite effect.Positive signal if an informed investor is willing to pay above market price for shares.Private Issues (Placements)Pros and Cons (cont.)Contributing SharesShares on which only part of the issue price has been paid.The issuing company can call up the unpaid part of the issue price in one or more instalments.The unpaid amount is referred to as ‘reserve capital’.Share Purchase PlansASX-listed companies can raise limited funds from existing shareholders through share purchase plans.Prospectus not required as long as comply with ASIC Policy Statement 125.Limit of $5000 from each shareholder per annum.Attractive because shares are issued at a discount to market price and there are no brokerage fees.Share OptionsShare options give the holder the right, but not the obligation, to purchase an ordinary share at a stated price at a future date.Exercise of the option will depend on the exercise price relative to the market price of the share around the exercise date.Share Options (cont.)Company options may be issued free with the underlying share or sold at a price set by the issuing company:To employees.As a sweetener to an equity issue.As a sweetener to a private debt issue.Company options often restrict the holder from exercising the option for a certain period after it has been granted.Choosing between Equity-Raising MethodsSeveral external sources of equity have been considered.Most involve long-term arrangements, for a significant one-off equity raising only rights issues and placements are practical.Chan & Brown (2004) find that listing rules about placements are important in determining sources of external equity.Companies generally prefer placements to rights issues — bias for placements up to regulatory limits.Choosing between Equity Raising Methods (cont.)Advantages of placements include speed, (days rather than weeks), lower transaction costs and shares can be placed with ‘friendly’ shareholders.Rights issues are seen as equitable to existing shareholders.Possible to combine various sources, but placements are typically set at the regulatory limit and supplemented with the other possible sources.Employee Share PlansCompanies have raised significant funds through employee share plans.Primary purpose of such plans is to motivate senior managers and other employees by giving them an ownership interest in the company.Employee Share Plans (cont.)Types of employee share plans:Fully paid share plansPartly paid share plansOption plansEmployee share trustsReplicator plansInternal Equity Financing‘Internal equity financing’ refers to the positive net cash flows generated by a company — funds from operations.Management can influence the level of retained profits by the dividend policy.Depreciation ChargesThe above equation might give the impression that depreciation is a source of finance.Depreciation reduces profits and therefore funds available for distribution as dividends.A profitable company will end up retaining funds at least equivalent to depreciation charges.Retained EarningsRetained earnings are an obvious source of internal finance that can be controlled by dividend and other capital management policies.However, while there are no explicit financing costs, the funds are not free.Retained funds have an opportunity cost, shareholders can reinvest funds if they are not retained, therefore shareholders expect a return in excess of their next best alternative.Dividend Reinvestment PlansAllows shareholders the choice of reinvesting their dividends in the company (by purchasing additional shares) rather than receiving cash. Important source of equity for Australian companies.Advantages:Avoids relatively high transaction costs if shareholders used dividends to acquire additional shares.Shares often issued at a discount to current market price.If companies achieve a sufficient reinvestment rate, it enables them to pay franked dividends which transfer tax credits to shareholders and retain cash to fund investments.Dividend Reinvestment Plans (cont.)Disadvantages:Reinvestment of dividends could be dysfunctional if company has few prospects for future profitable investments, and/or if cash position is quite healthy.By increasing the company’s equity base, a DRP dilutes key indicators such as EPS.Dividend Reinvestment Plans (cont.)Managing a Company’s Equity Structure: Bonus Issues‘Free’ issue of shares made to existing shareholders in proportion to their current investment.Equivalent to a rights issue with a subscription price of zero.Should have no effect on shareholders’ wealth, however, there may be an announcement effect due to the information conveyed.Bonus Issues (cont.)A bonus issue may be made:To provide the market with information.To maintain total dividend payout with management reducing the dividend per share.If a company’s shares are thinly traded.Bonus issues are treated as dividends for taxation purposes unless made from the share premium reserve (identified for tax purposes).Share SplitsShare splits typically made by companies with a ‘thin’ market for their shares.Existing shares are replaced by new shares issued at a ratio of greater than 1 for 1.Large Australian companies that have made recent share splits include Computershare, Patrick Corporation and Toll Holdings.Justified as a means to increase liquidity and affordability of shares to retail investors.Share Splits (cont.)Theoretically, a share split should have no effect on share price or volume.Empirical evidence on benefits is mixed.Number of shareholders and transactions both rise after share splits but little evidence of volume increases.Splits increase bid–ask spreads and return volatility, signs of lower liquidity.Share ConsolidationsA share consolidation or reverse split decreases the number of shares on issue and increases the price per share.Reasons for share consolidations:Raise share price to a popular trading range and overcome perceptions that the company is not respectable because of its low share price.To reduce transaction costs and lower the cost of maintaining the company’s share registry.SummaryNew ventures can seek finance from wealthy individuals and private equity funds.New share issues must satisfy disclosure requirements — usually with a prospectus.Ordinary shares have a residual claim on a company — lowers financial risk.Benefits of equity finance — company is not required to pay dividends or redeem shares, also lowers cost of debt finance.Initial public offering of shares is referred to as floating a company.Book build is an increasingly popular means of issuing new securities.Existing public companies can raise funds through the use of rights issues, private placements, contributing and preference shares and share options.Internal equity — retained earnings is a low-cost and popular source of finance.Summary (cont.)