Tài chính kế toán - Chapter 5: Corporations issuing equity in the share market

Chapter 5Corporations issuing equity in the share marketWebsite:www.asx.com.auLearning objectivesUnderstand capital budgeting issuesExamine issues relevant to the choice between debt and equity fundingOutline the flotation and listing (IPO) process and equity-funding alternatives available to newly listed corporationsReview compliance requirements of listing a businessExplore equity-funding alternatives available to an established listed corporationChapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.1 The investment decisionThe objective of financial management is to maximise shareholder valueFour main aspects of financial management1. Investment decision (capital budgeting)Invest in which assets?2. Financing decision (capital structure)How to fund the purchase of these assets(cont.)5.1 The investment decision (cont.)Four main aspects of financial management (cont.)3. Liquidity (working capital) managementHow best to manage current assets and current liabilities4. Dividend policy decisionHow to retain and/or distribute profitsThis chapter focuses on the investment and financing decisions(cont.)5.1 The investment decision (cont.)A corporation first determines the assets in which it will invest funds according to organisational objectivesReal assets; e.g. plant and equipmentFinancial assets; e.g. equities, bondsCompeting investment alternatives should be evaluated on the basis of shareholder wealth maximisationTwo important measures used to quantify the contribution of an investment to shareholder wealth1. Net present value (NPV)2. Internal rate of return (IRR)(cont.)5.1 The investment decision (cont.)1. NPVThe difference between the present value of cash flows associated with an investment and the cost of the investmentThe NPV decision ruleAccept an investment that has a positive NPV; i.e. reject an investment with a negative NPVNPV (and IRR) influences:the accuracy of the forecasted cash flowsthe discount rate (required rate of return)(cont.)5.1 The investment decision (cont.)2. IRRThe required rate of return resulting in NPV = 0The IRR acceptance ruleAccept the investment if its IRR is greater than the firm’s required rate of returnLimitations of IRRNon-conventional cash flowsCan result in multiple IRRsMutually exclusive projectsWhere only one of two or more investment alternatives can be chosen, the IRR may not choose the project with the highest NPVChapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.2 The financing decisionThe financing decision concerns the capital structure used to fund the firm’s business activitiesThe financial objective of a corporation is to maximise return, subject to an acceptable level of riskReturns are generated from the net cash flows of the businessRisk is the uncertainty or variability of expected cash flows derived from:business riskfinancial risk(cont.)5.2 The financing decision (cont.)Business riskThe level of business risk depends upon the type of operations of the business, i.e.:industry sector that influences the level of fixed versus variable operating costsAlso affected by:sectoral growth ratesmarket shareaggressiveness of competitorscompetence of management and workforce(cont.)5.2 The financing decision (cont.)Financial riskExposure to factors that impact on the value of assets, liabilities and cash flowsThe level of financial risk of a company is borne by the security holders (debt and equity)Financial risk categoriesInterest rate riskRisk of adverse movements in interest ratesForeign exchange riskRisk of adverse movements in exchange rates(cont.)5.2 The financing decision (cont.)Financial risk categories (cont.)Liquidity riskRisk of insufficient cash in the short termCredit riskRisk of default or untimely payments by debtorsCapital riskRisk of insufficient shareholder funds to meet capital growth needs or absorb abnormal lossesCountry riskRisk of financial loss owing to currency devaluation or inconvertibility(cont.)5.2 The financing decision (cont.)Financial risk and the debt to equity ratio (D/E)D/E is the ratio of funds contributed by shareholders (equity) to funds borrowed (debt)D/E indicates the risk of being unable to meet interest due and principal repayments associated with use of debt, i.e. risk of insolvencyEarnings per share (EPS) is the net return on a company’s shares expressed in cents per share (CPS)If the cost of debt is less than the return achieved, issuing more debt will benefit shareholders on account of higher EPSHowever, high debt levels increase a company’s level of financial risk and, thus, the risk of insolvency(cont.)5.2 The financing decision (cont.)What is the appropriate D/E ratio?Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in practice are:industry normshistorical levels of firm’s ratiolimit imposed by lenders through loan covenants, i.e. restrictions placed on a borrower specified in a loan contractmanagement’s assessment of the firm’s capacity to service debt(cont.)5.2 The financing decision (cont.)After the GFC, some parts of the economic theory dealing with investment and D/E ratios was scrutinised. The importance of leverage (high D/E ratios) as a contributing factor to financial instability was highlighted. The GFC has even been described as a ‘Minsky Moment’.Hyman Minsky was an economist who argued that a crisis comes at the moment when it is realised that D/E ratios are too high and too risky given revised expectations about the future economic conditions. Chapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.3 Initial public offeringInitial public offering (IPO) is an offer to investors of ordinary shares in a newly listed company on a stock exchangeNew share issuer must meet ASX listing requirementsThe promoter appoints advisers (stockbroker, merchant bank, other specialists) and possibly underwritersUnderwritersEnsure a company raises the full amount of the issueAssist with advice on the structure, price, timing and marketing of the issue and allocation of securities(cont.)5.3 Initial public offering (cont.)Prospectus lodged with ASICDocument prepared by a company stating the terms and conditions of an issue of securities to the publicOut-clauseSpecific conditions precluding full enforcement of an underwriting agreementPublicly listed corporationHas its shares listed and quoted on a stock exchange(cont.)5.3 Initial public offering (cont.)Ordinary shares: limited liability companiesMajor source of equity fundingShareholders have voting rights at general meetingsShareholders’ voting rights may be transferred to a proxyShares usually sold fully paid, or can be partly paid (contributing basis) or paid by instalment receipt(cont.)5.3 Initial public offering (cont.)Ordinary shares: limited liability companies (cont.)Instalment receiptIssued upon payment of the first instalment on a share issue in lieu of the ordinary shareOn payment of a specified amount at a future date, a fully paid share is issued in place of instalment receiptShareholders’ liability is limited to the price of fully paid sharesPartly paid shareholders have a contractual obligation to pay the remaining amount when it is called or due(cont.)5.3 Initial public offering (cont.)Ordinary shares: no-liability companiesUsed for highly speculative venturesShares issued as partly paidShareholders may decide not to meet future calls, in which case they forfeit the partly paid sharesChapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.4 Listing a business on a stock exchangeA company seeking to have its securities quoted on a stock exchange (i.e. to join the official list) must comply with listing rules, which are additional to the corporations’ legislation obligationsA non-complying listed company can be suspended from quotation or delistedListing rule principles embrace the interests of listed entities, maintain investor protection, and maintain the reputation and integrity of the market(cont.)5.4 Listing a business on a stock exchange (cont.)Main principles of a stock exchange’s listing rules include the following:Minimum standards on quality, size, operations and disclosureSufficient investor interest required to warrant listingSecurity issues must be fair to both new and existing holdersRights and obligations attached to securities must be fair to both new and existing holders(cont.)5.4 Listing a business on a stock exchange (cont.)Main principles of a stock exchange’s listing rules include the following (cont.):Prescribed information must be provided to the exchange on a timely basisMaterial information that may affect security prices or investment decisions must be disclosed immediately to the exchangeDisclosure of relevant information of a sufficiently high standard to investorsHighest standards of behaviour on the part of company officersChapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.5 Equity funding for listed companiesDifferent forms of equity finance are available to established companiesAdditional ordinary sharesRights issue, placements, takeover issues, dividend reinvestment schemesPreference sharesQuasi-equityConvertible notes, options, warrants(cont.)5.5 Equity funding for listed companies (cont.)Rights issueIssue of ordinary shares to existing shareholdersIssued pro rata, e.g. 1:5 or 1 for 5Factors influencing the issue priceCompany’s cash flow requirementsProjected earnings flows from the new investments funded by the rights issueCost of alternative funding sources(cont.)5.5 Equity funding for listed companies (cont.)Rights issue (cont.)Two types1. Renounceable—shareholder may sell their right2. Non-renounceable—right may not be soldRights issued at a discount to current share price(cont.)5.5 Equity funding for listed companies (cont.)PlacementsAdditional new ordinary shares issued directly to selected investors (institutions and individuals) deemed to be clients of brokersNot required to register a prospectus but a memorandum of information must be preparedMinimum subscription $500 000 to not more than 20 participants(cont.)5.5 Equity funding for listed companies (cont.)Placements (cont.)Market price discount cannot be excessiveAllows smaller discount and shorter time frame than rights issueDilutes holding of non-participating shareholders(cont.)5.5 Equity funding for listed companies (cont.)Takeover issuesAcquiring company issues additional ordinary shares to owners of target company in settlement of the transactionAlleviates need for owners of acquiring company to inject cash for the purchase of the company(cont.)5.5 Equity funding for listed companies (cont.)Dividend reinvestment schemesShareholders have the option of reinvesting dividends in additional ordinary sharesUsually issued at a discount between 0% and 5%No brokerage or stamp duty payableIn growth periods it allows companies to pay dividends and pass on tax credits, while increasing equitySchemes may be suspended in low growth periods(cont.)5.5 Equity funding for listed companies (cont.)Preference sharesClassed as hybrid securities; i.e. they have characteristics of both debt and equityFixed dividend rates are set at issue dateRank ahead of ordinary shareholders in the payment of dividends and liquidation(cont.)5.5 Equity funding for listed companies (cont.)Preference shares (cont.)Include combinations of the following features:Cumulative or non-cumulativeRedeemable or non-redeemableConvertible or non-convertibleParticipating or non-participatingIssued with different rankings(cont.)5.5 Equity funding for listed companies (cont.)Preference shares (cont.)Advantages of preference sharesFixed interest borrowings but they are an equity finance instrumentAssist in maintaining debt to equity ratioWiden a company’s equity base, which allows further debt to be raised Dividends may be deferred on cumulative shares and not paid on non-cumulative shares, while interest on debt must be paid(cont.)5.5 Equity funding for listed companies (cont.)Convertible notesClassed as a hybrid instrument, issued for a fixed term at a stated rate of interest, either by direct placement or pro rata to shareholdersHolder has right to convert the note into ordinary shares at a specified future date and at a predetermined priceThe option to convert to equity has valueIf share price subsequently rises a gain is made(cont.)5.5 Equity funding for listed companies (cont.)Convertible notes (cont.)If share price falls, holder may not exercise conversion option and take the notes’ cash valueInterest paid on notes is usually lower than straight debt interestInterest payments are tax deductible to the companyNotes are often issued for longer periods than is possible with straight debt borrowings(cont.)5.5 Equity funding for listed companies (cont.)Company-issued optionsProvide the right, but not the obligation, to purchase shares at a stated price and dateAllow companies to raise further equity funds at planned future dates (providing holders exercise the option)Typically offered in conjunction with a rights issue or placementIssued free or sold at a price(cont.)5.5 Equity funding for listed companies (cont.)Company-issued options (cont.)Generally have value and may be tradedThe option will be exercised if the exercise price is less than the market price of the share at the exercise date(cont.)5.5 Equity funding for listed companies (cont.)Company-issued equity warrantsGenerally attach to corporate bond issues but may be issued unattachedHolder has option to convert warrant into ordinary shares at specified price over a given periodWarrants may be detachable from the bond and traded separatelyNo dividends but holders benefit from capital gains if share price rises above conversion priceChapter organisation5.1 The investment decision5.2 The financing decision5.3 Initial public offering5.4 Listing a business on a stock exchange5.5 Equity funding for listed companies5.6 Summary5.6 SummaryObjective of financial management is to maximise shareholder valueFour key financial management decisions involve investment, financing, liquidity (working capital) and dividendAppropriate investment decision techniques are NPV and IRR5.6 Summary (cont.)The financing decision concerns the choice of capital structure (D/E) and influences a firm’s financial riskAdmission to the ASX broadens financing opportunities for the firm and is achieved by satisfying listing requirementsAdditional equity can be raised through ordinary shares, preference shares, convertible notes and other quasi-equity