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Chapter 5 Corporations issuing equity in the share market Website: www.asx.com.au Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-1 Learning objectives • Understand capital budgeting issues • Examine issues relevant to the choice between debt and equity funding • Outline the flotation and listing (IPO) process and equity-funding alternatives available to newly listed corporations • Review compliance requirements of listing a business • Explore equity-funding alternatives available to an established listed corporation Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-2 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-3 5.1 The investment decision • The objective of financial management is to maximise shareholder value • Four main aspects of financial management 1. Investment decision (capital budgeting)  Invest in which assets? 2. Financing decision (capital structure)  How to fund the purchase of these assets (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-4 5.1 The investment decision (cont.) • Four main aspects of financial management (cont.) 3. Liquidity (working capital) management  How best to manage current assets and current liabilities 4. Dividend policy decision  How to retain and/or distribute profits • This chapter focuses on the investment and financing decisions (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-5 5.1 The investment decision (cont.) • 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 • Two important measures used to quantify the contribution of an investment to shareholder wealth 1. Net present value (NPV) 2. Internal rate of return (IRR) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 5-6 5.1 The investment decision (cont.) 1. 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 – NPV (and IRR) influences:  the accuracy of the forecasted cash flows  the discount rate (required rate of return) (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-7 5.1 The investment decision (cont.) 2. IRR – The required rate of return resulting in NPV = 0 – The IRR acceptance rule  Accept the investment if its IRR is greater than the firm’s required rate of return – Limitations of IRR  Non-conventional cash flows • Can result in multiple IRRs  Mutually exclusive projects • Where only one of two or more investment alternatives can be chosen, the IRR may not choose the project with the highest NPV Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-8 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-9 5.2 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 • Returns are generated from the net cash flows of the business • Risk is the uncertainty or variability of expected cash flows derived from: – business risk – financial risk Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 5-10 5.2 The financing decision (cont.) • Business risk – The 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 costs – Also affected by:     sectoral growth rates market share aggressiveness of competitors competence of management and workforce (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-11 5.2 The financing decision (cont.) • Financial risk – Exposure to factors that impact on 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  Foreign exchange risk • Risk of adverse movements in exchange rates (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-12 5.2 The financing decision (cont.) – Financial risk categories (cont.)  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 owing to currency devaluation or inconvertibility (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-13 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 insolvency – Earnings 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 EPS  However, high debt levels increase a company’s level of financial risk and, thus, the risk of insolvency (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-14 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 norms  historical 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-15 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. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-16 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-17 5.3 Initial public offering • Initial public offering (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 advisers (stockbroker, merchant bank, other specialists) and possibly underwriters – Underwriters  Ensure a company raises the full amount of the issue  Assist with advice on the structure, price, timing and marketing of the issue and allocation of securities (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-18 5.3 Initial public offering (cont.) – 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-19 5.3 Initial public offering (cont.) • Ordinary shares: limited liability companies – Major source of equity funding – Shareholders have voting rights at general meetings – Shareholders’ voting rights may be transferred to a proxy – Shares usually sold fully paid, or can be partly paid (contributing basis) or paid by instalment receipt (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-20 5.3 Initial public offering (cont.) • Ordinary shares: limited liability companies (cont.) – Instalment receipt  Issued upon payment of the first instalment on a share issue in lieu of the ordinary share  On payment of a specified amount at a future date, a fully paid share is issued in place of instalment receipt – Shareholders’ liability is limited to the price of fully paid shares – Partly paid shareholders have a contractual obligation to pay the remaining amount when it is called or due (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-21 5.3 Initial public offering (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 Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-22 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-23 5.4 Listing a business on a stock exchange • A 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 obligations • A non-complying listed company can be suspended from quotation or delisted • Listing rule principles embrace the interests of listed entities, maintain investor protection, and maintain the reputation and integrity of the market (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-24 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 disclosure – Sufficient investor interest required to warrant listing – Security issues must be fair to both new and existing holders – Rights and obligations attached to securities must be fair to both new and existing holders (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-25 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 basis – Material information that may affect security prices or investment decisions must be disclosed immediately to the exchange – Disclosure of relevant information of a sufficiently high standard to investors – Highest standards of behaviour on the part of company officers Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-26 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-27 5.5 Equity funding 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-28 5.5 Equity funding for listed companies (cont.) • Rights issue – Issue of ordinary shares to existing shareholders – Issued pro rata, e.g. 1:5 or 1 for 5 – Factors influencing the issue price  Company’s cash flow requirements  Projected earnings flows from the new investments funded by the rights issue  Cost of alternative funding sources (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-29 5.5 Equity funding for listed companies (cont.) • Rights issue (cont.) – Two types  1.  2. Renounceable—shareholder may sell their right Non-renounceable—right may not be sold – Rights issued at a discount to current share price (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-30 5.5 Equity funding for listed companies (cont.) • Placements – Additional new ordinary shares issued directly to selected investors (institutions and individuals) deemed to be clients of brokers – Not required to register a prospectus but a memorandum of information must be prepared – Minimum subscription $500 000 to not more than 20 participants (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-31 5.5 Equity funding for listed companies (cont.) • Placements (cont.) – Market price discount cannot be excessive – Allows smaller discount and shorter time frame than rights issue – Dilutes holding of non-participating shareholders (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-32 5.5 Equity funding for listed companies (cont.) • 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-33 5.5 Equity funding for listed companies (cont.) • Dividend reinvestment schemes – Shareholders have the option of reinvesting dividends in additional ordinary shares – Usually issued at a discount between 0% and 5% – No brokerage or stamp duty payable – 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 Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 5-34 5.5 Equity funding for listed companies (cont.) • Preference shares – Classed as 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-35 5.5 Equity funding 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-36 5.5 Equity funding for listed companies (cont.) • Preference shares (cont.) – Advantages of preference shares  Fixed interest borrowings but they are an equity finance instrument  Assist in maintaining debt to equity ratio  Widen 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.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-37 5.5 Equity funding for listed companies (cont.) • Convertible notes – Classed as a 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 – The option to convert to equity has value – If share price subsequently rises a gain is made (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-38 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 value – 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-39 5.5 Equity funding for listed companies (cont.) • Company-issued options – Provide the right, but not the obligation, to purchase shares at a stated price and date – Allow companies to raise further equity funds at planned future dates (providing holders exercise the option) – Typically offered in conjunction with a rights issue or placement – Issued free or sold at a price Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips (cont.) 5-40 5.5 Equity funding for listed companies (cont.) • 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 (cont.) Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-41 5.5 Equity funding for listed companies (cont.) • Company-issued equity warrants – Generally attach to corporate bond issues but may be issued unattached – Holder has option to convert warrant into ordinary shares at specified price over a given period – Warrants may be detachable from the bond and traded separately – No dividends but holders benefit from capital gains if share price rises above conversion price Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-42 Chapter organisation 5.1 5.2 5.3 5.4 5.5 5.6 The investment decision The financing decision Initial public offering Listing a business on a stock exchange Equity funding for listed companies Summary Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-43 5.6 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 Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-44 5.6 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 the firm and is achieved by satisfying listing requirements • Additional equity can be raised through ordinary shares, preference shares, convertible notes and other quasi-equity Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 5-45