Lecture 4

Chapter 5
Corporations Issuing Equity in the Share Market

52

Learning Objectives
Understand capital budgeting issues
Examine issues relevant to the choice between debt and equity

funding Capital structure

Outline the flotation and listing (IPO) process
Describe equity funding alternatives available to newly listed
and established corporations
Demonstrate share pricing methods

53

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

54

5.1

The Investment Decision

The objective of financial management is to maximise shareholder value

Corporate managers face important decisions in their attempt to maximise

shareholder wealth.
Four main aspects of management
Investment decision (capital budgeting)
Invest in which assets?
Financing decision (capital structure)
How to fund the purchase of these assets
Liquidity (working capital) management
How to best manage current assets and current liabilities
Dividend policy decision
How to retain and/or distribute profits
This lecture focuses on the investment and financing decisions

55

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

56

5.1

The Investment Decision (cont.)

Two important measures used to quantify the contribution of an

investment to shareholder wealth

Net present value (NPV)
Internal rate of return (IRR)

57

Pricing a Security
Definition of Financial Asset
Price is present value of expected future cash flows
Present value = CF/ (1+i)n
Price = CFi/ (1+i)n

CF = expected future cashflows

i = required Rate of return
n = number of periods

58

5.1

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

NPV (and IRR) influences

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

59

Example of NPV
A company is currently considering whether it should outlay

$500,000 for a machine that will have a useful life of five years.
The forecast net cash flows from using the machine are
$150,000 each year for the next five years with no residual value
at the end. What is the NPV of this project, given the required
rate of return is 10%

510

5.1

The Investment Decision (cont.)

IRR
The required rate of return resulting in NPV = 0
The IRR acceptance rule
Accept the investment if its IRR is greater than the firms required rate
of return

511

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
Equity-funding for Listed Companies
Summary

Exchange

512

5.2

The Financing Decision

Relates to the question of how a business investment is to be

funded
The financing decision concerns the capital structure used to
fund the firms business activities
The most important financing decision is choosing between debt
and equity
The financial objective of a corporation is to maximise return,
subject to an acceptable level of risk

513

5.2

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

derived from
Business risk
Financial risk

514

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

Exposures that a firm might have that could impact the day to day
operations of the organisation
Failure of computer system
Industrial actions of personnel
Sectoral growth rates
Market share
Aggressiveness of competitors
Competence of management and workforce
515

5.2

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
Foreign exchange risk
Risk of adverse movements in exchange rates

516

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 due to currency devaluation or inconvertibility

517

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 companys shares
expressed in cents per share
If the cost of debt is less than the return achieved, then issuing more
debt will benefit shareholders
However, high debt levels increase a companys level of financial risk
and, thus, the risk of insolvency

518

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
Historic levels of firms ratio
Limit imposed by lenders through loan covenants, i.e. restrictions
placed on a borrower specified in a loan contract
Managements assessment of the firms capacity to service debt

Gearing ratio = the percentage of a firms total funding provided by

debt
Loan covenants = conditions or restrictions placed on a borrower
and specified in a loan contract
519

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
Equity-funding for Listed Companies
Summary

Exchange

520

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

521

5.3

Initial Public Offering (cont.)

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

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

522

5.3

Initial Public Offering (cont.)

Ordinary shares: limited liability companies

Major source of equity funding
Shareholders have voting rights at general meetings
Shares usually sold fully paid, or can be partly paid (contributing
basis) or paid by 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

523

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

524

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

525

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
Main principles of a stock exchanges listing rules include
Minimum standards on quality, size, operations and disclosure
Sufficient investor interest required to warrant listing

526

5.4

Listing a Business on a Stock Exchange (cont.)

Main principles of a stock exchanges listing rules include (cont.)

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
Prescribed information must be provided to the exchange in 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 of company officers

527

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
Equity-funding for Listed Companies
Summary

Exchange

528

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

529

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
Companys cash flow requirements
Projected earnings flows from the new investments funded by the rights issue
Cost of alternative funding sources

Rights issued at a discount to current share price

Two types
Renounceableshareholder may sell their right
Non-renounceableright may not be sold

530

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
Market price discount cannot be excessive
Allows smaller discount and shorter time frame than rights issue
Dilutes holding of non-participating shareholders

531

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

532

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

533

5.5

Equity-funding for Listed Companies (cont.)

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
Include combinations of the following features
Cumulative or non-cumulative
Participating or non-participating
Issued with different rankings

534

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 companys equity base, which allows further debt to be
raised also
Dividends may be deferred on cumulative shares and not paid on
non-cumulative shares, while interest on debt must be paid

535

5.5

Equity-funding for Listed Companies (cont.)

Convertible notes
Are a hybrid instrument, issued for a fixed term at a stated rate

of interest for the term of the note

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
The notes are usually issued at a price close to the market price
of the shares at the time of issue and the rate of interest offered
on the notes is usually lower than that offered on straight debt
instruments.
It is usually lower because of the explicit option value embedded
in the security (option to convert to ordinary shares).If share price
subsequently rises a gain is made
536

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 payments are tax deductible to the company
Notes are often issued for longer periods than is possible with
straight debt borrowings

537

6.5

Pricing of Shares

Share price is mainly a function of supply and demand for a

share
Supply and demand are influenced mainly by information
Share price is considered to be the present value of future
dividend payments to shareholders
New information that changes investors expectations about future
dividends will result in a change in the share price

638

6.5

Pricing of Shares (cont.)

Estimating the price of a share

General dividend valuation model

D
t1
P
1rs t
t

Where:

P current share price

D expected dividend per share in period t
r required rate of return
0
t

(6.8)

639

6.5

Pricing of Shares (cont.)

Estimating the price of a share (cont.)

Valuing a share with a constant dividend (D0)
D

P
rs
0

(6.9)

Valuing a share with constant dividend growth (g)

(6.12)

1g

P D
0

r g
s

640

Question
The last dividend paid to shareholders by Mega Bank

Limited was $1.80 per share. The board of directors of the

bank plans to maintain a constant dividend growth policy of
8.5 per cent. An investor, in evaluating an investment in the
bank, has determined that she would require a 20 per cent
rate of return from this type of investment. If the current
price of Mega Bank shares in the stock market is $15.50,
should the investor purchase the shares? (Show your
calculations.)

Answer
Mega bank is planning to maintain constant dividend growth.

Therefore, the next dividend paid will be the last dividend

multiplied by the growth rate:
P0 = D0 (1 + g) / (rs g)
= 1.80 (1.085) / (0.20 0.085)
= $16.98
at a current market price of $15.50 the investor should consider
buying the shares

6.5

Pricing of Shares (cont.)

Cum-dividend and ex-dividend

Dividends are payments made to shareholders, expressed as
cents per share
Dividends are declared at one date and paid at a later, specified
date
During the period between the two dates, the shares have the
future dividend entitlement attached, i.e. cum-dividend

643

6.5

Pricing of Shares (cont.)

Cum-dividend and ex-dividend (cont.)

Once the dividend is paid the shares are traded ex-dividend
Theoretically, the share price will fall on the ex-dividend date by
the size of the dividend
Example:
Share price cum-dividend
Dividend paid
Theoretical ex-dividend price

$1.00
0.07
0.93
644

6.5

Pricing of Shares (cont.)

Bonus share issues

Where a company has accumulated reserves, it may distribute
these to existing shareholders by making a bonus issue of
additional shares
As with dividends, there will be a downward adjustment in share
price when shares go ex-bonus

645

6.5

Pricing of Shares (cont.)

Bonus share issues (cont.)

As no new capital is raised, there is no change in the assets or
expected earnings of the company
ExampleIf a bonus 1:4 issue is made:
Cum-bonus price

$5.00

Market value of 4 cum-bonus shares

$20.00

Theoretical value of 5 ex-bonus shares

$20.00

Theoretical value of 1 ex-bonus share

$4.00

646

6.5

Pricing of Shares (cont.)

Share splits
Involves division of the number of shares on issue
Involves no fundamental change in the structure or asset value of
the company
Theoretically, the share price will fall in the proportion of the split
Example5 for 1 split:
Pre-split share price
Theoretical ex-split share price

$50.00
$10.00

647

6.5

Pricing of Shares (cont.)

Pro-rata rights issue

Involves an increase in the companys issued capital
Typically issued at a discount to market price
Theoretically, the market price will fall by an amount dependent on
the:
number of shares issued
size of the discount

648

6.5

Pricing of Shares (cont.)

Pro-rata rights issue (cont.)

Examplemarket price cum-rights $1.00, with 1:5 rights issue
priced at $0.88:
Cum-rights share price

$1.00

Market value of 5 cum-rights shares

5.00

Plus new funds from 1:5 issue

0.88

Market value of 6 ex-rights shares

5.88

Theoretical ex-rights share price (5.88/6)

0.98

649

6.5

Pricing of Shares (cont.)

Pro-rata rights issue (cont.)

A renounceable right is a right that can be sold before it is
exercised
The value of the right is determined by Equation 6.12

Value of right N (cum rights price - subscription price)

N 1

(6.12)

Where N is the number of shares required

to obtain the rights issue share, and the subscription
price is the discounted price of the additional share.
650

Question
Bigandbold Limited has a current share price of $15.50. The

company has made a renounceable rights issue offer to

shareholders. The offer is a three-for-ten pro-rata issue of
ordinary shares at $15.35.
What is the price of the right?
Calculate the theoretical ex-rights share price.

Answer

where N is the number of shares required to obtain the rights

issue share, and the subscription price is the discounted price of

the additional share. Therefore:

Answer B
cum-rights share price

$ 15.50

Market value of 10 cum-rights shares

$155.00

plus:

new cash introduced through take-up of 3 for 10 issue

$ 46.05

gives:

market value of 13 ex-rights shares

$201.05

therefore:

theoretical ex-rights share price

$ 15.47

True/False questions
A company announces the payment of an interim dividend of

$0.20 per share. The cum dividend shares are trading at $5.40.
The theoretical ex-dividend price will be $5.60
In a one-for nine bonus issue, if the cum bonus price of the share
was $10, then the theoretical ex-bonus price would be $9
A pro-rata rights issue that has a 100 percent take up rate simply
increases the number of shares issued and has no effect on the
companys capital

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
The financing decision concerns the choice of capital structure
(D/E) and influences a firms 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

555