Topic 4: Equity

What are the 2 main sources of finance?

• Bank loans

• Investors’ equity

What are bank loans?

• pay annual interest

• repay loan on its maturity date

• if it fails to pay interest or loan bank can force bankruptcy

What are equity investors?

• no legal right to any form of repayment

• annual dividends not guaranteed.

• less financially stressful for company.

What do equity investors get in return?

• share in ownership of business

• potential to receive a share in profits (dividends)

• sell their shares at a profit if the business is successful.

What is the company view?

• The company is deciding whether to raise money by selling shares (equity).

  • No repayments required: Unlike a bank loan, the company does not have to repay the money invested.

  • Ownership is diluted: Founders give up a percentage of ownership to new shareholders.

  • More time-consuming: Raising equity can take longer to organise than getting a bank loan.

  • More people to satisfy: The company must consider the interests of many shareholders rather than dealing with just one bank.

What is the investor view?

The investor is deciding whether to invest money in the company.

• Higher risk: Investors are not guaranteed dividends or repayment of their investment.

• Less information: Managers usually know more about the company than investors do.

• Less negotiating power: Individual investors may have limited influence over the returns they receive.

• Higher potential returns: Shares can generate greater returns than bonds, but they carry greater risk.

• Historically higher returns: Equities have historically outperformed bonds by more than twice in the context of your notes.

What is ordinary share capital?

• most common in share capital

• real owners of the company

• shares have an official value when they are issued, but the price people buy and sell them for can be differen

• no guaranteed rights to dividend payments

What are ordinary shareholders voting rights?

• mergers, acquisitions and corporate policy

• board of directors and management

• decisions to raise/expand equity share capital

What are advantages of ordinary share capital?

• dividends (not guaranteed)

• (unlimited) capital gain

• limited liability

• internal corporate governance through voting

• preemptive rights

Disadvantages of ordinary shares?

• uncertain and irregular income

• limited control

• last to get paid if company goes bankrupt

What are preference shares created as a hybrid between?

equity and loans

What are preference shares?

give investors priority over ordinary shareholders when receiving dividends and getting their money back if the company closes down.

• reduce company debt without reducing company voting control

• lower-risk investment

What are the two types of preference shares?

• Cumulative preference shares: Missed dividends accumulate and generally must be paid before ordinary shareholders can receive dividends.

• Non-cumulative preference shares: Missed dividends do not accumulate, so investors may lose that dividend permanently.

What are advantages of preference shares?

• appeals to cautious investors

• classified as equity so limits debt

• provides flexibility

• used as incentives during transactions

Disadvantages of preference shares?

• low and limited return to investors

• no voting rights

• will only be paid once other creditors have been paid during bankruptcy

• lack of tax deductibility

What are depository receipts?

Certificated that allow investors to invest in foreign companies more easily

How do depository receipts work?

1. A foreign company's shares are held by a bank or custodian.

2. A bank issues certificates representing ownership of those shares.

3. Investors buy and sell these certificates on another country's stock market.

What are two main types of depository receipts?

• ADR - American Depositary Receipt (traded in US)

• GDR - Global Depositary Receipt (traded outside US)

Why are depository receipts useful?

• companies: attract investment from other countries

• investors: can buy foreign-company investments more conveniently through their local markets

• trading: ADRs priced in dollars, transactions easier for US investors.

What are the characteristics of ADRs?

• registered, issued, and traded in US

• get more US exposure and into the equity market

• most common way for US investors to invest and trade in foreign corporations

• dont remove currency risks or political and economic risks associated with home country.

What are primary markets?

Markets where a company sells shares to the public for the first time to raise money, known as an Initial Public Offering (IPO).

What are secondary markets?

Markets where investors buy and sell existing shares between themselves on a regular basis.

Why is liquidity in second markets critical?

• to raise equity finance, must sell newly issued shares to public investors

• successful equity needs strong primary and secondary market

• only subscribe to primary if confident they can be sold in secondary later

What is the structure of equity and bond markets?

What are institutional underwriters?

large financial institutions, such as investment banks, that help companies sell new shares to investors.

What is the structure of equity and bond markets?

What is initial public offering (IPO)?

when a private company sells its shares to the public for the first time and becomes listed on a stock exchange.

Why is IPO attractive to the company?

• Finances expansion

• Reduces debt-equity and risk exposure to loan interest payments

• opens way to secondary market, business founders reduce their stakes

• raises public profile of the company

What are the challenges of IPO?

• high costs

• more regulations and audits

• loss of control

• risk of incorrect share pricing

• must convince investors to buy shares

• must attract investors without underpricing

• meet tougher accounting standards

• regular reporting to investors

• needs an investor relations team

What is the under-pricing phenomenon?

Significant price surge on debut day.

generates strong initial investor enthusiasm and secondary market demand.

What is the downside for issuer from underpricing?

leaves cash on the table that could have funded corporate development

What are mis-priced IPOs?

when a company sets the initial share price too high or too low when it first sells shares to the public

What is a dilutive issue?

when a company created and sells new shares to raise more money

• company receives cash

• earnings may stay the same

• earning per share falls

• existing shares are diluted

What is a Non-dilutive issue?

when existing shares are sold to new investors, rather than the company creating new shares.

• founders reduce ownership

• benefit of an IPO

• more shareholders

What are successful M&A examples?

What causes mergers and acquisitions funded by equity issuance to fail?

• overvaluation

• poor timing

• cultural incompatibility

What are unsuccessful M&A examples?

What are techniques used to issue shares?

• what target needs to be achieved

• primary issuance execution mechanisms

What are the three ways to price and issue shares?

1. fixed pricing - sets share price in advance

2. tender auction - based on investors’ bids

3. book-building. - based on investor demand and willingness to pay

What are the targets to be achieved?

• all share issues sold - if not damaged reputation

• sell new shares at accurate price

• leave room for share price to rise modestly post issue

• demand should outstrip supply

How much room should be left for a post issued price rise?

(+10% to +15%)

What techniques are used to achieve targets? and what are the objectives?

• placing offers

• offer for sale

• book-building

• maximum security for company

• pricing shares fairly

What is a placing?

When a company uses an investment bank or broker to sell its new shares, mainly to large investors such as pension funds and investment companies.

What are the advantages of placing?

• guaranteed funds

• lower fees

• quicker and simpler

What are the limitations of placing?

• best for smaller issues

• fewer investors

• lower public profile

• risk of underpricing

What is an intermediaries offer?

Similar to placing, instead of using one bank or broker, they use several to sell its shares.

What is an offer for sale?

company invites the general public to buy its shares. unlike a placing, which mainly targets selected investor. Still goes through and investment bank or broker

What are the two main ways to set the share price for an offer for sale?

1. fixed-price offer - company and its investment bank set the share price in advance

2. tender auction - company asks investors to bid for the shares by stating how many they want and how much they are willing to pay. avoids committing to a price in advance.

What is book building?

instead of setting a price straight away, the company asks investors how many shares they want and how much they are willing to pay.

How does book building work?

1. company hires an investment bank

2. investors state their demand

3. bank ‘builds’ a book

4. final price is decided

What are the advantages of book building?

• replaces lengthy public offer for sale

• short period of intensive negotiations

• accelerates book building (often within 24-48 hours)

• full and fair pricing

• cut expenses and market risk

What is an introduction to an equity exchange?

When a company joins a stock exchange without issuing new shares to raise money at that time.

• no fresh capital

• much lower fees

• lower public profile

• liquid platform for future fundraising

What is a reverse takeover?

when a private company takes control of a company that is already listed on a stock exchange, allowing the private company to gain a listing indirectly.

• faster and cheaper

• immediate public profile

What is crowdfunding?

When lots of people invest smaller amounts of money in a company, usually through an online platform.

What can a company do after it has become publicly listed on a stock exchange?

• rights issues

• scrip issues

• stick splits

• share buybacks

Whats a rights issues?

company gives its existing shareholders the first opportunity to buy additional shares (normally at a discounted rate and before offered to the wider market).

What does a 1-for-4 rights issue mean?

you can buy 1 new share for every 4 shares you already own

What if you dont want to buy new shares from the rights issues?

• take up your rights

• sell your rights

• do nothing

Why are the new shares sold at a discount?

to encourage existing shareholders to buy them

What is the theoretical ex-rights price (TERP)?

calculated share price after a rights issue, assuming the share price adjusts to reflect the new shares being sold at a discounted price

What is the rights issue process?

• shareholders have 3-4 weeks to decide whether to subscribe

• if choose not to subscribe, can sell rights on the market

• requires calculating theoretical prices

What are nil-paid rights?

rights that allow an existing shareholder to buy new shares at a discounted price, but the shareholder has not yet paid for those new shares.

What is the cum-rights price (before issue)?

share price prior to rights issue

What is the ex-rights price?

share price after rights issue

What is the theoretical ex-rights price equations?

(the value of existing shares held + cost of new shares)/number of shares held after right issue

What is the standalone value of the right equation?

Standalone value of the right = theoretical ex-rights price – rights issue price