INVESTMENTS WEEK 2: LECTURE 2 Chara Charalambous

Objectives Point Public Companies’ Securities: Loan capital, preference shares, ordinary shares, convertibles and warrants. Chara Charalambous

Loan capital The part of a company's capital that is (1) not equity capital, (2) produces a fixed rate of interest instead of dividends, and (3) must be repaid within a specified period, irrespective of the company's financial position (either profits are made or not). Loan capital may be obtained from a bank or finance company as long-term loans and is usually secured by a fixed and/or floating charge on the company's assets. Unlike debt capital, it does not include short-term loans (such as overdraft). Also called borrowed capital. Funds are raised by issuing for example debentures against these funds, company has to pay the amount of the interest annually to debenture holders and principle amount at maturity date. Here they are not the owner of the company but the creditors. In the event of liquidation of the company the holders of loan capital will be repaid ahead of all classes of shareholders. debt capital   That part of a firm's total capital which commonly comprises of loan-capital and short term bank loans such as overdraft. Chara Charalambous

Loan Capital That part of a company's capital structure which is raised by loans. Such loans (typically debentures) are usually over a stated period of time and pay fixed interest to the person making the loan. At the end of the period the capital is repaid. This contrasts with share capital where shareholders are entitled to a proportion of the company's profits usually by way of dividends. Chara Charalambous

What is the secured Loan Capital? Debenture A promissory note or a corporate bond which (in the US) is backed generally only by the reputation and integrity of the borrower and (in the UK) by the borrower's specific assets. promissory note Written, signed promise by one party (the maker or promisor) to another (the payee or promisee) that commits the maker to pay a specified sum on demand, or on a fixed or a determinable date. Mortgage Debenture Corporate loan which is secured by a charge on a specific property – asset of the issuing firm. Guaranteed Loan Stocks These loans are secured by an outside guarantee – by major shareholders by a parent company or perhaps even by a subsidiary. Chara Charalambous

What kind of security are available to suppliers of loan capital? The principal kinds of security are a fixed or floating charge or perhaps some combination of both of these. A fixed charge could be given by a company on its fixed assets such as buildings or plant and machinery. A floating charge might be given over a company’s current assets as well as any other assets not covert by the fixed charge. Generally a fixed charge is more valuable security than a floating charge because the fixed assets are often more valuable and stable in value than the current assets and also a floating charge is subject to the prior claims of preferential creditors (rates and taxes). Chara Charalambous

Share capital Share capital is the money invested in a company by the shareholders. Share capital is a long-term source of finance. In return for their investment, shareholders gain a share of the ownership of the company. Shareholders benefit from the protection offered by limited liability – they are only liable for the amount they invest in share capital rather than the overall debts of the company A start-up company can also raise finance by selling shares to external investors Chara Charalambous

Types of Shares A. Ordinary Shares B. Preference Shares (Equity Shares) B. Preference Shares (Preferred Shares) Cumulative preference shares Non-cumulative Preference Shares

Do not generally carry voting rights Ordinary Shares: are the normal shares issued by a company and the ordinary shareholders are the real owners of the business. Carry voting rights Shareholders receive a divided at the discretion of the company directors Dividends is paid out of profits after the preference shareholders receive their dividend. Preference Shares: Do not generally carry voting rights Shareholders receive a fixed dividend (calculated as % of nominal value of shares held) Dividends is paid out in priority to ordinary dividend

Preference Shares: Dividends are cumulative (if for one year are not paid then are due next year together with the new dividends) unless specifically stated to be non- cumulative. Thus dividend arrears must be paid before any ordinary dividend can be paid. The share of preference shareholders in a company’s profits is strictly limited and therefore the preference shares are similar to loan capital but without the advantage of prior claim which loan capital enjoys. Chara Charalambous

What kind of preference shares companies issue? First, second, e.t.c Preference shares: like loans may run ahead of others or they may rank equally. Participating Preference shares: In addition to the usual right to a fixed dividend these may be entitled to a further limited participation in profits in some circumstances e.g. if the ordinary dividend exceeds a specified level. Convertible Preference shares: these carry the right of conversion into ordinary shares at specified date and prices. Preferred Ordinary Shares: they are really preference shares and they typically rank after all other issues of preference shares and they carry votes along with the ordinary shareholders. Chara Charalambous

Redeemable preference shares: Redeemable (buy back) preference shares which are repayable by the company at a specified future date. On this date the shares are cancelled and the shareholders repaid. These shares have the characteristics of debt and they shown as a liability in the Balance Sheet. Irredeemable preference shares are preference shares which are not redeemable. These shares are classified as equity-capital in the Balance Sheet. Chara Charalambous

Who should invest in preference shares? Investors looking for a mix debt and equity investment exposure Investors looking for medium risk and return (risk is higher than debt instruments but lower than ordinary shares) Chara Charalambous

Ordinary Shares Ordinary shares are often referred to as ‘equities’ because they are entitled to the equity, for example the residue of the: Profits after all prior charges: loan interest and preference dividends have been paid Assets after all prior debts, like tax, creditors, loan capital e.t.c, have been discharged on a liquidation. These twin features make ordinary shares at the same time more risky than loan or preference capital, but also potentially much more rewarding. Ordinary shares give the investor – as part owner of the business – an unlimited right to share in the profits of the company and this can make a holding extremely valuable. Chara Charalambous

Other kinds of ordinary shares Non-voting shares or A’ ordinary shares: carry no vote Restricted voting shares: give only limited rights e.g. 2 votes for every 5 shares Redeemable shares (buy back) : have all the rights of ordinary shares – voting rights, entitlement to dividends etc. Deferred dividend shares: have full rights as to voting and rank with the ordinary shares on liquidation, but their entitlement to a dividend is deferred (postponed, delayed) until a specified date. Such shares are cheaper than ordinary shares. Deferred shares or founder shares: these are entitle to share in profits only after the ordinary shareholders have received a fixed or limited dividend. In such cases the ordinary shares are really a kind of preference share, and the founder shares are the real equity capital. Deferred shares may however receive more favorable voting rights. Chara Charalambous

Convertibles and Warrants What are convertible loan stocks? Convertible loan stock is stock that starts out as straightforward debt, but can be converted by the lender into equity.Are fixed interest stocks with rights to convert the stock into ordinary shares on specified terms – for example x number of shares for every £100 of stock – at certain future dates. Instead of issuing debenture stock, a company might have considered convertible loan stock as a means of raising money. The loan is usually unsecured, which means that it is not tied to specific assets of the borrowing company. To this extent it is not as safe as debenture stock. As with debenture stock, it pays a fixed rate of interest and the principal amount of the loan has to be repaid by the company at a specified future date if the loan is not "converted" to equity. The key difference is that the lender has the option of converting the loan into equity at some stage of its life. Chara Charalambous

Convertible loan stock continue….. Conversion terms are very specific: For instance, they might have said that every £4 of convertible loan stock could be converted by the lenders into one ordinary share at any time between 2000 and 2003. If at the time of the issue the share price is not higher than the conversion price and is not responding to the expectations of the investors regarding the value of the shares the lenders will not convert the loan stock into equity. If the share price rises and satisfies the expectations of the lenders/investors then it would make sense to convert the loan into equity. In a sense, the holders of convertible loan stock can have their cake and eat it. They can keep the debt if the share price of the company is lower than the conversion price, or convert it to equity if there is a premium available. Convertible loan stock can be an attractive option for companies because the rate of interest they have to pay on the loan is usually lower than for debenture stock. As an alternative to raising money by issuing new shares it also has attractions because it is "deferred equity". In other words, the loan stock can be converted into equity but until it is converted, it isn't equity! And companies quite like this because their earnings per share (the critical performance measurement) are not weak.. Chara Charalambous

Why investors prefer convertibles over shares? The fixed interest offers them higher and regular income than the related ordinary shares. Also they have the opportunity for capital gain. It is less risky: as a loan capital it will be repaid prior to the share capital in the even of liquidation. As part of the loan capital its price is more stable than that of the ordinary shares. Chara Charalambous

What are Warrants ? Warrants are securities issued by companies which give the holder the right to acquire ordinary shares at fixed or determinable prices in the future. The price is known as the subscription price. In this respect are similar to convertibles but actually they are a very different kind of investment. Warrants produce no income and they carry the right to subscribe for ordinary shares on specified terms usually several years after the issue. The value depends entirely on the performance of the company. Chara Charalambous

Warrants are usually issued to attract investors as part of a ‘rights issue package’ consisting of two separate securities: (i) fixed interest loan stock and (ii) warrants to subscribe for ordinary shares. The investor can take up both or neither or just one of them. Chara Charalambous

How are warrants value? The price at which a warrant holder can purchase the shares is called the exercise price. The subscription/exercise price is usually higher than the market price of the stock at the time of the warrant's issuance. Warrants are traded on the major exchanges and are subject to supply and demand. The price of the warrants can never be greater than the subscription price of the shares. Example: Warrants on a one –for-one basis might sell for 20p when the ordinary shares are quoted at 120p. The warrants carry the right to subscribe for new ordinary shares at a price of 130p in five years. This option period lasts for 5 years. This means that the investor has two alternatives: i. To buy the ordinary shares today at 120p or ii. To buy the warrants at 20p and subscribe for the shares at 130p in five years – total 150p. The difference between the two alternatives,30p, is the warrant premium. Chara Charalambous

If the price of the stock is above the exercise price of the warrant, the warrant must have what is known as a minimum value. For example, consider the warrants to purchase 100 shares of Company XYZ for $20 per share anytime in the next five years. If Company XYZ shares rose to $40 during that time, the warrant holder could purchase the shares for $20 each, and immediately sell them for $40 on the open market, pocketing a profit of ($40 - $20) x 100 shares = $2,000. Chara Charalambous