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 Chapter 5 Corporations issuing equity in the share market Website:

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 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 5-3 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 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 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) (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 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 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 5-9 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 (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 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 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 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 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 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 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 5-17 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 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 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 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 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 5-23 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 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 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 5-27 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 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 Equity funding for listed companies (cont.) Rights issue (cont.) –Two types  1.Renounceable—shareholder may sell their right  2.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 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 $ 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 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 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 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 (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 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 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 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 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 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 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 (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 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 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 5-43 Chapter organisation 5.1The investment decision 5.2The financing decision 5.3Initial public offering 5.4Listing a business on a stock exchange 5.5Equity funding for listed companies 5.6Summary

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 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 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