1. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 1 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter 5 Corporations Issuing Equity in the Share Market Website: http://www.asx.gov.au

2. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 2 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Learning Objectives Examine issues relevant to the choice between debt and equity funding Outline ASX floatation and listing rules Describe the equity-funding alternatives available to newly listed and established corporations Distinguish between equity and quasi- equity securities

3. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 5.1Introduction 5.2The Investment Decision 5.3The Financing Decision 5.4Initial Public Offering (IPO) 5.5Listing a Business on the Stock Exchange 5.6Equity-funding Alternatives for Listed Companies 5.7Summary

4. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.1Introduction The objective of financial management is to maximise shareholder value There are four main aspects of financial management – Investment decision (capital budgeting)  In which assets to invest? – Financing decision (capital structure)  How to fund the purchase of these assets?

5. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 5 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.1Introduction (cont.) – Liquidity (working capital) management  How to best manage current assets and current liabilities? – Dividend policy decision  How to retain and/or distribute profits? This chapter focuses on the financing (funding) decision

6. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 6 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 The Investment Decision 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

7. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 7 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 The Investment Decision (cont.) Two important measures used to quantify the contribution of an investment to shareholder wealth are – Net present value (NPV) – Internal rate of return (IRR)

8. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 8 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 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

9. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 9 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 The Investment Decision (cont.) NPV (and IRR) are influenced by – The accuracy of the forecasted cash flows – The discount rate (required rate of return)

10. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 10 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 The Investment Decision (cont.) IRR – The required rate of return that results in a NPV of zero The IRR acceptance rule – Accept the investment if its IRR is greater that the firm’s required rate of return

11. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 11 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.2 The Investment Decision (cont.) Limitations of IRR – Non-conventional cash flows  Can result in multiple IRRs – Mutually exclusive projects  A situation where, from a choice of two or more projects, only one project can be chosen

12. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 12 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 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

13. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 13 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 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, caused by either – Business risk – Financial risk

14. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 14 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 The Financing Decision (cont.) Business risk – The level of business risk depends upon the type of operations of the business i.e.  Industry sector which 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

15. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 15 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 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

16. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 16 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 The Financing Decision (cont.) – Financial risk categories (cont.)  Foreign exchange risk Risk of adverse movements in exchange rates  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

17. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 17 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 The Financing Decision (cont.) – Financial risk categories (cont.)  Country risk Risk of financial loss due to currency devaluation or inconvertibility  Debt to equity ratio (D/E) i.e. the ratio of funds contributed by shareholders (equity) to funds borrowed (debt) Risk of being unable to meet interest due and principal repayments associated with use of debt i.e. risk of insolvency

18. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 18 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 The Financing Decision (cont.) – Earnings per share (EPS) is the net return on a company’s shares expressed in cents per share  If the cost of debt is less than the return achieved, then issuing more debt will benefit shareholders due to higher EPS  However, high debt levels increase the company’s level of financial risk and, thus, the risk of insolvency

19. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 19 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.3 The Financing Decision (cont.) Is there an optimal debt to equity ratio? – No optimal debt to equity ratio – Optimal D/E for a company depends on  Industry norms  Historic levels of a firm’s ratio  Limits imposed through loan covenants  Firm’s capacity to service debt

20. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 20 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.4 Initial Public Offering (IPO) IPO is an offer to investors of ordinary shares in a newly listed company on a stock exchange – New share issuer must meet SX listing requirements – The promoter appoints advisors (stockbroker, merchant bank, other specialists) and possibly underwriters

21. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 21 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.4 Initial Public Offering (IPO) (cont.) – Underwriters  Ensure companies raise full amount of the issue  Assist with advice on the structure, price, timing and marketing of the issue and allocation of securities – Prospectus

22. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 22 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.4 Initial Public Offering (IPO) (cont.) Ordinary shares: limited liability companies – Major source of equity funding – Shareholders have voting rights at general meetings – Shareholders may transfer voting rights to a proxy

23. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 23 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.4 Initial Public Offering (IPO) (cont.) – Shares usually sold fully paid, or can be partly paid or by instalment receipt – Shareholder’s liability is limited to the extent of the fully paid shares – Partly paid shareholders have a contractual obligation to pay the remaining amount (the call) to the company

24. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 24 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.5Listing a Business on the Stock Exchange Listing rule principles Admission to a stock exchange Quotation of securities Cost of listing Continuing listing requirements

25. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 25 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Listing rule principles A company seeking to have its securities quoted on a stock exchange (i.e. join the official list) must comply with listing rules which are additional to the corporations legislation obligations Listing rule principles have been established to maintain market integrity and protect investors

26. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Listing rule principles (cont.) Listing rule principles are specific criteria that must be met and include – Minimum standards on quality, size, operations and disclosure – Sufficient investor interest required to warrant listing – New issues permitted if equitable

27. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 27 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6Equity-funding Alternatives 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

28. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 28 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Rights issue – Issue of ordinary shares to existing shareholders – Issued pro-rata (e.g. 1:5—1 for 5)

29. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 29 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Rights issue (cont.) – Two types  Renounceable—shareholder may sell their right  Non-renounceable—right may not be sold

30. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 30 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Placements – Additional new ordinary shares issued to selected investors (typically institutions) – Not required to register a prospectus

31. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 31 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Takeover issues – The acquiring company issues additional ordinary shares to the owners of the target company in settlement of the transaction – Alleviates the need for owners of the acquiring company to inject further equity for the purchase of the company

32. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Dividend reinvestment schemes – Shareholders have the option of reinvesting dividends in additional ordinary shares – Generally issued at a discount

33. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 33 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives 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

34. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 34 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Preference shares (cont.) – Advantages of preference shares  In effect preference shares are fixed interest borrowings, but are an equity finance instrument  Assists in maintaining debt to equity ratio  Widens a company’s equity base, which allows further debt to also be raised

35. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 35 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Convertible notes – Are a hybrid instrument—initially as a debt instrument issued for a fixed term – Interest payments are specified in the note – Bestows the right to convert the note into ordinary shares at a specified future date at a predetermined price

36. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 36 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Convertible notes (cont.) – The option to convert to equity has value – The conversion price is nominated at note issue—a gain is made if share price rises subsequently – If share price falls, holder may not exercise conversion option, and take the notes cash value

37. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 37 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Convertible notes (cont.) – 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

38. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 38 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Company-issued options – Provide the right but not the obligation to purchase shares, at a stated price and date – Issued for a period of up to 5 years – Allows companies to raise further equity funds at planned future dates (providing holders exercise the option)

39. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 39 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives 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

40. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 40 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Company-issued equity warrants – Generally attach to corporate bond issues; however, may be issued unattached – Holder has the option to convert the warrant into ordinary shares at a specified price over a given period

41. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 41 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 5.6 Equity-funding Alternatives for Listed Companies (cont.) Company-issued equity warrants (cont.) – Warrants may be detachable from the bond and traded separately – Holder does not receive dividends, but may benefit from capital gains if the share price rises above the conversion price