11. Equity

Question 1

Ordinary shares are issued by firms with ___ liability and represent the ______ of the firm.

Answer 1

• limited
• risk capital

Question 2

What are the 2 types of dividend payment known as?

Answer 2

1. Interim dividend
2. Final dividend payment

Question 3

What is a primary share offering?

What is a secondary share offering?

Answer 3

• 1st time shares are offered to public aka IPO
• An issuance of stock subsequent to IPO

Question 4

Prior to IPOs, company usually works with investment bank to advise on what? [4]

Answer 4

• type of security to issue
• best price to expect
• no. of shares to be issued
• when to bring IPO to mkt

Question 5

IPO pros & cons [2]

Answer 5

+ Helps growth
+ Helps with company finances
- New shares dilutes existing shareholders’ holdings
- Investors may regard IPO shares as risky

Question 6

IPO shares are deliberately ___ to increase their attractiveness to investors.

Answer 6

underpriced

Question 7

What are the 2 types of secondary offering, and are they dilutive or non-dilutive?

Answer 7

1. Seasoned equity offering - a company that has already performed an IPO can issue more new shares (dilutive)
2. Secondary offering - can involve sale of shares that have already been issued and are held by those close to the company (non-dilutive)

Question 8

How do pref shares differ to ordinary shares? [2]

Answer 8

• Unlike ordinary shares, they pay the investor a fixed divi, fixed as a % of the face value of the share
• and normally carry no voting rights.

Question 9

In the event of liquidation, pref shares are paid ___ ordinary stockholders.

Answer 9

before

Question 10

For investors, pref shares act more like a fixed int bond, why do companies benefit from issuing pref shares?

Answer 10

Because they are technically an equity vehicle rather than a debt security so prevents the company holding too much debt and thus impacting it’s debt-equity ratio.

Question 11

What is an American Depository Receipt (ADR), and why was it introduced?

Answer 11

• A stock that trades in the USA but represents an investment in a specified no. of shares in a non-US company.
• To facilitate the trading of shares in non-US companies in the USA.

Question 12

Why do foreign companies issue ADRs?

Answer 12

Because they get more US exposure & it allows them to tap into wealthy North American equity markets.

Question 13

Why do individuals invest in ADRs?

Answer 13

Because they are an easy and cost-effective way to invest in a foreign company (lower admin costs & avoids FX transaction taxes).

Question 14

What is placing regarding equity issuance and what size issues are they suitable for?

Answer 14

• Issuing firm places new securities with issue house (i.e. investment bank) who buys the lot and resells (‘places’) them to other investors.
• Smaller issues

Question 15

What are pros of placing equity issues? [2]

Answer 15

• By placing shares, firm is guaranteed to raise full amount of issue.
• Usually cheaper than alternatives

Question 16

What is accelerated book building regarding equity issuance?

Answer 16

Investment bank or similar institution seeks out interest of investors buying some of the issued shares - building up a “book” of investor interest. Accelerated means doing this quickly.

Question 17

What is offer for sale regarding equity issuance?

Answer 17

Like a placing, uses an issuing house to purchase all shares from firm, but the offers all of issue to general public instead of other investing institutions.

Question 18

Under an offer for sale equity issuance, the offer price of the shares is usually ___, and the issuing company ___ the issue by selling the shares to the issuing house first and so is assured of raising the required finance for its operations. The issuing house is acting as an ___ and will charge a fee for this.

Answer 18

• fixed
• ‘guarantees’
• underwriter

Question 19

What is offer for sale by tender regarding equity issuance?

Answer 19

Issuing capital by ‘inviting’ general public to bid for an issue, subject to a min price. Once the subscription deadline is reached, the firm will establish a striking price, which is calculated to ensure that the issue is fully subscribed.

Question 20

What is an advantage & disadvantage of offering equity for sale by tender

Answer 20

• • Firm may raise more than it initially expects.
• • Although firm sets a min price and therefore expects a min value from the issue, it will not know the exact amount that it will raise until all bids have been received & striking price set.

Question 21

What is offer for sale by subscription regarding equity issuance?

Answer 21

Firm, rather than issuing house, offers issue to general public.

Question 22

What is introduction regarding equity issuance?

Answer 22

Company joins main mkt without raising any capital.

Question 23

What is an advantage & disadvantage of introductions for issuing equity?

Answer 23

• • No underwriting fees & requires little advertising
• • Limits initial opportunities for boosting company’s profile & visibility

Question 24

What is equity crowdfunding regarding equity issuance?

Answer 24

People (“crowd”) invest in an early-stage unlisted company in exchange for shares.

Question 25

What is a **rights issue**?

Answer 25

Most popular secondary shares issue for firms whose shares are already listed on the stock exchange. Existing owners can subscribe to new shares in proportion to their current holdings at a fixed price, usually below current mkt price. No obligation.

Question 26

What is the name of the share price before a rights issue? And the theoretical new price after a rights issue?

Answer 26

- cum rights - ex-rights share price

Question 27

If investor sells the rights on a rights issue, what will each right usually be worth?

Answer 27

ex-rights price - subscription price

Question 28

What is a **scrip issue**?

Answer 28

Another form of secondary share issue which creates new shares, which are issued free of charge to existing shareholders in proportion to their existing shareholding.

Question 29

What is a **scrip dividend**, and why may in be good for investors?

Answer 29

- When companies make a scrip issue rather than pay a divi in cash to their investors. - Can reduce the investor's income tax liability.

Question 30

Ex-scrip issue price =

Answer 30

(Ordinary shares held x original share price) ÷ total no. of new shares held

Question 31

What is a **stock split** and when might a firm want to do one?

Answer 31

- Splitting issued shares into shares with a smaller par value (before & after mkt cap same, no dilution) - If firm believes ordinary share price is too high and doesn't want to make a scrip issue & capitalise reserves

Question 32

Name 2 things specified when a company does a share repurchase/buyback.

Answer 32

1. Qty of shares company looking to repurchase 2. Price they are willing to pay (usually premium to mkt price)

Question 33

Name 2 things company can do after buying back shares.

Answer 33

1. Retire them 2. Keep them as treasury for re-issuance

Question 34

What is the motivation for a share buyback? [2]

Answer 34

- Company has surplus equity and feels it cannot be employed in a useful way to expand the business (opposite of reason for a share issue) - Spare cash, mkt share price perceived to be 'cheap'

Question 35

What will a share buyback do to: - ROE - PE ratio

Answer 35

- improve it - lower it

Question 36

Holding period return =

Answer 36

HPR = (Ending Value - Beginning Value + Income) ÷ Beginning Value

Question 37

Dividend yield =

Answer 37

Divi paid ÷ Share price

Question 38

Name 2 limitations of divi yield.

Answer 38

- Only gives indication of current divi yield - Divis might change in future - When comparing divi yields of 2 firms, any diff may be due to differing divi policies

Question 39

Dividend cover =

Answer 39

EPS ÷ DPS where earnings are earnings attributable to ordinary shareholders are profit after interest & tax

Question 40

Dividend payout ratio =

Answer 40

Inverse of divi cover

Question 41

Companies can legally only pay out divi's if they have what?

Answer 41

The distributable reserves in their BS

Question 42

What is the std tool for valuing equities in the UK?

Answer 42

Dividend discount model

Question 43

What is the Gordon growth model? calc stock price

Answer 43

P = D1 ÷ R - g P = stock price D1 = divi payment in period 1 r = constant cost of equity capital g = constant growth rate

Question 44

What is the Gordon growth model? calc return offered or required

Answer 44

R = ((D0 (1+g)) ÷ P0) + g

Question 45

Growth rate of divi's or earnings = g

Answer 45

retention ratio x ROE where retention ratio = RE ÷ E

Question 46

What are **absolute value** techniques, vs **relative value** techniques when considering valuation techniques?

Answer 46

- based on discounting techniques where: equity value = PV of FC future returns - based on mkt multiples where: equity value = earnings power x mkt price multiple

Question 47

EPS =

Answer 47

Earnings ÷ no. of ordinary shares where earnings = profits after int, tax & pref divi's or equity divi's + REs

Question 48

3 drawbacks of EPS?

Answer 48

- Based on accounting earnings which may be distorted by accounting standards & policies, write-off's - Not useful for inter-company comparisons as an absolute measure - Affected by no. of shares in issue changing

Question 49

What is the **diluted EPS**?

Answer 49

A hypothetical EPS based on new no. of shares in issue if stock options had been exercised

Question 50

What is PE ratio used for?

Answer 50

To give an idea of the mkt's estimate of a firm's growth potential.

Question 51

What 2 conclusions can be drawn from a high PE ratio?

Answer 51

1. Investors believe future earnings will be relatively high 2. Company is overvalued

Question 52

Prospective PE =

Answer 52

price now ÷ FC earnings

Question 53

PEG ratio =

Answer 53

PE ÷ annual EPS growth

Question 54

Name 2 problems facing PE ratio.

Answer 54

1. What if co. has negative earnings 2. Earnings based on accounting estimates

Question 55

What ratio gets round PE ratio problem of potential co. negative earnings?

Answer 55

Price to book (PB) ratio

Question 56

What ratio gets round PE ratio problems of potential co. negative earnings and potential accounting policy distortions?

Answer 56

Price to sales (PS) ratio

Question 57

Name 2 issues of using PS ratio.

Answer 57

1. Sales don't mean profits 2. Sales generated not just by equity but debt also i.e. PS ignores gearing

Question 58

What is enterprise value to sales (EV / S)?

Answer 58

Looks at value of entire entity (EV = equity + debt - cash)

Question 59

What does EV/S ratio eliminate?

Answer 59

Effect of accounting & finance decisions

Question 60

What may investors read into a high EV/S?

Answer 60

Future sales may increase

Question 61

Name 2 pros and 2 cons of price to cash flow (PCF).

Answer 61

- + Unlike sales & book value, hard to manipulate cash flow - + cash flow multiples may provide a more accurate picture of a co. - - Cash flow can be calculated several ways - - Neglects impact of non-cash components i.e. deferred revenue

Question 62

What is the residual income method?

Answer 62

- The income generated by a firm after accounting for the true cost of equity capital

Question 63

When is the residual income method most appropriate?

Answer 63

- When a firm is not paying divi's or has an unpredictable divi pattern - Or when it has negative FCF

Question 64

What is **gearing**?

Answer 64

Level of company's debt relative to its equity capital.

Question 65

Debt-equity ratio =

Answer 65

Total LT debt ÷ total equity

Question 66

A higher proportion of debt capital compared to equity capital can make earnings more ___ and therefore ___ the probability that the firm will not be able to meet its obligations to debt holders.

Answer 66

- volatile - increase

Question 67

Debt is ___ than equity for a firm.

Answer 67

cheaper

Question 68

The providers of equity finance generally require a ___ return than the providers of debt finance. Why?

Answer 68

- higher - Because debt holders have the superior claim on the firm's assets should the firm fail, and cash flows paid to bond holders are more certain.