08. Equity Finance Flashcards
What is the main internal source of finance?
Retained earnings or rather retained cash.
Outline the Pecking Order Theory and the justifications for it.
According to Pecking Order Theory, companies should follow an established pecking order to raise finance in the simplest and most efficient manner.
The first justification for this theory is that companies should want to minimize issue costs:
- cheapest source = retained earnings because no issue costs.
- bond issue/bank loan is next.
- most expensive is fresh equity issue eg IPO with issue costs ranging between 2% and 8% of amount raised.
The second justification is that companies will want to minimise the time and expense involved in persuading outside investors of the merits of the project:
- if using retained earnings, it does not have to spend any time persuading outside investors.
- otherwise, time and expense associated with issuing debt is usually significantly less than that associated with a share issue.
A further justification is the existence of asymmetrical info and the presumed info transfer (“signal”) from management actions.
Improved working capital management can help release more internal equity finance. What are some ways to improve working capital management?
- reducing the time taken to receive payments from customers (eg offering discounts for quick payment or outsourcing debt collection to a factor).
- reduction in the amount of inventory (eg through improved supply chain management or even moving to Just-in-Time (JIT) production).
- taking increased credit from suppliers. However, care must be taken not to lose settlement discounts or compromise relationships with key suppliers.
If a company is already listed (ie a quoted company), what are 5 methods available for issuing new shares?
- Offer for subscription (public issue) - a direct sale to the general public, this is generally the most expensive method.
- Offer for sale - an indirect sale to the public accomplished by selling shares directly to an issuing house (merchant/investment bank), which then sells them to the public. (The issuing house guarantees to buy the shares.)
- Placing - in a placing, the sponsor (normally a merchant bank) places the shares with its clients (usually pension funds and insurance companies) rather than the shares being offered to the general public. This is generally the least expensive method.
- Rights issue - an offer to allow existing shareholders to buy new shares in proportion to their existing holdings.
- Offer for sale or subscription by tender - like an auction, with the public being invited to bid for shares. Useful where setting a price for the shares is difficult.
What are some options for unquoted companies for raising external equity finance?
- Become quoted - (ie raise new equity finance at the same time as becoming listed). Aka IPO. The method could be an offer for subscription or sale, tender or placing. Expensive process.
- Stay unquoted. Use a rights issue or private placement. However, there may be a limited source of funds from either existing owners or new private investors.
- To engage in what is known as “introduction”.
- no shares (neither existing nor newly-created) are made available to the market, so no new finance is raised.
- stock market grants a quotation, given that shares must already be widely held, so that a market can be seen to exist.
Useful to gain greater marketability of shares, a valuation for inheritance tax purposes or future easier access to additional capital.
What are five factors to consider before doing an IPO?
- Legal restrictions.
- Costs including:
- underwriting costs (ie the fees that must be paid to an investment bank to underwrite/guarantee the share issue) which are typically 5% to 7% of the offering.
- stock market listing fee (initial charge) for new shares.
- fees for the issuing house (investment bank), solicitors, auditors, PR.
- cost of printing and distributing the prospectus )the document in which the shares are offered for sale).
- advertising in national newspapers. - Valuation: the setting of a new price for the new shares to be issued.
- Stock exchange rules.
- Timing.
Outline what a rights issue is.
In a rights issue, the existing shareholders are offered more shares (usually at a discount to the current market price) in proportion to their existing holding.
What is the theoretical ex-rights price and what is the formula for it?
The theoretical ex-rights price (TERP) of a share is the expected share price following the rights issue.
It is calculated as:
TERP = (pre-existing value of equity + proceeds of rights issue + project NPV)/number of shares after the rights issue
Note: proceeds of rights issue should be added net of issue costs and if the project has been announced and the market is operating at semi-strong level of efficiency, the project’s NPV will already be reflected in the existing share price and it should not be included again in the formula above.
What is a bonus issue?
In a bonus issue, reserves (eg revaluation surplus or share premium accounts) are converted into share capital, which is distributed as shares to existing shareholders in proportion to their existing holdings.
No finance is raised.
Purpose is for marketability of the shares, as it increases the number of shares in existence and reduces their price. This creates a more active secondary market for the shares, which will help future issues to raise cash (eg rights issues).
Aka scrip issues or capitalization of reserves and signal a company’s strength to the market.
Outline stock splits.
Stock splits occur when ordinary shares are split in value (eg $1 share is converted into two 50-cent shares). This reduces the market price per share, increasing their marketability.
Outline two scenarios that show how the key decision areas in financial management are interrelated.
- An increase in dividends (dividend decision), will reduce the level of retained cash available and increase the need for external finance (the financing decision) in order to fund capital investment projects (the investment decision).
- An increase in CAPEX (the investment decision) would also increase the need for finance (the financing decision) which may be sourced internally by reducing dividends (the dividends decision).
State how the following factors may influence a company’s dividend policy:
1. Legal constraints
2. Liquidity requirements
3. Shareholder expectations
- Legal constraints - in most countries, a dividend can only paid paid if there’s a credit balance in the retained earnings account in the SOFP. No distributable reserves mean no dividends.
- b/f losses may cause debit balance even if profit was made in the current year.
- restriction may damage company’s ability to attract new equity investors to finance its growth. As such, some countries allow the retained earnings’ debit balance to be written-off against other reserves, which allows them to continue paying dividends. - Liquidity requirements - companies must maintain adequate liquidity. Dividend restrictions may be imposed to stay solvent or meet statutory capital maintenance requirements.
Cash for dividend payments may also be unavailable because the company may wish to hold significant cash to meet both routine and any unexpected expenses, and also to be able to move quickly into investment opportunities.
- Shareholder expectations - most shares in quoted companies are held by powerful institutional investors (eg pension funds). Therefore, directors of quoted companies have to carefully manage investor expectations regarding the level of dividends.
- if a large dividend is paid in the current year, this may create expectations of the same, or even higher, in the future. If these expectations are then not met, key investors may sell their shareholdings.
- in smaller owner-managed companies, there is no such agency problem and the dividend decision is influenced more by the personal tax position of the owner-managers than sensitivity over expectations.
State how the following factors may influence a company’s dividend policy:
4. Signalling
5. Stability
6. Borrowing covenants
- Signalling - in quoted cos. Where there is significant “divorce of ownership and control”, investors do not have access to all info about the co’s operations and prospects; they only have what is publicly available. Therefore, public announcements of the level of proposed dividend are seen as key signals of company strength or weakness.
- a surprise cut in dividend may be interpreted as a signal of liquidity problems, even if the cut is actually to finance attractive projects.
- a surprise increase may be taken as a signal of company strength, although some investors may question why the directors have not found suitable strategies for reinvestment of surplus cash. - Stability - companies often strive for a stable level of dividends or a constant level of growth. This is done to avoid sharp movements in share price.
- companies will therefore try to maintain the level of dividends in the face of fluctuating earnings.
- this is a very common approach for quoted companies. - Borrowing covenants - a loan agreement may include a clause which limits dividend payments (eg to a specified proportion of earnings) to help ensure the loan is more secure. If less cash is paid as dividends, liquidity might be better (though of course, cash can still be consumed on the purchase of non-current assets).
Outline the following alternative dividend policies:
1. Constant Dividend
2. Constant Growth
3. Constant payout ratio
4. Residual dividend policy
5. Zero dividend policy
- Constant dividends - fixed dividend per share regardless of what’s going on in the economy. Shareholders may be dissatisfied if earnings are growing but dividends are not. Too much retained earnings may leave them wondering if the company can’t find suitable investments.
- Constant growth - predictable and favored by shareholders but dividend growth rate may not match earnings growth rate.
- Constant payout ratio - paying a dividend which represents a constant proportion of each year’s earnings. Although this approach sounds logical it creates uncertainty and is therefore rarely adopted by quoted companies.
- Residual dividend policy - retained earnings are used to fund all positive NPV projects and any remaining earnings not needed to fund such projects are paid out as a dividend. Recall pecking order theory.
This policy leads to fluctuating dividends so isn’t common for quoted companies. It’s effectively a new form of equity issue.
- Zero Dividend Policy - a high growth company may find that, in early years, all surplus cash can be profitably reinvested back into the business - particularly if the company lacks access to external finance.
At some point however, there may be fewer positive NPV projects available and so should start paying dividends.
Outline the following Dividend Theory:
- Clientele Theory
Clientele Theory - the company’s historical dividend policy attracts certain investors based on their needs for current income, tax implications etc. management should therefore view shareholders as the company’s clientele.
E.g. pension funds have to provide incomes to pensioners and so will opt to invest in companies that payout regular, predictable dividends.
- Investment income and capital gains may be taxed differently.
- Abrupt changes in dividend policy will disturb investors’ portfolios and they’ll have to readjust their mix of shares which will incur transaction costs. Although they could sell the shares these would incur transaction costs and affect tax treatment.
- company should therefore maintain a stable dividend policy or risk losing major investors such as financial intermediaries (eg insurance companies and pension funds).
