Chapter 11

Question 1

what does ownership of ordinary shares represent

Answer 1

Part-ownership of the firm, subordinated to other forms of capital such as bonds.

Question 2

What are risks to investors of ordinary shares

Answer 2

• limited liability
• return on shares is not guaranteed
• shareholders have voting rights

Question 3

what are the 2 classes of ordinary shares

Answer 3

1 . voting rights
2. no voting rights

prices can vary between the two

Question 4

what is an IPO

Answer 4

Initial Public Offering - first time a stock of a private company is offered to the public. Often smaller young companies seeking capital

Question 5

What must IPOs be filed with

Answer 5

an appropriate regulatory body, such as the Securities and Exchange Commission (SEC) in the USA

Question 6

Why would you engage in an IPO?

Answer 6

• Help issuing company grown
• to acquire another company
  help company finances example, paying down debts
• deliberately underpriced to increase attractiveness to investors

Question 7

Risks associated with IPOs

Answer 7

• dilutes holdings of existing sharesholders and reduces their ownership in the company

Question 8

What is the distinction between two types of secondary offerings

Answer 8

Non dilutive issue and dilutive secondary offering

Question 9

What is a non-dilutive issue

Answer 9

Does not involve the issue of new stock

Question 10

What is a dilutive secondary offering

Answer 10

This involves the company creating and issuing new shares
- earning per share (EPS) is reduced
- value of existing shares is diluted

Question 11

Reasons for issuance of preference shares and implications to the investor

Answer 11

• pay the investor a fixed dividend
• carry no voting rights
• considered less risky in event of firm failure preference shareholders are paid before stockholders
• acts more like a bond
• offers greater flexibility for firms used as incentives during transactions as they offer more security to buyers and a fiscal guarantee to the seller

Question 12

What are the characteristics of global and American Depository Receipts

Answer 12

ADR is a stock that is traded in the US in a non-US company. An easy and cost effective way to invest in foreign company from the US. Foreign companies issue ADRs due to more exposure and wealth to the North America equity markets
GDR (Global Depository Receipts) - similar to ADRs, shares are held by a foreign branch of an international bank. They trade on the International Order Book of the London Stock Exchange. Not all GDRs and ADRs, because they can’t be publicly traded in the USA

Question 13

Distinguish between primary and secondary share issuance

Answer 13

Primary shares issues - involve a listing on the stock exchange for the first time
Secondary shares issues - occur when a firm that already has a listing seeks to raise more capital

Question 14

Define the key features of an equity issuance

Answer 14

Placing - issue equity by placing all new securities with an issuance house. Example, an investment bank can purchase all new shares and then resell ‘places’ these shares to other investors. Placing guarantees to raise the full amount of the issue.

Accelerated book building - process of investors seeking interest of investors buying some of the issued shares. Literally building a book of investor interest.

Intermediaries’ offer - a number of brokers placing an issue with their own clients. Widening the investor base compared to a normal placing.

Offer for sale - like a placing but the issuance house offers all of the issue to the general public instead of investing institutions. Usually offer price is fixed. LSE (London stock exchange) requires advertisement in press. The issuing house takes on the risk from the issuing company - whilst charging a fee.

Offer for sale by tender - invites the general public to bid for an issue, subject to a minimum price. All bids above or at the striking price are allotted shares at this price. Advantage - may raise more then expected. Disadvantage- firm doesn’t know the exact amount raised until bids and striking price set

Offer for sale by subscription - the firm not the issuing house offers issue straight to the general public. Only larger organisations that have the resource power and knowledge.

Introduction - firm can float in the stock market using an introduction. Flotation allows joining of main market without raising capital. Limits initial opportunities for boosting the companies profile and visibility.

Equity crowdfunding - early-stage unlisted company raises equity from people for shares in the company. Unknown for the future success or failure.

Question 15

Define and explain the purpose of a right issue

Answer 15

The most popular way of issuing new ordinary share capital for firms whose shares are already listed on the stock exchange. Known as a secondary share issue. Existing owners can subscribe to new shares at a lower fixed price to the market price. No obligation to take. The right to take the advantage can be sold to others. An investment bank may purchase all rights left available. A right issue typically leads to a fall in share price of stock but often accompanied by additional news that can lead to a rise in share price.

Question 16

Define and explain the purpose of a script issue

Answer 16

• Secondary share issue
• issues by firms with existing shares
• what a stock with rights is trading on an exchange - it has ‘cum-rights’, ‘with rights’ or ‘cum-script’.
• rather than paying dividends this is a scrip dividend

Question 17

Define and explain the purpose of a stock split

Answer 17

• when firms believe that its ordinary share prices are too high - and doesn’t want to make a script issue
  splits issued shares into shares with shares with smaller value
• market capitalisation stays the same and dilution doe snot occur

Question 18

Identify and explain the motivations behind a company buying back its own shares

Answer 18

-investors can state the number of shares and what price they will sell back
- firm decided what mix to buy the shares at the lowest cost
- occurs when there is spare cash - and share price is low
- will maximise share price and shareholder capital returns
- capital gains are taxed lower than dividends :> advantage
- can be held in treasury when bought back

Question 19

Factors influencing dividend decision by firms

Answer 19

• signals confidence to investors in a firm
• attract investors ‘clientele effect
• tax influences on payment of dividends
• if stable earning firm will pay out higher dividends
• need to retain earnings to avoid share issues leading to dilution of management control

Question 20

What are limitations to firm paying out dividends

Answer 20

• Has to comply with UK company law
• profits dont necessary mean cash

Question 21

what is the Gordon growth model

Answer 21

• model to understand the relationship between dividends, dividend growth and the discount rate
• useful guide to the expected return of a firm’s common stock

Question 22

How to estimate growth rate of dividends

Answer 22

• average past growth rate
• analysts forecast
• dividends G rate is the same as earnings G rate
• Growth rate of dividends or earning, g= retention ratio X ROE (return on equity) (retained earnings divided by earnings)

Question 23

Alternative valuation metrics: relative value VS. absolute value models

Answer 23

Relative value:
- estimates the value of equity
- Equity value = earnings power X market price multiple

Absolute value:
- Discount technique - estimate the value of equity as the present value of future equity returns to the investor

Question 24

Explain what is meant by earnings per share and diluted earnings per share

Answer 24

-EPS is total payout potential - unlike to pay out full as retaining earning can be reinvested for future growth
- Absolute measure - not good for inter-company comparisons
- when an EPS is reported there must be disclosure of ‘diluted’ EPS (hypothetical) - this is based on new number of shares and therefore EPS will fall

Question 25

What is the PE ratio (price-earnings ratio)

Answer 25

- used to give an idea of the market's estimate of a firm's growth potential - 'forward-thinking' shows wether stock price is relatively high or low compared to forecast earnings

Question 26

Problems with using PE ratio

Answer 26

- Negative earnings - equity valuation should be based on long-term prospects, not current state of the economy - earnings are subject to distortion from various accounting standards and policies - PE ratios can vary from analyst to analyst

Question 27

Alternative market multiple - (Price to Book)

Answer 27

- book values (net assets) more stable than earnings - negative earnings unlikely means negative book value - although possible - difference between value of assets and liability - market value of an asset reflects its earning power and expected cashflow - Firms with negative earnings can be valued with PB ratios when they cannot be valued using PE ratios

Question 28

Enterprise values to sales

Answer 28

The value of the entire entity (debt + equity - cash) which gives the enterprise value - eliminates the effect of accounting and financing decisions in comparing companies profitability - high EV/S ratio is not always bad, is a sign that investors believe that future sales will greatly increase. - lower EV/S future sales not attractive

Question 29

Price to cash flow advantages and disadvantages

Answer 29

Helps to create a relative valuation - provides are more accurate picture of a company - PCF ratio provides a more reliable indicator of value between companies Disadvantage - neglects the impact of non-cash components - like all ratios one metrics alone is not a complete picture - high price - may not generate enough cash flow - low PCF ratio generally preferred indicates a firm is generating plenty cash flows that is not reflected in the share price

Question 30

Explain the basics of free cash flow valuation methods and residual income valuation methods

Answer 30

FCFs - These are the cash flow’s available for distribution to the owners of a firm’s securities, including equity, debt and preferred stock Residual - income in excess of any opportunity cost measures relative to the book value of shareholders equity. - cost of equity generated by a capital asset pricing model (CAPM) - similar to methods such as dividend discount model or FCF approaches. - most appropriate when a firm is not paying dividends or has an unpredictable dividend pattern or negative FCF for a number of years Any one fundamental ratio/metric does not tell the entire story. The range of ratios will contribute to a more complete picture assessing the intrinsic value of an investment.

Question 31

Defining financial gearing and evaluate the effect on required equity returns and thus valuation

Answer 31

Gearing is the level of a companies debt relative to its equity capital, usually a percentage. - common measure of gearing is perhaps the debt-equity ratio - debt equity ratio reflects the capital structure of the business: a higher ratio is not necessarily a bad thing since debt is usually a cheaper source of financing and comes with tax advantages - low-geared company with a ratio of 15% would be able to pay off debt several times over - higher ratio upwards of 50% represents a much higher risk - small change in interest rates or profitability could mean bankruptcy or loan default

Question 32

Choosing the level of gearing

Answer 32

- larger companies can have higher percentages of debt-equity without alarming investors - debt is cheaper than equity for a firm - higher gearing therefore associated with higher risk of bankruptcy and higher agency costs - provider of equity finance is higher than the return required by the providers of debt - since debt holders have the superior claim on the firm’s assets should the firm fail, and cash flows paid in bonds holders are more certain