Topic 7: Other Direct Investments

Question 1

What is Market Capitalisation?

Answer 1

The ‘market’ value of a company, calculated by multiplying its current share value by the number of shares issued. Not very precise, but gives investors an idea of a company’s size and the risk involved in buying its shares compared to other companies in the same sector.

Question 2

What does over the counter (OTC) mean?

Answer 2

Institutional investors trade large blocks of securities with each other outside the normal markets. There is little publicity about the shares traded or prices paid. ‘Under the counter’ might be a more appropriate term!

Question 3

What are treasury bills?

Answer 3

Issued by the Treasury Debt Management Office (DMO) to provide short term government borrowing. Short-term – usually 91 days, no interest is paid but the bills are zero-coupon, which means they are issued at a discount to the face (par) value repaid at the end of the term.

Question 4

What is a Bearer instrument?

Answer 4

A fixed-income security with paperwork to indicate the investment, but no owner is recorded. Whoever holds the instrument is deemed to be the owner and will be entitled to the coupon payments and the redemption amount. They can be sold on by simply giving the instrument to the buyer.

Question 5

What are Certificates of deposit?

Answer 5

Effectively a fixed interest deposit issued by banks and building societies, with a certificate issued to verify the investment. Interest is paid at the end of the term, which is typically 3 or 6 months, although it can usually be rolled over into a new term at the end. There are heavy penalties for early withdrawals, but as bearer instruments they can be sold during the term.

Question 6

What is a commercial paper?

Answer 6

Unsecured debt (borrowing) instruments issued by a company to fund short term needs, such as working capital. The paper promises to repay the debt at the end of the term – typically 3 to 45 days. The paper can be rolled over at the end of the term to extend the borrowing if necessary. Interest rates depend on the borrower’s credit rating, although a bank guarantee can improve the rate for those with lower ratings.

Question 7

What are equities?

Answer 7

Equities, also known as ordinary shares, are the most important type of security that are issued by UK companies. They can be, and are, bought by private investors, but most transactions in equities are made by institutions and by life and pension funds.

Question 8

Holders of ordinary shares (shareholders) are in effect the owners of the company. The two main rights that they have are to:

Answer 8

1. receive a share of the distributed profits of the company as income in the form of dividends; and
2. participate in decisions about how the company is run, by voting at shareholders’ meetings.

Question 9

What are securities?

Answer 9

Financial assets that can be traded. They can be divided into two broad classes: those that represent ownership (equities) and those that represent debt (such as gilts and corporate bonds).

Question 10

What is Dividend?

Answer 10

A portion of a company’s profits that is distributed to shareholders. The level of dividend available is dependent on the profitability of the company and strategic decisions such as the need to reinvest profits to expand the business.

Question 11

Name 4 factors that affect share price?

Answer 11

1. Company profitability
2. Strength of the market sector
3. Strength of the UK and global economy
4. Supply of and demand for shares and other investments.

Question 12

How are shares bought and sold?

Answer 12

The London Stock Exchange (LSE) has been the UK’s market for stocks and shares for hundreds of years. Shares, issued by UK and overseas companies, gilts, corporate bonds and options are all traded on this market. There are two markets for shares: the main market (for which full listing is required) and the Alternative Investment Market.

Question 13

To be listed on the main market, companies must conform to the stringent requirements of the Listing Rules laid down by the Financial Conduct Authority (FCA), acting in its capacity as the UK Listing Authority (UKLA).

For a full listing, a considerable amount of accurate financial and other information must be disclosed. In addition:

Answer 13

• the applicant company must have been trading for at least three years;
• at least 25 per cent of its issued share capital must be in the hands of the
  public.

Question 14

The LSE, like most stock markets, is both a primary and secondary market. What are these?

Answer 14

• The primary market is where companies and financial organisations can raise finance by selling securities to investors. They will either be coming to the market for the first time, through the process of ‘going public’ or ‘flotation’, or issuing more shares to the market. The main advantages of listing include greater ease with which shares can be bought or sold, and the greater ease with which companies can raise additional funds.
• The secondary market is where investors buy and sell existing securities. It is much bigger than the primary market in terms of the number of securities traded each day.

Question 15

What is the Alternative Investment Market (AIM)?

Answer 15

The Alternative Investment Market (AIM) is mainly intended for new, small companies with the potential for growth.

Its purpose is to enable suitable companies to raise capital by issuing shares, and it allows those shares to be traded. In addition to the benefit of access to public finance, companies will enjoy a wider public audience and enhance their profiles by joining the AIM.

Rules for joining the AIM are fewer and less rigorous than those for joining the official list (the main market) and were designed with smaller companies in mind.

Question 16

Explain the Share Indicies?

Answer 16

It is possible to measure the overall performance of shares by using one or more of the various indices that are produced. These include the following:
- FTSE 100 Index (commonly known as the Footsie) – this is an index of the top 100 companies in capitalisation terms; each company is weighted according to its market value.
- FTSE 250 Index – the next 250 companies by market capitalisation after the FTSE 100.
- FTSE 350 Index – the FTSE 100 and FTSE 250 companies combined.
- FTSE All‐Share Index – this is an index of around 600 shares, split into sectors. It measures price movements and shows a variety of yields and ratios as well as a total return on the shares.

Question 17

What are ex-dividend shares?

Answer 17

Dividends are usually paid half‐yearly. Because of the administration involved in ensuring that all shareholders receive their dividends on time, the payment process has to begin some weeks before the dividend dates. A ‘snapshot’ of the list of shareholders is made at that point, and anyone who purchases shares between then and the dividend date will not receive the next dividend (which will be paid to the previous owner of the shares). Once the date has passed when the administrative process of paying the dividend starts, the shares are said to be ex‐dividend (or xd). The share price would normally be expected to fall by approximately the dividend amount on the day it becomes xd.

Alternatively, a share may be paid cum‐dividend, which means that it is purchased before it goes xd, and the purchaser receives the next dividend payment.

Question 18

The financial returns that shareholders hope to receive from their shares take two forms?

Answer 18

• the growth in the share price (capital growth); and
• the dividends they receive as their share of the company’s distributable
  profits (income).

Question 19

What is Earnings per share?

Answer 19

This is equal to the company’s post‐tax net profit divided by the number of shares, but it is not normally the amount of dividend to which shareholders are entitled on each of their shares. This is because a company may choose not to distribute all of its profits: some profits might be retained in the business to finance expansion, for instance. This in turn leads to the concept of dividend cover.

Question 20

What is Dividend cover?

Answer 20

This factor indicates how much of a company’s profits are paid out as dividends in a particular distribution. If, for example, 50 per cent of the profits are paid in dividends, the dividend is said to be covered twice. Cover of 2.0 or more is generally considered to be acceptable by investors, whereas a figure below 1.0 indicates that a company is paying part of its dividend out of retained surpluses from previous years.

Question 21

What is Price/ earning ratio?

Answer 21

the price/earnings (P/E) ratio is calculated as the share price divided by the earnings per share. It is generally considered to be a useful guide to a share’s growth prospects. If the market is operating in an efficient manner, then the P/E ratio should give an estimate of a company’s future potential to generate returns for shareholders.

Question 22

In brief, what are the calculations for earnings per share, dividend cover and P/E ratio?

Answer 22

Earnings per share (EPS) = post‐tax net profit ÷ number of shares

Dividend cover = how much of company profits are paid as dividends

P/E ratio = share price ÷ earnings per share

Question 23

Explain the taxation on owning shares?

Answer 23

As we saw in Topic 3, dividends are paid without deduction of tax but are subject to income tax. Everyone is entitled to a dividend allowance (DA). If an individual’s aggregate dividend income in a tax year falls within the DA, no tax is payable. If dividend income exceeds the DA, it is taxed at different rates depending on the tax band into which it falls.

Gains realised on the sale of shares are subject to capital gains tax (CGT), although investors may be able to offset the gain against their annual CGT exemption.

Question 24

What are Rights Issues?

Answer 24

Stock Exchange rules require that, when an existing company that already has shareholders wishes to raise further capital by issuing more shares, those shares must first be offered to the existing shareholders. This is done by means of a rights issue offering, for example, one new share per three shares already held, generally at a discount to the price at which the new shares are expected to commence trading. Shareholders who do not wish to take up this right can sell the right to someone else, in which case the sale proceeds from selling the rights compensate for any fall in value of their existing shares (due to the dilution of their holding as a proportion of the total shareholding).

Question 25

What are Script Issues?

Answer 25

A scrip issue, also known as a bonus issue or a capitalisation issue, is an issue of additional shares, free of charge, to existing shareholders. No additional capital is raised by this action – it is achieved by transferring reserves into the company’s share account. The effect is to increase the number of shares and to reduce the share price proportionately.

Question 26

What are preference shares?

Answer 26

As with ordinary shares, holders of preference shares are entitled to dividends payable from the company’s profits. They differ from ordinary shares in that they are generally paid at a fixed rate, and holders of preference shares are eligible for any dividend payout ahead of ordinary shareholders. Many preference shares are cumulative preference shares, which means that if dividends are not paid, entitlement to dividends is accumulated until such a time as they can be paid. Preference shares do not normally carry voting rights, although in some cases holders may acquire voting rights if their dividends have been delayed. If a company has to be wound up, there would generally be only a limited amount of money available to repay debts and shareholders. In this situation, the claims of creditors are repaid in a set order of priority. Shareholders rank lowest in the order of priority and are therefore most at risk of receiving nothing at all; however, holders of preference shares have a higher claim than holders of ordinary shares.

Question 27

What are Convertible preference shares?

Answer 27

Convertibles are securities that carry the right to be converted at some later date to ordinary shares of the issuing company. Traditionally they were issued as corporate bonds (with a lower rate of interest than conventional corporate bonds because of the right to convert to equity). In recent years, they have been increasingly issued as convertible preference shares.

Question 28

What are Warrants?

Answer 28

Warrants give the holder the right to buy shares at a fixed price at an agreed future date. The attraction is that they give the holder rights at a fraction of the cost of the shares themselves. At the date when the warrant can be exercised, it will be exercised if the share price is above the price at which the shares can be bought under the terms of the warrant. If the share price is at or below the terms offered by the warrant, it will not be worth exercising the warrant and it will lapse.

Question 29

Property investment can have benefits, including the following:

Answer 29

- Property is a very acceptable form of security for borrowing purposes. -The UK property market is highly developed and operates efficiently and professionally.

Question 30

On the other hand, there are a number of pitfalls of which inexperienced investors in particular should be made aware, including the following:

Answer 30

- Location is of paramount importance and a badly sited development may prove a problem. - The property market is affected by overall economic conditions – in times of recession, letting properties may be difficult and property prices may fall. - Property is a less liquid form of investment than most others.

Question 31

The government became increasingly concerned at the growth of the BTL sector and the way in which this reduced the availability of affordable housing for first‐time buyers. Consequently, a number of measures were put in place that reduced the attractiveness of BTL as an investment?

Answer 31

- Tax relief – previously, a BTL landlord could deduct the full cost of mortgage interest from their BTL income when calculating profits. This effectively gave tax relief at the landlord’s highest marginal income tax rate in respect of the interest costs. Tax relief is now limited to a tax credit at the basic rate only. - Wear and tear – the annual wear‐and‐tear allowance on the cost of furnishings in the property has been replaced by a furniture replacement relief that only allows the actual cost of replacing furnishings to be offset against profits. - Stamp duty land tax – as mentioned in section 7.5, second properties are now subject to an SDLT surcharge purchase.

Question 32

Commercial property tends to provide reasonably high rental income together with, in general, steady growth in capital value. The main advantages are?

Answer 32

- regular rent reviews, with typically no more than five years between each; „ - longer leases than for residential property; - more stable and longer‐term tenants; - typically lower initial refurbishment costs

Question 33

Drawbacks of commercial property include?

Answer 33

- the higher average value means that spreading the risk is more difficult; - commercial property does not generally show the spectacular growth in value that can sometimes be achieved in residential property; - if the investment is to be funded by borrowing, interest rates may be higher than for residential loans.

Question 34

What are Money Market Instruments?

Answer 34

‘Money‐market instruments’ is a generic term used to describe a number of forms of short‐term debt. Interest is not normally paid during the term of the transaction, the rate of interest being determined by the difference between the amount invested/borrowed and the amount repaid.

Question 35

What are treasury bills?

Answer 35

Treasury bills are short‐term redeemable securities issued by the Debt Management Office (DMO) of the Treasury. Like gilts, they are fundraising instruments used by the UK government, but they differ from gilts in a number of ways. Two major differences are: - Treasury bills are short term, normally being issued for a period of 91 days, whereas gilts can be long term or even undated; - Treasury bills are zero‐coupon securities, ie they do not pay interest. Instead, they are issued at a discount to their face value or par value (the amount that will be repaid on their redemption date).

Question 36

What are Certificates of deposit?

Answer 36

Certificates of deposits (CDs) are issued by banks and building societies. They are in effect a receipt to confirm that a deposit has been made with the institution for a specified period at a fixed rate of interest. The interest is paid with the return of the capital at the end of the term. Terms are typically three months or six months, although depositors who require a longer term can often obtain CDs that can be ‘rolled over’ for a further three or six months on specified terms. The amounts deposited are typically £50,000 or more.

Question 37

What are Bearer Securities?

Answer 37

Securities that are deemed to be owned by whoever physically possesses the document that confers ownership, rather than ownership being determined by an entry on a register, etc.

Question 38

What are Commercial Paper?

Answer 38

An unsecured promissory note – ie a promise to repay the funds that have been received in exchange for the paper. Most commercial paper is issued for periods of between 5 and 45 days, with an average of around 30 to 35 days. Firms that need to retain funds for longer than this regularly roll over their commercial paper – the advantages of this are: - flexibility; and - the fact that the rate of interest is not fixed for a long period.