Business Fiannce Peirson Chapter 9
Chapter 9 Sources of long-term finance: equity Solutions to questions 1.
The statement means that ordinary shareholders are paid last. In other words, ordinary shareholders are entitled to the profit (if any) that remains after all other claimants such as suppliers, employees, lenders and government bodies have been paid. Its significance is that ordinary shareholders are exposed to greater risk than all other claimants.
2. Generally there are just three rights that are important to shareholders in listed companies. These are: (a) the right to a proportional share of any dividend that is declared; (b) the right to vote, generally one vote per share; and (c) the right to sell the shares. 3.
Contributing shares and instalment receipts are both equity securities where only part of the issue price has been paid. Both will become fully-paid ordinary shares once the balance of the issue price has been paid. In the case of contributing shares, the balance of the issue price will be paid in one or more instalments (calls) where the timing of these calls is at the discretion of the company’s directors. In contrast, for instalment receipts, the amount and timing of all instalments is specified at the time the securities are issued. Other differences include: the instalments associated with instalment receipts are payable to the vendor of the shares rather than to the issuing company; and holders of instalment receipts are usually entitled to the same dividends as holders of fully-paid shares, rather than a partial dividend based on the proportion of the issue price that has been paid.
The main advantages of raising equity rather than borrowing are: dividends are at the discretion of directors, whereas payment of interest on debt is an obligation that must be met; there is no obligation to redeem ordinary shares, whereas borrowed funds must be repaid; and raising equity lowers the risk faced by lenders and should, therefore, lower the interest rate that lenders require.
The term ‘limited liability’ means that the liability of shareholders, in the event of the company’s liquidation, is limited to any amount unpaid on the shares held by them. In the
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case of ‘no-liability’ companies, the shareholders have no obligation to pay any amount unpaid on the shares held by them in the event of the company’s liquidation. Nor are they obliged to pay calls made on partly-paid shares. Because of the high risk of failure for mining and exploration companies, many such companies are formed as no-liability companies. Under the Corporations Act, only mining companies can be no-liability companies. 6.
Private equity refers to equity capital raised by issuing securities that are not publicly traded. It is often associated with a new business, and may involve development and use of new technology, in which case the term ‘venture capital’ is generally used. Other features of private equity include the following: major providers of private equity require a degree of control and involvement in decision-making; in the case of venture capital, the promised returns must be high to compensate investors for taking high risks; and investors are usually prepared to hold the investment for a period of 5 to 7 years, but favour companies that have good prospects for sale or stock exchange listing at the end of that time.
New ventures are generally funded in stages where each stage in the process is typically linked to the achievement of important milestones or performance benchmarks. The reasons for this approach include: the achievement of each ‘milestone’ reduces uncertainty, makes investors more confident about providing funds, and increases the amount of funds that can be raised; and staged funding can reduce the losses incurred by investors in new ventures that are found to be unsuccessful.
8. As discussed in section 9.4, the disclosure requirements relating to capital raisings are set out in Chapter 6D of the Corporations Act. The most comprehensive type of the documents that accompany capital raisings are prospectuses, and section 710 of the Act requires that a prospectus contains ‘all the information that investors and their professional advisers would reasonably require to make an informed assessment’. In contrast to what may happen if the regulators provided a ‘check-list’ of items for inclusion, this ‘catch-all’ approach to the regulation of prospectuses is designed to make it difficult for issuers to omit relevant information from the offer document on the grounds that it was not specifically mentioned in the checklist. 9. The main costs of public rather than private ownership of a business are: the entrepreneur will suffer some loss of control; direct costs such as stock exchange listing fees and the costs of servicing shareholders; costs associated with disclosure of information; and the value of management time devoted to investor relations.
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10. The procedures to be followed when floating a company are outlined in Section 9.5. Promoters may prefer a public issue to a private issue because: the company can obtain a sufficient spread of shareholders to obtain a stock exchange listing; and a private issue is unlikely to attract sufficient institutional support to ensure its success. 11. The assistance of a financial institution, such as an investment bank or large stockbroker, is usually sought because these institutions employ specialists in all aspects of fundraising. In comparison, the financial managers of companies are frequently not specialists, and their experience may be limited to occasional fundraising. As explained in Section 9.5, financial institutions usually provide advice on the terms of an issue, and underwrite and market the issue. 12. Book-building is discussed in Section 9.5.3. The technique is very useful in pricing initial public offerings (IPOs), and is sometimes used in pricing other equity issues such as placements. In comparison to fixed-price offers, book-building for an IPO generally results in an issue price that is closer to the market price when trading commences. The main advantages are that information provided by informed (institutional) investors can be used in setting the issue price, the risk of under-subscription is virtually eliminated, , and the issue price is likely to be higher than with a fixed-price offer. Book-building also has some disadvantages. Some investors may be reluctant to subscribe for an IPO because, at the time, the issue price is unknown. Also, book-building involves significant costs so it is usually viable only for large issues. 13. The main advantage of having a share issue underwritten is that the issuing company is assured of selling all of the shares—that is, any shares not purchased by investors prior to the closing date will be bought by the underwriters. Also, the fact that an issue is underwritten may encourage investors to purchase the shares by signalling that they are fairly priced. The main disadvantage of having an issue underwritten is the cost—the underwriter’s fee can be up to 7 per cent of the funds sought. 14. Underwriting fees are higher for company floats than for rights issues because a float involves greater risk for the underwriter. The risk of significant under-subscription is low for a rights issue where the subscription price can be set below the market price of the shares. In the case of a float, there is no observable market price to act as a guide and there is a risk that the issue will fail because investors believe that the subscription price is too high. 15. ‘Money left on the table’ in an IPO is usually measured as the number of shares issued to new investors multiplied by the difference between the closing price on the first day of trading, and the issue price. When an IPO is significantly underpriced, it follows that the value of the shares retained by the original owners is much greater than they expected. Thus, Loughran and Ritter suggest the pleasant surprise associated with this increase in Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder 3 of 9 ©McGraw-Hill Education (Australia) 2015
wealth may leave the original owners feeling satisfied, despite the fact that they have sold some shares for much less than their market value. 16. Camp et al. (2006) found that greater underpricing of IPOs is associated with higher trading volume in the post-listing market. Accordingly, greater liquidity appears to be a benefit of underpricing. 17. There is evidence that long-term returns on the shares of companies that raise equity by issuing shares are lower than the returns on the shares of otherwise comparable nonissuers. This phenomenon is puzzling, because it implies that public information is not fully reflected in the share prices of issuing companies at the time share issues are announced. Some authors dispute the validity of the evidence that supports the existence of the ‘new issues puzzle’. These authors argue that returns on the shares of issuing companies are not abnormally low when proper allowance is made for the effects of factors such as risk, company size and book-to-market ratio. 18. One reason for making a non-renounceable rights issue is that because the rights cannot be traded, the percentage ownership of shareholders in the company is more likely to remain the same than if the issue is renounceable. Issue costs may also be lower than for a renounceable issue and a non-renounceable issue will be quicker than a traditional renounceable issue. 19. A private placement often provides a company with the opportunity to raise funds more quickly, and with lower issue costs, than a rights issue. However, existing shareholders may not benefit from such an issue. It results in a dilution of their ownership interest in the company, and a probable decrease in the value of their investment (depending on the issue price attached to the placement and, of course, the reaction of the market to the issue). 20. The main factors to be considered include the following: (a) A rights issue can be used to raise a large amount of capital at one time, and, if all shareholders take up their rights, there is no change in the proportional ownership and control of any investor. A rights issue is slow although the institutional component of the funds can be raised very quickly if one of the accelerated offer structures is used, requires a prospectus, and involves relatively high issue costs, particularly if it is underwritten. (b) Share placements can be arranged quickly and issue costs are lower than for rights issues. The ownership and control of existing shareholders will be diluted but, for Australian Securities Exchange (ASX) listed companies, this problem is limited by listing rules 7.1 and 7.2 which restrict placements to 15 per cent of the issued shares in any 12-month period. Larger placements are possible with shareholders’ approval or, in some cases, by the ASX waiving the restrictions in the listing rules. Some companies have raised funds by combining an institutional placement with a Share Purchase Plan (SPP) that allows existing shareholders to buy additional shares at the same price. A SPP involves low issue costs, because funds can be raised from existing shareholders without issuing a prospectus, provided the issue complies with Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder 4 of 9 ©McGraw-Hill Education (Australia) 2015
Australian Securities and Investments Commission Regulatory Guide 125 (RG 125). RG 125 specifies that listed companies can raise a maximum of $15 000 per annum from each shareholder without issuing a prospectus. (c) A dividend reinvestment plan (DRP) can be used to raise moderate amounts of funds on a regular basis. The amounts that can be raised are limited by the company’s profits/dividends, and will depend on the extent to which shareholders decide to participate unless the DRP is underwritten. Participation can be encouraged by issuing shares at a discount, but this disadvantages shareholders who choose not to participate. Flexibility is possible, in that a DRP can be suspended if the company does not need additional funds. A DRP will involve some increase in clerical and postage costs. 21. A share purchase plan that accompanies an institutional placement allows all shareholders to purchase additional shares at the price set for the placement. However, this opportunity is not the same as the opportunity to participate in a rights issue, for two main reasons. First, share purchase plans are restricted to a maximum investment of $15 000 per annum for each shareholder, whereas a rights issue allows each shareholder to invest in proportion to their existing holding. Second, rights issues are usually renounceable, but the opportunity to invest via a share purchase plan cannot be transferred to anyone else. 22. It is reasonable to expect that the popularity of rights issues will increase, but it is very unlikely that placements will become rare. Placements still have some advantages relative to rights issues. For example, a placement can be arranged much more quickly than a rights issue, and transaction costs are likely to be lower because there is no need to print, post and process documents for each shareholder. 23. Two Accelerated Renounceable Entitlement Offer (AREO) structures are explained in Section 9.6.1. The offer of shares is divided into two separate offers; one to institutions, and another to retail shareholders, with the institutional offer closing much earlier than the retail offer. Shares not taken up by existing shareholders are sold to institutions through one or two book-builds. Shareholders who do not take up their entitlement will be paid the difference (if any) between the offer price and the price established in the relevant book-build. The differences between an AREO and a traditional rights issue include that: the duration of the issue process is shorter; the proceeds of the institutional offer are received within a few days of the offer opening; a shareholder who does not wish to participate in the offer does not need to take any action––the value of their entitlement will be paid to them by the company. 24. A further public offer of shares may be favoured if management wishes to attract a wider spread of shareholders. If the amount of funds sought is large, relative to the company’s existing capital, some shareholders may be unwilling or unable to provide all the funds sought, so a public offer may be considered in conjunction with a rights issue or other capital-raising measures.
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25. Options often serve as an incentive to employees and investors to subscribe to either debt or equity. The provision of options can be advantageous to the company. For example, employee options may improve loyalty and enhance the performance of employees. Also, options may enable the company to raise funds at a lower combined cost than if it made an issue with no options attached. Options may also benefit shareholders if they result in higher share prices. However, the benefit to shareholders should be compared with the benefit of alternative methods of raising funds. For example, rather than making a private debt issue with options attached, consideration could be given to making a rights issue. 26. An advantage with providing compensation in the form of shares as opposed to only salary is that it provides an incentive for managers to take action to increase the share price as this increases their own remuneration. This might also be achieved using company issued call options, in that management will benefit when the share price moves beyond the exercise price of the issued options. One disadvantage of using options rather than shares is that as the share price falls below the exercise price of the issued option, management’s compensation becomes fairly insensitive to further share price falls whereas if management held shares then their compensation would rise and fall with the share price. 27. Internal funds are funds generated by a company’s operations. The simplest measure of internal funds is cash profit which is measured before payment of interest and dividends and is not affected by depreciation. Internal funds may be favoured by management, as no issue costs are incurred and no explicit justification has to be provided by management for the manner in which the funds are invested. 28. During the global financial crisis which began in mid-2007, the operations of many financial markets were disrupted making it more difficult and at times impossible for many companies to raise funds by borrowing or by issuing securities. As discussed in Section 9.8, Australian companies relied more heavily than usual on internal funds during the twoyear period from mid-2007. 29. A share split involves dividing each of a company’s shares into two or more shares. A share split is similar to a bonus issue, but is recorded differently in the company’s accounts. Some managers may suggest various motives for a share split, which may include the following: to decrease the share price and hence increase liquidity in the market for the shares to enable the company to increase its dividend payout without significantly increasing the dividend per share. However, the evidence on market efficiency discussed in Chapter 16 indicates that investors are unlikely to regard these factors as a source of value. 30. A share consolidation reduces the number of shares on issue. For example, every 6 shares held prior to the consolidation may be replaced by one share, so share consolidations are also known as reverse splits. Sensible reasons for share consolidations include reducing the costs of running a company’s share registry, reducing the costs of servicing Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder 6 of 9 ©McGraw-Hill Education (Australia) 2015
shareholders and attracting institutional shareholders who may be precluded from holding shares with prices below a specified level such as $1. 31. In practice, there may be an increase in share price following the announcement by a company of a forthcoming bonus issue or share split, because the announcement may have information content. For example, the announcement may indicate that earnings are likely to increase in the future, or that management is confident that recent increases in earnings and/or dividends are likely to be maintained.
Solutions to problems 1.
The answer to this question will depend on the company chosen by the student.
With listing costs of 12 per cent, the total amount to be raised is equal to $7 920 000 $9 million. (1 0.12)
Using the dividend growth model, the value of a share is: P0
D1 ke g
$0.20 0.14 0.06 $2.50.
Therefore, the number of shares to be issued is 3.
$9 000 000 3 600 000 $2.50
(a) The theoretical value of a right can be calculated using Equation 9.3: R =
N(M S) N+1
(for explanation of symbols, see text)
4($5 $4) 4 +1 4 = $ 5
= 80 cents (b) The theoretical ex-rights share price can be calculated using Equation 9.4: NM S N+1 4($5) + $4 = 4 +1
= $4.80 Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder 7 of 9 ©McGraw-Hill Education (Australia) 2015
(c) Generally, an investor should neither gain nor lose through a rights issue. However, announcement of a rights issue may be associated with share price changes because of the information that investors read into the announcement. For example, the share price may increase because investors believe that the project(s) being financed by the issue has a positive NPV, or fall because investors interpret the company’s need for the funds as an indication of lower net cash flows. 4.
(a) The theoretical value of a right can be calculated using Equation 9.3: N (M S ) N 1 6($12 $10.60) 7 $1.20
(b) The theoretical ex-rights share price can be calculated using Equation 9.4: NM S N 1 6($12) $10.60 7 $11.80
(a) A renounceable rights issue is an issue of shares to existing shareholders on a pro-rata basis where the rights to take up the new shares can be sold. (b) It is unlikely that announcement of the rights issue would cause the share price to increase—the empirical evidence from several countries, including the United States and Australia, shows that announcement of an equity raising is generally associated with a fall in share price. The price increase is much more likely to be a response to the news about the success of the clinical trials. (c) The theoretical ex-rights share price can be calculated using Equation 9.4: NM S N 1 3($7) $6.20 4 $6.80
(d) The theoretical value of a right can be calculated using Equation 9.3: N( M S ) N 1 3($7 $6.20) 4 $0.60.
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(e) The fall in share price from 24 May to 25 May should be exactly offset by the value of the rights that each shareholder receives. For example, if an investor holds 3 shares, the total value of these shares is expected to fall from $21.00 to $20.40, but on 25 May the investor also has one right worth $0.60, so the total value of his/her investment remains at $21.00. 6.
(a) A placement without shareholder approval is limited to a maximum of 15 million shares and could therefore raise a maximum of 15 m. × $3.80 = $57 million. (b) To raise $500 million at an issue price of $3.80 per share, the number of shares that GBI will need to issue is $500 000 000/$3.80 = 131 578 900. Since this exceeds the number of shares currently on issue, a non-renounceable rights issue would not be allowable under ASX Listing Rules because, as shown in Table 9.4, the rules restrict such issues to a ratio of no more than 1 for 1. A traditional renounceable issue would be allowable but may not be feasible given the time that is available. As noted in Section 9.6.1, an issue of this type cannot be completed in less than 23 business days. The period from 15 October to 30 November (inclusive of both these days) is 35 business days. Thus, the feasibility of a traditional renounceable rights issue will depend on the ability of GBI and its advisers to prepare the required documents, which may include a prospectus, in the time available. (c) (i) No. Provided that the ASX is confident that the entitlement offer will raise the funds sought, which should be the case if the offer is underwritten, it is likely that it will apply the 15 per cent limit to the expanded capital base. For example, in the case of a 1-for-1 entitlement offer, which will involve 100 million new shares, the ASX would be expected to allow a placement of up to 30 million shares. (ii) If the placement is increased to 30 million shares it will raise $114 million leaving a balance of $386 million to be raised by the entitlement offer, so the number of shares required is $386 000 000/3.80 = 101 578 947. This number is still too high for a nonrenounceable entitlement offer but given that an accelerated offer structure is to be used, a renounceable offer should be feasible in the time available. (d) If the offer is renounceable, shareholders who renounce their entitlements will receive the value (if any) of those entitlements as determined by the institutional bookbuild(s). In other words, if the price established by the book-build exceeds the subscription price, the difference (premium) is paid to shareholders who did not take up the offer. If the offer is non-renounceable, any entitlements that are not taken up will simply lapse. While the subscription price is the same for all shareholders, the AREO structure does not ensure that all shareholders are treated equally. As noted in Section 9.6.1, institutional shareholders may not have sufficient funds available to take up their full entitlements in the very short time allowed for the institutional offer. Also, any premium distributed to renouncing shareholders can differ depending on whether the shareholder is an institution or a retail investor.
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