125.220 Topic 5: Equity markets
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- To understand role of share market, first need to know the nature of corporation.
- Differs from other business forms e.g. partnerships
- • Ownership claims are widespread & easily transferable.
- • Owners (shareholders) do not affect day-to-day affairs of the company.
- • Shareholder’s liability is limited to the fully paid-up value of the shares - Limited liability Act 1855 in England
Advantages of corporate form
- • Can obtain large amounts of finance relatively cheaply.
- • Specialised management-CEO & directors can be chosen (due to separation of ownership & control).
- • ‘Perpetual succession’: corporate form is unaffected by changes in management or ownership – shares have unlimited lives (in theory)
- • The corporate form is suited to large-scale operations.
Disadvantages of corporate form
- The primary disadvantage arises due to the separation of ownership & control of company ('agency theory').
- Management (as Agents) may not have strong incentive to act in the interests of the owners (shareholders).
- – Share options have been used to try to align interests
The Equity market
An equity or share market has many roles
- • Issuance of new share capital- primary market.
- • Acting as a secondary market facilitating the trading of existing shares.
- • Trading & settlements role.
- • Derivative market.
- • Interest rate market.
- • Information role.
- • Regulatory role.
1. Primary Market Role
- • Facilitates efficient & orderly sale of new share issues (IPOs).
- • IPO = when a company lists for the first time = raises equity financing from public for first time
- • Shares become listed on exchange & companies receive finance ( process-not frequent-usually increases in bull markets.
- –Role of underwriters- buy any unsold shares for a fee
- • Companies can raise new equity finance after listing- seasoned offering
2. Secondary Market Role
- • Facilitates trading in existing shares.
- • No new funds are raised by issuing company.
- – However, existence of active market in shares is important for company
- • Trading reveals current market price of shares.
- • Buy & sell orders are placed with a (stock) broker.
- • Brokers act as agents (not dealers) of buyer/seller.
2. Secondary Market Role-Daily Operations of
NZSX part of NZX
- • Centralised, continuous, organised, auction market. Computer systems - provided by Trayport NZX Home
- • not OTC like FX markets
- • Allows ‘uncertificated’ securities & eliminates need for transfer forms to be signed for security sales
- • Brokers, Stock Exchange & share registries all linked electronically
- • NZSX part of NZX provides market for trading share-related derivative products
- • Derivatives serve as a risk management tool and/or as a speculative instrument
- • Derivatives traded on the NZSX include
- – Options
- – Warrants
- • ASX Derivative market similar but include CFDs
5. Interest rate role
- In 2002, push by NZX to trade debt instruments as well. i.e. NZDX
- Recent changes –Under old head Mark Weldon, NZ Stock Exchange saw some changes & initiatives
- Now replaced in 2012 by Tim Bennett
- e.g. demutualization – members assigned units (like ASX). NZSE → limited liability company & name change to NZX with parts NZSX, NZAX & NZDX
- • NZAX (Alternative market) & now 2015 NZT
- • Continuous disclosure regime (like ASX).
6. Information role - NZSX has listing rules governing information
Info role-efficiency of the share market relates to how quickly price of share changes to new information that is publicly available
Requirement for company to release semi- & annual reports, & to release to NZSX all price sensitive info.
This is then released to share brokers & then eventually is released into the public domain.
Continuous disclosure regime details.
7. Regulatory role: Aim to operate an open & efficient market
One aim: to keep investors fully informed of company news.
In NZ, Financial Markets Authority: 2014 implementation of Financial Markets Conduct Act that replaces former legislation. Exchanges need rules e.g. If you own more than 5% of a company, it must be disclosed, as must any change in ownership. (+ or -).
Other countries- different rules e.g. UK situation, every transaction made by director of company must be disclosed.
S2. Compliance & Enforcement
Deals with role of market surveillance panel.
NZ Markets Disciplinary panel - responsible to NZSX.
Role: look at listing requirements, & unusual trades. i.e. price of company unexpectedly increases, Panel can ask company for a report, to see if something is amiss, e.g. insider trading. E.g. the stock Xero March 2015
Now newly formed FMA has a oversight role as well as Commerce Commission.
S3. Costs, Trust Deeds & Directors of Companies.
Governance issues concerning the rights of shareholders
e.g. new equity, employee shares, appointment of directors & fees; disposal & acquisition of assets; transactions with related parties; & voting restrictions.
- So long as it was disclosed, institutions could buy whatever percentage of a company they wish.
- From July 2001, NZ has new takeover code.
S5. Listing & Quotation
Minimum of 500 shareholders, with minimum of 25% of the company.
Note: The two old securities Law & Securities Markets Law - replaced by Financial Markets Conduct Act 2013, was implemented over 2014
Some current issues
Only small % of NZ companies are listed. Lack of confidence in enforcement of regulations governing operations
NZSX –not perceived as an area for individuals to invest in preference for debt & housing in NZ
Company Long-term Funding Choices
First decision for company- choice between debt or equity
• For debt financing, either:
– Indirectly through financial intermediary
- – Directly to financial markets if large company (with help of investment bank)
- • Issues (sells) debt security at acceptable interest rate
Internal equity finance
- - For starting business, owners of company provide equity funds,
- - As it grows, it may generate positive cash flows & retain funds from operations (profits)
- - There are advantages in using retained earnings (internal funds) as source of finance
- - Importance of internal equity finance
Equity financing cont
External sources of equity financing
- • Venture capitalists
- • Initial public offering of shares (IPO) & flotation
An offer to investors of ordinary shares in a newly listed company on a stock exchange.
Described as the floating of a business (public listing and quotation of a corporation on a stock exchange)
- • Major source of equity funding
- • Shareholders have voting rights at general meetings & rights to vote on important issues
- • Shareholders may transfer voting rights to a proxy
- • Authorised Capital: maximum number of shares authorised under Constitution
Managed Funds (Unit Trusts)
Form of indirect finance
- • Investors purchase units in a trust & so provide funds for managers to invest on their behalf
- • Trustee invests pooled funds
- • Entitled to a portion of the income stream of the trust
- • May be listed on the stock exchange if closed-end or unlisted if open-end
- • Additional new ordinary shares issued directly to selected investors (typically institutions)
- • Not required to register a prospectus
- • Minimum subscription-different countries different rules ($500,000 to not more than 20 participants)
- • Market price discount cannot be excessive
- • Allows smaller discount & shorter time frame than rights issue
- • Disadvantage of dilution for existing shareholders
Takeovers using equity
- • Takeover company issues extra ordinary shares to the owners of the target to settle the transaction
- • Removes the need for owners of the takeover company to inject further equity for the purchase of the company
Dividend Reinvestment Schemes
- • Shareholders have option to reinvest (convert) dividends into additional ordinary shares
- • Generally issued at a discount to market price
- • No brokerage or stamp duty payable
- • In growth periods it allows companies to pay dividends & pass on tax credits, while increasing equity
- • Schemes may be stopped in low growth periods
Preference (preferred) Shares
Hybrid security that pays fixed dividend and usually converts to ordinary share @ future date
- • Fixed dividend rates - set at issue date-preference shares have set maturity
- • Rank ahead of ordinary shareholders for dividend payment
- • Advantages: fixed interest borrowings, but are an equity finance instrument so may help with debt-equity ratio
Types of Preference shares
Cumulative = If company ain't able/doesn't pay out dividends for period, the amount of dividend due carries forward to the next period
Convertibe = May be converted to ordinary shares @ future date @ a specified price
Participating preference shares = Holders receive higher dividend if ordinary shareholders receive dividend above specified amount
Redeemable = May be redeemed for cash @ the expiration date
- • Convertible notes are a hybrid instrument—initially begins as a debt instrument issued for a fixed term
- • Interest payments specified in convertible note prospectus
- • Gives potential investors right to convert note into ordinary shares at specified future date at determinable price
- • Option to convert to equity has value for investors- the suppliers of funds
- • The conversion price is nominated at note issue—gain is made if share price rises subsequently
- • If share price falls, holder may not exercise conversion option, & take the notes cash value
- • Interest paid on notes is usually lower than straight debt interest
- • Interest payments are tax deductible to the company
- • Notes are often issued for longer periods than is possible with straight debt borrowings
- • Provide the right but not the obligation to purchase ordinary shares, at a stated price, at a future date
- • Issued by company for a period of up to 5 years
- • Allows companies to raise further equity funds at planned future dates (providing holders exercise the option)
- • Generally have value & may be traded up to maturity date
- • Exercising of option will depend upon exercise price of option relative to market price of share at exercise date
Some Indicators of company performance
- 1. Capital Structure
- 2. Liquidity
- 3. Debt Servicing
- 4. Profitability
- 5. Share Price
- 6. Risk
Examples of Financial Performance Indicators
1. Capital Structure
- • Proportion of finance (capital) obtained through debt or
- • Measured as Debt to equity ratio = Market value of debt/Market value of equity
- • Higher debt levels increase financial risk (i.e. company may not be able to meet interest payments)
- • The ability of a company to meet its short-term financial obligations
- • Common measure: Current ratio = CA/CL
- • Fails to consider the illiquid nature of certain current assets (e.g. inventory) ⇒ quick ratio
- • The higher the current & liquid ratios, the better the liquidity position of the company
• How effectively the company can meet its debt-related (i.e. interest) obligation
Interest cover = Earnings before financial lease charges, interest & tax/Financial lease charges & interest
• Ratio should be greater than 2 (rule of thumb)
• Wide variation in measurement of profitability:
After-tax Earnings of shareholder funds = Profit after tax/Shareholder funds
• Earnings per share (EPS): measures the earnings that are attributable to each ordinary share after abnormal items
- • EPS frequently reported in media
5. Share Price
• Share price represents the opinion of investors as to present value of future net cash flows of company
- • A important price-based performance indicator is:
- Price to Earnings (P/E):
- – Share price divided by earnings per share
- – Indicates investor’s valuation of future earnings prospects of the company
- – The higher the P/E the more optimistic the outlook for the future
(a) Systematic risk (market risk)
- – arises from factors affecting whole market
- – e.g. state of domestic economy & world economy
- – Can be measured by beta
- – Average share that matches market has beta of one
(b) Non-systematic (unique) risk
- – arises from firm-specific factors
- – example: management competence, labour productivity, financial & operational risks
• Non-systematic risk can be eliminated by forming a well-diversified portfolio
Pricing of Shares
- Share price = mainly a function of supply & demand for a share
- – Supply & demand are influenced mainly by
- – Share price is considered to be present value of future dividend payments to shareholders
- – New information that changes investors’ expectations about future dividends will result in a change in the share price
Pricing of shares
Estimating the price of a share
a) Valuing a share with a constant dividend (D0)
Pricing of shares
Estimating the price of a share
b) Valuing a share with constant dividend growth (g)
Pro-rata Rights Issue
- • Company seeks to raise more equity financing for project
- • Involves an increase in company’s issued capital
- • Typically, issued at a discount to market price
- • Theoretically, market price will fall, by an amount dependent on:
- – the number of shares issued
- – the size of discount to market price
Pro-rata Rights Issue
Example: Market price cum rights $2, with 1:4 rights issue priced at $1.80
Cum Rights (c.r) Price $2.00
Market Value of 4 c.r shares 8.00
Plus new cash from 1:4 Issue 1.80
Market Value of 5 x.r shares 9.80
Theoretical Price of 1 x.r share 1.96
- P = cum-rights price of existing shares
- N = number of existing shares with right to subscribe for new share
- S = subscription price for new shares
- = $1.96
Pro-rata Rights Issue
Pricing the Pro-rata Right Issue "Using textbook formula":
- Value of right = N(cum rights price - subscription price)/(N+1)
Value of right =
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