125.220 Topic 5: Equity markets

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125.220 Topic 5: Equity markets
2015-10-17 23:16:35
125 220 Topic

Equity markets
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  1. The Corporation
    • 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
  2. 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.
  3. 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
  4. 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.
  5. 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
  6. 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.
  7. 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
  8. 4. Derivatives
    • • 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
  9. 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).
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. S4. Takeovers
    • So long as it was disclosed, institutions could buy whatever percentage of a company they wish.
    • From July 2001, NZ has new takeover code.
  15. 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
  16. 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
  17. 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
  18. Equity Financing
    Choices between:
    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
  19. Equity financing cont
    External sources of equity financing
    • • Venture capitalists
    • • Initial public offering of shares (IPO) & flotation
  20. IPO
    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)
  21. IPO benefits
    • • 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
  22. IPO
    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
  23. (Share) Placements
    • • 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
  24. 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
  25. 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
  26. 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
  27. 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

    RedeemableMay be redeemed for cash @ the expiration date
  28. Convertible Notes
    • • 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
  29. Share Options
    • • 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
  30. Some Indicators of company performance
    • 1. Capital Structure
    • 2. Liquidity
    • 3. Debt Servicing
    • 4. Profitability
    • 5. Share Price
    • 6. Risk
  31. Examples of Financial Performance Indicators
    1. Capital Structure
    • • Proportion of finance (capital) obtained through debt or
    • equity
    • • 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)
  32. 2. Liquidity
    • • 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
  33. 3. Debt-Servicing
    • 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)
  34. 4. Profitability
    • 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
  35. 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
  36. 6. Risk
    (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
  37. 6. Risk
    (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
  38. Pricing of Shares
    • Share price = mainly a function of supply & demand for a share
    • – Supply & demand are influenced mainly by
    • information
    • – 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
  39. Pricing of shares
    Estimating the price of a share

    a) Valuing a share with a constant dividend (D0)
  40. Pricing of shares
    Estimating the price of a share

    b) Valuing a share with constant dividend growth (g)
  41. 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
  42. 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
    • Where:
    • 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

    • =9.80/5
    • = $1.96
  43. 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 =  =  = $0.16