Lecture 4 Long-term Finance: Equity

1. Lecture 4 Long-term Finance: Equity

2. What is equity finance? • Par value versus market value • Ordinary share account and share premium account • Authorised versus issued share capital • Risk and the creditor hierarchy • Shareholder returns not guaranteed • Cost of equity higher than cost of debt or cost of preference shares

3. Shareholder rights A shareholder has the right to • attend general meetings of company. • vote on appointment of directors. • vote on appointment, remuneration and removal of auditors. • receive annual accounts of company and report of its auditors. • receive a share of any dividend paid.

4. Shareholder rights A shareholder has the right to • vote on important issues, such as permitting repurchase of shares, using shares in a takeover bid or a change in authorised share capital. • receive a share of assets remaining after company has been liquidated. • participate in a new issue of shares of company (the pre-emptive right).

5. The stock exchange • Main market and AIM • Markets for ordinary shares, preference shares, bonds and depositary receipts • Regulated by the Financial Services Authority (FSA) acting as the UK Listing Authority (UKLA) • Key roles of sponsor and broker in new issues market

6. New issue methods • Placing: large blocks of shares are ‘placed’ with institutional investors • cheaper than public offer • narrower spread of public ownership • Public offer: shares offered to public either at fixed price or by tender • more expensive than placing • gives widespread of public ownership • used for very large issues

7. New issue methods • Introduction: shares become listed but no funds are raised • Which method is used depends on issue costs, ownership spread, aims and size of issue • Placing is the most popular new issue method on both main market and AIM • £3.6bn raised by new issues in 2004

8. Main Market AIM • Minimum 25% shares in public hands • Normally 3-year trading record required • Needs prior shareholder approval for substantial acquisitions and disposals • Sponsors needed for certain transactions • Minimum market capitalisation • No minimum shares to be in public hands • No trading record requirement • No prior shareholder approval for transactions • Nominated adviser required at all times • No minimum market capitalisation Listing requirements

9. The stock exchange Advantages of being listed • Raising finance by coming to market • Access to finance via capital markets • Shares can be used in acquisitions Disadvantages of being listed • Costs of gaining/maintaining quotation • Higher shareholder expectations • Increased financial transparency

10. Rights issues • Pre-emptive right means new shares offered first to existing shareholders. • Discounted price of rights issue guards against share price fall before issue. • Deep discount rights issue is possible but is rare. • Purpose of rights issue affects success in raising cash from shareholders.

11. Rights issues • Underwriting by institutional investors guarantees cash is raised. • Shareholders can sell rights if they wish. • Rights issues are not appropriate for raising large sums as issue is limited to existing shareholders. • Market efficiency says there is no best time for a rights issue, but companies avoid rights issues in bear markets.

12. Theoretical ex-rights price (TERP) • Cum rights price is share price giving right to participate in rights issue • TERP is weighted average of rights issue price and cum rights price of shares needed to obtain one new share • Example: • 1 for 4 rights issue at £2 per share, cum rights price is £2.50 per share • TERP = [(2.5 × 4) + 2]/5 = £2.40

13. Value of rights • Defined as ‘The difference between the theoretical ex-rights price and the rights issue price, divided by the number of qualifying shares’ • Example: TERP = £2.40 Rights issue price = £2.00 Value of rights per qualifying share = (2.40 – 2.00)/4 = 10p

14. Actual ex-rights price • TERP is only a guide, but a good one • Actual ex-rights price will depend on investors’ view of: • use to which funds are to be put. • prospects of company. • information released to the market. • market expectations. • £2bn raised by rights issues in 2004

15. Rights issues and shareholder wealth • Shareholder wealth is not affected by a rights issue provided rights are taken up or rights are sold. • TERP is therefore a benchmark against which share prices arising from use of new funds can be compared. • Share price from EPS arising from new funds can be found by multiplying new EPS by price-earnings ratio.

16. Patterns of share ownership

17. Scrip and other issues • Scrip issues or bonus issues convert capital reserves to ordinary shares. • Share splits increase number of issued shares by replacing existing shares. With new shares of lower par value, and so increase marketability of shares. • Scrip dividends offer new shares as an alternative to a cash dividend.

18. Scrip and other issues • Share repurchases decrease number of issued shares and so can increase EPS. • Capital employed decreases due to cash spent on buying back shares, hence ROCE may be increased. • Share repurchases increase gearing marginally, but may decrease cost of capital and so increase company value.

19. Preference shares • Equity or debt? • Preferential right to receive dividend • Although permanent capital, do not normally carry voting rights • Less risky than ordinary shares, more risky than debt • Cumulative and non-cumulative preference shares

20. Preference shares • Participating preference shares: both fixed and variable dividend income • Variable rate preference shares • Convertible preference shares • Popularity or otherwise of preference shares with companies and investors

21. Preference shares Advantages of preference shares • No need to pay dividend if profits are poor • Do not dilute ownership and control • Unsecured, so preserve debt capacity • No right to appoint a receiver Disadvantages of preference shares • Higher cost compared to debt due to tax inefficiency