Chapter 5 Corporations issuing equity in the share market Learning objective 1: understand issues related to the capital budgeting investment decision • The main objective of a business corporation is the maximisation of shareholder value. In

seeking to achieve this objective, a corporation will consider its investment decision (the capital budgeting process), its financing decision (the capital structure process), the management of liquidity and working capital, and the distribution of profits to shareholders.

• Investment decisions are based on the objectives of the corporation, which state, in part, those activities that the business intends to conduct. This determines the assets required to carry out those activities.

• Quantitative methods are used to determine business activities that should be profitable; that is, they add to shareholder value. Two methods are net present value (NPV) and internal rate of return (IRR).

• The NPV is the difference between the cost of an asset, or project, and the present value of its future returns. The present value is the discounted value today of a future cash flow or series of cash flows. The cash flows are discounted at the firm’s required rate of return on the investment. The corporation will accept investment proposals that indicate a positive NPV.

• The IRR is the discount rate on a project that results in an NPV of zero. If the firm’s required rate of return on an investment is less than the forecast IRR of the project, it may be acceptable. However, IRR suffers from two shortfalls: non-conventional cash flows and mutually exclusive investment opportunities. It should be noted that both methods are exposed to the limitations of forecast projections.

Learning objective 2: identify issues relevant to a corporation’s funding choice between debt and equity • A corporation must determine how it plans to finance its investment decisions. • A business must consider its current debt-to-equity ratio and the associated degree of financial

risk. If the ratio is such that increased debt can be sustained without an undue increase in financial risk, it is in the interests of the shareholders for the expansion to be funded through debt rather than equity.

• However, debt commitments (interest and principal) must be paid when due. Therefore, a corporation must forecast the business environment in which it operates and the impact of changes on future cash flows.

• Once a business reaches an appropriate debt-to-equity ratio, further expansion requires additional equity.

Learning objective 3: examine the listing and flotation (IPO) of a business on a stock exchange, including equity-funding alternatives that are available to a newly listed corporation • One way to access a much wider equity market is through the public listing (IPO) of the

company on a stock exchange. • The majority of companies will incorporate as limited liability companies and issue ordinary

shares. • A company engaged solely in mining may incorporate as a no liability company.

• In either case, the business will retain financial advisers with expertise in the procedures for listing on a stock exchange, in the appropriate form of incorporation, in the preparation of a prospectus, and in the timing, structure and pricing of the share flotation.

• The advisers may also arrange the underwriting of the issue and ensure that its structure meets stock exchange prerequisites for the admission of the company to its official list and for the quotation of its shares.

Learning objective 4: review important compliance requirements associated with listing a business on a stock exchange • A primary concern of a stock exchange is to maintain the efficiency and integrity of its markets. • This is achieved, in part, by requiring a company that is seeking admission to the stock exchange

to comply with the exchange’s listing rules. • Once listed, corporations must continue to comply with the rules or risk suspension or de-listing

of their securities from the official list. Learning objective 5: explore equity-funding alternatives that are available to an established listed corporation, including right issues, placements, takeover issues, dividend reinvestment schemes, preference shares, convertible notes and other quasi-equity securities • Companies that have listed on a stock exchange and have a track record of sound management,

good profitability and good share price performance are generally able to raise additional equity funding in a number of different ways.

• Additional ordinary shares may be issued on a pro-rata rights basis to existing shareholders. A rights issue is usually offered at a discount to the current market price. However, a pro-rata rights issue requires a prospectus and can take time.

• Therefore, some companies prefer a direct placement of shares with selected institutional investors, such as funds managers. This can be finalised much more quickly, does not require a prospectus (only a memorandum of information), and is often at a smaller discount.

• Additional ordinary shares may also be issued by a takeover company as full payment, or part payment with a cash component, in a merger and acquisition bid.

• Dividend reinvestment is another technique by which a listed corporation can raise additional equity funds. It allows shareholders to elect to convert their periodic cash dividend receipts into new shares in the company. Dividend reinvestment schemes also give existing shareholders the opportunity to increase their equity holding, usually without the normal transaction costs such as brokerage.

• A company may also issue preference shares to raise additional equity capital. Preference shares differ from ordinary shares in that they offer a fixed dividend that is set at the issue date, and most frequently have a fixed term to maturity. In both of these attributes they are more like debt than equity. However, they rank behind the company’s creditors in their claim on the assets of the company if the business fails. A preference share issue may or may not be cumulative, redeemable, participating, convertible, or issued with different rankings.

• Convertible notes are hybrid securities that have attributes of both debt and equity. Holders of convertible notes receive a predetermined rate of interest on their investment. However, the notes may be converted into shares at a future date.

• Other forms of quasi-equity are company-issued options and company-issued equity warrants. A company-issued option provides the holder with the right to purchase ordinary shares at a

predetermined price on a specified date. A company-issued equity warrant may be attached to a corporate bond debt issue and provides the holder with the right to convert the warrant into ordinary shares in the issuer company, also at a determinable price and on or by a specified date.

Essay questions The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion. 1. Explain the concept of capital budgeting. In your answer describe the role taken by a

corporation’s board of directors in the investment decision process. • capital budgeting refers to the investment decision process carried out by a firm • the board of directors will set the objectives and policies of the firm, that is, what the firm

intends to do and how that will be achieved • management is responsible for the day-to-day financial and operation management of the

organisation in order to achieve those objectives • within the constraints of the objectives and policies, management will consider a range of

investment opportunities, that is, projects that the firm will consider taking incorporating into its business operations

• projects need to maximise shareholder value, so quantitative measures, such as NPV and IRR, can be used to evaluate project opportunities and choices

2. Jumbuck Limited is considering the acquisition of a machine to manufacture widgets. The

machine will cost $200 000 and will produce a positive cash flow of $60 000 in the first year. The cash flows will increase by 15 per cent each year thereafter for another four years. At that stage the project will cease and the equipment will have no scrap value. The company expects a rate of return of 20 per cent on this type of project.

(a) Calculate the NPV and the IRR. Note: present value = S (1 + i)–n Using a Hewlett Packard Business 10B calculator:

payments per year = 1 net cash flows: period 0 = –$200 000

period 1 = $60 000 period 2 = $69 000 period 3 = $79 350 period 4 = $91 253 period 5 = $104 940 IRR key-strokes: 1 [second function] P/YR –200 000 CFj 60 000 CFj

69 000 CFj 79 350 CFj 91 253 CFj

104 940 CFj [second function] IRR/YR Answer: IRR = 26% NPV key-strokes

20 I/YR [second function] NPV

Answer: NPV = $9 571.77 (b) Should the company proceed with this investment opportunity? • the project has a positive NPV, plus it has an IRR greater than the required return, therefore the

company should proceed with the project • the underlying assumptions are that the company is confident with the cash flow forecasts, and

that it knows its required rate of return 3. Outback Enterprises Limited has identified that it is exposed to both business risk and

financial risk. List some sources of both forms of risk, and explain the relevance of the concept of financial risk to the funding decision of a corporation.

• business risk—exposures that a firm might have that could impact the day-to-day operations of the organisation. Examples include failure of computer systems, loss of communication systems, breakdown in machinery, denial of access to premises, industrial actions of personnel, fraud, fire, flood and the list goes on!

• financial risk—situations that affect the value of balance sheet asset and liabilities or the level of cash flows derived from business operations. For example, an increase in interest rates will increase the cost of debt funding and also increase the cash flow requirements to pay loan commitments. A change in the exchange rate could change the value of assets or liabilities that are denominated in a foreign currency, or increase the cost of imports or lower the sales revenue received from exports

• major financial risk exposures that a firm may be exposed to include interest rate risk, foreign exchange risk, liquidity risk, credit risk, capital risk and country risk

• a firm must consider financial risk when evaluating the funding decision. • debt funding—what is the current interest rate environment? Does the firm expect interest rates

to change? In which direction? Should the firm obtain funding with a fixed or variable interest rate? Should the funding be short-term or longer-term? How confident is the firm with the forecasts?

• overseas funding—should the firm borrow from the local or international markets? What are the foreign exchange risks associated with borrowing overseas? What is forecast to happen to the exchange rate into the future? What impact would changes in the exchange rate have on the amount borrowed and the cash flows required to repay the loan?

• is it possible to implement strategies to manage these risks? The above issues are just some of the questions that need to be addressed

4. ‘The optimal debt-to-equity ratio is the largest ratio that can be serviced by the firm’s expected future income flows.’ Discuss this statement in the context of a firm that operates within a competitive and cyclical business environment.

• the debt-to-equity ratio is the proportion of the assets of an organisation that are funded by debt and those funded by equity (owners’ funds)

• either form of funding may be used to maintain and expand the business operation, however debt instruments must be repaid by the organisation. One of the functions of equity on the other hand is its absorption of abnormal losses incurred by the organisation

• the ratio between debt and equity funding is important as increased debt levels allow a business to leverage and increase earning per share, but risk is increased if the organisation is unable to meet its debt repayment obligations

• for example, in a period of economic downturn or a change in the business cycle a firm will usually generate less revenues but will still need to make its loan repayments

• also, a firm that has high debt levels may be exposed to the loss of market share from new competitors or products

• in the early 1990s the Australian market experienced an economic downturn which resulted in a large number of businesses going into liquidation, or becoming vulnerable to hostile take-over, as a direct result of maintaining high debt-to-equity ratio

• therefore, decisions relating to the appropriate level of debt to equity funding must be based on future cash flow projections, not past performance; that is, they must take account of forecast changes in economic and business conditions that will affect the level of future income of the organisation

5. A small company has successfully grown over the years to a point where it is considering

becoming a publicly listed corporation. Outline the processes that are involved in the flotation (IPO) of a business on a stock exchange.

• determine the form of incorporation; a limited liability company or a no liability company • ordinary shares will be issued under a company structure • limited liability—the shareholders’ financial liability is limited to any unpaid portion of the share

holding • no liability—the shareholder may forfeit a shareholding by refusing to pay further calls on an

unpaid portion of the shares • consider the method, terms and conditions, and timing of the IPO • the promoters of the new business entity will seek advice from a range of advisers, including

financial (investment banks, accounting and taxation), legal and specialist advisers, such as engineers, geologists and economists

• specialist advice is important in the successful timing and pricing of the flotation • the IPO document, the prospectus, is drawn up and lodged with the corporate regulator • the prospectus will detail the past and forecast future performance • an application to subscribe for shares is attached to the prospectus • the promoters may engage an underwriter and sub-underwriting groups to provide a guarantee

that all shares on offer will be taken up • be aware of any out-clauses included in an underwriting agreement; the level of take-up by the

underwriters may be limited

• must comply with the listing rules of the stock exchange • consider the level of fees associated with the IPO. These may be around 10% and will reduce the

amount of funds raised in the flotation process 6. Techno Pty Ltd is a private company that has developed a range of innovative software

packages over the past five years. The company is considering seeking admission and quotation on the official list of a stock exchange. List and briefly explain the advantages to the company of a public listing.

• listing provides access to a large equity capital market that would otherwise not be available to an unlisted entity

• as a publicly listed company on a stock exchange, Techno will be subject to legal requirements of the Corporations Act and the listing rules of the exchange

• listed corporations that demonstrate successful business performance are able to raise additional funding through the stock exchange in order to expand the business

• listing turns a non-liquid investment (the private company) into liquid securities (listed ordinary shares). The stock exchange represents a deep and liquid secondary market that encourages investors to purchase shares in listed companies

• increased recognition or profile of the company in the markets. This has both financial and business advantages. Financial advantages include easier access to funding; business advantages include greater recognition of the company’s products and services.

7. A corporation is to make a pro-rata rights issue to its existing shareholders on a 2 for 7

basis. The issue price is $2.50 per share and the current market price is $2.85. The financial advisers to the corporation have recommended the use of an underwriting facility. The board of directors has noted that the underwriting facility has an out-clause if the market price drops below $2.35. Having regard to this information, answer these questions:

(a) What is a pro-rata rights issue? • the issue by a corporation of additional ordinary shares to existing shareholders at a ratio to the

existing shareholding, that is, a pro-rata issue • in the above example the shareholder will receive two new shares for each seven shares currently

held • the shares are usually issued at a discount to the current market price, partly as an incentive to

shareholders and partly to allow for the expected fall in the price due to the dilution effect of the additional shares

• in the example the shares are offered at a $0.35 discount • the right may be renounceable and listed on the stock exchange; the shareholder is entitled to sell

that right before the exercise date (b) What is an underwriting facility, and why might a corporation use such a facility? • a contractual undertaking by an underwriter to purchase securities that are not fully subscribed to

by investors • for example, the underwriter has agreed to buy any surplus shares providing the market price

remains above $2.35 • in a large issue of securities there will typically be a group of underwriters and sub-underwriters,

each accepting a portion of the underwriting exposure

• the underwriters will charge a fee for this service Benefits to the corporation: • the underwriters will provide advice on:

o the structure, pricing, timing and marketing of the issue o the allocation of the securities between underwriters, investors and markets

• underwriting an issue provides the corporation with a much higher level of certainty that it will raise the necessary funds from the issue, particularly in times of market volatility

(c) What is an out-clause? Explain, using the context above. • usually incorporated in an underwriting facility • specified conditions, situations or benchmarks will activate the out-clause and preclude the

underwriting agreement from being enforced • for example, an out-clause may relate to a specified change in a published share market index • in the example, the underwriter has an out if the share price falls below $2.35 8. The government is about to privatise a government enterprise by establishing a limited

liability company that will be a publicly listed corporation on a stock exchange. The government decides to issue shares at $4.50, but through the issue of instalment receipts. An initial payment of $2.00 is payable on application and a final payment of $2.50 is due twelve months later.

(a) Explain the nature of a limited liability company; in particular the rights and financial obligations of a shareholder.

• holders of ordinary shares have the right to vote for directors of the board, plus any other motions that may be put to a general meeting of shareholders

• shareholders have a residual claim on the assets of the firm, after all other creditors have been paid

• shareholders typically receive dividend payments, usually twice-yearly, distributed from the profits of the corporation

• limited liability company—the claims of creditors against shareholders are limited to the value of the fully paid ordinary shares issued

• for example, if the corporation has issued partly paid shares, then the shareholder is required to make the outstanding calls on the unpaid portion when due

• the holder of shares in a limited liability company cannot be forced to pay further monies to the corporation or its creditors

(b) Extend your answer to explain the use of instalment receipts in the above situation. • in the above example, the listing enterprise has issued instalment receipts. These are issued upon

payment of the first instalment ($2.00) towards the purchase of ordinary shares in the corporation • when the final instalment of $2.50 is paid the investor will receive the ordinary share of the

company • the instalment receipt holder usually retains the same rights as a shareholder, including the

receipt of any dividend payments

9. A mining corporation has obtained the rights to explore for gold in a new tenement. The corporation decides to establish a new subsidiary company that will carry out this high-risk venture. The new company will be listed on the stock exchange. The gold exploration company expects to complete its exploratory search over the next twelve months, at which time it will report back to shareholders and make recommendations on the viability of the project.

(a) What form of legal structure would you recommend the gold exploration company incorporate? Why would you recommend this structure?

• based on the available information it seems appropriate that the subsidiary be formed as a no-liability company

• as a start-up exploration company the company only needs to raise a limited amount of capital at the initial stage

• the company can issue partly-paid ordinary shares under its prospectus • as this is a high risk venture, investors are more likely to purchase partly-paid shares rather than

pay the full amount • the company will report back to shareholders in 12 months, and if the project is to proceed, will

make a further call on the shares • the shareholders will consider the reports at that time and decide whether they wish to pay the

call, or not. Non-payment of a call results in the forfeiture of shares (b) What are the advantages to the company and also to the shareholders of the structure you

recommended? • a shareholder in a no-liability company is able to decide not to pay the call. However, in this

circumstance the shareholder will forfeit the shares. The shareholder will have lost the value of the partly paid share

• if sufficient shareholders pay the next call on the shares the company is able to fund the next stage in the project

10. A stock exchange will establish listing rules that embrace the interests of listed entities,

maintain investor protection, and ensure the reputation and integrity of the markets. To achieve this, a stock exchange will adopt a number of listing-rule principles. List and explain five fundamental listing-rule principles.

The main principles that form the basis of a stock exchange’s listing rules include (note: students only need to select five principles):

• minimum standards of quality, size, operations and disclosure • sufficient investor interest must be demonstrated to warrant an entity's participation in the market • securities must be issued in circumstances that are fair to new and existing security holders • securities must have rights and obligations attaching to them that are fair to new and existing

security holders • prescribed information must be provided to the exchange in a timely manner • material information, which may affect security values or influence investment decisions, must

be disclosed immediately to the stock exchange • information must be produced according to the highest standards and, where appropriate, enable

ready comparison with similar information

• the highest standards of integrity, accountability and responsibility of entities and their officers must be maintained

• practices must be adopted and pursued which protect the interests of security holders, including ownership interests and the right to vote

• security holders must be consulted on matters of significance • market transactions must be commercially certain 11. A listed corporation decides that it wishes to increase its equity funding. Of the alternatives

available, the firm narrows the choice to either a pro-rata rights issue or a private placement. Advise the company on the relevant requirements, and on the advantages and disadvantages of these two alternatives.

• the listed company has the advantage of an established reputation which, if positive, will enable it to raise further equity funding at a favourable price

• the choice is between a pro-rata rights issue and a placement; both relate to the issue of additional ordinary shares

Rights issue: • a pro-rata rights issue occurs when existing shareholders are given an entitlement to subscribe

for additional shares in the company • in making a rights issue, the company must ensure that all shareholders receive an equivalent

opportunity to participate in the issue. This is achieved by making the offer on the basis of a fixed ratio of new shares to the number of existing shares held (pro-rata basis). For example, a 1:10 (one for ten) offer gives a shareholder the right to purchase one new share for every ten existing shares held

• often a rights issue is renounceable, that is, the shareholder is able to sell the option (right) to another party, but some issues are non-renounceable (cannot be sold)

• an advantage of a rights issue is that the company retains its existing shareholder base, and at the same time is able to raise additional equity funding

• a rights issue must conform to the prospectus requirements of the Corporations Act and this can be costly and time consuming

• the time lag between the pricing of the issue and the actual issue date exposes the company to pricing risk, that is, the share price might fall below the rights price

Placements: • a placement is an arrangement where a company may issue additional shares, with shareholder

approval, directly to selected institutional and individual investors who are deemed to be clients of brokers, without the need to register a prospectus

• subscriptions must be for not less than $500 000 and to not more than 20 participants • the advantages to the company include the reduced compliance costs (no prospectus, only an

information memorandum), the quickness in which the issue can be finalised, often at a lower discount to market price, and to investors that are friendly to the company

• a disadvantage to existing shareholders is ownership dilution, however placements are restricted to a maximum of 15% of capital in any 12-month period

12. The issuance of preference shares is a funding alternative for a corporation. (a) Describe the nature of a preference share. • preference shares are hybrid securities that combine the characteristics of both debt and equity • preference shares have their fixed dividend rates set at the issue date • they also rank ahead of ordinary shareholders in the event of the winding up of the company (b) What features might the corporation attach to the issue to ensure that the preference share

is attractive to investors? • preference share issues are normally listed on the stock exchange. This provides access to a

secondary market, although the liquidity of the issue will depend on the reputation and performance of the issuer-company.

• Attributes that may be attached to a preference share issue are that they may be: o cumulative—dividends not paid in one year are carried forward to ensuing years until

paid in full. Non-cumulative preference share dividends are lost if the company does not make sufficient profit in a particular year to make the payment

o redeemable—entitles the holder to redeem the preference share on a pre-determined date and receive the par value of the share

o convertible—may be converted into ordinary shares in the company at a future date, generally at the lesser of an amount nominated in the prospectus, or a discounted market price at conversion date

o participating—holders are entitled to dividends in excess of the stated dividend rate when ordinary shareholders receive a dividend in excess of a specified rate, or the profits of the company exceed a defined level

o issued at a different ranking—where first ranked preference shares have preference over second and other ranked issues for claims on dividends and, in the event of winding up of the issuer company, to residual assets

13. Companies sometimes offer a dividend reinvestment scheme to their shareholders. (a) How does a dividend reinvestment scheme operate? • dividend reinvestment schemes allow a shareholder to reinvest all or part of their dividend

entitlement in additional shares in the company • sometimes at a discount to the market price, and with no brokerage or other costs • dividend reinvestment schemes are an important source of equity funding for many companies • the company will typically issue such shares at the average market price of the shares traded on

the stock exchange for the five days following the ex-dividend date (b) Briefly outline the significance of dividend reinvestment schemes as an equity-raising

technique, and comment on the attractiveness of such schemes from the point of view of the corporation.

• the main attraction of dividend reinvestment schemes is that they enable a company to make dividend payments and, assuming a sufficient reinvestment rate, to retain sufficient equity funds to meet future funding needs

• at the same time, in countries such as Australia that allow dividend imputation, the company is able to pass on tax franking credits to its shareholders

(c) Under what circumstances might such schemes prove to be unattractive to the dividend-paying company?

• there may be periods when company investment opportunities are limited, such as in an economic downturn, and the additional funds raised through a dividend reinvestment scheme are not required, and may dilute earnings per share

• therefore, a company may need to suspend its scheme from time to time 14. Convertible notes and company-issued options are often referred to as ‘quasi-equity’. (a) What are the characteristics of each of these instruments that serve to distinguish them

from straight equity or debt? Convertible notes: • a convertible note is a hybrid security that exhibits the characteristics of both debt and equity

during the life of the security • it is issued for a nominated term, generally at a fixed rate of interest • the holder of the convertible note has the right to convert the note into ordinary shares in the

issuer-company at a specified future date • convertible notes are generally issued on a pro-rata basis to existing shareholders, and are often

not renounceable, that is, the holder cannot sell the entitlement Company-issued option: • provides the right, without the obligation, to purchase ordinary shares, at a stated price, at a

future date or dates • in Australia, the Corporations Act restricts the term of a share option to a maximum of five years • the option may be issued free with a new debt issue, or it may be sold at a premium by the

issuing company (b) Why might a company issue quasi-equity rather than straight debt or equity? • the issue of quasi-equity is another funding alternative to either straight debt or equity • allows a company to issue funding instruments that are flexible in that they can be structured to

meet the company’s cash flow and future funding requirements Convertible notes: • the notes are usually issued at a price close to the current market price • the rate of interest is usually lower than the cost of debt to the company • where conversion price is not favourable to the holder, that is share price has fallen, the investor

retains an option to convert to cash • the advantages to the company of a convertible note issue include obtaining funding at a price

lower than the cost of debt, and often at a longer maturity than would otherwise be available for a straight debt issue. Furthermore, interest payments are a tax deductible expense of the company

Company-issued option: • the issue of an option attached to an underlying debt issue may add to the attraction and

marketability of the debt issue • the company also does not incur the initial higher cost of dividend payments that would be

associated with a direct share issue

• the company can time the option exercise date/s with planned future funding requirements • the company is exposed to unfavourable price movements which may cause the option holder

not to exercise their right, and therefore the company will not raise the amount of funds anticipated