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Lecture 4 Long-term Finance: Equity

This lecture covers equity finance, including shareholder rights, stock exchange listing requirements, and the use of rights issues to raise capital. It also explores patterns of share ownership and the benefits and drawbacks of being listed on a stock exchange.

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Lecture 4 Long-term Finance: Equity

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  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

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