FINS1612 SUMMARIES

Week 3 Equity Markets 1 Part 1

The Share Market and The Corporation
1/3 The Nature of a Corporation :
Corporation:

A business organisation legally registered as an entity (person) that is

owned by one or more individuals or entities and has many rights and
duties of a person borrowing money, owning property (or other
Corporations)

Separate and distinct from owners

Forming involves preparing articles of association (or charter), that sets

out the name, life expectancy, purpose etc and bylaws, outlaying how the
company is to be run, that are submitted to the state in which the firm will
be incorporated (making it a resident)

Advantages (Result from separation of management and

ownership) :

In the 1990s
the
companies
law was
changed so
people could
form oneshare-onedirector
companies
so
individuals
could take
advantage

Ownership is represented by shares,

>>>Greater effectiveness in strategic planning and
implementation through specialised and expert
management teams.
Hence can be transferred easily - Hence unlimited
life
Liquidity of securities facilitates investor diversification
and encourages investment in corporate securities.
Large number of owners lowers risk of problems with few
owners

Corporation can borrow money in its own name

Hence Limited liability
o Shareholder liability Limited to issue price of
shares of a limited liability company and any
partly paid portion of shares in a no-liability
company

Easy to raise larger sums of capital by selling more shares.

Disadvantages:

Earnings are liable for corporate taxation

Though since 1987, the double-taxing of shares has been

removed due to Australias dividend-imputation taxation system

o Formalities of forming and running are complicated and take time and
money

The Primary goal of (financial mgmt of) any (forprofit) business:

>>>Maximise the value of the firm to shareholders<<<
(Maximising the market value of the existing owners equity)
Note: Sometimes simplified (in efficient markets where shares dont

Principal Agent Problems Shareholders and

Managers:

The Agency Relationship is where a principal (stockholders) hires an

agent (managers) to represent his/her interest (running a company)

The agency problem is when problems arise because of conflicts of

interest between principal and agent.

This is because the agency relationship has a separation of ownership and

control where the owners are not the people who manage the firm on a
daily basis.

Hence there are agency costs which are the costs of different parties
(managers) acting in a manner that is inconsistent with maximising
shareholder value.

Direct Agency Costs:

Managers act in their own self interest (reducing firm value to
shareholders)

Managers hence need to be monitored to ensure actions are in

the owners best interests Monitoring costs

Money is spent setting up contracts to control managers

Bonding costs

Indirect agency costs:

Arise when value maximising investment opportunities are rejected.

Mechanisms to solve this agency problem:

Internally:
Board of directors (executive and non-executive directors on the board),
Shareholder meetings (major shareholders can exert considerable influence

on the company)
Managerial compensation (compensation to incentivise managers to act in
the best interest of the shareholders)
Shareholder activism
Externally:
>>Public opinion & Political pressures
>>Managerial labour market (managers who act in line with principal
objectives command
higher demand and hence higher salaries)
>>Debt and legal constraints debt as a monitoring mechanism.
(The Companies Acts also covers directors)
Mergers and acquisitions market mass selling of shares to another entity

2/3 The Stock Exchange:

General Roles (Provision of):

Markets for a range of financial securities

Securities trading system

Clearing and settlement system

Regulation and monitoring of market integrity

Well-informed market

Specific Roles (7):

Primary Market Role

A stock exchange facilitates the efficient and orderly sale of new

financial securities

IPO Initial issue of shares to the public for cash. Listing on

stock exchange.

Rights Issue Issue of additional new shares to existing

shareholders on a proportional basis to their existing holding.
(pro-rate)

Private placement Exclusive issue of shares to a select

investor/group of investors who may not be currently investors
in the firm.

Dividend reinvestment plans Reinvestment of dividends

into corporation for additional shares..

Secondary Market Role

The stock exchange facilitates trading in existing shares

No new funds are raised by the issuing company funds flow to

owners of shares.

An active, liquid, well-organised secondary market

increases the appeal of buying new shares in the primary
market.
Market liquidity Ratio of share turnover to market
capitalisation
Market Turnover Number of shares on issue X current
share price

Derivative market role

The Stock exchange provides a market for trading equity-related
derivative products
(Provides a Risk-management tool for share traders)

Derivative A financial security that derives its price from an

underlying commodity (eg. Gold) or financial instrument (eg.
Shares)
Exchange-traded; Standardised financial contracts
traded on a formal exchange
Over-the-counter; Personalised contracts negotiated
between writer and buyer.

These serve as a speculative instrument and a risk

management tool (hedge)

Futures: A standardised contract that is traded on an

exchange and hence has clearing houses that guarantee the
transactions significantly lowering the probability of default
(unlike the private forward contracts) to almost never.
>>>Possess only one settlement date
o >>>Marked-to-market daily (daily changes are
settled day by day in cash payments from an initial
margin put up by both parties) and thus settled at
the settlement price (whether that is higher

or lower than at the time of entering the

contract)

Option: (OTC or EX) This is a contract between two parties for

a future transaction on an asset at a reference price the buyer
has the right but no obligation to engage in the transaction
whilst the seller has the obligation to fulfil if acted upon.
>>>The price of an option derives from the difference between
the reference price (decided) and the value of the underlying
asset plus a premium based on the proximity of timing to the
expiration of the option.

Warrants

Interest rate market role

The listing, quotation and trading of typically longer term debt
instruments on a stock exchange.

Straight corporate bonds (fixed interest security with face value

repaid at maturity)

Floating rate notes (same as above just with variable interest)

Convertible notes (hybrid fixed interest security with option to

turn into a note)

Preference shares (hybrid share with more preference in

bankruptcy than ordinary shares and a fixed dividend but
reduced/no voting rights)

Adds to value of debt issue due to

Transparency Information about price, yield, maturity,
credit rating of debt instruments.

Allowing Ease of entry Electronic trading system

facilitates buy and sell orders at minimum cost and time
delay at current market prices.

Enhancing Liquidity quotation on a stock exchange

provides access to a wider market.

Trading and settlement roles

The ASX uses CLICK XT, an integrated computer-based trading system to

trade all listed securities.

Clients orders are executed via computer from the brokers

office.

Orders are executed in order of;

Price > time > Order volume

CHESS (Clearing House Electronic Sub-register System)

Facilitates the settlement of transactions conducted
through CLICK XT
Settlement of transactions within 3 days (T + 3)
Provides an electronic sub-register that records the
ownership of listed securities.
o CHESS Sponsor Market participant with access
to CHESS (stockbroker etc)

o CDI (chess depository interest) developed to

overcome the issue of countries that do not accept
uncertified holdings or electronic transfers of titles.

Information role
Investor confidence in the ASX relies on informational efficiency.

Current share price should reflect all information available in

the market, determined by;
The speed at which new information flows to the
market
The speed at which that information is absorbed and
reflected in share prices.

Corporations Act 2001 (Cwlth) requires information

materially affecting the share price of a listed company to be
immediately given to the ASX.

Listing Rules stock exchange rules by which a listed entity

must comply
Change in companys financial forecasts
Appointment of a liquidator
Declaration of a dividend
Notice of a takeover bid
Disclosure of directors interests
o Corporations are also required to give the ASX their
financial statements.

Regulatory role;

Regulation aims to ensure market participants have confidence in the integrity of

market operations.

ASX - Ensures companies meet specified limited levels of

performance and standards of information disclosure so
investors can make informed decisions.
o CONTINUOUS DISCLOSURE
Prescribes appropriate behaviour of broker participants
(not just companies) on the exchange.
o Penalties, license revocation
Utilises electronic surveillance system to monitor trading
behaviour;
o Trades that fall outside certain limits
o Cross-references all trades against information on
company, directors and associated parties
NGF (national guarantee fund) compensates investors
for failure or misconduct by a stockbroker.

ASIC - Responsible for the supervision of Corporations Law and

markets in Australia.
>> Corporations Act 2001 (Cwlth)
Market integrity and consumer protection across the
financial system, covering investment, insurance and
superannuation products.
Supervises ASX addressing potential conflicts of interest
as the ASX is a publicly listed corporation ASX is listed
on the ASX.

3/3 The Private Equity Market:

Alternate funding source for companies unable (or not wanting to) access
equity capital through a public issue.

Source of funds;

Superannuation funds, Life insurance offices

Uses of funds;

Startups, business expansion, recovery finance, management

buyouts

 Aim:

Improve profitability sufficiently to realise value through an IPO

Break up business to achieve return on investment.

Week 3 Equity Markets 1 Part 2

Corporations Issuing Equity in the Share Market
FOUR (5 really) Financial Management Decisions:
1) The investment decision:
Capital Budgeting The process of planning and managing a firms long
term investments. Analysing the size, timing and risk of the cash flow for
potential long term investments.
2) The Financing decision:
Capital Structure How the firm obtains financing to support long-term
investments, the mix of long-term debt and equity. Analysing magnitude of
borrowing and borrowing sources and types.
Working Capital Management Managing the working capital (short-term
assets and liabilities) of a firm and deciding amounts, sources etc.

3) The Dividend Decision

Distribution of returns to shareholders (how much, how often, etc)
4) The Restructuring Decision:
Corporate actions that will benefit the firm

The Primary goal of (financial mgmt of) any (forprofit) business:

>>>Maximise the value of the firm to shareholders<<<
(Maximising the market value of the existing owners equity)
Note: Sometimes simplified (in efficient markets where shares dont
change hands often and are difficult to value) as maximising a firms

Intermediate Objectives of financial management:

Social and ethical responsibilities such as OH&S, Adhering to letter and
spirit of laws, environmental responsibility, charity.

1/5 P2 The investment Decision: Decisions in depth The investment decision:

Capital Budgeting The process of planning and managing a firms long term
investments. Analysing the size, type timing and risk of the cash flow for
potential long term investments.

Type - Real vs. Financial Assets:

Real Assets:
Assets that can be put to productive use to generate a return
(machinery and equipment for example)
Financial Assets:

Assets that represent a claim to a series of cash flows

against an economic unit such as shares (claim against a
company, cash flows = dividends and sale price), bonds (claim
against bond issuer, CF = interest and principal), bank accounts
(claim against bank, CF = interest and principal)

The four types of project:

Replacement
o

Maintenance of existing business

o Cost reduction

Expansion
o

Existing markets or products

o New markets or products

Safety and Environmental

o Mandatory investments to ensure compliance with government
legislation on safety or environmental issues.
o The investment may or may not result in any positive cash flows
for the firm.

Are there fines for non-compliance? Are these worth it (morally

and financially)

o These require analysis of how the firm will fund the investment and
impact on the firm.

Other Projects
o Infrastructure etc that does not fall under the previous categories.

5 Steps in the Capital Budgeting Process;

Generate Project Proposals:
Does the project fit with the firms long-term goals
Screening
How will the project affect the firm?
o Type
o Different options
Evaluation:
Quantitative analysis (worth > cost, Return > required return?)
o Forecast cash flows (Initial cost, expected cash flows, salvage
value)
o Determine risk of cash flows (discount rate based on risk,
alternative cash flow forecasts generated perhaps)
o Apply evaluation method (or more than one)
Qualitative Analysis
o Values, morals, ethics etc
Implementation and Control
Monitoring actual cash flows relative to forecasts
Post-implementation Audit
Project follow up and review

A note on Project Relationships;

One project simply has options of reject or accept

Multiple projects can be;

o Independent (no impact on each others cash flows)
analyse independently and accept one or more or reject all as
decision to accept or reject doesnt affect others.
o Mutually exclusive (accepting of one requires rejection of all others
usually because of resource constraints)
- analyse projects independently but rank relative to determine
which to undertake.
o Contingent (Acceptance of rejection of a project is dependent on the
decision to accept or reject a related project)
- analyse cash flow interactions of projects as well

Can be Complementary projects or substitute projects

Decisions in depth - QUANTIFYING investment decision NPV

Value of a project, accounting for initial outlay and discounted value of all FCF
(Influenced by accuracy of forecasted CF and R-ROR)
-

Measures increase in firm value (wealth of shareholders) from undertaking

a project above what shareholders could obtain by investing in
capital market themselves

Decision Rule Independent Projects:

Accept if NPV > 0 (or = 0 and have personal preference over giving cash
to shareholders to invest themselves)
Decision Rule Mutually exclusive Projects:
Accept if Highest positive NPV
To calculate: Treat as bond (which can be annuity if payments are equal)

MINUS Initial
Outlay

Discount rate represents ROR that could be earned on an investment in the

capital market with equivalent characteristics.
o NPV > 0 indicates project yields greater wealth than equivalent
capital market investment. The opposite for NPV < 0 and NPV = 0
means equivalent to capital market investment.

Advantages;
-Clear decision rule (& easy to interpret result)
- Doesnt ignore time value
- Considers all cash flows generated by a project
- Correctly ranks projects on shareholder wealth maximisation
- Incorporates risk of project
Disadvantages:
- Need extensive forecasts of future cash flows
- Can be difficult to choose appropriate discount rate
- NPV is hard for non-finance-trained managers to understand

Decisions in depth - QUANTIFYING investment decision IRR

Working out IRR without trial and error;

1. For UNIFORM CF firstly divide the initial outlay by the CF

o This therefore gives the PVIF Remember

TABLE A2 for

IRR
range!
2. Look on table A2, under the number
of periods
in the question, for this PVIF.
3. Then simply see the percentage listed (that is IRR)
o Note that if it is between one Trial and error or %-of-Difference
techniques may need to be utilised

NPV Profile:

This is a useful graph of the NPV against the discount rate which should
have a relationship such that;
o The higher the discount rate, the lower the NPV

Hence the IRR for a project is the point at which the profile crosses the
discount rate axis (NPV = 0)

Note the Multiple IRRs from non-normal

cash flows

Normal cash flows

Comparing IRR and NPV:

Considering if these two projects (A and B) are independent, we now look

at both IRR and NPV and how they would handle decisions on these two
projects.
o IRR would suggest that we could accept A,B or both depending on
the hurdle rate. If it is <18.49% then both would be undertaken.
o NPV would suggest, once again, both projects if the discount rate
were less than 18% because NPV > 0.
o Hence, when they are independent, NPV and IRR give the same
answer

Considering these projects as Mutually exclusive we once again

evaluate the responses of IRR and NPV
o IRR would suggest the highest IRR which is A (A > B = 21.22% >
18.49%)
o NPV would depend on if the discount rate </> the crossover
rate.

Higher than crossover, A >B

Lower than crossover, B > A

Comparing IRR and NPV Reinvestment of Funds

problem

The NPV approach assumes that funds generated by the project can be
reinvested at the discount rate (R-ROR)
o This is the more realistic assumption of the two

The IRR approach assumes that funds generated by the project can be
reinvested at the IRR rate.

Comparing IRR and NPV Scale Problem

Consider NPV and IRR for incremental cash flows

Comparing IRR and NPV Timing Problem

MIRR example

2/5 P2 The Financing Decision:

Capital Structure How the firm obtains financing to support long-term

investments, the mix of long-term debt and equity. Analysing magnitude of
borrowing and borrowing sources and types.
o The objective is to maximise return, subject to an acceptable level of
risk, which is divided into;

Business risk (which depends on);

The type of operations of the business (due to level of
fixed vs. variable operating costs), Sectoral growth rates,
Market share, Aggressiveness of competitors,
Competence of management and workforce

Financial Risk
>>Exposure to factors that impact on the value of assets,
liabilities and cash flows.
Level of financial risk is borne by the security holders
(debt and equity)
Categories (6);
o Interest rate risk Adverse movements in interest
rates
o Foreign exchange Risk Adverse movements in
exchange rates
o Liquidity Risk Insufficient cash in the short term
o Credit risk Default or untimely payments by
debtors
o Capital risk Insufficient shareholder funds to meet
capital growth needs OR absorb abnormal losses
o Country risk Financial loss owing to currency
devaluation or inconvertibility.
D/E Ratio Ratio of funds borrowed (debt) to funds
contributed by shareholders (equity).
o Indicates risk of being unable to meet interest due
and principal repayments associated with use of
debt (risk of insolvency)
o Influenced by industry norms, historical firm
ratios, lenders limits (loan covenants),
managements assessment of capacity to service
debt.

 EPS Net return on companys shares express in CPS

(cents per share)
o

If cost of debt is less than return achieved, more

debt will benefit shareholders because of higher
EPS

o HOWEVER, more debt raises financial risk and

insolvency risk

3/5 P2 Initial Public Offering (IPO):

Issuing New Shares:

Publicly listed corporation Has its shares listed and quoted on a stock
exchange

This is a complex alternative to retained earnings for raising capital for

investment.

Types of issuance:
o IPO Initial issue of shares to the public for cash
o Rights Issue Issue of new shares to existing shareholders on a
proportional basis to their existing holding.
o Private placement Exclusive issue of shares to a select
investor/group of investors who may not be currently investors in the
firm.

Ordinary Shares and company type:

Limited Liability Companies;

Shares are major source of equity funding

Shareholders have voting rights at general meetings (can be

transferred to proxy)

Shares usually sold fully paid but can be partly paid (contributing
basis) or paid by instalment receipt

Instalment receipt:

Issued upon payment of the first instalment on a share

issue in lieu of the ordinary share.

On payment of a specified amount at a future date, a full

paid share is issued in place of an instalment receipt

Shareholder liability is limited to the price of fully paid shares

Partly paid shareholders have a contractual obligation to

pay the remaining amount when it is called or due.

NO-Liability Companies;

Used for highly speculative ventures

Shares issued as partly paid

Shareholders may decide not to meet future calls BUT they forfeit the
partly paid shares in that case.

4/5 P2 Listing a Business on a Stock Exchange:

Procedure for issuance:
1. Get approval from BOD
2. Obtain expert opinion on financing options, pricing, marketing and level of
interest/support for the issue
Must meet listing requirements (Or can be suspended or delisted)
(These are in addition to a corporations legislated obligations)
o These principles embrace the interests of listed entities, maintain
investor protection and maintain regulation and integrity of market.

Minimum standards on quality, size, operations and disclosure

Sufficient investor interest required to warrant listing

Security issues must be fair to both new and existing holders

Rights and obligations attached to securities must be fair
to both new and existing shareholders.

Prescribed information must be provided to the exchange on a

timely basis

Material information that may affect security prices or

investment decisions must be disclosed immediately to the
exchange
Disclosure of information of a sufficiently high standard to
investors

Highest standards of behaviour on the part of company officers.

3. Hire an investment bank to assist with the sale

4. Write a prospectus and register it with the appropriate authorities
Out-Clause - Specific conditions precluding full enforcement of an
underwriting agreement
5. Conduct a marketing road-show
6. Receive applications
7. Allocate and distribute shares
8. Trading begins

Standby Underwriting

At the end of the issue, the issuer buys any shares not bought by the public

Underwriter bears the risk of not being able to sell the entire issue to
the public

Underwriter charges a fee for this service

o Most common type of underwriting in Australia

Best Efforts Underwriting

Underwriter makes Best Effort to sell securities at agreed offering price

Company bears the risk of the issue not being sold

Offer may be pulled if there is not enough interest at the offer price and
the company does not get the capital and have still incurred substantial
flotation costs

Not as common as it used to be

Issuing New Shares Cost of issuing new shares:

Costs of issuing new shares (and other forms of capital) are called flotation
costs.

Includes;
o Direct;

Management and/or underwriting fee

Filing, listing, legal, printing fees and taxes

o Indirect;

Management time

o Underpricing
o Abnormal returns and green shoe options

5/5 P2 Equity Funding for Listed Companies:

There are several forms of equity finance available to established

corporations;

Additional ordinary shares;

Rights issue - Issue of ordinary shares to existing

shareholders on a pro-rate basis (1 :5 or 1 for every 5 owned)

Renounceable Shareholder may sell their right

o

Non-renounceable; Right may not be sold.

Issue price (discount to current price) is influenced

by;

Companys CF requirements

Projected earnings flows from the new investments

funded by the rights issue

Cost of alternative funding sources (opportunity

cost)

Placement Additional new ordinary shares issued directly to

selected investors (institutions and individuals) deemed to be
clients of brokers.

No prospectus needed but do need a memorandum of

information

Minimum subscription to $500,000 to not more than 20

participants

Market price discount CANNOT be excessive

o Allows smaller discount and shorter time frame than
rights issue

Dilutes the holding of non-participating shareholders.

Takeover Issues The Acquiring company issues additional

ordinary shares to owners of the target company in settlement
of the transaction.

Alleviates need for owners of acquiring company to inject

cash for the purchase of the company.

Dividend Reinvestment Schemes Shareholders have the

option of reinvesting dividends into additional ordinary shares.

Usually discounted between 0 and 5%

No brokerage or stamp duty payable

In growth periods this allows companies to pay dividends

and pass on tax credits, whilst increasing equity
o The scheme may be suspended in low growth
periods

Preference Shares;

Classed as hybrid securities (characteristics of both debt and

equity)

Fixed dividend rates are set at issue date

Rank ahead of ordinary shareholders in the payment of

dividends AND in the event of liquidation.

Can have the following characteristics;

Cumulative (/not), = dividends can rolled over to be paid

next year.

Redeemable (/not), = Shares can be redeemed into

something else

Convertible (/not), = shares can be converted back to

original shares

Participating (/not), = shareholders able to participate in

bigger profits than would be allowed with fixed dividend
issues.

Issued with different rankings = different rankings of

entitlements to dividends/shares.

Advantages:

Fixed interest borrowings but they are an equity finance

instrument

Assist in maintaining D/E ratio

Widen a companys equity base (allowing further debt to

be raised)

Dividends may be deferred on cumulative shares and not

paid on non-cumulative shares
>>>Unlike Debt interest which MUST be paid

Convertible notes (Quasi-equity) -

Classed as a hybrid instrument, issued for a fixed term at a

stated rate of interest, either by direct placement or pro-rata to
shareholders.

Holder has right to convert the note into ordinary shares

at a specified future date and at predetermined price

The option to convert to equity has value

Gain is made on share prices subsequently rising.

If share price falls, holder may not exercise conversion

option and take the notes cash value.

Interest paid on notes is usually lower than straight debt

interest.

The interest is tax deductible

Notes are often issued for longer periods than is possible

with straight debt borrowings.

Company-issued Options

Provide the right, BUT NOT THE OBLIGATION, to purchase

shares at a stated price and date.

Allows companies to raise further equity funds at planned

future dates.

Providing holders exercise the option.

Typically offered in conjunction with a rights issue or placement.

Generally have value and can be traded

Option will be exercised if the exercise price is less than

the market price of the share at the exercise date

Company-issued Equity warrants

Generally attach to corporate bond issues but may be

issued unattached

Warrants may be detachable from the bond and traded

separately

Holder has option to convert warrant into ordinary shares at

specified price over a given period.

No dividends but holders benefit from capital gains if share

price rises above conversion price.