Financial Institutions, Instruments and Markets

8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 5
Corporations issuing equity in the share market
Learning objective 5.1: 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,
those adding 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 firms 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 firms 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.

Both the NPV and the IRR methods are exposed to the limitations and uncertainties of forecast
projections.
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Learning objective 5.2: Identify issues relevant to a corporations 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 5.3: Examine the listing and flotation or initial public offering (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 a 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 (IPO).

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

Learning objective 5.4: Consider important issues 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 exchanges 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.

A multinational corporation may choose to become a dual-listed company by listing its shares on
more than one stock exchange in order to access the wider international capital markets and
increase liquidity in the trading of its securities.

Learning objective 5.5: Explore equity-funding alternatives that are available to an established
listed corporation, including rights issues, share purchase plans, 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.

An alternative method (the share purchase plan) is to offer existing shareholders the opportunity
to invest a fixed dollar amount to purchase additional shares in a company.

Rather than offer additional shares to all existing shareholders, some companies prefer a direct
placement of shares with selected institutional investors, such as funds managers. This can be
finalised 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
are hybrid securities, and differ from ordinary shares in that they offer a fixed dividend that is set
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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 companys 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 at a predetermined price.

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.
The warrants may be detachable and sold separately to the host bond.

Essay questions
Thefollowingsuggestedanswersincorporatethemainpointsthatshouldberecognisedbyastudent.
Aninstructorshouldadvisestudentsofthedepthofanalysisanddiscussionthatisrequiredfora
particularquestion.Forexample,anundergraduatestudentmayonlyberequiredtobrieflyintroduce
points,explainintheirownwordsandprovideanexample.Ontheotherhand,apostgraduate
studentmayberequiredtoprovidemuchgreaterdepthofanalysisanddiscussion.

1. Thedecisiontoproduceandmarketanewproductisanimportantcapitalbudgeting
problemformanycompanies.Thisisespeciallythecaseforthosecompaniesoperatingat
thecuttingedgeofconsumertechnology.OnesuchcompanyisAppleCorporation.Discuss
thecapitalbudgetingprocessfromtheperspectiveofacompanylikeAppleandhowitmay
applytheprocesstoitsproductdecisions.(LO 5.1)

Capital budgeting refers to the investment decision process carried out by a firm.

Within the constraints of the objectives and policies, management will consider a range of
investment opportunities, that is, projects that the firm will consider proceeding with as part of
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.
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Apple is a very innovative company that builds value for shareholders by developing and
marketing new technology. The research and development divisions in Apple conceive the
potential new products that Apple will offer for sale to its customers.

Each new product may be examined within a capital budgeting framework to ensure that ideas
become projects only if there is a good chance that value will be created for shareholders. This
involves estimating costs and revenues and comparing the present value of the cash flows
generated by a project with the capital investment required today.

2. Disney Corporation is considering the re-release of its classic film library. The project will
involve an investment of $78 000 000 and will produce a positive cash flow of $25 000 000 in
the first year. The cash flows will increase by 10 per cent each year thereafter for another five
years (i.e. the project runs for six years). At that stage the project will cease. The company
expects a rate of return of 17 per cent on this type of project. (LO5.1)
(a) Calculate the NPV and the IRR.
Note: present value = S (1 + i)-n
payments per year = 1
net cash flows:

period 0 = -$78 000 000

period 1 = $25 000 000
period 2 = $27 500 000
period 3 = $30 250 000
period 4 = $33 275 000
period 5 = $36 602 500
period 6 = $40 262 750

Because the cash flows are conventional, an IRR can be computed. This can be undertaken by hand,
using a financial calculator or Excel. In Excel, simply use the IRR function to obtain the answer.
Answer:

IRR = 31%

To find the NPV, find the PV of each of the cash flows, add them up and subtract the $78 000 000
investment. The NPV = $32 491 841.
(b) Should the company proceed with this investment opportunity? Why? (LO 5.1)

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. Thehighertheratioofdebttoequity,thehigherthereturntotheshareholders.Therefore,
companiesshouldfundalloftheirprojectswithdebt.'(LO5.2)

Afirmwithahighdebttoequityratioissaidtobeleveraged.Leveragecanincreasethe
returnstoshareholders.

Becauseinterestpaymentsaretaxdeductibleanddebtfinancingmeansthatlessshareholder
equity is required, undertaking projects financed with debt will magnify the returns to
shareholdersiftheprojectsaresuccessful.

Unfortunately,thereisatradeoff.Asdebtfinancingandthedebttoequityratioincreases,
thereisagreaterriskofbankruptcy.Failedprojectsfinancedlargelyorsolelywithdebtleave
thecompanyanditsshareholdersexposed.Unlikedividends,interestpaymentsmustbemade
andacompanythatdefaultsonitsobligationsmaybedeclaredinsolvent.

As such, the debttoequity ratio must be managed prudently and carefully and careful
considerationmustbegiventotherisksinvolvedinincreasingthedebttoequityratio.

4. Debttoequityratiosmayvaryquiteconsiderablybetweenbusinesscorporations.(LO5.2)
(a) Discussthefourmaincriteriathatacorporationshouldanalysewhendeterminingthe
firmsappropriatedebttoequityratio.

Theappropriatedebttoequityratiowillvarybetweenfirms,industriesandstagesofthe
businesscycle.Thefourmaincriteriaare:
1.

Theratiothatisthenormintheindustryinwhichthefirmoperates,and
adoptsomethingnearthatratio.Significantdeviationsfromtheindustrynormmaycause
concernforthepotentialprovidersofbothdebtandequityfunds.

2.

Thehistoryoftheratioforthefirm.Theratioemployedinthepastmaybe
regardedasthenorm,andmanagementmaybereluctanttochangeitgreatly.Ifthebusiness
hasbeenperformingwithareturnonassetsthatisacceptabletoshareholders,itmaybe
deemedappropriatetocontinuewithasimilargearingratio.Anysignificantchangeinthe
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ratiomayresultinthedisaffectionofthecurrentshareholders.
3.

Thelimitimposedbylenders.Itisquitecommonforlenderstoimpose
variousloancovenantsontheborrowingsofacompany.Loancovenantsareconditionsor
restrictionsincorporatedinloancontractsthataredesignedtoprotecttheinterestsofthe
lender.Acommoncovenantisalimitontheratioofdebtliabilitiestototalassets.

4.

Managementsdecisionconcerningthefirmscapacitytoservicedebt.The
assessmentismadebydeterminingthecharges,theinterestpaymentsandtheprincipal
repaymentsassociatedwithagivenlevelofdebt,andassessingthecapacityofthefirms
expectedfutureincomeflowstocoverthepaymentswhileleavingsufficientprofitstosatisfy
shareholdersexpectationsforareturnontheirequity.

(b) Isthefirmsdebttoequityratiolikelytochangeovertime?Supportyouranswerwith
examples.

The debt to equity ratio is the proportion 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 earnings 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 revenue but will still need to make its loan repayments.

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. Again, the global
financial crisis that began in mid-2007 caused a global economic slowdown and evolved into
a sovereign debt crisis impacted business activity and cash flows

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
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forecast changes in economic and business conditions that will affect the level of future
income of the organisation

5. Theownersofasuccessfulprivatestationerybusinesshavedecidedthatthenextstepinthe
companysdevelopmentistoexpandintooverseasmarkets.Inordertoraisethecapital
necessarytosupportthisexpansion,thecompanysownershavedecidedtoinvestigatethe
possibilityoflistingthecompanyontheASX.Youworkforaboutiqueinvestmentbank
andreceivethefirstphonecallfromtheowners.Explaintherolethatyourcompanywill
playiftheownersdecidetoretainyourservicesasanIPOadviser.(LO5.3)

Yourinvestmentbank,actingasanadviser,willprovideadviceonthetimingandstructureof
theIPOandthepossiblepricerangeatwhichthesharesmaybeabletobesold.

Yourbankshouldhaveanunderstandingofthecurrentmarketconditions,especiallyasthey
relate to similar companies in similar industries. As such, the expectations of potential
shareholderscanbecommunicatedtotheownersandasoundapproachtothelistingprocess
canbeundertaken.

Iftheownersdecidetogoahead,yourbankwillprepareaprospectusandlodgeitwiththe
corporateregulator.Yourbankwillalsoensurethatanylegalandregulatoryrequirementsare
satisfied.

YourbankwillpromotetheIPOamongyourexistingclientsandseekoutnewinvestorsin
ordertomaximisethenumberofsharessoldandtheissueprice.

Inreturnforofferingtheseservices,yourinvestmentbankwillchargeafeeofapproximately
1.00percentoftheamountraised.Othercostsmayamounttoabout10.00percentofthe
amountraised.

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 a stock exchange. List and briefly explain the advantages to the company of a
public listing. (LO 5.3)

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 the 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 companys products and services.

7. SantosLimitedhasexpandeditsexplorationprogramandhasdecidedtofundthe
expansionthroughtheissueofadditionalordinarysharestoitsexistingshareholdersona
proratabasisofonenewshareforeach5sharesheld.Theissuepriceis$11.75pershare
andthecurrentmarketpriceis$11.95.Thefinancialadviserstothecorporationhave
recommendedtheuseofanunderwritingfacility.Theboardofdirectorshasnotedthatthe
underwritingfacilityhasanoutclauseifthemarketpricedropsbelow$11.45.Having
regardtothisinformation,answerthesequestions.(LO5.3)
(a)WhattypeofissueisSantosLimitedmakingtoitsshareholders?

The issue by Santos Limited of additional ordinary shares to existing shareholders at a ratio to
the existing shareholding is a pro-rata rights issue.

In the above example the shareholder will receive one new share for each five shares currently
held. The new rights shares will be issued at $11.75 each.

The issue price of $11.75 is 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 new shares.

The right may be renounceable and listed on the stock exchange; the shareholder is entitled to
sell that right before the exercise date; otherwise the right may be non-renounceable.

(b) What is an underwriting facility, and why might Santos use such a facility?

A contractual undertaking by an underwriter to purchase securities that are not fully subscribed
to by the existing shareholders; for example, the underwriter has agreed to buy any surplus
Santos rights issue shares providing the market price remains above $11.45.

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.

Why might Santos use an underwriter?

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) WhatistheoutclauseenteredintobySantos?Discusshowtheoutclauseoperates.

An out-clause is 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 Santos share price falls below $11.45.

8. RioTintoLimitedhasdecidedtosellitsshalecoalpartofthebusinessbyestablishinganew
limitedliabilitycompanytobeknownasShoalLimited.ShoalLimitedwillbealisted
corporationontheASX.RioTintoandShoaldecidetoissuethenewsharesat$2.65,but
throughtheissueofinstalmentreceipts.Aninitialpaymentof$1.25ispayableon
applicationandafinalpaymentof$1.40isdue12monthslater.(LO5.3)
(a)ShoalLimitedwillbealimitedliabilitycompany.Whataretherightsandfinancial
obligationsofshareholdersthatpurchasesharesinthecompany?

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.

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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.

As Shoal is a limited liability company, the claims of creditors against shareholders are limited to
the value of the fully paid ordinary shares issued; for example, as Shoal has issued partly paid
shares (instalment receipts), then the shareholders are required to make the outstanding
instalment payment 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)Thecompanydecidestostructuretheissueusinginstalmentreceipts.Explainhow
instalmentreceiptsoperateandwhythecompanymayhavedecidedonthisstrategy

Shoal Limited has issued instalment receipts. These are issued upon payment of the first
instalment ($1.25) towards the purchase of ordinary shares in the corporation.

When the final instalment of $1.40 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 future dividend payments.

The company may have decided to issue instalment receipts as this may be more attractive to
potential investors (shareholders) in that the full amount does not need to be paid immediately.
Also, the company may not require the use of the full amount of funds until the business is fully
operational and the instalment receipt structure can be designed to meet forecast cash flow
requirements.

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 12 months, at which time it will report
back to shareholders and make recommendations on the viability of the project. (LO 5.3)
(a) What form of legal structure would you recommend the gold exploration company
incorporate? Why would you recommend this structure?
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Based on the available information it seems appropriate that the subsidiary be formed as a noliability 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.

In reality, the shareholder would elect to sell the share prior to the call date.

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

10. An efficient stock exchange will establish listing rules that support the interests of listed
entities, maintain investor protection and ensure the reputation and integrity of the stock
market. To achieve this, a stock exchange will adopt a number of listing rule principles. (LO
5.4)
(a) List and explain five fundamental listing rule principles.
The main principles that form the basis of a stock exchanges listing rules include (Note: students
only need to select five principles):

Minimum standards of quality, size, operations and disclosure must be satisfied.

Sufficient investor interest must be demonstrated to warrant an entitys participation in the

market.

Securities must be issued in circumstances that are fair to new and existing security holders.
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Securities must have rights and obligations attaching to them that are fair to new and existing
security holders.

Timely disclosure must be made of information which may affect security values or influence
investment decisions, and information in which security holders, investors and ASX have a
legitimate interest.

Information must be produced according to the highest standards and, where appropriate, enable
ready comparison with similar entities.

The highest standards of integrity, accountability and responsibility of entities and their officers
must be maintained.

Practices must be adopted and pursued that 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.

(b)Ifamultinationalcorporationseeksduallistingontwostockexchanges,howwillthis
impactonthecorporationsadherencetothelistingrules?

Somelargemultinationalcorporationschoosetolistonmorethanoneexchange.Theshares
ofthecorporationaresaidtohaveaduallisting.

Duallistingisnormallyachievedbythecreationoftwoholdingcompanieseachentitledto
fiftypercentofthegroupsassets.Shareholdersinbothholdingcompanieshaveequivalent
economicandvotingrights.Forexample,BHPBillitonislistedontheASXplustheLondon
StockExchange(LSE)throughtwoholdingcompaniesBHPBillitonLimited(ASX)andBHP
BillitonPlc(LSE).

Theduallistedcorporationisrequiredtomeetthelistingrulerequirementsofeachstock
exchange.

11.WoolworthsLimitedisapubliclylistedcorporation.Itscorebusinessisinsupermarkets.
Woolworthshasdecidedtosetupamajorhardwaregoodschainincompetitionwiththe
WesfarmersLimitedownedBunningsstores.Woolworthsneedstoraiseadditionalequity
capitaltofundtheexpansion.Thecompanyadvisorsrecommendtheboardofdirectors
choosebetweenaproratarightsissueandaprivateplacement.Explaineachofthese

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fundingalternativesanddiscusstheadvantagesanddisadvantagesofeachalternative.(LO
5.5)

Woolworths Limited has the advantage of an established positive reputation which will enable it
to raise further equity funding.

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

Rightsissue:

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.

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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.Insomecountries,suchasAustralia,itiscommonforcorporationstooffershareholdersa
dividendreinvestmentscheme.(LO5.5)
(a) Explainhowdividendreinvestmentschemesoperateanddiscusstheirsignificanceasa
sourceofequityfunding.

Dividend reinvestment schemes allow ashareholder toreinvest all orpartoftheir dividend

entitlementinadditionalsharesinthecompany.

Dividendreinvestmentsharesaresometimesissuedatadiscounttothemarketprice,andwithno
brokerageorothercosts.

Dividendreinvestmentschemesareanimportantsourceofequityfundingformanycompanies.
Shareholders like the option to reinvest their dividend income rather than taking the cash,
particularlyifthecompanyissuccessful.

Thecompanywilltypicallyissuesuchsharesattheaveragemarketpriceofthesharestradedon
thestockexchangeforthefivedaysfollowingtheexdividenddate;lessaspecifieddiscountif
applicable.

(b) Discusstheadvantagesofadividendreinvestmentschemefromthepointofviewofthe
corporationandshareholders.

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.

Dividend reinvestment schemes allow existing shareholders to progressively increase their

shareholding in the company in small increments (the amount of the dividend).

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) Underwhatcircumstancesmightsuchschemesprovetobeunattractivetothedividend
payingcompany?

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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.

13.Fromtimetotime,corporationssuchastheNationalAustraliaBankLimitedmakean
issueofpreferencesharesaspartoftheoverallcapitalstructureoftheorganisation.(LO
5.5)
(a)Explainthestructureandcashflowsassociatedwithapreferenceshare.

Preferencesharesarehybridsecuritiesthatcombinethecharacteristicsofbothdebtandequity.

Preferenceshareshavetheirfixeddividendratessetattheissuedate.

Theyalsorankaheadofordinaryshareholdersintheeventofthewindingupofthecompany.
(b) WhatspecificfeaturesmighttheNationalBankincludeinthestructureofthe
preferencesharetoensureitisattractivetoinvestors,butatthesametimemeetsthe
fundingneedsofthebank?

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 cumulativedividends 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 redeemableentitles the holder to redeem the preference share on a pre-determined date
and receive the par value of the preference share
o convertiblemay 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 participatingholders 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

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o issued at a different rankingwhere first ranked preference shares have preference over
second and other ranked issues for claims on dividends and, in the event of winging up of
the issuer company, to residual assets.
14. Convertible notes, company-issued options and company issued warrants are often
referred to as quasi-equity. (LO 5.5)
(a) What are the characteristics of each of these instruments that serve to distinguish them
from straight equity or debt?
Convertible notes:

are a hybrid security that exhibits the characteristics of both debt and equity during the life of the
security

are issued for a nominated term, generally at a fixed rate of interest

may be converted into ordinary shares in the issuer-company at a specified future date by the
holder of the convertible note

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

may be restricted to a maximum term of five years in Australia, according to the Corporations
Act

may be issued free with a new debt issue, or it may be sold at a premium by the issuing company

Company-issued warrant:

is usually attached to a corporate bond debt issue

is attached to the bond as an incentive for an investor to purchase the bond

gives the warrant holder the right to purchase shares in the issuer company at a specified price
and date

may be detachable. As such warrant can be sold separately to the bond it was originally attached.

(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.

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It allows a company to issue funding instruments that are flexible in that they can be structured
to meet the companys cash flow and future funding requirements.

The special attributes of different quasi-equity instruments may be attractive to investors; for
example the ability to convert to equity at a future date, especially if the issuing company has
been successful and the current share price has risen above the conversion price.

The conversion attribute may mean that a company can issue the quasi-equity debt instrument at
a lower price than straight debt.

Interest payments may be tax deductible.

A company can set the conversion dates of the equity component of a quasi-equity issue to meet
forecast future funding requirements.

Extended learning question

15. Listing on a stock exchange might be highly desirable for a company, but there are a
number of requirements, conditions and costs associated with becoming a publicly listed
corporation. (LO 5.6)
(a) Identify and explain 10 specific requirements that must be met by an Australian company
seeking general admission to the ASX.
Subject to the more detailed requirements specified by the ASX, some of the broad requirements for
general admission to the official list include (question only requires choice of 10 requirements):

Theentitysstructureandoperationmustbeappropriateforalistedentity.

Theentitysconstitutionmustbeconsistentwiththelistingrules.

Aprospectus,productdisclosurestatementorinformationmemorandummustbeissuedand
lodgedwiththecorporateregulator,ASIC.

Aforeignentitymustestablish,inAustralia,anAustraliansecuritiesregister(orsubregister),
appointanagentforserviceofprocessandberegisteredasaforeigncompanyunderthe
CorporationsAct.

Iftheentityisatrust,itmustbearegisteredmanagedinvestmentsschemeandtheresponsible
entitymustnotbeunderanobligationtoallowasecurityholdertowithdrawfromthetrust.

Theentitymustapplyforandbegrantedpermissionforquotationofallthesecuritiesinitsmain
classofsecurities.

Theremustbeatleast500holderseachhavingaparcelofthemainclassofsecurities(excluding
restrictedsecurities)withavalueofatleast$2000.Alternatively,theremustbeatleast400
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holderseachhavingaparcelofthemainclassofsecurities(excludingrestrictedsecurities)with
avalueofatleast$2000,whoarenotrelatedpartiesoftheentitythatmustholdatleast25per
centofthetotalnumberofsecurities(excludingrestrictedsecurities)inthemainclass.(A
relatedpartyisonethathasanownershipinterestintheentityseekingadmission.)

Theentitymustsatisfyeithertheprofittestortheassetstest(discussedbelow).

Iftheentityissuesrestrictedsecuritiesbeforeitisadmitted,itmustcomplywiththerelated
listingrules.

Specialconditionsapplyifanentityissuedclassifiedassetsinthetwoyearspriortoapplication.

Iftheentityhasoptionsonissue,theexercisepriceforeachunderlyingsecuritymustbeatleast
20centsincash.

TheentitymustappointapersontoberesponsibleforcommunicationwiththeASXinrelation
tomattersassociatedwiththelistingrules.

Anentityseekinglistingmustadvisetheextenttowhichitwill,uponadmittance,complywith
therecommendationsoftheASXCorporateGovernanceCouncil.Theentitymustadvisethe
ASXofthereasonfornoncompliancewithalltherecommendations.

AnentitythatistobeincludedintheS&P/ASXAllOrdinariesIndexmusthaveanaudit
committee.Iftheentityisincludedinthetop300oftheindex,itmustcomplywiththe
recommendationoftheASXCorporateGovernanceCouncil.

TheentitymustagreetoauthenticateandprovidedocumentstotheASXelectronically.

TheentitymusthaveatradingpolicythatcomplieswiththeASXlistingrules.

(b) Discuss the ASX profit test and asset test requirements and explain why these rules are in
place.
TheobjectivesoftheASXincludetheprovisionofafairandwellinformedmarketforfinancial
securitiesandtheprovisionofaninternationallycompetitivemarket.TheASXlistingrulesarea
keyelementinachievingtheseobjectives.Theprofittestandassetstestareacomponentof
achievingthisobjective.Thatis,theASXlistingrulesseektoensurethatcompaniesobtaining
listingontheASXareabletodemonstrateacapacitytooperateafinanciallysustainable
business.
Tomeettheprofittestrequirementofadmission,anentitymustsatisfyeachofthefollowing
conditions:

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Theentitymustbeagoingconcern,orthesuccessorofagoingconcern.

Theentitysmainbusinessactivityatthedateitisadmittedmustbethesameasitwasforthe
lastthreefullfinancialyears.

Theentitymustprovideauditedfinancialstatementsforthelastthreefullfinancialyears.The
financialstatementsmustbeaccompaniedbyauditreports,whichmustnotbequalifiedwith
regardtotheentityscapacitytocontinueasagoingconcern,orsatisfytheprofitlevelsrequired.

Theentitysaggregatedprofitfromcontinuingoperationsforthelastthreefullfinancialyears
musthavebeenatleast$1million.

Theentitysconsolidatedprofitfromcontinuingoperationsforthe12monthstoadatenomore
thantwomonthsbeforethedatetheentityappliedforadmissionmustexceed$400_000.

TheentitymustgivetheASXastatementfromalldirectors(inthecaseofatrust,alldirectorsof
theresponsibleentity)confirmingthattheyhavemadeinquiriesandnothinghascometotheir
attentiontosuggestthattheeconomicentityisnotcontinuingtoearnaprofitfromcontinuing
operationsuptothedateofapplication.

Theassetstestrequirementofadmissionisasfollows:

Atthetimeofadmissionanentitymusthavenettangibleassetsofatleast$2millionafter
deductingthecostsoffundraising,oramarketcapitalisationofatleast$10million.

Theentitymusthaveeitheroneofthefollowing:
o Lessthanhalfoftheentitystotaltangibleassets,afterraisinganyfunds,mustbecashorina
formreadilyconvertibletocash.
o Halformoreoftheentitystotaltangibleassets,afterraisinganyfunds,mustbecashorina
formreadilyconvertibletocashandtheentitymusthavecommitmentsconsistentwithits
businessobjectivestospendatleasthalfofitscombinedcashandreadilyconvertibleassets.
Thebusinessobjectivesmustbeclearlystatedandincludeanexpenditureprogram.Ifthe
prospectusdoesnotcontainastatementofthebusinessobjectives,theentitymustgivea
statementofitsbusinessobjectivestotheASX.

Theentitymustsatisfyeachofthefollowing:
o Ifitsprospectus,productdisclosurestatementorinformationmemorandumdoesnotcontain
astatementthattheentityhasenoughworkingcapitaltocarryoutitsstatedobjectives,the
entitymustgivetheASXastatementpreparedbyanindependentexpert.
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o Theentitysworkingcapitalmustbeatleast$1.5million,or,ifitisnot,itwouldbeatleast
$1.5millioniftheentitysbudgetedrevenueforthefirstfullfinancialyearthatendsafter
listingwasincludedintheworkingcapital.Forminingexplorationentities,theamountmust
beavailableafterallowingforthefirstfullfinancialyearsbudgetedadministrationcostsand
thecostofacquiringplant,equipmentandminingtenements.Thecostofacquiringmining
tenementsincludesthecostofacquiringandexercisinganoptionoverthem.
o Anentitymustprovidefinancialstatementsforthelastthreefullfinancialyears.The
financialstatementsmustbeaudited,andmustincludeauditreports.
(c) Identify and explain the different costs that a company will have to meet in the process.
What impact will these have on the liquidity management of the firm?
Theextentofthecostsoflistingwilldependultimatelyonthecomplexityoftheissue,theamountof
equityissued,themethodofissuingthesecurities,thenumberofadvisersinvolvedandthelevelof
marketingundertaken.
Anindicativelistofinitialexpensesthatmaybeincurredinclude:

underwritingandhandlingfees

floatmanagementfees

legalfees

accountingandtaxationfees

otherexpertadviserfees

printingcosts

advertisingandmarketingcosts

shareregistryexpenses.

SpecificfeeschargedbytheASXinclude:

ASXinitiallistingfees

ongoingannuallistingfees

otherfeesasdeterminedbytheASX.

Specific fees payable to the ASX in relation to official listing include:

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aninprincipledecisionfee

aninitiallistingfee

afeeforexaminationofdocuments

annuallistingfees.

Fees charged by the stock exchange will vary from time to time, and will depend on the type of
security issued, equity or debt, and the amount of the securities listed. The cost of listing places a
significant initial demand on the liquidity management of a corporation. That is, the listing
corporation must ensure that it has access to sufficient sources of cash to be able to meet these
additional cash flow needs as they arise. This will usually be before capital has been received from
the listing.

FINANCIALNEWSCASESTUDY
In Chapter 5 we introduced the main types of equity funding available to corporations. We
learned that a significant step in the lifetime of any corporation is its initial listing on a stock
exchange. The IPO process is a multifaceted and sometimes dramatic event. This is especially
the case when the company that is listing on the exchange is a well-known one. Media
interest is high and speculation about the fate of the IPO can be very intense. In recent years,
the IPO of Facebook and the subsequent performance of its shares has attracted a lot of
attention. The story behind the IPO provides a fascinating insight into the process in a context
made all the more interesting by the strong likelihood that the average finance student will
have more than a passing familiarity with the companys product: a social network.

Soon after listing, Facebooks shares were trading at a considerable discount to the issue
price. A falling share price is something that owners of privately held companies do not have
to worry about. The companys value is important, of course, but it is not flashed before
everyones eyes on a daily basis. A private company is also insulated from what is generally
perceived to be the short termism of the stock market. Rather than concentrate on
continually beating a quarterly earnings estimate, management can focus on the longer-term
development of the company.
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The financial news media has argued that Facebooks founder, Mark Zuckerberg, perhaps
wary of the financial markets and Wall Streets professional money managers, wanted to put
off becoming a public company as long as possible and kept Facebook private for a much
longer period of time than other internet companies such as Amazon. Although this postponed
the constant scrutiny of market commentators, fund managers and analysts, it created another
problem. To raise capital, Facebook needed private investors. This placed a limit on how
much capital could be raised and started the clock ticking towards the day when these
investors would desire to sell their investment. Arguably, it also reduced the pressure on the
company to innovate. Facebook eventually listed on the stock exchange in 2012. According
to Forbes:

Waiting eight years to conduct an IPO, however, has turned out to be an impossible problem
to manage. The hype associated with the hottest company in Silicon Valley had created
massive expectations and lots of shareholders with tons of stock looking for an exit. But the
numbers that Facebook announced in its first quarterly earnings report were underwhelming.

With a falling stock price, high expectations, investors seeking to cash in their investments
and other investors waiting to see what Facebooks next big move or next big idea will be, the
business is being run under an intense spotlight. Although there are a number of reasons why
owners and managers might wish to keep a company in private hands, this approach also
entails risk. Sometimes, the constant scrutiny of Wall Street can force a company to keep
moving forward. According to Forbes:

The lesson of the Facebook fiasco for Silicon Valley is clear. Start-up entrepreneurs cannot
evade the discipline of the capital markets any more than can the prime ministers of Spain
and Italy. The markets have a way of focusing the mind. Zuckerberg & Co. might have not
been so late to embrace mobile or might have had more urgency to develop a monetizing
strategy had Facebook faced the trading hordes earlier.
SOURCE: Extract from Vardi, N., Mark Zuckerbergs Big Facebook Mistake, Forbes, 27 July 2012.

DISCUSSION POINTS
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Timing is everything in the IPO business. Did Facebooks management wait too long
before taking the company public? What are some of the funding problems that
beset the company as a result of delaying the IPO?
The author of the article certainly implies that Facebooks management waited too long
before taking the company public. The main problem is that capital still needs to be raised
and raising capital privately might postpone, but cannot eliminate, the eventual need to
access the organised capital markets. In fact, delay may create different problems,
including the creation of a group of shareholders who are increasingly anxious to realise
at least some of their profits. Upon eventually listing, therefore, the company faces a
more complex task in managing investor relations.

Discuss the rationale for delaying an IPO and keeping a company private.
The main rationale for keeping a company private is to avoid the discipline of the
markets. Some managers believe that the very short-term focus of the investment
business is an undesirable distraction from their pursuit of longer-term value creation.

Is being at the mercy of the markets something to be avoided or can the pressures
of being a publicly held company foster innovation?
Although arguments can be made to the effect that money managers focus too much on
the short term, it is also the case that a company that is punished in terms of a falling
share price for poor performance has an added incentive to focus its energies on creating
market value. That means finding and undertaking new project ideas.

True/False questions
1. FThetimevalueofmoneyconceptsaysthatmoneyreceivedtodayisworthnomoreandnoless
thanmoneyreceivedatsomepointinthefuture.
2. TAnimportantstepinmaximisingshareholdervalueistheselectionofprojectsthathave
positivenetpresentvalue.
3. TAprojectshouldbeacceptedandundertakenwhenevertheinvestmentcosttodayminusthe
presentvalueoftheprojectsfuturecashflowsispositive.
4. FWhenevertheNPVispositive,theIRRwillbelessthantherequiredrateofreturnandvice
versa.
5. FTheIRRwillreturnaclearcutresultwhenevertherearemorethantwochangesofsigninthe
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cashflowsseries.
6. FRegardlessofaperiodofeconomicgrowthoraneconomicdownturn,ahigherdebttoequity
ratioshouldgenerateahigherreturnonequityforshareholders.
7. FThecorporateregulatorhasstipulatedastandardoptimaldebttoequityratiothatmustbe
maintainedbyallcorporations.
8. TAprospectusincludesdetailedinformationonthepastandforecastactivitiesofan
organisation.
9. FTheflotationofabusinessreferstotheactionsoftheliquidatorswhenacompanygoesinto
liquidation.
10.

TAcompanyissuingnewsharesisassuredtheywillallbetakenupiftheissueis

underwritten,unlessanoutclauseintheunderwritingagreementistriggered.
11.

FThelistingrulesofthestockexchangeprovidecorporationswithausefulguidelineonhow

tostructuretheirbusinessactivities.
12.

TDuallistingprovidesmultinationalcorporationswithgreateraccesstotheinternational

capitalmarkets.
13.

FAproratarightsissueofnewsharestoexistingshareholdersissaidtobenon

renounceableiftherightcanbesoldtoanotherinvestor.
14.

FAnissueofordinarysharestoretailinvestorsmustbeaccompaniedbyamemorandumof

informationthatdetailstheactivitiesandfinancialpositionoftheissuingcorporation.
15.

TOneadvantageofaplacementofnewsharesisthatacompanycanissuethesharesquickly

andatalowerdiscounttothecurrentmarketpricethanitcouldwitharightsissue.
16.

FAcumulativepreferencesharenormallyreinveststheperiodicfixeddividendpayments

andtheaccumulatedtotalisrepaidatmaturity.
17.

FApreferenceshareissueisgenerallynotlistedonastockexchangeastheshareshaveonly

limitedliquidity.
18.

TConvertiblenotesaredebtinstrumentsthatprovidetheholderwiththerighttoconvertthe

notesintoordinarysharesatadeterminablepriceandataspecifieddate.
19.

FCompanyissuedshareoptionsguaranteetheissuingcompanyfutureequityfundingatthe

optionexercisedatewhichcanbesettocoincidewithfuturefundingrequirements.
25

20.

TCompanyissuedequitywarrantsareoftenattachedtoacorporatebonddebtissueandgive

theholdertherighttoconvertthewarrantintoordinarysharesintheissuingcompany.

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