ACCA paper f9 financial management study materials F9FM session08 d08

SESSION 08 – EQUITY FINANCE OVERVIEW Objective To understand the options available to a company considering an issue of equity funds EQUITY FINANCE METHODS OF SHARE ISSUE INTERNAL EQUITY FINANCE Quoted Unquoted Considerations Official Listing AIM Listing Rights issue Enterprise Investment Scheme Venture capital DIVIDENDS DIVIDEND POLICY Stable Constant payout ratio Residual dividend policy Clientele theory Bird in the Hand Theory Dividend Irrelevance Theory Share Buy Back Programmes Special Dividends Practical considerations OTHER TYPES OF SHARE ISSUE Bonus issue Stock splits Scrip dividends 0801 SESSION 08 – EQUITY FINANCE METHODS OF SHARE ISSUE 1.1 New shares — quoted companies If a company is already listed the following methods are available for the issue of new shares Method Explanation Offer for subscription (public issue) A sale direct to the general public This is generally the most expensive method of issuing new shares Offer for sale A sale indirect to the public via selling shares directly to an issuing house (merchant/investment bank) which then sells them to the public Placing In a placing the sponsor (normally a merchant bank) places the shares with its clients At least 25% of shares placed must, however, be made available to the general public This is generally the least expensive method of issuing new shares Rights issue An offer to existing shareholders to buy shares in proportion to their existing holdings Offer for sale or subscription by tender Like an auction – the public is invited to bid for shares Useful where setting a price for the shares is difficult Vendor placing Sometimes used in takeovers when a predator company buys a target company by offering its own shares but pre-arranges third party buyers for those shares The result is that the target company shareholders are confident that they will be able to sell the shares they receive in the predator company 1.2 Options for unquoted companies Become quoted, i.e raise new equity finance at the same time as becoming listed – known as an IPO (Initial Public Offering) The method could be an offer for subscription or sale, tender, or placing Stay unquoted Use rights issue or private placing However there may be a limited source of funds from either existing owners or new private investors Introduction Existing shares are given permission to be traded/”floated” on the Stock Exchange No new finance is raised Public must already hold at least 25% of the shares in the company Commentary The terms “quoted”, “floated” and “listed” all refer to the same thing i.e shares which are traded on a stock exchange 0802 SESSION 08 – EQUITY FINANCE Many small or medium sized enterprises (SME’s) find that raising equity is difficult This is an acknowledged problem and has been addressed by both government and commerce Attempted solutions include the AIM, Enterprise Investment Schemes, Venture Capital and Venture Capital Trusts (discussed later) 1.3 Considerations when considering a share issue Legal restrictions; Cost e.g fees must be paid to an investment bank to underwrite/guarantee the share issue Pricing problems; Stock Exchange rules as contained in the Yellow Book; Timing 1.4 The requirements for an Official Listing Before the shares of a company can receive an Official Listing i.e become traded on the full London Stock Exchange, the following requirements must be met: The market capitalisation (value) is at least £700,000; There is a three year trading record; At least 25% of the shares are made available to the general public; Detailed disclosure requirements are met; Any new issue of shares is accompanied by a detailed prospectus The costs of acquiring and maintaining an Official Listing mean that it is not really a possibility for Small or Medium-sized Enterprises (SME’s) These companies may find the AIM market more attractive 1.5 The requirements for an Alternative Investment Market (AIM) Listing The AIM market has fewer regulations and in this way is attractive to smaller companies Investors recognise that due to the more limited regulation, investment in AIM companies carries additional risk The requirements include: Companies must have plc or equivalent (if non-UK) status; The accounts must conform to UK or US accounting practice; A prospectus must be published prior to the initial quotation and any following issue of securities; The company must appoint a “nominated advisor” which may be an investment bank, accountancy or law firm to ensure that it understands and obeys the rules of the market 0803 SESSION 08 – EQUITY FINANCE 1.6 Rights issue In a rights issue existing shareholders are offered more shares (usually at a discount to the current market price) in proportion to their existing holding UK company law guarantees shareholders “pre-emptive rights” i.e the right to purchase new shares before they can be offered to other investors This is to protect shareholders from dilution of their control The result of issuing these shares at a discount is to reduce the market value of all the shares in issue Calculation of a theoretical ex-rights price Example A company has 100,000 shares with a current market price of $2 each It then announces that it is to take on a project with a NPV of $25,000 The project will be financed by a rights issue of one new share for every two existing shares The rights price is $1 per new share Required: What is the theoretical ex-rights price of the company’s shares? Shareholder wealth and rights issues Example Assume in Example above that Mr X owns 1,000 shares in the company Required: Show Mr X’s position if: (i) (ii) (iii) 0804 he takes up his rights; he sells his rights; he does nothing SESSION 08 – EQUITY FINANCE 1.7 Enterprise Investment Scheme (EIS) A UK scheme designed to encourage private investors to buy shares in unlisted trading companies Tax relief, at an income tax rate of 20%, is available for investors Maximum investment is £100,000 per annum Shares must be held for five years 1.8 Venture capital What is it? “Venture capital” simply means equity capital for small and growing businesses It includes funds provided for management buy-outs Typically $1m minimum is involved Who provides it? Specialist venture capital providers, e.g “Investors In Industry” (the 3i Group); Banks, insurance companies, pension funds; Local authorities and development agencies What they look for? Product with strong potential e.g a new innovation ; Solid management; High returns What conditions are normally attached? Providers of funds would normally expect: a business plan with medium-term cash flow and profit projections ; board representation; a dividend policy which promotes growth i.e high reinvestment of profits; an “exit route” e.g proposed time-scale for seeking a market quotation; provision of regular management accounting information Venture Capital Trusts (VCTs) VCTs are listed investment trust companies which invest at least 70% of their funds in a spread of small unquoted trading companies An investment trust company one is which invests in other companies The UK government gives tax incentives to individual investors in VCTs 0805 SESSION 08 – EQUITY FINANCE INTERNAL EQUITY FINANCE As an alternative to issuing new shares (or debt) a company can finance its investment projects using retained earnings i.e using internal finance rather than external finance The amount of internal finance available = cash generated from operations – dividend payments Creating accounting profits is not enough – the company must be converting profits into positive cash flows Note that Microsoft did not pay any dividends for many years - it reinvested all cash to produce growth of the company and its share price Any shareholder that required a dividend could simply sell some shares to take a capital gain and create a “home- made dividend” Company managers may prefer to use internal finance rather than external finance for the following reasons: a belief that using internal finance costs nothing – in fact this is not true as retained earnings belong to the shareholders who expect significant returns “asymmetry of information” – external investors not have as much knowledge of the business as the management and are therefore often reluctant to provide finance or will only provide it at high cost This is particularly significant for SME’s which often have problems attracting new investors due to little public knowledge of the business Using internal finance avoids the problem no issue costs on internal finance internal finance avoids possible change in control due to issue of new shares taxation position of shareholders: - they may prefer to make a capital gain than receive current income via dividends e.g in the UK individuals are given a large tax-free limit on capital gains This preference for internal finance has been refereed to as “Pecking Order Theory” DIVIDEND POLICY 3.1 Stable Stable level of dividends or constant level of growth to avoid sharp movements in share price Maintains the level of dividends in the face of fluctuating earnings Very common approach for quoted companies 0806 SESSION 08 – EQUITY FINANCE 3.2 Constant payout ratio Constant proportion of earnings paid out as dividend; Not particularly suitable as dividends will fluctuate 3.3 Residual dividend policy Remaining earnings, after funding all attractive projects, are paid out as dividend i.e dividend = cash generated from operations – capital expenditure Links to Pecking Order Theory i.e a dividend is only paid if more cash is available than required for reinvestment back into the business However it is likely to lead to fluctuating dividends and may not particularly suitable for quoted companies 3.4 Clientele theory The company’s historical dividend policy may have attracted particular investors to whom the policy is suited in terms of tax, need for current income, etc The company should then maintain a stable dividend policy or risk losing key investors Management should view shareholders as their “clientele” 3.5 Bird in the Hand Theory Shareholders may prefer higher dividends (and therefore lower potential capital gains) as a cash dividend today is without risk whereas future share price growth is uncertain 3.6 Dividend Irrelevance Theory Modigliani and Miller (finance theorists) argue that shareholders are indifferent to dividend policy If a company pays no dividend then the share price should rise due to reinvestment of earnings Any shareholder that requires a dividend can sell part of their holding to create a capital gain i.e to manufacture a “home made” dividend 3.7 Share Buy Back Programmes In recent years there has been a trend for traditional dividend payments to be replaced by share repurchase schemes With approval from shareholders the company uses surplus cash to buy back part of its share capital, on the assumption that shareholders can reinvest this cash more effectively than the company The buy back can be performed either by writing directly to all shareholders with an offer to buy shares at a fixed price (a “tender offer”) or by purchasing shares via the stock market at the prevailing price 0807 SESSION 08 – EQUITY FINANCE The shares are either cancelled as held by the company as Treasury Shares for possible future reissue If held by the company the shares carry no voting rights or dividend The result of a buy back programme is that there will be fewer shares in issue, and hence the share price should rise Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also improve 3.8 Special Dividends If a quoted company announces a larger than expected dividend this may raise market expectations of at least the same in future To avoid raising expectations to an unsustainable level the dividend may be announced as a “special” dividend – basically a bonus dividend The company is telling the markets that, from time to time, any exceptional cash surplus will be returned in this way, but that this should not be built into dividend per share forecasts 3.9 Practical considerations Company law - a dividend can only be legally paid if there is a credit balance on retained earnings in the statement of financial position Level of inflation Liquidity position Stability of earnings – if earnings are stable, a larger dividend can be more easily maintained “Signalling” – dividend announcements are seen by the financial markets as a sign of company strength/weakness OTHER TYPES OF SHARE ISSUE 4.1 Bonus issue Reserves e.g revaluation reserve is converted into share capital which is distributed as new shares to existing shareholders in proportion to their existing holdings No finance is raised Purpose − Increases the marketability of the shares, as it increases the number in existence and reduces their price Bonus issues can also be referred to as Scrip Issues or a Capitalisation of Reserves 0808 SESSION 08 – EQUITY FINANCE 4.2 Stock splits Where ordinary shares are split in value, e.g $1 shares converted into two 50 cent shares This reduces the market price per share, increasing their marketability 4.3 Scrip dividends Shareholders are offered extra shares instead of a cash dividend This preserves corporate liquidity and releases cash for reinvestment back into the business - linking to Pecking Order Theory Key points Ordinary shareholders take more risk than any other type of investor in a company This is because (i) ordinary dividends are discretionary i.e the company has no legal obligation to pay an ordinary dividend (ii) ordinary shareholders rank last in the event of bankruptcy/liquidation Shareholders require high returns to compensate for this risk and therefore issuing new shares is an expensive source of finance However sometimes a new share issue is the only available source of finance and therefore you need to be familiar with the methods of issue available to both listed and unlisted companies 0809 SESSION 08 – EQUITY FINANCE FOCUS You should now be able to: describe the methods available for issuing new shares; describe ways in which a company may obtain a stock market listing; calculate the theoretical ex-rights price of a share; explain the importance of internally generated funds; discuss the main dividend policies followed by companies; explain the purpose and impact of a bonus issue, scrip dividends and stock splits; discuss the financing problems of small and medium sized enterprises (SME’s); suggest appropriate sources of equity finance for SME’s e.g AIM, venture capital, EIS 0810 SESSION 08 – EQUITY FINANCE EXAMPLE SOLUTIONS Solution Ex-rights price = = MV of old shares pre - rights issue + Proceeds of rights issue + NPV No of shares ex - rights (100 ,000 × $2 ) + ( 50 ,000 × $1) + $25,000 = $1.83 100 ,000 + 50 ,000 Value of a right per new share = Ex-rights price – Subscription price = $1.83 – $1 = 83c Value of a right per existing share = 83c ÷ = 41c Note - If the market price of the existing shares had been given post the announcement of the project, then the NPV of $25,000 would already be included in the MV of the old shares This is the more usual circumstance Solution (i) Takes up rights Wealth prior to rights issue 1,000 × $2 $ 2,000 Wealth post rights issue Less Rights cost 1,500 × $1.831/3 500 × $1 2,750 (500) 2,250 ∴ $250 better off 0811 SESSION 08 – EQUITY FINANCE (ii) Sells rights Wealth prior to rights issue 1,000 × $2 $ 2,000 Wealth post rights issue Shares Sale of rights 1,000 × $1.831/3 500 × $0.831/3 1,8331/3 4162/3 2,250 ∴ $250 better off (iii) Does nothing Wealth prior to rights issue $ 2,000 Wealth post rights issue 1,8331/3 ∴ Loss of $166 0812 ... capital” simply means equity capital for small and growing businesses It includes funds provided for management buy-outs Typically $1m minimum is involved Who provides it? Specialist venture capital... development agencies What they look for? Product with strong potential e.g a new innovation ; Solid management; High returns What conditions are normally attached? Providers of funds would normally... profits; an “exit route” e.g proposed time-scale for seeking a market quotation; provision of regular management accounting information Venture Capital Trusts (VCTs) VCTs are listed investment trust