CT-2 Notes. Part I

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Finance and Financial Reporting

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Chapter 1

Key Principles of Finance

Introduction to Finance

Real assets mean the resources used by the company in their normal line of business to generate profits.

Real assets are of two types:

1) Tangible assetswhich physically exist

2) Intangible assetswhich physically do not exist

Financial manager stands between the Firms objective and Financial Market.

Main role of Financial manager is capital budgeting decision (What the real assets should the firm investin?) and financing decision (How to raise the finance for the real assets?).

For financial manager capital budgeting decision is often complicated because of

a) There is to choose one project between many possible profitable projects.

b) It is very difficult to anticipate the future profitability of the project.

Normally Financial decisions are taken by remit of controller, many times it is known as Chief Financial

Officers.

Role of Treasures:

1) Looks for after the companys cash2) Raises new capital and

3) Maintains relationships with banks, investors and shareholders.

Financial Analysis:

Progress in management depends on applying the logic to experiences, to known or assumed facts in

order to enlarge the area of understanding. Financial analysis may not improve the actual fortune of the

project but it may nevertheless be able to:

1) Delineate the risk involved with project.

2) Highlight the salient features of project.

3) Possibly suggest methods by which these risks can be reduced.In short financial analysis means, financial implications of different possible course of actions.


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Bussiness Objectives:

There are many groups involved in running a company: shareholders, managers,

employees, lenders, customers, suppliers, the government. We must consider theirinterests and their role.

A company is owned by the shareholders, shareholders appoint board of directors to run a

company on their behalf and directors appoint a managers which are expert in their field and

director delegate the operational decision making to the executives while retaining the control of

strategic issues. This is known as divorce of management from control.

Such separation of ownership from management

has advantages i.e. freedom for changing ownership without affecting to change the operational

activities, freedom to hire professional managers

has disadvantage i.e. if the advantages of owner and managers diverge.

Conflicts between providers of finance:

Conflict can arise between the shareholder and lenders of the company, shareholders may be interested

in the high return and high risk projects whereas lenders may not be interest in the such projects, they

simply interested in the getting their capital payments and interest promised.

This can be characterized as the difference between the lenders short term desire for security and the

shareholders long term interest in the development of the company.

Conflicts between employees and managers:

Conflicts can arise between the shareholder and managers may wish to invest in labour-saving

technology, but workers may fear the loss of jobs, and consumer fears issue of quality.

Conflicts between companies and community/government:

Shareholders, management and employees wish to expand production on a Greenfield site, but the local

community and local government fear reduction in quality of life and air pollution and more congestion.

Agency Theory

Agency theory, which considers the relationship between the principal and its agent, includes issues

such as the nature of the agency cost, conflicts of interest and how to avoid them and how to incentivize

and motivate the agents

a) Agency cost arise due to the monitoring the managersb) Agency cost arises due to the seeking to influence the managers actionc) Agency cost arises due to the managers do not act in the owners best interest.


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Maximisation of Shareholders WealthThe needs of shareholders will vary according to the factors such as:

1) Attitude towards risk2) Time preference and consumption needs3) Balance between need of income and capital growth4) Tax PositionCapitalMarkets

For large, publicly quoted companies, the stock market serves as the performance monitor.

Share prices of company changes with the markets perception to the firms profits and future

expected performance.

Business organizations are, therefore, directly and measurably subject to the disciplines of the

financial markets. These markets are continuously determining the valuations of business firms

securities, thereby providing measures of the firms performance. The presence of the capital

markets continuous assessment therefore stimulates efficiency and provides incentives to

business managers to improve their performance.

Key effects of the capital markets on a firm's decisions include:

Sound investment decisions require accurate measurement of the cost of

capital

Limitations in the supply of capital focus attention on methods of raising

finance

Mergers and take-overs create threats and opportunities to be exploited

Externalities require managers to determine the appropriate role oforganizations


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Chapter 2

Company ownership

Types of business entity

Sole Trader:

Description

A sole trader is business entity owned by one person and which is not a limited company. Sole traders

have unlimited legal liability for their business debts.

Definition refers to an ownership of a business, there can be sole traders who have employees working

for them.

The sole trader can decide what to do with the business. (eg pass it on to an offspring)

The sole trader can draw the money as and when he or she needs it.

Liability

Sole trader has unlimited liability. Means if a customer sues the sole trader, the total personal wealth of

the sole trader, including his house and bank deposits, would be available to pay off the liabilities.

Legal and accounting documentation

A sole trader has to fill in a normal income tax return & no specific documentation is needed to legally

establish this form of the business.

Partnership:

Description

A partnership is business entity which is owned by more than one person and is not a limited company.

Partnership can be owned in equal or unequal amount by partners. Usually, partners will be involved in

the running of business, but some partners may just provide the money and dont participate in day to

day running of the business, such partners are known as sleeping partners.

Partners will draw money out of the business time to time. This can be more or less (often less) than

their share of profits. The internal accounts will show any surplus/deficit in each partners capital

account resulting from over or under drawing and from capital (finance) provided to the partnership.


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Liability

The owners have unlimited liability towards their business debts. All the partners are jointly liable for

the business debts.

They will also be severally liable, that is, each partner is liable to the full extent of his/her personal

estate for the deficiencies of the partnership.


Most partnerships will have a legal documentation known as Partnership Agreement which sets out

the rights of individual partners. Like who will be taking decisions and how profits are shared among

partners.

The partnership also needs to provide the accounts to Her Majestys Revenue and Customs (HRMC) so

that they can work each partners liability for the tax on their share of profits.

Partners pay income tax.

Limited Companies:

Description

A limited company is the business entity which has legal identity separate from the owners of the

business.

It can own or deal in property in its own right. It can arrange contracts on its own behalf. It can sue and

sued. A company can be fined by the court (but cant be imprisoned!).

Most of the companies are owned by shareholders. They hold a certificate which states the number of

shares hold by them in the company. The shareholders appoint directors who are responsible for thecontrol of the business. Directors appoint managers who carry out directors policies on day to day basis.

Sometime directors are elected as managers, in which case they are known as executive directors.

Directors who are not involved on daily basis are known as non-executive directors.

Liability

The owners liability is limited to the fully paid value of their shares. Shareholders have been issued

Partly Paid then, in the event of liquidation, shareholders will only be liable to the outstanding

installments. If the shares are full paid, the shareholders have no further liability. If shares have been

issued at premium to their par value, the whole of this Share premium is payable at the outset, even if

the shares are issued on a partly-paid basis. If the company becomes insolvent, creditors cannot claimfurther payment from the shareholders personal wealth beyond the fully paid value of their shares.


Limited companies must have a Memorandum of Association and Article of Association.

The Memorandum of Associations states the name of the company, its objectives, the total share

values, their par values, etc. It must be sent to the registrar of the company before the company can be


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formed.

Articles of Association lay down the internal rules by which the directors run the company and set out

the rights of owners of the different classes of share capital. The contents includes internal

arrangements such as voting rights of different classes of shares, rules for electing directors, payment of

dividends and winding-up provisions.

All companies must produce audited accounts each year.

Companies pay corporation tax on the profits earned. Employee pay income tax on the wages and

salaries earned.

Limited Liability Partnerships:

Description

This is a business vehicle that gives the benefits of l imited liability whilst retaining other characteristics

of a traditional business partnership.

Any firm consisting of two or more members engaged in profit making venture, may become LLP. Unlikelimited companies, there are no directors and no shareholders.

LLP is separate legal entity, which can hold the property and to continue in existence regardless of

changes in membership. Any third party dealing with LLP makes a contact with the LLP rather than with

a member.

Liability

Whilst the LLP is responsible for its assets and liabilities, the liability of it members is limited. (As with

companies, however, actions may be taken against individual member who are found to be negligent

and fraudulent in their dealings.)

Legal and accounting documentationUnlike a limited company, it has no Memorandum and Articles of association. It is governed by the

partnership agreement that may already be in force within the existing partnership. In the absence of

any agreement mutual rights and duties, it will be governed by the default provision in the regulations.

Like a company it has to be registered at Companies House.

An incorporation document must be submitted and signed by at least two persons, who will become the

first members of LLP. A LLP is required to appoint at least two designated members who will be

responsible for number of duties in running the LLP.

LLP is taxed in the same way as partnerships are taxed.

Private and Public Limited Companies:

Public limited company

A public limited company is a company whose memorandum states that it is a public company and has a

share capital of at least 50,000 pounds. The name of the public limited company must end with Public

Limited Company or PLC.


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Private Limited Companies

All other companies are known as private limited companies. The private companies name must end

with word Limited. They are not allowed to issue their shares to public.

Pros and Cons ofLimited Company

Advantages of Limited Companies

1) it makes easier to raise the capital.

2) It is important for business ventures involving a risk of incurring substantial debts. Ex. Insurance

companies which cannot exist without limited liability.

3) It is also important for the business which requires large amounts of capital.

4) Limited Liability Company allows large number of people to invest small amount of money with

relatively minimal checking of the companys prospect which allows them to diversify their exposure to

the sectors and reduces the risk of failure.

Tight Shareholding

In small companies, each shareholder can be executive director and can have some control over the

company which is known as tight shareholding.

Divorce of ownership from control

In most of the companies, number of shareholders is very large and they take little or no part in the

management of the company which is known as divorce of ownership from control.

It allows the changes in the ownership without interference to operation of the business.

It also allows to hire the professional managers.

Disadvantages of Limited Companies

1) Once the companys assets have got exhausted, trade creditors have no way of ensuring the payment.

2) It allows people to invest in the company for their short term interest, without looking into the long

term interest of the company.

3) For shareholders, managers interest may be different from that of shareholders which is known as

agency problem.

4) There is also a problem of information asymmetries where different stakeholders in the company has

a different information about the company.


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Loan facility is the type of facility in which borrower can borrow amount in installments, giving bank a

few days notice before each new bit is taken out.

Multi currency loan is the type of loan in which bank acts as the middle man arranges the money for the

borrower in whichever currency it is best to borrow in.

Syndicated loan is the type of loan in which various banks come together and give loan to the single

project.

Short Term Company Finance

Bank Overdrafts

An overdraft is the facility in which a borrower can withdraw money out of its current account such that

it becomes negative, down to an agreed limit. The borrower makes interest payment on the amount by

which he or she is overdrawn. No explicit repayments are made.

Overdrafts offered to companies are secured by floating charge, which is more than the bank loan of

same amount.

A bank can demand immediate repayment of an overdraft without any prior notice.

Trade Credit

Trade credit is the type of agreement between the company and one of its suppliers to pay for the

goods and services after they have been supplied.

In most cases no explicit interest is charged, in most countries late payments are so common that

explicit discounts can be negotiated for not using trade credit.

Using trade credit to the full is the way to obtain free finance for the company, but the problem is that itcan damage the companys credit image.

Factoring

There are two types of factoring: Non-Recourse Factoring & Recourse Factory (Invoice Discounting)

Non Recourse factoring is where the supplier sells on its trade debts to a factor in order to obtain the

cash payment before the actual due date. The factor takes over all responsibility for credit analysis of

new accounts, payment collection and credit losses.

Recourse factoring is where invoice is sent to the factor who then gives the supplying company the

money. However, supplying company is still responsible for collecting its debts. When supplying

company eventually gets paid by a customer, it passes the amount to the factor.

The factor has no control over the collection of due payment, so it charges the supplying company

interest on the amount of invoice it has paid initially from the date the advance was made to the date

that the date on which supplying company gives back the money to factor.


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Bill of Exchange

A bill of exchange (effectively, a claim to the amount owed by a purchaser of goods on credit) may be

accepted by a bank (for a fee). This means that bank guarantees payment against the bill to

whomsoever holds the bill at maturity. The bill can be used to raise the short term finance.

Bills of exchange is also known as two name paper because they carry the name of the issuing

company which owes the money and of the accepting bank. Where the endorser is an eligible bank,

the bill is known as an eligible bill of exchange. An eligible bank is an investment bank whose endorsed

bills of exchange are eligible to be sold to the Bank of England.

CommercialPaper

Commercial paper is single name form of short-term borrowing used by large companies. It comes in the

form of bearer documents for large denominations which are issued at discount and redeemed at par.

Companies that wish to raise finance by issuing sterling commercial paper have to meet certain

minimum standards. Issuing companies must:

be listed on the London Stock Exchange.

issue a statement to confirm that they comply with the requirements of the Stock Exchange, and that

there have been no adverse changes in the companys circumstances since they last published accounts

in accordance with Stock Exchange rules. The minimum size in which sterling commercial paper can be

denominated is 500,000.


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Chapter-3

Taxation

Personal TaxationIt will be levied on all the financial resources of individuals.

Financial Resources of the individual can be as follows:

1. Income (whether earned wages and salary or unearned investment income and rent)

2. Profit from operating as a sole trader or partner

3. Inherited wealth

4. Investment gains

5. Value of assets held

Most countries also levi social security contributions on earnings apart from tax.

Considerations:

Taxing Cash flows

It is based on the cash available to finance the tax payable. Tax is determined on the value of assets,

there is possibility that these assets may have to be realized in order to generate the funds needed to

pay the taxes.

Taxing in Arrears

In addition to ability to pay tax, governments will also seek to ensure that citizens have sufficient

retained income and wealth to meet their essential needs. It is common, therefore, to assess taxliabilities in arrears taking into account all relevant sources of wealth and/or income, and to exempt

some basic levels of income or wealth from the calculations.

There can be arrangement where tax can be levied on the source of income throughout the tax period in

order to accelerate tax flow to the government.

In UK most of the employees pay income tax by PAYE(Pay As You Earn) scheme on weekly or monthly

basis.

In this case, the final assessment for the period will establish the final payments (or credit) needed to

generate the correct overall tax payments.

The self employed in the UK pay income tax twice a year, in January and July. An estimate is made of the

current years earnings and when the actual earnings are known, and amendment is made.

Taxing Once

Governments will seek to ensure that revenue flows are taxed only once in the hands of recipients.

However, if taxes are also levied on wealth or the value of specific assets, then double taxation will be

likely (since the assets may well have been acquired from after-tax funds).


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determining liability to tax. Other additional allowances may also exist like age allowances or additional

allowances for married couples.

Company TaxationCompanies are liable for corporate income tax i.e. corporation tax on their taxable profits.

Taxable profits usually include both income (less expenses) and capital gains.

Accounting profit

Profit on ordinary activities before taxation

Sales revenue

- Expenses

= Operating Profit

+ Non-trading income (interest, dividends, capital gains)

= Profit before tax and interest

- Interest paid

= Profit before tax

Taxable profit

1) Add back any business expenses or potential expenditure shown in the accounts which are not

allowable for tax. (E.g. entertainment of customers, fine for illegal acts etc).

2) Add back any charges for depreciation, and instead subtract the allowable capital allowance.

3) Deduct any special reliefs, eg research and development costs may be able to be deducted

immediately.

Use of corporation tax system

Dividends which are paid out of the post tax income, is known as franked income.

Most governments give at least some credit to shareholders for the tax that has been already paid.

In this way shareholders are imputed or ascribed at least part of the tax. Such an imputed tax system

ensures that there is no disadvantage experience by the shareholder when a company distributes

profits.

However, governments sometimes seek to incentivize companies to retain and reinvest earnings for

faster rate of economic growth. This may be achieved by levying higher taxes on dividends than on

retained profits, or by allowing tax relief for new investment (such as the capital allowances

mentioned above). Profits flowing from such investment would then be taxed in the usual way.

Accelerated depreciation

If company purchases a new equipment, then the life of equipment is estimated and cost of machine is


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therefore spread over the life of the machine. Accelerated depreciation allows the company to

depreciate a large part of the machine in the early years, thus increasing the companys costs,

decreasing its profit and therefore decreasing its tax liability in the early years. Profitability and

therefore tax liability will increase in the later years.

Capital Gain TaxIndividuals and companies are typically subject to capital gain tax on chargeable gains. This is normally

assessed in the year in which gain is realized, so that funds to pay the tax should be available.

Assets that are exceptions for calculating chargeable gains

1) Private motor cars

2) A main private residence

3) Foreign currency obtained for personal use

4) British Government securities and other qualifying fixed-interest stocks

5) Small tangible moveable assets worth less than 6000 pounds

Chargeable gain=Sale price purchase cost

Sale price can be increased by any costs associated with the sale and purchase price can be increased by

the cost associated with the purchase of the asset.

Indexation allowance

Some countries have allowances to remove the inflationary element of any gain, or to encourage

individuals to retain assets.

Inflation is calculated with reference to the Retail Price Index(RPI), which reflects the rise in the general

level of prices of goods in the UK.

Since April 2008 in the UK, for individuals( including sole traders and partners), no allowances are made

for inflation.

Capital Loss

Capital losses can normally be offset against capital gains in the same year.

Any unused capital loss may be carried forward to be offset against capital gains in any future years.

The rules for offsetting capital losses do not apply if the loss is only caused by the indexation allowance.

Other taxes1) Stamp duty on contract documents.

2) Inheritance taxes

3) Property taxes

4) Sales tax: It is collected only at the point of final sale to the consumer

5) Value Added Tax: It is collected at each stage of production process according to the value added at


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each stage of the production process.

6) Customs duties: It is a tax on imported goods. It is generally based on the physical size of the goods

and special taxes for certain industries such as the car industry based on emissions.

7) Excise duties are duties are taxes levied on goods produced and sold within the country, eg duties on

petrol, beer, cigarettes.

Double taxation relief

Double taxation relief (DTR) means that the local tax authority will allow companies and individuals with

overseas income to offset tax paid overseas against their liability to domestic corporation (or income)

tax on that income.

The maximum offset is the rate of tax that would have been paid locally on the grossed-up income.

DTR is only available on income received from abroad, not on revenue of a capital nature.


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Chapter 4

Financial Instruments

Loan capitalA company issues loan capital to raise money from the investors. It promises to give the series of

interest payments and capital payment which are specified at outset, If not specified then at least

formula to calculation will be specified.

Long term loan capital is known as Bonds.

Short term loan capital is known as Bill.

Issues of loan stock can be listed on stock exchange.

Holders of loan stock are creditors of the company, they will not have a voting rights.

Features

It is conventional to represent bonds in the units of 100 pounds nominal.

It is usual to represent interest payment as a percentage of the par value.

It is normal to issue a loan capital just near to, below or at par.

All most loan capitals are redeemed at par.

Variations

There can be various variations in the issue of loan capital such as:

1) The capital payment can be made between two dates at the companys option.

2) Interest payment may be set as a fixed margin over a benchmark interest rate. These are known as

variable rates issues.

3) Interest and redemption payments can be linked to inflation index, which is known as index linked

bonds.

4) Interest rates may increase in steps as in stepped preference shares; these are known as stepped

bonds.

5) The company may be able to repay loan anytime, known as call option on bonds.

6) The loan stock holder may be able to demand repayment at any time, known asput option on bond.

7) Capital payment can be made throughout the term of the loan, which is known as sinking bond.

Rights of bondholders

The rights of bondholders will be set out in the loan agreement drawn up when the loan is issued. In

most cases, a trustee is appointed to act on behalf of the bondholders. Usually trustee is bank or

insurance company. The legal documentation setting out the obligations of the company to its

bondholders is known as trust deeds.


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Debenture stocksDebenture stocks are the loans which are secured on some or all assets of the company.

This means that, if the company fails to make any of the interest or redemption payment then the

debenture holder can appoint a receiver to intercept the income from secured assets or can take

possession of the assets and can sell them to meet their debt.

There are two types of debentures:

1) Mortgage debentures(Fixed charge)Loan will be secured on the specific asset specified in the loan agreement.

2) Floating charge debentureThe company can change the secured asset during the normal course of business. It is trustees

responsibility to give permission for the change of assets.

When a company fails to make the payment, then debenture holder can apply to court to make

the floating charge become the fixed charge. This is known a crystallizing.

Interest payment to debenture holder is tax deductible, as it is paid by the company before the

tax calculation of the company.

Risk

Payments on the debenture are legal obligation to the company, loan holder gets fully repaid in

the event of the winding of the company before shareholder can receive anything. Therefore

debenture of a company is the secured for of investment than the ordinary or preference shareof a company.

The rights of the debenture are secured in hands of trustee.

Risk is still associated with debenture, as if the total assets secured become insufficient to repay

the loan in case of winding up.

Return

As debentures are the form of secure investment, hence it provides lower returns. This return

can be eroded against the inflation.

Total return of a debenture would be expected to be

Superior to that of convertible preference share since convertible share offers not only theincome yield but a capital gain as well. Hence lower than the debenture.

Less than that of an unsecured loan stock, because unsecured loan stock is more riskier and

offer no capital growth.

Marketability

Marketability of debenture is usually worse than the government bonds; there are bigger


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spreads between the buying and selling prices and lower the volume trades. Therefore trading

in debentures is less frequent.

Unsecured loan stockUnsecured loan stocks are the loans which dont have any specific security.

If the issuing company defaults the payment then to sue the company is the only remedy to the holder

of unsecured loan stock.

The unsecured loan stock holder stands after the debenture holder.

Other creditors rank equally with the unsecured loan stock holders.

Risk

Since there is no security for an unsecured loan stock it is more riskier and return is more than the high

rank loans.

Rights of the unsecured loan stock holder is specified in the trust deed and handled by trustee.

Return

Gross redemption is yield is more than on the debentures to compensate for poorer marketability and

more risk.

Corporate bonds are much more like government bonds.

They are less secure than the government bonds. The level of security depends on the type of security,

the company that has issued it and term.

They are less marketable than the government bonds, mainly because of its issue size is much smaller

than the government bonds.

Subordinated debtSubordinate debt ranks after the general creditors of the firm but before the preference shares or

ordinary shares.

The rating of the debt and, consequently the terms on which it is issued, will reflect this lower level of

security.

Eurobond loan capitalIt is used to raise the money overseas.

When a borrower issues a sterling denominated bonds in the UK market it is known as bulldog.

When a borrower issues a sterling denominated bonds in the US market it is known as Yankee bonds.


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Eurobonds are the form of bearer documents.

Most Eurobonds are redeemed at par on a set date with fixed coupon payments during the term of the

Eurobond. Eurobonds are usually make coupon payment annually rather than semi-annually.

Almost all Eurobonds are unsercured.

Eurobonds are issued to raise large sum of money minimum acceptable issue is $75m or more.Key difference between Eurobonds and unsecured loan stock is the way Eurobonds are marketed.

Floating Rate NotesFloating rate notes are medium term debt securities issued in the Euro market whose interest rate float

with short term interest rates, possibly with a stipulated minimum rate.

It is common for floating-rate notes to have a minimum interest rate below which the

coupons will not fall even if the benchmark interest rate falls lower. This is known as

an interest-rate floor.

Thus, the issuer does not need to estimate the likely levels of future inflation and

interest rates when issuing the notes, and the lender does not require aninflation risk premium. If inflation increases, short term interest rate increases. Hence issues of the

floating rate notes and the borrower, both of them need not worry about the future interest rate.

Share Capital

Ordinary Shares(Equities-Residual)Ordinary shares give rights to a share of the residual profits of the company, and to the residual capital

value if the company is wound up, together with voting rights and various other rights.

This is the major way by which companies are financed.

Ordinary shareholders are the owner of business. They have voting rights equal to the proportion of the

shares they held. They are eligible to receive the dividend payment. Dividends are not legal obligation of

the company. They are paid at the discretion of the directors of the company. In practice they try to pay

a steadily increasing stream of dividends.

Dividends are paid from the after tax profit of company, giving shareholder a tax credit. This is known as

franked investment income.

Ordinary shares are the lowest ranking form of investment. On winding up of the company they will rank

after all the creditors of the company.

Ordinary shares are always irredeemable. They have a par value which is not related to the market value

of share. No company is allowed to issue the ordinary share below its par value.

The accounts of a company show the nominal value of the issued share capital(number of shares x par

value)

The Memorandum of Association will set out the total nominal value of authorised share capital. This is

the maximum amount that the directors can issue without calling for a vote from the shareholders.


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Above this limit the directors need the shareholders approval to increase the amount of share capital.

The issued share capital is the nominal amount actually issued. The issued share capital cannot

be greater than the authorized share capital.

Rights of ordinary shareholders:1) To attend and speak at company meetings. They also have right to appoint a proxy who can attend

the company meetings on their behalf but cant speak.

2) To receive the annual report, accounts and memorandum and article of the company

3) To appoint a company directors

4) To vote to change the companies borrowing power

5) To reduce the dividend but not to increase

6) To vote to forego the pre-emptive rights to be offered any new shares to be issued

Variations in the issue of Ordinary Shares:

1) Deferred shares which come in two varieties: either no dividends are paid until normal ordinary

shareholders receive it or profit reach a certain level, or no dividends are paid until a given date.

2) Redeemable ordinary shares which will be repaid by the company on a certain date

3) Non-voting shares

4) Shares with multiple voting rights

5) Golden shares in newly privatized industries. Golden shares are those held by the government

following a privatization. These shares give the government certain rights, such as voting rights or veto

on some issues.

Expected return on the ordinary shares, will be influenced by the two things

1) How much yield it expects achieve

2) How much capital growth it expects to obtain by holding the share over a certain period.

Dividend yield=net dividend paid per share/market price per share

Ordinary shares are the riskiest form of an investment.

This can be defined into two components.

1) The uncertainty and volatility of the future income stream

2) The uncertainty of capital return in case of winding up of company

Since they are riskiest investment options, they give high return

Marketability of the Ordinary Shares

Marketability of the ordinary shares is much better than the marketability of the other loan capital of

the same company. This is mainly because of

1) For many companies, bulk of their capital is raised through the ordinary shares

2) For some companies, they have only ordinary shares whereas their loan capital is fragmented in


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different issues

3) Investors tend to buy and sell ordinary shares more frequently than the other loan capitals

Preference SharesPreference shares are much less common than ordinary shares.

The investment characteristics are much more like unsecured loan stock rather than ordinary shares.Assuming that the company makes a sufficient profit fixed stream of dividend is paid to the preference

shareholder.

They usually do not carry voting rights.

They have preferential right over either dividend or capital growth or both, compared to the ordinary

shareholder.

If no dividend paid to preference shareholder then no dividend is paid to ordinary shareholders.

Preference shareholders have voting rights, if the rights attaching to their shares are being varied.

Dividends on preference share are set to a limited amount which is always paid.

Most preference shares are cumulative or irredeemable.

Cumulative preference shares require any unpaid arrears of dividends, as well as the current years

dividend, to be paid before any dividend can be paid to ordinary shareholders.

Variations:

1) non-cumulative

2) Redeemable

3) Participating

4) Convertible

5) Stepped

Preference share rank below the loan capital and above the ordinary shares, if the company wound up.

Risk of preference shareholders not getting their dividends is greater than the risk of loan stockholder

not being paid, but less than the risk of ordinary shareholders not being paid.

Preference shares offer a relatively predictable future income stream, but uncertainty about the return

of capital in the event of winding up.

If there were no tax complications, the expected return on preference share will be more than the

expected return on loan capital for all shareholders.

Other types of long-term finance

Convertibles:

These are the form of the securities like unsecured loan stocks or preference shares that convert into

ordinary shares of the issuing company.

Convertible preference shares are preference shares which give the right to convert into ordinary shares

at a later date. The investor does not pay anything to convert other than surrendering the convertible

preference shares. Convertible unsecured loan stocks are unsecured loan stocks which give the right

to convert into ordinary shares of the company at a later date.


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pg. 22

The only difference between convertible loan stocks and convertible preference shares is the form of

the capital before it converts into equity. Convertible loan stocks are part of loan capital until

conversion, whereas convertible preference shares are part of share capital.

They are popular in the United States as a form of finance for new companies. These companies have no

track record and might find it difficult to raise funds in more conventional ways. Investors have thesecurity of a fixed return in the short term and the possibility of long term capital gain if they convert to

ordinary shares in the future.

This additional prospective return means that the issuer does not have to offer excessively high rates of

interest on the loan stocks in order to attract lenders.

If the holder chooses not to convert, then the security might continue as a loan stock or preference

share for a period of time known as the stub. Alternatively it might be redeemed on a prescribed basis

immediately.

There will be a specified number of ordinary shares for each convertible. The date of conversion might

be a single date or, at the option of the holder, one of a series of specified dates.

The period prior to the first possible date for conversion is known as the rest period. The period during

which conversion may take place is, not surprisingly, known as the conversion period.

At any time, the cost of obtaining one ordinary share by purchasing the required number of convertible

securities and converting can be compared with the market price of the share. The difference is known

as the conversion premium.

The characteristics of a convertible security in the period prior to conversion are a cross between those

of fixed-interest stock and ordinary shares. As the likely date of conversion (or not) gets nearer, it

becomes clearer whether the convertible will stay as loan stock or become ordinary shares. As this

happens, its behavior becomes closer to that of the security into which it will convert.

There will generally be less volatility in the price of the convertible than in the share price of the

underlying equity. The security of dividend payments for a convertible is higher than that of an ordinaryshare, and the option to convert to an ordinary share or leave it as a fixed-interest security allows the

investor to be sure of a minimum expected return.

Because convertibles do not benefit from the dividend growth enjoyed by ordinary shareholders,

convertibles generally provide higher income than ordinary shares. Conversely, because they do offer

the prospect longer term of benefiting from the growth of the dividends, convertibles will provide a

lower income than conventional loan stock or preference shares.

Warrants

Warrants are call options written by a company on its own stock.

When they are exercised, i.e. when the purchaser exercises his/her right to buy the shares, the company

issues more of its own shares and sells them to the option holder for the strike price. Thus, the exercise

of a warrant leads to an increase in the number of shares that are outstanding. This, in turn, leads to

some dilution in the value of the equity.

Warrants are also often given to investment banks as compensation for underwriting services or used to


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pg. 23

compensate creditors in the case of bankruptcy.

Typically, a warrant lasts for a number of years. Once they have been created, they sometimes trade

separately from the bonds to which they were originally attached.


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pg. 24

Chapter 6

Issue of shares

Obtaining a stock exchange quotation

Quotation means price of the security of the company is included in the official list of the exchange.

There are two different types of markets for UK equities:

1) Alternative Inevestment Market (AIM Established in Jun 95)2) The main market

Full listing in main market requires 25% of shares to be in public hands ( There is no such

requirement for an AIM)

Full listing requires a three-year trading record ( There is no such requirement for an AIM)

The reason for seeking a quotationObtaining a quotation has costs (eg. Accountants, solicitors and broker fees), also maintaining costs (eg.

Annual fees paid to the stock exchange)

To raise the capital for the company

obtaining a quotation allows company to sell new shares in wide market and thus raise large sums of

money as cheaply as available. Vast majority of companies choose a method of obtaining a quotation

which simultaneously raises new funds.

To make it easier for the company to raise further capital

once the company has quotation it will be easier to sell a new shares in future. In addition, providers ofdebts finance will be happier to lend more money to listed companies as they need to fulfillment the

stock exchanges requirements.

To give existing shareholders and exit route

This allows existing shareholders to capital. Specialist providers of equity capital to small unquoted

businesses usually want to realize their investment after few years, So quotation gives them a exit route.

To make shares more marketable and easy to value

1) The fact that shares can be easily values helps with inheritance and CGT tax calculations

2) Shareholders will find the shares more useful as backing for their own borrowing

3) Quoted companies usually offer their shares to offer to the target companys shareholders in atakeover bid. Quoted shares are much more effective for this purpose.

4) Some companies offer employees share schemes to help motivates staff. Such schemes will be more

attractive if the companies have quoted shares.


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Methods for obtaining a quotation

Offer for sale (at a fixed price)

In an offer for sale at a fixed price, a predetermined number of shares is offered to the general public at

a specified price via an issuing house.This is most common type of method used by companies to obtain the quotation.

The issuing house and underwriting

Rather than selling shares directly to public, company or existing shareholders sell their shares to an

issuing house. And then, issuing house takes all the responsibility to sell shares to public. In this way

issuing house underwrites the issue.

Issuing house are generally part of investment bank. Along with underwriting the offer for sale, their

role is to act as professional adviser to the issuing company, to overview the whole process and to co-

ordinate with other professional advisers.

Issuing house get the payment either charging the fees to company or the price at which company

issues share to the issuing house is slightly lower than the subsequent price at which issuing house sell

shares to the public.

Time table for the issue of sharesAbout an year before offer

The directors of company will start to talk to an issuing house at least an year before in order to issue of

shares. The issuing house will try to ensure the pre launch comments in the press are in their favor. The

company will also need to prepare itself eg by changing its Memorandum of Association to make it a

public limited company.

The weeks leading to the issue

In this period issuing house will advise on the price which should be set. The tradition is to be fairly

conservative in pricing new shares i.e. to set the price on low side. However, price will not be set until

the final prospectus is published.

Impact DayOnce the offer price is set prospectus is published and made available to public. It will also be

reproduced in any of the national newspaper, and the prospectus may be made available through the

other channels such as high street banks.

The prospectus contains a great deal of information about the company, its objectives, activities,

financial position, reasons for the issue and people involved in the issue. There is a duty of the

professional advisers to disclose all relevant information.

Applications

Typically, applications from the public to buy securities can be made for a period of about a week

following the issue of the prospectus.If issue is oversubscribed by the time the offer is closed. Issuing house needs to determine the basis of

allocation ie how it will determine which offers to accept in full, which to reject, and which to

scaledown.


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There are two objectives to be balanced:

1) Ensuring that the securities are widely held (so that there is an active market in the shares)2) Reducing administration costs.

Letters of acceptance

Letters of acceptance is sent out to everyone whose applications have been selected. And refund

cheque will be sent to those whose application got rejected or scaled down. Official trading will take

place after the day of posting the letter of acceptance.

Offer for sale by tenderAn offer for sale by tender is similar to an offer for sale at a fixed price. However, instead of inviting

applications at a specified price, the issuing house invites members of the public to submit a tender

stating the number of shares which they are prepared to buy, and the price which they are prepared to

pay.After the offer closes, the issuing house will determine a single strike price. This may be the highest price

at which all the stock can be allocated. However, a lower strike price will be chosen if this is necessary to

ensure a sufficient spread of shareholders. All applicants who bid at least as much as the strike

price will have their applications accepted. All successful applicants will pay the strike price, regardless

of how much more they had bid. Applicants who bid less than the strike price will have their

applications rejected.

Disadvantages of offer for sale by tender

1) Allocation process is more complex in nature.2) Probability for more concentrated ownership of the shares which leads to detrimental to their

marketability.

3) Smaller investors are put off by the tender process.Offer for subscriptionThese are similar to offers for sale. They are normally at a fixed price, but can be by tender. However,

the whole issue is not underwritten. The company sells shares directly to the public. The issuing

company bears (at least part of) the risk of under subscription. An issuing house will still be employed as

an adviser to the issue.

Placing (Selective Marketing)A simpler, cheaper method of making small issues is known as a placing or selective

marketing. The issuing house first buys the securities from the company. The issuing house,

or a stockbroking firm, will then individually approach institutional investors such as pension funds and

life offices directly. The institutions will be offered securities, but no public applications are invited.

Companies like placings because they are cheaper for two main reasons:

advertising and administration costs are minimised

no sub-underwriting is needed (the process of a placing itself is very similar to the process used to

obtain sub-underwriters anyway).


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pg. 27

IntroducitonsNot all of the reasons for wanting a stock exchange listing involve the immediate desire to raise new

money or the sale of existing shares. In these cases, a stock exchange may allow the shares to be

introduced to a stock exchange listing.

Introductions do not involve the sale of any shares. They simply mean that the existing shares will infuture be quoted on the London Stock Exchange.

As always for a full listing, 25% of shares must be in public hands, that is, the free float of shares

available for purchase excluding strategic holdings in subsidiaries or cross-holdings must be at least 25%

of the issued shares. The Stock Exchange only allows introductions in cases where this requirement is

already met.

Introductions can be used in several circumstances. For example:

where an overseas company is already listed in, say, the USA, but wants to have

a UK Stock Exchange listing as well

where an already listed company wants to de-merge into two or more separate

companies; the new companies will obtain a quotation by way of an introduction

where an unquoted company already has shares in wide ownership and sufficient

capital but wants to become quoted.

The role of underwriting1) Rather than run the risk of not managing to sell all the shares and raise enough money, the

company arranges to sell all the shares at an agreed price to the issuing house. The company will pay the

issuing house a fee. Alternatively, in the case of an offer for sale, the fee can be included in the

difference between the price at which the shares are sold to the issuing house and

the price at which the issuing house sells them to the public.

2) The issuing house accepts the risk that all the shares may not be bought. However, the issuing house

will not want to retain the entire risk. The issuing house will arrange sub-underwriting. In return for a

commission the sub-underwriters agree to take a proportion of the shares that are not bought by the

public.

3) Issues are priced so that they should be successful. Issuing houses take care not to over-price issues.

The main risk faced by underwriters is that an unexpected event occurs between agreeing to accept the

underwriting and the closing date for the offer for sale.

4) Fully subscribed issue: The issue goes ahead, and is fully subscribed. The issuing house and the sub-

underwriters will have made an underwriting profit equal to their underwriting commission less any

administrative expenses.

Partly subscribed issue: The issue goes ahead, but not all of the shares are purchased. The underwriters

and sub-underwriters get their fee/commission, but they also need to pay for all the shares that have

not been purchased.


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Issues made by the company already quoated

Company wanting to raise new ordinary share capital

Company wanting to increase the number of shares in issue, without raising new money

Company wanting to raise the new loan (or preference share) capital

Existing shareholders wanting to sell large block of shares

Rights Issues

A right issues the issue in which company offers further shares to existing share holders in proportion to

the number of shares held by them.

The price will be discount to the current price of the shares price.

The main effects of a successful rights issues are:1) New shares are created2) New money is raised for the company3) Total value of the company is increased by the extra money raised4) Price of the share falls depending on the number of shares issued and level of discount provided

Purpose of a rights issue

1) The company has a fundamental problem and its future depends on the new money raised2) To reduce the debt equity ratio3) Company has expanded too quickly, hence require more money to manage the expenses4) To pay for the purchase of the new company5) To finance the expansionary investment programs

Time table for the rights issue

Three to four weeks before company starts discussing with the professional advisors regarding rights

issue. Generally company uses rights issue in high market so as to maximize its new capital. A price is set

and company publishes the offer document for the rights issue. Shareholders are sent a provisional

allotment letters and the shares start to trade ex-rights ie seller of the shares have the rights not the

buyer of a shares. Shareholders will be given 3-4 weeks to accept the offer or to sell their nil paid rights

ie rights for which shareholder has not paid anything.

Impact on share price

Market capitalization = P x number of shares P=Share Price

Before a rights issues, the share price is given by:

P*= (Original market capitalization + extra value)/(Total number of shares)


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Extra value component in the calculation

+ The amount of new money raised by the rights issue

--- The expense of issue

+/- The change in the value based on the markets revised perception of the company and the use to

which the money is being put.

Deep Discount

Companies can avoid an underwriting by offering the issue at a cost very low to the market value of a

share. This is called as deep discount.

Problems with the deep discount:

The bigger the discount, higher is the price of nil-paid rights. This increases the CGT liability of the

investors who wish to sell their rights of issue.

Companies are not allowed to issue a offer less than its par value. This places an upper bound on the

size of the issue.

Deep discount is sometime used by the companies who dont get any underwriter for the issue,

therefore, a deep discount is generally taken as weakness of a company.

Scrip IssueA scrip issue is also known as capitalization or bonus issue. In this free shares are given to the

shareholders in a proportion to the number of shares they hold. No new money is raised.

The basic impact of a scrip issue should be:

y New shares are createdy No money is raisedy The fundamental value of the whole company remains unchangedy The price per share should fall in proportion to the increase in the number of sharesy The total value of each shareholders holding should remain unchangedy Shareholders reverse in the balance sheet should change to share capital

Purpose of Scrip issue

1) By lower price and more number of shares, the marketability gets increased.2) Shareholders might like the idea of being given extra shares free of charge.3) Scrip issues can take place only if there are sufficient reserves to be capitalized.

This means that scrip issues tend to be associated with successful companies

which have built up large reserves from retained profits.

4) A scrip issue reduces the price of a share. Therefore, having a scrip issue mayreduce a companys ability to have a future rights issue if its share pricedeclined following the scrip issue. So, if the directors decide to have a scrip

issue, they must be confident about the companys future prospects.

5) Some companies have a habit of having light scrip issues (eg 1 for 10) andsubsequently keeping the same dividend per share. In these cases, a scrip

issue may lead to, or be a sign of, higher dividends.

6) If dividends are expressed as a percentage of the nominal value the figure mayseem excessive. This could cause public relations problems, or problems with


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employees who feel that dividends are too high. This could be avoided by a

scrip issue.

7) It is a requirement of the Companies Act 1985 that a company must have aminimum issued share capital of 1m before it can act as a trustee. A scrip

issue converts reserves into share capital, so may allow a company to meet this

requirement.

Disadvantages

The administrative costs such as issuing new shares and informing

shareholders are met by the company.

Whenever records of dividends or share prices are needed, for example for

investment research or CGT calculations, care is needed to eliminate the

artificial effect of a scrip issue.

CT-2 Notes. Part I

Documents

Transcript of CT-2 Notes. Part I