Chapter 5

Corporations issuing equity in the share market

True/False questions

1.T The objectives of an organisation should seek to achieve the maximisation of shareholder value.

2.F The investment decision process is only applicable to mining and manufacturing companies because of their intensive capital equipment requirements.

3.F Net present value of a project is the cost of the projects asset less the forecast future cash flows generated by those assets.

4.T If the calculated IRR on an investment proposal is more than the required rate of return, the company should consider proceeding with the project.

5.T Shortcomings in the IRR decision process are non-conventional cash flows and mutually exclusive projects.

6.F Regardless of a period of economic growth or an economic downturn, a higher debt-to-equity ratio should generate a higher return on equity for shareholders.

7.F The corporate regulator has stipulated a standard optimal debt-to-equity ratio that must be maintained by all corporations.

8. T A prospectus includes detailed information on the past and forecast activities of an organisation.

9.F The flotation of a business refers to the actions of the liquidators when a company goes into liquidation.

10.T A company issuing new shares is assured they will all be taken up if the issue is underwritten, unless an out-clause in the underwriting agreement is triggered.

11. F The listing rules of the stock exchange provide corporations with a useful guideline on how to structure their business activities.

12. T Dual-listing provides multinational corporations with greater access to the international capital markets.

13.F A pro-rata rights issue of new shares to existing shareholders is said to be non-renounceable if the right can be sold to another investor.

14.F An issue of ordinary shares to retail investors must be accompanied by a memorandum of information that details the activities and financial position of the issuing corporation.

15.T One advantage of a placement of new shares is that a company can issue the shares quickly and at a lower discount to the current market price than it could with a rights issue.

16.F A cumulative preference share normally reinvests the periodic fixed dividend payments and the accumulated total is repaid at maturity.

17.F A preference share issue is generally not listed on a stock exchange as the shares have only limited liquidity.

18.T Convertible notes are debt instruments that provide the holder with the right to convert the notes into ordinary shares at a determinable price and at a specified date.

19.F Company-issued share options guarantee the issuing company future equity funding at the option exercise date which can be set to coincide with future funding requirements.

20.T Company-issued equity warrants are often attached to a corporate bond debt issue and give the holder the right to convert the warrant into ordinary shares in the issuing company.

Essay questions

The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.

1.BHP Billiton is a multinational corporation with business operations focused mainly in the mining and resources sector. Discuss the important issues the board of directors of BHP Billiton will need to consider in relation to the capital budgeting process for the corporation. (LO 5.1) Capital budgeting refers to the investment decision process carried out by a firm.

The board of directors will set the objectives and policies of the firm; that is, what the firm intends to do and how that will be achieved.

Management is responsible for the day-to-day financial and operation management of the organisation in order to achieve those objectives.

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.

2. Advanced Technologies Limited is considering the acquisition of a machine to manufacture electronic components. The machine will cost $140 000 and will produce a positive cash flow of $50 000 in the first year. The cash flows will increase by 10 per cent each year thereafter for another four years. At that stage the project will cease and the equipment will have a scrap value of $20 000. The company expects a rate of return of 15 per cent on this type of project. (LO5.1)

(a) Calculate the NPV and the IRR.

Note: present value = S (1 + i)-nUsing a Hewlett Packard Business 10B calculator:

payments per year = 1

net cash flows: period 0 = -$140 000

period 1 = $50 000

period 2 = $55 000

period 3 = $60 500

period 4 = $66 550

period 5 = $73 205 + $20 000 (scrap value of equipment)

IRR key-strokes:

1

[second function] P/YR

- 140 000CFj

50 000

CFj

55 000

CFj

60 500

CFj

66 550

CFj

93 205

CFj

[second function] IRR/YR

Answer: IRR = 32.3%

NPV key-strokes

15I/YR

[second function] NPV

Answer: NPV = $69 235.43

(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.Commercial banks are particularly exposed to the risk of loss of their computer systems and the risk that interest rates may change. (LO 5.2)

(a) In your own words, define the term risk within the context of the management of a commercial bank.

i. The principal financial objective of a corporation such as a commercial bank is to maximise shareholder value over the longer term, subject to an acceptable level of risk.

ii. Risk can be defined as the variability or uncertainty of returns from the businesss investments.

iii. Since returns are generated from the net cash flows of the business, risk is measured by the variance in net cash flows.

(b) Categorise the two risk exposures above and explain why banks must manage them.

1. Loss of computer systems is categorised as a business or operational risk. Banks are heavily reliant on their computer systems for most of their business operations; such as the maintenance of their data and records, delivery products to customers, and information systems.

2. Unexpected changes in interest rates is defined as interest rate risk. The majority of bank products generate income in the form of interest payments. An unexpected change in interest rates will impact upon forecast future income and cash flows.

(c) Identify and briefly explain two other risk exposures to which banks are exposed.

Choose two risk exposures from the following:

Foreign exchange risk is evident when a firm has balance-sheet assets and liabilities, and associated cash flows, denominated in a foreign currency. Movements in the exchange rate will affect the value of these items. For example, a company that imports goods from overseas, where payment is to be made in USD, will be adversely affected by a depreciation in the exchange rate; that is, it will be more expensive to purchase the USD required to pay for the imported items.

Liquidity risk is about having sufficient cash, liquid assets or access to funding sources to meet forecast day-to-day operating requirements. For example, a company needs to be able to pay creditors when due, purchase inventory, pay staff and meet other operating expenses. A bank overdraft may be used for this purpose.

Credit risk is a situation in which debtors do not repay their obligations on time or default in repayment. For example, a company might have provided goods to a client with payment due in 30 days, but the company is unable to collect the amount due because the client has gone into liquidation.

Capital risk occurs when shareholders funds are insufficient to meet capital growth needs or, in an adverse situation, to write off abnormal losses. For example, a corporation might be aware of a new business opportunity, but is unable to fund the purchase without breaching debt-to-equity loan covenants on an existing loan from its bank.

Country risk is the risk of financial loss associated with a fixed exchange-rate currency devaluation, currency inconvertibility, rescheduling of external debt, barriers to funds transfers, political developments in a nation-state resulting in expropriation, legal restrictions, freezing of company assets, or forced divestment of assets.

4.Debt-to-equity ratios may vary quite considerably between business corporations. (LO 5.2)

(a) Discuss the four main criteria that a corporation should analyse when determining the firms appropriate debt-to-equity ratio.

The appropriate debt-to-equity ratio will vary between firms, industries and stages of the business cycle. The four main criteria are:

1. The ratio that is the norm in the industry in which the firm operates, and adopt something near that ratio. Significant deviations from the industry norm may cause concern for the potential providers of both debt and equity funds.

2. The history of the ratio for the firm. The ratio employed in the past may be regarded as the norm, and management may be reluctant to change it greatly. If the business has been performing with a return on assets that is acceptable to shareholders, it may be deemed appropriate to continue with a similar gearing ratio. Any significant change in the ratio may result in the disaffection of the current shareholders.

3. The limit imposed by lenders. It is quite common for lenders to impose various loan covenants on the borrowings of a company. Loan covenants are conditions or restrictions incorporated in loan contracts that are designed to protect the interests of the lender. A common covenant is a limit on the ratio of debt liabilities to total assets.

4. Managements decision concerning the firms capacity to service debt. The assessment is made by determining the charges, the interest payments and the principal repayments associated with a given level of debt, and assessing the capacity of the firms expected future income flows to cover the payments while leaving sufficient profits to satisfy shareholders expectations for a return on their equity.

(b) Is the firms debt-to-equity ratio likely to change over time? Support your answer with 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 forecast changes in economic and business conditions that will affect the level of future income of the organisation

5.A private pharmaceutical research company has successfully developed a new medication for cystic fibrosis and decides to seek listing on the ASX as a public company in order to raise the equity capital necessary to take the medication into production. Identify and briefly explain the issues and processes that will be involved in the flotation (IPO) of the business on the stock exchange. (LO 5.3) Determine the form of incorporation; a limited liability company or a no liability company

Ordinary shares will be issued under a company structure

Limited liabilitythe shareholders financial liability is limited to any unpaid portion of the share holding

No liabilitythe shareholder may forfeit a shareholding by refusing to pay further calls on an unpaid portion of the shares

Consider the method, terms and conditions, and timing of the IPO

The promoters of the new business entity will seek advice from a range of advisers, including financial (investment banks, accounting and taxation), specialist advisers, such as lawyers, pharmacists, medical and hospital advisors, and government consultants

Specialist advice is important in the successful timing and pricing of the IPO

The IPO document, the prospectus, is drawn up and lodged with the corporate regulator

The prospectus will detail the past and forecast future performance

An application to subscribe for shares is attached to the prospectus

The promoters may engage an underwriter and sub-underwriting groups to provide a guarantee that all shares on offer will be taken up

Be aware of any out-clauses included in an underwriting agreement; the level of take-up by the underwriters may be limited

Must comply with the listing rules of the stock exchange

Consider the level of fees associated with the IPO. These may be around 10% and will reduce the amount of funds raised in the flotation process.

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.Santos Limited has expanded its exploration program and has decided to fund the expansion through the issue of additional ordinary shares to its existing shareholders on a pro-rata basis of one new share for each 5 shares held. The issue price is $11.75 per share and the current market price is $11.95. The financial advisers to the corporation have recommended the use of an underwriting facility. The board of directors has noted that the underwriting facility has an out-clause if the market price drops below $11.45. Having regard to this information, answer these questions. (LO 5.3)

(a) What type of issue is Santos Limited making to its shareholders?

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:

the structure, pricing, timing and marketing of the issue

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) What is the out-clause entered into by Santos? Discuss how the out-clause operates. 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.Rio Tinto Limited has decided to sell its shale coal part of the business by establishing a new limited liability company to be known as Shoal Limited. Shoal Limited will be a listed corporation on the ASX. Rio Tinto and Shoal decide to issue the new shares at $2.65, but through the issue of instalment receipts. An initial payment of $1.25 is payable on application and a final payment of $1.40 is due 12 months later. (LO 5.3)

(a) Shoal Limited will be a limited liability company. What are the rights and financial obligations of shareholders that purchase shares in the company?

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.

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) The company decides to structure the issue using instalment receipts. Explain how instalment receipts operate and why the company may have decided on this strategy

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?

Based on the available information it seems appropriate that the subsidiary be formed as a no-liability 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.

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) If a multinational corporation seeks dual-listing on two stock exchanges, how will this impact on the corporations adherence to the listing rules?

Some large multinational corporations choose to list on more than one exchange. The shares of the corporation are said to have a dual-listing.

Dual listing is normally achieved by the creation of two holding companies each entitled to fifty per cent of the groups assets. Shareholders in both holding companies have equivalent economic and voting rights. For example, BHP Billiton is listed on the ASX plus the London Stock Exchange (LSE) through two holding companies BHP Billiton Limited (ASX) and BHP Billiton Plc (LSE).

The dual-listed corporation is required to meet the listing rule requirements of each stock exchange.

11. Woolworths Limited is a publicly listed corporation. Its core business is in supermarkets. Woolworths has decided to set up a major hardware goods chain in competition with the Wesfarmers Limited-owned Bunnings stores. Woolworths needs to raise additional equity capital to fund the expansion. The company advisors recommend the board of directors choose between a pro-rata rights issue and a private placement. Explain each of these funding alternatives and discuss the advantages and disadvantages of each alternative. (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.

Rights issue:

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.

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. In some countries, such as Australia, it is common for corporations to offer shareholders a dividend reinvestment scheme. (LO 5.5)

(a)Explain how dividend reinvestment schemes operate and discuss their significance as a source of equity funding.

Dividend reinvestment schemes allow a shareholder to reinvest all or part of their dividend entitlement in additional shares in the company.

Dividend reinvestment shares are sometimes issued at a discount to the market price, and with no brokerage or other costs.

Dividend reinvestment schemes are an important source of equity funding for many companies. Shareholders like the option to reinvest their dividend income rather than taking the cash, particularly if the company is successful.

The company will typically issue such shares at the average market price of the shares traded on the stock exchange for the five days following the ex-dividend date; less a specified discount if applicable.

(b)Discuss the advantages of a dividend reinvestment scheme from the point of view of the corporation and shareholders.

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)Under what circumstances might such schemes prove to be unattractive to the dividend-paying company?

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. From time to time, corporations such as the National Australia Bank Limited make an issue of preference shares as part of the overall capital structure of the organisation. (LO 5.5)

(a) Explain the structure and cash flows associated with a preference share.

Preference shares are hybrid securities that combine the characteristics of both debt and equity.

Preference shares have their fixed dividend rates set at the issue date.

They also rank ahead of ordinary shareholders in the event of the winding up of the company.

(b)What specific features might the National Bank include in the structure of the preference share to ensure it is attractive to investors, but at the same time meets the funding needs of the bank?

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:

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

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

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

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

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.

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):

The entitys structure and operation must be appropriate for a listed entity.

The entitys constitution must be consistent with the listing rules.

A prospectus, product disclosure statement or information memorandum must be issued and lodged with the corporate regulator, ASIC.

A foreign entity must establish, in Australia, an Australian securities register (or sub-register), appoint an agent for service of process and be registered as a foreign company under the Corporations Act.

If the entity is a trust, it must be a registered managed investments scheme and the responsible entity must not be under an obligation to allow a security holder to withdraw from the trust.

The entity must apply for and be granted permission for quotation of all the securities in its main class of securities.

There must be at least 500 holders each having a parcel of the main class of securities (excluding restricted securities) with a value of at least $2000. Alternatively, there must be at least 400 holders each having a parcel of the main class of securities (excluding restricted securities) with a value of at least $2000, who are not related parties of the entity that must hold at least 25 per cent of the total number of securities (excluding restricted securities) in the main class. (A related party is one that has an ownership interest in the entity seeking admission.)

The entity must satisfy either the profit test or the assets test (discussed below).

If the entity issues restricted securities before it is admitted, it must comply with the related listing rules.

Special conditions apply if an entity issued classified assets in the two years prior to application.

If the entity has options on issue, the exercise price for each underlying security must be at least 20 cents in cash.

The entity must appoint a person to be responsible for communication with the ASX in relation to matters associated with the listing rules.

An entity seeking listing must advise the extent to which it will, upon admittance, comply with the recommendations of the ASX Corporate Governance Council. The entity must advise the ASX of the reason for non-compliance with all the recommendations.

An entity that is to be included in the S&P/ASX All Ordinaries Index must have an audit committee. If the entity is included in the top 300 of the index, it must comply with the recommendation of the ASX Corporate Governance Council.

The entity must agree to authenticate and provide documents to the ASX electronically.

The entity must have a trading policy that complies with the ASX listing rules.

(b) Discuss the ASX profit test and asset test requirements and explain why these rules are in place.

The objectives of the ASX include the provision of a fair and well-informed market for financial securities and the provision of an internationally competitive market. The ASX listing rules are a key element in achieving these objectives. The profit test and assets test are a component of achieving this objective. That is, the ASX listing rules seek to ensure that companies obtaining listing on the ASX are able to demonstrate a capacity to operate a financially sustainable business.

To meet the profit test requirement of admission, an entity must satisfy each of the following conditions:

The entity must be a going concern, or the successor of a going concern.

The entitys main business activity at the date it is admitted must be the same as it was for the last three full financial years.

The entity must provide audited financial statements for the last three full financial years. The financial statements must be accompanied by audit reports, which must not be qualified with regard to the entitys capacity to continue as a going concern, or satisfy the profit levels required.

The entitys aggregated profit from continuing operations for the last three full financial years must have been at least $1 million.

The entitys consolidated profit from continuing operations for the 12 months to a date no more than two months before the date the entity applied for admission must exceed $400_000.

The entity must give the ASX a statement from all directors (in the case of a trust, all directors of the responsible entity) confirming that they have made inquiries and nothing has come to their attention to suggest that the economic entity is not continuing to earn a profit from continuing operations up to the date of application.

The assets test requirement of admission is as follows:

At the time of admission an entity must have net tangible assets of at least $2 million after deducting the costs of fundraising, or a market capitalisation of at least $10 million.

The entity must have either one of the following:

Less than half of the entitys total tangible assets, after raising any funds, must be cash or in a form readily convertible to cash.

Half or more of the entitys total tangible assets, after raising any funds, must be cash or in a form readily convertible to cash and the entity must have commitments consistent with its business objectives to spend at least half of its combined cash and readily convertible assets. The business objectives must be clearly stated and include an expenditure program. If the prospectus does not contain a statement of the business objectives, the entity must give a statement of its business objectives to the ASX.

The entity must satisfy each of the following:

If its prospectus, product disclosure statement or information memorandum does not contain a statement that the entity has enough working capital to carry out its stated objectives, the entity must give the ASX a statement prepared by an independent expert.

The entitys working capital must be at least $1.5 million, or, if it is not, it would be at least $1.5 million if the entitys budgeted revenue for the first full financial year that ends after listing was included in the working capital. For mining exploration entities, the amount must be available after allowing for the first full financial years budgeted administration costs and the cost of acquiring plant, equipment and mining tenements. The cost of acquiring mining tenements includes the cost of acquiring and exercising an option over them.

An entity must provide financial statements for the last three full financial years. The financial statements must be audited, and must include audit reports.

(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?

The extent of the costs of listing will depend ultimately on the complexity of the issue, the amount of equity issued, the method of issuing the securities, the number of advisers involved and the level of marketing undertaken.

An indicative list of initial expenses that may be incurred include:

underwriting and handling fees

float management fees

legal fees

accounting and taxation fees

other expert adviser fees

printing costs

advertising and marketing costs

share registry expenses.

Specific fees charged by the ASX include:

ASX initial listing fees

ongoing annual listing fees

other fees as determined by the ASX.

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

an in-principle decision fee

an initial listing fee

a fee for examination of documents

annual listing fees.

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.

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