ABMF2103 Principles of Finance

ACADEMIC YEAR 2021/22

Chapter 10(b): Long Term Finance - Equities

TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

ABMF 2103 PRINCIPLES OF FINANCE

Tutorial: Chapter 10 (b) Long Term Financing – Equities

QUESTION 1
What are common stock? Discuss the characteristics of common stock.

Common shares are a type of equity investment and represent a form of

ownership of a business. Each share represents a portion of the rights of the company.
Those who own more shares will have more power. The key attribute of this type of
investment security is that it allows investors to participate in the profits of the company.
They are entitled to receive dividends from the company. This depends on the willingness
of the company to pay dividends. Typically, companies accept higher returns; they will
pay higher dividends to shareholders. Common stock represents equity or ownership in
the company. Any income generated by the company belongs to the owners. Owners are
called shareholders or stockholders. Each share purchased by an investor entitles them to
own and participate in the earnings and dividends of the company, to vote, and to have a
say in management. For example, buying shares in Aeon means having ownership of the
company.

Characteristics of common stock

Firstly, residual claims. In bankruptcy or liquidation, ordinary stockholders are paid

last after the bondholders, and preferred stockholders have been paid. Dividends are only
paid after the bondholders, and preferred stockholders have been paid first, so they can
only claim the residual amount. If the ordinary shareholders do not have the remaining
amount, they won't get anything and must bear their investment loss.

Next, common shareholders have voting rights. The common shareholders can vote
on important matters, such as whether to expand the business, which company they wish
to work with, etc. Public listed companies are required by law to hold annual general
meetings to approve the company's accounts and to appoint or remove auditors and the
board of directors. Voting rights depend on the number of shares held by shareholders.
The more shares an ordinary shareholder holds, the greater the voting rights. For
example, if you own 51% of the company's shares, you are the person who helps make
the company's major decisions and you are the person who leads the company.

Besides that, common shares have no maturity, and common shareholders can hold
their shares for as long as they wish. It is held in perpetuity. In the event of a
shareholder's death, these shares will be inherited by their next of kin, which is their next
generation. These shares will be legally transferred under an established trust or by
making a will.
 Then, the election of BOD. Shareholders can appoint or choose directors to act as
their representatives to help them manage the company and make more profits. Directors
are appointed to work for the benefit of shareholders.

Furthermore, the majority ownership can lead to appointments on the Board of

Directors, e.g. 20%, 30% or even more. Major shareholders are usually institutional
investors who may choose to have direct access to the management of the company to
ensure that it is managed, such as banks, EPFcompanies, unit trusts etc. This is because
they combine the money of savers and invest in other companies. To ensure that the
company they invest in is profitable, they will choose to direct that company.

Moreover, the issue of new ordinary shares is authorised. Raising additional

capital through a rights or bonus issue. Bonus issue- givingthem additional share for free,
the dividend is not pay in cash is in share.for example, there are 200 shares in the market,
RM4 each , total mkt value 8000, 2 for-1 bonus issue, the company will issue 4000
additional share , total shares is 6000 shares, share price will drop until Rm1.333, total
market value = RM8000.

In addition, the common shares are easy to buy and sell and the transaction costs
are not high. Similarly, in the secondary market, buyers and sellers trade frequently,
with high liquidity and low costs. Popular stocks, in particular, can be bought and sold
easily on the open market. It is not only that stocks are popular, but they are also cheaper
than bonds. Bonds can cost a million, two hundred thousand or other. However, some
stocks even cost the investor only a few cents.

Lastly, price and market information is widely disseminated in the news and
financial media. Investors can easily access the company's quotes on the stock exchange
for example Bursa Malaysia, as well as any financial related news such as financial
reports, reports on projects the company is undertaking and expansions.

QUESTION 2
Common stock are a popular form of investment. Discuss the advantages of common
shares from investor’s viewpoint

Firstly, there is no limit to the capital gain potential of a stock. The amount can
be gained to infinity. Stocks with higher returns will also have higher risk.

Next, dividend yields. Stocks can provide regular current income in the form of
annual dividends. However, not all stocks pay dividends, depending on the company, and
for most stocks that produce income, these tend to grow over time, adding more to the
returns for shareholders.

Besides that, common shares are very liquid and are easier to sell as they are
easily transferable compared to bonds, as they are listed on Bursa Malaysia.The
transaction costs are relatively low compared to buying bonds, which is why so many
people choose to buy shares.

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 Then, market information is easily available from daily newspapers, financial
papers or some financial websites and apps.

Furthermore, common shareholders have voting rights. As shareholders and

owners of a company, they are entitled to voting rights.

Moreover, the pre-emptive rights, also mean the rights issue. When a company
wants to issue new shares, the company must grant pre-emptive rights on a pro-rata basis.
This means that existing shareholders will have the right to choose whether or not to buy.
If you own 10% of a company and the company wants to issue new shares, the company
must give existing shareholders the right of first refusal based on the number of shares
they own.

In addition, investors may be appointed to the Board of Directors. If a

shareholder owns a large number of shares, he may be appointed to the Board of
Directors.

Lastly, a common share has no maturity date. It is held in perpetuity and can be
passed on to the next of kin.

QUESTION 3
i. What are the disadvantages of Common stock from investor’s viewpoint?

Firstly, common stocks are risky. Share prices are volatile and shares can not only
be bought now and sold later, they can also be sold first and then bought back. Anything
can affect the share price, even illogical things.

Next, as a residual owner of a company, there is no guarantee of a return.

Investors may not get any benefit at all. In the case of insolvency, bondholders and
preference shareholders must be paid first. Common shareholders are the last to be paid.

In addition, there is no guarantee of dividends. Investors may not receive income

because the company has the right not to pay any dividends. Shareholders who use this
investment vehicle are not obliged to receive a portion of the profits earned by the
business.

Lastly, the acquisition of common shares may result in ownership control. If

someone buys shares on the market and becomes a director of the company, the
shareholder may lose control of the company.

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 ii. Why are preference stocks also known as hybrid securities?

Preference shares are known as hybrid securities because they have both debt and equity
characteristics. It has priority over common shares in the payment of dividends and in
claims on the company's assets. Dividends on preference shares are usually fixed from
year to year. Although preference shares have a stated dividend, the company may not
pay it and this will not cause the company to become insolvent. Preference shares are like
debt, mainly in the sense that preference shareholders do not have voting rights. It is also
like equity in that it has an unlimited term and requires less of the company than a
bondholder's preference.

QUESTION 4
Discuss the characteristics of preferred stocks.

Firstly, there is the par value, also known as the principal value. Preference
shares have a par value, which is the original value of the preference shares. For example,
RM1 per share.

Next, there will be a fixed dividend. It pays a fixed dividend before the dividend
on the common shares.

Besides that, if the dividend on the preferred stocks is not earned, the directors
can omit it without making the company insolvent. The company can choose to pay it
later.

Furthermore, cumulative dividends. If the company they do not pay a dividend

in this period, it must be paid in the next period. Most preference stocks are cumulative in
terms of any dividends that are passed. This means that all dividends owed must be paid
before dividends are paid to ordinary shareholders. For example, each year the company
must pay a dividend of RM5 to investors, but in the first year they do not pay it, so it will
be brought forward to the second year, so in the second year, the company must pay
RM10.

Other than that, there is no maturity date for preference stocks. Investors can
hold the shares as they wish and even if they pass away, the shares can be transferred to
the next generation.

In addition, preference stocks are convertible. Preference stocks usually contain a

conversion feature that allows them to be converted into a specified number of common
stocks.

Lastly, preferred stockholders do not have voting rights. They are not usually
given the right to vote on corporate decisions.

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QUESTION 5
Explain the advantages of preferred stocks

As preferred shares require the company to pay only a fixed dividend to their holders,
their existence helps to increase the financial leverage of the company. The use of debt
will increase and the use of equity will decrease.

While preferred stocks provide essentially the same leverage as bonds, they differ from
bonds in that the issuer can pay dividends without making the company insolvent. This is
the biggest advantage for the company.

Because preferred stocks sometimes have no maturity date, they avoid the loss of cash
flow inherent in debt issues to repay principal. This is similar to common shares

QUESTION 6
What is meant by rights issues?
A firm wishing to raise new equity capital ( by selling share)has a choice of making the
sale to its existing shareholders or to an entirely new set of investors. If a sale to existing
shareholders is made at the price lower than he market price or discount, this is known a
right issue.
1) sell at discount
2) pro-rata basis
2-for-1
3-for-5
3) can take the right, sell the right, renounce right
new shares will be creates---- dilute ownership of shareholders

Convertible securities
Warrant

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