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Chapter 2
Securities and Issuance

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Learning Objectives
• Outline the flotation and listing (IPO) process
• Distinguish between equity and quasi-equity
• Pricing of Shares
• Distinguish between debt instruments
• Pricing of Bond

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1.Outline the flotation and listing (IPO)

process
1.1 Initial Public Offering
1.2 Listing a Business on a Stock
Exchange

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1.1 Initial Public Offering

• Initial public offering (IPO) is an offer to investors
of ordinary shares in a newly listed company on a
stock exchange
– New share issuer must meet ASX listing requirements
– The promoter appoints advisers (stockbroker, merchant
bank, other specialists) and possibly underwriters

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1.1 Initial Public Offering (cont.)

– Underwriters
 Ensure a company raises the full amount of the issue
 Assist with advice on the structure, price, timing and way of
the issue and allocation of securities
– Prospectus lodged with ASIC
 Document prepared by a company stating the terms and
conditions of an issue of securities to the public
– Out-clause
 Specific conditions precluding full enforcement of an
underwriting agreement
– Publicly listed corporation
 Has its shares listed and quoted on a stock exchange

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1.2 Listing a Business on a Stock

Exchange
• A company seeking to have its securities quoted
on a stock exchange (i.e. to join the official list)
must comply with listing rules, which are additional
to the corporations’ legislation obligations
• A non-complying listed company can be
suspended from quotation or delisted

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1.2 Listing a Business on a Stock

Exchange (cont.)
• Listing rule principles embrace the interests of
listed entities, maintain investor protection, and
maintain the reputation and integrity of the market
• Main principles of a stock exchange’s listing rules
include
– Minimum standards on quality, size, operations and
disclosure
– Sufficient investor interest required to warrant listing

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1.2 Listing a Business on a Stock

Exchange (cont.)
• Main principles of a stock exchange’s listing rules
include (cont.)
– Security issues must be fair to both new and existing
holders
– Rights and obligations attached to securities must be fair
to both new and existing holders
– Prescribed information must be provided to the exchange
in a timely basis
– Material information that may affect security prices or
investment decisions must be disclosed immediately to
the exchange

Question 1

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2. Equity and quasi-equity

2.1 Distinguish between equity and quasi-
equity (hybrid) instruments
2.2 Additional ordinary shares: Rights
issue, placements, takeover issues,
dividend reinvestment schemes
2.3 Preference shares
2.4Quasi-equity

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2.1 Equity-funding for Listed Companies

• Different forms of equity finance are available to
established companies
– Additional ordinary shares
 Rights issue, placements, takeover issues, dividend
reinvestment schemes
– Preference shares
– Quasi-equity
 Convertible notes, options, warrants

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2.2 Equity-funding for Listed Companies

(cont.)
• Rights issue
– Issue of ordinary shares to existing shareholders
– Issued pro-rata, e.g. 5:1 or 5 for 1
– Factors influencing the issue price
 Company’s cash flow requirements
 Projected earnings flows from the new investments funded
by the rights issue
 Cost of alternative funding sources

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2.2 Equity-funding for Listed Companies

(cont.)
• Rights issue (cont.)
– Two types
 Renounceable— shareholder may sell their right
 Non-renounceable—right may not be sold
– Rights issued at a discount to current share price

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2.2 Equity-funding for Listed Companies

(cont.)
• Placements
– Additional new ordinary shares issued directly to selected
investors (institutions and individuals) deemed to be
clients of brokers
– Not required to register a prospectus but a memorandum
of information must be prepared
– Minimum subscription $500 000 to not more than 20
participants

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2.2 Equity-funding for Listed Companies

(cont.)
• Placements (cont.)
– Market price discount cannot be excessive
– Allows smaller discount and shorter time frame than
rights issue
– Dilutes holding of non-participating shareholders

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2.2 Equity-funding for Listed Companies

(cont.)
• Takeover issues
– Acquiring company issues additional ordinary shares to
owners of target company in settlement of the transaction
– Alleviates need for owners of acquiring company to inject
cash for the purchase of the company

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2.2 Equity-funding for Listed Companies

(cont.)
• Dividend reinvestment schemes
– Shareholders have the option of reinvesting dividends in
additional ordinary shares
– In growth periods it allows companies to pay dividends
and pass on tax credits, while increasing equity
– Schemes may be suspended in low growth periods

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2.3 Equity-funding for Listed Companies

(cont.)
• Preference shares
– Are hybrid securities, i.e. they have characteristics of both
debt and equity
– Fixed dividend rates are set at issue date
– Rank ahead of ordinary shareholders in the payment of
dividends and liquidation

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2.3 Equity-funding for Listed Companies

(cont.)
• Preference shares (cont.)
– Include combinations of the following features
 Cumulative or non-cumulative
 Redeemable or non-redeemable
 Convertible or non-convertible
 Participating or non-participating
 Issued with different rankings

Question 2-3

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2.3 Equity-funding for Listed Companies

(cont.)
• Preference shares (cont.)
– Advantages of preference shares
 Fixed interest borrowings but they are an equity finance
instrument
 Assist in maintaining debt to equity ratio
 Widen a company’s equity base, which allows further debt
to be raised also
 Dividends may be deferred on cumulative shares and not
paid on non-cumulative shares, while interest on debt must
be paid

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2.4 Equity-funding for Listed Companies

(cont.)
• Convertible notes
– Are a hybrid instrument, issued for a fixed term at a
stated rate of interest, either by direct placement or pro-
rata to shareholders
– Holder has right to convert the note into ordinary shares
at a specified future date and at a predetermined price
– The option to convert to equity has value
– If share price subsequently rises a gain is made

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2.4 Equity-funding for Listed Companies

(cont.)
• Convertible notes (cont.)
– If share price falls, holder may not exercise conversion
option and take the notes’ cash value
– Interest paid on notes is usually lower than straight debt
interest
– Interest payments are tax deductible to the company
– Notes are often issued for longer periods than is possible
with straight debt borrowings

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2.4 Equity-funding for Listed Companies

(cont.)
• Company-issued options
– Provide the right, but not the obligation, to purchase
shares at a stated price and date
– Allow companies to raise further equity funds at planned
future dates (providing holders exercise the option)
– Typically offered in conjunction with a rights issue or
placement
– Issued free or sold at a price

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2.4 Equity-funding for Listed Companies

(cont.)
• Company-issued options (cont.)
– Generally have value and may be traded
– The option will be exercised if the exercise price is less
than the market price of the share at the exercise date

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2.4 Equity-funding for Listed Companies

(cont.)
• Company-issued equity warrants
– Generally attach to corporate bond issues but may be
issued unattached
– Holder has option to convert warrant into ordinary shares
at specified price over a given period
– Warrants may be detachable from the bond and traded
separately
– No dividends but holders benefit from capital gains if
share price rises above conversion price

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3. Pricing of Stock
3.1 Discount cash flow – (DDM)
• Common Stock Valuation
• Constant growth model
• Non-Constant Growth - Two stage constant
Growth
• The Cost of Stock
• WACC - Weight Average Cost of Capital
3.2 Relative valuation
-Price earnings ratio (P/E)
-Price book value ratios (P/BV)
-Price sales ratio (P/S)
-Price cash flow ratios (P/CF)

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3.1 Common Stock Valuation

Div1 Div2 Divn Pn

P0    ...  
(1  r )1 (1  r ) 2 (1  r ) n (1  r ) n

n
Divt Pn
P0   t

t 1 (1  r ) (1  r ) n

P0: Stock’s intrinsic value.

Dt: dividend the stockholder expects to receive at the end of year t
r: the required return on common stock
Pn: expected price of the stock at the end of year n

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3.1 Common Stock Valuation

Ex 1: Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next
three years, respectively. At the end of three years
you anticipate selling your stock at a market price
of $94.48. What is the price of the stock given a
12% expected return?

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3.1 Constant growth model (Gordon Model)

Constant growth model (Gordon Model):
-g=constant; n-> Exercise 1

-r>g and r≠ g Div1 Div0 (1  g )

P0  
rg rg
-Zero-growth Div
P0 
(Preference stock) r
Div1
-Expected return r  g
P0
-Growth rate g = RR × ROE ; RR= 1- %DPS; %DPS=Div/EPS

RR = retention rate; ROE: return on equity;

%DPS: dividend per share ratio (Dividend payout);
EPS: Earning per share

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3.1 Non-Constant Growth

• Valuing Non-Constant Growth

Div1 Div2 Divn Pn

P0  1
 2
 ...  
(1  r ) (1  r ) (1  r ) (1  r ) n
n

Divn 1
Pn 
rg

Exercise 2

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3.1 The Cost of Stock

1.Constant Dividend Growth Model
Div1
1.1 Retained Earning rs  P  g
0
Div1
1.2 New share Issue rN  P0  F
 g

F: Issuance cost
2.CAPM rs =rf + ß(Rm-rf)
 Rf: risk-free interest rate
 Rm: Required market return
 ß: beta of investment
 Rm-rf : Risk premium

Exercise 3

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3.1 WACC – Weight Average Cost of

Capital
WACC = ra= wdrd (1-T)+ wsrs
Wd: weight of debt
rd: cost of debt
Ws: weight of common stock
rs: cost of common stock

Exercise 4

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3.2 Relative Valuation Ratio

Model 1
P / E  ( P / E ) Industry
-Estimate P/E industry
-Estimate EPS

Model 2
D1 / E1 % DPS1
P / E1  
rg rg

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3.2 Additional Measures of Relative Value

• Price/Book Value Ratio
• Price-to-Sales Ratio
• Price/Cash Flow Ratio

Exercise 5

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Learning Objectives
4. Short-term Debt

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4. Short-term Debt
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Promissory Notes
4.5 Negotiable Certificates of Deposit
4.6 Inventory Finance, Accounts Receivable
Financing and Factoring

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4.1 Trade Credit

• Short-term debt is a financing arrangement for a
period of less than one year with various
characteristics to suit borrowers’ particular needs
– Timing of repayment, risk, interest rate structures
(variable or fixed) and the source of funds
• Matching principle
– Short-term assets should be funded with short-term
liabilities

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4.1 Trade Credit (cont.)

• A supplier provides goods or services to a
purchaser with an arrangement for payment at a
later date

• Often includes a discount for early payment (e.g.

2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)

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4.1 Trade Credit (cont.)

• The opportunity cost of the purchaser foregoing
the discount on an invoice (2/10, n/30) is

% discount 365
Opportunity cost  
1 % discount days difference between
early and late settlement
(4.1)
2% 365
 
1- 2% (30 - 10)
 37.2%

Earning after tax 30% -> option early payment

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4.2 Bank Overdrafts

• Major source of short-term finance
• Allows a firm to place its cheque (operating)
account into deficit, to an agreed limit
• Generally operated on a fully fluctuating basis
• Lender also imposes an establishment fee,
monthly account service fee and a fee on the
unused overdraft limit

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4.2 Bank Overdrafts (cont.)

• Interest rates negotiated with bank at a margin
above an indicator rate, reflecting the borrower’s
credit risk
 Financial performance and future cash flows
 Length of mismatch between cash inflows and outflows
 Adequacy of collateral
• Indicator rate typically a floating rate based on a
published market rate, e.g. BBSW

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4.3 Commercial Bills

• A bill of exchange is a discount security issued
with a face value payable at a future date
• A commercial bill is a bill of exchange issued to
raise funds for general business purposes
• A bank-accepted bill is a bill that is issued by a
corporation and incorporates the name of a bank
as acceptor

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4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved (bank-
accepted bill)

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4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Drawer
 Issuer of the bill
 Secondary liability for repayment of the bill (after the
acceptor)
– Acceptor
 Undertakes to repay the face value to the holder of the bill
at maturity
 Acceptor is usually a bank or merchant bank

Question 1

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4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Payee
 The party to whom the bill is specified to be paid, i.e. the
party who receives the funds
 Usually the drawer, but the drawer can specify some other
party as payee
– Discounter
 The party that discounts the face value and purchases the
bill
 The provider or lender of the funds
 May also be the acceptor of the bill

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4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Endorser
 The party that was previously a holder of the bill
 Signs the reverse side of the bill when selling, or
discounting, the bill
 Order of liability for payment of the bill runs from acceptor to
drawer and then to endorser

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4.3 Commercial Bills (cont.)

• The flow of funds (bank-accepted bills)

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4.4 Promissory Notes

• Also called P-notes or commercial paper, they are
discount securities, issued in the money market
with a face value payable at maturity but sold
today by the issuer for less than face value
• Typically available to companies with an excellent
credit reputation because
– There is no acceptor or endorser
– They are unsecured instruments

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4.5 Negotiable Certificates of Deposit

• Short term discount security issued by banks to
manage their liabilities and liquidity
• Maturities range up to 180 days
• Issued to institutional investors in the wholesale
money market
• The short-term money market has an active
secondary market in CDs

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4.6 Inventory Finance, Accounts

Receivable Financing and Factoring
• Inventory finance
– Most common form is ‘floor plan finance’
– Particularly designed for the needs of motor vehicle
dealers to finance their inventory of vehicles
 Bailment common—finance company holds title to
dealership’s stock
– Dealer is expected to promote financier’s financial
products

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4.6 Inventory Finance, Accounts

Receivable Financing and Factoring (cont.)
• Accounts receivable finance
– A loan to a business secured against its accounts
receivable (debtors)
– Mainly supplied by finance companies
– Lending company takes charge over a company’s
accounts receivable; however, the borrowing company is
still responsible for the debtor book and bad debts

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4.6 Inventory Finance, Accounts

Receivable Financing and Factoring (cont.)
• Factoring
– Company sells its accounts receivable to a factoring
company and in doing so
 In doing so it converts a future cash flow (receivables) into a
current cash flow
– Factoring provides immediate cash to the vendor; plus it
removes administration costs of accounts receivable

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4.6 Inventory Finance, Accounts

Receivable Financing and Factoring (cont.)
• Factoring (cont.)
– Main providers of factor finance are the finance
companies
– Factor is responsible for collection of receivables
– Notification basis: vendor is required to notify its
(accounts receivables) customers that payment is to be
made to the factor
– Recourse arrangement
 Factor has a claim against the vendor if a receivable is not
paid
– Non-recourse arrangement
 Factor has no claim against vendor company

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Learning Objectives
5.Pricing of Bond

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5.Pricing of Bond
5.1 The Fundamentals of Bond Valuation
5.2 Computing Bond Yields
5.3 The Duration Measure

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5.1 The Fundamentals of Bond Valuation

The present-value model

n
Ct Pp 1  (1  i) n  Pp
Pm   t
 C 
t 1 (1  i ) (1  i)n  i  (1  i)
n

Where:
Pm=the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond

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5.1 The Fundamentals of Bond Valuation

Example - France
 In December 2008 you purchase 100 Euros of
bonds in France which pay a 8.5% coupon every
year. If the bond matures in 2012 and the YTM is
3.0%, what is the value of the bond?

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5.1 The Fundamentals of Bond Valuation

The present-value model
2n
Ct 2 Pp 1  (1  i / 2)2n  Pp
Pm   t
 2n
 (C / 2)  
t 1 (1  i 2) (1  i 2)  i/ 2  (1  i / 2)2n

Where:
Pm=the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond

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5.1 The Fundamentals of Bond Valuation

Example - USA
 In February 2009 you purchase a 3 year US
Government bond. The bond has an annual coupon
rate of 4.875%, paid semi-annually. If investors
demand a 1.2% annual return, what is the price of
the bond? (Face value = 1,000$)

Exercise 7

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5.2 Computing Bond Yields

Yield Measure Purpose
Nominal Yield Measures the coupon rate

Current yield Measures current income rate

Yield to maturity Measures expected rate of return for

bond held to maturity
Yield to call Measures expected rate of return for
bond held to first call date

Nominal Yield
Measures the coupon rate that a bond investor
receives as a percent of the bond’s par value

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5.2 Current Yield

Similar to dividend yield for stocks

Important to income oriented investors
CY = Ci/Pm
where:
CY = the current yield on a bond
Ci = the annual coupon payment of bond i
Pm = the current market price of the bond

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5.2 Computing the Yield to Maturity

Assumes
Investor holds bond to maturity
All the bond’s cash flow is reinvested at the
computed yield to maturity

n
Ct Pp 1  (1  i) n  Pp
Pm   t
 C 
t 1 (1  i ) (1  i)n  i  (1  i)
n

Exercise 8
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5.3 The Duration Measure

What Determines the Price Volatility for Bonds
Four Factors
1. Par value
2. Coupon
3. Years to maturity
4. Interest rate

Exercise 9
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5.3 The Duration Measure

- Developed by Frederick R. Macaulay, 1938

• Since price volatility of a bond varies inversely with

its coupon and directly with its term to maturity, it is
necessary to determine the best combination of
these two variables to achieve your objective
• A composite measure considering both coupon
and maturity would be beneficial

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Exercise 10
C C C C PP
P    ....  
1  r (1  r ) 2 (1  r )3 (1  r ) n (1  r ) n
dP 1 1 1C 2C nC nPP 1
x  (   ...   )x
dr P 1  r 1  r (1  r )2 (1  r ) n (1  r ) n P

1C 2C nC n PP 1
D u ra tio n  (   ...   )
1 r (1  r ) 2 (1  r ) n (1  r ) n P

1xP V (C1 ) 2 xP V (C 2 ) n x P V ( C n ) n x P V (P P )
D u ra tio n    ...  
PV PV PV PV
Duration
MoD  ModifiedDuration 
1 r
%price volatility = P/P = -MoD x % interest rate volatility= -MoD x i

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Summary
• Initial public offering (IPO) is an offer to investors
of ordinary shares in a newly listed company on a
stock exchange
• Additional equity can be raised through ordinary
shares, preference shares, convertible notes and
other quasi-equity
• Pricing of stock Discount cash flow – (DDM) and
Relative valuation
• Distinguish Short-term debt instruments
• Pricing of Bond

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