L5 FINANCIAL MANAGEMENT

EQUITY (2): ORDINARY SHARES/PREFERENCE SHARES

Question 1.
A good answer will first discuss the various kinds of efficiency:

Operational: transaction costs, access to markets

Allocational: economic efficiency, optimisation of resource utilisation
Informational: information available to the majority at low cost
Pricing: market breadth and depth, liquidity, full reflection of
information, no one dominates market

The answer should then focus on whether AIM has adequate pricing efficiency:

 Targeted at young, dynamic companies which would struggle to meet the listing
requirements and costs of the main market
 The AIM is certainly less liquid than the main market due to lower transactions
volumes and not many players/new entrants/market-makers (breadth and depth)
 However, AIM is growing and because of the lower regulatory pressure more
companies are moving to AIM from the main market
 There are not as many disclosure requirements on AIM and therefore there is
less information available

Are prices on the AIM fair? Can be argued both ways. An argument around low
volume and low informational efficiency could suggest not. But an argument that
there is enough volume for the market to exist and that the exchange is growing
could argue prices are fair. Ultimately a fair price is one that people are willing to
pay, and the majority of AIM investors are institutional investors and wealthy
individuals who are experienced enough to know if a price is fair or not.

Question 2.
Whilst technically classified as equity finance, preference shares also exhibit some
properties of debt finance.

Like equity:
 They are (generally speaking) irredeemable.
 The dividends paid on them are not tax deductible.

However, like debt:

 If any ordinary dividend is paid, then the full X% on the preference shares
has to be paid - hence resembling interest. Only when the company pays
no ordinary dividend can the dividend coupon vary between 0 and X%.
 They have no voting rights.

Another point to note is that not only do preference shares receive their dividend
before ordinary shareholders but on liquidation preference shares rank higher in the
creditor hierarchy.

There are different types of preference share.

(1) Cumulative preference shares: allow the company to carry dividends forward to
future years if profits are insufficient to pay out in the current year.

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(2) Participating preference shares are similar to ordinary equity in that the dividends
are linked to corporate performance. Like ordinary shares preference shares are
issued on the primary capital markets and subsequently traded on a secondary
market. Because they possess characteristics of debt and equity finance, they earn a
return higher than debt but lower than ordinary equity and have greater risk than
debt but lower than ordinary equity.

From a company point of view, the specific advantages and disadvantages of

preference shares are:

Advantages:

 They do not attract voting rights and do not represent ownership of any part of
the company and therefore do not affect the control structure
 Although some gearing calculations treat preference shares as debt, they are
technically equity so may not limit the amount of debt the company can raise
in the future
 Dividend payments have some degree of flexibility in that there are some
circumstances when payment can be withdrawn or in the case of cumulative
preference shares, postponed.

Disadvantages:

 Preference shares do not carry the same dividend flexibility as ordinary

shares. If certain criteria are met (e.g. an ordinary dividend is declared) then
the dividend must be paid.
 Preference share dividends are paid after tax (like ordinary dividends) so they
are not a tax efficient source of financing (like debt)
 Preference shares are below debt in the creditor hierarchy which means they
are higher risk from an investors point of view. This leads to a higher cost
(risk vs reward) than debt.

Question 3.
Pre-emptive rights mean that the company has an obligation to offer any new issue
of shares to the existing shareholders before making a public offer. The advantage
to shareholders is that these rights prevent any significant change in the structure of
ownership and control of the company, since the shares are offered to existing
shareholders (although not necessarily taken up) in proportion to existing holdings.

The advantage to a company of a rights issue is that, depending on market and

trading conditions, it may be a cheaper way of increasing equity capital than making
a public offer. This is because the shares may be offered at a higher price to
existing investors, and because issue costs of a rights issue are lower than for a
public offer. A disadvantage of a rights issue to a company is that, if insufficient
funds are raised, further steps must be taken by the company to secure the
additional finance that it needs. This will be a more expensive and lengthy process
than would be the case if it were possible to make a single placing of shares instead.

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Question 4.

Advantages:

 Access to long term finance. Equity finance is a key long-term financing method
and can only be effectively realised on a large scale with a listing on a major
stock exchange. For companies in the UK that is the London stock exchange.
 Credibility. Listing on the London stock exchange raises the credibility of
companies with lots of different stakeholders. Investors are more attracted to
listed companies. Finance providers (e.g. lenders) will view listed companies as
more transparent and customers and suppliers may view the company as more
reliable, trustworthy and safer to do business with.
 Monetisation of ownership. A privately held firm may list in order that there
becomes a more liquid market for its shares so that some or all can be sold.
 Use of shares. A listing makes shares more attractive for use in takeovers and
also as security or backing for other deals. Share for share exchanges are
common in mergers and acquisitions but if a share is not listed the target
company may be reluctant to accept consideration through shares as it will be
hard to value the shares and hence how much in cash terms is being offered.

Disadvantages:

 Cost. Listing on the main London market is very expensive and total issues costs
including professional fees for a large IPO will easily run into £millions.
 Shareholder pressure. Once a company’s shares are listed it usually means the
ownership is no longer entirely with the founder or people directly involved or
employed by the business. This means shareholders may have their own
expectations of company performance and policy and will place pressure on
management to achieve their objectives. This could mean exercising voting rights
on key decisions and/or selling their shares.
 Susceptibility to takeover. If a company’s shares are listed, they become easier to
purchase, not just by investors but also other companies. A hostile takeover is a
takeover approach that is unwanted by the target company. Hostile takeovers are
more easily embarked upon is there is free access to shareholders as is the case
if shares are listed.

Question 5.

(1) Here there are two choices:

(a) Public Offer: Shares are offered at a fixed price to the public at large,
including both investing institutions and private individuals. Application forms
and a prospectus, setting out the relevant details of the company's past
performance and future prospects in accordance with Stock Exchange
regulations, must be published in the national press. A public offer gives a
wide spread of ownership and is used for raising large amounts of cash, but it
is more expensive that a placing (see below). Listing rules require that 25% or
more of a company’s issued shares must be in public hands and a public offer
can help to achieve this.

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A variation of this method is a public offer for sale by tender, where no prior
issue price is announced, but prospective investors are invited to bid for
shares at a price of their own choosing. The eventual striking price is
determined by the weight of applications at various prices, i.e. by supply and
demand.

(b) Placing: This occurs when shares are "placed" or sold to institutional
investors, selected by the merchant bank advising the company and its
stockbroker. Agreement by such investors to participate the placing is
obtained prior to the issue. In a placing, the general public have to wait until
official dealing in the shares begins before they can buy the shares. A placing
is cheaper than a public offer and use to raise relatively smaller amounts of
capital but will not lead to a wide spread of share ownership.

(2) If the company doesn’t want to raise new finance but wants to list then it
means the company already has shares in existence, and what it needs is an
‘introduction’. An introduction is possible if at least 25% of the company’s
shares are in public hands and there is a reasonable spread of shareholders
(so not 25% owned entirely by 1 person). The introduction process will simply
list the existing shares on the stock exchange without issuing any new shares
and therefore not raising any new capital.

Question 6.
Jumpjet plc has 6,000,000 ordinary shares in issue and the company has been
making regular annual profits after tax of £3,000,000 for some years. The share
price is £5. A proposal has been made to issue 2,000,000 new shares in a rights
issue, at an issue price of £4.50 per share. The funds would be used to redeem
£9,000,000 of 12% debenture stock. The rate of corporation tax is 33%. What
would be the predicted effect of the rights issue on the share price, and would you
recommend that the issue take place?

If the stock market is semi-strong form efficient, the share price will change when the
rights issue is announced in anticipation of the change in EPS. The current EPS is
50p per share, and so the current P/E ratio is 10.
£
Current annual earnings 3,000,000
Increase in earnings after rights issue
Interest saved (12% x £9,000,000) 1,080,000
Less tax on extra profits (33%) 356,400
723,600
Anticipated annual earnings 3,723,600

Number of shares (6,000,000 + 2,000,000) 8,000,000

EPS 46.545p
Current P/E ratio 10

Anticipated share price (if P/E ratio stays the same) £4.65 per share

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A 1 for 3 rights issue is proposed, so we can estimate the theoretical ex rights price:
£
Current value of three shares (3 x £5) 15.00
Rights issue price of one share 4.50
Theoretical value of four shares ex rights 19.50

Theoretical ex rights price = £19.50 / 4 = £4.875 per share

The anticipated share price after redeeming the debentures would be £4.65 per
share, which is less than the theoretical ex rights price. If the rights issue goes
ahead and the P/E ratio remains at 10, shareholders should expect a fall in share
price below the theoretical ex rights price, which indicates that there would be a
capital loss on their investment. The rights issue is for this reason not
recommended.

Phase Test Preparation:

Q1. E Once issued, a company's shares subsequently trade on the primary

Market
This statement is untrue – once issued, a company's shares subsequently trade on
the secondary market. All other statements are true.

Q2. B Because it allows them to preserve their proportional shareholding

in the company
This statement is true. All other statements are false.

Q3. B 1 for 2
No. of shares to issue = £10m/£4 = 2.5m. No. Shares already in issue = £50m/£5 =
10m. Therefore, the issue will be a 1 for 2.

Q4. D £2.63
Here the TERP is given by [(7 x £2.75) + (2 x £2.20)]/9 = £2.63

Q5. C Ordinary shares rank higher in the creditor hierarchy than preference
Shares
Here the reverse is true. Preference shares are one ahead in the creditor hierarchy
compared to ordinary shares.

Q6. D £1.50 £0.88

Ordinary share price is given by: [10 (1 + 0.05)]/ (0.12 – 0.05) = £1.50
Preference shares price is given by: 7p/0.08 = 88p

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