OVERVIEW
Objective
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To understand the options available to a company considering an issue of equity funds.DIVIDEND POLICY METHODS OF
SHARE ISSUE
OTHER TYPES OF SHARE ISSUE
¾ Quoted ¾ Unquoted ¾ Considerations ¾ Official Listing ¾ AIM Listing ¾ Rights issue
¾ Enterprise Investment Scheme ¾ Venture capital
¾ Bonus issue ¾ Stock splits ¾ Scrip dividends
INTERNAL EQUITY FINANCE
¾ Stable
¾ Constant payout ratio ¾ Residual dividend policy ¾ Clientele theory
¾ Bird in the Hand Theory ¾ Dividend Irrelevance Theory ¾ Share Buy Back Programmes ¾ Special Dividends
¾ Practical considerations EQUITY
1
METHODS OF SHARE ISSUE
1.1
New shares — quoted companies
If a company is already listed the following methods are available for the issue of new shares.
Method
Explanation
Offer for subscription
(public issue) A sale expensive method of issuing new shares. direct to the general public. This is generally the most Offer for sale A sale indirect to the public via selling shares directly to an issuing
house (merchant/investment bank) which then sells them to the public.
Placing In a placing the sponsor (normally a merchant bank) places the shares with its clients. At least 25% of shares placed must, however, be made available to the general public. This is generally the least expensive method of issuing new shares. Rights issue An offer to existing shareholders to buy shares in proportion to
their existing holdings. Offer for sale or
subscription by tender Like an where setting a price for the shares is difficult. auction – the public is invited to bid for shares. Useful Vendor placing Sometimes used in takeovers when a predator company buys a
target company by offering its own shares but pre-arranges third party buyers for those shares. The result is that the target
company shareholders are confident that they will be able to sell the shares they receive in the predator company.
1.2
Options for unquoted companies
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Become quoted, i.e. raise new equity finance at the same time as becoming listed – known as an IPO (Initial Public Offering) The method could be an offer for subscription or sale, tender, or placing.¾
Stay unquoted. Use rights issue or private placing. However there may be a limited source of funds from either existing owners or new private investors.¾
Introduction. Existing shares are given permission to be traded/”floated” on the Stock Exchange. No new finance is raised. Public must already hold at least 25% of the shares in the company.Commentary
Many small or medium sized enterprises (SME’s) find that raising equity is difficult. This is an acknowledged problem and has been addressed by both government and commerce. Attempted solutions include the AIM, Enterprise Investment Schemes, Venture Capital and Venture Capital Trusts (discussed later).
1.3
Considerations when considering a share issue
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Legal restrictions;¾
Cost e.g. fees must be paid to an investment bank to underwrite/guarantee the share issue¾
Pricing problems;¾
Stock Exchange rules as contained in the Yellow Book;¾
Timing.1.4
The requirements for an Official Listing
Before the shares of a company can receive an Official Listing i.e. become traded on the full London Stock Exchange, the following requirements must be met:
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The market capitalisation (value) is at least £700,000;¾
There is a three year trading record;¾
At least 25% of the shares are made available to the general public;¾
Detailed disclosure requirements are met;¾
Any new issue of shares is accompanied by a detailed prospectus.The costs of acquiring and maintaining an Official Listing mean that it is not really a possibility for Small or Medium-sized Enterprises (SME’s). These companies may find the AIM market more attractive.
1.5
The requirements for an Alternative Investment Market (AIM) Listing
The AIM market has fewer regulations and in this way is attractive to smaller companies. Investors recognise that due to the more limited regulation, investment in AIM companies carries additional risk.
The requirements include:
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Companies must have plc or equivalent (if non-UK) status;¾
The accounts must conform to UK or US accounting practice;¾
A prospectus must be published prior to the initial quotation and any following issue of securities;1.6
Rights issue
In a rights issue existing shareholders are offered more shares (usually at a discount to the current market price) in proportion to their existing holding.
UK company law guarantees shareholders “pre-emptive rights” i.e. the right to purchase new shares before they can be offered to other investors. This is to protect shareholders from dilution of their control
The result of issuing these shares at a discount is to reduce the market value of all the shares in issue.
Calculation of a theoretical ex-rights price.
Example 1
A company has 100,000 shares with a current market price of $2 each. It then announces that it is to take on a project with a NPV of $25,000. The project will be financed by a rights issue of one new share for every two existing shares. The rights price is $1 per new share.
Required:
What is the theoretical ex-rights price of the company’s shares?
Shareholder wealth and rights issues
Example 2
Assume in Example 1 above that Mr X owns 1,000 shares in the company.
Required:
Show Mr X’s position if:
1.7
Enterprise Investment Scheme (EIS)
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A UK scheme designed to encourage private investors to buy shares in unlisted trading companies.¾
Tax relief, at an income tax rate of 20%, is available for investors.¾
Maximum investment is £100,000 per annum¾
Shares must be held for five years.1.8
Venture capital
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What is it?“Venture capital” simply means equity capital for small and growing businesses. It includes funds provided for management buy-outs. Typically $1m minimum is involved.
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Who provides it? Specialist venture capital providers, e.g. “Investors In Industry” (the 3i Group); Banks, insurance companies, pension funds;
Local authorities and development agencies.
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What do they look for? Product with strong potential e.g. a new innovation ; Solid management;
High returns.
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What conditions are normally attached?Providers of funds would normally expect:
a business plan with medium-term cash flow and profit projections ; board representation;
a dividend policy which promotes growth i.e. high reinvestment of profits; an “exit route” e.g. proposed time-scale for seeking a market quotation; provision of regular management accounting information.
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Venture Capital Trusts (VCTs) VCTs are listed investment trust companies which invest at least 70% of their funds in a spread of small unquoted trading companies.
2
INTERNAL EQUITY FINANCE
As an alternative to issuing new shares (or debt) a company can finance its investment projects using retained earnings i.e. using internal finance rather than external finance.
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The amount of internal finance available = cash generated from operations – dividend payments.¾
Creating accounting profits is not enough – the company must be converting profits into positive cash flows.¾
Note that Microsoft did not pay any dividends for many years - it reinvested all cash to produce growth of the company and its share price. Any shareholder that required a dividend could simply sell some shares to take a capital gain and create a “home- made dividend”.¾
Company managers may prefer to use internal finance rather than external finance for the following reasons: a belief that using internal finance costs nothing – in fact this is not true as retained earnings belong to the shareholders who expect significant returns.
“asymmetry of information” – external investors do not have as much knowledge of the business as the management and are therefore often reluctant to provide finance or will only provide it at high cost. This is particularly significant for SME’s which often have problems attracting new investors due to little public knowledge of the business. Using internal finance avoids the problem.
no issue costs on internal finance
internal finance avoids possible change in control due to issue of new shares taxation position of shareholders: - they may prefer to make a capital gain than
receive current income via dividends e.g. in the UK individuals are given a large tax-free limit on capital gains.
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This preference for internal finance has been refereed to as “Pecking Order Theory”3
DIVIDEND POLICY
3.1
Stable
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Stable level of dividends or constant level of growth to avoid sharp movements in share price.3.2
Constant payout ratio
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Constant proportion of earnings paid out as dividend;¾
Not particularly suitable as dividends will fluctuate.3.3
Residual dividend policy
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Remaining earnings, after funding all attractive projects, are paid out as dividend i.e. dividend = cash generated from operations – capital expenditure.¾
Links to Pecking Order Theory i.e. a dividend is only paid if more cash is available than required for reinvestment back into the business.¾
However it is likely to lead to fluctuating dividends and may not particularly suitable for quoted companies.3.4
Clientele theory
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The company’s historical dividend policy may have attracted particular investors to whom the policy is suited in terms of tax, need for current income, etc¾
The company should then maintain a stable dividend policy or risk losing key investors.¾
Management should view shareholders as their “clientele”3.5
Bird in the Hand Theory
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Shareholders may prefer higher dividends (and therefore lower potential capital gains) as a cash dividend today is without risk whereas future share price growth is uncertain.3.6
Dividend Irrelevance Theory
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Modigliani and Miller (finance theorists) argue that shareholders are indifferent to dividend policy.¾
If a company pays no dividend then the share price should rise due to reinvestment of earnings. Any shareholder that requires a dividend can sell part of their holding to create a capital gain i.e. to manufacture a “home made” dividend.3.7
Share Buy Back Programmes
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In recent years there has been a trend for traditional dividend payments to be replaced by share repurchase schemes.¾
With approval from shareholders the company uses surplus cash to buy back part of its share capital, on the assumption that shareholders can reinvest this cash moreeffectively than the company.
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The shares are either cancelled as held by the company as Treasury Shares for possible future reissue. If held by the company the shares carry no voting rights or dividend.¾
The result of a buy back programme is that there will be fewer shares in issue, andhence the share price should rise.
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Ratios such as Earnings Per Share (EPS) and Return on Equity (ROE) should also improve.3.8
Special Dividends
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If a quoted company announces a larger than expected dividend this may raise market expectations of at least the same in future.¾
To avoid raising expectations to an unsustainable level the dividend may be announced as a “special” dividend – basically a bonus dividend.¾
The company is telling the markets that, from time to time, any exceptional cash surplus will be returned in this way, but that this should not be built into dividend per share forecasts.3.9
Practical considerations
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Company law - a dividend can only be legally paid if there is a credit balance on retained earnings in the statement of financial position.¾
Level of inflation.¾
Liquidity position.¾
Stability of earnings – if earnings are stable, a larger dividend can be more easily maintained.¾
“Signalling” – dividend announcements are seen by the financial markets as a sign of company strength/weakness.4
OTHER TYPES OF SHARE ISSUE
4.1
Bonus issue
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Reserves e.g. revaluation reserve is converted into share capital which is distributed as new shares to existing shareholders in proportion to their existing holdings.¾
No finance is raised¾
Purpose − Increases the marketability of the shares, as it increases the number in existence and reduces their price.4.2
Stock splits
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Where ordinary shares are split in value, e.g. $1 shares converted into two 50 cent shares.¾
This reduces the market price per share, increasing their marketability.4.3
Scrip dividends
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Shareholders are offered extra shares instead of a cash dividend.¾
This preserves corporate liquidity and releases cash for reinvestment back into the business - linking to Pecking Order TheoryKey points
³
Ordinary shareholders take more risk than any other type of investor in a company.³
This is because (i) ordinary dividends are discretionary i.e. the company has no legal obligation to pay an ordinary dividend (ii) ordinary shareholders rank last in the event of bankruptcy/liquidation.³
Shareholders require high returns to compensate for this risk and therefore issuing new shares is an expensive source of finance.FOCUS
You should now be able to:
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describe the methods available for issuing new shares;¾
describe ways in which a company may obtain a stock market listing;¾
calculate the theoretical ex-rights price of a share;¾
explain the importance of internally generated funds;¾
discuss the main dividend policies followed by companies;EXAMPLE SOLUTIONS
Value of a right per new share = Ex-rights price – Subscription price = $1.83 – $1 = 83c
Value of a right per existing share = 83c ÷ 2 = 41c
Note - If the market price of the existing shares had been given post the announcement of the project, then the NPV of $25,000 would already be included in the MV of the old shares. This is the more usual circumstance.
(ii) Sells rights
$ Wealth prior to rights issue 1,000 × $2 2,000
______ Wealth post rights issue
Shares 1,000 × $1.831/3 1,8331/3
Sale of rights 500 × $0.831/3 4162/3
______ 2,250 ______ ∴ $250 better off
(iii) Does nothing
$
Wealth prior to rights issue 2,000
______
Wealth post rights issue 1,8331/3
