Equity Financing

1. By MaroofHussainSabri Sources of Finance

2. Sources of Finance 2 MaroofHussainSabri

3. Equity Financing Maroof Hussain Sabri 3

4. Equity Financing Generation of funds for business from the OWNERS of the business. Broadly, Major Sources are: Maroof Hussain Sabri 4

5. Retained Earnings Maroof Hussain Sabri 5

6. Retained Earnings Retained earnings, unappropriated profits, accumulated profits or retained profits. Most important form of equity financing Low Cost Can be Cash or short-term investments Problems: May not be enough if company is trying to grow. Difficulty to retain sufficient earnings if shareholders require to maintain or increase dividend levels MaroofHussainSabri 6

7. Equity Shares & Markets Maroof Hussain Sabri 7

8. Stock Market Stock Market Stock Exchange is a market where shares and securities are bought and sold by members/brokers on behalf of their clients and also on their accounts. In Pakistan Karachi Stock Exchange Lahore Stock Exchange Islamabad Stock Exchange MaroofHussainSabri 8

9. Reason for Seeking a Stock Market Listing Reasons: Access to a wider pool of finance Improved marketability of shares Transfer of capital to other uses Enhancement of the company image Facilitation of growth by acquisition (Continued…) Maroof Hussain Sabri 9

10. Reason for Seeking a Stock Market Listing From Private Co. to “plc” (public company) Owner must accept the change-Significant loss of control to a wider circle of investors. The risk of the company being taken over will also increase following listing. To issue shares on a stock exchange, company has to obtain: Admission to listing from the financial services authority (SECP in Pakistan) Admission to trading from the Stock Exchange (KSE, LSE or ISE) Maroof Hussain Sabri 10

11. Ordinary Shares Issued to the owner of the company Have a nominal or face value, typically of £1 or 50p in UK, Rs. 10 in Pakistan No relationship between market value and nominal value of shares except when ordinary shares are issued for cash then it must be equal to or above the face value. Deferred Ordinary Shares: entitle to dividend only after a certain date or only if the profits rise above a certain amount Maroof Hussain Sabri 11

12. Circumstances for A New Issue of Shares To Wholly raise more cash & it can be: Right issue : Selling of new shares to existing shareholders in proportion to their existing shareholding Selling of shares to new shareholders: Number of new shares is small and the ownership of the company is minimally affected To partly raise cash but more importantly to float its shares on a stock market Issue new shares to the shareholder of another company, in order to take the company over. Maroof Hussain Sabri 12

13. Issues of Shares What is issue?Shares offered for sale Shares can be issued on London Stock Exchange y means of: Offer for Sale A Placing A Prospectus issue A stock exchange introduction Maroof Hussain Sabri 13

14. Offers for Sale Selling of shares to the public at large When company go public for the first time, a large issue probably take the form of an offer for sale. The issue price and offers for Sale: The offer price must be advertised a short time in advance Share is prices are set at a low level to ensure success of issue Share price rises to a premium above its issue price soon after trading begins. 20% above the price target premium is typical (Continue…) Maroof Hussain Sabri 14

15. Offers for Sale Over priced issue – undersubscribedunderwriters to buy up the unsold shares Too much under priced – oversubscribedCompany will be able to raise required capital by issuing fewer shares Share price of an issue - usually based on P/E ratio (continued) Maroof Hussain Sabri 15

16. Offers for Sale by Tender Offers for Sale by Tender: Issue price reflects the value of the shares as reflected by market Minimum price will be fixed and tenders will be invited with the price higher than it. Shares will be allotted at the highest price at which they will be taken up, the striking price (Continued…) Maroof Hussain Sabri 16

17. Offers for Sale by Tender Less common than Offers for sale due to: It reflects badly on the issuing house’s ability to determine the prices Major influence will be of the tenders of the institutional investors Determination of prices to be by the public rather than the City experts. Uncertain about the amount of finance that will be raised Deterrence of potential investors – unwilling to decide the price. Might follow a general increase in share values. Striking price is likely to be higher than the issue price set by the issuing company itself. Maroof Hussain Sabri 17

18. A Placing A placing is an arrangement: Shares are not offered to the Public Sponsoring market maker arranges for the most of the issue to be bought by the small number of investors. Usually Instt. Investors like Pension Funds & Insurance Companies Placings are much cheaper Most of the shares will be unlikely to be available for trading after floatation because of Instt. Investors 18

19. Choice B/w AN Offer for Sale and A Placing Large Issue – Offer for Sale Small Issue – A Placing – A Small number of investors Maroof Hussain Sabri 19

20. A Prospectus Issue Company offers its own shares to General Public An issuing house or Merchant Bank – Agent not underwriter Risky and rare Used by well known companies making a large new issue having already a quotation on the stock exchange Maroof Hussain Sabri 20

21. A Stock Exchange Introduction No shares are made available to market, neither existing nor newly created shares; nevertheless the stock exchange grants a quotation Reasons: Greater marketability for the shares A known share valuation for inheritance tax purposes Easier access in the future to additional capital Maroof Hussain Sabri 21

22. Intermediaries Offer For the companies obtaining listing of their shares for the first time Intermediaries such as broker or investments banks apply on behalf of their clients Maroof Hussain Sabri 22

23. Underwriting Underwriters – Financial Institutions which agree to buy at the issue price which are not subscribed for by the general public Remove risk of under-subscribed issue but at a cost to company Alternative to underwriting – shares offered at deep discount – in future dividends payable will be much higher Bought deal –Investment bank buys whole issue at a small discount to market Maroof Hussain Sabri 23

24. Factors for Pricing Shares Are there similar companies already quoated? Current market conditions? Accuracy of forecast of company’s future trading prospects A price which gives immediate premium Achievable steady growth in share price over the time. 24

25. The Timing and Costs of new equity Issue When share prices are high – high confidence level of investor – able to invest in companies with the potential to growth Issuing shares at high price Reduced Numbers of shares to raise capital Reduce the dilution of earnings for existing shareholders Lower share prices – lower business confidence Maroof Hussain Sabri 25

26. The Timing and Costs of new equity Issue Typical costs include: Underwriting costs Stock market listing fee Fee of issuing house, solicitors, auditors & P.R. Consultants Printing & Distribution expense of Prospectus Advesrtising Maroof Hussain Sabri 26

27. Right Issues & Vendor Placings A right issue is an offer to existing shareholders enabling them to buy more shares, usually at a price lower than the current market price Proportional to shareholder’s existing holdings. E.g. a right issue on a one for four basis at 280p per share Advantages: Cheaper than offers for sale. No prospectus, less cost of underwriting More beneficial to existing shareholders Relative voting rights are unaffected Finance raised may be used to reduce gearing to book value Maroof Hussain Sabri 27

28. Deciding the Issue Price for Right Shares Offer price will be lower than the current market price – protection against price fall after announcement Offer price must be at or above the nominal value – Company law Variable Discount Size Low enough to secure the acceptance by shareholders – not too enough to dilute earnings per share Maroof Hussain Sabri 28

29. Deciding the Issue Price for Right Shares Break Even PointWhere dilution is zerowhere Right Price = Capital employed per share Dilution in EarningsDecreasing the earning per share due to increase in the number of shares. Capital Employed Per Share=Total capital / Paid up capital Maroof Hussain Sabri 29

30. Deciding the Issue Price for Right Shares Example Current Capital Structure: 200,000 shares of Re. 1 each 200,000Retained Earnings 100,000Total Capital Current Market Price Rs. 1.80 Proposal to raise funds Rs. 126,000 from a right issue Company can achieve a profit after tax of 20% Required: Calculate No. of Shares if right price is Rs.1.60, Rs. 1.50, Rs. 1.40, Rs. 1.20 Calculate the dilution in Earning per share in each case. Maroof Hussain Sabri 30

31. Deciding the Issue Price for Right Shares Solution: Present earnings = 20% of 300,000 = 60,000EPS = 0.30Forecasted Earnings after issue = 20% of 426,000 = 85,200 No. of new shares = 126,000/rights price EPS = 85,200/no. of shares Break Even Point , where 300,000/200,000 = 1.50 = Right Price (Continued…) Maroof Hussain Sabri 31

32. Deciding the Issue Price for Right Shares Maroof Hussain Sabri 32

33. The theoretical ex rights Price Price changes after the announcement of right issue Market Price will fall – Uncertainty w.r.t dividend, future profits & earnings Duration depend on no. of shareholders & size of the holdings Price will recover after this fall, recovery value Cum Rights – Shares with rights attached Ex-rights – Shares without rights attached. New market price will be the consequence of adjustment to allow for the discount price of the new issue Maroof Hussain Sabri 33

34. The theoretical ex rights Price Example: Fundraiser plc Ordinary Shares of 1,000,000 of £ 1 Market Price on Sep 1 = £2.10 per share Right issue offered at one for four shares at £ 1.50 per right Price Fall to £1.95 and recovered to £2 (Cum rights price) Calculate TERP? (Continued) Maroof Hussain Sabri 34

35. The theoretical ex rights Price TERP can be calculated by using formula :- Where N=No. of shares required to buy one new share Cum Right price will be the price till rights issue Issue price is Price of Right issue as offered Maroof Hussain Sabri 35

36. The theoretical ex rights Price Using formula: N=4, Cumrights price 2, Issue price = 1.50 Putting in the formula, TERP = £1.90 Alternative Method Value of portfolio for a shareholder of 4 shares before the rights issue: 4 shares at £2.00 £8.001 share at £1.50 £1.50 £9.50 Value per share after right issue (TERP) is 90.5/5=1.90 Maroof Hussain Sabri 36

37. The Value of Rights The value of rights is the theoretical gain a shareholder would make by exercising his rights If offered price in the rights issue 1.50 and expected market price after issue (TERP) is 1.90, 0.40 gain for each new share he will buy If cannot buy, sell the right to new subscriber. New subscriber will pay 1.50 for each share + 0.40 to the right holder Value of rights attached to each share = gain/N = 0.4/4 = 0.1 or 1p Maroof Hussain Sabri 37

38. Theoretical Gain or Loss to Shareholders Investor can take following courses of action: Take up or exercise the rights – Maintain their %age holdings in company To renounce the rights and sell them on the market – Low %age holdings of the company’s equity & total value of shares will be less To renounce part of rights & take up the remainder – total market value of shareholding remaining the same To do nothing – Company will sell to new subscribers as per stock exchange rules for the benefit of shareholders entitled to rights Maroof Hussain Sabri 38

39. Theoretical Gain or Loss to Shareholders EXAMPLE: Gopher plc Golper plc has issued 3,000,000 ordinary shares of £1 each, which are at present selling for £4 per share. The company plans to issue rights to purchase one new equity share at a price of £3.20 for every three shares held. A shareholder who owns 900 shares thinks that he will suffer a loss in his personal wealth because the new shares are being offered at a market price lower than market value. On the assumption that the actual market value of shares will equal to the TERP, what would be the effect on the shareholders wealth if: He sells all the rights He exercises half of the rights and sells the other half He does nothing at all Maroof Hussain Sabri 39

40. Theoretical Gain or Loss to Shareholders Solution TERP = £3.80Value of rights per new share = 3.80-3.20 =0.60Value of Rights attached to each existing share = 0.60/3 = 0.20 These values are calculated using formulae previously given (Continued…) Maroof Hussain Sabri 40

41. Theoretical Gain or Loss to Shareholders If he sells all his rights: Sale Value of rights = 0.20 x 900 = 180 Market Value of his 900 shares, ex rights = 900 x 3.80 = 3,420 Total wealth = 180 + 3420 = 3,600 No gain no loss but shareholding proportion in company will be lower (Continued..) Maroof Hussain Sabri 41

42. Theoretical Gain or Loss to Shareholders If exercise half of the rights and sells the other half: Sale Value of rights = 900/2 x 0.20 = 90 Market Value of his shares = (900+450/3) x 3.80 = 3990 Total = 90+3990=4080 Additional Investment = 4080 – 3600 = 480 No Gain No loss, increased investment in company by 480 Maroof Hussain Sabri 42

43. Theoretical Gain or Loss to Shareholders If he does nothing, Market value of 900 shares cum rights = 3600 Market Value of 900 shares ex right = 3420 Loss in wealth = 180 To protect his invesment he must exercise his rights or sell them. If not Company will may sell new securities to others to safeguard his benefit Maroof Hussain Sabri 43

44. The Actual Market Price After Right Issues The actual market price may differ from TERP. When Expected yield from new funds raised ≠ Earning yields from existing fund Decision to take up the offer will depend on: Expected rate of return on the investment The return obtainable from other investments Maroof Hussain Sabri 44

45. Example: Right Issues Example Musk plc has 4,000,000 ordinary shares in issue, valued at $ 2 each, and the company has actual earnings equal to 20% of the market value of the shares. A one for four rights issue is proposed, at an issue price of $ 1.50. If the market continue to value the shares on P/E ratio of 5, what would be the value per share if the new funds are expected to earn, as a percentage of the money raised : 15%? 20% 25% How do these values in 1,2,3 compare with TERP? Ignore issue costs. Maroof Hussain Sabri 45

46. Example: Right Issues Solution TERP = $ 1.90 New funds raised = 1.50 x 1,000,000 = 1,500,000 (Note: 1,000,000 for 4,000,000 shares) P/E ratio is 5 (Note P/E ratio multiplied with earnings will give price of shares, market price) (Continued…) Maroof Hussain Sabri 46

47. Example: Right Issues Earnings will be as follows: Additional earning (15% of 1,500,000) Current earnings (8,000,000 x 0.2) (Continue) Maroof Hussain Sabri 47

48. Example: Right Issues P/E ratio is 5, Market value will be Total earnings x 5 T. Earnings x P/E = Market Value of Shares Price per share = Total Market value/No. of shares Maroof Hussain Sabri 48

49. The Actual Market Price After Right Issues Earnings with the Same Rate:TERP = Actual Market Value At a lower rate:TERP > AMV (Loss to shareholder) At a higher rateAMV > TERP (Profit to shareholder) Maroof Hussain Sabri 49

50. Vendor Placing A vendor placing occurs when there is an issue of shares by one company to take over another The shares are then sold in a placing to raise cash This cash will be used to pay to the shareholders in the target company who are selling their shares in the take over Maroof Hussain Sabri 50

51. Other instances of issuing shares Open Offer: Offer to existing shareholders, but different from right shares: Not necessarily pro-rata to existing shareholding Offer is not allotted renounceable documents Capitalization Issue Scrip issue Does not raise funds Capitalize reserves of the company – New shares to shareholders at a pro-rata to existing shareholding Maroof Hussain Sabri 51

52. Other instances of issuing shares Vendor Consideration Issue Issue of shares in a take over or merger For example, A plc wishes to take over B plc, a paper offer from A plc to shareholders of B plc to subscribe for newly issued shares of A plc. Very common due to mergers and takeovers nowadays Employees Share Options Offer to the employees to subscribe for shares at or below the market price. Maroof Hussain Sabri 52

53. Scrip Dividends, Scrip Issues & Stock Splits Not methods of raising funds: Alter the capital structure of Company Increase the Share Capital of Company A way of increasing no. of shares without raising funds Scrip Dividend Schemes Involve shareholders being issued shares in lieu of a cash dividend Maroof Hussain Sabri 53

54. Scrip Dividends, Scrip Issues & Stock Splits Scrip Dividend: Takes the form of new shares instead of cash. Converts Profit & Loss reserves into capital Optional for shareholder to take cash or bonus dividend. Scrip issue: Issue of bonus shares issued, also called bonus issue. Convert equity reserves into share capital Stock Split: Ordinary share is split into two shares to increase its marketability. Leaves reserves unaffected Maroof Hussain Sabri 54

55. Preference Shares Preference shares carry priority over ordinary equity shares with regard to dividend payments. Fixed percentage dividend Have no Voting rights Attractive for corporate investors. Tax Treatment: Dividend received are not subject to corporation tax Dividend Payments are not tax-deductible for the issuing company Maroof Hussain Sabri 55

56. Preference shares Positive Features: No dividend in the years where profits are poor Avoid dilution of control of existing shareholders Lower the company’s gearing (Unless redeemable which are treated as debt) Doesn’t restrict company’s borrowing power (as this capital is not secured by fixed assets) In case of non payment of dividend, shareholders cannot appoint receiver (as in Debentures) Negative features: Dividend payments on P.S. are not tax deductible To attract investors, level of payments should be higher than the interest yields on loan Maroof Hussain Sabri 56

57. Stock Market Ratios Indicators that can be used to asses investors returns The dividend yield Earning Per Share (EPS) Price to Earning ratio (P/E ratio) Dividend Cover Dividend Pay out ratio Maroof Hussain Sabri 57

58. The Dividend Yield & the Interest Yield Dividend Yield Dividend Yield = Gross dividend per share/market price per share x 100 Gross dividend include Dividend paid + appropriate tax credit (normally for preference shares) so that a direct comparison with interest yield can be made Interest Yield Interest Yield = Gross interest/Market Value of Loan stock x 100 It may be different from coupon rate It is investors rate of return Maroof Hussain Sabri 58

59. The Dividend Yield & the Interest Yield Normally dividend yield on shares of quoted companies is lower than Interest yield on debentures & loan stock, however share holders get benefit as follows due to which there return exceeds interest yield: Dividend in the long run Capital Gain Both these contribute a greater return then from fixed interest securities Maroof Hussain Sabri 59

60. The Dividend Yield & the Interest Yield Example: A company pays a dividend of 15p(net) per share. The Market Price is 240p. What will be the dividend yield if the rat e of tax credit is 10%? Solution: Gross dividend per share=15x100/(100-10)=16.67 Dividend Yield = 16.67p/240p=6.95% Note: Gross Dividend per share(15p=100+(100-10) Maroof Hussain Sabri 60

61. The Dividend Yield & the Interest Yield Example: An investment buys $1,000(par value) of a bond with a coupon of 8% for the current market value of $750 Interest Yield=(8%of1000)/750 x 100 = 10.67% Maroof Hussain Sabri 61

62. Earnings per Share EPS=Net Profit/No. of ordinary shares Widely used as a measure of a company’s performance Particularly important in comparing results over a period of several years Investors also look for growth in the EPS from one year to the next Maroof Hussain Sabri 62

63. EPS Example:ABC Ltd.Profit before tax = $9,320,000Tax amounted to $ 2,800,000 Share Capital is as follows:Ordinary Shares (10,000,000 shares at $1) = 10,000,0008% preference shares=2,000,000 Total 12,000,000 Calculate EPS Solution: ABC Ltd.Profit before tax 9,320,000Less Tax 2,800,000P Profits after tax 6,520,000 Pref Dividend 160,000 Earnings 6,360,000 No. of ordinary shares=10,000,000 EPS = 63c Maroof Hussain Sabri 63

64. Price to Earnings Ratio Price to Earning ratio = Market price of share/Earning per share Or Total Market value of equity/Total earnings Example: A company has recently declared a dividend of 12p per share. The share price is £3.72 cum div & earnings for most recent year were 30p per share. P/E ratio = MV ex div/EPS = 3.60/30p = 12 Maroof Hussain Sabri 64

65. Dividend Cover & Dividend Pay Out Ratio Dividend Cover = Max. possible dividend that could be paid out of current profits/Actual dividend for ordinary shares Dividend pay out ratio = DPS/EPS x 100 or Div for the year/PAIT x 100 Maroof Hussain Sabri 65

66. Dividend Cover & Dividend Pay Out Ratio Example: The EPS of York plc is 20p. The dividend was 20% on 25p ordinary shares. div cover = 20p/(20% of 25p) = 4 Means co is retaining 75% for reinvestment purposes Div. payout ratio = 20% of 25p /20p x 100% =25% Maroof Hussain Sabri 66