Chapter 5 - Equities

Question 1

What are deferred shares?

Answer 1

Shares whereby the holders are not entitled to dividend until:
•A specified period of time has elapsed, or
•Other share classes have been paid a certain level of dividend

Question 2

What are Golden Shares?

Answer 2

Shareswith special voting rights, such as power of veto

These allow the holder to outvote other shareholders in specific circumstances, like during a takeover.

Question 3

Give the basic features of ‘vanilla’ preference shares

Answer 3

•Pay a fixed dividend
•Priority over Ord shareholders with dividends and in liquidation
•Unsecured
•No voting rights
•Taxes the same as Ord shares

Question 4

What is the fixed rate of dividend preference shareholders are paid?

Answer 4

Nominal value x dividend rate

Question 5

What are the features of a cumulative preference share?

Answer 5

•Unpaid dividends are carried forward to next year
•Ordinary dividend cannot be paid until pref share dividends paid

Question 6

What are the features of a participating preference share?

Answer 6

Right to receive additional dividends when the profits of the company exceed a certain level

The additional amount payable is usually expressed and paid as a proportion of the Ord dividend

Question 7

What are the features of a redeemable preference share?

Answer 7

Preference shares that can be bought back by the company (callable)

The terms of redemption will be specified in the articles

Question 8

What is a convertible preference share?

Answer 8

Can be converted into a fixed number of Ord shares at a point in the future

Question 9

What is the cum-rights price?

Answer 9

The price before the rights issue

Question 10

What is the ex-rights price?

Answer 10

The price after the rights issue (TERP)

Question 11

What is the nil-paid price?

Answer 11

Cash value of the right in a rights issue

Question 12

What options do shareholders have in a rights issue?

Answer 12

•Exercise and buy shares at a discounted price (also prevents dilution)
•Lapse
•Sell the rights (unless an open offer)
•Sell some of the right to purchase some (splitting the rights/swallowing the tail)

Question 13

How would you calculate the ex-rights price? And the nil paid price?
Eg. 1:4 rights issue, subscription price £1.50, cum-rights price £1.75.

Answer 13

4 x £1.75 = £7.00
1 x £1.50 = £1.50
= 5 =£8.50

8.50 / 5 = £1.70 per share (TERP)

£1.70 - £1.50 =£0.20 (NPP)

Question 14

How would you calculate the maximum subscription of a rights issue at nil cost?

Answer 14

Number of rights available x subscription price / theoretical ex rights price

Question 15

What is the tax impact of taking up rights in a rights issue?

Answer 15

Treated as a separate acquisition for CGT purposes

Question 16

What is the tax impact of selling nil paid rights in a rights issue?

Answer 16

Treated as part disposal, unless consideration is not higher than 5% of value of shares or more than £3k.

If it is the latter, the gain is deferred until later when shares are sold

Question 17

What’s the impact of a rights issue on a balance sheet?

Answer 17

Share capital increased by nominal value of shares issued

Share premium increased by the excess received above nominal value

Question 18

What is the purpose of a bonus issue?

Answer 18

Reduce share price

Increase liquidity

Question 19

How would you calculate the ex-bonus price?
Eg. 1:2 bonus issue, share price £15.

Answer 19

2 x £15= £30
1 x £0 = £0
= 3 = £30

30 / 3 = £10 per share

Question 20

What is the effect of a bonus issue on the balance sheet?

Answer 20

•Increases the share capital

•Reduces share premium, and if not enough, the retained earnings as well

•No impact on equity (shareholders funds)

Question 21

What is the share capital on a balance sheet?

Answer 21

Reflects the number of shares in issue (specifically the NV)

Question 22

What is the share premium on a balance sheet?

Answer 22

Part of Capital reserves, share premium arises when the company issues shares at a price above their nominal value.

Share premium is the amount over the value of share capital issued.
Eg. If £200 NV is issued (share capital), and £300 is earned from this, £100 would be the share premium.

Question 23

What impact does a Bonus issue have on:
Market value
Nominal value
Share capital
Reserves

Answer 23

MV = decreased
NV = no change
Share capital = increased
Reserves = decreased

MV -> share price goes down
NV -> shares issued for free so no change
Share capital -> more shares in issue
Reserves -> ‘pay’ for free distribution of shares

Question 24

What impact does a stock split have on:
Market value (share price)
Nominal value
Share capital
Reserves

Answer 24

MV = decreased
NV = decreased
Share capital = no change
Reserves = no change

Question 25

What is the effect of a stock split on the balance sheet? | (Share Capital & Share Premium accounts)

Answer 25

No impact. ## Footnote Eg. For a 2-1 stock split, where share capital is 100,000. 100,000 shares NV £1 would then become 200,000 shares NV £0.50, so in both cases the share capital would still be £100,000.

Question 26

What are the reasons for a company to do a share buy-back?

Answer 26

•distribution to shareholders, alternative to increasing dividend. •reduces the number of shares outstanding so increases share price

Question 27

How might share buy-backs be viewed by the market?

Answer 27

•could be adverse as may be indicative of a lack of investment opportunities for the company to put cash into •may also be positive if company has done really well & looking to offload cash - which makes it less of a takeover target

Question 28

What are the different accounting methods of a share buy-back?

Answer 28

•shares can be cancelled, so get rid of share capital Or •shares can be held as Treasury Stock, shown as capital reserve, and re-issued at a later date

Question 29

How would you calculate the present value of a preference share?

Answer 29

Annual cash flow / required yield ## Footnote Using the Perpetuity formula

Question 30

What does the Gordon’s Growth Model do?

Answer 30

It calculates the price of a share using an assumed growth rate of dividends

Question 31

What is Gordon’s Growth model formula?

Answer 31

Next dividend / (r - g) ## Footnote G = the growth rate of dividends

Question 32

Part of the Gordon’s Growth model is the ‘g’, what does this stand for and what is it made up of?

Answer 32

G = Growth rate of dividends Made up of: Return on Equity x Retention Rate ## Footnote ROE = profit company has made relative to the equity finance that’s been invested in the company RR = how much profit is retained by the company for reinvestment in itself

Question 33

How would you calculate the share price today of: Company expected payout ratio of 55%, required return 10%, sustained growth 8% and next years earnings £5.

Answer 33

{Using Gordon’s Growth model for the valuation: cash flow / (r-g) } Next dividend = £5(0.55) =£2.75 2.75 / (0.1 - 0.08) = £137.50

Question 34

What’s the formula to calculate the next dividend per share to be paid?

Answer 34

EPS x Dividend Payout Ratio

Question 35

What are the 2 ways to calculate the PE ratio?

Answer 35

Price0 / EPS1 & DPR / r - g ## Footnote DPR stands for Dividend Payout Ratio

Question 36

How would you calculate the PE ratio from the following: Eg. Companies EPS in a years time £10 and it pays 40% as dividends, required return 12% and ROE is 14%x

Answer 36

Need to use {PE = DPR / r - g } No g given so: G = 14% x 0.6 = 8.4% £10(0.4) / (0.12 - 0.084) = 11.1x

Question 37

What does a PE ratio indicate?

Answer 37

Is used to determine how much investors are willing to pay for a stock relative to the company’s earnings - whether it is fairly valued. ## Footnote If a company has a higher PE ratio relative to peers it can be considered overvalued, if lower it could be considered undervalued.

Question 38

What are the assumptions of the Efficient Markets Hypothesis?

Answer 38

•The market has a large number of rational profit maximising participants •Participants analyse and value securities independently •New info comes to the market randomly •Prices update the minute new info becomes available •All available info is incorporated into the price of the security

Question 39

What does the weak form of Efficient Market Hypothesis claim?

Answer 39

Prices reflect all past market information Disregards technical analysis as it is not possible to predict future prices changes based on past changes

Question 40

What does the semi-strong form of Efficient Market Hypothesis claim?

Answer 40

Prices reflect all past market information and publicly available information Disregards Technical & Fundamental analysis

Question 41

What does the strong form of Efficient Market Hypothesis claim?

Answer 41

Prices reflect all information, past, public and inside information Claims there is some evidence that it is possible to beat the market, but this is offset entirely by costs paid Disregards all active management techniques

Question 42

What is the name of the formula you would use to calculate the share price of an ordinary share?

Answer 42

Gordon’s Growth Model

Question 43

What is Algorithmic Trading?

Answer 43

Use of algorithms to automatically buy or sell securities on regulated markets and MTFs. The algorithms may be based on timing, price, quantity or AI models.

Question 44

What are the 3 risks a large fund manager runs when placing large buy/sell orders?

Answer 44

1. Traders will see the size and front-run the order with the expectation that the order will move the market in the desired direction so they profit 2. Market risk is therefore increased due to market already starting to move due to front-run orders. 3. Other brokerages or affiliated third-parties see the large order, agile traders can position themselves quickly to benefit at the fund’s expense.

Question 45

Why is Algorithmic Trading used?

Answer 45

To disguise the true intent of large Fund Managers by efficiently executed large orders in a series of sub-orders, where pools of liquidity appear - thus not unduly moving the market ## Footnote A consequence is markets are now becoming less transparent, and algorithmic trading is also used for arbitrage purposes. FCA has begun brining rules in and will continue to do so.

Question 46

What does the Modigliani & Miller theory state?

Answer 46

Shareholders are indifferent to receiving returns via a dividend or capital gains and the value of the firm is the same regardless of capital structure (debt to equity) Dividends are irrelevant as they dont impact companies valuation, instead valuations should be driven by profits. If the company doesn’t pay dividends, shareholders can simply sell their shares for cash.

Question 47

What are the 3 unrealistic assumptions the Modigliani & Miller theorem makes?

Answer 47

• Taxes do not exist/no difference between CGT and Income • There are no transaction costs • Leverage from higher debt has no impact on the WACC.