Reading 48 LOS's

Question 1

LOS 48a: Describe characteristics of types of equity securties

LOS 48b: Describe differences in voting rights and other ownership characteristics among different equity classes

Answer 1

Common Shares

Investors in common shares have an ownership interest in the company. They share the operating performance of the company, participate in the governance process through voting rigths, and have a residual claim on the company’s net assets in case of liquidation.

Companies may issue different classes of common shares, each with different ownership and voting rights.

Common shares may also be callable or putable

• Callable common shares give the issuing company the right but not the obligation to buy back shares from investors at a later date at the call price. Companies are likely to buy back shares when their market price is higher than the call price. This is beneficial to the company as they are able to:
  
  • Buy shares at a lower price and resell at a higher price
  • SAve on dividend payments and preserve its capital
• callable common shares are also beneficial to the investor as they get a guranteed return on their investment when the shares are called
• Putable common shares give the investor the right, but not the obligation, to sell their shares back to the issuing company at the put price. Investors are likely to do this when the market price of shares is lower than the put price

Preference Shares or Preferred

They have the following characteristics:

• They do not give holders the right to participate in the operating performance of the company and they do not carry voting rigths unless explicitly allowed for at issuance
• They receive dividends before ordinary shareholders. Further, preferred dividends are fixed and are usually higher than dividends to common shares
• In case of liquidation, they have a higher priority in claims on the company’s net assets than common shares
• They can be perpretual, can pay dividends indefinitely, and can be callable or putable

They can be classified into the following categories

• Cumulative unpaid dividends accrue over time and must be paid in full before dividends on common shares can be paid
• Noncummulative unpaid dividends for one or more periods are forfeited permanently and are not accrued over time
• Participating These are entitled to preferred dividends plus additional dividends if the company’s prfots exceed a pre-specified level
• Nonparticipating These are only entitled to a fixed preferred dividend and the par value of shares in the event of liquidation
• Convertible these are convertible into a specified number of common shares based on a conversion ratio that is determined at issuance.

Question 2

LOS 48c: Distinguish between public and private securities

Answer 2

Private securities have the following characteristics:

• There is no active secondary market for them as they are not listed on public exchanges. Therefore, they do not have market-determined quoted prices
• They are highly illiquid, and require negotiations between investors in order to be traded
• The issuing companies are not required by regulatory authorities to publish financial statements and other important info regarding the company, which makes it difficult to determine their fair values

Types of Private Equity Investments

• Venture Capital VC funds invest in companies that are still in the early stages of development and require additional capital for expansion. These nvestments are usually made through limited partnerships and require a time horizon of several years. Eventual exit is very important consideration of such investments and available exit routes include buyouts and IPOs
• Leveraged Buyout (LBO) an LBO occurs when a group of investors uses debt financing to purchase all of the outstanding common shares of a publicily traded company. The company is then taken private, restructured, and then take public again by issuing new shares
• Private investment in public equity Sometimes private investors may invest in a public company that is in need of additional capital quickly in return for a significant ownership position

Advantages of Private Companies

• The longer investment horizon allow investors to focus on long-term value creation and to address any underlying operational issued facing the company. As a result, private equity firms are increasingly issuing convertible preference shares to attract investors with thier greater total return potential
• Certain costs that public companies must bear, such as those incurred to meet regulatory and stock exchange filing requirements, are avoided by private companies

Advantages of Public Companies

• Public equity markets are much larger than private equity networks. Therefore they provide more opportunities to companies for raising capital cheaply
• Publicly traded companies are encouraged to be open about their policies, which ensures that they act in shareholder interest

Question 3

LOS 48d: Describe methods for investing in nondomestic equity securities

Answer 3

Direct Investing

The most obvious way is to buy and sell securities directly in foregin markets. However, direct investing has the following implications:

• All transactions are in the company’s, not the investor’s domestic currency. therefore investors are also exposed to exchange rate risk
• Investors must be familira with the trading, clreaing, and settlement regulations and procedures of the foreign market
• Investing directly may lead to less transparency and increased volatiltiy

Depository Receipts

a DR is a security that trades like an ordinary share on a local exchnage and represents an economic interest in the foreign company. It is created when a foregin company deposits its shares with a bank in the country on whose exchange the shares will trade. The bank then issues a specific number of receipts representing deposited shares based on pre-determined ratio. Hence one DR might represent one share, a number of shares, or a fractional share of the underlying stock

A DR can be sponsored or unsponsored

• A sponsored DR is when the foregin company that deposits its shares with the depository has a direct involvement in the issuance of receipts. Investors in sponsored DRs have the same rights as those enjoyed by direct owners of the company’s common shares
• In an unsponsored DR, the foreign company the deposits its shares with the depository has no involvement in the issuance of receipts. Therefore, it is the depository, not the investors, that enjoys rights as a direct owner of the company’s common shares

There are two types od depository receipts:

1. Global Depository Receipts (GDRs) are issued by the depository bank outside of the company’s home country and outside of the US. Their main advantage is that they are not subject to foreign ownership and capital flow restrictions that may be imposed by the issuing company’s home country, as they are sole outside of the home country
2. American Depository Receipts (ADRs) are denominated in US dollars and trade like a common share on US exchanges. They are basicaly GDRs that can be publicly traded in the US

Global Registered Shares (GRS)

A GRS is an ordinary share that is quoted and traded in different currencies on different stock exchanges around the world. GRSs offer more flexibility than DRs as the shares represent actual ownership in the issuing company, they can be traded anywhere, and currency conversions are not required to trade them

Basket of Listed Depository Receipts (BLDR)

this is an exchange traded fund (ETF) that represents a portfolio of DRs. Like all other ETFs, it trades throughout the day and can be bought, sold, or sold short

Question 4

LOS48e: Compare the risk and return characteristics of types of equity securities

Answer 4

The 2 main sources of an equity security’s total return are:

• capital gains from appreciation
• dividend income

Total return , R_t = (P_t - P_t-1 + D_t) / P_t-1

Companies in the early stages of development might not pay a dividend, as they try to reinvest their profits to avail growth opportunities. Older companies might not have as much growth potential, so they compensate investors with dividends.

Investors in DRs and foreign shares also incur foreign exchange gains. These arise due to changes in the exchange rate between the investor’s domestic currency and the foreign currency over the investment horizon. Appreciateion of the foreign currency leads to foreign exchange gains.

Another source of return arises from the compounding effects of renienvested dividends.

Risks of Equity Securities

The risk of an equity security refers to the uncertainty associated with its expected future cash flows or expected total return

• Prefernce shares are less risky than common shares because:
  
  • Dividends for preference are known and fixed, reducing the uncertainty about future cash flows
  • Preferred Shareholders receive dividends and other disbursments first
  • The amount that preference shareholders stand to receive if the company is liquidated is known, where as common might not get anything
• Common shares are more risky because
  
  • A relatively large proportion of their total return comes from capital gains and future dividends, which are unkown
  • They might not get anything when liquidated
• Putable common shares are less risky than callable or noncallable common shares
  
  • The option to sell the shares back to the issuer at a pre-determined price establishes the minimum expected return
• Callable common and preference shares are more risky than their noncallable counterparts
  
  • The option held by the issuer to buy back the shares at a pre-determined price limits the investors potential total return
• Cumulative preference shares are less risky than noncumulative shares as they accrue unpaid dividends
  *

Question 5

LOS 48f: Explain the role of equity securities in the financing of a company’s assets

LOS 48g; Distinguish between the market value and book value of equity securities

Answer 5

A company may issue equity securities to raise capital, to acquire another company, provide stock option-based incentives to employees, acquire long-lived assets, invest in expansion projects, enter new markets, improve capital adequacy ratios or to ensure that debt covenants are met.

The primary aim of management is to increase the book value and market value of a company

• Book value is calculated as total assets less total liabilities (shareholders equity on balance sheet). It reflects the historical operating and financing decisions made by the company
• market value is primarily determined by investors’ expectations about the amount, timing, and uncertainty of the company’s future cash flows.

A useful ratio to evaluate investor’s expectations about a company is the price-to-book ratio (aka market-to-book)

• If a company has a price-to-book ratio that is greater than industry average, it suggests that investors believe that the company has more significant future growth opportunities than its industry peers
• It may not be appropriate to compare price-to-book ratios of companies in different industries because the ratio also reflects investors’ growth outlook for the industry itself

Question 6

LOS 48h: Compare a company’s cost of equity, its accounting return on equity, and investors’ required rate of return

Answer 6

Accounting Return on Equity

ROE measures the rate of return earned by a company on its equity capital. It indicates how efficient a firm is in generating profits from every dollar of net assets.

• ROE = Net income / Average Book Value of equity

When evaluating ROE, analysts should bear in mind that net income and book value are directly affected by the management’s choice in accounting methods. These differences can make it difficult to compare ROE across firms

An increase in ROE might not always be a positive sign for the company

• The increase in ROE may be the result of net income decreasing at a slower rate than shareholders equity. A declining net income is a source of concern for investors
• The increase in ROE may be the result of debt issuance proceeds being used to repurchase shares. This would increase the company’s financial leverage

Investors should examine the changes in ROE using DuPont decomposition

The Cost of equity and Investors’ Required Rate of Returns

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders

For investors who provide equity capital to the company, the future cash flows taht they expect to receive are uncertain, so their minimum required rate of retun must be estimated. Further, each investor may have different expectations regarding future cash flows. Therefore, the company’s cost of equity may be different from investors’ minimum required return on equity

You should think about the cost of equity as the minimum expected rate of return that a company must offer investors to purchase its shares in the primary market and to maintain its share price in the secondary market.

• If investors require a higher return than the company’s cost of equity, they will sell the company’s sahres and invest elsewhere, which would bring down the company’s stock price. This decline in stick price will lead to an increase in the company’s cost of equity and bring it in line with the higher required rate of return

Please note

• The company’s cost of equity can be estimated using the DDM and CAPM