CHAPTER 9

SHARES
Topics
9.1

Emerging firms

9.2

Equity securities

9.3

Assessing share value

9.4

Initial public offerings

9.5

Raising additional equity

LEARNING OBJECTIVES
Describe how emerging businesses raise
equity capital
Describe the main features of ordinary and
preference shares
Explain the factors that are considered when
valuing shares
Explain the initial public offering of a
companys shares and identify its advantages
and drawbacks
Describe the main processes for raising
additional equity: rights issues, private
placements of new shares and dividend
reinvestment plans

INTRODUCTION
The financing decision refers to a firms
relative use of debt and equity in financing
its operations
Recall that equity is the funds supplied to
the business by its owners
payments to equity suppliers are not a
binding commitment from the firm and
they have the lowest payment priority
(i.e. they are residual)
as the returns to equity suppliers are
more risky, its expected return (or cost)
will exceed that of debt

9.1 EMERGING FIRMS

An
emerging
firm is a
business
that aspires
to grow into
a large
company

It seeks external equity

from the venture capital
market to finance its
development
This is equity invested by
patient, risk-taking
investors in aspiring
growth businesses

One source of venture capital is business

angels
risk-taking, wealthy, patient investors
who participate in the running of the firm
during its development stage

VENTURE CAPITAL
Another source is venture capital fund
managers
raise funds from super funds, insurance
companies, banks and wealthy
individuals
they invest in a number of new
businesses to spread the risk of loss
may specialise in certain industries or
stages of development
usually represented on the board
Many firms are unsuccessful in attracting
venture capital financing

VENTURE CAPITAL
FUND MANAGERS

INVESTMENT READY

This means the firm:

has achieved a substantial size
has an effective management structure
can produce regular financial reports
has a history of being profitable

At this stage the venture capital investor

can exit their investment through an IPO or
a trade sale

Venture capital investments are high risk

and return and can result in the complete
loss of the invested amounts

9.2 EQUITY SECURITIES

1. Ordinary shares
represent
ownership of a
company
typically have no
maturity date
can have their
ownership
transferred
are limited liability
when fully paid

entitle their
owners to a share
of profits which are
paid as dividends
entitle their
owners to vote in
company elections
have potential for
capital gains

9.2 EQUITY SECURITIES continued

Preference shares:

pay a promised
dividend which have
priority over ordinary
dividends

can have a
variety of
features such
as:
nonparticipating
cumulative

have restricted
voting rights, and

converting
redeemable

also represent
ownership of a
company

9.3 ASSESSING SHARE VALUE

Assessing a shares value is difficult because
of the uncertainty of its future payments
The two broad approaches are:
Technical analysis
- uses past data to
identify future
trends, or
behavioural
techniques such as
momentum trading

Fundamental
analysis - attempts
to estimate a
shares fair value
using pricing models

9.3.1 FUNDAMENTAL ANALYSIS

Attempts to calculate share value as the present
value of future earnings, having regard to the
risks involved
Includes a top-down assessment of:
Global
economy

Economy

Secto
r

Industr
y

Firms
managem
ent

Whereas a bottom-up approach analyses

financial statements and market data using
various ratios such as NTA, dividend yield, P/E,
EPS

9.3.1(a) P/E ANALYSIS

A firms P/E ratio is its share price divided by its
earnings per share
P/E ratios reflect the markets assessment of
the future growth rate in the firms earnings
and the riskiness of that growth
a high P/E may reflect the expectation
earnings will grow quickly, whereas
a low P/E can mean the earnings are risky

P/E ANALYSIS continued

Industry P/Es provide a benchmark against
which individual shares can be compared
If P/E ratios are stable, a forecast of future
earnings can be used to estimate a future
share price:
P1 P/ E 0 xE1
This assumes the change in earnings is
permanent and the P/E ratio is unaffected
by the changed earnings

P/E EXAMPLE
A firms share price is currently $7.50, and its
most recent EPS is 50 cents. Suppose you
forecast the firms earnings will permanently
increase to 60 cents per share. What future
share price would you expect?

shareprice 7.50
P/ E0

15times
EPS
0.50

P1 P/ E 0 xE1 15x0.6 $9.00

9.3.1(b) GORDONS DIVIDEND

GROWTH MODEL
The value of a share should be equal to the
present value of its expected future
payments
A companys dividend stream forms a
perpetuity the present value of which is:
Dividend payment D
P0

i
ir
where
ir is the required return on equity
P0 is the estimated present value or price
today

GORDONS DIVIDEND GROWTH

MODEL continued
If the dividends can be assumed to grow at
a constant rate (g), their present value
would be:
D0 1 g
P0
ir g
where D0 is the current annual dividend
payment
This is Gordons dividend growth model it
requires analysts to estimate:
the annual growth rate in dividends, and
the required return on the firms equity

ESTIMATING THE
DIVIDEND GROWTH RATE
For example, ANZs annual dividend grew
from 95 cents in 2003 to $1.45 in 2012
Using a compound interest formula, the
growth rate can be calculated
as:
1

Dn n
g 1
D1
1.45

0.95

4.81%

1

9

ESTIMATING THE
REQUIRED RETURN ON EQUITY
The estimate of the required return on equity
uses the capital asset pricing model:
where:

rr rriskfree rmarket rriskfree

rrisk-free is the current risk-free rate, such as

the yield on Treasury bills
rmarket is the return on the market portfolio
is the riskiness of the share relative to the
riskiness of the market (its systematic risk)

ESTIMATING THE
REQUIRED RETURN ON EQUITY
continued
Use the CAPM to estimate ANZs required
return given the Treasury bill rate is 3%, the
expected return on the market is 9.9% and
ANZs beta is 0.90
rr rriskfree rmarket rriskfree
3 0.90 9.9 3
9.21%

DIVIDEND GROWTH MODEL

continued
We can now estimate ANZs share price
based on our estimates of
a current (most recent) dividend of
$1.45,
a dividend growth rate of 4.81%, and
a required return on ANZ shares of
9.21% (iD
rr)
r or
1.45 1 0.0481
0 1 g
P0

ir g 0.0921 0.0481
$34.54

9.4 INITIAL PUBLIC OFFERINGS

An IPO, going public or float refers to
the first issue of shares to the public by a
company for the purpose of listing on an
exchange
An IPO:
raises additional equity capital to fund
growth, and/or
allows some or all of the owners to sell
some or all of their investment

IPOs continued
Most IPOs in Australia are for new or
emerging firms (these are usually small,
raising up to a few hundred million)
Institutional investors are typically only
interested in large IPOs
many of these have been privatisations
(Telstra), carve-offs or demutualisations
(AMP)
IPOs are an expensive and major
undertaking that are arranged by
investment banks and stockbroking firms

9.4.1 THE DECISION TO GO PUBLIC

Advantages
Additional equity
enhances the
companys financial
strength
Gives investors
liquidity
Enhances the
companys capacity
to remunerate its
management and
employees

Disadvantages
The process is
expensive
Continuing owners
experience dilution
Agency costs result
from the separation of
ownership and
management
May encourage a
short-term
performance bias

9.4.2 THE ISSUE PROCESS

The firm selects
a manager
(arranger) for
the IPO

Due diligence is
performed
meaning any claims
made in the
prospectus are
verified

The issue
documents
including the
prospectus are
prepared

Financial
statements are
prepared and
audited

9.4.2(a) THE PROSPECTUS

IPOs are conducted under ASIC (and ASX)
rules which require a prospectus
The purposes of the prospectus are:
to provide potential investors with
accurate and comprehensive
information about the company and its
directors, the issue and the issuing
process and the financial prospects of the
shares as an investment and
to help in the marketing of the shares
(and most are glossy documents)

9.4.2(b) THE MARKETING PROCESS

Large IPOs have three marketing phases:

Premarketi
ng

Road shows
and the
taking of
orders via
the
bookbuild

The
determination
of the issue
price and the
allocation of
shares

IPO managers hire financial analysts who

prepare investment reports but they face a
conflict of interest are their
recommendations biased?

9.4.3 THE PRICING

AND TIMING OF AN IPO
Smaller IPOs

Large IPOs

Setting the price poses

difficulties due to a
lack of data or
comparable IPOs
Are mostly conducted
on a best-efforts basis this gives the
managing bank
incentive to set a low
price
Have little choice about
timing

Usually have better

information

Use the bookbuild

process to set the
price

Try to time issues

with bull markets

9.4.3(a) THE UNDERPRICING

PHENOMENON
Historically IPOs are underpriced that
is, the IPO issue price is less than the
closing price on the first day of listing on
the share market
the difference is the money left on the
table
this means IPO companies raise less funds
than they could have
and investors who buy shares in the IPO
can make an immediate profit

EXPLANATIONS
FOR UNDERPRICING
The desire
Providing buyers of IPOs with a
of the seller
capital gain to encourage them
for a
to make further equity
successful
investments in the company
IPO
Compensation
The superior
for risk, given
To benefit
negotiating
that
retaining
power of the
underpricing is
owners
investment
not
bank
guaranteed

9.5 RAISING
ADDITIONAL EQUITY
Listed firms raise new equity through:
1. retained earnings raise small but
steady amounts
2. the issue of additional shares (seasoned
offerings) through:

rights issues
private placements
dividend re-investment schemes
shareholders can receive additional
shares instead of dividends

9.5.1 RIGHTS ISSUES

The issue of rights to existing shareholders
entitling them to purchase more shares in the
company so as to raise additional share
capital
Rights are allocated to shareholders in
proportion to the number of shares they
hold, e.g., 1-for-5
Rights are allocated on the ex-rights date
The subscription price is set below the
current share price, and must be paid by
the subscription date

RIGHTS ISSUES continued

Rights are usually renounceable they are
given to existing shareholders but become
temporary securities that they can exercise,
sell or let lapse
They are used to raise large amounts of
additional equity capital but:
there is a risk of failure if the share price
falls below the subscription price (though
this can be underwritten)
requires a prospectus and are expensive

THE RIGHTS ISSUE

PROCESS

9.5.1(a) VALUING RIGHTS

The value of each right is derived from the
amount of the discount it offers:
R

n P S
n 1

where:
R is the value of a right
n is the number of shares required to
receive one right
P is the cum-rights share price
S is the subscription price

IMPACT ON SHARE PRICE

A rights issue involves selling additional
shares at a price lower than the current
market price
and will therefore lower the share price
this occurs on the ex-rights date (when
the rights separate from the existing
shares)
nP S price:R
The theoretical
ex-rights
Pexrights
or P
n 1
n

EXAMPLE OF A RIGHTS ISSUE

A company seeks to raise $728m through a
renounceable rights issue
it sets the subscription price at $2.60 (a
substantial discount on its current share
price of $3.60) and so issues 280 million
rights to its shareholders
($728 m/$2.60 = 280 m)
since it currently has 2240 million shares,
each shareholder receives 1 right for
every 8 shares held
(2240 m/280 m = 8)

EXAMPLE continued
i.

The value of a right:

R

n P S
n 1

8 3.60 2.60
8 1

$0.89

ii. The ex-rights price:

nP S
R
Pexrights
or Pexrights P
n 1
n
(8*$3.60) $2.60
0.89

3.60
8 1
8
$3.49
$3.49

WEALTH EFFECTS
OF RIGHTS ISSUE
Theoretically, shareholder wealth does not
change:
Before
the exrights
date 8
shares
were
worth
8*3.60 =
$28.80

The day after

the ex-rights
date 8 shares
would be worth
8*3.49 =
$27.92 plus
one right worth
89 cents (a
total of $28.81)

If shareholders
exercised the
right they have
to invest a
further $2.60
and would hold 9
shares worth
9*3.49 = $31.41
which equals
$28.80 + $2.60

9.5.1(b) ACCELERATED
RIGHTS ISSUE
This refers to a new way of conducting rights
issues that was developed during the GFC to
speed up fund raising
These issues have two parts
1. an accelerated issue to institutional

investors, (usually through a bookbuild

process), followed by
2. a non-accelerated offer to retail

investors

The advantage being the company receives

the majority of its funding from institutional
investors quickly

9.5.2 PRIVATE PLACEMENTS

OF NEW SHARES

Advantages
They are quick and
cheap
The price per share is
usually higher than
received through a rights
issue
Placements can be made
to investors who
support the current
board

Disadvantage
s
Private
placements
dilute existing
shareholder
ownership
and are
limited by
ASX rules

REVIEW OF LEARNING OBJECTIVES

Describe how emerging businesses raise equity
capital
Equity funds are raised from business angels and
venture capital fund managers - these are both risk
taking, patient investors
Describe the main features of ordinary and
preference shares
Ordinary shares represent an ownership interest in
the firm - they have no maturity date, are limited
liability, are transferable, pay dividends, confer
voting rights and have potential for capital gains
Preference shares also represent ownership but
usually pay a fixed dividend that has priority over
ordinary dividends and have restricted voting
rights - they can also have other features including
being participating, cumulative, converting or
redeemable

REVIEW OF LEARNING OBJECTIVES

Explain the factors that are considered
when valuing shares
Techniques can be described as technical or
fundamental
Fundamental analysis attempts to calculate a
shares fair value - this involves top-down and
bottom-up analysis, P/E ratios and dividend
growth models

REVIEW OF LEARNING OBJECTIVES

Explain the initial public offerings of a
companys shares and identify its
advantages and drawbacks
An IPO is the initial issue of a companys
shares to the public for the purpose of the
shares being listed on the exchange
The main advantages are that it can raise
equity for the firms growth and provide its
shareholders with liquidity
However the process is expensive, can dilute
the control of the original owners of the
business and place reporting requirements on
the companys directors

REVIEW OF LEARNING OBJECTIVES

Describe the processes for raising
additional equity
A rights issue can raise very substantial
additional equity by providing shareholders
with the entitlement to buy additional shares
at a discount to the current share price
Private placements can quickly raise additional
equity whereas dividend reinvestment
schemes can raise equity gradually over time