fins2618 W8 (Q's)

Convertible notes, company-issued options and company-issued warrants are often referred to as quasi-equity. a. What are the characteristics of each of these instruments that serve to distinguish them from straight equity or debt?

Convertible notes: · are a hybrid security that exhibits the characteristics of both debt and equity during the life of the security · are issued for a nominated term, generally at a fixed rate of interest · may be converted into ordinary shares in the issuer-company at a specified future date by the holder of the convertible note · are generally issued on a pro-rata basis to existing shareholders, and are often not renounceable, that is, the holder cannot sell the entitlement Company-issued option: · provides the right, without the obligation, to purchase ordinary shares, at a stated price, at a future date or dates · may be restricted to a maximum term of five years in Australia, according to the Corporations Act · may be issued free with a new debt issue, or it may be sold at a premium by the issuing company Company-issued warrant: · is usually attached to a corporate bond debt issue · is attached to the bond as an incentive for an investor to purchase the bond · gives the warrant holder the right to purchase shares in the issuer company at a specified price and date · may be detachable. As such warrant can be sold separately to the bond it was originally attached.

Disney Corporation is considering the re-release of its classic film library. The project will involve an investment of $78 000 000 and will produce a positive cash flow of $25 000 000 in the first year. The cash flows will increase by 10 per cent each year thereafter for another five years (i.e. the project runs for six years). At that stage the project will cease. The company expects a rate of return of 17 per cent on this type of project. a. Calculate the NPV and the IRR. b. Should the company proceed with this investment opportunity? Why?

Note: PV = S (1 + i)^-n payments per year = 1 net cash flows: period 0 = -$78 000 000 period 1 = $25 000 000 period 2 = $27 500 000 period 3 = $30 250 000 period 4 = $33 275 000 period 5 = $36 602 500 period 6 = $40 262 750 Because the cash flows are conventional, IRR can be computed. In Excel, use IRR function to obtain answer. Answer: IRR = 31% To find NPV, find PV of each of the cash flows, add them up and subtract $78 000 000 investment. The NPV = $32 491 841. • project has positive NPV, and IRR > required return → therefore company should proceed with project. • underlying assumptions = company is confident with cash flow forecasts, and that it knows its required rate of return.

An efficient stock exchange will establish listing rules that support the interests of listed entities, maintain investor protection and ensure the reputation and integrity of the stock market. To achieve this, a stock exchange will adopt a number of listing rule principles. a. List and explain five fundamental listing rule principles.

The main principles that form the basis of a stock exchange's listing rules include (Note: students only need to select five principles): · Minimum standards of quality, size, operations and disclosure must be satisfied. · Sufficient investor interest must be demonstrated to warrant an entity's participation in the market. · Securities must be issued in circumstances that are fair to new and existing security holders. · Securities must have rights and obligations attaching to them that are fair to new and existing security holders. · Timely disclosure must be made of information which may affect security values or influence investment decisions, and information in which security holders, investors and ASX have a legitimate interest. · Information must be produced according to the highest standards and, where appropriate, enable ready comparison with similar entities. · The highest standards of integrity, accountability and responsibility of entities and their officers must be maintained. · Practices must be adopted and pursued that protect the interests of security holders, including ownership interests and the right to vote. · Security holders must be consulted on matters of significance. · Market transactions must be commercially certain.

b. Discuss the advantages of a dividend reinvestment scheme from the point of view of the corporation and shareholders.

· The main attraction of dividend reinvestment schemes is that they enable a company to make dividend payments and, assuming a sufficient reinvestment rate, to retain sufficient equity funds to meet future funding needs. · Dividend reinvestment schemes allow existing shareholders to progressively increase their shareholding in the company in small increments (the amount of the dividend). · At the same time, in countries such as Australia that allow dividend imputation, the company is able to pass on tax franking credits to its shareholders.

Techno Pty Ltd is a private company that has developed a range of innovative software packages over the past five years. The company is considering seeking admission and quotation on a stock exchange. List and briefly explain the advantages to the company of a public listing

Listing provides access to a large equity capital market that would otherwise not be available to an unlisted entity. · As a publicly listed company on a stock exchange, Techno will be subject to the legal requirements of the Corporations Act and the listing rules of the exchange. · Listed corporations that demonstrate successful business performance are able to raise additional funding through the stock exchange in order to expand the business. · Listing turns a non-liquid investment (the private company) into liquid securities (listed ordinary shares). The stock exchange represents a deep and liquid secondary market that encourages investors to purchase shares in listed companies. · Increased recognition or profile of the company in the markets. This has both financial and business advantages. Financial advantages include easier access to funding; business advantages include greater recognition of the company's products and services.

Santos Limited has expanded its exploration program and has decided to fund the expansion through the issue of additional ordinary shares to its existing shareholders on a pro-rata basis of one new share for each five shares held. The issue price is $5.75 per share and the current market price is $6.50. The financial advisers to the corporation have recommended the use of an underwriting facility. The board of directors has noted that the underwriting facility has an out-clause if the market price drops below $5.50. Using this information, answer these questions.

a. What type of issue is Santos Limited making to its shareholders? · The issue by Santos Limited of additional ordinary shares to existing shareholders at a ratio to the existing shareholding is a pro-rata rights issue. · In the above example the shareholder will receive one new share for each five shares currently held. The new rights shares will be issued at $11.75 each. · The issue price of $11.75 is at a discount to the current market price, partly as an incentive to shareholders and partly to allow for the expected fall in the price due to the dilution effect of the additional new shares. · The right may be renounceable and listed on the stock exchange; the shareholder is entitled to sell that right before the exercise date; otherwise the right may be non-renounceable.

b. What is an underwriting facility, and why might Santos use such a facility?

· A contractual undertaking by an underwriter to purchase securities that are not fully subscribed to by the existing shareholders; for example, the underwriter has agreed to buy any surplus Santos rights issue shares providing the market price remains above $11.45. · In a large issue of securities there will typically be a group of underwriters and sub-underwriters, each accepting a portion of the underwriting exposure. · The underwriters will charge a fee for this service. Why might Santos use an underwriter? · The underwriters will provide advice on: o the structure, pricing, timing and marketing of the issue o the allocation of the securities between underwriters, investors and markets. · Underwriting an issue provides the corporation with a much higher level of certainty that it will raise the necessary funds from the issue, particularly in times of market volatility.

b. What are the advantages to the company and also to the shareholders of the structure you recommended?

· A shareholder in a no-liability company is able to decide not to pay the call. However, in this circumstance the shareholder will forfeit the shares. The shareholder will have lost the value of the partly paid share. · In reality, the shareholder would elect to sell the share prior to the call date. · If sufficient shareholders pay the next call on the shares the company is able to fund the next stage in the project.

In recent years, the popularity of all-share takeover deals has declined. What is an 'all-share takeover deal' and what are some reasons for the decline in popularity?

· An all-share deal is a take-over where the bidding company offers shares in itself in exchange for shares in the target company. · When equity values are extremely high and thought to be rising higher, all-share deals can rise in popularity. This was particularly the case during the late 1990s when a number of massive deals in the tech sector were undertaken as all-share deals. · In recent years, the amount of cash that companies hold on their balance sheets has made all-cash offers much more feasible. Of course, once one company makes an all cash offer, other interested parties may be forced to follow suit.

c. What is the out-clause entered into by Santos? Discuss how the out-clause operates.

· An out-clause is usually incorporated in an underwriting facility. · Specified conditions, situations or benchmarks will activate the out-clause and preclude the underwriting agreement from being enforced; for example, an out-clause may relate to a specified change in a published share market index. In the example, the underwriter has an out if the Santos share price falls below $11.45.

A mining corporation has obtained the rights to explore for gold in a new tenement. The corporation decides to establish a new subsidiary company that will carry out this high-risk venture. The new company will be listed on the stock exchange. The gold exploration company expects to complete its exploratory search over the next 12 months, at which time it will report back to shareholders and make recommendations on the viability of the project. a. What form of legal structure would you recommend the gold exploration company incorporate? Why would you recommend this structure?

· Based on the available information it seems appropriate that the subsidiary be formed as a no-liability company. · As a start-up exploration company the company only needs to raise a limited amount of capital at the initial stage. · The company can issue partly-paid ordinary shares under its prospectus. · As this is a high risk venture, investors are more likely to purchase partly-paid shares rather than pay the full amount. · The company will report back to shareholders in 12 months, and if the project is to proceed, will make a further call on the shares. · The shareholders will consider the reports at that time and decide whether they wish to pay the call, or not. Non-payment of a call results in the forfeiture of shares.

In some countries, such as Australia, it is common for corporations to offer shareholders a dividend reinvestment scheme. a. Explain how dividend reinvestment schemes operate and discuss their significance as a source of equity funding.

· Dividend reinvestment schemes allow a shareholder to reinvest all or part of their dividend entitlement in additional shares in the company. · Dividend reinvestment shares are sometimes issued at a discount to the market price, and with no brokerage or other costs. · Dividend reinvestment schemes are an important source of equity funding for many companies. Shareholders like the option to reinvest their dividend income rather than taking the cash, particularly if the company is successful. · The company will typically issue such shares at the average market price of the shares traded on the stock exchange for the five days following the ex-dividend date; less a specified discount if applicable.

Rio Tinto Limited has decided to sell its shale coal part of the business by establishing a new limited liability company to be known as Shoal Limited. Shoal Limited will be a listed corporation on the ASX. Rio Tinto and Shoal decide to issue the new shares at $2.65, but through the issue of instalment receipts. An initial payment of $1.25 is payable on application and a final payment of $1.40 is due 12 months later a. Shoal Limited will be a limited liability company. What are the rights and financial obligations of shareholders that purchase shares in the company?

· Holders of ordinary shares have the right to vote for directors of the board, plus any other motions that may be put to a general meeting of shareholders. · Shareholders have a residual claim on the assets of the firm after all other creditors have been paid. · Shareholders typically receive dividend payments, usually twice-yearly, distributed from the profits of the corporation. · As Shoal is a limited liability company, the claims of creditors against shareholders are limited to the value of the fully paid ordinary shares issued; for example, as Shoal has issued partly paid shares (instalment receipts), then the shareholders are required to make the outstanding instalment payment on the unpaid portion when due. · The holder of shares in a limited liability company cannot be forced to pay further monies to the corporation or its creditors.

JB Hi-Fi is expanding its retail operations and seeks to raise capital to do so. The company advisers recommend the board of directors choose between a pro-rata rights issue or a private placement. Explain each of these funding alternatives and discuss the advantages and disadvantages of each alternative.

· JB Hi-Fi has the advantage of an established positive reputation which will enable it to raise further equity funding. · The choice is between a pro-rata rights issue and a placement; both relate to the issue of additional ordinary shares. Rights issue: · A pro-rata rights issue occurs when existing shareholders are given an entitlement to subscribe for additional shares in the company. · In making a rights issue, the company must ensure that all shareholders receive an equivalent opportunity to participate in the issue. This is achieved by making the offer on the basis of a fixed ratio of new shares to the number of existing shares held (pro-rata basis). For example, a 1:10 (one for ten) offer gives a shareholder the right to purchase one new share for every ten existing shares held. · Often a rights issue is renounceable, that is, the shareholder is able to sell the option (right) to another party, but some issues are non-renounceable (cannot be sold). · An advantage of a rights issue is that the company retains its existing shareholder base, and at the same time is able to raise additional equity funding. · A rights issue must conform to the prospectus requirements of the Corporations Act and this can be costly and time consuming. · The time lag between the pricing of the issue and the actual issue date exposes the company to pricing risk, that is, the share price might fall below the rights price. Placements: · A placement is an arrangement where a company may issue additional shares, with shareholder approval, directly to selected institutional and individual investors who are deemed to be clients of brokers, without the need to register a prospectus. · Subscriptions must be for not less than $500,000 and to not more than 20 participants. · The advantages to the company include the reduced compliance costs (no prospectus, only an information memorandum), the quickness in which the issue can be finalised, often at a lower discount to market price, and to investors that are friendly to the company. · A disadvantage to existing shareholders is ownership dilution; however placements are restricted to a maximum of 15% of capital in any 12-month period.

b. If a multinational corporation seeks dual listing on two stock exchanges, how will this impact on the corporation's adherence to the listing rules?

· Some large multinational corporations choose to list on more than one exchange. The shares of the corporation are said to have a dual-listing. · Dual listing is normally achieved by the creation of two holding companies each entitled to fifty per cent of the group's assets. Shareholders in both holding companies have equivalent economic and voting rights. For example, BHP Billiton is listed on the ASX plus the London Stock Exchange (LSE) through two holding companies - BHP Billiton Limited (ASX) and BHP Billiton Plc (LSE). · The dual-listed corporation is required to meet the listing rule requirements of each stock exchange.

b. Why might a company issue quasi-equity rather than straight debt or equity?

· The issue of quasi-equity is another funding alternative to either straight debt or equity. · It allows a company to issue funding instruments that are flexible in that they can be structured to meet the company's cash flow and future funding requirements. · The special attributes of different quasi-equity instruments may be attractive to investors; for example the ability to convert to equity at a future date, especially if the issuing company has been successful and the current share price has risen above the conversion price. · The conversion attribute may mean that a company can issue the quasi-equity debt instrument at a lower price than straight debt. · Interest payments may be tax deductible. · A company can set the conversion dates of the equity component of a quasi-equity issue to meet forecast future funding requirements.

c. Under what circumstances might such schemes prove to be unattractive to the dividend-paying company?

· There may be periods when company investment opportunities are limited, such as in an economic downturn, and the additional funds raised through a dividend reinvestment scheme are not required, and may dilute earnings per share. Therefore, a company may need to suspend its scheme from time to time.

The owners of a successful private stationery business have decided that the next step in the company's development is to expand into overseas markets. In order to raise the capital necessary to support this expansion, the company's owners have decided to investigate the possibility of listing the company on the ASX. You work for a boutique investment bank and receive the first phone call from the owners. Explain the role that your company will play if the owners decide to retain your services as an IPO adviser.

· Your investment bank, acting as an adviser, will provide advice on the timing and structure of the IPO and the possible price range at which the shares may be able to be sold. · Your bank should have an understanding of the current market conditions, especially as they relate to similar companies in similar industries. As such, the expectations of potential shareholders can be communicated to the owners and a sound approach to the listing process can be undertaken. · If the owners decide to go ahead, your bank will prepare a prospectus and lodge it with the corporate regulator. Your bank will also ensure that any legal and regulatory requirements are satisfied. · Your bank will promote the IPO among your existing clients and seek out new investors in order to maximise the number of shares sold and the issue price. · In return for offering these services, your investment bank will charge a fee of approximately 1.00 per cent of the amount raised. Other costs may amount to about 10.00 per cent of the amount raised.

b. The company has decided to structure the issue using instalment receipts. Explain how instalment receipts operate and why the company may have decided on this strategy.

· instalment ($1.25) towards the purchase of ordinary shares in the corporation. · When the final instalment of $1.40 is paid the investor will receive the ordinary share of the company. · The instalment receipt holder usually retains the same rights as a shareholder, including the receipt of any future dividend payments. · The company may have decided to issue instalment receipts as this may be more attractive to potential investors (shareholders) in that the full amount does not need to be paid immediately. Also, the company may not require the use of the full amount of funds until the business is fully operational and the instalment receipt structure can be designed to meet forecast cash flow requirements.

Marketing is often portrayed as a creative enterprise. Why would a marketing executive need to have an understanding of the capital budgeting process and techniques such as net present value and internal rate of return?

• capital budgeting → investment decision process • within constraints of objectives and policies → management will consider range of investment opportunities i.e. projects the firm will consider proceeding with as part of business operations. • projects need to maximise shareholder value → quantitative measures, e.g. NPV and IRR, used to evaluate project opportunities and choices. • marketing campaigns → simply another type of project the firm will analyse using these techniques → marketing executive explain how proposed campaign will create market value → if challenged about potential for marketing campaign to create value, marketing executive will need to be familiar with capital budgeting techniques

Explain the effect on the firm's market value of an increase in the firm's debt-to-equity ratio.

• cost of borrowing money through debt instruments such as bonds = typically lower than cost of raising capital through issuing equity → this is because CF's (interest payments and principal repayment) associated with debt securities are more predictable and less risky from an investor's perspective, compared to dividends and capital gains associated with equity investments → also in event of bankruptcy = bondholders have higher claim on company's assets than equity holders → making debt securities less risky and therefore, less expensive. • cost of debt capital is further reduced because interest payments are tax deductible → company takes on more debt, overall cost of capital decreases → thus, increasing PV of projects and market value of firm → however, there is a trade-off → as debt financing and debt-to-equity ratio increases = greater risk of bankruptcy → failed projects financed largely or solely with debt leave company and its SH exposed → unlike dividends, interest payments must be made and a company that defaults on obligations may be declared insolvent. • after some point → risk of bankruptcy will increase and cost of debt and equity capital will begin to rise → at this point, the firm's market value begins to fall as investors become more pessimistic about the company's prospects.

Compare and contrast the average debt-to-equity ratios of commercial banks and major retailers, such as Woolworths. Why is there such a big difference?

• debt-to-equity ratios of major commercial banks are many times in excess of average debt-to-equity ratios. · A major bank will usually have a debt-to-equity ratio in excess of 10, while the average is less than 1.00. · Major retailers such as Woolworths usually have below-average debt-to-equity ratios. These might be as low as less than 0.50. · The main source of the difference is that banks fund their business (making loans) by borrowing money. This dramatically increases their debt-to-equity ratios relative to other types of companies.