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2015, Study Session # 14, Reading # 48

OVERVIEW OF EQUITY SECURITIES


MP
CP
PP
PE
DRs
CPS

=
=
=
=
=
=

Market Price
Call Price
Put Price
Private Equity
Depository Receipts
Convertible Preferred
Shares

GDRs = Global Depository


Receipts
ADRs = American Depository
Receipts
ADS = American Depository
Shares
SD = Standard Deviation
BV = Book Value
MV = Market Value

Types of Equity Securities

48.a

Common Shares

Callable Common Shares

 Represent ownership interest.


 Residual claim on assets in case of liquidation.
 Voting rights (board selection, mergers etc).

Statutory Voting

 Firm has right to repurchase stock at pre specified price.


 When MP > CP firm usually call.
 Allows the firm to reduce dividend payment (similar to share
repurchase).

Cumulative Voting

Each share held is assigned one


vote in the election of each
member of BOD.

 Can allocate votes to one


or more candidates as
they choose.
 Provides minority
shareholders a higher
level of representation
on the board.

Putable Common Shares

Preference Shares

 Right of shareholder to sell the shares back to firm at specific price.


 Put option places a floor on security value.
 Investors normally put the shares when MP < PP.

 Features of both common stock & debt.


 Shares usually dont mature & shares can have put or call features.
 Fixed periodic payments & usually have no voting rights.
Types

Cumulative

Non-Cumulative

Participating Preference
Shares

 Cumulative dividends
paid before common
shareholders dividend.

 Dividends dont
accumulate when not
paid.
 Dividends must be paid
before being paid
common shareholders.

 Receive extra dividend


if firms profit exceed a
predetermined level.
 May receive value > par
value at liquidation.

Non-Participating
Preference Shares

 Claim equal to par


value at liquidation.
 Do not share in firms
profit.

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Convertible Preference
Shares

2015, Study Session # 14, Reading # 48

48.a

Types
Convertible Preference Shares

 Exchanged for common stock at a conversion ratio.


 Advantages:
 Preferred dividend is > common dividend.
 Investor can share in profits through conversion.
 Conversion option is more valuable when stock price.
 PS have less risk than common shares (priorities in dividends &liquidation proceedings).
 CPS often used to finance risky venture capital & private equity transactions.

48.b
 Firm may have different classes of common stock.
 Classes may be treated differently with respect to voting power,
seniority, dividends, stock splits & other transactions with
shareholders.
 Company filings with regulators contain information regarding
ownership & voting rights of different classes.

48.c
 Private equity securities usually issued via private placements.
 Private markets are smaller than public markets.
 Characteristics of PE: (compared to public equity).
 Less liquid & share price is not determined in market.
 Limited financial disclosure & lower reporting costs.
 Potentially weaker corporate governance.
 Greater ability to focus on long-term prospects (no public pressure) &
potentially greater return for investors.

Main Types of PE Investments

Venture Capital

Leveraged buyout (LBO)

 Capital provided to fund


development & growth of firms
life cycle stages.
 VC investments are illiquid
(usually three to ten years).
 VC financing include seed or start
up capital, early stage &
mezzanine financing.

 Buy a public firms common stock


outstanding using debt financing.
 If buyer is firms current
management the LBO is
management buyout.
 Candidate firm usually generate
high levels of cash flows, used to
make interest and principal
payments on issued debt.

Private Investment in Public


Entity (PIPE)
 Public firm sells PE to investors.
 Investors may buy the stock at a
sizeable discount to MP.

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2015, Study Session # 14, Reading # 48


48.d





Integrated market free capital flows across borders.


Worlds financial markets are becoming more integrated but global capital flow barriers still exist.
When foreign ownership restrictions, equity market performance.
Firms perspective foreign stock exchange listing  publicity, liquidity & transparency.

Direct Investing
 Investing in the equity of companies outside of investors local market.
 Obstacles:
 Investments & returns are denominated in foreign currency.
 Foreign stock exchange may be illiquid & may have less strict
reporting requirements.
 Investors must be familiar with regulations & procedures of market
in which they invest.

Methods for Investing in Foreign Companies

Depository Receipts

Global Depository Receipts

 Deposit shares of foreign firm into bank & then issues


receipts representing ownership of specific no. of foreign
shares.
 Depository bank (custodian) manages dividend
payments, stock splits & other taxable events.
 Value of DR is affected by exchange rate , firm
fundamentals, market conditions & any other factors.

 Issued outside U.S & issuers home


country.
 Usually $ denominated & can be sold to
U.S institutional investors.
 Not subject to capital flow restrictions.

Types

 $ denominated & trade on U.S. exchanges.


 ADS security on which ADR is based (trade in firms domestic market).

Sponsored DR
 Equity issuing firm is involved
in the issue of receipts.
 Provide voting rights to
investors & subject to greater
disclosure.

American Depository Receipts

Unsponsored DR
 Firm is not involved.
 Depository bank retains the
voting rights.

Trading location

SEC registration
required
Ability to raise
capital in U.S.
Firm listing fees

Level I
Over-thecounter(OTC)

Level III
NYSE,
Nasdaq, or
AMEX
Yes

Rule 144A
Private

Yes

Level II
NYSE,
Nasdaq, or
AMEX
Yes

No

No

Yes

Yes

Low

High

High

Low

Global Registered Shares

Basket of Listed Depository Receipts

Traded in different currencies around the world.

An ETF that is a portfolio of DRs.

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No

2015, Study Session # 14, Reading # 48


48.e

Equity Securities

Returns

Risks

 Returns consist of price changes, dividend


payments & in exchange rates (foreign
currency equity investment).
 Domestic return  when foreign currency
appreciates.
 Gains from dividends & dividend reinvestment
have been an important part of equity
investors long-term returns.

 Risk is measured as SD of return.


 PS is less risky than common stock pay
lower avg. return than common stock.
 Cumulative PS has less risk than noncumulative (right to receive missed dividends).
 Putable shares are less risky & callable shares
are more risky than option free.

48.f
 Equity capital to purchase long-term
assets, equipment & expansion into new
businesses or geographic areas etc.
 Publicly traded securities provide liquidity.

48.g

48.h

Equity Securities

BV of Equity

MV of Equity

 BV of equity = balance sheet assets liabilities.


 Positive NI & retained earnings  BV.

 Total of firms outstanding equity shares based


on market price.
 MV & BV of equity are seldom equal.
 MV reflects investor expectations about firms
future cash flows.

  =


 



= (
 )

Alternatively
 =




First method is more appropriate when it is an industry convention to use average book values or BV is volatile.
Latter method is appropriate when examining ROE for a no. of years or when BV is stable.
  ROE is generally viewed as positive for firm (reason for an  should be examined e.g BV is  rapidly than NI, ROE will 
but not favorable).
  
  
=
   
 Firms anticipated future growth,   ratio.
Firms with ()  are considered value (growth) stocks.

Investors Required Return & the Cost of Equity


 Cost of equity firms expected equilibrium total return on its shares in the market.
Estimated through dividend discount model or CAPM
 If investors expected return > minimum required rate of return shares are attractive
investment.

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