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Tutorial 3 Equity Markets

The Share Market and the Corporation


Question 3

a) Briefly explain the concept of corporate governance within


the context of a corporation.

Corporate governance relates to policy and practice that define the


relationship between shareholders, the board and management. A
company must implement corporate governance processes that put
policies and procedures in place to ensure the accountability and
transparency become an integral part of the corporate culture. Clear
responsibility and reporting structures need to be established to facilitate
the long-term survival of the organisation and the maximisation of
shareholder value.

b) What is the relationship between corporate governance and


the so-called agency problem?

The maximisation of shareholder value presumes the board of directors


will establish appropriate objects and policies and that management will
implement strategies that seek to increase the value of the organisation.

The agency problem is the conflict of interest between shareholders and


management of a corporation. Managers control the day-to-day operation
of the business and may not necessarily act in the best interests of
shareholders. For example, managers may maximise their own benefits at
the expense of the shareholder, such as increasing staff levels for prestige
and power, extending management remuneration schemes, increasing
sales at the expense of profitability and sustainability.

The board of directors must implement policies that align the interests of
management with those of the shareholders. Corporate governance
policies seek, in part, to address potential agency problems.

Question 4

Most developed or developing countries seek to establish modern


and efficient stock exchanges.

a) Identify and discuss the five principal functions of a modern


and efficient stock exchange.

The five principal functions of a modern and efficient stock exchange are:

Establishment of markets in a range of financial securities this


includes primary and secondary markets in equity (ordinary shares),
listed debt securities (preference shares, convertible notes,
subordinated debt), and derivatives (options, warrants, futures).
Provision of a securities trading system most modern and efficient
stock exchanges have implemented electronic trading systems, for
example the ASX Trade platform used by the ASX. Buy/sell orders
are placed into ASX Trade by authorised brokers. The system
matches orders and executes the trade.
Operation of a clearing and settlements system global competitive
forces require exchanges to settle transactions within T + 3 days.
The system used by the ASX is known as CHESS. CHESS
instantaneously records the transfer of ownership and facilitates the
financial settlement of a transaction thus removing the possibility of
settlement risk.
Regulation and monitoring of the integrity of the exchanges
markets the efficiency and integrity of the market is important.
The ASX has its own set of listing rules. The exchange monitors the
behaviour of listed companies and authorised brokers, and is able to
apply penalties including delisting a company or revoking the
licence of a broker.
Provision of a well-informed market, to secure the confidence of all
participants the price of a share is a function of available
information about that stock; changes in the current price will be in
response to new information coming into the market that will have
an impact on the future performance of the listed entity. Clearly it is
essential that continuous disclosure of material information must be
advised to the exchange immediately.

b) Why is it important to maintain modern and efficient stock


exchanges?

It is important to maintain modern and efficient stock exchanges because


they compete within an international market that is characterised by the
rapid and continuous flow of information to the markets within a
regulatory environment that allows capital to move almost
instantaneously around the world.

A stock exchange provides a market where companies may become listed


corporations, which are the principal drivers of economic growth within a
country.

The stock exchange facilitates efficient access to large amounts of equity


funding that is essential for a corporation. This includes the listing of
ordinary shares, hybrid and debt securities.

A modern and efficient stock market, incorporating a deep liquid primary


and secondary market, encourages investors to provide investment
capital to corporations. If the investment capital is used wisely by
corporations, this should lead to prosperity for the company and its
shareholders, plus increased economic growth.
Question 5

Discuss why a strong primary market is important for economic


growth within a country and explain how each of the main
participants in the primary issue of securities interacts with each
other during the share issuance process.

A strong primary market is important for economic growth within a


country because it ensures the efficient and orderly sale of new-issue
securities, and includes all of the support facilities that are required to
enable this to happen. The primary market issue of new equity is the
source of capital funds for the corporation; these funds allow the
maintenance and growth of a business. Primary market issues facilitate
the process of conversion of savings to investment, which theoretically
leads to an accumulation of capital capacity, economic growth, increased
production and higher levels of employment.

Corporations occupy the central position in the process, receive funds


from the issuance of securities. Underwriters and advisors guide
corporations through the issuance process and funds flow through brokers
from individuals, institutions and overseas investors with surplus funds to
invest. This process is facilitated by a stock exchange.

Question 6

a) Discuss the secondary market role of a stock exchange and


its importance to the corporation. Illustrate your answer by
using examples.

Secondary market transactions in a stock exchange involve the buying


and selling of existing financial securities, principally ordinary shares, at
current market prices. The current market price should reflect the
performance outcomes and forecast prospects of individually listed
companies within the context of the relevant industry sector, and the
domestic global economies.

An efficient share market facilitates transfer of ownership amongst


investors and enhances liquidity in listed securities. Securities initially
issued through the primary market may be subsequently traded through
the stock market as a secondary market transaction.

Economic growth derives from primary market investment, however a


successful primary market requires the support of a deep and liquid
secondary market.

An active secondary market encourages investors to purchase new


securities because the investors are confident they will be able to sell
those securities in the future in the secondary market quickly at the
current market price.

b) What is meant by the liquidity of the share market? Explain


why liquidity in the secondary market is important to both
shareholders and to the corporation.

Liquidity in the share market means that participants can buy and sell
shares without unduly disturbing current market prices of the shares that
are being traded.

The liquidity of a share market are important to both investors and


corporations because corporations are able to raise equity at a lower cost
and investors are able to actively manage and lower risk exposures.

Question 12

a) Using the example of the trading and settlement platforms


used by the ASX, explain the process whereby one investor
places a buy order for 1000 Rio Tinto Limited shares and
another investor places a sell order for 1000 Rio Tinto
Limited shares; both orders at market price.
The ASX operates a technology based trading platform (ASX Trade) and a
settlements systems (Clearing House Electronic Sub-Register System
CHESS).

If stockbrokers received orders to buy RIO shares and another to sell RIO
shares, the stockbrokers initiate buy/sell orders of their clients by entering
the orders into the ASX Trade platform. ASX Trade matches buy and sell
orders and initiates the transaction.

Under the CHESS arrangements shareholders no longer receive and hold a


share certificate, but rather hold uncertificated securities, being an
electronic record of shareholdings. The buying and selling of shares is
facilitated by a CHESS sponsor, such as a stockbroker. The current CHESS
arrangements require settlement of a share transaction to occur in three
days (T + 3).

b) Within the context of the above share transaction, define


and provide examples of the following:
Uncertified shares
Share contract note
Settlement risk
T + 3 business days

Uncertified shares occur when there is an electronic record of share


ownership and the original share certificate is not issued. An example are
shares listed on the ASX.

A share contract note is sent by a stockbroker advising details of a share


transaction. It includes details of the stock, the date, the number of
shares, the price per share, fees and charges, total cost and settlement
date.
A settlement risk is the possibility that one party to a financial transaction
will not deliver value. An example is the delivery of the stock and transfer
of ownership may occur, but financial settlement does not eventuate.

T + 3 business days is used to describe the settlement of a share


transaction that will occur in three business days.

Question 13

a) It may be argued that information is the life-blood of an


efficient stock market. Explain this proposition.

Listed corporations raise their equity funds and part of their debt funds
through the issue of securities on a stock exchange. Investors purchase
these securities because they have confidence in the operation of the
primary and secondary markets on the exchange. The current price of a
security reflects all known information relevant to that stock. The stock
price will change in response to new information coming to the market.
Therefore, the efficiency at which information is provided to the market
and the speed at which it is absorbed will directly affect the pricing of
listed securities.

b) Within the context of the ASX, explain the requirements and


purpose of continuous reporting.

Continuous reporting rules are designed to ensure a well-informed market.

Any information concerning a listed entity that a reasonable person would


expect to have a material effect on the price or value of the entitys
securities must immediately be given to the ASX. The Corporations Act
states that a reasonable person would consider information to be material
if it would likely to influence persons who commonly invest in securities in
deciding whether or not to subscribe to, or buy or sell, the securities.

c) Identify, using examples, five different pieces of information


that are regarded as being material and therefore should be
reported to the stock exchange.

Information that are regarded as being material and therefore should be


reported to the stock exchange include:

A change in the corporations financial forecasts of expectations


The appointment of a receiver, manager, liquidator or administrator
A recommendation or declaration of a dividend or distribution
Notice of a takeover bid or an intention to buy back issued shares
A proposal to restructure the capital base of the corporation
A notice of general meetings of shareholders, including motions to
be put to the meeting and the outcome of those motions
A change in the chairperson, directors or auditors
Copies of any documents forwarded to shareholders
Disclosure of directors interests

Question 14

Outline the regulatory structure and the responsibilities of the


main supervisors of market integrity and market participants
behaviour in Australian stock exchanges.

The main supervisors of market integrity and market participants


behaviour in Australian stock exchanges are the Australian Securities and
Investments Commission (ASIC) and each stock exchange itself.

ASIC has responsibility for the supervision of real-time trading on


Australias domestic licensed markets, including responsibility for the
enforcement of laws against misconduct in the markets and the
supervision of financial services licence holders. ASIC has an integrated
market surveillance system to support its commitment to market integrity
and a fair, orderly and transparent market.
Stock exchanges within Australia have a responsibility for the oversight of
listed entities under the exchanges listing rules. The exchange is also
required to monitor and enforce compliance by market, clearing and
settlement participants with its operating rules.

The Reserve Bank of Australia (RBA) is responsible for the monitoring and
assessment of licensed clearing and settlement platforms and systems. In
particular, the RBA ensures participants comply with its Financial Stability
Standards in order to reduce systemic risk within the financial system.
Corporations Issuing Equity in the Share Market
Question 2

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% each year thereafter for
another five years (i.e. the project runs for six years in total). At
that stage the project will cease. The company expects a rate of
return of 17% on this type of project.

a) Calculate the NPV and the IRR.

CF 1 n 5
NPV =CF 0+
r g( ( ))
1
1+ g
1+r
78000000+
25000000
0.10.17( ( ))
1
1.17
1.1
32491840.92

Using a financial calculator,


IRR=30.617

b) Should the company proceed with this investment


opportunity? Why?

The company should proceed with this investment opportunity because


the NPV is positive and the IRR is greater than the companys required
rate of return.

Question 3

The higher the ratio of debt-to-equity, the higher the return to


the shareholders. Therefore, companies should fund all of their
projects with debt.

Question 4

Debt-to-equity ratios may vary quite considerably between


business corporations.

a) Discuss the four main criteria that a corporation should


analyse when determining the firms appropriate debt-to-
equity ratio.

The four main criteria that a corporation should analyse when determining
the firms appropriate debt-to-equity ratio are:

First, a firm may consider the ratio that is the norm in the industry in
which the firm operates, and adopt something near that ratio.
The second criterion for determining future gearing ratios is the
history of the ratio for the firm. The ratio employed in the past may
be regarded as the norm, and management may be reluctant to
change it greatly. If the business has been performing with a return
on assets that is acceptable to shareholders, it may be deemed
appropriate to continue with a similar gearing ratio.
The third criterion, and a more appropriate one than the first two, is
the limited imposed by lenders. It is quite common for lenders to
impose various loan covenants on the borrowings of a company.
Loan covenants are conditions or restrictions incorporated in loan
contracts that are designed to protect the interests of the lender. A
common covenant is a limit on the ratio of debt liabilities to total
assets.
The fourth criterion in determining the debt-to-equity ratio, and
perhaps the most relevant, is managements decision concerning
the firms capacity to service debt. The assessment is made by
determining the charges, the interest payments and the principal
repayments associated with a given level of debt, and assessing the
capacity of the firms expected future income flows to cover the
payments while leaving sufficient profits to satisfy shareholders
expectations for a return on their equity

b) Is the firms debt-to-equity ratio likely to change over time?


Support your answer with examples.

The firms debt-to-equity ratio is likely to change over time due to


different interest rate scenarios.

Question 5

The owners of a successful private stationary business have


decided that the next step in the companys development is to
expand into overseas markets. In order to raise the capital
necessary to support this expansion, the companys 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.

The only choice facing most businesses is should the business incorporate
as a limited liability company or as a no liability company?

Question 6

Techno Pty Ltd is a private company that has developed a range


of innovation 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.
Question 7

Santos Limited is a private company that 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 5
shares held. The issue price is $11.75 per share and the current
market price is $11.95. 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 $11.45. Having regard to
this information, answer these questions.

a) What type of issue is Santos Limited making to its


shareholders?

Santos Limited is making a pro-rata rights issue to its shareholders.

b) What is an underwriting facility, and why might Santos use


such a facility?

An underwriting facility is a contractual undertaking to purchase securities


that are not subscribed to by investors.

Santos might use an underwriting facility to assist in the selling task and
to guarantee the promoter that all shares offered for sale will be taken up.
The underwriters will provide advice on:

The structure of the issue


The pricing of the issue
The timing of the issue
The marketing of the issue
The allocation of securities
c) What is the out-clause entered into by Santos? Discuss how
the out-clause operates.

An out-clause refers to specific conditions that prelude an underwriting


agreement from being fully enforced.

If the market prices fall below $11.45 and the new issue is unattractive
under the current circumstances, the underwriters may be left to take a
large proportion of the shares on issue. The underwriters may be released
from the underwriting obligation.

Question 8

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 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?

In a limited liability company, the claims of creditors against shareholders


are limited to the issue price of their fully paid shares.

As contributors of risk capital, shareholders are owners of the business


and are entitled to have control over its management. Control is derived
from the voting right attached to each share. The voting right entitles the
shareholder to vote for the board of directors and any other motions that
the directors may put to the shareholders from time to time.

Limited liability shares are usually sold on a fully paid basis; that is, on the
initial issue of the share, the shareholder pays the total issue price to the
corporation.

In the case of contributing shares and instalment receipts in a limited


liability company, the shareholder has a contractual obligation to pay the
remaining amount when it is called or due.

Importantly, with ordinary shares issued by a limited liability company, the


shareholders liability is limited to the extent of the fully paid share.
Therefore, if the share has been fully paid, the shareholder cannot be
required to make any further payment to the company, its creditors or a
liquidator.

b) The company decides to structure the issue using instalment


receipts. Explain how instalment receipts operate and why
the company may have decided on this strategy.

Instalment receipts are issued upon payment of the first instalment on a


new share issue; the ordinary share is issued when the final instalment is
paid.

Question 11

Woolworths Limited is a publicly listed corporation. Its core


business is in supermarkets. Woolworths has decided to set up a
major hardware goods chain in competition with the Wesfarmers
Limited-owned Bunnings stores. Woolworths needs to raise
additional equity capital to fund the expansion. The company
advisors 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.

A pro-rata rights issue is a proportional offer to buy securities based on an


investors current shareholding.

Advantages:
A rights issue is a financial instrument that provides a future right to
the holder, therefore the right has value.

Disadvantages:

A private placement is when additional ordinary shares are sold by a


corporation to selected institutional investors.

Advantages:

A placement can be arranged and finalised much more quickly than


a pro-rata rights issue.
The discount to current market price may be less than that for a pro-
rata rights issue.
It is also possible with a selective placement of shares for the board
of directors to sell the shares to institutional investors who are
deemed to be friendly to the company and are likely to support the
development of the business.

Disadvantages:

The placement dilutes the proportion of ownership of the company


by existing shareholders.
Placement issues can be abused, such as when boards of directors
favoured certain shareholders by placing shares with them at an
attractive price, but disenfranchised other shareholders by
excluding them from the offer.

Question 12

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 investment schemes allow shareholders to reinvest dividends by


buying additional shares in the company. Instead of receiving the cash
dividend, a shareholder may decide to reinvest the dividend back into the
company and receive some additional shares.

b) Discuss the advantages of a dividend reinvestment scheme


from the point of view of the corporation and shareholders.

The advantages of a dividend reinvestment scheme from the point for


view of the corporation and shareholders are:

The corporation typically meets the associated transaction costs,


such as brokerage fees, that otherwise would be incurred if
shareholders independently sought to use their dividends to
purchase additional shares.
Dividend investment schemes provide a simple savings regimen.
Shareholders can progressively top up their shareholding in the
company by reinvesting their dividends twice a year.
They allow companies simultaneously to pay dividends to
shareholders and, assuming a sufficient reinvestment rate, to
maintain the necessary equity finance to fund the companys future
investments and growth.
c) Under what circumstances might such schemes prove to be
unattractive to the dividend-paying company?

There may be times when reinvestment schemes are inappropriate, such


as during periods when the company sees few new prospects for future
profitable investments and when its cash position is quite healthy.