Part VII Equity Shares 1232020 1 Introduction n

Part - VII Equity Shares 12/3/2020 1

Introduction n Equity shares or shares of common stock of a company represent financial claims. That is they are a liability for the issuing corporation and an asset for the shareholder. n Unlike debt securities which merely connote a loan from the bondholder to the firm, equity shares confer ownership 12/3/2020 rights on the shareholders. 2 n

Shareholder’s Stake n Every shareholder is a part owner of the company. n His/her stake is equal to the fraction of the total share capital of the firm to which he/she has subscribed. 12/3/2020 3

Cash Flows from Shares n When a firm makes a profit it will typically pay out a fraction of it in the form of cash to the shareholders. n Such cash payments are called DIVIDENDS. 12/3/2020 4

Retained Earnings n It is not essential for a firm to have a profit in the year in which it chooses to pay a dividend. n n Profits accumulated from previous years’ operations can be used to pay dividends. Such accumulated profits are a part of the Reserves & Surplus account on the liabilities side of the balance sheet. 12/3/2020 5

Retained Earnings n Quite obviously, the Reserves and Surplus account will have a balance only if a firm has a habit of accumulating profits. n n In practice a firm will rarely pay out the entire profit made in a year as dividends. A fraction of the profit will be retained within the firm. n 12/3/2020 This amount is known as Retained Earnings. 6

Dividends n Dividends are not contractually guaranteed. n n That is, unlike interest on bonds, the rate of dividends is not fixed. Nor is the company obliged to pay dividends in a particular year. 12/3/2020 7

Dividends (Cont…) n That is, shareholders cannot demand dividends as a matter of right. n It is up to the board of directors to decide as to whether dividends should be paid, and if so, what should be the quantum of dividends. 12/3/2020 8

Dividends (Cont…) n n In principle therefore, dividends can fluctuate substantially from year to year. In practice however they rarely do. n Firms generally opt to maintain dividends at a steady level, even in years of financial hardship. n 12/3/2020 This is to avoid sending distress signals to the market, which could cause the market value of the firm to plunge. 9

Residual Claims n n Shareholders are residual claimants. This is true from two perspectives. Firstly bondholders have to paid the contractually promised rate of interest. Only then can the firm consider the possibility of rewarding its shareholders by way of dividends. 12/3/2020 10

Residual Claims (Cont…) n Secondly in the event of liquidation or bankruptcy, when the assets of the firm are sold; n n The bondholders must be paid their dues in part or in full depending on the proceeds from the sale of assets. Only if something were to remain, will the shareholders be entitled to compensation. 12/3/2020 11

Maturity n n Equity shares never mature. Every firm is set up as a Going Concern. n n That is, an entrepreneur will not set up a firm with the stated objective of winding up after a given period. Since the firm is expected to stay alive for ever, its shares never mature. 12/3/2020 12

Rights of Shareholders n Equity shareholders have voting rights. n They have a say in the election of the Board of Directors. 12/3/2020 13

Limited Liability n Shareholders have limited liability. n n That is, their financial commitment to the firm is limited to the extent of their shareholdings. In other words, in the event of financial difficulties, neither the company nor its creditors can stake a claim on the personal assets of the shareholders. 12/3/2020 14

Voting Rights n Most equity shares carry voting rights n n This includes the right of shareholders to elect the directors of the firm. The most common arrangement is one vote per share. n But in practice shares with differential voting rights are issued 12/3/2020 15

Example of Differential Voting Rights. The Case of the Ontario Securities Act n The Act defines three types of restricted shares: n Subordinated voting shares n n 12/3/2020 These shares carry the right to vote But in such cases there exist one or more other classes of shares that carry a greater voting right on a per share basis. 16

Example (Cont…) n Non voting shares n n n Holders of such shares usually have no right to vote. Sometimes they may have the right to vote in certain limited circumstances. Restricted Voting Shares n 12/3/2020 They carry the right to vote subject to specified restrictions. 17

Differential Rights (Cont…) n Except for the voting restrictions these shares are usually similar to normal shares n n Holders of such shares have an unlimited right to participate in the earnings of the corporation They have the same rights over the assets of the firm upon liquidation, as the normal shareholders. 12/3/2020 18

Differential rights (Cont…) n n n Thus these shares carry the same risk as normal shares. However there are cases where such shares are paid dividends at a different rate as compared to normal shares. Such shares usually trade at a lower price as compared to regular shares. 12/3/2020 19

Proxies n In order to be eligible to vote at a meeting of shareholders, the shareholder must be the Owner of Record n That is, his name must be present in the register of shareholders on the prescribed Record Date. 12/3/2020 20

The Record Date n n The record date is usually a few days prior to the date of the meeting of shareholders or the date on which the actual voting will take place. A person whose name figures in the register on the record date may however have sold his shares prior to the date of the meeting. 12/3/2020 21

Proxies (Cont…) n n In such cases, the only way that the current shareholder can vote is if he is given a proxy by the shareholder of record. In practice a shareholder can always give a proxy to someone else, even if he continues to be the owner of the share. 12/3/2020 22

Proxies (Cont…) n Why are proxies allowed? n n n Most shareholders cannot be realistically expected to attend meetings and vote in person. So companies routinely send out proxies. Shareholders can then fill these and authorize representatives of the management to vote on their behalf. 12/3/2020 23

Proxies (Cont…) n In practice managers solicit proxies from absentee shareholders for a valid reason n Usually a quorum is required by law for a meeting to be legally recognized n n 12/3/2020 That is the percentage of shares represented at the meeting should exceed a prescribed minimum. Thus shareholders are encouraged to be either present or else have themselves represented by 24 proxy.

Par Value versus Book Value n n Most equity shares usually have a Par Value also known as the Face Value or the Stated Value. Historically corporate assets were considered to be a part of a trust fund that was protected by the board of directors n And the par value was supposed to represent this fund. 12/3/2020 25

Par Value…(Cont…) n n Thus standard par values like $10 or $100 were specified. Today par values have no practical significance. n n They can be therefore fixed at arbitrary levels, like say 10 cents. In fact some shares may not even have a par value. 12/3/2020 26

Reasons for Low Par Values n In some states in the U. S. , the incorporation fees for the firm are a function of the par value of the shares being registered. n So companies issue low or no par value stock to minimize these expenses. 12/3/2020 27

Book Value n n n The book value is the value of the assets behind a share, as per the balance sheet. It is found by adding up the par value + any share premium + retained earnings, and then dividing by the number of shares outstanding. The book value may differ substantially from the market value of the share, which is the price of the share on the stock exchange. 12/3/2020 28

Classified Common Stock n Companies sometimes issue different categories of stock. n The most common reason for this is that they wish to confer different voting rights on different categories of shareholders. 12/3/2020 29

Example n The Ford Motor Company has two classes of shares n n The shares available to the public carry voting rights As of 1998 one billion one hundred and fourteen million plus shares were outstanding. n But of these, 70. 90 million shares were classified as Class B. 12/3/2020 30

Example (Cont…) n Class B shares are owned by the Ford family and certain key officers. n n These shares have weighted voting rights that allow them to control nearly 40% of the votes. Class B shareholders have always voted as a unified block. n Thus the majority of shareholders cannot easily force a decision on the company. 12/3/2020 31

Classified Shares (Cont…) n For many years the NYSE did not permit non voting shares to be listed n This policy has been subsequently relaxed. 12/3/2020 32

Dividend Related Dates n In the context of a dividend payment, there are four dates that are important n n The The 12/3/2020 Declaration Date Record Date Ex-dividend Date Distribution Date 33

Declaration Date n It is the date on which the decision to pay a dividend is declared by the directors and the amount of the dividend is announced. 12/3/2020 34

The Record Date n n The dividend announcement will mention the Record Date. Only those shareholders whose names appear on the register of shareholders as of the record date, will be eligible to receive the forthcoming dividend. 12/3/2020 35

The Ex-Dividend Date n n This is specified by the exchange on which the stocks are traded. An investor who purchases the stock on or after the ex-dividend date will not be eligible for the dividend. 12/3/2020 36

The Ex-Dividend Date (Cont…) n Obviously the ex-dividend date will be such that share transactions prior to that date will be reflected in the register of shareholders as on the record date, whereas transactions on or after that date will be reflected on the register only after the record date. 12/3/2020 37

The Ex-Dividend Date (Cont…) n This date will therefore be set a few days before the share transfer book is scheduled to be closed. n This to enable the registrar to complete all the administrative formalities 12/3/2020 38

The Ex-Dividend Date (Cont…) n This date is a function of the settlement cycle followed by the exchange. n For instance the NYSE follows a T+3 cycle. n n That is, if a trade occurs on day T, then delivery of shares to the buyer and payment of funds to the seller will take place on day T+3. Thus a transfer of shares two days before the record date or later will not be reflected in the books on the record date. 12/3/2020 39

The Ex-Dividend Date n Thus on the NYSE the ex-dividend date is specified as two business days prior to the record date announced by the firm. 12/3/2020 40

Cum-Dividend and Ex-Dividend n Prior to the ex-dividend date, the shares will be trade cum-dividend. n n This implies that the buyer of the share is eligible for the forthcoming dividend. On the ex-dividend date the shares will begin to trade ex-dividend. n Thus buyers of the share on or after this date will not be eligible for the approaching dividend. 12/3/2020 41

Ex-Dividend Prices n On the ex-dividend date the share price ought to, in theory, decline by the amount of the dividend. n n For instance if the cum-dividend price is $50 per share and the quantum of the dividend is $2 per share, then theoretically the share should trade at $48 ex-dividend. In practice however, the price decline may not be exactly equal to the amount of the dividend. 12/3/2020 42

The Distribution Date n This is the date on which the dividends are actually paid or distributed. 12/3/2020 43

Stock Dividends n These are called Bonus Shares in India. n It is a dividend that is paid in the form of shares of stock rather than in the form of cash. 12/3/2020 44

Stock Dividends (Cont…) n This entails the issue of additional shares without monetary consideration. n n What happens is that funds are transferred from the Reserves & Surplus account to the Share Capital account. This is called the Capitalization of Reserves 12/3/2020 45

Stock Dividends (Cont…) n n From a theoretical standpoint, stock dividends do not create any value for their shareholders. We will illustrate this using a numerical example. 12/3/2020 46

Example n Assume that a shareholder owns 500 shares of CISCO and that the firm has issued 500000 shares in all. n n So this investor owns 1/1000 th of the firm. Now assume that the firm announces a 10% stock dividend n Which means that it will issue one additional share for every 10 existing shares. 12/3/2020 47

Example (Cont…) n Thus the firm will issue 50000 shares n n n Of which the investor will receive 50 Thus after the issue he will be in possession of 550 shares which is 1/1000 th of the total number of shares outstanding. Thus his stake in the company will remain unaltered. 12/3/2020 48

Example (Cont…) n As far as the firm is concerned, the additional shares do not represent: n n n Either a change in its asset base, or A change in its earnings capacity Thus the issue of additional shares should lead to a decline in the share price. 12/3/2020 49

Example (Cont…) n n Assume that the share price prior to the bonus issue was $ 55. The ex-bonus price, P, should be such that: n 500000 x 55 = 550000 x P P = 50 12/3/2020 50

Ex-Bonus Price Declines n In practice, the ex-bonus price may not fall to its theoretically predicted value. n n This is because the market may interpret the bonus issue as a signal of enhanced future profitability. What is the rationale for such a viewpoint? 12/3/2020 51

Rationale n n Companies usually refrain from lowering their cash dividend payouts, unless they are forced to by exceptional circumstances. When a bonus issue is declared, the number of shares will go up. n So in future cash dividends will have to be paid on a greater number of shares. 12/3/2020 52

Rationale (Cont…) n n n So if the dividend payout per share is not likely to decline then quite obviously the firm must be anticipating greater profitability. This kind of an interpretation will boost the demand for the shares. The enhanced demand will cause share prices to be higher than theoretically predicted value. 12/3/2020 53

Stock Dividends (Cont…) n Sometimes, a firm may declare a bonus issue prior to the payment of a cash dividend. n If so the impact on the share price will be as illustrated in the following example. 12/3/2020 54

Example n n Assume that CISCO has 500000 shares outstanding which are trading at $55 each. The company announces a cash dividend of $2 per share and a bonus issue of 10%. n Assume that the dividends will be paid on the additional shares as well. 12/3/2020 55

Example (Cont…) n n The cum-bonus cum-dividend price is $55. The market value of 500000 shares is: n n 500000 x 55 = 27, 500, 000 The theoretical market value of 550000 ex-bonus cum-dividend shares will also be 27, 500, 000 since the bonus issue per se does not add any value. 12/3/2020 56

Example (Cont…) n Thus theoretical ex-bonus exdividend price will be: n 27, 5000, 000 – 2 x 550, 000 ___________ = $48 550, 000 12/3/2020 57

Splits & Reverse Splits n Meaning of a stock split n An n: 1 split means that n new shares will be issued to an existing shareholder for every old share that he is holding. n n n For instance a 11: 10 split means that a holder of 10 existing shares will receive 11 shares. This is exactly analogous to a 10% stock dividend. Thus theoretically, stock splits and stock dividends are mathematically equivalent. 12/3/2020 58

Differences n Stock dividends entail the capitalization of reserves n n n Stock splits do not What happens in the case of a split is that the par value of an existing share is reduced. The number of shares will increase proportionately. 12/3/2020 59

Differences (Cont…) n The product of the par value and the number of shares outstanding or The Issued Capital will remain unchanged. 12/3/2020 60

Price Behaviour n n The share price after a split will behave exactly as in the case of an equivalent stock dividend. We will illustrate this with the help of a numerical example. 12/3/2020 61

Example n n An investor is holding 500 shares of CISCO worth $55 each. The company announces a 11: 10 split. n n So he will have 550 shares after the split These will theoretically be worth $50 each. 12/3/2020 62

Why Split Shares? n Companies generally go in for a split when the share price becomes too high. n n If so the scrip is considered to be out of reach for small and medium investors. What is high is subjective n n 12/3/2020 But the belief is that most managers have a feel of the popular price range for the stock. That is, they know the range in which the stock should trade in order to attract enough investor attention. 63

Why Split Shares? (Cont…) n Investors normally prefer to trade in round lots n n n A round lot is usually defined as 100 shares Anything less than a 100 is considered to be an odd lot. At very high prices, small and medium investors may be unable to afford odd lots. 12/3/2020 64

Reverse Splits n If a company perceives its stock price to be too low it can go in for a reverse split n n In an n: m split, n is greater than m In an n: m reverse split, n is less than m 12/3/2020 65

Example Assume that CISCO announces a 9: 10 reverse split. n A holder of 500 shares prior to the reverse split will have 450 shares after the split. n The post reverse split price would be: 500, 000 x 55 P =_____ = 61. 11 12/3/2020 450, 000 n 66

Rationale for Reverse Splits n Exchanges like the NYSE discourage the listing of securities which are consistently trading at very low prices n This is because such prices have a tendency to attract inexperienced traders with unrealistic price expectations, who could get their fingers burnt. 12/3/2020 67

Pre-emptive Rights n The laws governing companies usually require that existing shareholders be given pre-emptive rights to new shares that are being issued for a monetary consideration, as and when they are issued. n This is to enable them to maintain their proportionate ownership in the company. 12/3/2020 68

Rights Issues (Cont…) n Often, rights issues are made at a price that is lower than the prevailing market price of the share. n n When this happens, the rights acquire a value of their own. In such cases an existing shareholder can either exercise his rights or else sell them to someone else. 12/3/2020 69

Illustration of the Value of a Right n n n Assume that CISCO has 500000 shares outstanding and announces a rights issue. Shareholders are entitled to one new share for every 10 shares that they hold. n So in all 50000 shares will be issued. Assume that the prevailing share price is $50 and that the additional shares are being offered at $40 each. 12/3/2020 70

Illustration (Cont…) n The market value of the firm prior to the rights issue is: n n The post issue theoretical firm value will be: n n 500, 000 x 50 = 25, 000, 000 + 50, 000 x 40 = 27, 000 The ex-rights price should be: 27, 000 _____ = 49. 09 550, 000 12/3/2020 71

Illustration (Cont…) n Considering that fact that a share worth 49. 09 is being made available at 40, the value of the right is 9. 09. 12/3/2020 72

Losers? n Are the existing shareholders losing? n n n The ex-rights price is 49. 09 which is less than the cum-rights price of 50. No! The shareholders are being given an opportunity to buy new shares at $40, and this opportunity compensates for the decline in the share price. 12/3/2020 73

Losers? (Cont…) n Take the case of an investor who has 50 shares. n n The value prior to the rights issue is $2, 500 If he exercises his rights he can acquire 5 additional shares by paying $40 for each. The value of his shareholdings after the issue will be: 49. 09 x 55 = 2, 700 = 2, 500 + 5 x 40 Thus there is no dilution of value 12/3/2020 74

Renunciation n The shareholder can always renounce his rights in favour of someone else if he chooses not to exercise them. The rights can be sold for $9. 09 each. The value of his position after the renunciation will be: n 49. 09 x 50 + 9. 09 x 5 = 2, 500 12/3/2020 75

Ex-rights Price n n The ex-rights price is often higher in practice than theoretically predicted value. This is because the rights issue may be perceived as an information signal by investors. n The very fact that additional shares are being issued may be construed as a signal of enhanced future profitability. 12/3/2020 76

Ex-rights Price (Cont…) n n One reason for this perception could be the belief that the new funds will be used for more profitable projects. Another reason could once again be that since cash dividends are usually maintained at steady levels the issuance of additional shares is a sign on increased profitability from existing ventures. 12/3/2020 77

Ex-rights Price (Cont…) n Both these factors could cause the demand for the shares to rise. n Consequently the decline in the price will be less than what is predicted by theory. 12/3/2020 78