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Chapter 5

Corporations issuing equity in the share market


True/False questions
1. T The objectives of an organisation should seek to achieve the maximisation of shareholder
value.
2. F The investment decision process is only applicable to mining and manufacturing
companies because of their intensive capital equipment requirements.
3. F Net present value of a project is the cost of the projects asset less the forecast future cash
flows generated by those assets.
4. T If the calculated IRR on an investment proposal is more than the required rate of return,
the company should consider proceeding with the project.
5. T Shortcomings in the IRR decision process are non-conventional cash flows and mutually
exclusive projects.
6. F Regardless of a period of economic growth or an economic downturn, a higher debt-to-
equity ratio should generate a higher return on equity for shareholders.
7. F The corporate regulator has stipulated a standard optimal debt-to-equity ratio that must be
maintained by all corporations.
8. T A prospectus includes detailed information on the past and forecast activities of an
organisation.
9. F The flotation of a business refers to the actions of the liquidators when a company goes
into liquidation.
10. T A company issuing new shares is assured they will all be taken up if the issue is
underwritten, unless an out-clause in the underwriting agreement is triggered.
11. F The listing rules of the stock exchange provide corporations with a useful guideline on how
to structure their business activities.
12. T Dual-listing provides multinational corporations with greater access to the international
capital markets.
13. F A pro-rata rights issue of new shares to existing shareholders is said to be non-
renounceable if the right can be sold to another investor.
14. F An issue of ordinary shares to retail investors must be accompanied by a memorandum of
information that details the activities and financial position of the issuing corporation.
15. T One advantage of a placement of new shares is that a company can issue the shares quickly
and at a lower discount to the current market price than it could with a rights issue.
16. F A cumulative preference share normally reinvests the periodic fixed dividend payments
and the accumulated total is repaid at maturity.
17. F A preference share issue is generally not listed on a stock exchange as the shares have only
limited liquidity.
18. T Convertible notes are debt instruments that provide the holder with the right to convert the
notes into ordinary shares at a determinable price and at a specified date.
19. F Company-issued share options guarantee the issuing company future equity funding at the
option exercise date which can be set to coincide with future funding requirements.
20. T Company-issued equity warrants are often attached to a corporate bond debt issue and give
the holder the right to convert the warrant into ordinary shares in the issuing company.
Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. BHP Billiton is a multinational corporation with business operations focused mainly in the
mining and resources sector. Discuss the important issues the board of directors of BHP
Billiton will need to consider in relation to the capital budgeting process for the corporation.
(LO 5.1)
Capital budgeting refers to the investment decision process carried out by a firm.
The board of directors will set the objectives and policies of the firm; that is, what the firm
intends to do and how that will be achieved.
Management is responsible for the day-to-day financial and operation management of the
organisation in order to achieve those objectives.
ithin the constraints of the objectives and policies, management will consider a range of
investment opportunities, that is, projects that the firm will consider proceeding with as part of
its business operations.
!rojects need to ma"imise shareholder value, so #uantitative measures, such as $!% and &RR,
can be used to evaluate project opportunities and choices.
2. !"an#e! Te#hnologies Limite! is #onsi!ering the a#quisition o$ a ma#hine to manu$a#ture
ele#troni# #omponents. The ma#hine %ill #ost &1'( ((( an! %ill pro!u#e a positi"e #ash $lo% o$
&5( ((( in the $irst year. The #ash $lo%s %ill in#rease )y 1( per #ent ea#h year therea$ter $or
another $our years. t that stage the pro*e#t %ill #ease an! the equipment %ill ha"e a s#rap
"alue o$ &2( (((. The #ompany e+pe#ts a rate o$ return o$ 15 per #ent on this type o$ pro*e#t.
(LO5.1)
(a) Cal#ulate the ,-. an! the /00.
$ote' present value ( S )* + i,
-n
-sing a .ewlett !ac/ard 0usiness *10 calculator'
payments per year ( *
net cash flows' period 1 ( -2*31 111
period * ( 241 111
period 5 ( 244 111
period 6 ( 271 411
period 3 ( 277 441
period 4 ( 286 514 + 251 111 )scrap value of e#uipment,
&RR /ey-stro/es'
* 9second function: !;<R
- *31 111 C=j
41 111 C=j
44 111 C=j
71 411 C=j
77 441 C=j
>6 514 C=j
9second function: &RR;<R
?nswer' &RR ( 65.6@
$!% /ey-stro/es
*4 &;<R
9second function: $!%
?nswer' $!% ( 27> 564.36
()) 1houl! the #ompany pro#ee! %ith this in"estment opportunity2 3hy2 (LO 5.1)
The project has a positive $!%, plus it has an &RR greater than the re#uired return, therefore the
company should proceed with the project.
The underlying assumptions are that the company is confident with the cash flow forecasts, and
that it /nows its re#uired rate of return.
3. Commercial banks are particularly exposed to the risk of loss of their computer systems
and the risk that interest rates may change. (LO 5.2)
)a, In your own words, define the term risk within the context of the management of a
commercial bank.
i. The principal financial objective of a corporation such as a commercial bank is to
maximise shareholder value over the longer term, subject to an acceptable level of
risk.
ii. Risk can be defined as the variability or uncertainty of returns from the businesss
investments.
iii. Since returns are generated from the net cash flows of the business, risk is measured
by the variance in net cash flows.
)b, Categorise the two risk exposures above and explain why banks must manage them.
1. Loss of computer systems is categorised as a business or operational risk. Banks are heavily
reliant on their computer systems for most of their business operations; such as the maintenance
of their data and records, delivery products to customers, and information systems.
2. Unexpected changes in interest rates is defined as interest rate risk. The majority of bank
products generate income in the form of interest payments. An unexpected change in interest rates
will impact upon forecast future income and cash flows.
)c, Identify and briefly explain two other risk exposures to which )anks are exposed.
Choose two risk exposures from the following:
Foreign exchange risk is evident when a firm has balance-sheet assets and liabilities, and
associated cash flows, denominated in a foreign currency. Movements in the exchange rate will
affect the value of these items. For example, a company that imports goods from overseas, where
payment is to be made in USD, will be adversely affected by a depreciation in the exchange rate;
that is, it will be more expensive to purchase the USD required to pay for the imported items.
Liquidity risk is about having sufficient cash, liquid assets or access to funding sources to meet
forecast day-to-day operating requirements. For example, a company needs to be able to pay
creditors when due, purchase inventory, pay staff and meet other operating expenses. A bank
overdraft may be used for this purpose.
Credit risk is a situation in which debtors do not repay their obligations on time or default in
repayment. For example, a company might have provided goods to a client with payment due in 30
days, but the company is unable to collect the amount due because the client has gone into
liquidation.
Capital risk occurs when shareholders funds are insufficient to meet capital growth needs or, in
an adverse situation, to write off abnormal losses. For example, a corporation might be aware of a
new business opportunity, but is unable to fund the purchase without breaching debt-to-equity loan
covenants on an existing loan from its bank.
Country risk is the risk of financial loss associated with a fixed exchange-rate currency
devaluation, currency inconvertibility, rescheduling of external debt, barriers to funds transfers,
political developments in a nation-state resulting in expropriation, legal restrictions, freezing of
company assets, or forced divestment of assets.
4. Debt-to-equity ratios may vary quite considerably between business corporations. (LO 5.2)
)a, Discuss the four main criteria that a corporation should analyse when determining the
firms appropriate debt-to-equity ratio.
The appropriate debt-to-equity ratio will vary between firms, industries and stages of the
business cycle. The four main criteria are:
1. The ratio that is the norm in the industry in which the firm operates, and
adopt something near that ratio. Significant deviations from the industry norm may cause
concern for the potential providers of both debt and equity funds.
2. 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. Any significant change in the
ratio may result in the disaffection of the current shareholders.
6. The limit 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.
4. 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 debt to e#uity ratio is the proportion the assets of an organisation that are funded by debt
and those funded by e#uity )ownersA funds,.
Bither form of funding may be used to maintain and e"pand the business operation; however
debt instruments must be repaid by the organisation. Cne of the functions of e#uity on the
other hand is its absorption of abnormal losses incurred by the organisation.
The ratio between debt and e#uity funding is important as increased debt levels allow a
business to leverage and increase earnings per share, but ris/ is increased if the organisation
is unable to meet its debt repayment obligations.
=or e"ample, in a period of economic downturn or a change in the business cycle a firm will
usually generate less revenue but will still need to ma/e its loan repayments.
? firm that has high debt levels may be e"posed to the loss of mar/et share from new
competitors or products.
&n the early *>>1s the ?ustralian mar/et e"perienced an economic downturn which resulted
in a large number of businesses going into li#uidation, or becoming vulnerable to hostile
ta/e-over, as a direct result of maintaining high debt-to-e#uity ratio. ?gain, the global
financial crisis that began in mid-5118 caused a global economic slowdown and evolved into
a sovereign debt crisis impacted business activity and cash flows
therefore, decisions relating to the appropriate level of debt to e#uity funding must be based
on future cash flow projections, not past performance; that is, they must ta/e account of
forecast changes in economic and business conditions that will affect the level of future
income of the organisation
5. A private pharmaceutical research company has successfully developed a new medication
for cystic fibrosis and decides to seek listing on the ASX as a public company in order to
raise the equity capital necessary to take the medication into production. Identify and
briefly explain the issues and processes that will be involved in the flotation (IPO) of the
business on the stock exchange. (LO 5.3)
Determine the form of incorporation; a limited liability company or a no liability company
Crdinary shares will be issued under a company structure
Eimited liabilityFthe shareholdersA financial liability is limited to any unpaid portion of the
share holding
$o liabilityFthe shareholder may forfeit a shareholding by refusing to pay further calls on an
unpaid portion of the shares
Consider the method, terms and conditions, and timing of the &!C
The promoters of the new business entity will see/ advice from a range of advisers, including
financial )investment ban/s, accounting and ta"ation,, specialist advisers, such as lawyers,
pharmacists, medical and hospital advisors, and government consultants
Gpecialist advice is important in the successful timing and pricing of the &!C
The &!C document, the prospectus, is drawn up and lodged with the corporate regulator
The prospectus will detail the past and forecast future performance
?n application to subscribe for shares is attached to the prospectus
The promoters may engage an underwriter and sub-underwriting groups to provide a guarantee
that all shares on offer will be ta/en up
0e aware of any out-clauses included in an underwriting agreement; the level of ta/e-up by the
underwriters may be limited
Must comply with the listing rules of the stoc/ e"change
Consider the level of fees associated with the &!C. These may be around *1@ and will reduce
the amount of funds raised in the flotation process.
4. Te#hno -ty Lt! is a pri"ate #ompany that has !e"elope! a range o$ inno"ati"e so$t%are
pa#kages o"er the past $i"e years. The #ompany is #onsi!ering seeking a!mission an!
quotation on a sto#k e+#hange. List an! )rie$ly e+plain the a!"antages to the #ompany o$ a
pu)li# listing. (LO 5.5)
Eisting provides access to a large e#uity capital mar/et that would otherwise not be available to
an unlisted entity.
?s a publicly listed company on a stoc/ e"change, Techno will be subject to the legal
re#uirements of the Corporations Act and the listing rules of the e"change.
Eisted corporations that demonstrate successful business performance are able to raise additional
funding through the stoc/ e"change in order to e"pand the business.
Eisting turns a non-li#uid investment )the private company, into li#uid securities )listed ordinary
shares,. The stoc/ e"change represents a deep and li#uid secondary mar/et that encourages
investors to purchase shares in listed companies.
&ncreased recognition or profile of the company in the mar/ets. This has both financial and
business advantages. =inancial advantages include easier access to funding; business advantages
include greater recognition of the companyAs products and services.
7. 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 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. (LO 5.3)
(a) What type of issue is Santos Limited making to its shareholders?
The issue by Gantos Eimited of additional ordinary shares to e"isting shareholders at a ratio
to the e"isting shareholding is a pro-rata rights issue.
&n the above e"ample the shareholder will receive one new share for each five shares
currently held. The new rights shares will be issued at 2**.84 each.
The issue price of 2**.84 is at a discount to the current mar/et price, partly as an incentive to
shareholders and partly to allow for the e"pected fall in the price due to the dilution effect of
the additional new shares.
The right may be renounceable and listed on the stoc/ e"change; the shareholder is entitled
to sell that right before the e"ercise date; otherwise the right may be non-renounceable.
()) 3hat is an un!er%riting $a#ility6 an! %hy might 1antos use su#h a $a#ility2
? contractual underta/ing by an underwriter to purchase securities that are not fully subscribed
to by the e"isting shareholders; for e"ample, the underwriter has agreed to buy any surplus
Gantos rights issue shares providing the mar/et price remains above 2**.34.
&n a large issue of securities there will typically be a group of underwriters and sub-underwriters,
each accepting a portion of the underwriting e"posure.
The underwriters will charge a fee for this service.
3hy might 1antos use an un!er%riter2
The underwriters will provide advice on'
o the structure, pricing, timing and mar/eting of the issue
o the allocation of the securities between underwriters, investors and mar/ets.
-nderwriting 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 mar/et volatility.
(#) What is the out-clause entered into by Santos? Discuss how the out-clause operates.
?n out-clause is usually incorporated in an underwriting facility.
Gpecified conditions, situations or benchmar/s will activate the out-clause and preclude the
underwriting agreement from being enforced; for e"ample, an out-clause may relate to a
specified change in a published share mar/et inde".
&n the e"ample, the underwriter has an out if the Gantos share price falls below 2**.34.
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 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. (LO 5.3)
(a) Shoal Limited will be a limited liability company. What are the rights and financial
obligations of shareholders that purchase shares in the company?
.olders 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.
Ghareholders have a residual claim on the assets of the firm after all other creditors have been
paid.
Ghareholders typically receive dividend payments, usually twice-yearly, distributed from the
profits of the corporation.
?s Ghoal is a limited liability company, the claims of creditors against shareholders are limited
to the value of the fully paid ordinary shares issued; for e"ample, as Ghoal has issued partly paid
shares )instalment receipts,, then the shareholders are re#uired to ma/e 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.
(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
Ghoal Eimited has issued instalment receipts. These are issued upon payment of the first
instalment )2*.54, towards the purchase of ordinary shares in the corporation.
hen the final instalment of 2*.31 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.
?lso, the company may not re#uire 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
re#uirements.
7. mining #orporation has o)taine! the rights to e+plore $or gol! in a ne% tenement. The
#orporation !e#i!es to esta)lish a ne% su)si!iary #ompany that %ill #arry out this high8risk
"enture. The ne% #ompany %ill )e liste! on the sto#k e+#hange. The gol! e+ploration #ompany
e+pe#ts to #omplete its e+ploratory sear#h o"er the ne+t 12 months6 at %hi#h time it %ill report
)a#k to sharehol!ers an! make re#ommen!ations on the "ia)ility o$ the pro*e#t. (LO 5.5)
(a) 3hat $orm o$ legal stru#ture %oul! you re#ommen! the gol! e+ploration #ompany
in#orporate2 3hy %oul! you re#ommen! this stru#ture2
0ased on the available information it seems appropriate that the subsidiary be formed as a no-
liability company.
?s a start-up e"ploration 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.
?s this is a high ris/ venture, investors are more li/ely to purchase partly-paid shares rather than
pay the full amount.
The company will report bac/ to shareholders in *5 months, and if the project is to proceed, will
ma/e 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. $on-payment of a call results in the forfeiture of shares.
()) 3hat are the a!"antages to the #ompany an! also to the sharehol!ers o$ the stru#ture you
re#ommen!e!2
? shareholder in a no-liability company is able to decide not to pay the call. .owever, in this
circumstance the shareholder will forfeit the shares. The shareholder will have lost the value of
the partly paid share.
&n reality, the shareholder would elect to sell the share prior to the call date.
&f sufficient shareholders pay the ne"t call on the shares the company is able to fund the ne"t
stage in the project.
1(. n e$$i#ient sto#k e+#hange %ill esta)lish listing rules that support the interests o$ liste!
entities6 maintain in"estor prote#tion an! ensure the reputation an! integrity o$ the sto#k
market. To a#hie"e this6 a sto#k e+#hange %ill a!opt a num)er o$ listing rule prin#iples. (LO
5.')
(a) List an! e+plain $i"e $un!amental listing rule prin#iples.
The main principles that form the basis of a stoc/ e"changeAs listing rules include )$ote' 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 entitys 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) If a multinational corporation seeks dual-listing on two stock exchanges, how will this
impact on the corporations 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 groups 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.
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 nee!s to raise additional equity
capital to fund the expansion. The company advisors recommend the board of directors
choose between a pro-rata rights issue and a private placement. Explain each of these
funding alternatives and discuss the advantages and disadvantages of each alternative. (LO
5.5)
oolworths Eimited has the advantage of an established positive reputation which will enable it
to raise further e#uity funding.
The choice is between a pro-rata rights issue and a placement; both relate to the issue of
additional ordinary shares.
Rights issue:
? pro-rata rights issue occurs when e"isting shareholders are given an entitlement to subscribe
for additional shares in the company.
&n ma/ing a rights issue, the company must ensure that all shareholders receive an e#uivalent
opportunity to participate in the issue. This is achieved by ma/ing the offer on the basis of a
fi"ed ratio of new shares to the number of e"isting shares held )pro-rata basis,. =or e"ample, a
*'*1 )one for ten, offer gives a shareholder the right to purchase one new share for every ten
e"isting shares held.
Cften 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,.
?n advantage of a rights issue is that the company retains its e"isting shareholder base, and at
the same time is able to raise additional e#uity funding.
? rights issue must conform to the prospectus re#uirements 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 e"poses the company to
pricing ris/, that is, the share price might fall below the rights price.
Placements:
? 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 bro/ers, without the need to register a prospectus.
Gubscriptions must be for not less than 2411,111 and to not more than 51 participants.
The advantages to the company include the reduced compliance costs )no prospectus, only an
information memorandum,, the #uic/ness in which the issue can be finalised, often at a lower
discount to mar/et price, and to investors that are friendly to the company.
? disadvantage to e"isting shareholders is ownership dilution; however placements are restricted
to a ma"imum of *4@ of capital in any *5-month period.
12. In some countries, such as Australia, it is common for corporations to offer shareholders a
dividend reinvestment scheme. (LO 5.5)
(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.
(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 ma/e
dividend payments and, assuming a sufficient reinvestment rate, to retain sufficient e#uity funds
to meet future funding needs.
Dividend reinvestment schemes allow e"isting shareholders to progressively increase their
shareholding in the company in small increments )the amount of the dividend,.
?t the same time, in countries such as ?ustralia that allow dividend imputation, the company is
able to pass on ta" fran/ing credits to its shareholders.
(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 re#uired, and may dilute earnings per share. Therefore, a company may need to suspend its
scheme from time to time.
13. From time to time, corporations such as the National Australia Bank Limited make an
issue of preference shares as part of the overall capital structure of the organisation. (LO
5.5)
(a) Explain the structure and cash flows associated with a preference share.
Preference shares are hybrid securities that combine the characteristics of both debt and equity.
Preference shares have their fixed dividend rates set at the issue date.
They also rank ahead of ordinary shareholders in the event of the winding up of the company.
(b) What specific features might the National Bank include in the structure of the
preference share to ensure it is attractive to investors, but at the same time meets the
funding needs of the bank?
!reference share issues are normally listed on the stoc/ e"change. This provides access to a
secondary mar/et, although the li#uidity of the issue will depend on the reputation and
performance of the issuer-company. ?ttributes that may be attached to a preference share issue
are that they may be'
o cumulativeFdividends not paid in one year are carried forward to ensuing years until
paid in full. $on-cumulative preference share dividends are lost if the company does not
ma/e sufficient profit in a particular year to ma/e the payment
o redeemableFentitles the holder to redeem the preference share on a pre-determined date
and receive the par value of the preference share
o convertibleFmay be converted into ordinary shares in the company at a future date,
generally at the lesser of an amount nominated in the prospectus, or a discounted mar/et
price at conversion date
o participatingFholders are entitled to dividends in e"cess of the stated dividend rate when
ordinary shareholders receive a dividend in e"cess of a specified rate, or the profits of the
company e"ceed a defined level
o issued at a different ran/ingFwhere first ran/ed preference shares have preference over
second and other ran/ed issues for claims on dividends and, in the event of winging up of
the issuer company, to residual assets.
1'. Con"erti)le notes6 #ompany8issue! options an! #ompany issue! %arrants are o$ten
re$erre! to as quasi8equity. (LO 5.5)
(a) 3hat are the #hara#teristi#s o$ ea#h o$ these instruments that ser"e to !istinguish them
$rom straight equity or !e)t2
Con"erti)le notes9
are a hybrid security that e"hibits the characteristics of both debt and e#uity during the life of the
security
are issued for a nominated term, generally at a fi"ed 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 e"isting shareholders, and are often not renounceable,
that is, the holder cannot sell the entitlement
Company8issue! option9
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 ma"imum term of five years in ?ustralia, 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
Company8issue! %arrant9
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. ?s such warrant can be sold separately to the bond it was originally attached.
()) 3hy might a #ompany issue quasi8equity rather than straight !e)t or equity2
The issue of #uasi-e#uity is another funding alternative to either straight debt or e#uity.
&t allows a company to issue funding instruments that are fle"ible in that they can be structured
to meet the companyAs cash flow and future funding re#uirements.
The special attributes of different #uasi-e#uity instruments may be attractive to investors; for
e"ample the ability to convert to e#uity 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 #uasi-e#uity debt instrument at
a lower price than straight debt.
&nterest payments may be ta" deductible.
? company can set the conversion dates of the e#uity component of a #uasi-e#uity issue to meet
forecast future funding re#uirements.
E+ten!e! learning question
15. Listing on a sto#k e+#hange might )e highly !esira)le $or a #ompany6 )ut there are a
num)er o$ requirements6 #on!itions an! #osts asso#iate! %ith )e#oming a pu)li#ly liste!
#orporation. (LO 5.4)
(a) /!enti$y an! e+plain 1( spe#i$i# requirements that must )e met )y an ustralian #ompany
seeking general a!mission to the 1:.
Gubject to the more detailed re#uirements specified by the ?GH, some of the broad re#uirements for
general admission to the official list include )#uestion only re#uires choice of *1 re#uirements,'
The entitys structure and operation must be appropriate for a listed entity.
The entitys constitution must be consistent with the listing rules.
A prospectus, product disclosure statement or information memorandum must be issued and
lodged with the corporate regulator, ASIC.
A foreign entity must establish, in Australia, an Australian securities register (or sub-register),
appoint an agent for service of process and be registered as a foreign company under the
Corporations Act.
If the entity is a trust, it must be a registered managed investments scheme and the responsible
entity must not be under an obligation to allow a security holder to withdraw from the trust.
The entity must apply for and be granted permission for quotation of all the securities in its main
class of securities.
There must be at least 500 holders each having a parcel of the main class of securities (excluding
restricted securities) with a value of at least $2000. Alternatively, there must be at least 400
holders each having a parcel of the main class of securities (excluding restricted securities) with a
value of at least $2000, who are not related parties of the entity that must hold at least 25 per cent
of the total number of securities (excluding restricted securities) in the main class. (A related
party is one that has an ownership interest in the entity seeking admission.)
The entity must satisfy either the profit test or the assets test (discussed below).
If the entity issues restricted securities before it is admitted, it must comply with the related
listing rules.
Special conditions apply if an entity issued classified assets in the two years prior to application.
If the entity has options on issue, the exercise price for each underlying security must be at least
20 cents in cash.
The entity must appoint a person to be responsible for communication with the ASX in relation to
matters associated with the listing rules.
An entity seeking listing must advise the extent to which it will, upon admittance, comply with
the recommendations of the ASX Corporate Governance Council. The entity must advise the
ASX of the reason for non-compliance with all the recommendations.
An entity that is to be included in the S&P/ASX All Ordinaries Index must have an audit
committee. If the entity is included in the top 300 of the index, it must comply with the
recommendation of the ASX Corporate Governance Council.
The entity must agree to authenticate and provide documents to the ASX electronically.
The entity must have a trading policy that complies with the ASX listing rules.
()) ;is#uss the 1: pro$it test an! asset test requirements an! e+plain %hy these rules are in
pla#e.
The objectives of the ASX include the provision of a fair and well-informed market for financial
securities and the provision of an internationally competitive market. The ASX listing rules are a
key element in achieving these objectives. The profit test and assets test are a component of
achieving this objective. That is, the ASX listing rules seek to ensure that companies obtaining
listing on the ASX are able to demonstrate a capacity to operate a financially sustainable
business.
To meet the profit test requirement of admission, an entity must satisfy each of the following
conditions:
The entity must be a going concern, or the successor of a going concern.
The entitys main business activity at the date it is admitted must be the same as it was for the
last three full financial years.
The entity must provide audited financial statements for the last three full financial years. The
financial statements must be accompanied by audit reports, which must not be qualified with
regard to the entitys capacity to continue as a going concern, or satisfy the profit levels required.
The entitys aggregated profit from continuing operations for the last three full financial years
must have been at least $1 million.
The entitys consolidated profit from continuing operations for the 12 months to a date no more
than two months before the date the entity applied for admission must exceed $400_000.
The entity must give the ASX a statement from all directors (in the case of a trust, all directors of
the responsible entity) confirming that they have made inquiries and nothing has come to their
attention to suggest that the economic entity is not continuing to earn a profit from continuing
operations up to the date of application.
The assets test requirement of admission is as follows:
At the time of admission an entity must have net tangible assets of at least $2 million after
deducting the costs of fundraising, or a market capitalisation of at least $10 million.
The entity must have either one of the following:
o Less than half of the entitys total tangible assets, after raising any funds, must be cash or in a
form readily convertible to cash.
o Half or more of the entitys total tangible assets, after raising any funds, must be cash or in a
form readily convertible to cash and the entity must have commitments consistent with its
business objectives to spend at least half of its combined cash and readily convertible assets.
The business objectives must be clearly stated and include an expenditure program. If the
prospectus does not contain a statement of the business objectives, the entity must give a
statement of its business objectives to the ASX.
The entity must satisfy each of the following:
o If its prospectus, product disclosure statement or information memorandum does not contain
a statement that the entity has enough working capital to carry out its stated objectives, the
entity must give the ASX a statement prepared by an independent expert.
o The entitys working capital must be at least $1.5 million, or, if it is not, it would be at least
$1.5 million if the entitys budgeted revenue for the first full financial year that ends after
listing was included in the working capital. For mining exploration entities, the amount must
be available after allowing for the first full financial years budgeted administration costs and
the cost of acquiring plant, equipment and mining tenements. The cost of acquiring mining
tenements includes the cost of acquiring and exercising an option over them.
o An entity must provide financial statements for the last three full financial years. The
financial statements must be audited, and must include audit reports.
(#) /!enti$y an! e+plain the !i$$erent #osts that a #ompany %ill ha"e to meet in the pro#ess.
3hat impa#t %ill these ha"e on the liqui!ity management o$ the $irm2
The extent of the costs of listing will depend ultimately on the complexity of the issue, the amount of
equity issued, the method of issuing the securities, the number of advisers involved and the level of
marketing undertaken.
An indicative list of initial expenses that may be incurred include:
underwriting and handling fees
float management fees
legal fees
accounting and taxation fees
other expert adviser fees
printing costs
advertising and marketing costs
share registry expenses.
Specific fees charged by the ASX include:
ASX initial listing fees
ongoing annual listing fees
other fees as determined by the ASX.
Gpecific fees payable to the ?GH in relation to official listing include'
an in-principle decision fee
an initial listing fee
a fee for examination of documents
annual listing fees.
=ees charged by the stoc/ e"change will vary from time to time, and will depend on the type of
security issued, e#uity or debt, and the amount of the securities listed. The cost of listing places a
significant initial demand on the li#uidity management of a corporation. That is, the listing
corporation must ensure that it has access to sufficient sources of cash to be able to meet these
additional cash flow needs as they arise. This will usually be before capital has been received from
the listing.

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