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Investment Decision Making

There are 3 aspects of financial management
Investment decisions

ð  In which asset to invest?
Financing (funding) decisions
ð  How to fund the purchase of these assets?
Dividend Policy decisions
ð  How to retain and/or distribute profits?
This chapter focuses on the financing decision

Funding Decisions

Financial objective of a corporation is to maximise return subject to an acceptable level of risk
Returns generated from net cash flows of the business
Risk is the variability of these cash flows, caused by either
–      1.Business Risk
–      2.Financial Risk

Business Risk
–      The level of business risk depends upon the type of operations of the business
–      Also affected by
ð  Sectoral growth rates
ð  Market share
ð  Aggressiveness of competitors
ð  Competence of management and workforce

Financial Risk
–      Impacts directly on the company’s cash flows
–      Financial risk categories
ð  Interest rate risk
v  Risk of adverse movements in interest rates
ð  Foreign exchange risk
v  Risk of adverse movements in exchange rates
ð  Liquidity risk
v  Risk of insufficient cash in short-term
ð  Credit risk
v  Risk of default of untimely payments by creditors
ð  Capital risk
v  Risk of insufficient shareholder funds to meet capital growth needs or absorb abnormal losses
–      The level of financial risk of a company is borne by the security holders (debt and equity)

Debt to Equity Ratio

Ratio of funds contributed by shareholders (equity) to funds borrowed (debt)
If the cost of debt is less than the return achieved, then issuing more debt will benefit shareholders
However, high debt levels increase the company’s level of financial risk
What is the appropriate debt-to equity ratio?
–      Optimal ratios for a company will depends upon
ð  1. Industry norms
ð  2. History of ratio for the firm
ð  3. Limits imposed
ð  4. Firm’s capacity to service debt

Limited Liability: Equity Funding

Major source of equity funding
Shareholders have voting rights at general meetings
Shareholders may transfer voting rights to a proxy
Authorised capital: maximum number of shares authorised under Memorandum of Association
Paid up Capital: the number of shares actually issued
Shares may be sold ‘fully-paid’ or ‘partly-paid’
‘Partly-paid’ shareholders have contractual obligation to pay the remaining amount (the call) to the company
Shareholder’s liability is limited to the extent of the fully paid shares

Ordinary Shares

Used for highly speculative ventures
Shares issued as ‘partly-paid’
Shareholders may decide not to meet future ‘calls’, in which case the shareholders will forfeit the ‘partly-paid’ shares

Unit Trusts

Investors purchase units in a trust
Trustee invests pooled funds
Unit holders are entitled to a portion of the income stream of the trust
Unit trusts may be listed on the stock exchange or unlisted

Equity Funding Alternatives

Additional ordinary shares
–      Rights issues
–      Placements
–      Takeover issues
–      Dividend reinvestment schemes
Preference shares
–      Quasi-equity
–      Convertible notes
–      Options
–      Warrants

Additional Ordinary Equity
Rights issue
–      Issue of ordinary shares to existing shareholders
–      Issued pro-rata (eg 1:5)
–      Two types
ð  Renouncable: shareholder may sell their right
ð  Unrenounceable: may not be sold
–      Rights issue made at a discount to a current price
Share placements
–      Additional new ordinary shares issued directly to selected investors (normally institutions)
–      Market price discount can not be excessive
–      Allows smaller discount and shorter time frame than rights issue
–      The takeover company issues additional ordinary shares to the owners of the target company in settlement of the transaction
–      Removes the need for the owners of the takeover company to inject further equity for the purchase for the company
Dividend reinvestment schemes
–      Shareholders have the option to reinvest (convert) dividends into additional ordinary shares
–      Generally issued at a discount to market price
–      No brokerage or stamp duty payable
–      In growth periods it allows companies to pay dividends and pass on tax credits, while increasing equity
–      Schemes may be suspended in low growth periods

Preference Shares

Preference shares are hybrid securities (characteristics of both debt and equity)
Fixed dividend rates are set at issue date
Rank ahead of ordinary shareholders in the payment of dividends
Features of preference shares
–      Cumulative or non-cumulative
–      Redeemable or non-redeemable
–      Convertible or non-convertible
–      Participating or non-participating
–      Different priority rankings
Advantages of preference shares
–      In effect preference shares are fixed interest borrowing, but are an equity finance instrument
–      Assists in maintaining debt-to-equity ratio
–      Widens a company’s equity base, which allows further debt to be raised
–      Dividends may be deferred on cumulative shares, while debt interest must be paid

Convertible Notes

Convertible notes are a hybrid instrument – initially as a debt instrument issued for a fixed term
Interest payments specified in the note
Bestows the right to convert the note into ordinary shares at a specified future date at a determinable price
The option to convert to equity has value
The conversion price is nominated at note issue – gain is made if share price rises subsequently
If share price falls, holder may not exercise conversion option, and take the notes cash value
Interest paid on notes is usually lower than straight debt instruments
Interest payment are tax deductible for the company
Notes are often issued for longer periods than is possible with straight debt borrowings

Provide the right but not the obligation to purchase ordinary shares, at a stated price, at a future date

Share Options

Issued for a period of up to 5 years
Allows companies to raise further equity funds at planned future dates (providing holders exercise the option)
Generally have a higher value and may be traded
The exercising of the option will depend upon the exercise price of the option relative to the market price of the share at the exercise date

Equity Warrants

Generally attached to corporate bond issues (long-term debt securities), however may be issued unattached
Gives the holder the option to convert the warrant into ordinary shares at a determinable price over a given period
Warrants may be detachable from the bond and traded separately
Holder does not receive dividend payments, but may benefit from capital gains if the underlying share price increases
Alternative equity warrants issues include
–      Low initial price, high exercise price
–      High initial price, low exercise price