Overview of Equity Securities (Reading 50)

Learning Outcome Statements (LOS)

a

Describe characteristics of types of equity securities:

  Common shareholders have a claim on firm assets after the debtholders and preferred stockholders and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay.

  Callable common shares benefit the firm because it gives the firm the right to repurchase the stock at a pre-specified price. Putable common shares benefit the shareholder because it gives the shareholder the right to sell the shares back to the firm at a pre-specified price.

  Preferred stock does not have voting rights, does not mature, and has dividends that are fixed in amount but are not a contractual obligation of the firm. Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends. Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio.

b

Describe differences in voting rights and other ownership characteristics among different equity classes:

  Different classes of common equity (ex: Class A and Class B shares) may have different voting rights and priority in liquidation.

c     

Distinguish between public and private equity securities:

  Cons: Private Equity Firms                                             Pros: Private Equity Firms

  Illiquid                                                                              Lower reporting costs

  Firm financial disclosure may be limited                     Greater ability to focus on long-term prospects

  Corporate governance may be weaker                              Greater return for investors once the firm goes public 

d    

Describe methods for investing in non-domestic equity securities:

  Direct Investing refers to buying a foreign firm’s securities in foreign markets.

  GDRs: Global depository receipts are issued outside in the United States and outside the issuer’s home country, Mostly traded on London and Luxembourg exchanges; Usually denominated in U.S. dollars.

  ADRs: American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges.

  GRS: Global registered shares are common shares of a firm that trade in different currencies on stock exchanges throughout the world.

  BLDR: Baskets of listed depository receipts are ETFs that invest in depository receipts.

e  

Compare the risk and return characteristics of types of equity securities:

  Return Characteristics: Equity investor returns consist of dividends, price changes and any foreign exchange gains/losses. Compounding of reinvested dividends has been an important part of long-term return.

  Risk Characteristics:

f 

Explain the role of equity securities in the financing of a company’s assets:

  Equity securities provide funds to the firm to buy productive assets, to buy other companies, or to offer to employees as compensation. Equity securities provide liquidity that may be important when the firm must raise additional funds.

g

Distinguish between the market value and book value of equity securities:

Book value of equity = Financial Statement Value of Assets – Financial Statement Value of Liabilities;

Book values reflect the firm’s past operating and financing choices.

Market value of equity = Share Price * Number of Shares Outstanding

Market value reflects investors’ expectations about the timing, amount, and risk of the firm’s future cash flows.

h

Compare a company’s cost of equity, its (accounting) return on equity, and investor’s required rates of return:

  The accounting return on equity (ROE) is calculated as the firm's net income divided by the book value of common equity. Higher ROE is generally viewed as a positive for a firm, but the reason for an increase should be examined. (ex: A firm can issue debt to repurchase equity, thus decreasing the book value of equity and increasing the ROE, but increasing the firm’s financial leverage, not a good sign.)

  The firm's cost of equity is the minimum rate of return that investors in the firm's equity require. A decrease in share price will increase the expected return on the shares and an increase in share price will decrease expected returns, other things equal.

Formulas:

Book value of equity = Financial Statement Value of Assets – Financial Statement Value of Liabilities;

Market value of equity = Share Price * Number of Shares Outstanding

ROEt ==    (more appropriate when it is the industry convention or when book value is volatile)

ROEt =         (more appropriate when examining ROE for a number of years or when book value is stable)                                    

*Net Income refers to net income available to common (net income minus preferred dividends)

Exercise Problems:

1.      The advantages to an investor owning convertible preference shares of a company most likely include:

A. less price volatility than the underlying common shares.

B. preference dividends that are fixed contractual obligations of the company.

C. an opportunity to receive additional dividends if the company’s profits exceed a pre-specified level.

Ans: A;

A is correct. Convertible preference shares tend to exhibit less price volatility than the underlying common shares because the dividend payments are known and more stable.

B is incorrect. Preference dividends are fixed but are NOT contractual obligations of the company.

C is incorrect. A preference share can be converted to a common stock at a pre-specified conversion ratio.

2.      The holder of the type of security that has a claim subordinated to those of a debt holder but senior to those of a common stockholder is most likely to have:

A. no voting rights.

B. statutory voting rights.

C. cumulative voting rights.

Ans: A ; 

In the event of liquidation, the holder of a preferred stock has priority in liquidation less than that of bonds issued by the company but ahead of that of common stock. Therefore, the type of security described here is preferred stock. Preferred stocks have no voting rights.

3.      The type of voting in board elections that is most beneficial to shareholders with a small number of shares is best described as: 

A. statutory voting.

B. voting by proxy.

C. cumulative voting.

Ans: C;

Cumulative voting allows shareholders to direct their total voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates. Thus, applying all of the votes to one candidate provides the opportunity for a higher level of representation on the board than would be allowed under statutory voting.

4.      Which of the following is least likely an obstacle to direct investing in the securities of foreign companies?

A. The investment and return are denominated in  a foreign currency

B. The reporting requirements of foreign stock exchanges may be stricter.

C. The foreign stock exchange may be illiquid.

Ans: B;

B is not an obstacle in that the reporting requirements of foreign stock exchanges are actually less strict and thus impede analysis;

A and C are both obstacle to direct foreign investment.

5.      The type of equity security that gives its owners the right to vote the shares of and receive dividends from a foreign company is most likely a:

A. global depository receipt

B. sponsored depository receipt

C. fully-owned depository receipt

Ans: B ; 

The owner of a sponsored depository receipt has the same voting rights and receives the same dividends as the owner of a common stock.

A is incorrect. A global depository receipt may be sponsored or unsponsored.

6.      Which of the following is (are) shared characteristics of Global Depository Receipts and American Depository Shares?

I. They are both usually denominated in U.S. dollar.

II. They can both be privately placed.

A. I only

B. II only

C. I and II

Ans: C ; 

I is correct. ADRs are obviously denominated in U.S. dollars and trade in the U.S.  Although not listed in U.S. exchanges, GDRs are usually denominated in U.S. dollars and can be sold to U.S. institutional investors.

II is correct. Both can be privately placed.

7.      Institutional investor prefers to invest in depository instruments of foreign equity securities that are privately placed in the U.S. and not subject to the foreign ownership and capital flow restrictions. The type of security that is most appropriate for this investor is: 

A. global registered shares.

B. global depository receipts.

C. American depository shares.

Ans: B ; 

A is incorrect. Global registered shares (GRS) are traded in different currencies on stock exchanges around the world and thus not privately placed.

C is incorrect. American depository receipts (ADRs) are subject to the capital flow restrictions imposed by government.

8.      Returns from a depository receipt are least likely impacted by which of the following factors? 

A. Exchange rate movements

B. Analysts' recommendations

C. The number of depository receipts

Ans: C ; 

The price of each depository receipts and returns will be affected by factors that affect the price of the underlying shares, such as exchange rate movements, company fundamentals, economic events, market conditions, analysts’ recommendations and any other factors that affect the value of any stock.

9.      A company has issued only one class of common shares and it does not pay dividends on them. It has also issued two types of preference shares – one that is putable and the other callable – and both have a non-cumulative feature. Which of these securities will most likely offer the highest expected return to the investor?

A. Common shares.

B. Putable preference shares.

C. Callable preference shares.

Ans: C;

C is correct. Callable shares are most risky of the three because if the market price rises, the firm can call the shares, limiting the upside potential of the shares. Because of this feature, callable shares usually have higher dividend yields than non-callable shares.

B is incorrect. Putable shares are least risky because if the market price drops, investors can put the shares back to the firm at a fixed price. Because of this feature, putable shares usually have a lower return than non-putable shares.

A is incorrect. From above we could see that in terms of risk, putable < common < callable, therefore in terms of return, putable

10.  Which of the following statements is most accurate?

A. Investors prefer to invest in callable common shares rather than putable common shares.

B. The issuing company is obligated to buy callable common shares at a predetermined price.

C. Putable common shares facilitate raising capital because of their appeal to investors over callable common shares.

Ans: C ; 

A is incorrect. Investors prefer to invest in putable rather than callable common shares because the put feature gives investors the right to sell the shares back to the issuing company when the market price is below the pre-specified put price.

B is incorrect. The issuing company has the right but is not obligated to buy callable common shares at a predetermined price.

11.  Which of the following least likely explains why preferred stock is less risky than common stock?

A. Preferred stockholders receive their distributions before common shareholders.

B. Preferred stock has a higher average return than common stock.

C. Common dividends can vary with earnings whereas preferred stock pays a fixed dividend.

Ans: B ; 

B does not explain why. Preferred stock has a lower average return than common stock because it is less risky.

A and B are both reasons why preferred stock is less risky than common stock.

12.  In a transaction referred to as a management buyout (MBO):

A. management sells its shares to an investor group attempting to gain control of a company.

B. management buys a controlling interest in a public company to gain control of the board directors.

C. an investor group that includes management buys all the shares of a company and they no longer trade on an exchange.

Ans: C ; 

Management buyout refers to a situation where an investor group that includes the firm’s key management purchases all the outstanding shares (not just a controlling interest) of a public company in order to take it private. Once this is done, the shares are no longer registered for public trading and, as a result, are no longer traded on exchanges or in other public markets.

13.  Which of the following statements is least accurate about market value of equity?

A. When management makes decisions that increase income and retained earnings, they increase the market value of equity.

B. The market value of equity is the total value of a firm’s outstanding equity shares.

C. Market value of equity reflects expectations of investors about the firm’s future performance and seldom equals book value of equity.

Ans: A ; 

A is least accurate because management increase the book value of equity when they make decisions that increase income and retained earnings.

Statements B and C are correct about market value of equity.

14.  The change in the intrinsic value of a firm’s common stock resulting from an increase in ROE most likely:

A. increase the stock’s intrinsic value.

B. decrease the stock’s intrinsic value.

C. depends on the reason for the increase in ROE.

Ans: C ; 

While an increase in a firm’s ROE due to a sharp increase in earnings will, if unexpected, lead to an increase in the intrinsic value of its shares, an increase in a firm’s ROE due to the repurchase of stock with debt will not necessarily increase the intrinsic value of the firm’s shares, as this would increase the ROE but also make the firm’s shares riskier due to the increased financial leverage.

15.  Given the figures below for Almost Heaven Inc., the return on average equity and the price-to-book ratio are:

       Return on average equity     Price-to-book ratio

A. 20.02%                              2.40

B. 20.16%                              2.40

C. 20.16%                              2.33

Ans: B ; 

ROEt==

==20.16%

Book value per share at the end of 2011 =201,543/30,650 =$6.58

Price-to book ratio at the end of 2011 = 15.80/6.58=2.40