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Part - VIIEquity Shares

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Introduction 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.

Unlike debt securities which merely connote a loan from the bondholder to the firm, equity shares confer ownership rights on the shareholders.

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Shareholder’s Stake Every shareholder is a part owner

of the company. His/her stake is equal to the fraction

of the total share capital of the firm to which he/she has subscribed.

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Cash Flows from Shares When a firm makes a profit it will

typically pay out a fraction of it in the form of cash to the shareholders. Such cash payments are called

DIVIDENDS.

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Retained Earnings It is not essential for a firm to have a

profit in the year in which it chooses to pay a dividend. 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.

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Retained Earnings Quite obviously, the Reserves and

Surplus account will have a balance only if a firm has a habit of accumulating profits. 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. This amount is known as Retained Earnings.

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Dividends Dividends are not contractually

guaranteed. 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.

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Dividends (Cont…) That is, shareholders cannot

demand dividends as a matter of right. 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.

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Dividends (Cont…) In principle therefore, dividends can

fluctuate substantially from year to year. In practice however they rarely do.

Firms generally opt to maintain dividends at a steady level, even in years of financial hardship.

This is to avoid sending distress signals to the market, which could cause the market value of the firm to plunge.

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Residual Claims 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.

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Residual Claims (Cont…) Secondly in the event of liquidation

or bankruptcy, when the assets of the firm are sold; 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.

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Maturity Equity shares never mature. Every firm is set up as a Going

Concern. 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.

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Rights of Shareholders Equity shareholders have voting

rights. They have a say in the election of the

Board of Directors.

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Limited Liability Shareholders have limited liability.

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.

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Voting Rights Most equity shares carry voting

rights This includes the right of shareholders

to elect the directors of the firm. The most common arrangement is

one vote per share. But in practice shares with differential

voting rights are issued

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Example of Differential Voting Rights-The Case of the Ontario Securities Act The Act defines three types of

restricted shares: Subordinated voting shares

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.

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Example (Cont…) Non voting shares

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 They carry the right to vote subject to

specified restrictions.

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Differential Rights (Cont…) Except for the voting restrictions

these shares are usually similar to normal shares 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.

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Differential rights (Cont…) 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.

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Proxies In order to be eligible to vote at a

meeting of shareholders, the shareholder must be the Owner of Record That is, his name must be present in

the register of shareholders on the prescribed Record Date.

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The Record Date 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.

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Proxies (Cont…) 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.

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Proxies (Cont…) Why are proxies allowed?

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.

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Proxies (Cont…) In practice managers solicit proxies from

absentee shareholders for a valid reason Usually a quorum is required by law for a

meeting to be legally recognized 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 proxy.

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Par Value versus Book Value 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 And the par value was supposed to

represent this fund.

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Par Value…(Cont…) Thus standard par values like $10

or $100 were specified. Today par values have no practical

significance. They can be therefore fixed at

arbitrary levels, like say 10 cents. In fact some shares may not even

have a par value.

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Reasons for Low Par Values 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. So companies issue low or no par

value stock to minimize these expenses.

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Book Value 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.

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Classified Common Stock Companies sometimes issue

different categories of stock. The most common reason for this is

that they wish to confer different voting rights on different categories of shareholders.

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Example The Ford Motor Company has two

classes of shares The shares available to the public carry

voting rights As of 1998 one billion one hundred and

fourteen million plus shares were outstanding. But of these, 70.90 million shares were

classified as Class B.

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Example (Cont…) Class B shares are owned by the Ford

family and certain key officers. 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. Thus the majority of shareholders cannot

easily force a decision on the company.

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Classified Shares (Cont…) For many years the NYSE did not

permit non voting shares to be listed This policy has been subsequently

relaxed.

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Dividend Related Dates In the context of a dividend

payment, there are four dates that are important The Declaration Date The Record Date The Ex-dividend Date The Distribution Date

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Declaration Date 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.

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The Record Date 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.

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The Ex-Dividend Date 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.

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The Ex-Dividend Date (Cont…) 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.

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The Ex-Dividend Date (Cont…) This date will therefore be set a

few days before the share transfer book is scheduled to be closed. This to enable the registrar to

complete all the administrative formalities

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The Ex-Dividend Date (Cont…) This date is a function of the settlement

cycle followed by the exchange. For instance the NYSE follows a T+3 cycle.

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.

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The Ex-Dividend Date Thus on the NYSE the ex-dividend

date is specified as two business days prior to the record date announced by the firm.

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Cum-Dividend and Ex-Dividend Prior to the ex-dividend date, the

shares will be trade cum-dividend. 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. Thus buyers of the share on or after this

date will not be eligible for the approaching dividend.

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Ex-Dividend Prices On the ex-dividend date the share

price ought to, in theory, decline by the amount of the dividend. 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.

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The Distribution Date This is the date on which the

dividends are actually paid or distributed.

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Stock Dividends These are called Bonus Shares in

India. It is a dividend that is paid in the form

of shares of stock rather than in the form of cash.

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Stock Dividends (Cont…) This entails the issue of additional

shares without monetary consideration. What happens is that funds are

transferred from the Reserves & Surplus account to the Share Capital account.

This is called the Capitalization of Reserves

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Stock Dividends (Cont…) From a theoretical standpoint,

stock dividends do not create any value for their shareholders.

We will illustrate this using a numerical example.

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Example Assume that a shareholder owns 500

shares of CISCO and that the firm has issued 500000 shares in all. So this investor owns 1/1000th of the firm.

Now assume that the firm announces a 10% stock dividend Which means that it will issue one additional

share for every 10 existing shares.

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Example (Cont…) Thus the firm will issue 50000 shares

Of which the investor will receive 50 Thus after the issue he will be in

possession of 550 shares which is 1/1000th of the total number of shares outstanding.

Thus his stake in the company will remain unaltered.

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Example (Cont…) As far as the firm is concerned, the

additional shares do not represent: 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.

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Example (Cont…) Assume that the share price prior

to the bonus issue was $ 55. The ex-bonus price, P, should be

such that: 500000 x 55 = 550000 x P P = 50

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Ex-Bonus Price Declines In practice, the ex-bonus price may

not fall to its theoretically predicted value. 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?

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Rationale 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. So in future cash dividends will have to

be paid on a greater number of shares.

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Rationale (Cont…) 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 the theoretically predicted value.

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Stock Dividends (Cont…) Sometimes, a firm may declare a

bonus issue prior to the payment of a cash dividend. If so the impact on the share price will

be as illustrated in the following example.

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Example 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%. Assume that the dividends will be

paid on the additional shares as well.

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Example (Cont…) The cum-bonus cum-dividend price is

$55. The market value of 500000 shares is:

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.

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Example (Cont…) Thus the theoretical ex-bonus ex-

dividend price will be: 27,5000,000 – 2 x 550,000 ______________________ = $48 550,000

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Splits & Reverse Splits Meaning of a stock split

An n:1 split means that n new shares will be issued to an existing shareholder for every old share that he is holding.

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.

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Differences Stock dividends entail the

capitalization of reserves 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.

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Differences (Cont…) The product of the par value and

the number of shares outstanding or The Issued Capitalwill remain unchanged.

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Price Behaviour 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.

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Example An investor is holding 500 shares

of CISCO worth $55 each. The company announces a 11:10

split. So he will have 550 shares after the

split These will theoretically be worth $50

each.

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Why Split Shares? Companies generally go in for a split

when the share price becomes too high. If so the scrip is considered to be out of

reach for small and medium investors. What is high is subjective

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.

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Why Split Shares? (Cont…) Investors normally prefer to trade in

round lots 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.

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Reverse Splits If a company perceives its stock

price to be too low it can go in for a reverse split In an n:m split, n is greater than m In an n:m reverse split, n is less than

m

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Example Assume that CISCO announces a 9:10

reverse split. A holder of 500 shares prior to the reverse

split will have 450 shares after the split. The post reverse split price would be:

500,000 x 55P =__________ = 61.11

450,000

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Rationale for Reverse Splits Exchanges like the NYSE discourage

the listing of securities which are consistently trading at very low prices This is because such prices have a

tendency to attract inexperienced traders with unrealistic price expectations, who could get their fingers burnt.

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Pre-emptive Rights 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. This is to enable them to maintain their

proportionate ownership in the company.

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Rights Issues (Cont…) Often, rights issues are made at a

price that is lower than the prevailing market price of the share. 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.

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Illustration of the Value of a Right 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. 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.

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Illustration (Cont…) The market value of the firm prior to the

rights issue is: 500,000 x 50 = 25,000,000

The post issue theoretical firm value will be: 25,000,000 + 50,000 x 40 = 27,000,000

The ex-rights price should be:27,000,000

__________ = 49.09 550,000

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Illustration (Cont…) Considering that fact that a share

worth 49.09 is being made available at 40, the value of the right is 9.09.

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Losers? Are the existing shareholders losing?

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.

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Losers? (Cont…) Take the case of an investor who has

50 shares. 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

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Renunciation 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: 49.09 x 50 + 9.09 x 5 = 2,500

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Ex-rights Price The ex-rights price is often higher in

practice than the theoretically predicted value.

This is because the rights issue may be perceived as an information signal by investors. The very fact that additional shares are

being issued may be construed as a signal of enhanced future profitability.

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Ex-rights Price (Cont…) 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.

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Ex-rights Price (Cont…) Both these factors could cause the

demand for the shares to rise. Consequently the decline in the price

will be less than what is predicted by theory.