Investments WEEK 3: LECTURE 3 1Chara Charalambous CDA COLLEGE

Chara Charalambous CDA COLLEGE 1

Investments

WEEK 3: LECTURE 3


Learning Outcomes

• 1.What is capital?• 2.What is a share and what are the

types of a share? 3.What is a share capital? 4. What is a dividend? 5. Types of share capital. 6. Capitalization 7. Rights Issues


CapitalFor all three types of organization: sole trader, partnership and company , the money contributed by the individual, the partners or the shareholders is referred to as the business capital.

In the case of a company the capital is divided into shares.


• Total capital of the company is divided into a number of small units of a fixed amount and each unit is called share. The fixed value of the share, printed on the share certificate, is called nominal/par/face value of a share.

• Funds raised by issuing shares in return for cash. The amount of share capital a company has can change over time because each time a business sells new shares to the public in exchange for cash, and thus the amount of share capital will increase. Share capital can be composed of both common and preferred shares. .

Also known as "equity financing“. capital .


• Share capital is the money invested in a company by the shareholders. Share capital is a long-term source of finance.

• In return for their investment, shareholders gain a share of the ownership of the company.

• Shareholders benefit from the protection offered by limited liability – they are only liable for the amount they invest in share capital rather than the overall debts of the company

• The shareholder obtains a return on this investment through dividends (payments out of profits) and/or increases in the value of the company when it is eventually sold.

• A start-up company can also raise finance by selling shares to external investors


Types of Shares

A. Ordinary Shares(Equity Shares)

B. Preference Shares(Preferred Shares)

Cumulative preference shares

Non-cumulative Preference Shares


Ordinary Shares: are the normal shares issued by a company and the ordinary shareholders are the real owners of the business.

• Carry voting rights• Shareholders receive a divided at the discretion of the

company directors• Dividends is paid out of profits after the preference

shareholders receive their dividend.Preference Shares:

• Do not generally carry voting rights• Shareholders receive a fixed dividend (calculated as % of

nominal value of shares held)• Dividends is paid out in priority to ordinary dividend


Cumulative preference shares:if the dividend is not paid in a given year, it is still owned to the shareholders in the following year (and must be paid ahead of any ordinary dividend)Non-Cumulative preference shares: if the dividend is not paid in a given year , then in the following year, only that years preference dividend need to be paid before an ordinary dividend.





Other categories of preference shares

• Redeemable (buy back) preference shares which are repayable by the company at a specified future date. On this date the shares are cancelled and the shareholders repaid. These shares have the characteristics of debt and they shown as a liability in the Balance Sheet.

• Irredeemable preference shares are preference shares which are not redeemable. These shares are classified as equity-capital in the Balance Sheet.


Dividends

• Dividends are the share of profits paid out to shareholders.

• Dividends on preference shares are a fixed amount.


Preference Dividends

• Preference Dividends: Redeemable preference share dividends are classified as

finance costs. Irredeemable preference share dividends are classified as

dividends.

• If at the end of the year the company has not paid all the dividends due to preference shareholders , the company will show the amounting owing as a current liability in the Balance Sheet under the heating ‘proposed dividends’ or ‘interest accrual’.


Ordinary Dividends• Dividends of ordinary shareholders are often paid

twice each year: an interim dividend during the accounting year and a final dividend after the Balance Sheet date when the profit of the year is known.

• Dividends will vary according to the company’s level of profits and dividend policy.

• Ordinary dividends are often expressed in terms of cents (or Euros /dollars) per share. E.g. 10 cent per share.

• No dividend may be paid on the ordinary shares until the preference share dividend has been paid in full.


• Previously, issued capital comprised common equity shares as well as all preferred shares. But now only irredeemable preferred shares can be shown as part of issued share capital.

• Issued capital consists of the shares that have been sold to the shareholders against cash. For example, if a company sold 100,000 shares which have a face value of $ 1 per share, then the issued share capital of such a company is $100,000.

• Share capital of a company can change. Some companies issue new shares to the existing shareholders or new shareholders. These additional shares increase the value of issued share capital. Some companies even redeem or repurchase their own shares. This will reduce the amount of issued share capital.

• It should be kept in mind that issued share capital is not affected by the market price of shares. The value of issued capital presented in the financial statements is simply the number of issued shares multiplied by the face value of each share. If company has issued 100,000 equity shares of face value $ 1 per share and the market value of each share is $ 2, even then the issued share capital of such a company will be $ 100,000 (Not $ 200,000).

• Share capital can be different from authorized share capital. Authorized share capital is the maximum amount of equity capital that a company can issue to the shareholders. The issued capital can be less than the authorized share capital but it cannot be more than it.


Types of share capital• Authorised share capital is also referred to as registered

capital. It is the total of the share capital which a limited company is allowed (authorised) to issue. – Shares authorised = Shares issued + Shares unissued

• Issued share capital is the total of the share capital actually issued to shareholders. This may be less or equal to the authorised capital.

• Called up share capital is the total amount of issued capital for which the shareholders are required to pay.

• Paid up share capital is the amount of share capital paid by the shareholders. This may be less than the called up capital as payments may be in instalments ("calls-in-arrears").

http://en.wikipedia.org/wiki/Shares_authorized

http://en.wikipedia.org/wiki/Unissued_stock


• The maximum number of shares that a corporation is legally permitted to issue, as specified in its articles of incorporation. Authorized stock, also known as “authorized shares” or “authorized capital stock,” is also usually listed in the capital accounts section of the balance sheet. Authorized shares should not be confused with outstanding shares, which are the number of shares the corporation has actually issued that are held by the public.

• The number of authorized shares is typically higher than those actually issued, which allows the company to sell more shares if it needs to raise additional funds. For example, if a company had 1 million authorized shares, it might only sell 500,000 of the shares during its IPO (Initial public offering (IPO) or stock market launch is a type of public offering in which shares of stock in a company usually are sold to institutional investors (that price the company receives from the institutional investors is the IPO price) that in turn sell to the general public, on a securities exchange, for the first time).

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Bonus issue or Scrip Issue'Bonus Issue‘ → issue of shares but not with the usual way

• An offer of free additional shares to existing shareholders. A company may decide to distribute further shares as an alternative to increasing the dividend payout. The company doesn’t receive any additional payment from the shareholders.

• The shareholders get additional shares free of cost instead of cash dividends. In this manner the company can keep its shareholders happy as well as save the cash funds from being distributed.

Also known as a "scrip issue"• New shares are issued to shareholders in proportion to their holdings.

For example, the company may give one bonus share for every five shares held.

This involves the capitalization of reserves!!!Chara Charalambous CDA COLLEGE


IN ORDER FOR A COMPANY TO HAVE BONUS OR SCRIPT ISSUE IT MUST DONE CAPITALIZATION.


Capitalization issueThe conversion of reserves into share capital.

• Either the Revenue Reserves – those arising from retained profits – or Capital Reserves - those arising from the share premium account or from government subsidies (financial support) or donated funds, Profit on sale of fixed assets, Profit on sale of investment or Profit on revaluation of assets and liabilities or Profit on purchase of an existing business – can be used.

• Capitalization issues normally take place when the company has substantial revenue reserves: out of profits.


Capitalization issue• In order to understand capitalization we must first review the

following definitions. Every share issued by a limited company has a nominal value

(face value). Nominal value or par value means the value per share stated on the face of the share certificate. When a company issues shares it may issue them at par, at discount or at premium. Share premium is the amount in excess of par value received on the issue of shares. For example a company issues shares with a face value of say $1 at a price of $1.50. This means that $1.0 is the par value and $0.50 is the premium per share.

When a company issues shares at premium the amount of such premium needs to be transferred to an account called as share premium account. .


• For example, a company issues 100 ordinary shares of a nominal value of $1 each at a subscription price of $4 per share. The $300 difference will go to the share premium account.

• At the same time, the company issues 50 preference shares with a par value of $0.5. These shares are bought by investors for $1 each.

The firm's balance sheet at this point consists of only four items:Assets:Cash: $450Liabilities: nilShareholders' equity:Common stock: $100,Preference stock: $25,Share premium: $325 SPA = Number of new shares issued x (issue price - par value)


• The retained earnings account is built up over time as the firm ‘saves’ a part of its earnings/profits rather than paying out as dividends.

• Retained Earnings refers to the portion of net income of a corporation that is retained (reserved/taken/engaged/saved) by the corporation rather than distributed to shareholders as dividends.

• Similarly, if the corporation incurs a loss, then that loss reduces the corporation's retained earnings balance. If the balance of the retained earnings account is negative it may be called retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year.

• Retained earnings are reported in the shareholders' equity section of the corporation's balance sheet. A report of the movements in retained earnings or losses are presented in the Statement of Retained Earnings or Statement of Retained Losses


Comparative Income Statement for years ending 31st Dec (millions of Euros except the per share data) 2000 1999Net Sales 1500 1435 Cost of Goods Sold (1230) (1176.7)Gross Profit 270 258.3Fixed operating expenses (90) (85)Depreciation (50) (40)Earnings before interest and taxes (EBIT) 130 133.3Interest (40) (35)Earnings before Taxes (EBT) 90 98.3Taxes (40%) (36) (39.3)Net Income 54 59Dividends of preference shares 0 0Earnings available to common stockholders (EAC) 54 59Common Dividends (29) (27)Addition to retain earnings 25 32

Per Share data(25,000,000 shares):

Shares issued (quantities) 25 25Common stock price €23 €23 Earnings per share €2.16 €2.36Dividends per share €1.16 €1.08

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Comparative Balance sheets as at 31 Dec (millions of Euros)

Fixed Assets 2000 1999Plant and Equipment 680 600Less: Accumulated Depreciation (300) 380 (250) 350Current AssetsInventory 270 200Debtors 180 160Cash 15 465 40 400Total Assets 845 750Equity and Liabilities Owner’s equityPaid – in Capital 0 0Common stock (25,000,000 shares) 130 130Retained Earnings 285 260 415 390Long Term Loans 300 255Current LiabilitiesCreditors 30 15Accruals 100 90Total Equity and Liabilities 845 750

Chara Charalambous CDA COLLEGE


Evaluating a Firm’s EPS We can use the income statement to determine the earnings per share

(EPS) and dividends. EPS = Net income/Number of shares outstanding Example 1: A firm reports a net income €54 million and has 25 million

shares outstanding, what will be the earnings per share (EPS)? EPS = Net income ÷ Number of shares = €54 million ÷ €25 million = €2.16• Book value per share = (Common equity)/Shares €16.60 • Market value per share (stock price) €23.00• Earnings per share = (Net income)/Shares €2.16 • Dividends per share = (Common dividends)/Shares €1.16


• USA: The Internal Revenue Service (“IRS”) excludes from an association’s taxable income those amounts which are properly kept and used for capital contributions. In several significant Revenue Rulings, the IRS considered special assessments for major repairs and replacements to be capital contributions in addition to capital contributions to reserve funds from annual assessments.


How does Capitalization issue work?• In the example below the company has £100,000 ordinary shares and £130,000

of reserves. In the second and third columns we show just two of the ways in which the company could make a capitalization issue – in this case a 1 for 1 –

one new share for every old share. Before issue After issue Case 1 Case 2Ordinary Shares £100,000 £200,000 £ 200,000 Share Premium Account £ 50,000 0 £ 20,000 Revenue Reserves £ 80,000 £30,000 £ 10,000 Net Worth £ 230,000 £ 230,000 £ 230,000

• The net worth is being unchanged. In case 1 the company first uses its capital reserves like the share premium account. In our example a holder of 1000

shares will now have a holding of 2000 shares.


What is a Right Issue ?• Rights issue means that when a company issues further shares

then the existing shareholders have a pre-emptive right – protective and legal right - to buy the shares. If the shareholders do not take up these shares, they can be issued to outsiders or third parties. This right is important because otherwise the shareholder might see its percentage holding in the company being weakened.

• The usual purpose of a rights issue is to raise additional capital for a specific purpose, but sometimes the proceeds raised go in part to replace existing borrowings. Unlike the capitalization issue therefore the rights issue does involve a subscription in cash and this results in a real increase in the assets of the company. Its is therefore highly significant.

• A rights issue is an issue of new shares carrying the same rights as the old shares .


Appendix


• A rights issue is an issue of new shares carrying the same rights as the old shares. It will be made at a price above the nominal value and below the market value of the existing shares. If an issue were to be made above the market price it would of course attract no attention and an issue below the nominal or par value would be illegal. It is customary for it to make the rights shares more attractive by issuing them at a discount to the prevailing market price. Thus the result of a rights issue is that it reduces the market price of the share, see example below:

• Example: shares of nominal value £1, 1 share for 4 rights issue. The old shares stand £1.60 but the rights issue is being made at £1.20 per share.

1000 ‘Old’ shares at market £1.60 £1600 250 ‘New’ shares at £1.20 £300 1250 £1900 ( 1900/1250= £1.52) The holding in this case now consist of 1250 shares with a theoretical

market value of £1900


How close to reality is the theoretical rights price?• In the previous example it was assumed that the price of the

ordinary shares will fall immediately from 1.60 to 1.52. There are reasons why thus may not happen:

1. The supply of the company’s shares has been increased without a clear increase in demand .Not all the shareholders will wish to take up the new shares and others will not have the resources to do so.

2. Doubts may be expressed about the company’s ability to achieve a satisfactory return on the new share capital.

3. This doubt may be increased if the company has important borrowings.

• So if the market did not respond well to the rights issue the price in the example case might fall more. On the other hand the news of a rights issue may appear to cause a rise in the price of the Shares. When this happens the cause is more likely to be some exciting news such as the development of a new product than the rights issue it self.


- Appendix -• The amount of share capital a company reports

on its balance sheet only accounts for the initial amount for which the original shareholders purchased the shares from the issuing company. Any price differences arising from price appreciation/depreciation as a result of transactions in the market are not included .


- Appendix -Market Value of Shares The current quoted price at which investors buy or sell a share of common stock or a bond at a given time. Also known as "market price." The market value of shares fluctuates according to the success and supposed

expectations of a company. If a company is listed on the stock exchange, the value is determined by reference to recent transactions between buyers and sellers of shares. This value is not shown in the financial statements.

Market price per share is never found on the financial statements. Rather you can find it from stock market reports. Some companies mention average market price over the year based on stock market reports.

In the context of securities, market value is often different from book value because the market takes into account future growth potential. Most investors who use fundamental analysis to pick stocks look at a company's market value and then determine whether or not the market value is adequate or if it's undervalued in comparison to it's book value, net assets or some other measure.


- Appendix -o Earnings per share are always reported on the

Income Statement. It is calculated by dividing the earnings after tax by the number of shares issued and outstanding at the year end.Dividend per share is also reported in the financial statements in the Income Statement.– Shares outstanding are those issued shares which are

not treasury shares. These are all the shares held by the investors in the company.

– Treasury shares are those issued shares which are held by the issuing company itself, the usual result of a buyback.

– Shares issued = Shares outstanding + Treasury shares

http://en.wikipedia.org/wiki/Shares_outstanding

http://en.wikipedia.org/wiki/Treasury_shares

http://en.wikipedia.org/wiki/Share_repurchase

http://en.wikipedia.org/wiki/Shares_outstanding

http://en.wikipedia.org/wiki/Treasury_shares

Documents

Investments WEEK 3: LECTURE 3 1Chara Charalambous CDA COLLEGE