The Original Function of a Stock Exchange - Assignment Example

International Financial Markets 7 December Question The original function of a Stock Exchange was to mobilize capital for long-term expansion.This key function has been compromised in recent decades as secondary trading now accounts for a high proportion of its trading activities. There are a number of factors that are responsible for this. Two of these are: The relatively stringent requirements for listing on the Main market; and the ongoing disclosures that will become necessary to remain listed. According to information in one of the publications of the London Stock Exchange: “the sheer range of topics that need to be considered building up to IPO can seem like a daunting task.” A guide to listing on the London Stock Exchange, (20l0 p3). There are relatively stringent requirements to become listed on the stock exchange. In addition to fulfilling the UKLA requirements, the company would need to provide prospective investors as well as the UKLA with a prospectus. A prospectus is a document that introduces the company. This document “describes and discusses the company’s business and operations. It provides details on the strengths and strategies of the company, its principal products and services and its employees. It also gives an overview of the industry in which the company operates, so that prospective investors can understand more of what they may be getting into if they decide to invest Additional information in the prospectus are three years of audited financial statements to help prospective investors assess the current financial performance and financial position of the business, and an operational and financial review which gives information on the key drivers of the business. The directors would also need to provide a statement that there were no significant changes in the operations of the business since the last financial year. Financial resources are also required to get the prospectus done and if the company does not have its financial accounts up to date, a firm would have to be contracted to get it done. Investors will have to be convinced that investing in the company is a worthwhile venture. These financial statements would be subject to scrutiny. In addition to the increased scrutiny and the relatively high cost of listing on the main market, the process can be very time consuming and daunting. The second factor is the ongoing requirements for disclosures which are very costly and time consuming. To remain listed on the main market of the London stock exchange, a company is required to publish financial statements on a quarterly basis. These financial statements have to be available within a specified timeframe after the quarter has ended. What this means is that the company will need to have the necessary resources in place to ensure that these deadlines are met. If the deadline is not met the company risks being delisted. Additionally, the directors will be under increased scrutiny and they will not have the same level of power as before since the company would now be open to public scrutiny. All related party transactions would have to be disclosed. The directors of private company’s have become accustomed to doing things a certain way and having certain privileges which they do not want to dispense with. Therefore, some of them prefer to remain fairly static instead of going public. The essential problem here is the accountability that is required from the directors of the company. They are not interested in being accountable to a large group of people. They want the resources to expand the business but they do not want to be under the spotlight of neither the authorities nor the shareholder. What is important to note, is that these will not be the only groups looking on. There are the advisers, the general public and potential investors. This has not impacted significantly on the growth of business in the UK. Since 1995, there has been the establishment of the alternative investment market (AIM) which has much less stringent requirements than a listing on the main market requires. AIM has resulted in growth in the number of companies on the market. The cost to register in aim is much less. The requirements for three years of audited financial statements which had been a major deterrent is do not apply. Therefore, a company could start on AIM and transition to a listing on the main market. Despite the introduction of AIM, there is still some hesitance. However, a number of the companies on AIM are registered in other countries. There is still some amount of paper work and approval required for which some companies cannot be bothered. However, statistics provided by the London Stock Exchange suggests that the number of registrations on AIM is running higher than that of NASDAQ in the United States. Question 2 (a) Gearing Ratio = Interest bearing loans Ordinary share capital + interest bearing loans = £4,000,000 × 100% £4,000,000 + £4,000,000 = £4,000,000 × 100% £8,000,000 = 50% Interest bearing loans relate to the 5% Debentures and the 2 ½% Preference shares. The amounts were calculated as follows. 5% Debentures 400,000 × £4 = £1,600,000 2 ½ % Preference shares 600,000 × £4 = £2,400,000 (b) The dividend declared on ordinary shares is: Profit available for distribution is: £800,000 Percentage declared as dividends: 40% Amount declared as dividends is: 40% of £800,000 = 40/100 × £800,000 = £240,000 That is a dividend per share of: Amount declared as dividends ÷ number of ordinary shares £240,000/1,000,000 = 24p per share The return on investments (ROI) relates to the return on ordinary shareholders investment in the business and is calculated as follows. ROI = Net Profit after Taxes × 100% Ordinary Shareholder’s Equity = £800,000 × 100% 4,000,000 = 20% (c) Before we can calculate the Price Earnings ratio we will require two pieces of information that have not been given to us but for which we have information that is necessary to … Earnings per Share (EPS) = Profits attributable to ordinary shareholders Weighted average number of ordinary shares = £800,000 1,000,000 = £0.80 Price/Earnings (P/E) Ratio = Market price per share of common stock Earnings per share £4 = 5 £0.8 We did not have the necessary information on the market price and therefore the nominal price was used in the calculation. This figure “reflects the amount investors are willing to pay for each dollar of earnings. The average P/E ratio in a particular industry can be based as the guide to a firm’s value if it is assumed that investors value the earnings of a given firm in the same manner as they do the “average” firm in that industry.” “The level of the P/E ratio indicates the degree of confidence (or certainty) that investors have in the firm’s future performance. The higher the P/E ratio, the greater the investor confidence in the firm’s future.” (Gitman, 1997) Question 3 A rights issue gives current shareholders the right to purchase additional shares in a company in direct proportion to their number of owned shares. (Gitman, 1997). It is a common source of financing for companies listed on the stock exchange. These rights have to be exercised within a certain time period. If it is accepted, it allows the company’s shareholders to maintain their existing proportionate control of the company. The subscription price is generally below that of the market. The decision of the shareholder to take up these rights will depend on the value of the rights. According to Gitman (1997 p564): “If the rights have a very low value and a rights holder owns only a small number of shares, the rights may be allowed to expire. There advantages and disadvantages connected to the holding of a rights issue. These will be discussed in turn. There are a number of advantages that can accrue to shareholders in a company as a result of a rights issue. Three (3) advantages of a rights issue to shareholders are discussed below as follows. Existing shareholders are given the opportunity of owning more shares at a lower price. This means that they have an advantage over investors who have to go straight to the market. If the share price remains the same or is increased they would make financial gains. The company having no further repayment obligations would impact positively on the net worth of the company. This can have positive implications for the price/earnings ratio and therefore the share price. If the company had to take on additional debts, for example Debentures on which they are obligated to pay interest then this would mean less funds available to pay dividends or to retain for future expansion. Having more funds to pay dividends or for future expansion would affect shareholders positively as it has implications for share price increases and EPS which impacts a company’s P/E ratio. The company will have the ability to increase its borrowing capacity and therefore will not have to return to shareholders for additional funds. This would prevent any further dilution of earnings, since the company in now in a position to obtain funding from additional sources in the form of Debentures. There are a number of disadvantages that could arise for shareholders of a company on the holding of a rights issue. Three (3) disadvantages are explained below. There is a potential dilution of earnings. According to Gitman (1997, p568): when additional share are issued, more shares have a claim on the firm’s earnings. This often results in a short-term decline in earnings per share (EPS), which in turn can and often does negatively affect the stock’s market price.” Therefore if there is no significant increase in earnings the shareholders will be worse off than they were before the issue. This can be illustrated as follows: Before the rights issue the company had earnings of £800,000 and ordinary shares of 1,000,000 resulting in an EPS of 80p per share. If a rights issue of one (1) share for every ten (10) shares held is given, ordinary shares in issue would increase by 100,000 units to 1,100,000 units. Then, if earnings remain the same the EPS would now be 72p (£800,000 ÷ 1,000,000) a dilution of 8p (80p – 72p). Another disadvantage for shareholders, which is directly linked to the foregoing, is what Gitman describes as:”the potential dilution of control”. Here the issuing of additional shares can result in changes in proportional control. This usually happens when existing shareholders to whom a rights issue applies, do not take up the offer. That is, if a shareholder currently holds 10% (100,000) of the current 1,000,000 units of issued shares in a company and the company has a rights issue of one (1) share for every ten (10) and the shareholder for some reason does not take up the offer, he would lose his proportional holding. Proportionate shareholdings in this example would fall from 10% to 9% (100,000 ÷ 1,100,000) of the total shares in issue. This represents a 1% dilution of control An additional disadvantage is the negative signal that a rights issue sends to the market. According to Gitman (1997, p368): “Market participants perceive the sale of common stock by the firm to reflect management’s belief that the stock is ‘overvalued’; as a result, the stock price declines.” The case of Standard Chartered can be used to explain this disadvantage where Brown, 2010 in his article states: “The market seemed unimpressed with the news of the right issue with the share price dropping 3% on opening. This could be for the same reason that Gitman explains where some shareholders will see this as a means of selling their stockholdings before the price falls further. If the price is not carefully set, it could fall below the rights issue price. A negative signal could also relate to the fair of dilution of their earnings, as explained earlier. References Burrows, D (2010). Daily Finance: Standard Chartered plans £3bn rights issue. http://www.dailyfinance.co.uk/2010/10/13/standard-chartered-plans-3bn-rights-issue/ 5 Dec 2010 Gitman, L. J. 1997, Principles of Managerial Finance. 8th Ed., Addison Wesley, US London Stock Exchange (2010), A guide to listing on the London Stock Exchange. White Page Ltd, London http://www.londonstockexchange.com/home/guide-to-listing.pdf 7 Dec 2010 Read More