Module 7 - Risk Management PDF

Module 7 - Risk Management Shares Introduction The Financing Decision refers to a firm’s relative use of debt and equity in financing it’s operations Payments to equity suppliers are not a binding commitment from the firm and they have the lowest payment priority. (They are residual) - Debt holders...

Module 7 - Risk Management Shares Introduction The Financing Decision refers to a firm’s relative use of debt and equity in financing it’s operations Payments to equity suppliers are not a binding commitment from the firm and they have the lowest payment priority. (They are residual) - Debt holders are paid on first priority for providing their funds over the equity holders in terms of an interest payment. - Income statement of a company shows us that debt is paid before equity. - From income at the end of the year, the company’s will pay shareholders but is not mandatory. As the returns to equity suppliers are more risky, it’s expected return )or cost) will exceed that of debt. - ROE is not certain and therefore involves greater risk to shareholders, making equity more expensive for the company, as they would need to compensate the investors for this risk. Part A. Emerging Firms Emerging Firms - Firms at the start of their life cycle - Traditionally, companies follow a lifecycle known as the startup financing cycle in the emerging stages of the firm/prior to IPO - Firms are not usually profitable at start as company initially is unknown and is timely to break even at startup - Break even point is reached dependent on how much startup financing is required - A service industry with less capital outlay will reach break even point before a firm like a pharmaceutical company how have a large capital outlay before products are even launched. - Emerging firms are companies in early stage of development and may be in process of building products to release to the market or building a consumer base to generate greater revenue. - During negative profit and very early stages, firms seek funding from angel investors - At stages prior to the IPO, firms seek funding from venture capital, mergers and acquisitions, strategic alliances. - Some company’s don’t survive beyond first month or year due to limited financial resources, minimal grant recognition and little to no established market presence. - Life cycle could describe a new product or already established market type for the product. Venture Capital An emerging firm is a business that aspires to grow into a large company - Emerging firms with innovative business ideas or disruptive technology that lack their own developmental funding, seek venture capital from market to initially finance developments. Venture capital is a type of private equity investment that produces funding in early stage high growth companies that have potential to provide significant return form investment and ownership stakes in the business. One source of venture capital is business angels; risk taking, wealthy, patient investors who participate in the running of the firm during developmental stages. They can provide guidance and networking to the firms. - Angels may be willing to take more risk as they invest more money where as institutional investors have to describe why they are investing to their shareholders. Risk: - Might just be a patent or idea, minimal track record but no evidence of success - Caution of error due to firm failure but can yield very high returns if successful. Investors provide guidance, networking Venture capital is often larger amounts in early but later stages however angel investors are smaller amounts in early stage companies Venture Capital Fund Managers Typically investors that manage a fund that invest in early stage companies with high growth potential. Fund manager pool funds together and funds different companies. Fund managers responsible for identifying and evaluating best investment opportunities Role of VC Fund manager: - Raising capital from investors like high net worth individuals or families or institutional investors. - Work closely with management team of company they’re investing in to help them grow. - Raise funds from super funds, insurance companies, banks and wealthy individuals - Invest in a number of new businesses to spread the risk of loss - May specialise in certain industries or stages of development - Usually represented on the board Success of a VC fund is dependent on the success of the companies inside the portfolio and therefore fund managers must invest in companies with greatest potential. Investment Ready A company is ready for investment when; 1) They have achieved substantial size 2) Has an efficient management structure 3) Can produce regular financial reports 4) Has potential for profitable operations At this stage, the venture capital company can sell their shares through an IPO Venture capital investments are high risk and can result in the complete loss of the invested amounts. Part B. Equity Securities silts buy)sell on ASX(NASDA2 etc. include individual institutional Ike fund managers other company investors Y Still have to release financial Info to gov & ATO Shares of priv firms are no traded & can be difficult for shareholders to sell shares buy Very illiquid share or Venture capital investments are high risk and can result in the complete loss of the invested amounts. Shareholders of public companies include individuals, households, institutional investors like fund managers of pension and superfund trusts and other company investors. Public companies are subject to many regulations and reporting requirements Shareholders of a public firms have some say in strategic decisions however day to day management is led by board of directors and professional management team appointment by board of directors. Market Capitalisation = Number of shares x Value of Share Price - Manufacturing companies used to be highest in Aus Corporations top 10 Market Cap but world has moved more towards servicing industry with our markets now dominated by banking services, mining, electricity. Publicly Listed Companies 1) Securities sold to general public and investors can trade shares 2) Have an unlimited number of shareholders 3) Have strict financial reporting requirements that must be publicly accessible 4) Have shares initially sold to the public through a Initial Public Offering often with a signed underwriter to buy the remaining shares Public company shareholders include individual investors, institutional investors including banks and fund managers of trust such as pensions and superannuation and other company investors Shareholders of firms have some say in the strategic decisions of the company however dat to day management is led by the board of directors and management team which is chosen by the board of directors. Ordinary Shares: Features; - Positive - Ordinary shares represent part ownership of a company - Typically have no maturity date - Can have their ownership transferred - Are limited liability when fully paid - Entitle shareholders to a share of profits which are paid as dividends if company decides to pay dividends - Entitle shareholders to vote in company elections - Have potential for capital gains - Negative - Risk of last to be paid in time of bankruptcy with debt holders being paid first Ordinary shares are most widely held type of shares in company Provide investors with greatest potential for long term capital Value of ordinary shares dependent on profits of company and market’s perception of market’s future performance Value can fluctuate widely known as volatility due to things such as change in fincnail performance, industry trends, change in macroeconomic conditions, what competitors do. Overall, ordinary shares represent away for investors to invest in company and participate in growth and successful over LT but have higher risk than ST and LT money market instruments. Sources of Return for an Investor - Investors in ordinary shares earn a return from the dividend payments and from capital gains or losses that arise from changes in market value of shares prices. - These are not guaranteed as company can come to not pay dividends and the share price can decrease. - Dividends typically paid half yearly as an interim and final dividend. - Interim dividend and final dividend payment can be of different value Risk Attached to Investment in Ordinary Shares - Investors face risk of earning lower returns due to smaller dividends or no dividends as a result of the company’s capital losses - Maximum loss is the price paid for the shares. - However, shareholders are not liable for the invested company’s capital losses thus there largest loss would only be from a decrease in market value of the share price. Preference Shares Features - Positive - Represent part ownership - Pay promised dividend which have priority over ordinary dividends if company goes into liquidation or have limited capital. - Negative - Have restricted voting rights: cannot vote in company decisions, voting of management - Limited potential for capital appreciation Features of both equity and debt, is known as a hybrid security Can have a variety of types including; 1) Non Participating 2) Cumulative; Accumulates unpaid dividends by the company and turns them into a liability that must be repaid to the SH before dividends are paid to ordinary shareholders. 3) Converting: Converted shares can be converted into ordinary shares at a predetermined price. 4) Redeemable: Can be bought by company at predetermined price Steady stream of income Part C. Assessing Share Value Value determined by supply and demand Part D. Initial Public Offerings An IPO, going public or float, refers to the first issue of shares to the public by a company for the purpose of listing on an exchnage. Undertaken by companies seeking to raise capital to fund growth and expansion plans and to provide liquidity to existing shareholders such as founds, employees, early investors During IPO company hires investment banks or stockbroking firms to help price and market shares to investors. Most IPOs in Australia are for newer or emerging firms Institutional investors are usually only interested in large IPOs. - Many of these have been privatisations (Telstra), carve offs or demutualisation (AMP) When shares are offered to public, they can be traded on ASX, NY stock exchange or NASDAC Advantages and Disadvantages of Going Public Advantages: - Additional equity enhances the company’s financial strength and funds company growth through access to broader capital & visibility - Gives investors liquidity - Enhances the company’s capacity to remunerate its management and employees - Allows shareholders to sell their investments. - Provides company with greater visibility - Access to greater customer base - Raise additional funds in the future within the secondary markets. - Increased credibility in the marketplace - Adds value through increase in perceived value from the public Disadvantages - Expensive - Continuing owners experience dilution of company ownership, loss of control - Agency costs result from separation of ownership and management - May encourage short term performance bias to deliver in short term however disregard LT goals. - Increased scrutiny and pressure from shareholders to deliver strong financial results - Stricter regulatory compliance requirements which can be time consuming and costly The IPO Process 1) Firm selects a manager/arranger of the IPO such as an investment bank or stockbroking firm 2) The issue documents including the prospectus are prepared 3) Financial Statements are prepared and audited 4) Due diligence is performed meaning any claims made in the prospectus are verified 1) The Prospectus - IPOs are conducted under ASIC and ASX rules which require a prospectus - A prospectus provides investors with accurate and comprehensive information about the company and its directors, the issue and the issuing process and the financial prospectus of the shares as an investment. Like a sales or marketing document - Prospectus provides reasoning as to why the company wants to become public - The prospectus helps in the marketing of the shares. - It includes; a) A business overview b) Financial information; statements, income, state, balance sheet, revenue & earning forecasts c) Who the management and board of directors are, their experience and qualifications d) Potential risk factors of investing in the company including market risk, regulatory risk and business/competition risk e) Any legal or regulatory matters; information like legal or regulatory precludes that it’s involved in or that could impact its procedures f) Describe how the company intend to use the proceeds form the IPO 2) The Market Process - Investment bank advises company how, where and when to list on the ASX through it’s IPO - Underwriter determines demand for company shares prior to the IPO - Involves a Bookbuild: which involves collecting indications of interest for potential investors to help bank and underwriters to determine offering price and number of shares sold in IPO - During Bookbuild process, the company works with underwriter throughout the offering to determine the offering price - Share price is initially presented as a range and finally come up with an actual price during IPO - Reach out to investors/high net worth to get feedback on investor likelihood. - Investor submits indication of interest to on how many shares investor is willing to buy at a specific price point - Based on interest, underwriters determine level of demand and offering price and then, lock in that offering price. - Once Bookbuild process is complete, the underwriter sets the final IPO price based on the demand and company’s financial situation with the primary goal of setting a price that is attractive to investors and maximises potential capital for the company. 3) The Pricing and Timing of an IPO - Smaller IPOs: - Setting the prices poses difficulties due to a lack of data on comparable IPOs - Are mostly conducted on a best efforts basis which gives the managing bank incentive to set a low price - Have little choice about timing - Larger IPOs: - Usually have better information history - Use the Bookbuild process to set the price - Try to time issues with bull markets. The Underpricing Phenomenon Historically IPOs are underpriced: That is, the IPO issue is less than the closing price on the first day of listing on the share market - The difference is, the money left on the table - This means IPO companies raise less funds than they could have - This also means investors who buy shares in the IPO can make an immediate profit Although underpricing can initially seem positive as investors can purchase shares at a discount, it can be negative for the investor going public as it results in a loss of potential funds, forgone opportunity cost Explanations for Underpricing of IPOs; - Not completely understood but possibly; a) Desire of the seller to have a successful IPO b) Provides buyers of IPO shares with enough capital gain to encourage the to provide further equity in the future c) Compensation for risk, given that underpricing is not guaranteed d) To benefit retaining owners e) The superior negotiating power of the investment bank f) Limited supply can create excess demand and this height can drive up the price as shares go beyond the IPO price Part E. Raising Additional Equity Listed firms raise money through; 1) Retained Earnings: Raise small but steady amounts 2) The issue of Additional Shares (Seasoned Offerings) through: a) Rights issues: Process by which a company issues rights to exisiting share holders entitling them to purchase newly issued shares in the company at a discounted price, to raise additional share capital - Rights are allocated to shareholders in proportion to the number of shares they hold. E.g. 1 new share for 5 owned - The price and quantity of shares offered to each shareholder, is determined by the company’s board of directors. - Rights are allocated on the ex-rights date - The subscription price is set below the current share price and must be paid by the subscription date - Does not dilute ownership of existing share holders. - No fees incurred compared to when issuing a new IPO - Usually renounceable: they are given to exisiting shareholders but become temporary securities they can exercise, sell or lapse - They are used to raise large amounts of additional equity capital but risk failure if share price falls below subscription price (though they can be underwritten) and requires prospectus which can be expensive - If shareholders choose not to purchase, they typically have the option to sell the rights on an open market and if they are placed on the market, new buyers have potential to buy them at this lower subscription price. b) Private placements: Company issues new shares of its stock to a selected group of investors, not general public through IPO - Typically used by companies that want to raise capital quickly and efficiently without the costs of issuing an IPO - Company works with investment bank or other financial institutions who identified potential investors such as institutional investors such as venture capital or private equity firms or high net worth individuals who may be interested in purchasing new shares - Price of shares and quantity of shares offered are negotiated between the company and its investors, they aren’t predetermined. - Shares can be at a discount to market price and current shareholders may negotiate for additional rights and privileges as part of the investment - Generally subject to less regulatory requirements than public offerings. - Subject to some security laws and regulations. - Investors in private placement must typically be accredited investors and must have capital of a certain amount c) Dividend re-investment plans: Shareholders can receive additional shares instead of dividends. - DRPs are programs freed by companies by shareholders to reinvest their dividends automatically in additional shares instead of receiving cash payments. - Convenient way for investors to reinvest their earnings without incurring transaction fees. - Reinvesting dividends can help to compound returns over time. - Popular currently - To take part in a DRP, the investor would sign up with a company;s transfer agent, and they will manage the reinvestment of dividends on the company’s behalf. When the dividends are paid, the agent will use the funds to purchase additional shares and accreditation it to the investor’s account on the ASX. - Consider terms of scheme and risk associated with the company’s stock before deciding to invest.