Part-03
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Part-03
Equity Shares & Preferred Shares 1
Introduction Equity shares Shares of common stock of a company Represent financial claims
• asset for the shareholder • equity shares confer ownership rights on the shareholders
• liability for the issuing corporation
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Shareholder’s Stake
Shareholder is part owner of company
Stake = fraction of the total share capital of the company
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Cash Flows from Shares
Dividends
When a firm makes a profit it will typically pay out a fraction of it in the form of cash to the shareholders.
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Dividends
Dividends are not contractually guaranteed
Unlike interest on bonds, the rate of dividends is not fixed.
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Dividends (cont…)
• Shareholders cannot demand dividends as a matter of right
• The company is not obliged to pay dividends •BOD decide whether dividends should be paid, and if so, how much
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Dividends (cont…)
Dividends can fluctuate substantially from year to year.
Firms opt to maintain dividends at a steady level, even in years of financial hardship
To avoid sending distress signals to the market, which could cause the market value of the firm to plunge Copyright Tarheel Consultancy Services
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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 can be used to pay dividends
Accumulated profits are a part of the Reserves & Surplus account on the liabilities side of the balance sheet
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Retained Earnings (cont)
Reserves and Surplus account = accumulated profits
x(profit) = Dividends
y(profit) = Retained Earnings
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Shareholders residual claimants Bondholders
Shareholders
Bondholders have to be paid the contractually promised rate of interest
Only then can the firm consider the possibility of rewarding its shareholders by way of dividends
In the event of liquidation or bankruptcy, bondholders must be paid their dues in part/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
An entrepreneur will not set up a firm with the stated objective of winding up after a given period
If firm is expected to stay alive for ever, its shares never mature.
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Rights of shareholders
12
Rights of Shareholders
1. Equity shareholders have voting rights. A say in the election of the Board of Directors
1. Shareholders have limited liability
Their financial commitment to the firm is limited to the extent of their shareholdings In the event of financial difficulties, company/creditors cannot stake a claim on the personal assets of the shareholders
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Voting Rights
Most equity shares carry voting rights
Right of shareholders to elect the directors of the firm
Common arrangement is 1 vote per share.
In practice shares with differential voting rights are issued Copyright Tarheel Consultancy Services
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Proxies
To be eligible to vote, the shareholder must be the Owner of Record
Name must be present in the register of shareholders on the prescribed Record Date. Copyright Tarheel Consultancy Services
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The Record Date
Is usually a few days prior to ‘date of the meeting’ of shareholders or ‘date of actual voting’ takes place
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Proxies (cont…)
Person whose name figures in the register on the record date may have sold his shares prior to ‘date of meeting’
The only way the current shareholder can vote is if he is given 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 Copyright Tarheel Consultancy Services
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Proxies (cont…)
Why are proxies allowed?
Most shareholders cannot be realistically expected to attend meetings and vote in person
Companies routinely send out proxies
Shareholders can fill these and authorize representatives of the management to vote on their behalf Copyright Tarheel Consultancy Services
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Proxies – reason (cont…)
In practice managers solicit proxies from absentee shareholders for a valid reason
A quorum is required by law for a meeting to be legally recognized
%shares represented at the meeting should exceed a prescribed minimum
Shareholders are encouraged to be present or have themselves represented by proxy
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Par value & Book value
20
Par Value vs. Book Value
Equity shares have a Par Value also known as the Face Value / Stated Value
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Par value (cont…) Historically
Today
Corporate assets were part Par values have no of a trust fund protected
practical significance
by BOD The par value was
Some shares may not
supposed to represent this even have a par value fund Standard par values like
Can be fixed at arbitrary
$10 / $100 were specified levels e.g. 10c Copyright Tarheel Consultancy Services
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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
Companies issue low/no par value stock to minimize these expenses Copyright Tarheel Consultancy Services
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Book Value
Book value is the value of the assets behind a share, as per the balance sheet.
Book value = (par value + any share premium + retained earnings) / no. of shares outstanding
Book value may differ substantially from the market value of the share (price of share on the stock exchange)
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Classified shares
25
Classified Common Stock
Companies sometimes issue different categories of stock.
Reason for this being they wish to confer different voting rights on different categories of shareholders
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Example - Ford
Ford Motor Company has 2 classes of shares
Shares available to the public carry voting rights
As of 1998 1114 million+ shares were outstanding
Of these, 70.90 million shares were classified as Class B
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Example – Ford (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
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Dividend Related Dates
In the context of a dividend payment, there are four dates that are important
1. The Declaration Date 2. The Record Date 3. The Ex-dividend Date 4. The Distribution Date Copyright Tarheel Consultancy Services
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1. Declaration Date
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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2. 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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3. 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…)
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’ transactions on or after that date will be reflected on the register only after the ‘record date’
This date will 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 Copyright Tarheel Consultancy Services
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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.
Trade occurs on day T Delivery of shares to the buyer on day T+3 Payment of funds to the seller on day T+3
A transfer of shares 2 days before the ‘record date’ or later will not be reflected in the books on the record date. On the NYSE the ‘ex-dividend date’ is specified as 2 business days prior to the record date announced by the firm. Copyright Tarheel Consultancy Services
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Cum-Dividend and Ex-Dividend Prior to the
ex-dividend
dividend
date
The shares will be traded cum
This implies that the buyer of the
share is eligible for the forthcoming dividend
On the ex-
The shares will begin to trade ex-
dividend date dividend
Buyers of the share on or after this
date will not be eligible for the approaching dividend Copyright Tarheel Consultancy Services
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Ex-Dividend Prices In theory
On the ex-dividend date the share
price ought to decline by the amount of the dividend. E.g. Cum-dividend price is $50 per share
Quantum of the dividend is $2 per
share, The share should trade at $48 ex-
dividend.
In practice The price decline may not be exactly Copyright Tarheel Consultancy Services
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4. The Distribution Date
This is the date on which the dividends are actually paid or distributed.
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Stock dividend
40
Stock Dividends
These are called Bonus Shares in India.
Dividend is paid in the form of shares of stock rather than in cash
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Stock Dividends (cont…)
Entails the issue of additional shares without monetary consideration Reserves & Surplus account
funds transferred
Share Capital account
This is called the Capitalization of Reserves Copyright Tarheel Consultancy Services
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Stock Dividends (cont…)
From a theoretical standpoint, stock dividends do not create any value for their shareholders.
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Example
A shareholder owns 500 shares of CISCO CISCO has issued 500,000 shares in all
The firm announces a 10% stock dividend
The investor will receive 50
After the issue shareholder will hold 550 shares
It will issue 1 share for every 10 existing shares
The firm will issue totally 50,000 shares
This investor owns 1/1000th of the firm
This is 1/1000th of the total number of shares outstanding
Shareholder’s stake in the company will remain unaltered
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Ex-Bonus Prices In theory
For the firm, the additional shares do not represent:
Either a change in its asset base, or A change in its earnings capacity
The issue of additional shares should lead to a decline in the share price. 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
The ex-bonus price may not fall In The market may interpret the bonus issue as practice
a signal of enhanced future profitability. Copyright Tarheel Consultancy Services
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Rationale
Companies usually refrain from lowering their cash dividend payouts, unless they are forced to
When a bonus issue is declared
The number of shares will go up
In future cash dividends will have to be paid on a greater number of shares.
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Rationale (cont…)
If ‘dividend payout per share’ is not likely to decline then 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
CISCO has 500000 shares outstanding
Shares are trading at $55 each
CISCO announces a cash dividend of $2 per share & a bonus issue of 10%
The dividends will be paid on the additional shares as well.
The cum-bonus cum-dividend price is $55
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Example (Cont…)
Market value of 500,000 shares is:
Theoretical market value of 550,000 ex-bonus cum-dividend shares will also be 27,500,000
500,000 x 55 = 27,500,000
Since the bonus issue per se does not add any value.
Theoretical ex-bonus ex-dividend price will be:
{27,5000,000 – (2 x 550,000)} / 550,000 = $48 Copyright Tarheel Consultancy Services
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Treasury stock
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Treasury Stock
Shares which were issued to the public have been subsequently reacquired by the company either through an open market purchase or via a tender offer These shares:
Have no voting rights Receive no dividends Are not used to compute EPS
Such shares are used for purposes such as ESOPs Copyright Tarheel Consultancy Services
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Why repurchase? Situation
Why repurchase?
In difficult markets shares Companies can buy a often trade below their
dollar’s worth of assets
book value
for less than a dollar
People often acquire
Shares are purchased to
voting control in order to thwart corporate raiders. sell the assets of the
By stashing away
company piece by piece, treasury stock, often to its competitors managements can acquire greater control
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Why repurchase? (cont…) Situation
Why repurchase?
A company is generating By repurchasing shares more cash flows than can and returning capital to be profitably invested. If it shareholders long term declares a special
capital gains are taxed at
dividend it is likely to be
a lower rate
taxed at the normal rate
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Stock split
55
Splits & Reverse Splits
Meaning of a stock split
An n:1 split n new shares will be issued to an existing shareholder for every old share that he holds
E.g. a 11:10 split a holder of 10 existing shares will receive 11 shares
This is analogous to a 10% stock dividend
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Differences Theoretically, stock splits and stock dividends are mathematically equivalent.
Stock dividends
Stock splits
Stock dividends entail the Stock splits do not capitalization of reserves The par value of an existing share is reduced – no. of shares will increase proportionately The product of the par value and the no. of shares outstanding or Issued Capital will remain 57 Copyright Tarheel Consultancy Services unchanged
Price Behaviour
The share price after a split will behave exactly as in the case of an equivalent stock dividend.
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Example – Price Behavior
An investor is holding 500 shares of CISCO worth $55 each He will have 550 shares after the split
The company announces a 11:10 split
These will theoretically be worth $50 each Copyright Tarheel Consultancy Services
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Why Split Shares? 1. 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/medium investors
What is high is subjective the belief is that managers have a feel of the ‘popular price range’
the range in which the stock should trade to attract enough investor attention. Copyright Tarheel Consultancy Services
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Why Split Shares? (cont…) 2. Investors normally prefer to trade in
round lots
round lot 100 shares
odd lot <100 shares
At very high prices, small/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
an n:m split n > m
an n:m reverse split n < m
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Example An investor is holding 500 shares of CISCO worth $55 each CISCO announces a 9:10 reverse split
He will have 450 shares after the split
Post reverse split price would be: 500,000 x 55 P = ____________ = 61.11 450,000 Copyright Tarheel Consultancy Services
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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
Low prices have a tendency to attract inexperienced traders with unrealistic price expectations, who could get their fingers burnt. Copyright Tarheel Consultancy Services
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Rights issue
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Pre-emptive Rights
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.
Enables them to maintain their proportionate ownership in the company. Copyright Tarheel Consultancy Services
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Rights Issues (cont…)
Often, price of rights issue < prevailing market price of the share.
When this happens, the rights acquire a value of their own.
An existing shareholder can either exercise his rights or else sell them to someone else.
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Example – 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 Copyright Tarheel Consultancy Services
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Example (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 ________________ = 49.0 550,000
Considering that fact that a share worth 49.09 is being made available at 40, the value of the right is 9.09 Copyright Tarheel Consultancy Services
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Losers?
Are the existing shareholders losing? No!
The ex-rights price is 49.09 which is less than the cum-rights price of 50
The shareholders are being given an opportunity to buy new shares at $40
This opportunity compensates for the decline in the share price
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Example – Losers? 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) There is no dilution of value Copyright Tarheel Consultancy Services
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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)
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 Copyright Tarheel Consultancy Services
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Why belief of future profitability 1. The belief that the new funds will be used
for more profitable projects 2. Since cash dividends are usually maintained
at steady levels the issuance of additional shares is a sign on increased profitability from existing ventures.
Both these factors could cause the demand for the shares to rise. Copyright Tarheel Consultancy Services
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Preferred shares
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Preferred Shares
These shares represent ownership in a corporation However they do not carry voting rights.
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Why Preferred?
The term “preferred” connotes that such shares have certain associated privileges.
Dividends must be paid to the preferred shareholders before equity holders.
If the firm is liquidated the preferred shareholders have to be paid in part or in full, before the balance if any can be paid to the equity holders.
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Dividends
These shares carry a fixed rate of dividends.
E.g. $3.50 preferred means that shares carry a dividend of $3.50/share
Or
E.g. 3.5% preferred a dividend of $3.50 on a par value of $100 Copyright Tarheel Consultancy Services
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No Growth
Preferred shares offer an opportunity for generous dividend returns with no growth opportunities.
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Why no growth?
Because of better prospects for the firm
Why do equity prices increase?
Preferred shares carry fixed dividends
Hence greater anticipated profits will have no consequence for such shares
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Why no growth?
Does this mean that such shares will never display fluctuations in price?
NO
Since the rate of dividends is fixed, they are a form of a fixed income security - just like a bond Declining interest rates will lead to higher share prices. Rising interest rates will lead to lower prices
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Callable Preferred Stock
In a period of high interest rates, preferred shares have to compete with other debt securities to offer high dividend rates.
The firm may feel that this is a passing phase
In future it could issue shares with a lower rate of dividends.
If so, it could issue Callable Shares
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Callable…(cont…)
Such shares can be recalled or retired at a predetermined price.
Shares without this feature are said to be non-callable.
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Callable shares Adv. for investors
Disadv. for investors
Sometimes companies offer
The ability to recall works
shares which cannot be
against the investors shares
recalled for the first five to ten will be recalled when rates are years
falling, which is when the holders would like to hold on to the shares
A conversion option is another way of sweetening a preferred issue Copyright Tarheel Consultancy Services
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Convertible Preferred Shares
A company believes its prospects are bright in medium/long term and its equity shares will appreciate in value.
It can issue preferred shares with option to convert to equity shares ; at a later date at a pre-specified conversion rate.
If investors perceive this option to be beneficial they may accept these shares at a lower rate of dividend than they would otherwise. Copyright Tarheel Consultancy Services
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Example Alpha corporation has issued preferred shares each of which is convertible into 5 equity shares Assume that the preferred shares are trading at PP and that the equity shares are trading at PE
The conversion ratio is therefore 5:1
If PP = 5PE then the two types of shares are said to be at parity
E.g. if the preferred shares are trading at $125 & the equity shares at $25 then this would be the case Copyright Tarheel Consultancy Services
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Example (cont…)
Once parity is reached
Dividend on the converted shares > Dividend on the preferred shares then the shareholders will normally convert.
Preferred shares Preferred shares are paying a dividend of $10
Equity shares Equity shares are paying $2.20
If investor holds on to the An investor who converts, preferred shares he will would receive $11 from receive only $10. the 5 equity shares after conversion Copyright Tarheel Consultancy Services
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Convertible…(cont…)
Trade above parity
If preferred share > value of the converted equity shares E.g. if the preferred share = $140 & equity shares = $27 each,
Then the share is said to be trading above parity.
Obviously no one will convert in this case.
They would rather sell the preferred share and buy the equity shares.
In the process they will save some money Copyright Tarheel Consultancy Services
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Convertible… (cont…)
Arbitrageurs will step in when
Value of the equivalent equity shares > value of the preferred share
This will cause the prices to reverse to parity as the following example will illustrate.
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Example – Convertible… Assume the preferred share is selling at $125 & the equity shares are selling at $27 each An arbitrageur will buy the preferred share and will immediately convert it to 5 equity shares which he will then sell
Outflow = 125 Inflow = 27 x 5 = 135 Profit = $10
As the arbitrageurs step up their activity the price of the preferred shares will rise while that of the equity shares will fall. Eventually parity will be 90
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Cumulative Preferred Shares
In the case of non cumulative preferred shares
An unpaid or missed dividend is lost forever
In the case of cumulative preferred shares;
All outstanding dividends including the current dividend must be paid before any dividends can be paid to equity holders
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Illustration
Convergys has issued
1 preferred share with a dividend of $5 to Harry
1 equity share to Sally
They are the only two shareholders.
The company has a policy of paying the entire earnings for the year as dividends.
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Earnings over a 5 Year Horizon Year
Convergys Earnings ($)
2000
5
2001
2
2002
8
2003
0
2004
12
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Dividend Distribution The Case of Non Cumulative Shares Year
Earnings
2000
5
5
0
2001
2
2
0
2002
8
5
3
2003
0
0
0
2004
12
5
7
($)
Preferred Common Dividends Dividends
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Analysis - The Case of Non Cumulative Shares Year Earnings ($)
Preferred Dividends
Common Dividends
2000
5
This is just adequate to pay the preferred shareholder
There is nothing left for the equity holder
2001
2
The entire amount will go The equity the preferred shareholder. holder will obviously He is eligible for $5 but receive nothing the earnings are inadequate
2002
8
Preferred shareholder will The balance $3 95 Copyright Tarheel Consultancy Services
Analysis - The Case of Non Cumulative Shares Year Earnings
2003
0
Preferred
Common
Dividends
Dividends
The company has
Neither
nothing to distribute
shareholder will receive anything
2004
12
$5 will go to the
Balance $7 to the
preferred shareholder
equity holder
Copyright Tarheel Consultancy Services
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Dividend Distribution The Case of Cumulative Shares Year
Earnings ($)
Preferred Common Dividends Dividends
2000
5
5
0
2001
2
2
0
2002
8
8
0
2003
0
0
0
2004
12
10
2
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Analysis - The Case of Cumulative Shares Year Earnings ($)
Preferred Dividends
Common Dividends
2000
5
This will be adequate to pay the preferred shareholder
The equity holder will get nothing
2001
2
The entire earnings will go The equity to the preferred holder will get shareholder nothing
2002
8
Only $5 is required for The equity paying the preferred holder will shareholder. But there is receive nothing backlog of $3 from the previous year.So the entire 98 amount ofTarheel $8Consultancy will go to the Copyright Services
Analysis - The Case of Cumulative Shares Year Earnings
Preferred Dividends
Common Dividends
2003
0
Neither shareholder will Neither receive anything shareholder will receive anything
2004
12
$10 will go to the The remaining $2 preferred shareholder. will go to the Out of this $5 will be for equity holder this year and the balance $5 will be the arrears for the previous year.
Copyright Tarheel Consultancy Services
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Adjustable Rate Preferred Shares
They are similar to floating rate bonds
The dividends are not fixed but are subject to periodic revision based on a pre-specified formula.
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Tax Advantages Preferred shares One would expect preferred shares to trade at a lower price than bonds since these shares are inherently riskier than bonds
Bonds One would expect bonds with an identical interest rate to trade at a higher price.
In the U.S. 70% of the Interest from bonds is dividends received by fully taxable corporate holders of preferred shares are tax free The tax rate for corporations Copyright Tarheel Consultancy Services is 34%. So the effective tax
101
Tax Advantages (cont…) Preferred shares
Bonds
The after tax return is
The after tax rate of return
greater
is lower
Preferred shares trade at a Bonds trade at a lower higher price than
price than otherwise
otherwise similar bonds
similar preferred shares
Note: This tax benefit is not available for individual investor
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Dual / Multiple listing
103
Dual / Multiple Listing
Refers to the listing of the shares of a company on the markets of more than one country
Copyright Tarheel Consultancy Services
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Advantages of Dual Listing Companies must meet the securities market regulations of the foreign country and foreign stock exchange.
1.
This very often requires a company to comply with stringent disclosure norms
To list its shares on a U.S. exchange, an Indian company has to comply with SEC and NYSE/Nasdaq requirements. It has to ensure that its accounts are in accordance with U.S. GAAP
For companies in developed countries, such compliance leads to greater transparency, which benefits the domestic shareholders Copyright Tarheel Consultancy Services
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Advantages of Dual Listing 2. Foreign listings provide MNCs with indirect
advertising for their product brands 3. It raises the profile of the company in
international capital markets
Makes it easier for them to borrow or raise debt overseas
2. A spread of shareholders across the globe
reduces the threat of hostile takeovers.
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GDRs and ADRs
Depository Receipts (DRs)
Foreign equity is traded on international markets in the form of Depository Receipts.
Global Depository Receipts (GDRs) Copyright Tarheel Consultancy Services
American Depository Receipts (ADRs) 107
What is an ADR?
A special share of foreign equity priced in U.S.D. a. It is a DR issued to American investors on the basis of
shares issued by a foreign entity b. Each receipt represents ownership of a specific
number of securities
These would have been placed with a custodian bank in the issuer’s country
Copyright Tarheel Consultancy Services
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An ADR issue process India
India
Domestic shares
Custodial Bank
Wipro
SBI
Depository Bank
ADRs
USA
USA
JP Morgan Bank of New York Copyright Tarheel Consultancy Services
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ADRs (cont…)
ADRs can be packaged to ensure that they trade at the appropriate price range in the U.S.
ADRs can be a fraction/multiple of the underlying foreign shares
Copyright Tarheel Consultancy Services
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Illustration
India
USA
Domestic shares
ADRs
USA
Rs. 30 / share
60c /share
1 ADRs = 10 domestic shares $6 /share
Copyright Tarheel Consultancy Services
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Fungibility
The ability to interchange with an identical item
One way fungibility Two way fungibility The holder of an ADR can sell Shares can be surrendered to the DR back to the depository the depository in the home country and ADRs acquired in depository will in turn lieu have the equivalent number of shares sold in the home market Less attractive from the standpoint of an American investor
Required to ensure that there are no arbitrage opportunities between the U.S and the home market
Has potential to reduce liquidity and the floating stock Copyright Tarheel Consultancy Services
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Arbitrage
How will arbitrage work in the case of ADRs?
Assume that the ADRs are overvalued in the U.S. A trader in the U.S. can short sell ADRs in the U.S. acquire shares in India have USA them converted to ADRsIndia and cover his short position in the U.S. Domestic ADRs shares Overvalued hence shortsell
Buy in India Convert to ADRs
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Arbitrageur – Infosys ADR overvalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares
Domestic shares
$210 / ADR
Rs.1000 /share Acquire 10 shares (-Rs.10,000) $200
Shortsell 1 ADR(+$210) Convert Profit = $10
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Arbitrage (Cont…)
What if ADRs are undervalued in the U.S?
An arbitrageur will buy ADRs in New York surrender them to the overseas depository bank in exchange for domestic shares and will then sell the domestic shares in India
USA
India
ADRs
Domestic shares
Undervalued hence buy
Sell in India
Convert to domestic shares Copyright Tarheel Consultancy Services
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Arbitrageur – Infosys ADR undervalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares
Domestic shares
$190 / ADR
Rs.1000 /share
Buy 1 ADR(-$190) Convert
Sell 10 shares (+Rs.10,000) $200
Profit = $10 Copyright Tarheel Consultancy Services
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ADRs - History
First ADR was created by J.P. Morgan in 1927
From the standpoints of clearing and settlement:
ADR
a domestic U.S security
Traded on NYSE, AMEX, Nasdaq, and OTC markets
1996: $13,655 billion worth of DRs were raised through 80 public offerings by companies from 80 countries.
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ADRs (Cont…)
Four levels of ADRs in the U.S.
They differ with respect to the amount of information that is required to be provided to the investors.
This therefore has implications for the level of access granted to the U.S. capital market. Copyright Tarheel Consultancy Services
118
Levels of ADRs
Levels of ADRs
Unsponsored ADRs
Sponsored Level-1 ADRs
Sponsored Level-2 ADRs
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Sponsored Level-3 ADRs
119
Levels of ADRs Unsponsored Sponsored ADRs
Sponsored
Level-I ADRs Level-II ADRs
Sponsored Level-III ADRs
Issued by Do not require Require Require even depositories in compliance financial more the U.S in with U.S. statements paperwork response to GAAP, or conforming to market disclosure U.S. GAAP, demand beyond what and disclosure is required in in accordance the home with SEC country regulations Copyright Tarheel Consultancy Services
120
Levels of ADRs Unsponsored Sponsored
Sponsored
Sponsored
ADRs
Level-I ADRs Level-II ADRs
Level-III ADRs
Issues are not initiated by the parent foreign company
Can be traded Can be traded on OTC mkts on U.S. in the U.S. and exchanges on some exchanges outside the U.S
Allow issuance and sale of new shares to raise equity capital in the U.S.
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Benefits to Issuers 1. Company’s image is boosted at home and
abroad 2. Stock prices are brought in alignment with international trends 3. Useful mechanism for raising capital in foreign exchange 4. Issuer does not bear the risk of exchange rate fluctuations
since dividends are paid to the domestic custodian bank in domestic currency Copyright Tarheel Consultancy Services
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Benefits to Holders 1. Get access to assets which are quoted
in USD and trade like any U.S. security 2. Get dividends in USD
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Equity Shares & Preferred Shares 1
Introduction Equity shares Shares of common stock of a company Represent financial claims
• asset for the shareholder • equity shares confer ownership rights on the shareholders
• liability for the issuing corporation
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Shareholder’s Stake
Shareholder is part owner of company
Stake = fraction of the total share capital of the company
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Cash Flows from Shares
Dividends
When a firm makes a profit it will typically pay out a fraction of it in the form of cash to the shareholders.
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Dividends
Dividends are not contractually guaranteed
Unlike interest on bonds, the rate of dividends is not fixed.
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Dividends (cont…)
• Shareholders cannot demand dividends as a matter of right
• The company is not obliged to pay dividends •BOD decide whether dividends should be paid, and if so, how much
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Dividends (cont…)
Dividends can fluctuate substantially from year to year.
Firms opt to maintain dividends at a steady level, even in years of financial hardship
To avoid sending distress signals to the market, which could cause the market value of the firm to plunge Copyright Tarheel Consultancy Services
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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 can be used to pay dividends
Accumulated profits are a part of the Reserves & Surplus account on the liabilities side of the balance sheet
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Retained Earnings (cont)
Reserves and Surplus account = accumulated profits
x(profit) = Dividends
y(profit) = Retained Earnings
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Shareholders residual claimants Bondholders
Shareholders
Bondholders have to be paid the contractually promised rate of interest
Only then can the firm consider the possibility of rewarding its shareholders by way of dividends
In the event of liquidation or bankruptcy, bondholders must be paid their dues in part/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
An entrepreneur will not set up a firm with the stated objective of winding up after a given period
If firm is expected to stay alive for ever, its shares never mature.
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Rights of shareholders
12
Rights of Shareholders
1. Equity shareholders have voting rights. A say in the election of the Board of Directors
1. Shareholders have limited liability
Their financial commitment to the firm is limited to the extent of their shareholdings In the event of financial difficulties, company/creditors cannot stake a claim on the personal assets of the shareholders
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Voting Rights
Most equity shares carry voting rights
Right of shareholders to elect the directors of the firm
Common arrangement is 1 vote per share.
In practice shares with differential voting rights are issued Copyright Tarheel Consultancy Services
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Proxies
To be eligible to vote, the shareholder must be the Owner of Record
Name must be present in the register of shareholders on the prescribed Record Date. Copyright Tarheel Consultancy Services
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The Record Date
Is usually a few days prior to ‘date of the meeting’ of shareholders or ‘date of actual voting’ takes place
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Proxies (cont…)
Person whose name figures in the register on the record date may have sold his shares prior to ‘date of meeting’
The only way the current shareholder can vote is if he is given 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 Copyright Tarheel Consultancy Services
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Proxies (cont…)
Why are proxies allowed?
Most shareholders cannot be realistically expected to attend meetings and vote in person
Companies routinely send out proxies
Shareholders can fill these and authorize representatives of the management to vote on their behalf Copyright Tarheel Consultancy Services
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Proxies – reason (cont…)
In practice managers solicit proxies from absentee shareholders for a valid reason
A quorum is required by law for a meeting to be legally recognized
%shares represented at the meeting should exceed a prescribed minimum
Shareholders are encouraged to be present or have themselves represented by proxy
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Par value & Book value
20
Par Value vs. Book Value
Equity shares have a Par Value also known as the Face Value / Stated Value
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Par value (cont…) Historically
Today
Corporate assets were part Par values have no of a trust fund protected
practical significance
by BOD The par value was
Some shares may not
supposed to represent this even have a par value fund Standard par values like
Can be fixed at arbitrary
$10 / $100 were specified levels e.g. 10c Copyright Tarheel Consultancy Services
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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
Companies issue low/no par value stock to minimize these expenses Copyright Tarheel Consultancy Services
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Book Value
Book value is the value of the assets behind a share, as per the balance sheet.
Book value = (par value + any share premium + retained earnings) / no. of shares outstanding
Book value may differ substantially from the market value of the share (price of share on the stock exchange)
Copyright Tarheel Consultancy Services
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Classified shares
25
Classified Common Stock
Companies sometimes issue different categories of stock.
Reason for this being they wish to confer different voting rights on different categories of shareholders
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26
Example - Ford
Ford Motor Company has 2 classes of shares
Shares available to the public carry voting rights
As of 1998 1114 million+ shares were outstanding
Of these, 70.90 million shares were classified as Class B
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Example – Ford (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
30
Dividend Related Dates
In the context of a dividend payment, there are four dates that are important
1. The Declaration Date 2. The Record Date 3. The Ex-dividend Date 4. The Distribution Date Copyright Tarheel Consultancy Services
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1. Declaration Date
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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2. 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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3. 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…)
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’ transactions on or after that date will be reflected on the register only after the ‘record date’
This date will 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 Copyright Tarheel Consultancy Services
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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.
Trade occurs on day T Delivery of shares to the buyer on day T+3 Payment of funds to the seller on day T+3
A transfer of shares 2 days before the ‘record date’ or later will not be reflected in the books on the record date. On the NYSE the ‘ex-dividend date’ is specified as 2 business days prior to the record date announced by the firm. Copyright Tarheel Consultancy Services
36
Cum-Dividend and Ex-Dividend Prior to the
ex-dividend
dividend
date
The shares will be traded cum
This implies that the buyer of the
share is eligible for the forthcoming dividend
On the ex-
The shares will begin to trade ex-
dividend date dividend
Buyers of the share on or after this
date will not be eligible for the approaching dividend Copyright Tarheel Consultancy Services
37
Ex-Dividend Prices In theory
On the ex-dividend date the share
price ought to decline by the amount of the dividend. E.g. Cum-dividend price is $50 per share
Quantum of the dividend is $2 per
share, The share should trade at $48 ex-
dividend.
In practice The price decline may not be exactly Copyright Tarheel Consultancy Services
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4. The Distribution Date
This is the date on which the dividends are actually paid or distributed.
Copyright Tarheel Consultancy Services
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Stock dividend
40
Stock Dividends
These are called Bonus Shares in India.
Dividend is paid in the form of shares of stock rather than in cash
Copyright Tarheel Consultancy Services
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Stock Dividends (cont…)
Entails the issue of additional shares without monetary consideration Reserves & Surplus account
funds transferred
Share Capital account
This is called the Capitalization of Reserves Copyright Tarheel Consultancy Services
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Stock Dividends (cont…)
From a theoretical standpoint, stock dividends do not create any value for their shareholders.
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Example
A shareholder owns 500 shares of CISCO CISCO has issued 500,000 shares in all
The firm announces a 10% stock dividend
The investor will receive 50
After the issue shareholder will hold 550 shares
It will issue 1 share for every 10 existing shares
The firm will issue totally 50,000 shares
This investor owns 1/1000th of the firm
This is 1/1000th of the total number of shares outstanding
Shareholder’s stake in the company will remain unaltered
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Ex-Bonus Prices In theory
For the firm, the additional shares do not represent:
Either a change in its asset base, or A change in its earnings capacity
The issue of additional shares should lead to a decline in the share price. 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
The ex-bonus price may not fall In The market may interpret the bonus issue as practice
a signal of enhanced future profitability. Copyright Tarheel Consultancy Services
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Rationale
Companies usually refrain from lowering their cash dividend payouts, unless they are forced to
When a bonus issue is declared
The number of shares will go up
In future cash dividends will have to be paid on a greater number of shares.
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Rationale (cont…)
If ‘dividend payout per share’ is not likely to decline then 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.
Copyright Tarheel Consultancy Services
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Example
CISCO has 500000 shares outstanding
Shares are trading at $55 each
CISCO announces a cash dividend of $2 per share & a bonus issue of 10%
The dividends will be paid on the additional shares as well.
The cum-bonus cum-dividend price is $55
Copyright Tarheel Consultancy Services
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Example (Cont…)
Market value of 500,000 shares is:
Theoretical market value of 550,000 ex-bonus cum-dividend shares will also be 27,500,000
500,000 x 55 = 27,500,000
Since the bonus issue per se does not add any value.
Theoretical ex-bonus ex-dividend price will be:
{27,5000,000 – (2 x 550,000)} / 550,000 = $48 Copyright Tarheel Consultancy Services
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Treasury stock
51
Treasury Stock
Shares which were issued to the public have been subsequently reacquired by the company either through an open market purchase or via a tender offer These shares:
Have no voting rights Receive no dividends Are not used to compute EPS
Such shares are used for purposes such as ESOPs Copyright Tarheel Consultancy Services
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Why repurchase? Situation
Why repurchase?
In difficult markets shares Companies can buy a often trade below their
dollar’s worth of assets
book value
for less than a dollar
People often acquire
Shares are purchased to
voting control in order to thwart corporate raiders. sell the assets of the
By stashing away
company piece by piece, treasury stock, often to its competitors managements can acquire greater control
Copyright Tarheel Consultancy Services
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Why repurchase? (cont…) Situation
Why repurchase?
A company is generating By repurchasing shares more cash flows than can and returning capital to be profitably invested. If it shareholders long term declares a special
capital gains are taxed at
dividend it is likely to be
a lower rate
taxed at the normal rate
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Stock split
55
Splits & Reverse Splits
Meaning of a stock split
An n:1 split n new shares will be issued to an existing shareholder for every old share that he holds
E.g. a 11:10 split a holder of 10 existing shares will receive 11 shares
This is analogous to a 10% stock dividend
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Differences Theoretically, stock splits and stock dividends are mathematically equivalent.
Stock dividends
Stock splits
Stock dividends entail the Stock splits do not capitalization of reserves The par value of an existing share is reduced – no. of shares will increase proportionately The product of the par value and the no. of shares outstanding or Issued Capital will remain 57 Copyright Tarheel Consultancy Services unchanged
Price Behaviour
The share price after a split will behave exactly as in the case of an equivalent stock dividend.
Copyright Tarheel Consultancy Services
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Example – Price Behavior
An investor is holding 500 shares of CISCO worth $55 each He will have 550 shares after the split
The company announces a 11:10 split
These will theoretically be worth $50 each Copyright Tarheel Consultancy Services
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Why Split Shares? 1. 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/medium investors
What is high is subjective the belief is that managers have a feel of the ‘popular price range’
the range in which the stock should trade to attract enough investor attention. Copyright Tarheel Consultancy Services
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Why Split Shares? (cont…) 2. Investors normally prefer to trade in
round lots
round lot 100 shares
odd lot <100 shares
At very high prices, small/medium investors may be unable to afford odd lots.
Copyright Tarheel Consultancy Services
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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
an n:m split n > m
an n:m reverse split n < m
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Example An investor is holding 500 shares of CISCO worth $55 each CISCO announces a 9:10 reverse split
He will have 450 shares after the split
Post reverse split price would be: 500,000 x 55 P = ____________ = 61.11 450,000 Copyright Tarheel Consultancy Services
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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
Low prices have a tendency to attract inexperienced traders with unrealistic price expectations, who could get their fingers burnt. Copyright Tarheel Consultancy Services
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Rights issue
65
Pre-emptive Rights
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.
Enables them to maintain their proportionate ownership in the company. Copyright Tarheel Consultancy Services
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Rights Issues (cont…)
Often, price of rights issue < prevailing market price of the share.
When this happens, the rights acquire a value of their own.
An existing shareholder can either exercise his rights or else sell them to someone else.
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Example – 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 Copyright Tarheel Consultancy Services
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Example (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 ________________ = 49.0 550,000
Considering that fact that a share worth 49.09 is being made available at 40, the value of the right is 9.09 Copyright Tarheel Consultancy Services
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Losers?
Are the existing shareholders losing? No!
The ex-rights price is 49.09 which is less than the cum-rights price of 50
The shareholders are being given an opportunity to buy new shares at $40
This opportunity compensates for the decline in the share price
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Example – Losers? 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) There is no dilution of value Copyright Tarheel Consultancy Services
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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
Copyright Tarheel Consultancy Services
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Ex-rights Price
The ex-rights price is often higher in practice (than the theoretically predicted value)
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 Copyright Tarheel Consultancy Services
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Why belief of future profitability 1. The belief that the new funds will be used
for more profitable projects 2. Since cash dividends are usually maintained
at steady levels the issuance of additional shares is a sign on increased profitability from existing ventures.
Both these factors could cause the demand for the shares to rise. Copyright Tarheel Consultancy Services
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Preferred shares
75
Preferred Shares
These shares represent ownership in a corporation However they do not carry voting rights.
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Why Preferred?
The term “preferred” connotes that such shares have certain associated privileges.
Dividends must be paid to the preferred shareholders before equity holders.
If the firm is liquidated the preferred shareholders have to be paid in part or in full, before the balance if any can be paid to the equity holders.
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Dividends
These shares carry a fixed rate of dividends.
E.g. $3.50 preferred means that shares carry a dividend of $3.50/share
Or
E.g. 3.5% preferred a dividend of $3.50 on a par value of $100 Copyright Tarheel Consultancy Services
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No Growth
Preferred shares offer an opportunity for generous dividend returns with no growth opportunities.
Copyright Tarheel Consultancy Services
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Why no growth?
Because of better prospects for the firm
Why do equity prices increase?
Preferred shares carry fixed dividends
Hence greater anticipated profits will have no consequence for such shares
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Why no growth?
Does this mean that such shares will never display fluctuations in price?
NO
Since the rate of dividends is fixed, they are a form of a fixed income security - just like a bond Declining interest rates will lead to higher share prices. Rising interest rates will lead to lower prices
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Callable Preferred Stock
In a period of high interest rates, preferred shares have to compete with other debt securities to offer high dividend rates.
The firm may feel that this is a passing phase
In future it could issue shares with a lower rate of dividends.
If so, it could issue Callable Shares
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Callable…(cont…)
Such shares can be recalled or retired at a predetermined price.
Shares without this feature are said to be non-callable.
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Callable shares Adv. for investors
Disadv. for investors
Sometimes companies offer
The ability to recall works
shares which cannot be
against the investors shares
recalled for the first five to ten will be recalled when rates are years
falling, which is when the holders would like to hold on to the shares
A conversion option is another way of sweetening a preferred issue Copyright Tarheel Consultancy Services
84
Convertible Preferred Shares
A company believes its prospects are bright in medium/long term and its equity shares will appreciate in value.
It can issue preferred shares with option to convert to equity shares ; at a later date at a pre-specified conversion rate.
If investors perceive this option to be beneficial they may accept these shares at a lower rate of dividend than they would otherwise. Copyright Tarheel Consultancy Services
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Example Alpha corporation has issued preferred shares each of which is convertible into 5 equity shares Assume that the preferred shares are trading at PP and that the equity shares are trading at PE
The conversion ratio is therefore 5:1
If PP = 5PE then the two types of shares are said to be at parity
E.g. if the preferred shares are trading at $125 & the equity shares at $25 then this would be the case Copyright Tarheel Consultancy Services
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Example (cont…)
Once parity is reached
Dividend on the converted shares > Dividend on the preferred shares then the shareholders will normally convert.
Preferred shares Preferred shares are paying a dividend of $10
Equity shares Equity shares are paying $2.20
If investor holds on to the An investor who converts, preferred shares he will would receive $11 from receive only $10. the 5 equity shares after conversion Copyright Tarheel Consultancy Services
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Convertible…(cont…)
Trade above parity
If preferred share > value of the converted equity shares E.g. if the preferred share = $140 & equity shares = $27 each,
Then the share is said to be trading above parity.
Obviously no one will convert in this case.
They would rather sell the preferred share and buy the equity shares.
In the process they will save some money Copyright Tarheel Consultancy Services
88
Convertible… (cont…)
Arbitrageurs will step in when
Value of the equivalent equity shares > value of the preferred share
This will cause the prices to reverse to parity as the following example will illustrate.
Copyright Tarheel Consultancy Services
89
Example – Convertible… Assume the preferred share is selling at $125 & the equity shares are selling at $27 each An arbitrageur will buy the preferred share and will immediately convert it to 5 equity shares which he will then sell
Outflow = 125 Inflow = 27 x 5 = 135 Profit = $10
As the arbitrageurs step up their activity the price of the preferred shares will rise while that of the equity shares will fall. Eventually parity will be 90
Copyright Tarheel Consultancy Services
Cumulative Preferred Shares
In the case of non cumulative preferred shares
An unpaid or missed dividend is lost forever
In the case of cumulative preferred shares;
All outstanding dividends including the current dividend must be paid before any dividends can be paid to equity holders
Copyright Tarheel Consultancy Services
91
Illustration
Convergys has issued
1 preferred share with a dividend of $5 to Harry
1 equity share to Sally
They are the only two shareholders.
The company has a policy of paying the entire earnings for the year as dividends.
Copyright Tarheel Consultancy Services
92
Earnings over a 5 Year Horizon Year
Convergys Earnings ($)
2000
5
2001
2
2002
8
2003
0
2004
12
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93
Dividend Distribution The Case of Non Cumulative Shares Year
Earnings
2000
5
5
0
2001
2
2
0
2002
8
5
3
2003
0
0
0
2004
12
5
7
($)
Preferred Common Dividends Dividends
Copyright Tarheel Consultancy Services
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Analysis - The Case of Non Cumulative Shares Year Earnings ($)
Preferred Dividends
Common Dividends
2000
5
This is just adequate to pay the preferred shareholder
There is nothing left for the equity holder
2001
2
The entire amount will go The equity the preferred shareholder. holder will obviously He is eligible for $5 but receive nothing the earnings are inadequate
2002
8
Preferred shareholder will The balance $3 95 Copyright Tarheel Consultancy Services
Analysis - The Case of Non Cumulative Shares Year Earnings
2003
0
Preferred
Common
Dividends
Dividends
The company has
Neither
nothing to distribute
shareholder will receive anything
2004
12
$5 will go to the
Balance $7 to the
preferred shareholder
equity holder
Copyright Tarheel Consultancy Services
96
Dividend Distribution The Case of Cumulative Shares Year
Earnings ($)
Preferred Common Dividends Dividends
2000
5
5
0
2001
2
2
0
2002
8
8
0
2003
0
0
0
2004
12
10
2
Copyright Tarheel Consultancy Services
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Analysis - The Case of Cumulative Shares Year Earnings ($)
Preferred Dividends
Common Dividends
2000
5
This will be adequate to pay the preferred shareholder
The equity holder will get nothing
2001
2
The entire earnings will go The equity to the preferred holder will get shareholder nothing
2002
8
Only $5 is required for The equity paying the preferred holder will shareholder. But there is receive nothing backlog of $3 from the previous year.So the entire 98 amount ofTarheel $8Consultancy will go to the Copyright Services
Analysis - The Case of Cumulative Shares Year Earnings
Preferred Dividends
Common Dividends
2003
0
Neither shareholder will Neither receive anything shareholder will receive anything
2004
12
$10 will go to the The remaining $2 preferred shareholder. will go to the Out of this $5 will be for equity holder this year and the balance $5 will be the arrears for the previous year.
Copyright Tarheel Consultancy Services
99
Adjustable Rate Preferred Shares
They are similar to floating rate bonds
The dividends are not fixed but are subject to periodic revision based on a pre-specified formula.
Copyright Tarheel Consultancy Services
100
Tax Advantages Preferred shares One would expect preferred shares to trade at a lower price than bonds since these shares are inherently riskier than bonds
Bonds One would expect bonds with an identical interest rate to trade at a higher price.
In the U.S. 70% of the Interest from bonds is dividends received by fully taxable corporate holders of preferred shares are tax free The tax rate for corporations Copyright Tarheel Consultancy Services is 34%. So the effective tax
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Tax Advantages (cont…) Preferred shares
Bonds
The after tax return is
The after tax rate of return
greater
is lower
Preferred shares trade at a Bonds trade at a lower higher price than
price than otherwise
otherwise similar bonds
similar preferred shares
Note: This tax benefit is not available for individual investor
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Dual / Multiple listing
103
Dual / Multiple Listing
Refers to the listing of the shares of a company on the markets of more than one country
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Advantages of Dual Listing Companies must meet the securities market regulations of the foreign country and foreign stock exchange.
1.
This very often requires a company to comply with stringent disclosure norms
To list its shares on a U.S. exchange, an Indian company has to comply with SEC and NYSE/Nasdaq requirements. It has to ensure that its accounts are in accordance with U.S. GAAP
For companies in developed countries, such compliance leads to greater transparency, which benefits the domestic shareholders Copyright Tarheel Consultancy Services
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Advantages of Dual Listing 2. Foreign listings provide MNCs with indirect
advertising for their product brands 3. It raises the profile of the company in
international capital markets
Makes it easier for them to borrow or raise debt overseas
2. A spread of shareholders across the globe
reduces the threat of hostile takeovers.
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GDRs and ADRs
Depository Receipts (DRs)
Foreign equity is traded on international markets in the form of Depository Receipts.
Global Depository Receipts (GDRs) Copyright Tarheel Consultancy Services
American Depository Receipts (ADRs) 107
What is an ADR?
A special share of foreign equity priced in U.S.D. a. It is a DR issued to American investors on the basis of
shares issued by a foreign entity b. Each receipt represents ownership of a specific
number of securities
These would have been placed with a custodian bank in the issuer’s country
Copyright Tarheel Consultancy Services
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An ADR issue process India
India
Domestic shares
Custodial Bank
Wipro
SBI
Depository Bank
ADRs
USA
USA
JP Morgan Bank of New York Copyright Tarheel Consultancy Services
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ADRs (cont…)
ADRs can be packaged to ensure that they trade at the appropriate price range in the U.S.
ADRs can be a fraction/multiple of the underlying foreign shares
Copyright Tarheel Consultancy Services
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Illustration
India
USA
Domestic shares
ADRs
USA
Rs. 30 / share
60c /share
1 ADRs = 10 domestic shares $6 /share
Copyright Tarheel Consultancy Services
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Fungibility
The ability to interchange with an identical item
One way fungibility Two way fungibility The holder of an ADR can sell Shares can be surrendered to the DR back to the depository the depository in the home country and ADRs acquired in depository will in turn lieu have the equivalent number of shares sold in the home market Less attractive from the standpoint of an American investor
Required to ensure that there are no arbitrage opportunities between the U.S and the home market
Has potential to reduce liquidity and the floating stock Copyright Tarheel Consultancy Services
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Arbitrage
How will arbitrage work in the case of ADRs?
Assume that the ADRs are overvalued in the U.S. A trader in the U.S. can short sell ADRs in the U.S. acquire shares in India have USA them converted to ADRsIndia and cover his short position in the U.S. Domestic ADRs shares Overvalued hence shortsell
Buy in India Convert to ADRs
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Arbitrageur – Infosys ADR overvalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares
Domestic shares
$210 / ADR
Rs.1000 /share Acquire 10 shares (-Rs.10,000) $200
Shortsell 1 ADR(+$210) Convert Profit = $10
Copyright Tarheel Consultancy Services
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Arbitrage (Cont…)
What if ADRs are undervalued in the U.S?
An arbitrageur will buy ADRs in New York surrender them to the overseas depository bank in exchange for domestic shares and will then sell the domestic shares in India
USA
India
ADRs
Domestic shares
Undervalued hence buy
Sell in India
Convert to domestic shares Copyright Tarheel Consultancy Services
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Arbitrageur – Infosys ADR undervalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares
Domestic shares
$190 / ADR
Rs.1000 /share
Buy 1 ADR(-$190) Convert
Sell 10 shares (+Rs.10,000) $200
Profit = $10 Copyright Tarheel Consultancy Services
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ADRs - History
First ADR was created by J.P. Morgan in 1927
From the standpoints of clearing and settlement:
ADR
a domestic U.S security
Traded on NYSE, AMEX, Nasdaq, and OTC markets
1996: $13,655 billion worth of DRs were raised through 80 public offerings by companies from 80 countries.
Copyright Tarheel Consultancy Services
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ADRs (Cont…)
Four levels of ADRs in the U.S.
They differ with respect to the amount of information that is required to be provided to the investors.
This therefore has implications for the level of access granted to the U.S. capital market. Copyright Tarheel Consultancy Services
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Levels of ADRs
Levels of ADRs
Unsponsored ADRs
Sponsored Level-1 ADRs
Sponsored Level-2 ADRs
Copyright Tarheel Consultancy Services
Sponsored Level-3 ADRs
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Levels of ADRs Unsponsored Sponsored ADRs
Sponsored
Level-I ADRs Level-II ADRs
Sponsored Level-III ADRs
Issued by Do not require Require Require even depositories in compliance financial more the U.S in with U.S. statements paperwork response to GAAP, or conforming to market disclosure U.S. GAAP, demand beyond what and disclosure is required in in accordance the home with SEC country regulations Copyright Tarheel Consultancy Services
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Levels of ADRs Unsponsored Sponsored
Sponsored
Sponsored
ADRs
Level-I ADRs Level-II ADRs
Level-III ADRs
Issues are not initiated by the parent foreign company
Can be traded Can be traded on OTC mkts on U.S. in the U.S. and exchanges on some exchanges outside the U.S
Allow issuance and sale of new shares to raise equity capital in the U.S.
Copyright Tarheel Consultancy Services
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Benefits to Issuers 1. Company’s image is boosted at home and
abroad 2. Stock prices are brought in alignment with international trends 3. Useful mechanism for raising capital in foreign exchange 4. Issuer does not bear the risk of exchange rate fluctuations
since dividends are paid to the domestic custodian bank in domestic currency Copyright Tarheel Consultancy Services
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Benefits to Holders 1. Get access to assets which are quoted
in USD and trade like any U.S. security 2. Get dividends in USD
Copyright Tarheel Consultancy Services
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