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Chapter 4

The share market and the corporation


Learning objective 1: understand the corporate structure and identify advantages and
disadvantages of being a publicly listed corporation
A company that has its shares listed and quoted on a stock exchange is known as a publicly listed
corporation.

The main type of equity issued by a corporation is the ordinary share, or common stock.

An investor who purchases shares issued by a company is a shareholder and has an ownership
interest in the company.

Learning objective 2: consider the origins and structure of a stock exchange


The development of stock exchanges and share markets has supported the rise of the corporation
as the dominant business structure.

Shareholders, as equity owners, acquire the right to elect the board of directors of a corporation.

The board of directors is responsible for setting the objectives and policies of the organisation
and appointing executive management.

Executive management is responsible for the day-to-day operational and financial management
of the business.

The predominant type of company listed on a stock exchange is the limited liability company,
where shareholders financial commitment to the corporation and its creditors is limited to the
issue price of the fully paid shares.

The corporate form allows the separation of ownership and management of an organisation,
thereby ensuring that a change in ownership does not directly affect normal business operations.

Listing on a stock exchange affords a corporation access to a greater pool of both equity finance
and debt finance. Listed corporations are more able to gain cost advantages from their larger
scale.

One potential disadvantage of the corporate form is the agency problem, that is, the possibility of
a conflict of interest between the owners and managers of a firm, such that shareholder value
may not be maximised.

Learning objective 3: discuss the primary market role of a share market, through which
corporations raise new equity funding
A stock market serves as the primary market through which shares are initially issued in order to
obtain equity finance.
It is this primary market transaction which provides new funding for a corporation and allows
increased investment in productive capital and economic growth.
The initial listing of a company on a stock exchange is called a float or an initial public offering
(IPO).
Previously listed corporations may issue new shares through a rights issue to existing
shareholders on a pro-rata basis, or by placement with institutional investors.
An offer to raise funds from the public must be made through a prospectus.

Learning objective 4: discuss the secondary market role of the share market, through which
existing shares are bought and sold
A stock market also provides for secondary market transactions in a companys existing shares.
Liquidity in the secondary markets is essential if investors are to be encouraged to invest in the
primary market.
If management is not perceived to be performing in the best interests of shareholders,
dissatisfaction may be expressed through the sale of shares. Sufficient share sales will result in a
fall in the price of the companys shares.
Therefore, the secondary market role is important in reconciling the conflicts that may arise as a
result of the separation of ownership and management of the corporation.
Learning objective 5: consider the derivatives market role of a stock exchange
A derivative is essentially a risk management product that derives its price from an underlying
commodity or financial instrument that is available in a physical market.
Standardised, exchange-traded contracts quoted on a stock exchange may include options,
warrants and futures.
An option gives the buyer the right, but not the obligation, to buy or sell a specified security at a
predetermined price on or by a predetermined date. The buyer pays a premium to the writer of
the option.
A warrant also gives the holder the right to buy or sell a security at a specified price on or by a
predetermined date.
A futures contract is an agreement between two parties to buy or sell a specified commodity or
financial instrument at a predetermined price on a predetermined date. For example, a futures
contract may be based on the shares of a listed corporation or on a stock market index.
Learning objective 6: explain the interest rate market role of a stock exchange
A stock exchange may also list a range of debt or hybrid securities issued by corporations,
financial institutions and governments.
Types of securities include long-term corporate bonds such as debentures and unsecured notes,
floating rate notes, convertible notes, preference shares and government bonds.
Listing and quoting of debt securities on a stock exchange adds liquidity to those securities,
improves information transparency, lowers the cost of borrowing and provides a wider range of
investment choices.
Learning objective 7: understand the electronic trading and settlement systems used for sharemarket transactions
In order for a stock exchange to compete within the global market, it must have systems in place
that facilitate an efficient market.
In the Australia, the ASX uses a scripless trading system using uncertificated shareholdings. This
enables transactions to take place in T + 3 business days.
The former days of open outcry trading have been replaced with electronic systems.
The ASX trading system is known as CLICK XT/ITS and the settlement system as CHESS.
An investor places a buy/sell order with a stockbroker that has access to the CLICK XT/ITS
system. The CLICK XT/ITS system matches corresponding trades, the broker issues a contract

note to the buyer/seller, and the transfer of ownership and value settlement occur through
CHESS.
Learning objective 8: recognise the importance of information flows to the efficiency of share
markets
For a stock market to be efficient, it must be fully informed.
The listing rules of an exchange will require a corporation to advise the exchange, and therefore
the market, of its half-yearly and annual financial statements, plus, immediately it becomes
evident, any material change that might affect the corporations share price.
Learning objective 9: identify the principal regulators that affect the behaviour of participants in
the share market
Associated with the flow of information into the markets is the regulation of the markets.
In the first instance, the ASX monitors the activities of markets participants.
At the same time, ASIC supervises the application of the Corporations Act 2001 and the overall
integrity of the markets.
Learning objective 10: explain the structure and purpose of the private equity market
Private equity is an alternative source of equity funding for a company.

Private equity may be provided for start-up companies, business expansion for existing
companies, recovery finance for corporations in financial difficulty, or management buy-outs.

Specialist private equity funds obtain the majority of their funds from institutional investors.

Private equity investment is usually regarded as higher risk.

The principal objectives of private equity funds may be to improve company performance in
preparation for an IPO, or the break-up a company so that the parts may be sold separately.

Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. A fundamental characteristic of a publicly listed corporation is the separation between
owners and managers. Briefly discuss the rights, roles and responsibilities of the
shareholders, board of directors and executive management.
a publicly listed corporation is a legal entity formed under the provisions of the corporations law of a
nation-state and listed on a formal stock exchange

a shareholder has a right to vote in the affairs of the corporation, in particular vote on resolutions
put to a general meeting of the company

shareholders elect the board of directors of a corporation

shareholders, as owners of a company, do not have a right to participate directly in the day-today operation and management of the business

the objectives and policies of a corporation are determined by a board of directors

directors have a legal responsibility to ensure that the corporation operates in the best interests of
the shareholders

the board of directors appoints an executive management group that is responsible for achieving
specified objectives and policies through the management of the day-to-day financial and
operational affairs of the company

executive management is responsible to the board of directors. The board of directors reports to
shareholders

2. Why might a business organisation seek listing as a publicly listed corporation? Include in
your answer the advantages of the corporate form of business organisation.
a publicly listed corporation is a legal entity formed under the provisions of the Corporation Law
of a nation-state, and listed on a formal stock exchange
shares can be readily bought and sold in the market without directly affecting the continuing
existence of the business
the liability of shareholders for the debts of the business is limited
large amounts of equity funding can be obtained more easily through access to the stock market
investors willing to purchase shares in the knowledge that the stock exchange provides an active
secondary market for the future sale of those shares
shareholders can reduce the risks of share ownership by holding a diversified portfolio of share
investments
the separation of ownership (shareholders) and control (managers) means that the corporation
can choose specialised and skilled personnel to run the business
the corporate form allows for continuity in the activities of the business. The death or bankruptcy
of a shareholder will not impact the existence of the business.
the corporate form is almost essential for large-scale undertakings. Corporations gain access to a
larger and wider range of equity and debt sources of funds
the separation of ownership and control enables the corporation to plan and implement strategic
decisions more effectively
the cost advantages of large-scale production are a further benefit of the corporate form of
business organisation.
3. Maximisation of shareholder value is a principal objective of an organisation. What is the
relationship between this objective and the so-called agency problem?
the maximisation of shareholder value presumes the board of directors will establish appropriate
objectives and policies and that management will implement strategies that seek to increase the
share price of the organisation
agency theory considers the potential problems that may arise from the separation of ownership
and control of a corporation
managers control the day-to-day operation of the business and may not necessarily act in the best
interests of the shareholders

for example, managers may maximise their own benefits at the expense of the shareholder, such
as increasing staff levels for prestige and power, extending management remuneration schemes,
increasing sales at the expense of profitability and sustainability
the board of directors must implement policies that align the interests of management with those
of the shareholders
corporate governance policies seek, in part, to address potential agency problems

4. List and briefly explain the five principal functions of a modern and efficient stock
exchange.
the establishment of markets in a range of financial securitiesthis includes the primary and
secondary markets in equity (ordinary shares); listed debt securities (preference shares,
convertible notes, subordinated debt); and derivatives (options, warrants, futures)
the provision of a securities trading systemmost modern and efficient stock exchanges have
implemented electronic trading systems, for example the CLICK XT/ITS system used by the
ASX. Buy/sell orders are placed into CLICK XT/ITS by authorised brokers. The system matches
orders and executes the trade
operation of a clearing and settlements systemglobal competitive forces require exchanges to
settle stock transactions within T+3 days. This time line will be reduced even further as systems
become even more efficient. The system used by the ASX is known as CHESS. CHESS
instantaneously records the transfer of ownership and facilitates the financial settlement of a
transaction thus removing the possibility of settlement risk
regulation and monitoring of the integrity of the exchanges marketsthe efficiency and
integrity of the market is important. The ASX has its own set of listing rules. The exchange
monitors the behaviour of listed companies and authorised brokers, and is able to apply penalties
including delisting a company or revoking the licence of a broker
provision of a well-informed market to secure the confidence of all participantsthe price of a
share is a function of available information about that stock; changes in the current price will be
in response to new information coming into the market that will have an impact on the future
performance of the listed entity. Clearly it is essential that continuous disclosure of material
information changes must be advised to the exchange immediately. The efficiency of the market
is a measure of how quickly new information is absorbed by the market and reflected in changes
in share prices
5. A stock exchange provides a formal market that facilitates the flow of equity funds into the
capital markets. Explain this flow-of-funds process from the perspective of a listed
corporation issuing equity securities through the share market.
a stock exchange facilitates the flow of funds firstly, through the primary market issue and
secondly, the secondary market trading of existing securities (the secondary market role is
discussed in question 6)
the primary market role of the stock exchange facilitates the raising of capital by publicly listed
corporations through the issue of new equity-based securities to investors
the principal equity security issued is the ordinary share, or common stock
shares may be issued on the initial flotation of the company (IPO), or by a rights issue to existing
shareholders, or by private placement with institutional investors
hybrid securities such as preference shares and convertible notes may also be issued

the primary market issue of new equity is the source of capital funds for the corporation; these
funds allow the maintenance and growth of a business
primary market issues facilitate the process of conversion of savings to investment, which
theoretically leads to an accumulation of capital capacity, economic growth, increased
production and higher levels of employment

6. Discuss the secondary market role of the share market and its importance to the
corporation. Demonstrate your answer through the use of examples.
the secondary market role of a share market is to provide an organised and efficient market
where existing listed securities may be bought and sold at current market prices
the current market price should reflect the performance outcomes and forecast prospects of
individually listed companies within the context of the relevant industry sector, and the domestic
and global economies
an efficient share market facilitates transfer of ownership amongst investors and enhances
liquidity in listed securities
securities initially issued through the primary market may be subsequently traded through the
stock market as a secondary market transaction
secondary market transactions will include a range of securities listed on the exchange, including
ordinary shares, rights issues, preference shares, instalment receipts, debentures and notes
economic growth derives from primary market investment, however a successful primary market
requires the support of a deep and liquid secondary market
an active secondary market encourages investors to purchase new securities because the
investors are confident they will be able to sell those securities in the future in the secondary
market quickly at the current market price
7. What is meant by the liquidity of the share market? Explain why liquidity in the secondary
market is important to both shareholders and to the corporation.
liquidity in the share market relates to the ability of the holder of a security to buy or sell listed
securities without unduly disturbing the current market price of the shares being traded
the standard measure of share market liquidity is the ratio of the value of turnover to market
capitalisation. Market capitalisation is calculated by multiplying the number of shares on issue
by their current market price
liquidity in the secondary market for shares encourages investors to initially purchase new issues
by corporations. Shareholders are confident that shares may be easily and quickly sold without
incurring a capital loss as a direct result of the sale transaction (capital loss/gain may result from
other factors such as company performance outcomes)
a liquid share market provides advantages to both the investor (shareholder) and the corporation
in that it facilitates the raising of long-term capital while providing short-term liquidity to the
investor
8. Three equity-based derivative products that may be offered through a stock exchange are
an options contract, an equity warrant and a futures contract. Briefly explain the main
features of each of these products. Why might an investor use these products?
a derivative is a financial security that derives its price from an underlying commodity or
instrument, for example a share listed on a stock exchange

derivatives traded on a stock exchange are standardised exchanges traded contracts


derivatives are designed to facilitate the management of risk exposures
for example, an investor might hedge the risk that a share price may fall by implementing a
strategy to lock in the current share price using a derivatives contract
option contractgives the buyer of the option the right, but not the obligation, to buy (sell) at a
predetermined price at or by a predetermined date. A call option is the right to buy; a put option
the right to sell. The buyer of the option will pay a premium to purchase the contract from the
option writer. The contract price is the exercise or strike price
equity warrantan equity call warrant gives the warrant holder the right to buy the underlying
security (shares) at a particular price, on or before a predetermined date. A put warrant gives the
right to sell. A warrant issuer is a third party, such as a bank, authorised by a stock exchange to
write warrant contracts
futures contactan agreement to buy or sell a specified commodity or instrument at a
predetermined price and date

9. Many market participants lament the disappearance of share-market trading by open


outcry on the floor of the exchange. What has happened to the chalkies?
in the good old days, stockbrokers competed through open cry on the floor of the stock
exchange to buy and sell listed securities on the exchange
transactions were recorded by stock exchange clerks, in chalk, on a large blackboard which
contained all listed companies. Thus the name chalkies
when the market was particularly active the open cry shouting by the stockbrokers would
become quite intense
while the open outcry system is less efficient than technology based trading systems, it certainly
provided atmosphere to the market-place
while the majority of exchanges, including the ASX, have disposed of the trading floor, the
NYSE has retained a combination of advanced technology supporting continued floor trading.
The Chicago Board of Trade and the Chicago Mercantile Exchange still retain open outcry floor
trading in commodities and derivative products
therefore, the introduction of technology based trading systems has mostly seen the chalkies
disappear
10. Electronic trading and settlements systems have been introduced in major international
stock exchanges, including the ASX. What does this mean, and how do they operate?
scripless share trading has been introduced into a number of share markets in an effort to
improve the efficiency of the markets trading and settlements system
the ASX has introduced a technology based trading system (CLICK XT/ITS) and a settlements
systems (Clearing House Electronic Sub-register SystemCHESS)
stockbrokers initiate buy/sell orders of their clients by entering the orders into the CLICK
XT/ITS system
CLICK XT/ITS matches buy and sell orders and initiates the transaction
under the CHESS arrangements shareholders no longer receive and hold a share certificate, but
rather hold uncertificated securities, being an electronic record of shareholdings
the buying and selling of shares is facilitated by a CHESS sponsor such as a stockbroker

the current CHESS arrangements require settlement of a share transaction to occur in three days
(T + 3)
the combination of CLICK XT/ITS and CHESS form the basis of the ASXs strategy to remain
an efficient and competitive international stock exchange. The possibility of T+1 settlement is
currently being investigated by a number of stock exchanges

11. A listed corporation is considering issuing debt securities in the capital markets. The
corporation is also investigating the possibility of having the debt securities quoted on the
stock exchange. What are the advantages to a corporation and a potential investor in having
the debt securities listed? What types of securities might the corporation issue?
Advantages to a corporation and an investor in listing on a stock exchange include:
transparencythe stock exchange keeps the markets informed
ease of entry and exita deep and liquid market using electronic trading (CLICK XT/ITS) and
settlement systems (CHESS)
liquidityexistence of price makers and a large pool of investors
listing increases the corporate image and profile in the financial markets
the receipt of a known income stream, being interest coupons
an investment option for surplus funds
a strategic investment option to manage interest rate risk exposures
an opportunity to diversify an investment portfolio
Types of listed securities include:
straight corporate bonda longer-term fixed interest security that pays periodic interest coupons
and repays the face value of the bond at maturity. The bond may have security attached in the
form of a charge over the assets of the company (known as a debenture)
floating rate notea corporate bond that pays a variable interest rate that is usually tied to a
published reference interest rate such as LIBOR or BBSW
convertible notea fixed interest debt instrument that will offer the holder the right to convert
the note into ordinary shares of the company at a predetermined price and date
preference shareinitially have characteristics of debt in that they pay a fixed dividend, but
offer the right to convert into ordinary shares or redeem into cash at a future date
12. Define and provide examples of the following:
uncertificated shares
ownership of stock listed on an exchange is recorded electronically, for example the ASX no
longer issues actual share certificates
share contract note
advice sent from a stockbroker to a client confirming the full details of a buy or sell transaction
that has been carried out by the broker on behalf of the client. Includes details of the stock, the
date, the number of shares, the price per share, fees and charges, total cost and settlement date
settlement risk
the probability that one party to a buy/sell transaction will not fulfil their contractual obligations.
For example, delivery of the stock and transfer of ownership may occur, but financial settlement
does not eventuate
T + 3 business days

used to describe settlement of a share transaction when transfer of ownership and value will
occur on the transaction day plus three days
electronic sub-register.
a system that facilitates a record of share ownership using an electronic computer-based system,
for example the ASX uses CHESS
13. (a) Why is the flow of information into a stock exchange important in the efficient
functioning of a share market?
listed corporations raise their equity funds and part of their debt funds through the issue of
securities on a stock exchange
investors purchase these securities because they have confidence in the operation of the primary
and secondary markets on the exchange
the current price of a security reflects all known information relevant to that stock
the stock price will change in response to new information coming to the market
therefore, the efficiency at which information is provided to the market and the speed at which it
is absorbed will directly affect the pricing of listed securities
(b) Identify and explain one standard form of periodic reporting that a listed corporation
should make to the stock exchange.
once an entity is, or becomes, aware of any information concerning the corporation that a
reasonable person would expect to have a material effect on the price or value of the entitys
securities, the entity must immediately tell the ASX that information
the Corporations Act states that a reasonable person would consider information to be material if
it would be likely to influence persons who commonly invest in securities in deciding whether or
not to subscribe for, or buy or sell, the securities
(c) Identify, using examples, five different pieces of information that might be regarded as
being material and therefore should be reported to the stock exchange.
Will include a selection from:
a change in the corporations financial forecasts or expectations
the appointment of a receiver, manager, liquidator or administrator
a transaction for which the consideration payable or receivable is a significant proportion of the
written down value of the entitys consolidated assets
a recommendation or declaration of a dividend or distribution
notice of a takeover bid, or an intention to buy-back issued shares
a proposal to restructure the capital base of the corporation
an intention to issue equity options, or vary the exercise price on existing options
the notice of general meetings of shareholders, including motions to be put to the meeting and
the outcomes of those motions
any change of address of the corporate office or the share registry
a change in the chairperson, directors and auditors
copies of any documents forwarded to shareholders
disclosure of directors interests
a recommendation or decision that a dividend or distribution will not be declared

under-subscriptions or over-subscriptions to an issue


a copy of any financial documents lodged with an overseas stock exchange or other regulator
which is available to the public

14. Identify and briefly outline the powers of the main supervisors of share-market integrity
and the behaviour of market participants in the Australian share market.
the two principal regulators and supervisors of market integrity and behaviour are the Australian
Stock Exchange (ASX) and the Australian Securities and Investment Commission (ASIC)
the ASX prescribes appropriate behaviour for corporations listed on the exchange, including
specified minimum levels of performance and standards of information disclosure
the ASX may impose penalties, including de-listing, on companies that breach the ASX rules
the ASX operates a continuous disclosure regime whereby a listed corporation must immediately
advise the exchange of any material changes
the ASX also monitors the behaviour of brokers and may discipline, penalise of remove the
licence of a securities dealer
the ASX operates a number of sophisticated electronic monitoring systems to ensure market
integrity and behaviour is maintained
ASIC is the authority responsible for the administration of the Corporations Act
ASIC is also responsible for market integrity and consumer protection across the financial
system, covering investment, insurance and superannuation products
15. The private equity market is an alternative source of equity funding for business. Explain
how this market typically operates.
private equity funding is usually provided to higher risk companies that often do not have
adequate collateral or profit performance to attract investors within the normal share market or
banking sources of funds
private equity market funding is usually directed towards:
o start-up funds for new companies to allow the business to develop its products and
services
o business expansion funds that allow a company to grow the current business operations
o recovery finance for companies that are currently experiencing financial difficulty
o management buy-out financing where the existing company managers seek to buy the
existing business funded, in part, with private equity.
the majority of private equity is provided through funds that are established for this purpose; that
is the funds specialise in seeking out and analysing potential private equity opportunities or
targets
within Australia, the major providers of funds for the private equity funds are superannuation
funds and life insurance offices. These institutional investors seek to increase the overall return
on their large investment portfolios by including a proportion of higher risk investments
the investment horizon of private equity investors is often for less than five to seven years
as private equity has limited liquidity, that is, it cannot be sold through the share market, a
principal objective of private equity investors is to significantly improve the profit performance
of the company so that the company can be listed on a stock exchange through an initial public
offering (IPO)

alternatively, the investors may seek to break-up the company and sell the component parts in
order to achieve a return on investment
private equity funding tends to grow in times of sustained economic growth. On the other hand,
in times of an economic down-turn, new private equity funding may fall significantly.

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