FINS1612 Tutorial 2

Chapters 4 and 5

Chapter 4: Q.3
a) Briefly explain the concept of corporate
governance within the context of a
corporation.
) Corporate governance relates to the relationships that
should exist between the shareholders of a company,
the board of directors and executive management.
) A company must implement corporate governance
processes that put policies and procedures in place to
ensure that accountability and transparency become
an integral part of the corporate culture.
) Clear responsibility and reporting structures need to
be established to facilitate the long-term survival of
the organisation and the maximisation of shareholder
value.

Chapter 4: Q.3
b) What is the relationship between corporate governance
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
value 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.

Chapter 4: Q.5
One of the principal roles of a stock exchange is its primary market
role.
a) Within the context of a primary market transaction, briefly explain:
i) an initial public offering (IPO):
) An IPO is the floating or listing of a new corporation on a stock exchange.
) The newly listing corporation, in conjunction with its advisers, brokers and
underwriters, will apply to a stock exchange to list its ordinary shares on the
exchange.
) Investors (individuals, institutions and international investors) may apply
through the published prospectus to buy shares in the company.
) If investors do not buy all the shares, the underwriter may be required to buy
the outstanding shares (subject to the terms of the underwriting agreement).
ii) a rights issue to shareholders:
) A listed corporation may seek to raise additional equity funds through the
issue of new ordinary shares to existing shareholders.
) The shares are usually offered to all existing shareholders on a pro-rata
basis; for example one new share for each ten shares held.

Chapter 4: Q.5
One of the principal roles of a stock exchange is its primary market
role.
b) Discuss why a strong primary market is important for economic
growth within a country.
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 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.

Chapter 4: Q.7
(a) As a stockbroker, you have been approached by a client seeking
to establish a diversified portfolio of domestic shares. After
identifying the clients investment needs, you recommend the client
use an exchange traded fund (ETF) to achieve her investment
objectives. Explain to the client how an ETF will achieve the
objective of a diversified share portfolio.
Exchange traded funds (ETF) offered through a stock exchange such as the
ASX invest in a basket of securities listed on the ASX, securities listed on an
international stock exchange, foreign currencies or commodities.
Investors purchase units in an ETF.
The investors gain a diversified portfolio of shares because the fund
manager of an equity-based ETF seeks to track the performance of a
benchmark stock exchange index, for example, the S&P/ASX200.
The funds raised from the sale of units in the ETF are used to purchase a
securities portfolio that replicates the specified index. For example, the ETF
would hold all or the majority of shares included in the S&P/ASX200 index.
Units in an ETF are bought and sold through a stock exchange exactly the
same as ordinary shares of listed corporations are bought and sold.

Chapter 4: Q.7
(b) The client also wishes to gain an
investment exposure to the international
share markets. Is it possible to use ETFs
to achieve this objective? Explain.
An investor is able to gain an exposure to the
international share markets by purchasing an
appropriate ETF; for example, the iShares
S&P500 gives exposure to the US markets,
while iShares S&P Europe350 provides
exposure to major European corporations
listed on a number of European exchanges.

Chapter 4: Q.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:
start-up funds for new companies to allow the business to develop its
products and services
business expansion funds that allow a company to grow the current business
operations
recovery finance for companies that are currently experiencing financial
difficulty
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.

Chapter 4: Q.15
The private equity market is an alternative source of equity
funding for business. Explain how this market typically operates.
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.

Chapter 5: Q.4
Debt-to-equity ratios may vary quite considerably between business
corporations.
a) Discuss the four main criteria that a corporation should analyse
when determining the firms appropriate debt-to-equity ratio.
The appropriate debt-to-equity ratio will vary between firms, industries and
stages of the business cycle. The four main criteria are:
The ratio that is the norm in the industry in which the firm operates, and adopt
something near that ratio. Significant deviations from the industry norm may cause
concern for the potential providers of both debt and equity funds.
The history of the ratio for the firm. The ratio employed in the past may be regarded as
the norm, and management may be reluctant to change it greatly. If the business has
been performing with a return on assets that is acceptable to shareholders, it may be
deemed appropriate to continue with a similar gearing ratio. Any significant change in
the ratio may result in the disaffection of the current shareholders.
The limit imposed by lenders. It is quite common for lenders to impose various loan
covenants on the borrowings of a company. Loan covenants are conditions or
restrictions incorporated in loan contracts that are designed to protect the interests of
the lender. A common covenant is a limit on the ratio of debt liabilities to total assets.
Managements decision concerning the firms capacity to service debt. The assessment
is made by determining the charges, the interest payments and the principal
repayments associated with a given level of debt, and assessing the capacity of the
firms expected future income flows to cover the payments while leaving sufficient
profits to satisfy shareholders expectations for a return on their equity.

Chapter 5: Q.4
Debt-to-equity ratios may vary quite considerably between business corporations.
b) Is the firms debt-to-equity ratio likely to change over time? Support your
answer with examples.
The debt to equity ratio is the proportion the assets of an organisation that are funded by
debt and those funded by equity (owners funds).
Either form of funding may be used to maintain and expand the business operation; however
debt instruments must be repaid by the organisation. One of the functions of equity on the
other hand is its absorption of abnormal losses incurred by the organisation.
The ratio between debt and equity funding is important as increased debt levels allow a
business to leverage and increase earnings per share, but risk is increased if the organisation
is unable to meet its debt repayment obligations.
For example, in a period of economic downturn or a change in the business cycle a firm will
usually generate less revenue but will still need to make its loan repayments.
A firm that has high debt levels may be exposed to the loss of market share from new
competitors or products.
In the early 1990s the Australian market experienced an economic downturn which resulted
in a large number of businesses going into liquidation, or becoming vulnerable to hostile
take-over, as a direct result of maintaining high debt-to-equity ratio. Again, the global
financial crisis that began in mid-2007 caused a global economic slowdown and evolved into
a sovereign debt crisis impacted business activity and cash flows
therefore, decisions relating to the appropriate level of debt to equity funding must be based
on future cash flow projections, not past performance; that is, they must take account of
forecast changes in economic and business conditions that will affect the level of future
income of the organisation

Chapter 5: Q.13
From time to time, corporations such as the
National Australia Bank Limited make an
issue of preference shares as part of the
overall capital structure of the organisation.
a) Explain the structure and cash flows
associated with a preference share.
Preference shares are hybrid securities that
combine the characteristics of both debt and
equity.
Preference shares have their fixed dividend rates
set at the issue date.
They also rank ahead of ordinary shareholders in
the event of the winding up of the company.

Chapter 5: Q.13
b)What specific features might the National Bank include in the
structure of the preference share to ensure it is attractive to
investors, but at the same time meets the funding needs of the
bank?
) Preference share issues are normally listed on the stock exchange. This
provides access to a secondary market, although the liquidity of the issue will
depend on the reputation and performance of the issuer-company. Attributes
that may be attached to a preference share issue are that they may be:
cumulativedividends not paid in one year are carried forward to ensuing years until
paid in full. Non-cumulative preference share dividends are lost if the company does not
make sufficient profit in a particular year to make the payment
redeemableentitles the holder to redeem the preference share on a pre-determined
date and receive the par value of the preference share
convertiblemay be converted into ordinary shares in the company at a future date,
generally at the lesser of an amount nominated in the prospectus, or a discounted
market price at conversion date
participatingholders are entitled to dividends in excess of the stated dividend rate
when ordinary shareholders receive a dividend in excess of a specified rate, or the
profits of the company exceed a defined level
issued at a different rankingwhere first ranked preference shares have preference
over second and other ranked issues for claims on dividends and, in the event of
winging up of the issuer company, to residual assets.

Chapter 5: Q.14
Convertible notes, company-issued options and company
issued warrants are often referred to as quasi-equity.
a) What are the characteristics of each of these
instruments that serve to distinguish them from straight
equity or debt?
Convertible notes:
are a hybrid security that exhibits the characteristics of both
debt and equity during the life of the security
are issued for a nominated term, generally at a fixed rate of
interest
may be converted into ordinary shares in the issuer-company
at a specified future date by the holder of the convertible note
are generally issued on a pro-rata basis to existing
shareholders, and are often not renounceable, that is, the
holder cannot sell the entitlement

Chapter 5: Q.14
a)
Company-issued option:
provides the right, without the obligation, to purchase ordinary
shares, at a stated price, at a future date or dates
may be restricted to a maximum term of five years in Australia,
according to the Corporations Act
may be issued free with a new debt issue, or it may be sold at a
premium by the issuing company
Company-issued warrant:
is usually attached to a corporate bond debt issue
is attached to the bond as an incentive for an investor to
purchase the bond
gives the warrant holder the right to purchase shares in the
issuer company at a specified price and date
may be detachable. As such warrant can be sold separately to
the bond it was originally attached.

Chapter 5: Q.14
b) Why might a company issue quasi-equity rather than
straight debt or equity?
The issue of quasi-equity is another funding alternative to either
straight debt or equity.
It allows a company to issue funding instruments that are flexible
in that they can be structured to meet the companys cash flow
and future funding requirements.
The special attributes of different quasi-equity instruments may
be attractive to investors; for example the ability to convert to
equity at a future date, especially if the issuing company has
been successful and the current share price has risen above the
conversion price.
The conversion attribute may mean that a company can issue the
quasi-equity debt instrument at a lower price than straight debt.
Interest payments may be tax deductible.
A company can set the conversion dates