Part - VII Equity Shares

Part - VII Equity Shares

Introduction • Equity shares or shares of common stock of a company represent financial claims. • That is they are a liability for the issuing corporation and an asset for the shareholder. • Unlike debt securities which merely connote a loan from the bondholder to the firm, equity shares confer ownership rights on the shareholders.

Shareholder’s Stake • Every shareholder is a part owner of the company. • His/her stake is equal to the fraction of the total share capital of the firm to which he/she has subscribed.

Cash Flows from Shares • When a firm makes a profit it will typically pay out a fraction of it in the form of cash to the shareholders. • Such cash payments are called DIVIDENDS.

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’ operations can be used to pay dividends. • Such accumulated profits are a part of the Reserves & Surplus account on the liabilities side of the balance sheet.

Retained Earnings • Quite obviously, the Reserves and Surplus account will have a balance only if a firm has a habit of accumulating profits. • In practice a firm will rarely pay out the entire profit made in a year as dividends. • A fraction of the profit will be retained within the firm. • This amount is known as Retained Earnings.

Dividends • Dividends are not contractually guaranteed. • That is, unlike interest on bonds, the rate of dividends is not fixed. • Nor is the company obliged to pay dividends in a particular year.

Dividends (Cont…) • That is, shareholders cannot demand dividends as a matter of right. • It is up to the board of directors to decide as to whether dividends should be paid, and if so, what should be the quantum of dividends.

Dividends (Cont…) • In principle therefore, dividends can fluctuate substantially from year to year. • In practice however they rarely do. • Firms generally opt to maintain dividends at a steady level, even in years of financial hardship. • This is to avoid sending distress signals to the market, which could cause the market value of the firm to plunge.

Residual Claims • Shareholders are residual claimants. • This is true from two perspectives. • Firstly bondholders have to paid the contractually promised rate of interest. • Only then can the firm consider the possibility of rewarding its shareholders by way of dividends.

Residual Claims (Cont…) • Secondly in the event of liquidation or bankruptcy, when the assets of the firm are sold; • The bondholders must be paid their dues in part or in full depending on the proceeds from the sale of assets. • Only if something were to remain, will the shareholders be entitled to compensation.

Maturity • Equity shares never mature. • Every firm is set up as a Going Concern. • That is, an entrepreneur will not set up a firm with the stated objective of winding up after a given period. • Since the firm is expected to stay alive for ever, its shares never mature.

Rights of Shareholders • Equity shareholders have voting rights. • They have a say in the election of the Board of Directors.

Limited Liability • Shareholders have limited liability. • That is, their financial commitment to the firm is limited to the extent of their shareholdings. • In other words, in the event of financial difficulties, neither the company nor its creditors can stake a claim on the personal assets of the shareholders.

Voting Rights • Most equity shares carry voting rights • This includes the right of shareholders to elect the directors of the firm. • The most common arrangement is one vote per share. • But in practice shares with differential voting rights are issued

Example of Differential Voting Rights-The Case of the Ontario Securities Act • The Act defines three types of restricted shares: • Subordinated voting shares • These shares carry the right to vote • But in such cases there exist one or more other classes of shares that carry a greater voting right on a per share basis.

Example (Cont…) • Non voting shares • Holders of such shares usually have no right to vote. • Sometimes they may have the right to vote in certain limited circumstances. • Restricted Voting Shares • They carry the right to vote subject to specified restrictions.

Differential Rights (Cont…) • Except for the voting restrictions these shares are usually similar to normal shares • Holders of such shares have an unlimited right to participate in the earnings of the corporation • They have the same rights over the assets of the firm upon liquidation, as the normal shareholders.

Differential rights (Cont…) • Thus these shares carry the same risk as normal shares. • However there are cases where such shares are paid dividends at a different rate as compared to normal shares. • Such shares usually trade at a lower price as compared to regular shares.

Proxies • In order to be eligible to vote at a meeting of shareholders, the shareholder must be the Owner of Record • That is, his name must be present in the register of shareholders on the prescribed Record Date.

The Record Date • The record date is usually a few days prior to the date of the meeting of shareholders or the date on which the actual voting will take place. • A person whose name figures in the register on the record date may however have sold his shares prior to the date of the meeting.

Proxies (Cont…) • In such cases, the only way that the current shareholder can vote is if he is given a 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.

Proxies (Cont…) • Why are proxies allowed? • Most shareholders cannot be realistically expected to attend meetings and vote in person. • So companies routinely send out proxies. • Shareholders can then fill these and authorize representatives of the management to vote on their behalf.

Proxies (Cont…) • In practice managers solicit proxies from absentee shareholders for a valid reason • Usually a quorum is required by law for a meeting to be legally recognized • That is the percentage of shares represented at the meeting should exceed a prescribed minimum. • Thus shareholders are encouraged to be either present or else have themselves represented by proxy.

Par Value versus Book Value • Most equity shares usually have a Par Value also known as the Face Value or the Stated Value. • Historically corporate assets were considered to be a part of a trust fund that was protected by the board of directors • And the par value was supposed to represent this fund.

Par Value…(Cont…) • Thus standard par values like $10 or $100 were specified. • Today par values have no practical significance. • They can be therefore fixed at arbitrary levels, like say 10 cents. • In fact some shares may not even have a par value.

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. • So companies issue low or no par value stock to minimize these expenses.

Book Value • The book value is the value of the assets behind a share, as per the balance sheet. • It is found by adding up the par value + any share premium + retained earnings, and then dividing by the number of shares outstanding. • The book value may differ substantially from the market value of the share, which is the price of the share on the stock exchange.

Classified Common Stock • Companies sometimes issue different categories of stock. • The most common reason for this is that they wish to confer different voting rights on different categories of shareholders.

Example • The Ford Motor Company has two classes of shares • The shares available to the public carry voting rights • As of 1998 one billion one hundred and fourteen million plus shares were outstanding. • But of these, 70.90 million shares were classified as Class B.

Example (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.

Classified Shares (Cont…) • For many years the NYSE did not permit non voting shares to be listed • This policy has been subsequently relaxed.

Dividend Related Dates • In the context of a dividend payment, there are four dates that are important • The Declaration Date • The Record Date • The Ex-dividend Date • The Distribution Date

Declaration Date • It is the date on which the decision to pay a dividend is declared by the directors and the amount of the dividend is announced.

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.

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.

The Ex-Dividend Date (Cont…) • Obviously 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, whereas transactions on or after that date will be reflected on the register only after the record date.

The Ex-Dividend Date (Cont…) • This date will therefore 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

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. • That is, if a trade occurs on day T, then delivery of shares to the buyer and payment of funds to the seller will take place on day T+3. • Thus a transfer of shares two days before the record date or later will not be reflected in the books on the record date.

The Ex-Dividend Date • Thus on the NYSE the ex-dividend date is specified as two business days prior to the record date announced by the firm.

Cum-Dividend and Ex-Dividend • Prior to the ex-dividend date, the shares will be trade cum-dividend. • This implies that the buyer of the share is eligible for the forthcoming dividend. • On the ex-dividend date the shares will begin to trade ex-dividend. • Thus buyers of the share on or after this date will not be eligible for the approaching dividend.

Ex-Dividend Prices • On the ex-dividend date the share price ought to, in theory, decline by the amount of the dividend. • For instance if the cum-dividend price is $50 per share and the quantum of the dividend is $2 per share, then theoretically the share should trade at $48 ex-dividend. • In practice however, the price decline may not be exactly equal to the amount of the dividend.

The Distribution Date • This is the date on which the dividends are actually paid or distributed.

Stock Dividends • These are called Bonus Shares in India. • It is a dividend that is paid in the form of shares of stock rather than in the form of cash.

Stock Dividends (Cont…) • This entails the issue of additional shares without monetary consideration. • What happens is that funds are transferred from the Reserves & Surplus account to the Share Capital account. • This is called the Capitalization of Reserves

Stock Dividends (Cont…) • From a theoretical standpoint, stock dividends do not create any value for their shareholders. • We will illustrate this using a numerical example.

Example • Assume that a shareholder owns 500 shares of CISCO and that the firm has issued 500000 shares in all. • So this investor owns 1/1000th of the firm. • Now assume that the firm announces a 10% stock dividend • Which means that it will issue one additional share for every 10 existing shares.

Example (Cont…) • Thus the firm will issue 50000 shares • Of which the investor will receive 50 • Thus after the issue he will be in possession of 550 shares which is 1/1000th of the total number of shares outstanding. • Thus his stake in the company will remain unaltered.

Example (Cont…) • As far as the firm is concerned, the additional shares do not represent: • Either a change in its asset base, or • A change in its earnings capacity • Thus the issue of additional shares should lead to a decline in the share price.

Example (Cont…) • Assume that 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

Part - VII Equity Shares