FINS1612 week 3 tutorial answers

Chapter 4The share market and the corporationLearning 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 ofa conflict of interest between the owners and managers of a firm, such that shareholder valuemay 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 company’s 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 company’s 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 share-market 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 contractnote to the buyer/seller, and the transfer of ownership and value settlement occur throughCHESS.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 becomesevident, any material change that might affect the corporation’s 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 questionsThe 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 betweenowners 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-to-day 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 shareholders2. Why might a business organisation seek listing as a publicly listed corporation? Include inyour 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 therelationship 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 problems4. List and briefly explain the five principal functions of a modern and efficient stockexchange.•the establishment of markets in a range of financial securities—this 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 system—most 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 system—global 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 exchange’s markets—the 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 participants—the 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 prices5. A stock exchange provides a formal market that facilitates the flow of equity funds into thecapital 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 employment6. Discuss the secondary market role of the share market and its importance to thecorporation. 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 price7. What is meant by the liquidity of the share market? Explain why liquidity in the secondarymarket 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 investor8. Three equity-based derivative products that may be offered through a stock exchange arean 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 contract—gives 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 warrant—an 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 contact—an agreement to buy or sell a specified commodity or instrument at a predetermined price and date9. Many market participants lament the disappearance of share-market trading by openoutcry 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 disappear10. Electronic trading and settlements systems have been introduced in major internationalstock 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 market’s 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 System—CHESS)•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 ASX’s 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 exchanges11. A listed corporation is considering issuing debt securities in the capital markets. Thecorporation 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: •transparency—the stock exchange keeps the markets informed•ease of entry and exit—a deep and liquid market using electronic trading (CLICK XT/ITS) and settlement systems (CHESS)•liquidity—existence 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 portfolioTypes of listed securities include:•straight corporate bond—a 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 note—a corporate bond that pays a variable interest rate that is usually tied to a published reference interest rate such as LIBOR or BBSW•convertible note—a 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 share—initially 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 date12. 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 certificatesshare 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 eventuateT + 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 dayselectronic sub-register.• a system that facilitates a record of share ownership using an electronic computer-based system, for example the ASX uses CHESS13. (a) Why is the flow of information into a stock exchange important in the efficientfunctioning 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 corporationshould 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 entity’s 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 asbeing material and therefore should be reported to the stock exchange.Will include a selection from:• a change in the corporation’s 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 entity’s 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 public14. Identify and briefly outline the powers of the main supervisors of share-market integrityand 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 products15. The private equity market is an alternative source of equity funding for business. Explainhow 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 serviceso business expansion funds that allow a company to grow the current business operationso recovery finance for companies that are currently experiencing financial difficultyo 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)。