Equity instruments are one of the primary source of financial instruments. Basically, each share has a minimum feature as following: To share proportionately in profits and losses, the right to vote for directors, to share proportionately in assets upon liquidation and Pre-emptive right for any new share issues. Within each class, each share is equal. Ease of transfer of ownership makes them advantageous for both issuing corporation and investor so share becomes more attractive investment. Investor in shares makes a permanent investment in a company in return for an expectation of a financial return in the form of dividend and capital growth. There are different types of shares that contains different rights and privileges to the shareholders but the most important ones are Common Shares and Preference Shares. The first part of this essay will argue different types of shares that a company may issue to increase its capital and the second part of it will examine a valuation method of common stocks.
Regarding to common shares, a key distinctive feature is that they are associated to the greatest opportunity for capital growth but also the most financial exposure if the business is unsuccessful because if liquidation occurs the holders' claim on the company assets are the last in the queue after the creditors and preferred shareholders. Therefore, investors in common shares will expect a return to compensate them for the risk that they will not be repaid in the event of winding up.
As for Capital growth, the market value of the shares may be appreciated and it may be realized by selling the shares to a third party or by waiting for the company to distribute surplus assets or to be wound up. A further distinctive feature is that, the return to the holder is not fixed. Dividends may vary depending on the profitability of the company. It has to be noted that dividends can only be paid when the companies make distributable profits and in general shareholders does not have an absolute right to claim dividend in the way that a provider of debt finance could claim. Besides these, dividend will be paid after dividend at a fixed rate is paid on preferred shares. Entitlement to dividend distribution is based on the nominal value of the shares held by each shareholder. This rule can be displaced: if so authorized by its articles, a company can pay a dividend in proportion to the amount paid up on each share rather than its nominal amount. Dividend must be paid in cash unless the articles otherwise provide.
Moreover, common shareholders generally entitled to participate in internal governance through voting. It is also possible to have non-voting shares or ordinary shares which carry multiple votes. From company perspective common shares are advantageous for being non-redeemable so it a permanent source of fund without any repayment liability and it does not involve any obligatory dividend payment. However, common shares are costly for higher risk, it has a high floatation cost and it leads to dilution of control.
When it comes to preference shares, they have preferential rights for their holders such as fixed rate of dividend, priority as to payment of dividend and preference as to repayment of capital during liquidation of the company. Generally, they do not have voting rights but they can only vote on resolutions directly affect attached to his preference shares or if dividend remain unpaid for two years (cumulative or non-cumulative). Preferred stock has some of the characteristic of both common stock and bonds and that's why it can be called as a hybrid security. Preferential shares can also be divided into different parts such as (i) cumulative preference share where- fixed rate goes on cumulating till it is all paid- or non-cumulative, (ii) participating preference share -which participates in surplus profits during the lifetime- or non-participating, (iii) Convertible preference share -whose owners have right to convert into equity- or non-convertible, (iv) redeemable - which can be purchased back by the company after a certain period and its call price normally higher than original issue price- and irredeemable, (v) straight preferred shares that have no maturity date and pay a fixed dividend and finally (vi) retractable preferred share that investor can sell it back to the issuer.
It is also worth stating that the right to receive audited financial statements and examine the records show the ownership of the shares, transfers of ownership and the minutes of shareholder meetings are common features for all common and preferred shareholders. Furthermore, there are other types of stocks such as income stock, speculative stock, cyclical stock, defensive stock, mid-cap stocks and small-cap stocks. In conclusion, all the above mentioned different type of equity instruments may be used in financing the company.
Value of the common shares is based on the value of the company. For instance, If the company operates profitably and doubles in value, each common share will be double in value and shareholders can receive their return by selling their shares if dividends are not paid. If a company does not issue a dividend, then CAPM assess the value of the stock. On the other hand, if a company issues a dividend then it is better to use Dividend Valuation Model which is also divided into two (i) Constant Growth Dividend Valuation Model and (ii) Non-Constant Dividend Valuation Model depending on the assumption whether the dividend grows at a constant rate in perpetuity.
CAPM is the most widely used technique for measuring systematic risk in equity investment and for estimating investors' required rate of return. CAPM assesses the required rate of return on an equity investment by reference to the risk-free rate of return available to an investor, the premium required by investor to compensate them for the general systematic risk of investing in the equity market and the undiversifiable systematic risk of a particular investment relative to the equity market. This undiversifiable risk inherent in holding a particular share is known as its beta.
The formula is as following : Cost of Equity = Rf + Equity Beta * (E(Rm)-Rf)
Risk free rate of return is a minimum return an investor expects from any investment. (Generally government/US bonds). Beta measures systematic risk. Every equity has its own beta. B=0 means the risk free asset. B=1 means the average systematic risk. If a company has a beta higher than 1 it means the company has higher risk than average and vice versa. (E(Rm)-(Rf) is the Market risk premium. (Rm) is the expected return on the market portfolio. It is important to highlight that to estimate the cost of common equity is harder than the cost of preference shares because common shares do not have a contractually defined return similar to the dividends on preference shares.
As I mentioned before, if dividends grow at a constant rate then the formula will be;
R= DIV1/P0 + g
DIV1= Estimated dividend for a year. P0= Market price of the share DIV1/P0= Dividend yield and g= growth rate. The company cannot change its value of "r" by paying higher or lower dividends or by growing faster or slower, unless these changes also affect the risk of the stock.
As a conclusion, a company may issue shares to public when they need to raise money. It is more like taking new partners into the company. There are different types of shares but in this essay I examined the common and preference shares in detail. I can say that common stock is riskier than preference shares but they usually outperform preference shares in the long run. Moreover, a firm pays the shareholders as a return for holding the firm's equity and we estimate this return with the help of CAPM model if there is no dividend. If there a company gives dividend, then we are looking at the growth rate whether it is constant or irregular. Then we decide to use the either of the above mentioned formulas to calculate rate of return for the investor.
Atty Gonenc Yay, LLM