a) where a company gives investors shares in

a)     
The
differences between issuing shares and bonds as financial instruments as means
of acquiring funds for a company.

 

Stock or shares are units of ownership
interest in a corporation or financial asset that provide for an equal
distribution in any profits, if any are declared, in the form of dividends. Common
shares and preferred shares are the two main types of shares. When starting a corporation,
owners may choose to issue common stock or preferred stock. Most companies
issue common stock. The stock may benefit shareholders through appreciation and
dividends, making common stock riskier than preferred stock. Common stock also
comes with voting rights, which give shareholders more control over the
business. In addition, certain common stock comes with pre-emptive rights,
ensuring that shareholders may buy new shares and maintain their percentage of
ownership when the corporation issues new stock. In contrast, preferred stock
normally does not offer appreciation in value or voting rights in the
corporation. However, the stock typically has set payment criteria; a dividend
that is paid out regularly, making the stock less risky than common stock. Commonly,
preferred stock may be redeemed at a more beneficial price compared to common
stock. If the business files for bankruptcy and pays its lenders, preferred
shareholders receive payment before common shareholders because preferred stock
takes priority over common stock.

 

In
financial markets, stock capital is raised by issuance and distribution of
shares by a corporation or joint-stock company. Shares requires a company to
sell a percentage of its interests to investors. Funds raised by the company by
issuing shares is known as equity. This is where a company gives investors
shares in the company’s ownership in exchange for capital. Companies sell
shares on the stock market or through a private offering. Equity financing
distributes ownership or equity among stockholders. The companies may
distribute a portion of any profits made to stockholders. Moreover, companies have
no repayment obligation, thus the risks fall on the investors or shareholders. However,
the more shareholders a company has, the less decision-making power owners and
management have over a business’ operations.

 

On the other hand, a bond is a debt
investment in which an investor loans money to an entity, usually corporate or
governmental, which borrows the funds for a fixed period of time at a variable
or fixed interest rate. Bonds are used by companies, municipalities, states and
sovereign governments to raise money and finance a variety of projects and
activities. Bond owners are debtholders, or creditors, of the issuer. When
companies or other entities need to raise money to finance new projects,
maintain ongoing operations, or refinance existing other debts, they may issue
bonds directly to investors instead of taking loans from bank. The issuer
issues a bond that contractually states the interest rate (coupon) that will be
paid and the time at which the loaned funds (bond principal) must be returned
(maturity date). The issuance price of a bond is normally set at par, usually $100 or
$1,000 face value per individual bond. The actual market price of a bond
depends on several factors including the credit quality of the issuer, the
length of time until expiration, and the coupon rate compared to the general
interest rate environment at the time.

 

Shares represent an ownership interest in a
corporation. Bonds are a form of long-term debt in which the issuing
corporation promises to pay the principal amount at a specific date. Shares pay
dividends to the owners, but only if the corporation declares a dividend.
Dividends are a distribution of a corporation’s profits. Bonds pay interest to
the bondholders. In general, the bond contract requires that a fixed interest
payment be made every six months. Every corporation has common stock. Some
corporations issue preferred stock in addition to its common stock. However,
most corporations do not issue bonds. Stocks and bonds issued by the largest
corporations are usually traded on stock and bond exchange, while stocks and
bonds of smaller corporations are usually held by investors and are never
traded on an exchange.

 

In addition, stocks are only issued by
corporations but bonds can be issued by either corporations or government
entities. Bonds are debt, while shares are equity. This is an important
distinction between the two securities. By purchasing share, an investor
becomes an owner in a corporation. Ownership includes voting rights and the
right to share in any future profits whereas by purchasing bonds, an investor
becomes a creditor to the government or corporation. The major benefit of being
a creditor is that you have a higher claim on assets compared to shareholders. In
the case of bankruptcy, a bondholder will get paid before a shareholder.
However, the bondholder does not share in the profits if a company does well.
They are entitled only to the principal plus interest. Briefly, there is
generally less risk in owning bonds than in owning stocks, but this comes at
the cost of a lower return.

 

b)     
The terms
of stock splits, bonus issues and right issues.

 

Stock split is the issuance of
additional shares by a company to its shareholders without collecting any contribution
from them. Such issue increases the number of shares issued and outstanding
without increasing the total balance of common stock and market capitalization
of the company. The result of a stock split is to split the par value and
market price per share. As a matter of fact, the sole purpose of the stock
split is to reduce the market price per share to make it more attractive for
investors. Stock splits are designed by companies concerning their intended
effect on the market price. If a company wants to reduce its market price to
half, it will issue 2-for-1 stock split which means the company shall issue
additional 1 share per 1 share currently issued and outstanding therefore
doubling the total number of shares. There might be a 3-for-2 stock split, for
example, which means that 3 shares are to be issued for each 2 shares of
currently issues shares. The balance of equity account is not affected by stock
split however, it just increases the number of shares and reduces par value.
For example, Blue Ltd. has 2 million of $10 par value common stock issued and
outstanding which is currently trading at $300 per share. The management
thought that the share price is too high and it intends to reduce it to its
1/3. The company would need to issue a 3-for-1 stock split which means that for
each of currently issued common shares the company shall issue 3 shares. It
will increase the total number of shares issued and outstanding to 6 million (2
million × 3) resulting in a par value of $3.33 ($10 ÷ 3) and a market price of
$100 ($300 ÷ 33).

 

Stock’s
price is affected by a stock split. After a split, the stock price will be
reduced since the number of shares outstanding has increased. For instance, in
a 2-for-1 split, the share price will be divided equally into two (halved). The
market capitalization remains constant even though the number of outstanding
shares and the stock price changes. Stock split is usually performed by
companies that have seen their share price increase to levels that are too high
or beyond the price levels of similar companies in their sector. The main
reason is to make shares appear more affordable to small investors despite the
fact that the underlying value of the company has not changed. Besides, stock
split can cause a stock price to increase, following the decrease immediately
after the split. Since many small investors buy the stock as they think that
the stock is now more affordable, they end up boosting demand and drive up
prices. Another reason for the price increase is that a stock split indirectly
shows that the company’s share price has been increasing and people believe
that this growth will go on in the future, and lift demand and prices again.

Furthermore,
a bonus issue, also known as a capitalization issue or a scrip issue is an
offer of free additional shares to existing shareholders. A corporation may
give out additional shares as an option to increase the dividend pay-out. As an
illustration, a company may give one bonus share for every five shares held.
Companies give out bonus shares to shareholders when companies are short of
cash and shareholders expect a regular income. Shareholders may sell the bonus
shares and meet their liquidity needs. Issuing bonus shares does not involve
cash flow. Bonus shares may also be issued to restructure company reserves. It
increases the company’s share capital but not its net assets. Bonus shares are
issued based on each shareholder’s stake in the company. A 3-for-2 bonus issue
grants every shareholder three shares for every two shares they hold before the
issue, which means a shareholder with 1,000 shares receives 1,500 bonus shares
(1000 x 3 / 2 = 1500).

 

Stock
splits and bonus shares have a lot of similarities and differences. When a
stock split takes place in a company, number of shares increases but the
investment value remains the same. Companies normally declare a stock split as
a way of infusing additional liquidity into shares, increasing the number of
shares trading and making shares more affordable to retail investors. No increase
or decrease in the company’s cash reserves takes place when a stock is split,
but when a company issues bonus shares, the shares are paid for out of the cash
reserves, and the reserves deplete.

 

Last but not least, rights issue
is when a company issues its existing shareholders a right to buy additional
shares in the company. The company will offer the shareholder a specific number
of shares at a specific price. Time limit will be set by the company for the
shareholder to buy the shares. Usually, shares are offered at a discounted
price to encourage existing shareholders to take the company up on their offer.
If a shareholder does not take the company up on their rights issue, they have
the option to sell their rights on the stock market just like the way they
would sell ordinary shares. However, their shareholding in the company will
become weak. A company will offer more shares to its shareholders to gain extra
money for the company. Companies with poor cash flow usually use rights issue
to increase cash flow and pay off existing debts. Sometimes, right issues are
issued by companies with healthy balance sheets in order to fund research and
development projects or to purchase new companies. Discounted shares issued by
a company can be appealing but it is important to find out the reason for the
rights issue of shares. A company may be using the rights issue as a quick cash
fix to pay off debts masking the real reason for the company’s cash flow
failing such as poor leadership. Hence, caution must be taken when offered with
a rights issue.

 

The
advantage of raising money through a rights offering is that the company can
bypass underwriting fees. In some cases, a company may use rights offering to
raise money if there are no other viable financing alternatives. This is normal
during economic slowdowns where banks become reluctant to lend to companies.
The benefit of a rights offering to shareholders is that shares are generally
offered at a discount. This discount can be quite high at times, it actually depends
on how much a company feels the need to encourage its shareholders to be
involved in the rights offering. In spite of that, a rights offering by a big,
established company may be taken by the market as evidence that a company is
struggling. The reason is that rights offerings flood the market with more
shares, hence reducing the value of shares that are available. Shareholders can
become disgruntled when their shares are diluted. But, a rights offering is
meant to calm this concern because only existing shareholders are given the
opportunity to buy additional shares. This is unless, shareholders decide to
sell these rights.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

c)      Characteristics
of convertible bonds and how can it be a good option for the company.

Convertible
bonds are bonds that can be exchanged for, or converted into, common stock at
the option of the holder. Conversion does not bring in additional capital for
the issuing firm, rather, debt is simply replaced by common stock. This
reduction of debt will strengthen the firm’s balance sheet and make it easier
to raise additional capital. However, this effect represents a separate action.
In many cases, a convertible bond is issued as a temporary substitute for
common stock when the market price of a firm’s stock is depressed but is
expected to improve in the future. If the company wants to ensure that a
convertible bond will be converted into common stock once stock prices rise,
the original convertible will include a call provision. The firm will then call
the bond when the market price of the common stock rises to a point where
bondholders would prefer to convert the bonds rather than return them to the
firm. When the conversion takes place, the firm has effectively issued stock.
Once the conversion is made, investors cannot convert back to bonds.

 

A
conversion feature permits the bondholder (investor) to exchange, or convert,
the bond into shares of common stock at a fixed price. Investors have greater
flexibility with convertible bonds than with straight bonds, because they can
choose whether to hold the company’s bond or convert it into stock. One of the
most important provisions of a convertible bond is the conversion ratio, which
is defined as the number of shares of stock that the convertible holder
receives upon conversion. Related to the conversion ratio is the conversion
price, which is the effective price paid for the common stock obtained by
converting a convertible bond. For instance, a $1,000 convertible bond with a
conversion ratio of 20 can be converted into 20 shares of common stock, so the
conversion price is $50 = $1,000 / 20. If the market value of the stock rises
above $50 per share, it would be beneficial for the bondholder to convert the
bond into stock.

 

Convertible
bonds, also known as convertible securities can be used to take advantage of
some of the benefits associated with both debt and equity. Debt with a
conversion feature offers investors greater flexibility by providing them with
the opportunity to ultimately be either a debtholder or a stockholder. Thus,
such a feature generally allows the firm to sell debt with lower coupon
interest rates and with fewer restrictive covenants than debt that does not
have this feature. Even though convertibles do not bring additional funds into
the firm at the time of conversion, they are nevertheless useful features that
help the firm achieve “delayed equity financing” when conversion occurs.
Convertibles generally are subordinated to mortgage bonds, bank loans, and
other senior debt, so financing with these instruments leaves the company’s
access to “regular” debt unimpaired. In addition, convertibles provide a way of
effectively selling common stock at prices higher than those prevailing when
the issue was made. Many companies actually want to sell common stock and not
debt, but they believe that the prices of their stocks are temporarily
depressed and too many shares would have to be sold to raise a given amount of
money. Such firms might use convertibles if they expect the prices of common stocks
to rise sufficiently in the future to make conversion attractive. When the
conversions take place, the firms have obtained “delayed equity financing” that
eliminates the original debt.

 

Convertible
bond is a type of debt security which can be converted into a predetermined
amount of the underlying company’s equity at certain times during the bond’s
life, normally at the bondholders’ discretion. This bond is a flexible financing
option for companies and is useful for companies, especially those with high risk/reward
profiles. Convertibles bonds are issued by companies for some reasons. Issuing
convertible bonds help minimize negative investor interpretation of its
corporate actions. As an example, if a public company chooses to issue stock,
the market often interprets this as a sign that the company’s share price is
overvalued. In order to avoid this negative impression, company may choose to
issue convertible bonds, which bondholders are likely to convert to equity
anyway if the company continue to do well.

 

For
instance, Black Inc. issues a $1,000 face value convertible bond paying 4%
interest with convertible ratio of 100 shares of the company for each
convertible bond and a maturity of 10 years for $1,000. At the end of year
nine, which is the year before maturity, the investor is entitled to $1,000 in
principal with additional $40 in interest payments, a total of $1,040 if the
bond is not converted into equity. However, after a successful quarter, the
company’s shares are now trading at $11; hence, 100 shares of the company are
now worth $1,100 (100 shares x $11 share price), surpassing the value of the bond.
By converting the bond into equity, the investor receives 100 shares in the process,
the share can then be sold in the market for a total of $1,100.

Convertible
bonds are issued because investors seek for a security that optimally protests
their principal on the downside but also allows them to participate in the
upside should the underlying company succeed. For example, a start-up or relatively
new company, may have a risky project that loses a great deal of money on one
end but may lead the company into profitability and outsize growth. A
convertible bond investor can get back some principal upon failure of the company
but can benefit from capital appreciation by converting the bonds into equity
if the company is successful. Convertible bonds are a practical financing
option for companies and investors when the company’s success resembles a
binary outcome. Moreover, convertible bonds allow companies issuing them to
lower their borrowing costs. From investor’s point of view, convertible bond
has a value-added component. Convertible bond is a bond with a stock option,
particularly a call option, attached to it. Therefore, it tends to offer a
lower rate of return in exchange for the value of the option to trade the bond
into stock. Or else, the bond just pays interest to the investor for his
capital investment.

 

It
takes time for the bondholders to trade their bonds for stock, so issuing
convertible bonds helps a corporation secure equity financing in a delayed
manner. This action will delay the common stock and earnings per share
dilution. Because of the stock purchase option, corporations can sell bonds at
a lower coupon rate compared to a standard bond. The higher the conversion
feature is worth, the lower the yield it will need to sell the bond. More
operating income is accessible to common stockholders until the bonds is converted
into stocks, as convertible bondholders are entitled to only a small, fixed
income. Thus, allowing common stockholders to maintain voting control of the
corporation temporarily while using the investment income from the convertible
bondholders.