Fall 2022 Class Test Solutions on Characteristics of Shares- Finance, Georgetown University

Below are the questions asked in the Fall 2022 finance test on the characteristics of corporate securities at Georgetown university. You can use these questions to prepare and master how to do your finance exams. We have included well-researched solutions to help you revise and act as a reference. We are open to directly helping you take your exam on characteristics of shares, so hire us today for excellent results.

List and discuss the different types of shares issued in a company.

Exam Solution:The shares which form the basic capitalization of a company are called ordinary shares or common stock. Other shares are distinguished from them by having different rights in certain specified respects, notably as regards voting and preferred or deferred claims on income and return of capital.

1. Ordinary shares

Ordinary shares are the most familiar type of security to the average investor. They are likely to be a greater number of shares and a greater spread of holders than for the other types of securities a company may have in the issue. This makes them more marketable and generally more easy to value than other securities. A framework for analyzing the worth of ordinary shares has become well-established and widely understood, involving such measures as the price-earnings ratio, dividend yield, asset backing, and the variability of the expected return compared with the market as a whole.

2. Shares with different voting rights

Standard voting rights are for each shareholder to have one vote if a resolution is to be considered on a show of hands, while if a poll is demanded the formula is usually one vote for each share. In some instances, usually for historical reasons relating to the founding shareholders' wish to retain control and raise new capital, shares will be created with different voting rights. There may be 'A' shares with one vote per share and 'B' shares with say ten votes per share. The original shareholders can then raise capital by issuing more 'A' shares to the public while retaining voting control through their 'B' shares. The public may well value their shares in relation to the earnings, dividends, and asset backing which would be identical to the 'B' shares, without much concern over the inferior voting rights.

The current attitude of stock exchanges to differing voting rights is unfavorable. They will not normally grant listings to new issues on these terms. Where shares with different voting rights have been in existence for many years, it is difficult to insist on a change. Pressure may be applied by the authorities or by institutional holders for the directors voluntarily to propose that all voting rights should be made identical. It is common practice to give holders of shares with superior voting rights a bonus issue (say on the basis of one-for-ten) to compensate them for the loss of their voting advantage.

3. Preference or preferred shares

Shares that have generally superior rights to ordinary shares are called 'preference' shares. Shares whose rights differ only in one area may be called 'preferred' shares.

4. Shares with deferred rights

Shares may be issued with deferred rights, usually as regards income. For example, a company may acquire by an issue of shares assets (such as development sites) which may not yield income for some years. The company may not be able to maintain its dividend if the new shares rank for the dividend. before the assets acquired can contribute income.

In this case, the shares may be issued on terms that they do not rank for dividends for a certain period of time, estimated to be the period before the assets generate profits. At the end of this period, the deferred shares will automatically become ordinary shares and rank for dividends equally with them. This device may also assist in maintaining reported earnings per share. Shares that do not rank for dividends are not normally included in the earnings and dividends per share calculation. However, 'fully diluted earnings per share, that is assuming all shares rank for dividend, should also be shown in the accounts, either on the face of the profit and loss statement or as a note.

Deferred shares have also been used as a fundamental part of tax schemes to lessen the amount of transfer duty. If the shares transferred have such inferior rights that their value may be argued to be negligible, their transfer may be effected with little or no transfer tax. This method of avoidance has been tolerated in certain jurisdictions in the past but it seems likely that changes in legislation will render it obsolete.

5. Treatment in takeovers

Shares that lack voting rights in normal conditions are largely ignored in takeovers and treated as part of a tidying-up exercise at the end of the day. However, as noted above, if a dividend is not current, preference shareholders are likely to have votes and, in some circumstances, may even have a majority of votes. In addition, provisions to protect their preferential right to assets may give them a veto over certain types of reorganization planned as part of the takeover or merger. Preference shares with special rights may be used specifically to put in place a 'poison pill' defense, giving the holders rights which make a takeover of the company prohibitively expensive to a hostile predator.

6. Convertibility

Shares may be issued with rights that they can be converted into ordinary shares. The method and terms of conversion are normally the same as those applying to convertible loan stock which is described below. Convertible preference shares are very close to outright equity. They would typically be issued in circumstances where the company would prefer to issue ordinary shares except for the technical or tactical reasons mentioned above.

Deferred or preferred shares may become identical to ordinary shares on the triggering of some event to which their preferred or deferred status specifically relates. For example, preferred shares may be entitled to a higher dividend than ordinary shares initially. When the income on the ordinary shares increases so that it exceeds the preferred share dividend, the preferred shares automatically become ordinary shares. Deferred shares which, for example, do not rank for dividends for a certain period become ordinary shares when that period has elapsed.

Discuss 4 main characteristics of ordinary shares

Exam Solution

1. Cost of ordinary shares

Ordinary shares carry no fixed servicing obligations. Of course, shareholders are none too pleased if no dividends are paid but there is no legal sanction triggered against the company. Whether to pay or recommend dividends lies in the discretion of the directors.

This gives rise to different attitudes to the cost of ordinary shares. In theory, as ordinary shares (other than certain types of deferred shares covered below) carry the greatest risk of all the securities issued by the company, it would be expected that holders would demand the greatest return. Expressing this from the company's point of view, ordinary shares are in some sense the most expensive type of capital for a company to employ. However, in cash terms, they are the cheapest, both in the sense that no dividends are actually required and because a normal dividend payment is likely to put a share on a lower yield than the interest rate on debt. From the point of view of cash servicing costs, it is cheaper and safer for a company to raise a given sum by the issue of shares than it is by bank borrowings or the issue of other securities.

Financial theory suggests that the difference between the cash returns on shares and the interest payable on loan stock or bank borrowing should be more than made up by the expected capital gain to holders of the shares. On the other hand, some managements may regard the share price of the company in the stock market as capricious, particularly in the short term, and largely beyond their control. Whether shareholders will actually reap a capital gain to compensate them for the lower cash income depends on many factors, including the timing of the investors' purchase and sale, the mood of the stock market, and the economic cycle. What the directors of the company can control is the level of dividend payments. While theory tells them shares are the most expensive form of financing, they may be tempted to measure reality in terms of cash paid out.

2. Timing and pricing of issues

Another paradox concerns the timing and pricing of issues of ordinary shares. Directors may feel that money raised by issues of ordinary shares is 'cheapest' when the share price is high. Issue activity tends to intensify at market peaks. To the shareholder, this may prove the most expensive time to increase his holdings. Shareholders may look back and rue an issue made near a market peak while the directors congratulate themselves on their foresight, having raised money for the company cheaply and at the right moment. This policy may expose shareholders to capital losses on their investments rather than the capital gains needed to supplement the dividend yield.

3. Voting rights

A fundamental right of ordinary shares is that they normally carry the voting control of companies. In most takeover bids, the premium for acquiring control of a company attaches entirely to the ordinary shares. Preference shares or loan stock which may be more valuable on an income basis do not share in this bonanza unless they carry unusual rights to block or hinder a takeover.

A register of shareholders is usually maintained by the company, in which case the registered holder has the power to vote at meetings of the company or to appoint a proxy to vote on his behalf. Shares held in 'street names' and not yet registered by a purchaser cannot be voted by the new owner until the transfer of ownership has been registered by the company. Some companies (mostly private) have issued securities in bearer form which allows the person in physical possession of the certificates to attend meetings and vote for the shares he holds.

4. Claims on income and assets

Holders of ordinary shares participate pro rata in the profits of the overall business attributable to them. The dividends they receive and capital gains they enjoy should be determined over a period of time by the performance of the company.

The articles of association of a company usually contain provisions preventing the dilution of shareholders' claims on the company's income and assets. In some jurisdictions, further issues of shares for cash are required to be made by 'rights'. which ensures that the existing shareholders have the opportunity to maintain their percentage shareholding in the company. Bonus issues, sometimes called 'scrip' or 'capitalization' issues, are made to existing shareholders out of the company's share premium account or by capitalizing reserves.

When a bonus issue is made, no cash is paid by shareholders or received by the company. In theory, the issue should leave the value of a shareholder's holding unchanged. For example, if a shareholder holds 100 shares with a market price of $1 and a one-for-ten bonus issue is declared, the total shares he owns will increase to 110 but the price should decline to approximately 50.91 ($1 multiplied by a factor of 100/110). However, in some markets bonus issues are well received, perhaps as a sign of favorable progress by the company, and the total market value of a shareholder's investment in the company may be observed to increase instead of adjusting fully.

Explain the main characteristics that distinguish preference shares from other shares in the company

Exam Solution

1. As regards income and capital

Shares may be issued with rights to income and return of capital which are superior to those of ordinary shares. The dividend on a preference share is normally expressed as a fixed percentage of the par value or the issue price, for example, 8%. Preference shareholders may, on occasion, participate in some percentage of the dividend paid to ordinary shareholders, giving holders some possibility of increasing income. Preference shares can be issued with a dividend linked to other variable factors such as the rates obtainable in the money market, but this is unusual.

The dividend rights of preference shares are normally 'cumulative'. If a dividend is not paid for one period, it must be subsequently paid together with the current dividend before dividends may be paid on the ordinary shares.

As with ordinary shares, there is no legal sanction on the company for failure to pay a preference dividend. Missing a preference dividend, as well as restrictions of the payment of dividends to ordinary shareholders, may trigger voting rights or other powers for the preference shareholders. Preference shareholders cannot usually vote at general meetings of the company except on matters which affect their rights.

2. Issues in place of ordinary shares

Issues of preferred or preference shares can be useful when it is difficult to issue par ordinary shares. If the price of the ordinary shares is low, perhaps close to or even lower than the par value (in jurisdictions where a par value applies), an issue will not be possible. In such jurisdictions, it is not legal to issue shares at below value. However, a new class of shares may be issued, designed to be valued at par because of its superior rights. This may also prove useful in a takeover bid, where there may be some doubt about the value of the ordinary shares or the bidder wishes to argue he is being generous to the target company's shareholders.

In situations where it is not practical to pay a dividend on the whole of the share capital owing to poor performance, it may still be possible to pay a dividend on a lesser number of preference shares. Preference shares are widely used in reconstructions. A company's equity needs to be increased but new investors are not willing to put in fresh money unless their investment ranks ahead of that of the original shareholders. As preference shares are counted as equity, an issue of preference shares serves to reduce gearing and to increase borrowing limits while giving new investors greater protection. An issue of unsecured loan stock, which might have similar rights, would not achieve this purpose.

3. Ability to redeem

Preference shares are usually redeemable. This is a useful right in jurisdictions that prevent repayment of capital without court sanction and may restrict a company in purchasing its own shares. In such jurisdictions, it is possible for a company to redeem its preference shares out of a further issue of preference shares or if it has sufficient distributable reserves in its balance sheet and adequate financial resources. The possibility of redemption of a part of the share capital adds flexibility in adjusting the overall level of gearing of the company. This feature has been found useful in some investment trusts to cater for the objectives of different types of investors.