WEEK 1

• Dilutive securities


  • Financial instruments that enable their holders to obtain ordinary shares
  • Reduce (dilute) earnings per share (EPS) by increasing the number of shares outstanding, if converted or exercised
• Examples of dilutive securities

  • Convertible Bonds
  • Convertible Preference Shares
  • Warrants and Employee Share Options
• Basic EPS


  How much income is earned by each ordinary share
• Diluted EPS


  How much income is earned by each ordinary share if we include all potentially converted ordinary shares

  
• Antidilutive securities


  Securities that would increase EPS, if exercised or converted, and are generally not considered in diluted EPS
• Convertible bonds are accounted for as a compound financial instrument (i.e., they have both debt + equity components)
• Applying the "with-and-without" approach to value convertible debt

  1. Determine the total fair value of convertible debt

  2. Determine the liability component by computing the net present value of all future cash flows

  3. Subtract the liability component from the total fair value to get the equity component

  
• Convertible preference shares


  • Provide investors with downside protection (like debt) and unlimited upside potential (like ordinary shares)
  • Reported as part of equity
  • No gain or loss recognized when converted or repurchased
• Share warrants


  • Certificates that give the holder the right to obtain shares at a fixed price within a pre-specified period
  • If exercised, they become ordinary shares and usually have a dilutive effect similar to convertible securities
  • Holder must pay for shares
• Convertible preference shares


  Shares that can be converted into a fixed number of ordinary shares
• Convertible preference shares


  • Provide investors with (some) downside protection (like debt) and unlimited upside potential (like ordinary shares)
  • Are not compound securities and are reported as part of equity
  • When converted or repurchased, there is no gain or loss recognized
• A company should not recognize any gains and losses made on transactions with its own shareholders
• Share warrants


  Certificates that give the holder the right to obtain shares at a fixed price within a pre-specified period
• Share warrants


  • If exercised, they become ordinary shares and usually have a dilutive effect similar to convertible securities
  • Holder must pay for shares
• Employee share options (ESOs)

  A form of warrant that give key employees the option to purchase ordinary shares at a given price over an extended period of time
• Dilutive securities


  Financial instruments that enable their holders to obtain ordinary shares and reduce (dilute) earnings per share (EPS) by increasing the number of shares outstanding, if converted or exercised

  
• Effective compensation programs


  • Base compensation on performance
  • Motivate employees
  • Help retain executives and recruit new talent
  • Maximize employee's after-tax benefit and minimize employer's after-tax cost
  • Use performance criteria over which employee has control
• Examples of dilutive securities

  • Convertible Bonds
  • Convertible Preference Shares
  • Warrants and Employee Share Options
• Employee share options (ESOs)

  • Incentivize employees to act in the interest of shareholders due to the direct link between compensation and firm value
  • Attract highly motivated and entrepreneurial employees without (directly) expending cash (e.g., tech start-ups)
  • Typically structured so that only employees who remain with the firm can benefit from them, providing retention incentives
  • Encourage executive risk-taking (mitigate risk aversion)
• Basic EPS


  How much income is earned by each ordinary share
• Diluted EPS


  How much income is earned by each ordinary share if we include all potentially converted ordinary shares
• Antidilutive securities


  Securities that would increase EPS if exercised or converted, and are generally not considered in diluted EPS
• Convertible bonds


  Bonds that can be changed into equity shares (or other corporate securities)
• Top managers used legal and illegal accounting tricks to inflate earnings (earnings management)
• Reasons to invest in convertible bonds

  • Benefit of a bond (guaranteed interest and principal)
  • Exchangeable for shares (call option)
• Fair-value method


  Acceptable option-pricing models (e.g., Black-Scholes) are used to value the options at the grant date
• Intrinsic value method


  Compensation is the difference between the market price of shares and the exercise price of an option at the grant date (which is 0 if market price = option price)

  
• Reasons to issue convertible bonds

  • Obtain debt financing at cheaper rates
  • Raise equity capital with less dilution of ownership control
• Determining expense for employee share options

  • The total compensation expense is the fair value of the options on the date they grant them to their employees (the grant date)
• Allocating compensation expense for employee share options

  • The compensation expense is recognized in the periods in which employees perform the service—the service period (= vesting period, if not stated otherwise)
• Vesting period


  The period of time that employees must wait before they can exercise their stock options
• Compound financial instrument

  Convertible bonds have both debt and equity components
• Applying the "with-and-without" approach to value convertible bonds

  1. Determine the total fair value of convertible debt

  2. Determine the liability component by computing the net present value of all future cash flows

  3. Subtract the liability component from the total fair value to get the equity component

  
• Adjusting employee share option compensation expense

  • Depends on whether the adjustment is caused by a service condition (e.g., change in vesting period) or a market condition (e.g., change in stock price)
• Accounting for convertible bonds at issuance

  1. Determine total fair value

  2. Determine liability component by computing present value of future cash flows

  3. Subtract liability component from total fair value to get equity component

  
• Restricted shares


  Shares that cannot be sold or transferred until vesting occurs
• Accounting for convertible bonds at settlement

  1. Repurchase at maturity

  2. Conversion at maturity

  3. Conversion before maturity

  4. Repurchase before maturity

  
• Restricted shares


  • Fair value is the market price of shares at the grant date (usually no pricing model needed)
  • Expensed over the service (vesting) period
  • Shares are issued directly at the grant date and do not become completely worthless
• Convertible preference shares


  Shares that enable holders to convert into a fixed number of ordinary shares
• Share-appreciation rights (SARs)


  Give employees the right to receive compensation equal to the increase in value (i.e., share appreciation) of their shares