By USMAN HAYAT
April 15 - 21, 2002
Once a public company has decided to issue further
share capital, it has to decide a subscription price. The shares can be
issued at par, premium, or discount. The typical par in Pakistan is Rs
10, therefore, a company can issue shares at Rs 10, above Rs 10, or
below Rs 10. When its share is selling below par in the market, the
issuer would have to consider offering them below par, i.e., at a
discount, otherwise shareholders would be unlikely to subscribe. The
objective here is to discuss some of the issues involved in the rate of
discount on further issue of shares.
Public companies are allowed to issue shares at a
discount from par under section 84 of the Companies Ordinance 1984 but
only after fulfilling some legal requirements. There are two scenarios:
i. If the discount rate is 10% of par or less, then
issuer first takes the approval from its shareholders by means of a
special resolution in a general meeting and then takes the approval from
Securities & Exchange Commission of Pakistan (SECP).
ii. If the discount rate is more than 10% of par,
then the issuer first takes the approval from SECP and then from its
Some key questions need to be answered in a discount
Should discounts on par be
How to determine the rate
Who should determine the
rate of discount?
LETS TAKE THESE QUESTIONS IN
1. SHOULD DISCOUNTS BE ALLOWED?
Whether or not discount should be allowed depends on
the purpose and nature of the issue.
Where a company is issuing shares to meet capital
adequacy requirements, discounts would go against the very purpose of
increasing capital. If left entirely to the issuers, it is likely that
they would try to issue shares at maximum discount to minimize
additional investment. Recently SBP has increased the minimum paid-up
capital, including unencumbered general reserves, for an investment bank
to Rs 500 million. Similarly, SECP has raised the minimum capital
requirement for leasing companies to Rs 200 million. If these companies
issue shares at a deep discount, say 90%, it would mean that the company
would pay in only Rs 1 to increase its paid-up capital by Rs 10 and the
purpose of enhancing the capital requirements would be defeated.
OFFERS OTHER THAN RIGHTS
If shares are offered below the market price without
right offer, then it would be transfer of wealth from existing to new
shareholders. A company can issue shares without rights under Section 86
of the Companies Ordinance 1984, however, first the issue must be
approved by the shareholders by means of a special resolution and
second, the issue must be approved by SECP. The issuer would have to
justify to SECP that the issue is in the interest of the shareholders.
Due to these twin approvals, this door of manipulation is closed.
ACCOUNTING TREATMENT OF
ISSUING SHARES AT DISCOUNT
Say a company issues 10 million shares with a par of
Rs 10 at a subscription price of Rs 5. This would increase the company's
cash by Rs 50 million but Paid-up Capital by Rs 100 million. The
difference of Rs 50 million would be amortized over five years at Rs 10
million each. The amortization expense would be reported on the income
statement but it would not be tax deductible. The amount to be amortized
would appear in Deferred Costs on the Balance Sheet. Unless the
company's profits offset the amortization expense, it would add to the
losses and reduce the reserves.
Before the Issue
After the Issue
Other Assets: 900
Paid-up Capital: 500
Deferred Cost: 50
Other Assets: 900
Paid-up Capital: 600
MANIPULATION OF DISCOUNT
The discount may be manipulated by some to enhance
their shareholding and control in a company. For instance, shares of an
issuer selling at Rs 5 might be issued at a par of Rs 10, with the
directors or sponsors underwriting the issue. It is only likely that
common shareholders would not exercise the right to buy these shares and
they would be picked by the directors. By not giving a discount,
directors can make an issue unattractive for other shareholders.
INCENTIVE FOR SHAREHOLDERS
If a share is selling at par, some discount might be
necessary to make the issue attractive for the shareholders.
Shareholders might not be interested in buying something for Rs 10 that
is selling for Rs 10. They might have better investment opportunities,
they also might not have cash enough at that point in time to invest in
rights, and so on. A discount of a few rupees might just be the solution
to make the shareholders interested.
HOW DISCOUNTS SHOULD BE
Economically speaking, the rate
of discount depends on three things:
Share price before the
Expected share price after
How representative the
share price is of the true value
SHARE PRICE BEFORE THE ISSUE
For a share selling at Rs 5, would you be willing to
buy it at Rs 10? Not really and nor would a common shareholder. Clearly,
a discount rate should consider the market price when the share is
trading below par. However, no less important is the expected price with
EXPECTED SHARE PRICE WITH THE
Expectations would determine the market reaction to
the share price. There is a long lag time involved when shareholders
receive their right shares and the company receives the proceeds.
However, the market would start reacting when the information in the
issue is made public which is usually when the notice of the general
meeting with the relevant resolution appears in the newspapers. The
market would revise the price of the share based on its own expectations
of the financial performance of the issuer after the issue.
Theoretically, share price should stay the same if the Net Present Value
(NPV) of the purpose for which new shares are issued is zero. It should
increase if the NPV is positive and vice versa.
For the shareholders, buying new shares would be
worthwhile if the share price after the issue increases enough so that
the gain on existing shares offsets the premium paid over the market
price on the new shares. Interestingly, the expectations on share price
after the issue also depend on the mode of financing. Management, that
knows more about its financial prospects than others, is likely to issue
debt when things are looking good because leverage makes good times
better and bad times worse. This is why an equity issue is generally
considered an unfavourable signal of future prospects, which should
decrease the share price. In Paksitan, one can question whether shares
prices are determined by market as they should be.
THE TRUTH IN MARKET PRICE
For large capitalization frequently traded stocks,
the weak form market efficiency — that all publicly available
information is incorporated in the prevailing market price — is likely
to hold and market price would be a workable estimate of the true value
of the stock. But this may apply to only a few companies in Pakistan.
There are 743 companies currently listed at KSE but 95% of the trading
takes place in 3% of the shares. Many stocks have a very small free
float on the market and they are very thinly traded, if traded at all.
It is hard to say that their prices are a true reflection of their
intrinsic value based on publicly available information. Table 1 gives a
few examples of shares selling below par in different industries in
which the share price did not budge a paisa throughout the year.
Table 1: Some shares with a constant price in 2001
Escorts Investment Bank
Lafayette Industries Synthetics
KSE Daily Quotations, 2002
Past precedents show that companies whose share price
is unlikely to represent the true value of share are more likely than
others to need the discounts. Determining a discount rate for such
companies and for unlisted public companies would need be based on
estimated fair price determined by techniques like discounted cash flow
DIRECTORS VS COMMON
The directors have a vested interest in the viability
of the company because in case the company gets into financial
difficulties, they stand to lose not only their investment but also
their jobs, perks, privileges, social status, contacts and so on. Often
the latter are of greater value to them than the former and they usually
are more willing to buy the shares above the market price. Therefore,
all shareholders ought to have a say in the discount.
FORMULA BASED DISCOUNTS
Recently Fauji Cement has used an interesting rule
for determining the discount on an issue without right. The rule was
that the subscription price would be determined such that the percentage
discount from par would be equal to the percentage premium over average
market price. The market price used was the trading volume weighted
average closing price of the last ten trading days prior to the general
meeting in which Fauji Cement obtained the approval of its shareholders
to the issue. Based on this formula, if the average market price is Rs
6, then the subscription price would be Rs 7.5 because Rs 7.5 is 25%
above Rs 6 and 25% below Rs 10. This rule can also be modified such that
instead of percentage discount, the absolute Rs discount form par would
equal the absolute Rs premium over average market price. If the market
price is Rs 6, then subscription price would be Rs 8 because it is Rs 2
below par and Rs 2 above market price. The absolute version would lead
to higher subscription prices than the relative version, therefore, it
is likely that the existing shareholders would prefer the latter. The
market price can be averaged over different periods in different ways to
suit the situation. One cannot term these formula based discounts
objective but making the subscription price a function of market price
yet to be determined does reduce the subjectivity involved. This can be
particularly useful in reaching an agreement for discounts on other than
WHO SHOULD DETERMINE THE
RATE OF DISCOUNT?
One of the reasons behind SECP's approval of the
discount is that while passing a special resolution requires at least
75% of votes in favour, the minimum quorum for a general meeting is only
25%, therefore, a special resolution can be passed with shareholding
ranging from 18.75% to 75% or more. That is, it is possible to pass a
special resolution in favour of a discount when it is not representative
of the will of the majority. The question that who should determine the
rate of discount depends on why the shares are being issued and what is
the potential of abuse in the issue. If the issue is of right shares and
the shares are being issued for purposes other than meeting the capital
adequacy requirements, then the decision should not be of the regulator.
After all, it is shareholders' money and shareholder's company.
Some recent cases of a discount
Pak-Gulf Leasing Company
Sigma Leasing Corporation
Network Leasing Corporation
Prudential Commercial Bank
Determining the appropriate rate of discount from par
might be tricky but it is best left to the shareholders. The role of
government and regulators should be to promote disclosure,
accountability, and competition rather than approve specific business
decisions for shareholders. It would not be unreasonable to say that
discounts on par should be regulated only when deregulation has
substantial likelihood of abuse.
WE WOULD LIKE TO RECOMMEND THE FOLLOWING:
i. If shares are
being issued for purposes other than meeting capital adequacy and are
with a right offer, then the decision should be entirely of the
shareholder's to be taken by means of a special resolution.
ii. No discount
should be allowed until a company has met its capital adequacy
requirement. Exceptions to be decided by SECP.
iii. Discount on
issue without right offer should be approved by SECP and formulas should
be used in such cases, whenever possible.
iv. Directors and
sponsors should not underwrite any right issue without shareholders' and
SECP's prior approval.