Principles of Corporate Finance

Transcription

1 Principles of Corporate Finance Chapter 16. How corporations issue securities Ciclo Profissional 2 o Semestre / 2009 Graduação em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

2 Topics covered 1 Venture capital 2 The initial public offering 3 Other new-issue procedures 4 Security sales by public companies 5 Private placements and public issues V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

3 Venture capital markets Most new companies rely initially on family funds and bank loans Some of them continue to grow with the aid of equity investment provided by wealthy individuals known as angel investors Many adolescent companies raise capital from specialist venture capital firms V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

4 Venture capital Definition A venture capital firm is a firm that pools money from individual investors and other financial intermediaries to fund relatively small, new businesses Venture capital firms are also specialized in restructuring, or providing equity capital for more mature firms that are making fundamental changes in the way they are doing business Some large technology firms act as corporate venturers: Intel Johnson and Johnson Sun Microsystems V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

5 Venture capital investment in the U.S. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

6 Venture capital firms Venture capital firms provide the firms they invest in with managerial support They provide ongoing advice and play a major role in recruiting the senior management team Their judgement and contacts can be valuable to a business in its early years V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

7 Venture capital firms Most venture capital funds are organized as private partnerships Limited partners are pension funds and other investors The management company, which is the general partner, is responsible for making and overseeing the investments The management company receives in return a fixed fee and a share of the profits, called carried interest V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

8 Venture capitalists The Rockefeller family has made the initial capital contribution to a number of successful businesses Of the early partnerships, the most well-known is American Research and Development (ARD), which was formed in 1946 Its success was largely due to investment in DEC Among the more recent venture capitalists, Arthur Rock & Co. of San Francisco is the best known because of its huge success with Apple Computer and other high-tech firms Recent estimated put the number of venture-capital firms at about 2,000 Only very best business plans can expect to attract funds (2%) V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

9 Venture capital firms Venture capital firms may cash in on their investment in two ways: the new business can be sold to a larger firm the new business may decide to go public and provide to original backers with an opportunity to cash-out The venture capital market therefore needs an active stock exchange, such as Nasdaq, that specializes in trading the shares of young, rapidly growing firms V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

10 Venture capital and risk Very few new business make it big For every 10 first-stage venture capital investments, only two or three may survive as successful, self-sufficient business In the 20 years to 2005 investors in theses funds would have earned an average annual return of nearly 17% That is nearly 5% more a year than they would have earned from investing in the stocks of large public corporations Does this compensate for the extra risks of investing in venture capital? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

11 Venture capital Success of a new firm is highly dependent on the effort of the managers Restrictions are placed on management by the venture capital firm Usually funding is dispersed in stages, after a certain level of success is achieved V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

12 Venture capital: an fictitious example Three entrepreneurs raised $100,000 from savings and personal bank loans They created one million shares in the new company: Marvin Enterprises At this zero-stage investment, the company s assets were $90,000 in the bank ($10,000 for legal and other expenses of setting up the company) the idea for a new product V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

13 Venture capital: a fictitious example The bank account drained away as design and testing proceeded Local banks were not convinced by the project The entrepreneurs prepared a business plan describing the product, its potential market, the underlying technology and the resources (time, money, employees, plant and equipment) needed Meriam Venture Partners was impressed by the presentation and agreed to buy one million new shares for $1 each V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

14 Venture capital: a fictitious example Meriam Venture Partners implicitly put a $1 million value on the entrepreneur s idea and their commitment to the entreprise The entrepreneurs obtained a $900,000 paper gain over their original investment In exchange they gave up half their company and accepted Meriam s representatives to the board of directors V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

15 Venture capital: a fictitious example Meriam actually bought preferred stock designed to convert automatically into common stock when (and if) Marvin Entreprises succeeded in an IPO, or consistently generated more than a target level of earnings If Marvin Entreprises had failed, Meriam would have been first in line to claim any salvageable assets This provides incentives for the managers to work to maximize firm value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

16 Venture capital: a fictitious example After having designed and tested a prototype, Marvin Entreprises was back asking for more money for pilot production and test marketing The second-stage financing was $4 million $1.5 million came from Meriam $2.5 million from other venture capital firms and wealthy individual investors The new investors accepted to buy 800,000 shares, valuing one share to $5 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

17 Venture capital: a fictitious example When a new business raises venture capital, cash-flow rights and control rights are usually negotiated separately The venture capital firm will want a say in how that business is run and will demand representation on the board and a significant number of votes The venture capitalist may agree that it will relinquish some of these rights if the business subsequently performs well V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

18 The initial public offering (IPO) A company may decide to make an initial public offering of stocks The offering may be split in two parts primary offering: new shares are sold to raise additional cash for the company (implying dilution of control rights) secondary offering: existing shareholders (partners) decide to cash in by selling part of their holdings Second offerings are not confined to small, immature businesses in 1998, Du Pont sold off a large part of its holding in Conoco for $4.4 billion the British government raised $9 billion from its sale of British Gas stock the 2006 IPO of the state-owned Industrial and Commercial Bank of China, raised $22 billion V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

19 Advantages of going public Better access to capital markets Shareholders gain liquidity Original owners can diversify Enhances the firm s credibility with customers, employees, and suppliers Monitoring and information are provided by external capital markets the firm s stock price provides a signal of performance the firm can reward the management team with stock options V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

20 Disadvantages of going public Expensive Costs of dealing with shareholders: reporting burden Information revealed to competitors Public pressure V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

21 Motives for going public V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

22 IPO In many countries, large businesses remain privately owned In Italy there are about 280 listed companies 10 times more in U.K. 20 times more in U.S. Sometimes firm go into reverse and return to being privately owned Aramak, a food service company began life in 1936 It went public in 1960 In 1984 a management buyout led to the company going private In 2001 the company had its second public offering in 2006 Aramak was again the object of a buyout V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

23 SEO If a firm is already publicly traded and is simply selling more common stock, it is making a seasoned offering (SEO) or follow on Both IPOs and SEOs can include primary and secondary issues V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

24 The issuing process The firm that wants to go public has first to select underwriters Underwriters of a security issue are investment bankers that perform four functions 1 origination 2 distribution 3 risk bearing 4 certification V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

25 Origination It involves giving advice to the issuing firm about the type of security to issue the timing of the issue the pricing of the issue Origination also means working with the firm to develop the registration statement and forming a syndicate of investment bankers to market the issue The managing or lead underwriter performs all these tasks V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

26 Registration statement The Securities Acts of 1933 and 1934 require that companies file a registration statement with the SEC The required registration statement contains: General information about the firm and detailed financial data A description of the security being issued The agreement between the investment bank that acts as the underwriter The composition of the underwriting syndicate V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

27 Distribution The distribution or selling of the issue is carried out by a syndicate of banks formed by the lead underwriter The banks in the syndicate are listed in the prospectus along with how much of the issue each has agreed to sell The prospectus is a printed document that includes the most important sections of the registration statement, providing the most relevant information about the security and the firm The prospectus is widely distributed before the sale of the securities V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

28 Distribution: book building The underwriters arranged a road show to present the firm and the IPO to potential investors (mainly institutional investors: mutual funds, pension funds) The investors give their reactions to the issue and indicate how much stock they wish to buy To keep in the underwriters good books, investors should be careful not to go back on their expressions of interest After the discussions of fund managers, the underwriters can build up a book of potential orders: this is the book building process and the managing underwriter is known as the bookrunner The underwriters and the firm then meet to fix the issuing price V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

29 Distribution: fixing the price Underwriters are usually cautious Not only they would be left with any unsold stock if they overestimated investor demand But also they argue that some degree of underpricing is needed to tempt investors to buy the stock V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

30 Risk bearing In most cases, the underwriter has agreed to buy the securities the firm is selling and to resell them to its clients and the public at a slightly higher price: firm commitment offering If the issue does poorly, the underwriter may be stuck with securities that must be sold at bargain prices The underwriters bear the risk of not selling the issue, and the firm s proceeds are guaranteed Because the offering price usually is not set until the underwriters have investigated how receptive the market is to the issue, the risk is usually minimal V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

31 Risk bearing In some other cases the underwriters promise to sell as much of the issue as possible but do not guarantee to sell the entire amount: best effort offering The more well-known firms that do IPOs tend to use firm commitment offerings, but the less established firms tend to go public with best-efforts offerings V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

32 Risk bearing On October 15, 1987, the British government finalized arrangements to sell its holding of BP shares at 3.30 a share This huge issue involved more than $12 billion and was underwritten by an international syndicate Four days after the underwriting was agreed, the October crash caused stock prices around the world to nose-dive The underwriters appealed to the British government to cancel the issue but without success By the closing date of the offer, the price of BP stock had fallen to 2.96, and the underwriters had lost more than a billion dollars V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

33 Certification An additional role of an investment bank is to certify the quality of an issue This requires that the bank maintain a sound reputation in capital markets If an underwriter substantially misprices an issue, its future business is likely to be damaged V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

34 The underwriters The top managing underwriters from January 2006 to December 2006 Values include global debt and equity issues Figures in billions V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

35 Green shoe option Many underwriting contracts contain a Green Shoe option or an overallotment option which gives the members of the underwriting group the option to purchase additional shares at the offering price Green Shoe option usually last for about 30 days and involve no more than 15 percent of the newly issued shares The Green Shoe option is a benefit to the underwriting syndicate and a cost to the issuer If the market price of the new issue goes above the offering price within 30 days, the underwriting can buy shares from the issuer and immediately resell the shares to the public V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

36 Green shoe option Some underwriters use the Green Shoe option to get the ability to support prices if the demand is weak Initially underwriters decide to sell 115% of the originally allotted shares If the stock proves unpopular and traded below the issue price then underwriters can buy back shares (using the extra money of the extra 15% shares) and help to stabilize the price V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

37 Costs of an IPO Spread or underwriting discount: underwriters are allowed to buy shares for less than the offering price at which shares were sold to investors Since many of the costs incurred by the underwriters are fixed, the percentage spread should decline with issue size It is partially the case since the spread is never below 7% (Puzzle: non-competitive markets?) These fees are lower in Europe than in U.S. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

38 Costs of an IPO Other direct expenses: costs incurred by the issuer that are not part of the compensation to underwriters: administrative costs (legal counsel, accountants, registration fees, printing and mailing costs) Green Shoe option Underpricing V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

39 Underpricing of IPOs Investors who buy at the issue price on average realize very high returns other the following days Underpricing is measured by the initial return which is the return over the first trading day The average initial returns for 15,000 U.S. IPOs from 1960 to 2006 was about 18% The offering price for 3.5 million shares of ebay was $18 Dealers were flooted with orders to buy ebay: the stock closed the day at a price of $47 In China the gains from buying IPOs (A shares traded domestically) have averaged over 250% V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

40 Underpricing of IPOs V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

41 What explains underpricing? The incentives of underwriters Managers of the issuing firm have better information than investors Some investors have better information than other investors Investors have information that the underwriters don t have V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

42 The incentives of underwriters The underwriter s incentive is to set the offering price low enough to ensure that all the shares will sell without much effort and without subjecting the underwriter to excessive risk An underwriter might also want to underprice an issue because of the costs that could arise from investor lawsuits brought on by a subsequently poor performance of the issue Underpricing the issue makes the underwriter s job easier and less risky V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

43 Managers of the issuing firm have better information than investors Often firms go public as a precursor to a larger seasoned issue in the near future The managers can then first test the market with a small issue If this issue is successful, it is easier to subsequently raise additional equity capital The beliefs is that investors will be more likely to subscribe to a firm s seasoned offering after making money in the IPO V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

44 Some investors have better information than other investors Groucho Marx said I would never join a club that would have me for a member It is important for an investor to ask whether the IPO is really so hot if his broker is able to get him the shares Suppose there are two kinds of investors: informed and uniformed Informed investors know the true value of the shares (through costly research) Those informed investors will put in an order only if the shares are underpriced V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

45 Some investors have better information than other investors Uninformed investors do not know what shares are worth and put in orders for all IPOs Uninformed get allocated 100% of the overpriced IPOs and only a fraction of the underpriced stars : this is called the winner s curse Investors who are aware of their lack of knowledge would avoid buying IPOs Investment bankers may underprice the issues to induce uninformed investors to buy them V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

46 Some investors have better information than other investors The argument based on the winner s curse was proposed by Rock (1986) One implication of this line of reasoning is that riskier IPOs that are more subject to the winner s curse must be underpriced more, on average, than the less risky IPOs The Rock model provides a good explanation for underpricing in countries (U.K., Finland, Singapore) that use the fixed-price method Most non-u.s. IPOs were sold with the fixed-price method In U.K. fixed-price offerings advertise the number of shares and the offer price by prospectus 14 days before accepting applications from interested investors In addition, shares are allocated in oversubscribed offerings using some fixed formula, like a pro-rata basis. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

47 Investors have information that the underwriters don t have In the book-building method, the underwriters generally have considerable discretion on how to allocate shares (scandal in Japan) In the book-building method, the underwriters rely on information learned from potential investors when they price the IPO If investors express enthusiasm for the issue, the underwriter raises the price If investors are less enthusiastic, the underwriter lowers the price Because their information affects the price, investors have an incentive to distort their true opinions of an IPO Investors might want to appear pessimistic about the IPO in hopes of getting allocated shares of the issue at a more favorable price Obtaining truthful information may be especially difficult when there are one or two market leaders V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

48 Investors have information that the underwriters don t have Influential investors can play a very important role in determining the success or failure of an offer Indeed, smaller investors may ignore their own information and decide whether to subscribe to an issue based on the stated opinions of market leaders Fidelity Investments decision are likely to influence the decisions of other investors since the firm buys about 10% of all newly issued shares V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

49 Investors have information that the underwriters don t have Empirical studies suggest that in the book-building method, IPOs are prices and shares are allocated as follows Investment banks underreact to information provided by investors when they price the IPOs Investors who provide more favorable information are allocated more shares Informed investors, therefore, would like to be allocated a large share of good IPOs To receive a greater allocation, investors truthfully reveal their favorable opinion of the issue V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

50 What are the long returns of IPOs? A series of academic papers have shown that long-term return to investing in IPOs is surprisingly low The shareholder return to owning a portfolio of IPOs for up to five years after the companies went public is in the range of 3 to 5% Given these returns, the terminal value of an IPO portfolio after 5 years is only 70 to 80% of the value of a portfolio that invested in all NYSE and AMEX stocks or invested in the S&P 500 Index More recent evidences suggest that when the performance of IPOs is measured relative to stocks with equivalent size and book-to-market ratios, the underperformance disappears Most IPOs can be categorized as small growth stocks and these stocks have historically extremely low returns V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

51 Hot new-issue periods IPO proceeds in the U.S. and average first-day returns, V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

52 Hot new-issue periods The degree of underpricing fluctuates sharply from year to year Why hot new-issues periods arise? Possible explanations: Investors are prone to period of excessive optimism Would-be issuers time their IPOs to coincide with these periods A fall in the cost of capital or an improvement in the economic outlook may mean that a number of new or dormant projects suddenly become profitable Entrepreneurs rush to raise new cash to invest in these projects V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

53 Other new-issue procedures The book-building method allows underwriters to set the issue price in order to offer a reward to some specific investors choose how to allocate shares between investors when rationing is necessary Before 1989 book-building was widely used in Japan before a scandal: It was revealed that investment banks had been allocating shares in hot IPOs to government officials Book-building is not the only method to sell new stock V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

54 Auctions Investors are invited to submit their bids, stating how many securities they wish to buy and the price The securities are then sold to the highest bidders Most governments, including U.S. Treasury, sell their bonds by auction In the U.S. auctions of common stock have been rare Google raised in 2004 the largest ($1.7 billion) IPO proceeds by a auction V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

55 Type of auctions Suppose the government wishes to auction 4 million bonds Three would-be buyers submit bids Investor A bids $1,020 each for 1 million bonds Investor B bids $1,000 each for 3 million bonds Investor C bids $980 each for 2 million bonds The bids of the two highest bidders (A and B) absorb all the bonds on offer and C is left empty-handed What price do the winning bidders pay? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

56 Type of auctions Discriminatory auction: every winner is required to pay the price that he bid Uniform-price auction: both winners would pay the price of the lowest winning bidder It might seen that the proceeds from a uniform-price auction would be lower than from a discriminatory auction However, uniform-price auction provides better protection against the winner s curse Bidders know that there is little cost of overbidding in a uniform-price auction But there is potentially a very high cost to doing so in a discriminatory auction Uniform-price auction should result in higher proceeds V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

57 Type of auctions Sales of bonds by U.S. Treasury used to take the form of discriminatory auctions Now it has switched to a uniform-price auction In France, Israel and Japan, auctions were commonly used to sell new issues of stock V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

58 Security sales by public companies As an already public firm grows, it is likely to make further issues of securities General Cash offers: SEO, bonds Right issues V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

59 General cash offers When a public corporation makes a general cash offer of debt or equity it goes through much the same procedure as when it first went public In 2005 the SEC created a new category of firm termed a well-known seasoned issuer (WKSI). These firms are exempt from certain filing requirements Large companies can file a single registration statement covering financing plans for up to three years into the future: self-registration the registration statement is ready and can be used as needed if the firm perceive a window of opportunity in which interest rates are temporarily low, then it can invite bids some intermediaries (investment banks) can offer to buy bonds proposing a bid V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

60 International Security Issues Companies often issue bonds in another country s domestic market In that case, the issue will be governed by the rules of that country Alternatively, the company can make an issue of eurobonds This kind of issue is underwritten by a group of international banks The issue is offered simultaneously to investors in a number of countries Very large debt issues may be sold as global bonds One part sold internationally in the eurobond market The remainder sold in the company s domestic market V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

61 International Security Issues Equity issues may be sold in foreign countries In 2006, Trina Solar, a solar power company from China raised $500 million by an IPO in the U.S. Traditionally New York has been the natural home for such issues In recent years companies have preferred to list in London or Hong Kong These stock markets have more flexible regulatory systems and fewer corporate lawsuits V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

62 The costs of a general cash offer A firm issuing securities incurs substantial administrative costs The firm also needs to compensate the underwriters by selling them securities below the price that they expect to receive from investors Underwriting spreads for debt securities are lower than for common stocks (less than 1% for many issues) Larger issues tend to have lower spreads than smaller issues This can be partly explained from fact that there are fixed costs Large issues are generally made by large companies, which are better known and easier for underwriters to monitor V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

63 The costs of a general cash offer V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

64 The costs of a general cash offer Total direct costs as a percentage of gross proceeds Total direct costs are composed of underwriter spreads and other direct costs (filing fees, legal fees, and taxes) reported in the prospectus V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

65 Market reaction to stock issues Announcement of a seasoned offering of common stock has generally result in a decline in the stock price For industrial issues in U.S. this decline amounts to about 3% This is equivalent in average to nearly a third of the new money raised by the issue What s going on here? It may be a consequence of the additional supply However the price fall does not increase with the size of the stock issue There are other plausible reasons V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

66 Managerial information Assume managers have superior information and know when the firm is overvalued They might be attempt to issue new shares of the stock when the market value exceeds the correct value Potential new shareholders are not stupid They will infer overvaluation from the new issue, thereby bidding down the stock price on the announcement date of issue V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

67 Falling earnings Investors have a reasonable fix on the firm s upcoming investments and dividend payouts Capital expenditure and future dividends are often well-known If a manager raises capital in amounts that are unexpectedly large, investors may anticipate unexpected shortfalls in future earnings Announcement of a new stock issue will also reveal a future earnings shortfall V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

68 Debt capacity A stereotypical firm chooses a debt-to-equity ratio that balances the tax shield from the debt with the cost of financial distress Assume the manager has special information that the probability of financial distress has risen The firm is then more likely to raise capital through stock than through debt If the market infers this chain of events, the stock price should fall on the announcement date of an equity issue V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

69 Rights issues An issue of common stock to existing stockholders is called a rights offering Each shareholder is issued an option to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights expire For example, a firm whose stock is selling at $30 may let current stockholders buy a fixed number of shares at $10 per share within two months Such options are called share warrants or rights V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

70 The mechanics of a rights offering The process of issuing rights differs from the process of issuing shares of stock Existing stockholders are notified that they have been given one right for each share of stock they own Exercise occurs when a shareholder sends payment to the firm s subscription agent (usually a bank) Shareholders have several choices: exercise some of the rights sell some of the rights do nothing and let the rights expire V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

71 The mechanics of a rights offering The financial manager of the issuing firm must answer the following questions: 1 What price should the existing shareholders be allowed to pay for a share of new stock? 2 How many rights will be required to purchase one share of stock? 3 What effect will the rights offering have on the existing price of the stock? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

72 Subscription price The subscription price is the price that the existing shareholders are allowed to pay for a share of stock A rational shareholder will only subscribe to the rights offering if the subscription price is below the market price Consider the example of National Power: The company has 1 million outstanding shares with current market price of $20 The company wants to raise $5 million Assume it chooses a subscription price of $10 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

73 Number of rights needed to purchase a share In order to raise $ 5 million in new equity with a subscription price of $10 it must issue 500,000 shares Stockholders typically get one right for each share of stock they own: 1 million rights will be issued The number of rights needed to buy a share of stock is thus 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

74 Effect of rights offering on price of stock Rights give the possibility to buy a share of stock that worths $20 for $10: Rights are valuable Consider a shareholder that owns 2 shares before the rights offering the shareholder s total holding is worth $40 This stockholder will receive 2 rights and thus the opportunity to purchase one additional share for $10 Assume he exercises these rights he will have three shares with value $40 + $10 = $50 The price per share would drop to $50/3 = $16.67 The value of one right must then be $16.67 $10 2 = $3.33 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

75 Effect of rights offering on price of stock The difference between the old share price of $20 and the new share price of $16.67 reflects the fact that the old shares carried rights to subscribe to the new issue The difference $20 - $16.67 = $3.33 must be equal to the value of one right V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

76 Effect of rights offering on price of stock An individual buying the stock prior to the ex-rights date will receive the rights when distributed An individual buying the stock on or after the ex-rights date will not receive the rights In our example, the price of the stock prior to the ex-rights date is $20 The price on or after the ex-rights date is $16.67 The number of the shares will increase to 1.5 million and the value of the firm will increase to $25 million An outside investor can buy 2 rights (paying $6.67) and exercise the right (paying $10) to buy one share: the total cost for one share is $16.67 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

77 Effect of rights offering on price of stock V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

78 Effect of rights offering on shareholders Shareholders can exercise their rights or sell them In either case, the stockholder will neither win nor loose by the rights offering Consider a shareholder with two shares: his holdings worth $40 If he exercises the rights he ends with three shares that worth a total of $50: he is spending $10 to increase the value of his holdings by $10 The investor is neither better nor worse off If he sells the rights he gets $6.67 cash: because the two shares worth now $16.67, the shareholder s wealth is $40 The investor is neither better nor worse off V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

79 The underwriting arrangements Undersubscription can occur if investors throw away rights or if bad news causes the market price of the stock to fall below the subscription price To insure against these possibilities, rights offering are typically arranged by standby underwriting The underwriters makes a firm commitment to purchase the unsubscribed portion of the issue at the subscription price less a fee The underwriter usually receives a standby fee as compensation for his risk-bearing function V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

80 Rights puzzle As long as the company successfully sells the new shares, the issue price in a rights offering is irrelevant That is not the case for general cash offer If the company sells stock to new shareholders for less than the market price, the buyer makes a profit at the expense of existing shareholders Consider a firm with 2 million shares each with a $50 price 1 million new shares are issued and sold $40 After the issuance, the price of a share will be $140/3 = $46.67 General cash offers are typically sold at a small discount of about 3% on the previous day s closing price Since such cost could be avoided completely by using a rights issue, it is puzzling to observe the apparent preference of companies for general cash offers V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

81 Private placements Companies can sell their securities privately A drawback of a private placement is that the investor cannot easily resell the security However, institutions such as life insurance companies invest huge amounts in corporate debt for long-term and are less concerned about its marketability It costs less to arrange a private placement than to make a public issue: this a particular advantage for companies making smaller issues In 1990 the SEC adopted Rule 144A which relaxed its restrictions on who can buy and trade unregistered securities Large financial institutions were allowed to trade unregistered securities among themselves This kind of issue was proved very popular to foreign corporations V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

82 Question In 2001 the Pandora Box Company made a rights issue at $5 a share of one new share for every four shares held Before the issue there were 10 million shares outstanding and the share price was $6 1 What was the total amount of new money raised? $12,500,000/$4 = 3,125,000 shares 2 What was the value of the right to buy one new share? 6-5/(4+1)=$ What was the prospective stock price after the issue? (10, 000, 000 6) + 12, 500, , 000, , 500, 000 = $5.85 A stockholder who previously owned four shares had stocks with a value of: (4 $6) = $24. This stockholder has now paid $5 for a fifth share so that the total value is: ($24 + $5) = $29. This stockholder now owns five shares with a value of: (5 $5.80) = $29, so that she is no better or worse off than she was before. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

83 Question In 2001 the Pandora Box Company made a rights issue at $5 a share of one new share for every four shares held Before the issue there were 10 million shares outstanding and the share price was $6 1 What was the total amount of new money raised? $12,500,000/$4 = 3,125,000 shares 2 What was the value of the right to buy one new share? 6-5/(4+1)=$ What was the prospective stock price after the issue? (10, 000, 000 6) + 12, 500, , 000, , 500, 000 = $5.85 A stockholder who previously owned four shares had stocks with a value of: (4 $6) = $24. This stockholder has now paid $5 for a fifth share so that the total value is: ($24 + $5) = $29. This stockholder now owns five shares with a value of: (5 $5.80) = $29, so that she is no better or worse off than she was before. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

84 Question In 2001 the Pandora Box Company made a rights issue at $5 a share of one new share for every four shares held Before the issue there were 10 million shares outstanding and the share price was $6 1 What was the total amount of new money raised? $12,500,000/$4 = 3,125,000 shares 2 What was the value of the right to buy one new share? 6-5/(4+1)=$ What was the prospective stock price after the issue? (10, 000, 000 6) + 12, 500, , 000, , 500, 000 = $5.85 A stockholder who previously owned four shares had stocks with a value of: (4 $6) = $24. This stockholder has now paid $5 for a fifth share so that the total value is: ($24 + $5) = $29. This stockholder now owns five shares with a value of: (5 $5.80) = $29, so that she is no better or worse off than she was before. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82

85 Question In 2001 the Pandora Box Company made a rights issue at $5 a share of one new share for every four shares held Before the issue there were 10 million shares outstanding and the share price was $6 1 What was the total amount of new money raised? $12,500,000/$4 = 3,125,000 shares 2 What was the value of the right to buy one new share? 6-5/(4+1)=$ What was the prospective stock price after the issue? (10, 000, 000 6) + 12, 500, , 000, , 500, 000 = $5.85 A stockholder who previously owned four shares had stocks with a value of: (4 $6) = $24. This stockholder has now paid $5 for a fifth share so that the total value is: ($24 + $5) = $29. This stockholder now owns five shares with a value of: (5 $5.80) = $29, so that she is no better or worse off than she was before. V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 82