REVIEW: CORPORATE FINANCE:

Transcription

1 REVIEW: CORPORATE FINANCE: TOPIC 1: RAISING CAPITAL: EQUITY: What factors do firms consider most important when deciding whether to issue equity? Maintaining our target D/E ratio Possible EPS dilution The amount by which our shares are undervalued by the market Shares are least risky source of funds Shares are our cheapest source of funds Whether our profits are sufficient to fund expenditures (not supporting the Pecking Order Theory given that it is so far down the list!) Issuing shares gives shareholders a good impression of the firm Inability to obtain debt Capital gains consequences to our shareholders The Nature of Capital: The basic resource of a company I the stream of future cashflows generated by its assets (assets being tangible assets, or parts of the company e.g. departments etc.) Companies raise external capital by issuing financial securities = claims over these cashflows A financial security evidences the rights and obligations of both the issuer and the investor The nature of Capital: Differences: Voting For ordinary equity, this is one vote per share Does this imply that debtholders cannot exert influence? No. Convenants and interest are ways of exerting influence by debtholders Return For ordinary equity, there are three ways for shareholders to generate a return: Capital gains Dividends Imputation Credits Risk Uncertain return on capital Why? i) Business risk ii) No obligation to pay dividends iii) Financial risk (when taking on any debt into capital structure) If equity is so risky, why invest in it? Higher expected returns! How do unlisted firms raise equity capital? IPOs Listing shares for the first time How do you set the price?

2 Decision by firm through help of investment bank Very often, IPOs are underpriced (see later in the lecture for the 7 reasons why) Private equity Venture capital Slop drip feed of cash Start-up/seed funding Typically staggered financing Risk is high Very risky way of funding an investment approximately 1/10 venture capital funded firms succeed Listed versus Unlisted Shares What are some of the benefits of holding listed rather than unlisted shares? Freedom of trade Improves liquidity of the stock speed and pricing influence above price ASX regulations Continuous disclosure reduction of agency costs and information asymmetry Audit How do listed firms raise new equity capital? Rights issues Private Placements Dividend Reinvestment plans Which of the above three are most common? Placements Rights Issues Other IPOs (listed firms can undertake IPOs if they are issuing previously unlisted securities rather than just ordinary equity for the first time) DRPs (essentially small rights issues) How do firms choose between the methods? Costs Direct Sending prospectus Indirect Opportunity cost Time to implement Quick? Slow? Potential transfer from old shareholders to new shareholders Cash? Voting power? INITIAL PUBLIC OFFERINGS (IPOs) IPOs are also known as floatation or an unseasoned equity offering Existing shares to new shareholders

3 NSW Government sold a 100% interest in GIO for $1.2billion by offering for sale its 500m shares to the public New shares to new shareholders CBA raised $1.3b by issuing 248 million new shares to the public diluted the Federal government s ownership by 70% Demutualisation and share issuance Where members (i.e. in a mutual society) become shareholders in a firm Listed firm has more flexibility in investment decisions than a mutual society IPOs: Determination of offer/issue price i) Fixed pricing traditional method Price is set (with the help of an investment bank), prospectus is sent out and offers are received Risks to issuer: Price is set too high and there is a large shortfall Price is set to low and there is money left on the table Under-writing (put option) Essentially guarantees all shares will be purchased (if it is fixed-basis underwriting) ii) Bookbuilding Quite common now Competitive bidding by institutional investors Advantages? Can allow for more accurate assessment of price, thus minimizing the risk of mispricing of the shares issued Open pricing: Bids taken from the market Final price is that which clears all shares Constrained open pricing: Bid range has pre-specified upper and lower bounds, otherwise essentially the same as open pricing Example: Goodman Fielder 2005 Bookbuild for institutional investors for between $1.85 and $2.00 Final price reached was $2 with scaleback in place PRIVATE PLACEMENTS: Raising cash from institutions Typically, private placements issue shares at a discount to ordinary shareholder price, but occasionally shares will be bought at a premium by institution as they can see that a positive NPV project that will be undertaken as a result of the capital raised will add value to the firm Advantages: Quick

4 No prospectus Disadvantages: Dilution in value due to discount Dilution in control Private placements: Transfer of wealth: You and 2 friends are at a bar about to drink your pint of beer, when your lecturer arrives with only a glass of beer You do the right thing and get new schooner glasses and redistribute the beer evenly amongst the four of you i.e. it is a zero sum game; dilution of original shareholder wealth law seeks to protect the old shareholders through ASX listing rule 7.1 Private placements and agency issues: Separation of ownership and control Potential conflict between existing shareholders and management ASX Listing Rule 7.1 prohibits a company from issuing more than 15% of its issued capital within a given 12 month period without first obtaining the approval of its shareholders Exceptions to this rule influence a rights issue Why? This is as in a rights issue, the old shareholders are the new shareholders (assuming all old shareholders subscribe to the issue) RIGHTS ISSUES: An offer by a company of new shares to existing shareholders at a fixed price on a pro-rata basis Each shareholder receives an entitlement to new shares at a fixed proportion of the number of the number of shares already held The issue (or offer) price is usually at a 10-30% discount to the share price at the time the issue is announced (to avoid shortfall of shares) Much longer than a private placement usually 2-3 months longer Intuition behind a rights issue: Benefit of new shares at a discount is exactly offset by dilution value of your own shares (assuming each shareholder subscribes) I.e. there is no dilution of percentage ownership if shareholders fully participate in the rights issue but inevitably there are some shareholders who do not participate (especially if the rights issue is note renounceable) Other e.g. some shareholders may have moved and not notified the company of the address change etc. Question: What is the maximum price you would pay for the right to buy a share in a company that is currently trading for $3.50 for only $2.50? Answer: Less than $1 due to dilution Rights Issues Some specifics Subscription price (s) Pro-rata entitlement (1:N)

5 Trading cum rights and ex rights Announcement date Trading cumrights Trading ex-rights Ex-rights date Payment date On the ex-rights date, there will be a drop off of R/N (i.e. the value of the right per share) Valuation: A 1:N rights issue gives the holder an entitlement to purchase 1 additional share for every N shares currently held at a price of $S R = the value of the right X = the theoretical price of the share ex-rights (TERP) M = the market price of the share cum-rights Value of the right: How much would the market pay for the right to purchase one additional share at the discounted price? N( M S) R N 1 Theoretical ex-rights price What is the value of the share once it begins trading ex-rights? NM S X N 1 Rights Issues: An example: A company has issued capital of 10million with a current market price of $3.50 per share The company wishes to raise $5m for a new investment The company makes a 1:5 rights issue with a subscription price of $2.50 per share TERP use formula Value of the right use formula Note: Reduction in share price is value of the right per share (i.e.g must account for ratio of rights issue (N)) on the ex-rights date: Important note: Companies tend to issue shares when they believe they are overvalued (i.e. sell high), thus (prior to recent economic times) an issue of equity has been perceived negatively by the market thus evidence for the Pecking Order Theory of capital structure

6 M R/N X Rights Issues: Example Suppose an investor had 1000 shares in the company prior to the rights issue Look at her position after the issue, assuming that she exercises her right to subscribe to the new shares Before After $3.50 = $3500 $3.33 = $4000 Cash = $500 Total wealth = $4000 Total wealth = $4000 Rights issues some specifics: Renounceability Most issues are renounceable; shareholders may either: Exercise rights and acquire the new shares Consequences? No change in shareholder wealth Allow the rights to lapse and do nothing Consequences? Value of share holding will decrease (due to dilution of share price as the rights issue was done at a discount) and dilution of control Sell the rights to a third party (trading rights occurs on the ASX) Consequences? This just compensates investors for not having the capital to undertake the rights issue Often companies will now sell the rights and give the proceeds to the shareholder if the shareholder lets the rights lapse, by default Question: What should theoretically happen to share price on the ex-rights date? Will fall by R/N Rights Issues: Announcement effects: Why might a share price change in response to the announcement of a rights issue? When companies issue equity, the market (often) pereceives this as a signal that the firm feels the firm is overvalued (i.e. want to sell when the price is high), thus is interpreted negatively Note, that with current market situation, the market s perception of negativity for issuing shares has decreased, but is still negative in general

7 Note: Announcement effect is entirely different mechanics to drop in right Rights issues why use them? Constraints on private placements Due diligence Cannot exercise during take-overs 15% cap on issue (without shareholder approval) Convenient source of funds Preserves voting patterns Rights issues can be costly Prospectus Underwriting Administration costs Slow! Rights issues option interpretation: The owner has the right, but not obligation to buy the new shares at a fixed price at a later date This option value is incorporated into the value of the right itself E.g. Colonial Group rights issue: Subscription price = $4.50 Payable by 13 th July 11 th June Share price = $4.53 Rights price $0.145 It is 3c in the money, but how can you explain the other 11.5c options! I.e. from a shareholder perspective, the call option that is held (because of the time value associated, and that the owner has the right but not obligation to buy the new shares at a fixed price at a later date) should not be exercised unless the dividends received from the share will outweigh the opportunity cost and the time value associated with the right Thus, often the rights price will have a time value associated with it Payoff / right price Time value (11.5c)

8 Intrinsic value (3c) Share price S = $4.50 $4.53 DIVIDEND REINVESTMENT PLANS: Use part of all of a dividend to apply for new shares with minimal transaction costs and usually at a discount (5-10%) to current market price Substantial source of capital for major companies Rationale: allows high dividend payout (to distribute imputation credits) while lessening impact on cash outflows A DRP is essentially a very small rights issue Regulatory environment: Capital raising by companies in Australia is regulated by: Corporations Law ASX Listing Rules Articles of Association (company specific) Trade Practices Act Special Legislation (industry specific) Corporations Law: Objective of the fundraising provisions of the CL is investor protection Requires full information disclosure Prohibits advertising and availability of securities except under prescribed conditions The Basic Rule: An offer of securities of a corporation must be accompanied by a prospectus unless it is an excluded offer Prospectus: Must be lodged with ASIC Markting tool/information guide CL does not specify a checklist of contents Determined by the issuer Must include all information that a reasonably careful investor might be expected to require in relation to the securities on offer and the issuer of those securities Onerous penalties for false or misleading statements in or omissions from a prospectus Excluded Offers Small scale offerings Rights Issues Sophisticated investors Large offers

9 Offers to wealth investors Executive officers and associates ASX Listing Rules All listed corporations must continue to meet certain requirements in order to be listed on ASX ASX Listing Rules include: Continuous disclosure Companies must immediately notify ASX if there is any information likely to affect the share price Rules governing how new share issues must be carried out How share registries and CHESS (Clearing House) registration must be maintained Consequences? Cost of firm Reduction of information asymmetry and agency costs Underwriting: Historically, most floats have been underwritten Between 1994 and 1999, 81.8% of floats were underwritten In 2006/07 only 26.1% were underwritten Increasing use of bookbuilding reduces need for underwriting Principal role of the underwriter is to guarantee the success of the issue Fixed basis Underwriter agrees to purchase issued shares that are not taken up by the float i.e. purchase any shortfall Thus higher fee must be paid to the underwriter Best efforts basis Underwriter simply agrees to market the shares on their best efforts such that all the issued shares will be sold, and that no shortfall occurs If shortfall does occur, then underwriter is under no obligation to purchase shares Insurance function Underwriter is required to act only if the issue is not fully subscribed Underwriting risk = risk of a shortfall Contract gives the company the right but not the obligation to sell the new shares to the underwriter at the issue price the company has bought put options on the shares Thus, underwriter takes risk Pay more for underwriting (more reputable underwriter) then sends a signal to the market that it is a good float same principal with auditing Other roles include: Distribution / management Advice Sub-underwriting Used to lay-off risk