JEM034 Corporate Finance Winter Semester 2017/2018 Lecture #8 Olga Bychkova
Topics Covered Today Overview of corporate financing (chapter 14 in BMA) How corporations issue securities (chapter 15 in BMA) Payout policy (chapter 16 in BMA)
Overview of Corporate Financing Financial Manager Questions 1. Should the company borrow short term or long term? 2. Should the debt be fixed or floating? 3. Should you borrow dollars or some other currency? 4. What promises should you make to the lender? 5. Should you issue straight or convertible bonds?
Patterns of Corporate Financing Firms may raise funds from external sources or plow back profits rather than distribute them to shareholders. Should a firm elect external financing, they may choose between debt or equity sources.
Stock Preferred Stock Stock that takes priority over common stock in regards to dividends. Floating Rate Preferred Stock Preferred stock paying dividends that vary with short term interest rates.
Corporate Financing: Problem 6, Chapter 14 of BMA Textbook In 2008 Pfizer had 12,000 million shares of common stock authorized, 8,863 million in issue, and 6,746 million outstanding (rounded to millions). Its equity account was as follows (all values are in $ million): (a) What was the par value of each share? Par value = common stock number of issued shares = $443 million 8, 863 million = $0.05.
Corporate Financing: Problem 6, Chapter 14 of BMA Textbook (b) What was the average price at which shares were sold? Price = = common stock + additional paid in capital number of issued shares $443 million + $70, 283 million 8, 863 million (c) How many shares have been repurchased? = $7.98. = Number of repurchased shares = = number of issued shares number of outstanding shares = = 8, 863 million 6, 746 million = 2, 117 million.
Corporate Financing: Problem 6, Chapter 14 of BMA Textbook (d) What was the average price at which shares were repurchased? Repurchase price = = treasury stock number of repurchased shares = $57, 391 million 2, 117 million = $27.11. (e) What was the net book value of Pfizer s common equity? Net common equity = = common stock + additional paid in capital + + retained earnings treasury stock = = $443 million + $70, 283 million + + $44, 148 million $57, 391 million = $57, 483 million.
Corporate Financing: Problem 12, Chapter 14 of BMA Textbook Which of the following features would increase the value of a corporate bond? Which would reduce its value? (a) The borrower has the option to repay the loan before maturity. Less valuable. (b) The bond is convertible into shares. More valuable. (c) The bond is secured by a mortgage on real estate. valuable. (d) The bond is subordinated. Less valuable. More
Phases in Firm Development and Their Financing Implications
Initial Offering Initial Public Offering (IPO) First offering of stock to the general public. Underwriter Firm that buys an issue of securities from a company and resells it to the public. Spread Difference between public offer price and price paid by underwriter. Prospectus Formal summary that provides information on an issue of securities. Underpricing Issuing securities at an offering price set below the true value of the security.
Average Initial IPO Returns
Motives for an IPO Percent of CFOs who strongly agree with the reason for an IPO
Total Direct Costs of Raising Capital
Issuance of Securities: Problem 14, Chapter 15 of BMA Textbook In 2011 the Pandora Box Company made a rights issue at e5 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 e6. (a) What was the total amount of new money raised? e5 10 million 4 = e12.5 million. (b) What was the value (per share) of the right to participate in the issue? Value of right = rights on price issue price N + 1 = e6 e5 4 + 1 = e0.2.
Issuance of Securities: Problem 14, Chapter 15 of BMA Textbook (c) What was the expected stock price after the issue? Stock price = 10 million e6 + 2.5 million e5 10 million + 2.5 million = e5.8. A stockholder, who previously owned four shares, had stocks with a value of: 4 e6 = e24. This stockholder has now paid e5 for a fifth share so that the total value is: e24 + e5 = e29. This stockholder now owns five shares with a value of: 5 e5.8 = e29, so that he is no better or worse off than he was before. (d) How far could the total value of the company fall before shareholders would be unwilling to exercise their right? The share price would have to fall to the issue price per share, or e5 per share. Firm value would then be: 10 million e5 = e50 million.
Issuance of Securities: Problem 15, Chapter 15 of BMA Textbook Suppose that the company had decided to issue new stock at e4. How many new shares would it have needed to sell to raise the same sum of money? Recalculate the answers to questions (b) and (c) in the previous problem. Show that the shareholders are just as well off if the company issues the shares at e4 rather than e5. Number of new shares = e12.5 million e4 = 3.125 million. 10 million N = = 3.2 rights per share. 3.125 million rights on price issue price e6 e4 Value of right = = N + 1 3.2 + 1 = e0.48.
Issuance of Securities: Problem 15, Chapter 15 of BMA Textbook Stock price = 10 million e6 + e12.5 million 10 million + 3.125 million = e5.52. A stockholder who previously owned 3.2 shares had stocks with a value of: 3.2 e6 = e19.2. This stockholder has now paid e4 for an additional share, so that the total value is: e19.2 + e4 = e23.2. This stockholder now owns 4.2 shares with a value of: 4.2 e5.52 = e23.18 (difference due to rounding).
Payout Policy: Topics Covered Dividend decision vs. investment/capital structure decision. Facts about payout. How firms pay dividends and repurchase stock How do companies decide on payouts? The information in dividends and stock repurchases. The payout controversy.
Dividend Payments Mechanics
Types of Dividends Cash Dividend Regular Cash Dividend Special Cash Dividend Stock Dividend Stock Repurchase (4 methods) 1. Buy shares on the market 2. Tender offer to shareholders 3. Dutch auction 4. Private negotiation (Green Mail)
The Payout Decision Dividend Decision Survey Executives who agree or strongly agree (%)
The Payout Decision 1. Managers are reluctant to make dividend changes that may have to be reversed. They are particularly worried about having to rescind a dividend increase and, if necessary, would choose to raise new funds to maintain the payout. 2. To avoid the risk of a reduction in payout, managers smooth dividends. Consequently, dividend changes follow shifts in long run sustainable earnings. Transitory earnings changes are unlikely to affect dividend payouts. 3. Managers focus more on dividend changes than on absolute levels. Thus paying a $2 dividend is an important financial decision if last year s dividend was $1, but no big deal if last year s dividend was $2.
Dividend Policy Controversy Dividends increase value some investors prefer cash flows, dividends save transaction costs, avoid legal issues (endowments cannot spend capital) do not affect value Miller and Modigliani (1961) proved that dividend policy is irrelevant in a world without taxes, transaction costs, and other market imperfections decrease value dividends taxed more than capital gains, if company were to issue stock to finance dividends it would need to pay transaction costs
Dividend Policy Irrelevant? This firm pays out a third of its worth as a dividend and raises the money by selling new shares. The transfer of value to the new stockholders is equal to the dividend payment. The total value of the firm is unaffected.
Dividend Policy Irrelevant? Two ways of raising cash for the firm s original shareholders. In each case the cash received is offset by a decline in the value of the old stockholders claim on the firm. If the firm pays a dividend, each share is worth less because more shares have to be issued against the firm s assets. If the old stockholders sell some of their shares, each share is worth the same but the old stockholders have fewer shares.
Dividends Increase Value Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company s good fortune and its manager s confidence in future cash flows.
Dividends Decrease Value Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.
Payout Policy: Problem 6, Chapter 16 of BMA Textbook Here are key financial data for House of Herring, Inc.: House of Herring plans to pay the entire dividend early in January 2016. All corporate and personal taxes were repealed in 2014. (a) Other things equal, what will be House of Herring s stock price after the planned dividend payout? Stock price = $130 $2.75 = $127.25.
Payout Policy: Problem 6, Chapter 16 of BMA Textbook (b) Suppose the company cancels the dividend and announces that it will use the money saved to repurchase shares. What happens to the stock price on the announcement date? Assume that investors learn nothing about the company s prospects from the announcement. How many shares will the company need to repurchase? Nothing; the stock price will stay at $130. 40 million $2.75 $130 = 846, 154 shares will be repurchased.
Payout Policy: Problem 6, Chapter 16 of BMA Textbook (c) Suppose the company increases dividends to $5.5 per share and then issues new shares to recoup the extra cash paid out as dividends. What happens to the with and ex dividend share prices? How many shares will need to be issued? Again, assume investors learn nothing from the announcement about House of Herring s prospects. The with dividend price stays at $130. Ex dividend price drops to $130 $5.5 = $124.5. 40 million ($5.5 $2.75) $124.5 = 883, 534 shares will be issued.