LONG-TERM FINANCING Chapter 15

Alex Tajirian

Long-Term Financing

15-2

1. INTRODUCTION # Sources of Long-term Financing ! ! ! ! Equity Debt Hybrid Bank loans, and venture capital (not included)

Issuing New Securities ! Reasons " IPO (Initial Public Offering)1: Company issues equity for the first time. Finance projects: Company issues additional equity.

"

! ! !

Procedures Role of investment banks Price effects of new equity issue

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2. TYPES OF SECURITIES Equity, Debt, Hybrid, Bank Loans, and venture capital

2.0 TERMINOLOGY
! Par Value: a # assigned to stock for no good reason, usually $1. $ value of original equity offer Value of additional equity raised.

! ! !

Common Stock: Book Value:

Additional Paid-in Capital:

Common Stock + Additional Paid-in Capital + Retained Earnings

Shareholders' Voting Rights Q Q Voting: usually one share one vote Proxy Voting through management Other shareholders (proxy fight) Other Rights: Preemptive Rights Sometimes companies have a preemptive right contained in the firm's articles of incorporation. This gives existing shareholders priority in buying new equity issues.

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Classes of Stock2 A different class is usually issued with no voting rights. Thus, equity is issued without dilution.

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3. COMMON STOCK AS A SOURCE OF FUNDS

# Advantages ( ! No burden of committing CFs in the future, as compared to bonds or preferred stock. If company believes that its current stock price is over-valued (high), then it can issue fewer shares to raise the needed capital.

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Disadvantages !

Stock dilution (too many stock holders). Existing shareholders might not be able to dictate management policy. No dilution with debt. New shareholders participate in the gains from the company. Bond holders do not, since they get fixed payments (coupons + Face Value) Floatation costs of new equity are higher than new debt.

If there is no "core investor," then there is no guarantee that management will act in the best interest of shareholders. Also true for bonds, but not for bank loans.

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4. WHY GO PUBLIC
# Advantages ( ! Vulture capitalists (equity owners before going public) can now diversify their investments. Increases the ease of selling the company. Easier to raise new capital

! !

Disadvantages ; ! ! Cost of reporting to SEC Disclosure of information. Q Q Provides signals (info) to competitors Original owners might not want their net worth to be disclosed.

Agency problem

Which Exchange? Q Q Small and not well established firms: NASDAQ. Larger and more established firms: NYSE or AMEX

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5. BASIC PROCEDURES FOR A NEW ISSUE

1. 2. Obtain Approval from Board of Directors File Registration Statement with SEC Information on company to be used by prospective buyers 3. 20-Day Waiting Period File Price Amendment with SEC Provide Preliminary Prospectus (Red Herring) Place Tombstone Ad Provide a final prospectus

4.

Sell Securities to the public

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6. INVESTMENT BANKING PROCESS

1. 2. 3. Firm determines $ to be raised, or IPO How to sell them: public offering, direct sale, private placement If public offering, select a lead investment bank ! ! competitive bid negotiated deal price at which investment banks buy the shares from the company; discount from price offered to public 4. Lead Investment Banks' Responsibility # # Types of securities to be issued Quantity: How much obligated to sell? ! ! # # best effort firm commitment: investment banks buy entire issue at a discounted price

Price of new offering Offering to Public ! ! Lead underwriter Underwriting syndicate Q Q price risk: if market price drops below offer price easier to sell entire offer

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INVESTMENT BANKING PROCESS

Issuing Firm
Type of offer

Shelf Register

Public Offering

Direct sale

Private Placement

Selecting Investment Bank

Negotiated Offer

Competitive Bid

Type of Agreement

Best effort

Underwriting

Underwriting Syndicate

Investment Bank 1

Lead Banker

Investment Bank N

Selling Group Ultimate investor

Investors
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Alex Tajirian

Few

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7. SEASONED EQUITY SALES AND VALUE OF FIRM Puzzle 5 : Price of stock generally decreases after a new issue. Plausible Reasons ! Investors might think that management would only issue new equity if they (managers) believe that the stock price is currently high. Investors might think that company already has too much debt, and that is why management is resorting to the more expensive equity issue. Issue costs are high. Thus, price falls.

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Long-Term Financing

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Best Effort v. Firm Commitment

Gross Proceeds

Total # of Offerings

# of Firm Commitment

# of Best Efforts

Fraction of best efforts

$ 100,0001,999,999 2,000,0003,999,999 4,000,00015,999,999 6,000,0009,999,999 10,000,000120,174,195 All Offerings

Source:

243 311

68 165

175 146

0.720 0.469

156 137

133 122

23 15

0.147 0.109

180

176

0.022

1,027

664

363

0.353

J. R. Ritter, "The Costs of Going Public," Journal of Financial Economics 19 (1987).

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Long-Term Financing Some IPO Costs (floatation costs)

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Firm commitment offerings Gross Proceeds ($million) (1) Underwriter discount (%) 9.84% 9.83 9.10 8.03 7.24 8.67 (2) Other expenses (%) 9.64% 7.60 5.67 4.31 2.10 5.36 (3) Total direct discount (1)+(2) 19.48% 17.43 14.77 12.34 9.34 14.03 (4) underpricing (%) 26.92% 20.70 12.57 8.99 10.32 14.80 (6) Underwriting discount (%) 10.63% 10.00 9.86 9.80 8.03 10.26 (7) Other expenses (%) 9.52% 6.21 3.71 3.42 2.40 7.48

Best effort offerings (8) Total direct discount (6)+(7) 20.15% 16.21 13.57 13.22 10.43 17.74 (9) Underpricing (%) 39.62% 63.41 26.82 40.79 -5.42 47.78 (10) Total expenses (%) 31.89% 36.28 14.49 25.97 -0.17 31.87

(5)Total expenses (%) 31.73% 24.93 20.90 17.85 16.27 21.22

1-1.999 2-3.999 4-5.999 6-9.999 10120.174 All offerings

Less than 25 observations Source. ibid.

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Illustration:
Given: IPO subscription price (primary market) = $14, underwriter discount = 9%, underpricing = 50%, over-subscription = 3.

Implications: ! Investment banker buys entire subscription at 9% discount Y = ($14)(100% - discount) = (14)(100 - 9)= (14)(91%) = (14)(.91) ! ! Investment banker sells to subscribers (primary market) at $14 On day of stock going public, if underpricing is 50%, Y price jumps (in secondary market) by (.5)($14) = $14 + underpricing = 14 + 7 = $21. Thus, firm should in principle get the ($21 - discount) as opposed to ($14 - discount). Each subscriber receives 33.3% of subscription.

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PLAUSIBLE EXPLANATION OF UNDER-PRICING: winner's curse Assume two types of IPO investors: Informed (institutional investors): 1,000 shares Uninformed (average investors): 100 shares Case 1: Case 2: deal "attractive" Y over-subscription (2 times) Y each receives 50% of desired shares. deal "un-attractive" Yinformed investor stays out Y average investor gets 100% of "un-attractive" deal Y average investor at disadvantage (winner's curse).

Solution: To induce average investor to participate, IPO are under-priced so as to avoid "winner's curse."

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8. FIVE CONCLUSIONS ON FLOATATION COSTS 1. There are substantial economies of scale in issuing securities.

2.

Best effort cost more than firm commitments. Since mostly smaller firms: Q more research on firm is needed Q harder to sell

3.

For smaller issues, the cost of underpricing may exceed direct issue cost. Underpricing is more severe for "best efforts" than for "firm commitments." It costs more to float an IPO than a seasoned offering.

4.

5.

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9. ENDNOTES
1. For recent IPOs, see LAT 7/26/92 p.E170,9/23/92 p. E168, Robert Mondavi SFC 4/24/93 p. E173, and WSJ 1/4/93 p. E175. 2. For a new "smoke-free" class, see FT 3/3/93 p. E167.

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Long-Term Financing

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10. QUESTIONS True/False-Explain

1. Investment banks always have to sell the entire subscription of new equity.

2.

In large issues, there are more than one investment bank.

3.

After a new equity issue, a firm's stock price generally decreases.

4.

Old bondholders suffer from an IPO.

5.

Firms choose their investment banker based on competitive bids.

6. 7.

IPOs have historically been underpriced. If a company needs external financing, for management to avoid losing voting control, the company has no choice but to issue debt.. From the company's view, "best effort" is cheaper than "firm commitment". Stock repurchase has no advantage over regular dividend. New equity can only be issued through an investment banker. In a "best effort" equity issue, investment banks charge different prices to different clients for the same issue.

8. 9. 10. 11.

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Alex Tajirian

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11.0 ANSWERS TO QUESTIONS True/False-Explain

1. 2. False. Not if it is based on best effort. True. (a) (b) One investment bank cannot sell the entire issue. Risk of price of stock going down. Thus, they share this risk if there are more than one investment bank.

3. 4.

True. see notes p. 418. False. There are no bond holders prior to an IPO. Publicly traded equity is being issued for the first time. False. A more common, and less expensive, method is a "negotiated deal." True. Empirical evidence (p. 420) so indicates. Moreover, in some instances, underpricing has exceeded floatation costs. False. The firm can issue either a new class of equity with no voting power, preferred stock, or borrow from a bank. False. This might be counter intuitive! "Best effort" is usually associated with relatively unknown small companies. Investment bankers need to spend more time gathering information and researching the firm. Moreover, they are harder to sell, since the public does not know much about them. Thus, investment bankers charge more to compensate for their extra effort. False. The advantage of stock repurchase is that the firm does not commit itself to any future dividends. False. The firm can go directly to the general public or go through a private placement. False. No Way! Their clients would be all over them!

5. 6.

7.

8.

9.

10. 11.

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Alex Tajirian