1

Equity and Debt

First some revision

2

Debt /Equity

• Can the Value of the company be affected by changing the proportions of debt and equity used to finance the company?

i.e. if debt is 7% and equity 12% then1. 30%Debt and 70% equity Wacc = .3 x 7 + .7 x 12 = 2.1 + 8.4 = 10.5 Will2. 50% debt and 50% equity Wacc = .5 x 7 + .5 x 12 = 3.5 + 6 = 9.5 or

3

Debt /Equity

Or Will the increased risk cause the required rate of return on equity to rise such that there is no advantage?

.5 x 7 + .5 x 14 =

3.5 + 7 = 10.5

4

Debt /Equity

• Argument continued until Modigliani and Miller on assumption of perfect markets, with the arbitrage proof, proved that a company cannot add value by doing something, borrow money, that a shareholder could do for themselves.

• Value only comes from what is produced, not how it is financed

5

Debt /Equity

• But reintroduce some imperfections,

bankruptcy costs, financial distress and so on but mainly

• Tax

• Assuming taxable income and therefore a tax shield then -

6

Debt /Equity

CoA CoBEBIT 805 805Int 105 ___EBT 700 805Tax @ 40% 280 322 420 483

Capital Equity 3,500 5,000 Debt 1,500 @ 7% -ROE = 420/3,500 = 12% 483/5,000 = 9.7%

7

Debt /Equity

• What if interest taken after tax? EBIT 805 Tax @ 40% 322 EBI 483 Int 105 Net 378 378/3,500 = 10.8% 12 – 10.8 = 1.2% And 105 x .4 = 42 and 42/3,500 = 1.2% So extra 1.2% a gift from the government

8

Debt /Equity

• Increase debt to 50% stil at 7% EBIT 805 Int 175 EBT 630 Tax 252 Net 378 378/2,500 = 15.12% But if required return = 14% then 378/.14 = 2,700

9

Debt /Equity

• So a decision to be madeHow much debt and how much equity?- Industry norms- Coverage ratios- Asset types- Non debt tax shields- Size- Earnings volatility

10

Equity

• Sources of equity

• Angels, Venture capital, Institutional Investors, Corporate investors

• Focus on IPO’s

Initial Public Offering or Flotation

11

Equity

• Primary and Secondary Offerings

– Primary Offering• New shares available in a public offering that raise

new capital

– Secondary Offering• Shares sold by existing shareholders in an equity

offering

12

Equity• PREFERRED STOCK • DEFINITION

Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred stock is that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible. also called preference shares.

• This content can be found on the following page:• http://www.investorwords.com/3778/preferred_stock.html

13

Equity

• Reasons for listing Liquidity Better access to capital But investors more widely dispersed so Agency issues.

The firm must satisfy all of the requirements of public companies.

• SEC filings, Sarbanes-Oxley, Stock Exchange Listings etc.

14

Equity

• Procedure similar in UK and USA• Appointment of lead manager/ underwriter• Lead manager will pull together a syndicate.

Multinational IPO’s may have as many as three syndicates to cover e.g. UK and Europe, USA and Canada, Far East.

• Legal advisors• Lead managers will market the IPO• Roadshows, • Lead manager will be involved in advising on

price.

15

Equity

• Lead manager will be involved in advising on price.• Price arrived at by• 1) NPV methodology or• 2) Using comparables• A company that is planning an IPO appoints lead

managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building.

16

Equity

• Process• During the fixed period of time for which the subscription

is open, the book runner collects bids from investors at various prices, between the floor price and the cap price. Bids can be revised by the bidder before the book closes. The process aims at tapping both wholesale and retail investors. The final issue price is not determined until the end of the process when the book has closed. After the close of the book building period, the book runner evaluates the collected bids on the basis of certain evaluation criteria and sets the final issue price.

• If demand is high enough, the book can be oversubscribed. In these case the greenshoe option is triggered.

17

Equity

Methods of selling - Best efforts basis Underwriter does not guarantee that all the stock will be sold. May have an - All or None contract - Firm commitment Where the underwriter guarantees the sale of the shares at the offer price and will purchase all of the shares. If the price drops they are in trouble - Bought deal - Auction

18

Equity• In the business of initial public offering, the underwriting contract is the contract

between the underwriter and the issuer of the common stock. the following types of underwriting contracts are most common.[1]

• In the firm commitment contract the underwriter guarantees the same of the issued stock at the agreed-upon price. For the issuer, it is the safest but the most expensive type of the contracts, since the underwriter takes the risk of sale.[1]

• In the best efforts contract the underwriter agrees to sell as many shares as possible at the agreed-upon price. [1]

• Under the all-or-none contract the underwriter agrees either to sell the entire offering or to cancel the deal. [1]

• Stand-by underwriting, also known as strict underwriting or old-fashioned underwriting is a form of stock insurance: the issuer contracts the underwriter for the latter to purchase the shares the issuer failed to sell under stockholders' subscription and applications. [2]

• [edit] References• ^ a b c d "The Investment Banking Handbook" by J. Peter Williamson, 1988,

ISBN 0471815624 , ""Underwriting Contracts", p. 128 • ^ "The Law of Securities Regulation" by Thomas Lee Hazen, 1996, ISBN

0314085874, p. 405. • Retrieved from "http://en.wikipedia.org/wiki/Underwriting_contract"

19

Equity• A bought deal occurs when an underwriter, such as an investment bank or a

syndicate, purchases securities from an issuer before selling them to the public. The investment bank (or underwriter) acts as principal rather than agent and thus actually "goes long" in the security. The bank negotiates a price with the issuer (usually at a discount to the current market price, if applicable).

• The advantage of the bought deal from the issuer's perspective is that they do not have to worry about financing risk (the risk that the financing can only be done at a discount too steep to market price.) This is in contrast to a , where the underwriters have to "market" the offering to prospective buyers, only after which the price is set.

• The advantages of the bought deal from the underwriter's perspective include:• Bought deals are usually priced at a larger discount to market than fully marketed

deals, and thus may be easier to sell; and • The issuer/client may only be willing to do a deal if it is bought (as it eliminates

execution or market risk.) • The disadvantage of the bought deal from the underwriter's perspective is that if it

cannot sell the securities, it must hold them. This is usually the result of the market price falling below the issue price, which means the underwriter loses money. The underwriter also uses up its capital, which would probably otherwise be put to better use (given sell-side investment banks are not usually in the business of buying new issues of securities.)

20

Equity

• Best-Efforts, Firm Commitment and Auction IPOs

– Auction IPO

• A method of selling new issues directly to the public

– Rather than setting a price itself and then allocating shares to buyers, the underwriter in an auction IPO takes bids from investors and then sets the price that clears the market.

21

EquityExample 23.2

22

EquityThe Mechanics of an IPO

• Underwriters and the Syndicate

– Lead Underwriter• The primary investment banking firm responsible

for managing a security issuance

– Syndicate• A group of underwriters who jointly underwrite and

distribute a security issuance

23

EquityThe Mechanics of an IPO (cont'd)

• SEC Filings

– Registration Statement• A legal document that provides financial and other

information about a company to investors prior to a security issuance

– Preliminary Prospectus (Red Herring)• Part of the registration statement prepared by a

company prior to an IPO that is circulated to investors before the stock is offered

24

EquityThe Mechanics of an IPO (cont'd)

• SEC Filings

– Final Prospectus

• Part of the final registration statement prepared by a company prior to an IPO that contains all the details of the offering, including the number of shares offered and the offer price

25

EquityThe Mechanics of an IPO (cont'd)

• Valuation

– There are two ways to value a company.

• Compute the present value of the estimated future cash flows.

• Estimate the value by examining comparables (recent IPOs).

26

EquityExample 23.3

27

EquityExample 23.3 (cont'd)

28

EquityGreenshoe Provision

• Allows the underwriter to issue more shares up to an agreed %

• E.g. Issue 3,000,000 at 12.50 Greenshoe provision 15% or 450,000Short sell full 3,450,000If successful and price met then exercise

Greenshoe provisionIf unsuccessful then can fulfil obligation by

purchasing in the market with the benefit that this will provide some support for the price

29

EquityIPO Puzzles

• Underpricing

– Generally, underwriters set the issue price so that the average first-day return is positive.

• As mentioned previously, research has found that 75% of first-day returns are positive.

• The average first day return in the United States is 18.3%.

30

EquityIPO Puzzles (cont'd)

• Underpricing

– The underwriters benefit from the underpricing as it allows them to manage their risk.

– The pre-IPO shareholders bear the cost of underpricing. In effect, these owners are selling stock in their firm for less than they could get in the aftermarket.

31

Figure 23.3 International Comparison of First Day IPO Returns

32

EquityIPO Puzzles (cont'd)

• Underpricing

– Although IPO returns are attractive, all investors cannot earn these returns.

• When an IPO goes well, the demand for the stock exceeds the supply. Thus the allocation of shares for each investor is rationed.

• When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely.

– Thus, the typical investor will have their investment in “good” IPOs rationed while fully investing in “bad” IPOs.

33

EquityCyclicality of IPOs

• The number of issues is highly cyclical.

– When times are good, the market is flooded with new issues; when times are bad, the number of issues dries up.

Figure 23.4 Cyclicality of Initial Public Offerings

in the United States,

(1975–2004)

35

EquityCosts of Issuing an IPO

• A typical spread is 7% of the issue price.

– By most standards this fee is large, especially considering the additional cost to the firm associated with underpricing.

– It is puzzling that there seems to be a lack of sensitivity of fees to issue size.

• One possible explanation is that by charging lower fees, an underwriter may risk signaling that it is not the same quality as its higher-priced competitors.

36

Figure 23.5 Relative Costs of Issuing Securities

37

EquityLong-Run Underperformance

• Although shares of IPOs generally perform

very well immediately following the public offering, it has been shown that newly listed firms subsequently appear to perform relatively poorly over the following three to five years after their IPOs.

38

EquityThe Seasoned Equity Offering

• Seasoned Equity Offering (SEO)

– When a public company offers new shares for sale

• Public firms use SEOs to raise additional equity.

• When a firm issues stock using an SEO, it follows many of the same steps as for an IPO.

– The main difference is that a market price for the stock already exists, so the price-setting process is not necessary.

39

EquityThe Mechanics of an SEO

• Primary Shares– New shares issued by a company in an equity

offering

• Secondary Shares– Shares sold by existing shareholders in an

equity offering

• Tombstones– A newspaper advertisement in which an

underwriter advertises a security issuance

40

EquityThe Mechanics of an SEO (cont'd)

• There are two types of seasoned equity offerings.

– Cash Offer• A type of SEO in which a firm offers the new shares

to investors at large

– Rights Offer• A type of SEO in which a firm offers the new shares

only to existing shareholders– Rights offers protect existing shareholders from

underpricing.

41

Equity

Price Reaction

• Researchers have found that, on average, the market greets the news of an SEO with a price decline.

– This is consistent with the adverse selection discussed in Chapter 16.

42

Figure 23.7 Post-SEO Performance

43

Equity

Costs

• Although not as costly as IPOs, seasoned offerings are still expensive.

– Underwriting fees amount to 5% of the proceeds of the issue.

• Rights offers have lower costs than cash offers.

44

Equity

Any Questions?