Issuing Securities to Public

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McGraw-Hill Ryerson 2003 McGrawHill Ryerson Limited

Corporate FinanceRoss Westerfield Jaffe

Sixth Edition

19

Chapter Nineteen

Issuing Securities to the

Public

Prepared by

Gady Jacoby

University of Manitoba

and

Sebouh Aintablian

American University of

Beirut


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Executive Summary

Issuing securities involves the corporation in anumber of decisions.

This chapter looks at how corporations issue

securities to the investing public.

The basic procedure for selling debt and equity

securities are essentially the same. This chapter

focuses on equity.


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Chapter Outline

19.1 The Public Issue19.2 The Basic Procedure for a New Issue

19.3 The Cash Offer

19.4 The Announcement of New Equity and theValue of the Firm

19.5 The Cost of Issuing Securities

19.6 Rights

19.7 The Private Equity Market

19.8 Summary and Conclusions


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19.1 The Public Issue

Regulation of the securities market in Canada is carriedout by provincial commissions.

In the U.S., regulation is handled by a federal body

(SEC).

The regulators goal is to promote the efficient flow ofinformation about securities and the smooth functioning

of securities markets.

All companies listed on the TSE come under the

jurisdiction of the Ontario Securities Commission(OSC).

Other provinces have similar legislation and regulating

bodies


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19.2 The Basic Procedure for a New Issue

Steps involved in issuing securities to the public:

1. Management obtains approval from the board of directors.

2. The firm prepares a preliminaryprospectus to the OSC.

3. The OSC studies the preliminary prospectus and notifies

the company of any changes required.

4. Once the revised, final prospectus meets with the OSCs

approval, a price is determined and a full-fledged selling

effort gets under way.


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19.3 The Cash Offer

Underwriters are usually involved in a cash offer. Underwriters perform the following services:

Formulating the method used to issue the securities.

Pricing and selling the new securities. The difference between underwriters buying price

and the offering price is called the spread.

Because underwriting involves risk, underwriters

combine to form an underwriting group called asyndicate


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19.3 The Cash Offer (cont.)

Types of Underwriting: two types of underwriting areinvolved in a cash offer.

1. Regular Underwriting

firm commitment underwriting best efforts underwriting

2. Bought Deal

In a bought deal, the issuer sells the entire issue

to one investment dealer or to a group.


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The selling period: while the issue is being sold to the public,the underwriting group agrees not to sell securities for less

than the offering price until the syndicate dissolves.

The overallotment option: known as the Green Shoe

provision gives members of the underwriting group theoption to purchase additional shares at the offering price less

fees and commissions.

Investment Dealers:

In 2000, RBC Dominion Securities was the leading underwriter byrevenue.

TD securities was the first ranked by assets.


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The offering price: Determining the correct offering price is an underwriters

hardest task.

The issuing firm faces a potential cost if the offering price

is set too high or too low.Underpricing:

Underpricing is a common occurrence and it clearly helps

new shareholders earn a higher return on the shares they

buy. In the case of an IPO, underpricing reduces the proceeds

received by the original owners.


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19.4 The Announcement of New Equity

and the Value of the Firm

The market value ofexisting equity drops on theannouncement of a new issue of common stock.

Reasons include

Managerial Information

Since the managers are the insiders, perhaps they are

selling new stock because they think it is overpriced.

Debt Capacity

If the market infers that the managers are issuing newequity to reduce their debt-to-equity ratio due to the

specter of financial distress the stock price will fall.

Falling Earnings


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19.5 The Cost of Issuing Securities

1. Spread or underwriting discount2. Other direct expenses

3. Indirect expenses

4. Abnormal returns5. Underpricing

6. Green Shoe option


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The Costs of Public Offerings

Costs of Going Public in Canada: 1984--97Fees 6.00 %

Underpricing 7.88 %

TOTAL 13.88 %

The above figures understate the total cost because

they ignore indirect expenses or the overallotment

option.


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19.6 Rights

An issue of common stock offered to existingshareholders is called a rights offering.

Prior to the 1980 Bank Act, chartered banks were

required to raise equity exclusively through rights

offerings.

Ifa preemptive right is contained in the firms

articles of incorporation, the firm must offer any

new issue of common stock first to existingshareholders.

This allows shareholders to maintain their

percentage ownership if they so desire.


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Mechanics of Rights Offerings

The management of the firm must decide: The exercise price (the price existing shareholders must

pay for new shares).

How many rights will be required to purchase one new

share of stock.

These rights have value:

Shareholders can either exercise their rights or sell their

rights.


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Rights Offering Example

Popular Delusions, Inc. is proposing a rightsoffering. There are 200,000 shares outstanding

trading at $25 each. There will be 10,000 new

shares issued at a $20 subscription price.

What is the new market value of the firm?

What is the ex-rights price?

What is the value of a right?


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What is the new market value of the firm? There are 200,000 outstanding shares at $25

each.There will be 10,000 new shares issued at a

$20 subscription price.

shares

20$shares000,10

share

25$shares000,200000,200,5$


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What is the ex-rights price? There are 110,000 outstanding shares of a firm

with a market value of $5,200,000.

Thus the value of an ex-rights share is:

7619.24$shares000,210

000,200,5$

Thus the value of a right is

$0.2381 = $25$24.7619


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Theoretical Value of a Right

The theoretical value of a right during the rights-onperiod is:

R0 = (M0S) / (N +1)

Where,

M0 = Common share price during the rights-on period

S = Subscription price

N = Number of rights required to buy one new share


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Cost of Rights Offerings

Until the early 1980s, rights offerings were the mostpopular method of raising new equity in Canada for

seasoned issuers because of lower flotation costs.

In the late 1980s and early 1990s, with the rise of

POP, bought deals replaced rights offers as the

prevalent form of equity issue.


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19.7 The Private Equity Market

The previous sections of this chapter assumed that acompany is big enough, successful enough, and old

enough to raise capital in the public equity market.

There are many firms that have not reached this

stage and cannot use the public equity market.

For start-up firms and firms in financial trouble, the

public equity market is often not available.


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Private Placements

Avoid the costly procedures associated with theregistration requirements that are a part of public

issues.

The OSC and SEC restrict private placement issues

of no more than a couple of dozen knowledgeable

investors including institutions such as insurance

companies and pension funds.

The biggest drawback is that the securities cannotbe easily resold.


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Venture Capital

The limited partnership is the dominant form ofintermediation in this market.

There are five types of suppliers of venture capital:

1. Old-line wealthy families.

2. Private partnerships and corporations.3. Large industrial or financial corporations with

established venture-capital subsidiaries.

4. The federal government (through crown-relatedfirms).

5. Individuals, typically with incomes in excess of

$100,000 and net worth over $1,000,000. Often these

angels have substantial business experience and are

able to tolerate high risks.


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Stages of Financing

1. Seed-Money Stage:

Small amount of money to prove a concept or develop a product.

2. Start-UpFunds are likely to pay for marketing and product refinement.

3. First-Round Financing

Additional money to begin sales and manufacturing.4. Second-Round Financing

Funds earmarked for working capital for a firm that is currently sellingits product but still losing money.

5. Third-Round Financing

Financing for a firm that is at least breaking even and contemplatingexpansion; a.k.a. mezzanine financing.

6. Fourth-Round FinancingFinancing for a firm that is likely to go public within six months; a.k.a.

bridge financing.


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19.10 Summary and Conclusions

Larger issues have proportionately much lowercosts of issuing equity than small ones.

Firm-commitment underwriting is far moreprevalent for large issues than is best-effort

underwriting. Smaller issues probably use besteffort because of the greater uncertainty.

Rights offering are cheaper than general cash offers.

Shelf registration is a new method of issuing new

debt and equity. Venture capitalists are an increasingly important

influence in start-up firms and subsequentfinancing.

Documents

Issuing Securities to Public