Long-Term Financing
I. Equity issues - general
II. Dilution issues
III. Initial public offerings
IV. Rights offerings
V. Long term debt issues
Why issue stock
Advantages:
• firm not committed to fixed payout (repayment)
• increases collateral for bondholders - makes debt more valuable and reduces its cost
• may allow for a reserve of borrowing power
• may move firm toward its optimal capital structure
Disadvantages:
• Give up some control
• Flotation costs are higher than for debt (3.5 - 22% v. 1 - 14%); commissions & other expenses
• Dividends not deductible
• Could be more than optimal capital structure
• Dilution ????????? (share value w/ new s/h)
Dilution
• Ownership (control)
• Earnings per share
• Value
Example of Dilution (Value & EPS)
Suppose we have a company with the following characteristics. (For simplicity assume this company has no debt.)
• $5,000,000 earnings forever (i.e., a perpetuity)
• Re = 10%
• 1,000,000 shares outstanding
Thus:
• Value of firm = 5,000,000/10% = $50,000,000
• Value per share = $50
• EPS = $5,000,000 / 1,000,000 = $5.00
Case 1a:
Now, suppose the firm has a new project it needs to finance, and that it plans to do so with equity.
• I0 = $5,000,000 (amount of investment)
• Risk ==> Re = 10%
• The investment generates $400,000 earnings forever
Suppose firm sells 100,000 shares at current price of $50
• Raises 5,000,000
• Shares O/S = 1,100,000
• Earnings = 5,400,000
• EPS = 5,400,000 / 1,100,000 = $4.91 < $5.00
• Value of firm = 5,400,000 / 10% = $54,000,000
• Price / share = 54,000,000 / 1,100,000 = $49.09
••• Is this dilution?? EPS & share price lower
••• Yes, but why?;
The project has a negative NPV!
••• NPV = (1,000,000) ======> Cost = $5,000,000; PV of inflows = $4,000,000
••• (1,000,000) / 1,100,000 = $0.91 loss on all shares
•• $1 / share loss on project for old s/h + $.09 gain from new S/H paying too much
Now note: The loss on the project is being shared with new S/H. Will new S/H pay $50 for shares shortly to be worth $49.09?? ===> No!!
(Homework Consider the effect of selling 111,111 new shares @ $45 to raise the new equity)
Case 1b: What will new shareholders pay?
• Have to raise $5,000,000
• Let Pn = price of new shares
• Let Nn = # new shares; No = # old shares
Now, what is value of firm:
• Value Vf = 5,400,000 / 10% = $54,000,000
We know that:
1. Pn * Nn = $5,000,000 (Price per share times number of new shares has to equal the $5,000,000 we are trying to raise)
Pn = 5,000,000 / Nn
2.(Nn + No)*Pn = $54,000,000 (The number of old shares plus the number of new shares, that is total shares O/S, times the price has to equal the total value of the firm.
We have two equations and two unkowns. The two unknowns are Pn and Nn. Just plug in Pn from equation 1 into equation 2.
(Nn + 1,000,000)*Pn = $54,000,000 ======> (Nn + 1,000,000)*5,000,000/Nn = 54,000,000
Nn = 5,000,000*1,000,000 / 49,000,000
Nn = 102,041 shares
Pn = 5,000,000 / 102,041 = $49
Thus:
• Earnings = 5,400,000
• EPS = 5,400,000 / 1,102,041 = $4.90
• Vf = $54,000,000 as before
• Value per share = $54,000,000 / 1,102,041 = $49.00
===> old S/H lose $1 per share
• = $1,000,000 in total
• = negative npv amount
===> new S/H always pay fair price (price protect themselves)
===> all of change in NPV is borne by existing S/H.
Of course, we could have gotten Pn and Nn much more easily by understanding that new S/H will pay fair value, and the that fair price per share is $49, or the original $50 minus the $1 per share negative NPV. Then simply divide this fair price into the amount to be raised, $5,000,000, to get the number of new shares.
Case 2:
• I0 = $5,000,000
• Earnings = 550,000
• Risk ==> Re = 10%
What will new S/H pay?
1. Pn * Nn = $5,000,000
2. Vf = 5,550,000 / 10% = 55,500,000; thus,
(Nn + 1,000,000)*Pn = $55,000,000
• Nn = 5mm*1mm / 50.5mm = 99,010 shares
• Pn = 5,000,000 / 99,010 = $50.50
Thus:
• Earnings = 5,550,000
• EPS = 5,550,000 / 1,099,010 = $5.05
• Vf = 5,550,000 / 10% = $55,500,000
• Vf per share = $50.50
===> old S/H gain $0.50 per share
= 500,000 total
= amount of NPV
===> new S/H pay fair price (paid 50.50 for something worth 50.50)
===> old S/H get all of NPV
Where is dilution? EPS & share value increased!
Case 3:
• Io = $5,000,000
• Earnings = 500,000
• Risk ==> ke = 10%
What will new S/H pay??
1. Pn * Nn = $5,000,000
2. (Nn + 1,000,000)*Pn = 55,000,000 = value of firm
• Pn = $50.00
• Nn = 100,000
===> No effect on share price why?
In summary
1. New s/h pay fair price
2. All of project's NPV goes to old S/H. New S/H 'price protect' themselves.
3. No earnings dilution unless:
a. New S/H pay less than fair value
b. Negative npv project (or both)
Initial public offerings
Life cycle of company:
• Small, with one or two owners
• Perhaps original owners put up more capital or get bank loan
• Venture Capital financing
- Value added financing
- Add management, marketing, financial and other expertise
- Reputation; experience; exit strategy
• Initial Public Offering (IPO) - is where a previously private corporation issues shares to the public at large for the first time
Why go public?
1. Stockholder diversification - initial owners have all their own cash tied up in corp.;
2. Establishes a value for shares - market price of shares is determined; shares more liquid
3. Makes it easier to raise cash - if not public, have to raise from existing owners or go public
Disadvantages
1. Disclosure requirements -
• Accounting / reporting to SEC, S/H's, etc
• Valuable co. Info.; Profitability; S/H wealth
2. Control - relinquish some control to outsiders; market for corporate control is heated today
How does a firm go public?
1. Determine how much capital to raise -
• long range business plan
• pro forma f/s
• cash budget
2. Line up an investment banker -
• negotiated - sit down and select yourself
• competitive bids - allow IB's to bid; offer a block to the highest bidder
Major factor - reputation capital -
• What is firm's experience in underwriting (very complicated & involved)
• Pricing reputation - under or over pricing?
Competitive is cheaper, but more firms use negotiated: (monitoring - IB does more due diligence)
3. Best efforts v. Firm commitment:
Best efforts - IB offers to sell as many securities as possible at the predetermined price
• usually all or none type deal
• speculative firms tend to use
• more costly - risk and underpricing
Firm commitment - the ib guarantees a certain amount of proceeds to the company
• risk is on side of IB (except pricing decision is night before typically)
• firm knows how much it will get
4. File registration statement with SEC
5. Determine the offering price:
• usually done night before
• IB issues red herring - to drum up interest & estimate demand
• Overallotment agreement - gives ib option to purchase an additional amount of the shares
Costs: difference between offering price and proceeds to company; the costs, as a percentage of the amount raised, vary inversely with the size of the offering due to fixed costs. These costs, enumerated below, ranged from 13.2% of proceeds for the larger offerings, to 33.3% for the smaller offerings.
• commissions (5.2% for larger to 9.0% for smaller)
• other expenses (accts, attorneys, etc) (.51% for larger to 7.9% for smaller)
• underpricing - (7.5% for larger to 16.36% for smaller)
• closing price - offering price
• dilutes interest of original owner; new owners get shares at a bargain price
Explanation for underpricing:
• Adverse selection - for uninformed investor there is higher probability of getting overvalued shares (get more of what you don't want); informed investor only submits orders for undervalued.
• in order for uninformed to submit orders, on avg they must earn risk adjusted return
Example: Home Shopping Network; YAHOO
Shelf registration: a company registers with the SEC all securities it expects to sell in the next 3 years. Can then issue immediately.
• gives management a timing option
Rights offerings
• gives existing S/H the right to buy
• x # of new shares for each y shares currently held
• at a given price
Example:
Suppose: 1,000,000 shares O/S, current mkt price = $30
• Consider a rights issue where for each 5 shares you own, you are entitled to buy 1 share at a price of $25
• suppose you initially own 5 shares
• initial value of holding: 5*30 + 25 = $175
If all exercised:
• 1,200,000 shares o/s
• total value = 30,000,000 + 5,000,000 = 35,000,000
• value per share = 35,000,000/1,200,000 = $29.17
• the $30 share is called a rights-on share
• the 29.17 share is an ex-rights share
• value of right = 0.83
• total value of your holding = 6*29.17 = 175.00
= 5*30 + 25 = initial value of holding
Note:
1.Could structure in any way; ie, one right for each share, etc.
2. Does the issue price matter? If ALL are exercised, the rights price does not matter. However, in order to induce everyone to exercise, the offering price must be set sufficiently below the current market price.
Suppose:
• issue 1 right for each share owned at price of $5
• raise the same 5,000,000 as before; issue 1,000,000 shs
• total value of firm = 3,500,000
• value per share = 3,500,000/2,000,000 = $17.50
• total value of holding = 10 shares * 17.50 = 175.00
Bottom line:
• Determine how much you want to raise
• Set issue price low enough so all are exercised
• Costs are much lower; sometimes use a standby arrangement - IB, for a fee, agrees to buy up unissued rights
• not clear why more corporations do not use
For Homework, consider what happens if not all persons exercise.
Long-term Debt
Types:
• Mortgage bond - secured bond; indenture agreement
• Debenture - unsecured bond
1. Computation of yield:
• just like computing IRR
• find rate which discounts cash flows to cost
• sinking fund - treat as cash flows
• yield to first call - discount CF's to first call
Callable gives company right to buy back bonds at a fixed price
• When called? After interest rates have fallen.
• Investors will demand higher yields on callable bonds? (Why?)
2. Agency problems of debt:
Mangegement may take actions which benefit S/H's at expense of B/H's.
• payment of dividend
• junk debt
• riskier than expected (by B/H's) projects
B/H's will price protect themselves - will demand a higher yield to compensate for expected actions by management.
A way to lower the higher yield from agency costs is through bond covenants.
Bond covenants: - legally contracted restrictions on the behavior of management.
• working capital restrictions
• dividend restrictions
• investment restrictions (asset substitution)
• restriction on disposition of assets
• maintenance of properties
Trustee normally monitors compliance with covenants;
If not met ==> potential bankruptcy
3. Other debt:
• Zero coupon - (pure or deep discount) no interest payments; like T-bills
• floating rate - rate is adjusted periodically
• junk bonds - below investment grade
Are junk bonds good or bad?
a. Help finance takeovers (remove entrenched mgmt)
b. Going private (LBO's) defensive?
c. Overleveraged?
d. Have investors anticipated proper default risk?
e. Effect of economic downturn?
4. Factors influencing issuance of debt:
• Collateral (availability and type)
• Matching maturity of liabilities and assets, to avoid interest rate risk
• Co's tend to issue debt after interest rates have fallen
Forecasting interest rates - what does unbiased expectation theory of term structure say?