Chapter 20 Issuing Securities to the Public

Securities and Exchange Commission - A government commission created by Congress to regulate the securities markets and protects investors. Registration Statement a statement that contains financial information, including a financial history, details of the existing business, proposed financing, and plans for the future SEC Rule 415 b allow you to register in advance, self-registration for securities and approved. File an amendment statement when you want. 20 day waiting period when the SEC studies the registration statement and meanwhile the firm may distribute copies of a preliminary prospectus. Red Herring Prospectus file registration, but you can release these prospectus that allows you to look into in detail in order to determine whether you want Filing with the SEC, securities cant be sold yet as the file isnt registered Tombstone advertisements that are used during and after the waiting period The Cost of New Issues Gross Spread or Underwriting Discount the spread is the difference between the price and issuer receives and the price offered to the public o How do investment bankers earn money on any deal? Example: Public at $8.50 the underwriting discount is $0.595 and therefore the proceeds are $7.905 per share When they sell equity or stock, they sell for a higher price. In this case, 7% of the offer price. o The average underwriting discount currently is around 2-3%. o If they buy all the shares of a company, what happens if they cant sell it all? Then the investment bank needs to fund with capital. Other Direct Expenses easy to quantify (such as filing fee, lawyer fees) but smaller than indirect expenses Indirect Expenses o Everybody in the organization gets pulled into the transaction o Larger because people spend more time on the deal for an IPO per say than the business Abnormal Returns the price usually drops upon the announcement of the issue. The drop protects new shareholders from buying overpriced stock o Causes a drop due to simple supply and demand theory Underpricing For IPOs the stock typically rises substantially after the issue date. The underpricing is a cost to the firm because the stock is sold for less than its efficient price in the aftermarket. Green Shoe Option gives the underwriters the right to buy additional shares at the offer price to cover overallotments. This is a cost to the firm because the underwriter will buy additional shares only when the offer price is below the price in the aftermarket. o So shares don't get diluted Abnormal Returns A public traded firm faces lower stock prices when you sell more shares (follow supply and demand diagram, current equilibrium price) Significant Negative abnormal CARs associated with new equity offers or leverage decreasing transactions o Company offering equity always does worse (19 times over 20) o Negative signaling

o o o

Bigger underwriting discount Stock issuing is negative signaling When you issue new common stock, it will drive down the stock price

Significant Positive abnormal CARs associated with new debt offers or leverage increasing transactions o If company issues debt, increase the company risk, increase in beta, volatility of your returns o Managers are the one who decide to issue debt o Smaller underwriting discount not as expensive as equity o Signaling theory says managers will never take the risk if it affects themselves, so they will only issue debt when they are certain that they are able to pay back. o Bonds

Underpricing on IPOs, persistent & systematic, why? 1. When the price of a new issue is too low, the issue is often oversubscribed a. Investors will not be able to buy all of the shares they want, and the underwriters will allocate the shares among investors b. However usually, there are positive initial returns on IPOs 2. Risk a. Cause underwriter a loss on his own holdings Green Shoe Option gives the members of the underwriting group the option to purchase additional shares at the offering price Example: Part (3) in the RealNetworks, Inc. Who makes profit with this option? The underwriters. If the issue is oversold, that signifies demand exceeds supply, this is free money for the underwriter To cover excess demand and oversubscription Gives the members of the underwriting group the option to purchase additional shares at the offering price. To cover excess demand and oversubscription Cash Offer when stock is sold to interested investors Investment bank (underwriter) buys the securities for less than the offering price and accepts the risk of not being able to sell them To minimize risks, an underwriting group forms (syndicate) to share the risk and to help sell the issue. Underwriters pitch the stock through road shows Best Efforts Underwriting the syndicate avoids the risk under a best efforts because it does not purchase the shares. Instead, it merely acts as an agent, receiving a commission for each share sold Dutch Auction Underwriting the underwriter does not set a fixed price for the shares to be sold Conducts an auction in which investors bid for shares Rights Offering - an issue of common stock to existing shareholders In order for each owner to keep his proportionate share Each shareholder is issued an option to buy a specified number of new shares from the firm at a specified price within a specified time until expiry. Also known as share warrants or rights Subscription Price the price at which existing shareholders are allowed to pay for a share of stock

Only when the subscription price is below the market price of the stock

Therefore, a shareholder must give up the number of rights needed to buy a share of stock plus the subscription price By doing so, the company will be able to raise the required funds Ex-Rights Price

Effects of Rights Offering Price on Stock The value of each share will most likely drop

Stockholders They will not suffer a loss from the offering The stock price decline will be compensated because the shareholders will receive rights in equal value to the price drop Dilution a loss in existing shareholders value The impact of new issues on stock price per share is relevant to a firms stockholders

The Capital Structure Puzzle: The Evidence Revisited

M&M says that In a world without taxes, the value of the levered firm is the same as the value of the unlevered firm the choice of debt-to-equity is indifferent In a world WITH taxes, firms should take on as much debt as it increases the value of the firm with leverage Costs of Financial Distress Debt puts pressure on the firm because interest and principal payments are obligations. If they are not met, risk more financial distress o Ultimate distress if bankruptcy Stockholders expect dividends but are not legally entitled like bondholders are to interest and principal payments Leverage increases the likelihood of bankruptcy. However, bankruptcy does not, itself, lower the cash flow to investors. Rather, it is the costs associated with the bankruptcy that lowers cash flows Examples of Costs of Financial Distress Direct costs: legal and administrative costs of liquidation or reorganization Lawyers Administrative and accounting fees Indirect costs: Impaired ability to conduct business Sales go down due to fear of impaired service and loss of trust Agency costs: conflicts of interests between the bondholders and stockholders Incentive to take large risks because they believe they are playing with other peoples money Investment toward Underinvestment Stockholders o Choosing projects with negative NPV Milking the Property o Pay out extra dividends or other distributions in times of financial distress, leaving less in the firm for bondholders. Reducing the Costs of Debt Managers have an incentive to reduce these costs by using Protective Covenants A loan document between stockholders and bondholders o Stockholders must pay higher interest rates as insurance against their own selfish strategies Should reduce the costs and ultimately increase the value of the firm Integration of Tax Effects and Financial Distress Costs M&M suggests that the firms value rises with leverage in the presence of corporate taxes With more debt, the PV of these costs rise at an increasing rate Bankruptcy costs increase faster than the tax shield - and leads to a reduction in firm value WACC falls with more leverage Optimal when the marginal subsidy to debt equals the marginal cost Pecking order theory o People always prefer to write the check, pay upfront, - internally finance o issue debt next because it is a fixed rate claim, less uncertainty o After cash debt

Then issue new equity, its more expensive, investment bankers always pay less, fees are high, and the price gets discounted.

Underinvestment problem (intangible growth opportunity) vs overinvestment problem (agency theory) Overinvestment o Size of the company matters, managers get paid more when they work for bigger companies o When a company has excess free CF, managers are always attempted to reinvest, regardless of its NPV just to make the company even bigger o Refer to Hansson private label case: people propose investments and they want to invest, but we must be careful and analyze o One way to stop that is to borrow money debt will be prioritized (as a debt service payment) to be paid than to reinvest in the company o Debt keeps the managers to prevent re investing in unnecessary projects o Debt tell people that the company will distribute its cash accordingly Underinvestment o Companies that are big growth companies, look at growth opportunities o They tend to not borrow money o If you have a lot of debt financing, it must be paid first o If you have debt service that takes the money, you cant take the great investment proposal, cant take the opportunities to grow more o If they invest, the value goes to the bond holders and not the stock holders o Bondholders dont vote for the company, it is always wanted to transfer the value to the stock holders. o You are afraid of underinvestment with intangible growth opportunities Signaling Theory o New common stock significant negative abnormal returns o Stock market will hurt you CFOs and financial slack o CFOs job is to give capital for an approved project o Love financial slack because if the board approves the project, the CFO just withdraws capital for the investment o Leads to the pecking order theory Firm Value Using M&M I, the value of the levered firm is However, this does not include any non-marketable claims, such as bankruptcy or agency costs Value of Equity is calculated by

Dividends and Other Payouts

Dividend a cash distribution of earnings Ex dividend date the dates where the individual will not receive the current dividend Before ex-dividend date: Price = $P+ Dividend On or after ex dividend date: Price = $P The amount drop may depend on tax rates Value of the firm stems from its ability to generate and pay out its free cash flow Value of a share of stock is equal to the PV of its future expected dividend payouts Irrelevance of Dividend Policy The timing of dividends do not change the present value of the dividends per share If Dividends = Cash Flow with 1000 shares outstanding, the value of each share is:

If Initial Dividend > Cash Flow The firm will have a total dividend payout that is larger that its free cash flow The extra payout must be raised by issuing that amount of bonds or stock However, the value of each share will be the same as the previous policy Firms should never give up a positive NPV project to increase a dividend (or to pay a dividend for the first time. Repurchase of Stock A stock repurchase reduces equity while leaving debt unchanged the debt ratio rises A firm could use its excess cash to reduce debt but this is a capital structure decision.

Dividend Theory
Irrelevance Dividends dont matter because you can make them your self Dividends are taxed There are transactions costs and taxes If you own common stock, you get dividends anyways, and you can reinvest but you will reinvest less due to tax M&M says that all fees are regulated super cheap to sell Irrelevance proposition goes away Bird in Hand Google better to have dividends today than to re-invest tomorrow take tomorrow as a chance than present Google stockholders believe that the bird in hand theory is not applicable, they still see growth opportunities Nestle needs to keep CF for new products, in retail what matters is shelf space and life, when they launch a new product, it is very difficult to make it truly successful. Signaling this is real if managers announce dividend increase, the stock price will react as a signal of success they wouldnt increase dividends if they know they cant sustain it. Were not doing well but were going to pay dividends anyways, what does this mean? Caterpillar because we are confident that we can turn the bad situation into one that is good. Clientele Theyre buying it for a reason Clientele effect is important United tech relatively high dividend payout ratio for its industry Dividend Stability This matters because they use dividends to pay other people You have to keep paying or else your shareholders will be unhappy and upset Caterpillar - Great dividend payout ratio, paying more than their net income They had large fluctuating returns from 2008 to 2009 and they saw an overreaction so much volatility Steady stair step If management cut the dividends it shows that the firm cannot sustain this anymore bad news and stocks are affected violently Ford cut dividend payout ratio to zero and levered the entire company, save money, and invested in fixing their business. They mortgaged every asset they had and turned it into cash. Exxon have relatively low dividend payout ratio, and is stable. RIM no dividends FCF or residual dividend policy You should look at all your good investment opportunities and use the rest for dividends

But nobody does this.

Stock Repurchases Transactions costs are enormous if you do both distributing dividends and selling equity This decision is completely illogical Caterpillar was zero now and they cut it from last year in order to save money! If CF are relatively large and are afraid to raise their dividends because once you raise it you cant lower it unless it will affect your shareholders, then companies prefer to do stock repurchases as this is more flexible and they can keep changing it. Exxon Mobil they have been buying back a lot of stocks, they chose to keep the dividend growth slow, and the excess in buying back shares When you cut your dividends, the stock market is harsh They were afraid that their stockholders will become completely adjusted and thought it was unsustainable Caterpillar stopped stock repurchases in order to fulfill dividend payouts Stock repurchases are good news Reduces shares outstanding Managers get money by bonuses and stock options stock price goes down when you pull wealth out of a company If you buy back your shares, your price goes up! If youre a manager and you own stock options, you would want the price to rise and prefer to repurchase stocks than payout dividends Investment Opportunities set impacts dividends and leverage Coca cola - not a high investment opportunity firm matured higher dividend payout ratios Walmart - when they were young fast growing company, they paid dividends Now they are mature, and dont pay dividends, and use it for retained earnings The firm is successful, cash flow is enormous Exxon if oil prices rise ,there will be less investment opportunities for them, show the stock repurchase theory Google expect great investment opportunities no dividends for stockholders. Intel started paying dividends relatively recently, before everything went to investment opportunities, growth and no dividends. Now they are looking for regular cash flow stream.

Short term Finance and Planning Tracing Cash Activities that Increase Cash (Sources of Cash) Increasing Long term debt Increasing equity (selling some stock) Increasing current liabilities Decreasing current assets other than cash Decreasing fixed assets (selling some property) Activities that Decrease Cash (Uses of Cash) Decreasing long term debt Decreasing equity (repurchasing some stock) Decreasing current liabilities (paying off loan) Increasing current assets other than cash (buying some inventory for cash) Increasing fixed assets Operating Cycle is the time we acquire some inventory to the time we sell it and collect the cash Inventory period is the time it takes to acquire and sell the inventory Account receivable period is the time it takes to collect on the sale Describes how a product moves through the current assets accounts Cash Cycle is the number of days that pass before we collect the cash from a sale, measured from when we actually pay for the inventory Accounts Payable Period is the number of days it takes to pay the inventory Best Combination Low inventory days o Low account receivable days o Average accounts payable days o If you have too high, youll end up with negative cash cycle Positive Cash Cycle Most likely means that company needs external financing for inventories and receivables Lengthening Cash Cycle Indicate that he firm is having trouble moving inventory or collecting on its receivables Shorter Cash Cycle Lower is the firms investment in inventories and receivables Total assets are lower And total turnover is higher

Warrants and Convertibles

Warrants are securities that give holders the right and not the obligation to buy shares of common stock directly from a company at a fixed price for a given period of time until expiry Call options are issued by individuals and warrants are issued by firms When a warrant is exercised, a firm must issue new shares of stock and number of shares outstanding increase Convertibles give the holder the right to exchange it for a given number of shares anytime up to and including the maturity date of the bond. Conversion Ratio is the number of shares the bond can be exchanged into Conversion Price is the bond face value divided by the conversion ratio. This is the price the stock must rise to for conversion to be worthwhile. Conversion Premium is (Conversion Price Current Stock Price)/Current Stock Price. This is the % amount the stock price must rise to make conversion worthwhile Conversion Value is The Conversion Ratio times the Current Market Price per share the current value of the bond due to its conversion option only. Convertible Debt versus Straight Debt Convertibles pay a lower interest rate than straight debt o Potential gain from conversion takes on risk o Provide cheap financing because coupon rate is lower Worse off it the underlying stock subsequently does well and vice a versa o Bonds are converted and dilutes equity o It is obligated to sell the convertible holders a chunk of the equity at a belowmarket price Convertible Debt versus Common Stock Better off issuing convertible if the stock price rises, it will receive substantially more for a share upon conversion o Cheap financing because it issues stock at high prices when bonds are converted If the prices fall, it would be better if they issue stock o Expensive financing because firm could have issued common stock at high prices MM suggests that abstracting from taxes and bankruptcy costs, the firm is indifferent to whether it issues stock or issue debt Policy to maximize shareholder value and minimize bondholder value: Call the bond when its value is equal to the call price