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Copyright 2002 by Harcourt, Inc. All rights reserved.

Initial Public OfferingsInvestment Banking and Regulation

The Maturity Structure of Debt

Refunding Operations

The Risk Structure of Debt

CHAPTER 19Initial Public Offerings, Investment

Banking, and Financial Restructuring

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The Securities and Exchange

Commission (SEC) regulates:Interstate public offerings.National stock exchanges.Trading by corporate insiders.

The corporate proxy process.

The Federal Reserve Board controlsmargin requirements.

What agencies regulate

securities markets?

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States control the issuance ofsecurities within their boundaries.The securities industry, through the

exchanges and the National

Association of Securities Dealers(NASD), takes actions to ensure theintegrity and credibility of the tradingsystem.Why is it important that securities

markets be tightly regulated?

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How are start-up firms usually financed?

Founders resources

Angels

Venture capital fundsMost capital in fund is provided by

institutional investors

Managers of fund are called venturecapitalists

Venture capitalists (VCs) sit on boardsof companies they fund

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In a private placement,such as to

angels or VCs,securities are sold to afew investors rather than to the publicat large.

In a public offering, securities areoffered to the public and must beregistered with SEC.

Differentiate between a private

placement and a public offering.

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Privately placed stock is not

registered, so sales must be toaccredited (high net worth)investors.

Send out offering memorandum with20-30 pages of data and information,prepared by securities lawyers.

Buyers certify that they meet net

worth/income requirements and theywill not sell to unqualified investors.

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Advantages of going publicCurrent stockholders can diversify.

Liquidity is increased.

Easier to raise capital in the future.

Going public establishes firm value.

Makes it more feasible to use stock asemployee incentives.

Increases customer recognition.

Why would a company consider

going public?

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Disadvantages of Going Public

Must file numerous reports.Operating data must be disclosed.

Officers must disclose holdings.

Special deals to insiders will bemore difficult to undertake.

A small new issue may not beactively traded, so market-determinedprice may not reflect true value.

Managing investor relations is time-consuming.

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What are the steps of an IPO?

Select investment banker

File registration document (S-1) with

SEC

Choose price range for preliminary(or red herring) prospectus

Go on roadshow

Set final offer price in finalprospectus

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What criteria are important in choosing

an investment banker?Reputation and experience in this

industry

Existing mix of institutional and retail(i.e., individual) clients

Support in the post-IPO secondary

marketReputation of analyst covering the

stock

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A negotiated deal.

The competitive bid process is onlyfeasible for large issues by major firms.Even here, the use of bids is rare forequity issues.

It would cost investment bankers toomuch to learn enough about thecompany to make an intelligent bid.

Would companies going public use a

negotiated deal or a competitive bid?

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Most offerings are underwritten.

In very small, risky deals, theinvestment banker may insist on abest efforts basis.

On an underwritten deal, the price isnot set untilInvestor interest is assessed.Oral commitments are obtained.

Would the sale be on an

underwritten or best efforts basis?

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Since the firm is going public, there isno established price.

Banker and company project thecompanys future earnings and freecash flows

The banker would examine marketdata on similar companies.

Describe how an IPO would be priced.

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Price set to place the firms P/E andM/B ratios in line with publicly tradedfirms in the same industry havingsimilar risk and growth prospects.

On the basis of all relevant factors,the investment banker woulddetermine a ballpark price, and

specify a range (such as $10 to $12)in the preliminary prospectus.

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What is a roadshow?

Senior management team, investmentbanker, and lawyer visit potentialinstitutional investors

Usually travel to ten to twenty cities in atwo-week period, making three to fivepresentations each day.

Management cant say anything that isnot in prospectus, because company isin quiet period.

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What is book building?

Investment banker asks investors toindicate how many shares they plan

to buy, and records this in a book.Investment banker hopes for

oversubscribed issue.

Based on demand, investmentbanker sets final offer price onevening before IPO.

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What are typical first-day returns?

For 75% of IPOs, price goes up onfirst day.

Average first-day return is 14.1%.About 10% of IPOs have first-day

returns greater than 30%.

For some companies, the first-dayreturn is well over 100%.

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There is an inherent conflict of interest,because the banker has an incentive toset a low price:to make brokerage customers happy.to make it easy to sell the issue.

Firm would like price to be high.

Note that original owners generally sellonly a small part of their stock, so ifprice increases, they benefit.

Later offerings easier if first goes well.

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What are the long-term returns to

investors in IPOs?Two-year return following IPO is

lower than for comparable non-IPO

firms.On average, the IPO offer price is too

low, and the first-day run-up is too

high.

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What are the direct costs of an IPO?

Underwriter usually charges a 7%spread between offer price andproceeds to issuer.

Direct costs to lawyers, printers,accountants, etc. can be over$400,000.

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What are the indirect costs of an IPO?

Money left on the table(End of price on first day - Offer price) x

Number of shares

Typical IPO raises about $70 million,and leaves $9 million on table.

Preparing for IPO consumes most ofmanagements attention during thepre-IPO months.

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If firm issues 7 million shares at $10,

what are net proceeds if spread is 7%?

Gross proceeds = 7 x $10 million

= $70 millionUnderwriting fee = 7% x $70 million

= $4.9 million

Net proceeds = $70 - $4.9= $65.1 million

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What are equity carve-outs?

A special IPO in which a parentcompany creates a new public

company by selling stock in asubsidiary to outside investors.

Parent usually retains controlling

interest in new public company.

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How are investment banks involved in

non-IPO issuances?Shelf registration (SEC Rule 415), in

which issues are registered but the

entire issue is not sold at once, butpartial sales occur over a period oftime.

Public and private debt issuesSeasoned equity offerings (public

and private placements)

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A rights offering occurs when currentshareholders get the first right to buynew shares.

Shareholders can either exercise theright and buy new shares, or sell theright to someone else.

Wealth of shareholders doesntchange whether they exercise right orsell it.

What is a rights offering?

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Going private is the reverse of goingpublic.Typically, the firms managers team up

with a small group of outsideinvestors and purchase all of thepublicly held shares of the firm.

The new equity holders usually use alarge amount of debt financing, sosuch transactions are calledleveraged buyouts (LBOs).

What is meant by going private?

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Gives managers greater incentivesand more flexibility in running thecompany.

Removes pressure to report highearnings in the short run.

After several years as a private firm,owners typically go public again.Firm is presumably operating moreefficiently and sells for more.

Advantages of Going Private

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Firms that have recently gone

private are normally leveraged tothe hilt, so its difficult to raise newcapital.

A difficult period that normallycould be weathered mightbankrupt the company.

Disadvantages of Going Private

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Maturity matching

Match maturity of assets and debt

Information asymmetries

Firms with strong future prospects willissue short-term debt

How do companies manage the

maturity structure of their debt?

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Zero Coupon Bonds

Bonds have no coupon, and pay nointerest.

Only payment is face value at

maturity.Bonds are sold at discount. If

market rates are 9% and firm issues

zero coupon bond with 5 years tomaturity,

Price5 = $1000 / (1.09)5 = $649.93

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Tax Treatment of Zero Coupon Bond

Imputed interest expense is equal tothe expected price appreciation,based on initial yield.

Bond has initial yield of 9%,expected price at end of first year is:

Price4 = $1000 / (1.09)4 = $708.43

Imputed interest = $708.43 - $649.93= $58.5

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Tax Deduction

Company deducts $58.5 in the firstyear, even though it makes no cash

payment of interest.Imputed interest payment changes

each year as price of bond (based on

original 9% yield) approaches $1000.

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If interest rates have fallen since thebond was issued, the firm can replace

the current issue with a new, lowercoupon rate bond.

However, there are costs involved in

refunding a bond issue. For example,The call premium.

Flotation costs on the new issue.

Under what conditions would a firm

exercise a bond call provision?

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The NPV of refunding compares theinterest savings benefit with thecosts of the refunding. A positiveNPV indicates that refunding today

would increase the value of the firm.

However, it interest rates areexpected to fall further, it may be

better to delay refunding until sometime in the future.

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Managing Debt Risk with Project

FinancingProject financings are used to finance

a specific large capital project.

Sponsors provide the equity capital,while the rest of the projects capital issupplied by lenders and/or lessors.

Interest is paid from projects cashflows, and borrowers dont haverecourse.

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