Finance 7330

Advanced Corporate Finance

Information and Financial Decisions

Lecture 11

Fall 2009

Issues in Raising Capital

• What securities to issue

• Changes in Ownership and Control

• Alternative Marketing Options

Market Reaction to Security Offer Announcements

» Industrial Utility

• Common Stock -3.14% -0.75%

• Preferred Stock -0.19%* 0.08%*

• Convertible Preferred -1.44% -1.38%

• Straight Debt -0.26%* -0.13%*

• Convertible Debt -2.07%

* Means not statistically significant

Explanations

• EPS Dilution

• Price Pressure

• Optimal Capital Structure

• Information Asymmetry– Implied Cash Flow Change – Leverage Change

• Unanticipated Announcements

EPS Dilution

• Suppose earn $1 million and have 200,000 shares, and the P/E ratio is 15. Then: EPS = $5.00

Price = $75.

What happens if you issue 50,000 new shares?

Price Pressure

Demand and Supply

Optimal Capital Structure

Leverage versus firm value

Information Asymmetry

• Managers who have better information about the future of the firm than do outside stockholders, try to time the issues to take advantage of stockholders.

• Stockholders recognize this and thus react, in general, negatively to announcements of new security offerings.

Issue Common Stock

(-1.6%)

Conv. Bond Sale to retire debt

Common/preferred E.O.

Preferred/debt E.O.

Common sale to retire debt

Call of convertible bondsCall of convertible preferred

Calls of Non-convertible bonds

Convertible preferred sale

Convertible debt sale

Investment decrease

Dividend decrease

Debt/Debt E.O. Dividend increase

Investment increase

Preferred sale

Debt sale

Common repurchase financed with debt

Debt/Common E.O.

Preferred/common E.O.

Debt/preferred E.O.

Income bond/preferred

E.O

Common Stock repurchase

(+16.2%)

The two Basic Effects

• Cash Flow implications of a security offering

• Leverage effect of a security offering

Cash Flow In

Leverage Decreasing

(-) (-)

Cash Flow Neutral

Leverage Decreasing

(0) (-)

Cash Flow out

Leverage Decreasing

(+) (-)

Cash Flow In

Leverage Neutral

(-) (0)

Cash flow Neutral

Leverage Neutral

(0) (0)

Cash Flow Out

Leverage Neutral (+) (0)

Cash Flow In

Leverage Increasing

(-) (+)

Cash Flow Neutral

Leverage Increasing

(0) (+)

Cash Flow Out

Leverage Increasing

(+) (+)

Evidence

• Optimal Capital Structure Theory– No evidence from announcement effects

• Cash Flow Changes Implied – Negative returns when issued– Positive Returns when retired

• Leverage Changes• Announcement Anticipation • Ownership changes• Price Pressure – No evidence

Organizational Changes

• Mergers (Target 20% versus Bidder 0.2%*)

• Spin off (3.4%)

• Sell off (seller: 0.7%:buyer: 0.7% )

• Go Private (30%)

• Vol. Liquidation (33%)

• Proxy Fight (1.1%)

In general, giving stockholders more transparency and control increases value

Ownership Changes

• Tender Offer (Target 30%, Bidder 0.8%*)• Large Block Acquisitions (2.6%)• Secondary Distributions of management holdings

(-2.9%, -0.8%)• Targeted Share Repurchase (-4.8%)

Transactions that decrease ownership concentration decreases stock price, whereas increasing ownership concentration tends to increase stock price

Marketing Securities Issues

• Rights Offering

• Underwriting– Firm commitment– Best Efforts

• Private Placement

• Shelf Registration versus conventional

Why Underwritten Offering

• Costs 3 to 30 times what a non-underwritten offering would cost

• Comprises 80% of offerings

Why?

For Underwritten Offerings,

• Negotiated versus competitive bids– In Negotiated Bid: Firm negotiates the

conditions of the sale directly with the underwriter

– In competitive Bid: Firm structures the deal and lets underwriter bid for the deal.

• Negotiated much more expensive but are chosen in an overwhelming number of cases

• Why?

Why Negotiated rather than Competitive Bids?

• Variance of issuing costs higher for competitive bids

• With negotiated bids can share confidential information with underwriters that you might not want to make public

• The underwriter bridges the gap of mistrust between the market and the firm

Thus you expect that equity offerings will be done mostly with negotiated bids, but bonds done more with competitive bids.

Initial Public Offerings (IPO’s)• What is the right price?

– Stock price behavior? (15% underpricing) i.e. there is an immediate run-up of 15% from the initial offering price

– An attempt to resolve the Uncertainty

• Best Efforts versus Firm Commitment– With firm commitment the investment bank buys the

securities directly, whereas in best effort it simply acts as agent for the firm

– Underpricing Much larger in Best Efforts where uncertainly is likely to be largest

Overall Message

• We can think of the firm’s dealing with outside investors in a similar way to that of a used car dealer.

• Put into place mechanisms that try to mitigate the impact of the information advantage the firm has over the outside investors

Summary

• Security Issues: Reveals information that managers know regarding the future of the firm. This information is that reflected price stockprice changes

• Organizational Change: Changes in the organization that gives more transparency and allows better measure of performance is rewarded on the market

•

Summary

• Ownership Changes: Increased ownership concentration rewarded on the market. Allows for improved monitoring and control

• Marketing: Firms use underwriting as a means to assure outsiders that they will not take advantage of them.

Innovation in Financial Markets

Overall Principle: All securities in an efficient (and complete) market sell at a price equal to the Present

Value of the payments to the security holders.

That is, from an Issuer's point of view, the security issuance itself is a zero NPV. From the purchasers’ point of view, the Purchase is at a zero NPV as well.

So, in order to get $1 million from security holders they must expect to receive (in PV terms) an amount equal to

$1 million in expected cash flow and option values.

So why do we see innovative securities being issued by firms?

Markets are not efficient.

Markets are not complete.

Resolve a conflict of interest among claimants to the firm's cash flow.

"Tax or Regulatory arbitrage“

Encourage an efficient productive process.

Markets are not efficient. The investing public can be manipulated and consistently taken advantage of.

Seems unlikely We have systems in place which are designed to protect investors

Markets are not complete.

Firms are taking advantage of excess demand for specific securities which are not readily available elsewhere.

Caution here, you get rewarded for being the first only if investors want the security.

Example: Pepsico Zero Coupon Bonds

Resolve a conflict of interest among claimants to the firm's cash flow.

1. Resolve the conflict of interest between outsiders and insiders.

Information conflictAgency Problem

2. Resolve the Conflict of Interest between bondholders and stockholders.

Risk Shifting (Overinvestment)Underinvestment

3. Non-investors Implicit Claims CustomersEmployees

Suppliers and distributors

Tax or Regulatory arbitrage“

Tax Factors: The Corporate Tax Benefit The Personal Tax Penalty

Zero Coupon Bonds: Lehman Bros. ECAPS

Accreted value of a zero-coupon bond (old analysis)

Time to Value Interest IRS

Maturity Earned Interest

10 463 37 53.7

9 500 40 53.7

8 540 43 53.7

7 583 47 53.7

6 630

ECAPS

• 60 year maturity

• Carry routine payments

• Interest can be deferred in times of financial distress

• Yet can get tax exemption

How do you characterize Debt?

• Unconditional promise to pay a fixed amount on demand or at a given time in the future

• Holders must be able to force payments• Holders cannot participate in management • Are stockholders separate from holders of

the issue• Is instrument treated as debt for non-tax

purposes

Permitting a more efficient productive process.

The problem is that we have a long-term security that could get in the way of efficient production

This is a particular problem for growth companies

Growth Companies

Large appetite for Cash

Must have Growth Opportunities

Difficult to determine Value

Based on Expectations

Makes the credibility problem more severe

Absence of Hard Assets makes it difficult to resolve Bondholders’ claims

Bank Loans Custom Tailor ProvisionsCan be renegotiated easily

Venture Capitalists Take active Role in ManagementShift Risk to Managers

Resolves the credibility problemProvide managers incentives to do wellStage Financing

Convertible Preferred Stock

Private Placements

Bank Loans and Venture Capital are expensiveAllows private information to be shared Renegotiation Possible Complication: Not liquid requiring restrictions

Convertible Securities

Summary

In order to increase stockholders’ wealth, a security issue must do something other than simply act as a source of Funds

There are agency, and information problems which must be resolved in any issue

This is particularly severe for growth firms

The Security must be able to resolve these issues to be successful