issuing securities and the role of investment banking

© Prentice Hall, 2004

1919

Corporate Financial Management 3e

Emery Finnerty Stowe

Issuing Securities and the Role of

Investment Banking

Raising Long-Term Funds Externally

Main sources: Common stock Preferred stock Debt

Flotation or issue costs Fixed costs Variable costs

Issue Methods Public offerings Private placement

Public Offerings

General cash offers Securities are offered to investors at large. Underwriters are often used.

Rights offering New common stock is sold to existing

stockholders.

General Cash Offers

Decide what to issue: Amount of capital to be raised Type of security

Obtain required approvals.File a registration statement: Must be approved by the SEC prior to the

actual sale Preliminary prospectus Red herring

General Cash Offers

Determine initial pricing and file an amended registration statement.

Close the offering.

Primary and Secondary Offerings

In a primary offering, the firm sells newly issued shares to investors.

In a secondary offering, insiders and large institutional shareholders sell shares they hold in a registered public offering.

Role of the Underwriters

Investment bankers An intermediary between the issuer and the purchaser. Provide advice regarding type of security, terms, and price. Helps prepare documentation.

Underwriting A form of insurance. Risk bearing. Fixed. Best effort. Overallotment (Greenshoe).

Syndicated offering process

Role of the Underwriters

Underwriters compensation Gross underwriting spread

Management fee (15% to 20%) Underwriting fee (15% to 20%) Selling concession (60% to 70%)

Other out-of-pocket expenses Legal fees Accounting fees Printing costs

Flotation Costs

Include both the gross underwriting spread and the out-of-pocket expenses.Economies of scaleVary by security type: Holding issue size constant, Common stock has highest flotation cost. Bonds have the lowest flotation costs. Flotation costs of preferred stock are in

between.

Negotiated versus Competitive Offerings

In a negotiated offering, the issuer selects one or more firms to manage the offering. works closely with them in designing and pricing the

issue.

In a competitive offering, the issuer specifies the type and amount of security to be sold. selects the investment banker through a competitive

bidding process.

Shelf Registration

Since November 1983, the SEC allows firms to register an inventory of securities of a particular type for up to two years.

Issue can then sell securities at any time within this time period.

Rule gives firms financial flexibility and reduces flotation costs.

Private Placements

Securities are sold directly to institutional investors.

Exempt from registration requirements.

Securities have restrictions: Limited number of investors may buy the

securities. Restrictions on resale.

Advantages of Private Placements

Lower issuance costs.

Issue can be placed quickly.

Greater flexibility of issue size.

Greater flexibility of security arrangements.

More favorable share price reaction than a public offering.

Lower cost of resolving financial distress.

Disadvantages of Private Placements

Higher yield required by investors.

More stringent covenants and restrictive terms.

Largest Buyers of Private Placements

John Hancock Life InsuranceTeachers Insurance &

Annuity AssociationPrudential InsuranceHartford Investment

Management CompanyMetropolitan LifeCitigroup Global InvestmentsAmerican General

Investment ManagementNew York Life Investment

Management

AIG/SunAmerica Investments

Principal Capital Management

Cigna Investment Management

ING Investment Management

Provident Investment Management

Nationwide Insurance Companies

Main Features of Common Stock

Features specified in the corporate charter

Perpetual security

Not redeemable

May or may not have a par value

Charter specifies the number of authorized shares: Outstanding shares Treasury shares

Multiple classes of common stock

Rights and Privileges of Common Stock

Dividend rights

Voting rights Cumulative Noncumulative Voting by proxy

Liquidation rights

Preemptive rights

Public Offering of Common Stock

Cost of offering Gross underwriting spread Out-of-pocket expenses Market impact

A firm’s share price often declines upon the announcement of a public offering. Managers sell new shares when shares are

overpriced.

Rights Offerings

Firm issues one right per share outstanding.

Rights are options on newly issued shares: subscription price subscription period

Rights are issued in-the-money.

Rights offerings are frequently underwritten.

Rights Offerings

Advantages Allows shareholders to retain their proportionate

ownership in the firm. Protects existing shareholders from loss of wealth

resulting from a public offering. Beneficial if firm does not have broad ownership.

Disadvantages Takes longer to complete. Cannot sell large blocks of new shares to institutional

shareholders.

Rights Offering

Stansfield Enterprises currently has 1,000,000 shares outstanding trading at $10 per share.The firm announces a rights offering.Current shareholders are allowed to buy one additional share for every share they currently own at a subscription price of $9.50 per share.Shareholders who do not wish to exercise their rights may sell them.It sounds like a good deal, an opportunity to buy a $10 stock for $9.50.Is it that good of a deal?

Value of a Right

What is the value of one right?

To determine this, let’s look at the value of the firm after the rights offering.

There will be 2,000,000 shares outstanding and the firm will have raised additional equity of $9,500,000

The new share price will be $9.75

shares 000,000,2

equity new $9,500,000equity old 000,000,10$shareper 75.9$

The Value of a Right

A shareholder who chooses to exercise his rights starts with one $10 share, pulls $9.50 out of his wallet and finishes the day with 2 shares of a $9.75 stock for a total portfolio value of:

$9.75 × 2 = $19.50.


If he does nothing, he goes to bed with one share of a $9.75 stock and $9.50 in his wallet.

Total = $19.25

Doing nothing will cost him $0.25


He can avoid that loss by exercising the right with $9.50 in cash and then selling the extra share for $9.75

So, we can be pretty sure that he won’t sell his right for less than $0.25

Value of a Right

Can he sell his rights for more than $0.25? Consider an outsider. Would he pay $0.26 for a

right? This right will allow him to buy a $9.75 stock

for $9.50 plus the cost of one right. Any rational outsider will pay at most $0.25


Clearly if the least a seller will take is $0.25 and the most a buyer will pay is $0.25 it’s a pretty good bet that the rights will have a market-clearing price will be $0.25

Calculating the ex-rights Price

Consider the value of our shareholder who sells his rights.

He wakes up in the morning with a $10 stock.

Sells the right stapled to it for $0.25

Goes to bed with a $9.75 stock and $0.25 in the drawer of his nightstand.

The ex-rights price is $9.75. If it was anything else there would be an arbitrage opportunity.

Rights Offering

Now suppose Stansfield Enterprises currently has 1,000,000 shares outstanding trading at $10 per share.The firm announces a rights offering.Current shareholders are allowed to buy one additional share for every two shares they currently own at a subscription price of $9.50 per share.Shareholders who do not wish to exercise their rights may sell them.

Value of a Right

What is the value of one right?

To determine this, let’s look at the value of the firm after the rights offering.

There will be 1,500,000 shares outstanding and the firm will have raised additional equity of $4,750,000.

The new share price will be $9.83.

shares 000,500,1

equity new $4,750,000equity old 000,000,10$shareper 83.9$


A shareholder who chooses to exercise his rights starts with two $10 shares, pulls $9.50 out of his wallet and finishes the day with 3 shares of a $9.83 stock for a total portfolio value of:

$9.83 × 3 = $29.50.


If he does nothing, he goes to bed with two shares of a $9.83 stock and $9.50 in his wallet. Total = $29.16

Doing nothing will cost him $0.33.


He can avoid that loss by exercising the right with $9.50 in cash and then selling the extra share for $9.83.

So, we can be pretty sure that he won’t sell his right for less than $0.33.

Value of a Right

Can he sell his rights for more than $0.33? Consider an outsider. Would he pay $0.34 for a

right? This right will allow him to buy a $9.83 stock

for $9.50 plus the cost of one right. Any rational outsider will pay at most $0.33.


Clearly if the least a seller will take is $0.33 and the most a buyer will pay is $0.33, it’s a pretty good bet that the rights will have a market-clearing price will be $0.33

Calculating the ex-rights Price

The ex-rights price is $9.83.

If it was anything else there would be an arbitrage opportunity.

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Dividend Reinvestment Plans (DRiPs)

A DRiP allows each shareholder to use the dividends received to purchase additional shares of the firm.Purchase price is often below market price (5% discount).Resemble rights offerings.Lower transaction costs for purchaser than open market purchase.

Going Public

A firm “goes public” when it offers common stock to the public for the first time in its life. Initial Public Offering (IPO)

Subsequent issues of common stock are called “seasoned” issues.

Underwriters try to price the IPO issue at 10% to 15% below the expected trading price.

For Sale, but not on Ebay

Initial Public Offering Price

Proceeds to Company

Underwriting Discount

Per share $18.00 $1.26 $16.74

3,500,000 shares

Ebay, Inc.

Common stockPar value $0.01 per share

Going Private

A small group of investors purchase the entire common equity of a publicly traded firm.

Firm is no longer subject to reporting requirements.

Substantial transaction cost involved in going public and private.

Advantages of Going Public

Raise new capital

Achieve liquidity and diversification for current shareholders

Create a negotiable instrument

Increase the firm’s equity financing flexibility

Enhance the firm’s image

Disadvantages of Going Public

Disclosure requirements

Accountability to public shareholders

Market pressure to perform short-term

Pressure to pay dividends

Dilution of ownership interest

Expense of going public

Higher estate valuation

Features of Preferred Stock

Hybrid securities: Claims senior to common stock, junior to debt. Dividends must be paid to preferred before they

can be paid to common.

Usually have a par or stated value.Dividend rate is usually specified.Redemption provisions: Optional Mandatory

Financing with Preferred Stock

Why do firms issue preferred stock?

Sinking fund preferred is like debt: The “interest payments” are not tax-deductible,

but This is offset by the fact that missing a

scheduled payment does not lead to bankruptcy.


Preferred stock dividends also qualify for the 70% dividends-received deduction when the preferred shareholder is another corporation.

Because of this, preferred-stock yields are usually lower than the yields of comparable debt instruments.

Plus, if the firm is not paying taxes currently due to poor operating results, the forgone interest tax deduction is not an issue.


Utility companies have been the heaviest issuers of fixed-rate preferred stock.

Regulated utilities can pass the cost of preferred dividends through to their customers.