1. Chapter 13 Corporate Financing and Market Efficiency
Can Financing Decisions Create Value?
A Description of Efficient Capital Markets
The Different Types of Efficiency
The Evidence
Implications for Corporate Finance

2. Can Financing Decisions Create Value?
Example: Suppose Jays Electronics is thinking about relocating its plant to Mexico where labor costs are lower. In the hope that it can stay in Ontario, the company has submitted an application to the province to guarantee a five-year bank term loan for $2 million. With a provincial guarantee, a chartered bank has offered to make the loan (interest payments are paid at the end of each year) at an interest rate of 5 percent. This is an attractive rate because the normal cost of debt capital for Jays Electronics is 10%. What it the NPV of this potential financing transaction?

3. What Sort of Financing Decisions?
Typical financing decisions include:
How much debt and equity to sell
When (or if) to pay dividends
When to sell debt and equity
Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions.

4. How to Create Value through Financing
Fool Investors
Empirical evidence suggests that it is hard to fool investors consistently.
Reduce Costs or Increase Subsidies
Certain forms of financing have tax advantages or carry other subsidies.
Create a New Security
Sometimes a firm can find a previously-unsatisfied clientele and issue new securities at favorable prices.
In the long-run, this value creation is relatively small, however.

5. A Description of Efficient Capital Markets
An efficient capital market is one in which stock prices fully reflect available information.
The EMH has implications for investors and firms.
Since information is reflected in security prices quickly, knowing information when it is released does an investor no good.
Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.

6. Ex: How Does an Efficient Market Work?
Suppose the F-stop Camera Corporation (FCC) is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has a positive NPV.
Consider the share of FCC. One of the determinant of the share’s price is the probability that FCC will be the company to develop the new auto-focusing system first. In an efficient market we would expect the price of the shares of FCC to rise if this probability increases.
Now, suppose a well-known engineer is hired by FCC to help develop the new auto-focusing system. Assuming an efficient market, what do you think will happen to FCC’s share price when this is announced?

7. The Different Types of Efficiency
Weak Form
Security prices reflect all information found in past prices and volume.
Semi-Strong Form
Security prices reflect all publicly available information.
Strong Form
Security prices reflect all information—public and private.

8. Weak Form Market Efficiency
Security prices reflect all information found in past prices and volume.
Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.

9. Testing Random Walk Theory
The movement of stock prices from day to day DO NOT reflect any pattern.
Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

10. Random Walk Theory Coin Toss Game $106.09 $103.00 $100.43 $100.00
Heads
$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails

11. Random Walk Theory

12. Random Walk Theory

13. Random Walk Theory

14. Random Walk Theory S&P Composite (correlation = -.07)
Return in week t + 1, (%)
Return in week t, (%)

15. Efficient Market Theory
Microsoft Stock Price
$90 70 50
Actual price as soon as upswing is recognized
Cycles disappear once identified
Last Month
This Month
Next Month

16. Why Technical Analysis Fails
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.
Sell
Sell
Buy
Buy
Time

17. Semi-Strong Form Market Efficiency
Security prices reflect all publicly available information.
Publicly available information includes:
Historical price and volume information
Published accounting statements.
Information found in annual reports.

18. Event Studies: How Tests Are Structured
Event studies are one type of test of the semi-strong form of market efficiency.
This form of the EMH implies that prices should reflect all publicly available information.
To test this, event studies examine prices and returns over time—particularly around the arrival of new information.
Test for evidence of underreaction, overreaction, early reaction, delayed reaction around the event.

19. How Tests Are Structured (cont.)
Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day.
The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day:
AR= R – Rm
The abnormal return can be calculated using the Market Model approach:
AR= R – (a + bRm)

20. Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Overreaction to “good news” with reversion
Delayed response to “good news”
Efficient market response to “good news”
Days before (-) and after (+) announcement

21. Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Efficient market response to “bad news”
Stock Price
Delayed response to “bad news”
Overreaction to “bad news” with reversion
Days before (-) and after (+) announcement

22. Event Studies: Dividend Omissions
Efficient market response to “bad news”
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997)

23. Event Studies: Takeover Announcement
Announcement Date

24. Event Study Results
Over the years, event study methodology has been applied to a large number of events including:
Dividend increases and decreases
Earnings announcements
Mergers
Capital spending
New issues of stock
The studies generally support the view that the market is semistrong-form efficient.
In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements.

25. The Record of Mutual Funds
If the market is semistrong-form efficient, then no matter what publicly available information mutual-fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.
We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.

26. Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the Market Index

27. Strong Form Market Efficiency
Security prices reflect all information—public and private.
Strong form efficiency incorporates weak and semi-strong form efficiency.
Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.

28. Insider Trading
Officers, directors, and major shareholders of a firm are considered insiders who may have non-public important information. The SEC, the Ontario Securities Commission (and its counterparts in other provinces) prohibited the trade of securities based on pieces of information that have not yet become news.
To enforce regulation, the OSC and the SEC require insiders to reveal any trading they might do in their own company’s share.

29. Relationship among Three Different Information Sets
All information relevant to a stock
Information set of publicly available information
Information set of past prices

30. What the EMH Does NOT Say
If EMH holds there should be no upward trend in stock price.
If EMH holds, investors can not earn any return
If EMH holds, investors can throw darts to select stocks.
If EMH holds, stock prices should not go up over time.
If EMH holds, daily fluctuations should not exist as prices reflect the fundamental value of the firm.
EMH can not hold because there are not enough active traders.

31. Views Contrary to Market Efficiency
Stock Market Crash of 1987, Dot.com bubble.
The NYSE dropped between 20-percent and 25-percent Monday following a weekend during which little surprising information was released.
Nasdaq fell 72% during a two year period.
Temporal Anomalies
Turn of the year, —month, —week.
Speculative Bubbles
Sometimes a crowd of investors can behave as a single squirrel.
Size
Small cap stocks seem to outperform large cap stocks.
Value versus Growth
Value stock-price stocks outperform growth stocks.

32. Efficient Market Theory
2000 Dot.Com Boom

33. Why Doesn’t Everybody Believe the EMH?
There are optical illusions, mirages, and apparent patterns in charts of stock market returns.
The truth is less interesting.
There is some evidence against market efficiency:
Seasonality
Small versus Large stocks
Value versus Growth stocks
The tests of market efficiency are weak.

34. Implications for Corporate Finance
The EMH has three implications for corporate finance:
The price of a company’s stock cannot be affected by a change in accounting.
Financial managers cannot “time” issues of stocks and bonds using publicly available information.
A firm can sell as many shares of stocks or bonds as it desires without depressing prices.
There is conflicting empirical evidence on all three points.

35. Efficient Market Theory
IPO Non-Excess Returns
Year After Offering

36. Practice Questions: q8 Which statements contradicts EMH (specify type)
Tax-exempt municipal bonds offer lower pretax returns than taxable government bonds.
Managers make superior returns on their purchases of their company’s stock.
There is a positive relation between the return on the market in one quarter and the change in aggregate profits in the next quarter.
There is disputed evidence that stocks which have appreciated unusually in the recent past continue to do so in the future.
The stock of an acquired firm tends to appreciate in the period before the merger announcement.
Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earning announcement.
Very risky stock on average give higher returns than safe stocks.

37. Chapter 14: Corporate Financing
Common Stock
Preferred Stock
Corporate Long-Term Debt: The Basics
Patterns of Long-Term Financing

38. Example: Western Redwood Corp.
Formed in 1976 with 10,000 shares issued and sold for $1 per share.
By 2004, the company had retained $100,000.
Western Redwood Corporation Equity Accounts, 2004
Common stock
(10,000 shares outstanding)
$ 10,000
Retain earnings
100,000
Total shareholders’ equity
$ 110,000

39. Example: Western Redwood Corp.
Issues 100,000 shares at $20 per share at 2004
Western Redwood Corporation Equity Accounts, 2004
Common stock
(10,000 shares outstanding)
$ 210,000
Retain earnings
100,000
Total shareholders’ equity
$ 310,000

40. Market Value and Book Value
Market Value is the price of the stock multiplied by the number of shares outstanding.
Also known as Market Capitalization
Book Value
The sum of par value, (contributed surplus – value in access of par upon issue), accumulated retained earnings, and adjustments to equity is the common equity of the firm, usually referred to as the book value of the firm.

41. Enbridge Inc., 2003

42. Enbridge Inc., 2003

43. Enbridge Inc., 2003

44. Enbridge Inc., 2003

45. Authorized vs. Issued Common Stock
The articles of incorporation must state the number of shares of common stock the corporation is authorized to issue.
The board of directors, after a vote of the shareholders, may amend the articles of incorporation to increase the number of shares.
Authorizing a large number of shares may worry investors about dilution because authorized shares can be issued later with the approval of the board of directors but without a vote of the shareholders.

46. Enbridge Inc., 2003

47. Shareholders’ Rights
The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders.
Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote.
The exact mechanism varies across companies.
The important difference is whether shares are to be voted cumulatively or voted straight.

48. Cumulative versus Straight Voting
The effect of cumulative voting is to permit minority participation.
Under cumulative voting, if there are N directors up for election, then 1/(N+1) percent of the stock plus one share will guarantee you a seat.
With cumulative voting, the more seats that are up for election at one time, the easier it is to win one.
Straight voting works like a U.S. political election.
Shareholders have as many votes as shares and each position on the board has its own election.
A tendency to freeze out minority shareholders.

49. Cumulative vs. Straight Voting: Example 1
Imagine a firm with two shareholders:
Mr. MacDonald and Ms. Laurier.
Mr. MacDonald owns 60% of the firm ( = 600 shares) and Ms. Laurier 40% ( = 400 shares).
There are three seats up for election on the board.

50. Cumulative vs. Straight Voting: Example 2
There are 2 million shares outstanding. How many shares do you need to own to be certain that you can elect at least one director under:
a) straight voting? b) cumulative voting?

51. Proxy Voting
A proxy is the legal grant of authority by a shareholder to someone else to vote his or her shares.
For convenience, the actual voting in large public corporations is usually done by proxy.
If shareholders are not satisfied with management, an outside group of shareholders can try to obtain as many votes as possible via proxy.
Proxy battles are often led by large pension funds like the Ontario Teachers’ Pension Board or the British Columbia Investment Management Corporation.

52. Dividends
Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation.
A corporation cannot default on an undeclared dividend.
The payment of dividends by the corporation is not a business expense.
Therefore, they are not tax-deductible.
Dividends (of Canadian corporations) received by individual shareholders are partially sheltered by a dividend tax credit.
Canadian corporations do not pay taxes on dividends for amounts they receive from Canadian corporations.

53. Classes of Shares
When more than one class of share exists, they are usually created with unequal voting rights.
Many companies issue dual classes of common stock. The reason has to do with control of the firm.
Firms going public with dual classes of shares in Canada are often family controlled.
Lease, McConnell, and Mikkelson found the market prices of U.S. stocks with superior voting rights to be about 5-percent higher than the prices of otherwise-identical stocks with inferior voting rights.

54. Corporate Long-Term Debt: The Basics
Interest versus Dividends
Is It Debt or Equity?
Basic Features of Long-Term Debt
Different Types of Debt
Repayment
Seniority
Security
Indenture

55. Interest versus Dividends
Debt is not an ownership interest in the firm. Creditors do not usually have voting power.
The device used by creditors to protect themselves is the loan contract (i.e., indenture).
The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. Dividends are paid out of after-tax dollars.
Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm.
One of the costs of issuing debt is the possibility of financial failure.

56. Is It Debt or Equity?
Some securities blur the line between debt and equity.
Corporations are very adept at creating hybrid securities that look like equity but are called debt.
Obviously, the distinction is important for tax purposes.
A corporation that succeeds in creating a debt security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs.

57. Basic Features of Long-Term Debt
The bond indenture usually lists
Amount of Issue (typically denominated with a $1000 face value), Date of Issue, Maturity
Denomination (Par value)
Coupon, typically semiannual
Security
Sinking Funds
Call Provisions
Covenants
Features that may change over time
Rating
Yield-to-Maturity
Market Price

58. Enbridge Inc., 2003

59. Back to Preferred Shares
A preferred share represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy.
Preferred shares have a stated liquidating value.
For example, CIBC “$2.25 preferred” translates into a dividend yield of 9% of the stated $25 value.
Preferred dividends are either cumulative or noncumulative.
Firms may have an incentive to delay preferred dividends, since preferred shareholders receive no interest on the cumulated dividends.
Preferred shares have a lower yield than debt.

60. Tax loophole in Canada
Corporate investors are exempt from income taxes on dividends  they would be willing to pay a premium for these shares (compared to similar debt instruments); as a consequence, yields are low.
Low taxed companies may therefore prefer to issue these shares compared to debt (i.e., for these companies the debt tax shield is of limited usage).

61. Tax loophole in Canada
Zero Tax Ltd., a corporation not paying any income taxes, can issue preferred shares attractive to Full Tax Ltd., a second corporation taxable at a combined federal and provincial rate of 45%. Zero Tax is seeking $1000 in financing through either debt or preferred stock. Zero Tax can issue either debt with a 10% coupon or preferred stock with a 6.7% dividend.
Preferred (6.7%) Debt (10%)
Issuer: Zero Tax Ltd.
Preferred dividend/interest paid $ $100.00
Dividend tax at 40%
Tax deduction on interest
Total financing cost $ $100.00
After-tax cost % %
Purchaser: Full Tax Ltd.
Before-tax income $ $100.00
Tax
After-tax income $ $55.00
After-tax yield % %

62. Other Reasons for Preferred Shares
Regulatory firms can pass the tax disadvantage to their customers.
Firms issuing preferred shares can avoid the threat of bankruptcy while at the same time not surrender control (no voting rights on preferred shares).

63. Patterns of Long-Term Financing
For Canadian firms, internally generated cash flow dominates as a source of financing.
Firms usually spend more than they generate internally—the gap is financed by new sales of debt and equity.
Net new issues of equity are dwarfed by new sales of debt.
This is consistent with the pecking order hypothesis.
Leverage ratios for Canadian firms are considerably higher than they were in the 1960s.

64. The Long-Term Financial Gap
Uses of Cash Flow (100%)
Capital spending
Net working capital plus other uses
Sources of Cash Flow (100%)
Internal cash flow (retained earnings plus depreciation) 68.3%
Long-term debt and equity 31.7%
Internal cash flow
Financial deficit
External cash flow

65. Chapter 15 How Corporations Issue Securities
Issuing securities involves the corporation in a number of decisions.
This chapter looks at how corporations issue securities to the investing public.
The basic procedure for selling debt and equity securities are essentially the same. This chapter focuses on equity.

66. Topics Covered Venture Capital The Initial Public Offering
Other New-Issue Procedures
Security Sales by Public Companies
Rights Issue
Private Placements and Public Issues

67. Venture Capital
The limited partnership is the dominant form of intermediation in this market.
There are five types of suppliers of venture capital:
Old-line wealthy families.
Private partnerships and corporations.
Large industrial or financial corporations with established venture-capital subsidiaries.
The federal government (through crown-related firms).
Individuals, typically with incomes in excess of $100,000 and net worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.

68. Stages of Financing Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
Start-Up
Funds are likely to pay for marketing and product refinement.
First-Round Financing
Additional money to begin sales and manufacturing.
Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling its product but still losing money.
Third-Round Financing
Financing for a firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing.
Fourth-Round Financing
Financing for a firm that is likely to go public within six months; a.k.a. bridge financing.

69. U.S. Venture Capital Investments

70. Initial Offering
Initial Public Offering (IPO) - First offering of stock to the general public.
Underwriter - Firm that buys an issue of securities from a company and resells it to the public.
Offering price – The price of a share at IPO.
Spread - Difference between public offer price and price paid by underwriter.
Prospectus - Formal summary that provides information on an issue of securities. 7

71. The Top Managing Underwriters

72. The Public Issue in Canada
Regulation of the securities market in Canada is carried out by provincial commissions.
In the U.S., regulation is handled by a federal body (SEC).
The regulators’ goal is to promote the efficient flow of information about securities and the smooth functioning of securities’ markets.
All companies listed on the TSX come under the jurisdiction of the Ontario Securities Commission (OSC).
Other provinces have similar legislation and regulating bodies.
The Canadian Securities Administration (CSA) coordinates regulation.

73. New Issue Procedure
Steps involved in issuing securities to the public:
Management obtains approval from the board of directors.
The firm prepares a preliminary prospectus to the OSC.
The OSC studies the preliminary prospectus and notifies the company of any changes required.
Once the revised, final prospectus meets with the OSC’s approval, a price is determined and a full-fledged selling effort gets under way.

74. The Process of Raising Capital
Steps in Public Offering Time
1. Pre-underwriting conferences
2. Registration statements
3. Pricing the issue
4. Public offering and sale
5. Market stabilization
Several months
20-day waiting period
Usually on the 20th day
After the 20th day
30 days after offering

75. The overallotment option: known as the Green Shoe provision gives members of the underwriting group the option to purchase additional shares at the offering price less fees and commissions. The option has a short maturity and is limited to about 10% of original number of shares issued.
Investment Dealers:
In 2003, RBC Dominion Securities was the leading underwriter by revenue.

76. Underwriting Spreads US (2003)

77. Average Initial IPO Returns9

78. Initial Offering US
Average Expenses on 1767 IPOs from 8

79. The Costs of Public Offerings
Costs of Going Public in Canada:
Fees %
Underpricing %
TOTAL %
The above figures understate the total cost because they ignore indirect expenses or the overallotment option.

80. From CNN.COM (Aug 18, 2004)
Google plans to price the shares in a rare auction-style IPO. The deal promises to put more shares in the hands of ordinary investors rather than wealthy investment banking clients. The auction is also widely seen as a slap at Wall Street and the clubby culture that contributed to investigations into improper IPO trading activities at the height of the dot-com bubble.

81. General Cash Offers
Seasoned Offering - Sale of securities by a firm that is already publicly traded.
General Cash Offer - Sale of securities open to all investors by an already public company.
Shelf Registration - A procedure that allows firms to file one registration statement for several issues of the same security.
Private Placement - Sale of securities to a limited number of investors without a public offering. 11

82. Private Placements
Avoid the costly procedures associated with the registration requirements that are a part of public issues.
The OSC and SEC restrict private placement issues of no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds.
The biggest drawback is that the securities cannot be easily resold.

83. Market Reaction to SEO
Suppose that the CFO of a restaurant chain is strongly optimistic about its prospect. From her point of view, the company’s stock price is too low. Yet the company wants to issue shares to finance expansion into another county. What is she to do?

84. The Announcement of New Equity and the Value of the Firm
The market value of existing equity drops on the announcement of a new issue of common stock.
Reasons include
Managerial Information
Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced.
Debt Capacity
If the market infers that the managers are issuing new equity to reduce their debt-to-equity ratio due to the specter of financial distress the stock price will fall.
Falling Earnings

85. Rights
An issue of common stock offered to existing shareholders is called a rights offering.
Prior to the 1980 Bank Act, chartered banks were required to raise equity exclusively through rights offerings.
If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders.
This allows shareholders to maintain their percentage ownership if they so desire.

86. Mechanics of Rights Offerings
The management of the firm must decide:
The exercise (subscription) price (the price existing shareholders pay for new shares).
How many rights will be required to purchase one new share of stock.
These rights have value:
Shareholders can either exercise their rights or sell their rights.

87. Rights Offering Example
National Power has 1 million shares outstanding. Each share sells for $20. The company wants to raise $5 million in new equity. Suppose the exercise (subscription) price is set at $10 per share. Find
Market value of company after rights issue.
Number of new shares.
Number of rights needed to buy a share.
The value of the share after the rights offering.
The value of a right.
The cost of a new share to an “outside” investor.

88. Time Line Ex Right Date Right Issue Date Right Expiration Date
Rights announcement
P=$20
N=1m
P=$16.67
N=1m
P=$16.67
N=1m
R=$3.33
P=$16.67
N=1.5m

89. Theoretical Value of a Right
The theoretical value of a right during the rights-on period is:
R0 = (M0 – S) / (N +1)
Where,
M0 = Common share price during the rights-on period
S = Subscription price
N = Number of rights required to buy one new share

90. Value of a Right after Ex-Rights Date
When the stock goes ex-rights, its price drops by the value of one right.
Me = M0 – R0
Re = (Me – S) / N
Where,
Me is the common share price during the ex-rights period.

91. Self Practice a. How many new shares will Yoma issue?
Yoma Inc. is attempting to raise $5,000,000 in new equity with a rights offering. The subscription price will be $40 per share. The stock currently sells for $50 per share and there are 250,000 shares outstanding.
a. How many new shares will Yoma issue?
b. How many rights will be required to buy one share?
c. At what price will the stock sell when it goes ex‑rights if the total value of all stock increases by the amount of the new funds?
d. What is the theoretical value of 1 right?