© Prentice Hall, 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 scale Vary 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 Insurance Teachers Insurance & Annuity Association Prudential Insurance Hartford Investment Management Company Metropolitan Life Citigroup Global Investments American General Investment Management New 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

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.

The Value of a Right 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

The Value of a Right 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

The Value of a Right 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.

The Value of a Right 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.

The Value of a Right 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.

The Value of a Right 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.

The Value of a Right 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.

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$1.26$ ,500,000 shares Ebay, Inc. Common stock Par 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.

Financing with Preferred Stock 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.

Financing with Preferred Stock 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.