Corporate Financing Decisions Long-Term Financing 1Finance - Pedro Barroso

Common Stock Par and No-Par Stock Authorized versus Issued Common Stock Capital Surplus Retained Earnings Market Value, Book Value, and Replacement Value Shareholders’ Rights Dividends Classes of Stock 2Corporate Finance - Pedro Barroso

Par and No-Par Stock The stated value on a stock certificate is called the par value – Par value is an accounting value, not a market value. – The total par value (the number of shares multiplied by the par value of each share) is sometimes called the dedicated capital of the corporation Some stocks have no par value 3Corporate Finance - Pedro Barroso

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 4Corporate Finance - Pedro Barroso

Capital Surplus Usually refers to amounts of directly contributed equity capital in excess of the par value – For example, suppose 1,000 shares of common stock having a par value of $1 each are sold to investors for $8 per share. The capital surplus would be ($8 – $1) × 1,000 = $7,000 5Corporate Finance - Pedro Barroso

Retained Earnings Not many firms pay out 100 percent of their earnings as dividends The earnings that are not paid out as dividends are referred to as retained earnings 6Corporate Finance - Pedro Barroso

Market Value, Book Value, and Replacement 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, capital surplus, and accumulated retained earnings is the common equity of the firm, usually referred to as the book value of the firm Replacement Value – The current cost of replacing the assets of the firm At the time a firm purchases an asset, market value, book value, and replacement value are equal 7Corporate Finance - Pedro Barroso

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 straight 8Corporate Finance - Pedro Barroso

Cumulative versus Straight Voting The effect of cumulative voting is to permit minority participation – Under cumulative voting, the total number of votes that each shareholder may cast is determined first. Usually, the number of shares owned or controlled by a shareholder is multiplied by the number of directors to be elected. Each shareholder can distribute these votes over one or more candidates. 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. – There is a tendency to freeze out minority shareholders. 9Corporate Finance - Pedro Barroso

Cumulative vs. Straight Voting: Example Imagine a firm with two shareholders: Mr. Smith and Ms. Wesson. – Mr. Smith owns 60% of the firm ( = 600 shares) and Ms. Wesson 40% ( = 400 shares). – There are three seats up for election on the board. Under straight voting, Mr. Smith gets to pick all three seats. Under cumulative voting, Ms. Wesson has 1,200 votes ( = 400 shares × 3 seats) and Mr. Smith 1,800. Ms. Wesson can elect at least one board member. 10Corporate Finance - Pedro Barroso

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 11Corporate Finance - Pedro Barroso

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 received by individual shareholders are, for the most part, considered ordinary income by the IRS and are fully taxable – There is an intra-corporate dividend exclusion 12Corporate Finance - Pedro Barroso

Classes of Stock When more than one class of stock 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 Lease, McConnell, and Mikkelson found the market prices of stocks with superior voting rights to be about 5 percent higher than the prices of otherwise-identical stocks with inferior voting rights 13Corporate Finance - Pedro Barroso

Long-Term Debt Corporate debt can be short-term (maturity less than one year) or long-term Different from common stock: – Creditor’s claim on corporation is specified – Promised cash flows – No voting rights Over half of outstanding bonds are owned by life insurance companies & pension funds 14Corporate Finance - Pedro Barroso

Interest versus Dividends Debt is not an ownership interest in the firm, creditors do not usually have voting power Corporation’s payment of interest on debt 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 15Corporate Finance - Pedro Barroso

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 at tax time – A corporation that succeeds is creating a debt security that is really equity. It obtains the tax benefits of debt while eliminating its bankruptcy costs. 16Corporate Finance - Pedro Barroso

Features of Long-Term Debt Bond indenture (written agreement between the corporate debt issuer and the lender) usually lists – Amount of Issue, Date of Issue, Maturity – Denomination (Par value) – Annual Coupon, Dates of Coupon Payments – Security (Collateral) – Sinking Funds – Call Provisions – Covenants Features that may change over time – Rating – Yield-to-Maturity – Market price 17Corporate Finance - Pedro Barroso

Different Types of Debt A debenture is an unsecured corporate debt, whereas a bond is secured by collateral (e.g., by a mortgage on the corporate property) A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years 18Corporate Finance - Pedro Barroso

Repayment Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt by installments is called amortization Amortization is usually arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds 19Corporate Finance - Pedro Barroso

Sinking Fund There are many different kinds of sinking-fund arrangements: – Most start between 5 and 10 years after initial issuance – Some establish equal payments over the life of the bond – Most high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue Sinking funds provide extra protection to bondholders Sinking funds provide the firm with an option 20Corporate Finance - Pedro Barroso

Seniority Seniority indicates preference in position over other lenders – senior or junior debt Some debt is subordinated; In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first 21Corporate Finance - Pedro Barroso

Security - Collateral Security is a form of attachment to property – It provides that the property can be sold in event of default to satisfy the debt for which the security is given – A mortgage is used for security in tangible property – Debentures are not secured by collateral 22Corporate Finance - Pedro Barroso

Protective Covenants Agreements to protect bondholders Negative covenant: Shall not: – pay dividends beyond specified amount – sell more senior debt & amount of new debt is limited – refund existing bond issue with new bonds paying lower interest rate – buy another company’s bonds Positive covenant: Shall: – use proceeds from sale of assets for other assets – allow redemption in event of merger or spinoff – maintain good condition of assets – provide audited financial information 23Corporate Finance - Pedro Barroso

Bond Ratings What is rated: – The likelihood that the firm will default – The protection afforded by the loan contract in the event of default Who pays for ratings: – Firms pay to have their bonds rated – The ratings are constructed from the financial statements supplied by the firm Ratings can change, and raters can disagree 24Corporate Finance - Pedro Barroso

Bond Ratings: Investment Grade Moody's S&P's Credit Rating Description Aaa AAA Highest credit rating, maximum safety Aa1 AA+ Aa2 AA High credit quality, investment-grade bonds Aa3 AA- A1 A+ A2 A Upper-medium quality, investment grade bonds A3 A- Baa1 BBB + Baa2 BBB Lower-medium quality, investment grade bonds Baa3 BBB- 25Corporate Finance - Pedro Barroso

Bond Ratings: Below Investment Grade 26Corporate Finance - Pedro Barroso

Junk Bonds Anything with S&P “BB+” or Moody’s “Ba1” or below is a junk bond A polite euphemism for junk is high-yield bond There are two types of junk bonds: – Original issue junk – Fallen angels—rated Yield premiums versus default risk 27Corporate Finance - Pedro Barroso

Different Types of Bonds Callable Bonds Puttable Bonds Convertible Bonds Pure Discount Bonds Floating-Rate Bonds 28Corporate Finance - Pedro Barroso

Callable Bonds versus Noncallable Bonds Most bonds are callable. Some sensible reasons for call provisions include: taxes, managerial flexibility and the fact that callable bonds have less interest rate risk 29Corporate Finance - Pedro Barroso

Puttable Bonds Put provisions – Put price – Put date – Put deferment Extendible bonds Value of the put feature Cost of the put feature 30Corporate Finance - Pedro Barroso

Convertible Bonds Why are they issued? Why are they purchased? Conversion ratio: – Number of shares of stock acquired by conversion Conversion price: – Bond par value / Conversion ratio Conversion value: – Price per share of stock x Conversion ratio In-the-money versus out-the-money 31Corporate Finance - Pedro Barroso

Convertible Bond Prices 32Corporate Finance - Pedro Barroso

Preferred Stock 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 Preferred dividends are either cumulative or noncumulative No voting rights Similar to debt 33Corporate Finance - Pedro Barroso

Is Preferred Stock Really Debt? A good case can be made that preferred stock is really debt in disguise – The preferred shareholders receive a stated dividend – In the event of liquidation, the preferred shareholders are entitled to a fixed claim – No voting rights Unlike debt – Preferred stock dividends cannot be deducted as interest expense when determining taxable corporate income 34Corporate Finance - Pedro Barroso

Patterns of Financing Internally generated cash flow dominates as a source of financing, typically between 70 and 90% Firms usually spend more than they generate internally—the deficit 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 Firms in other countries rely to a greater extent than U.S. firms on external equity 35Corporate Finance - Pedro Barroso

Corporate Financing Decisions Issuing Securities to the Public 36Corporate Finance - Pedro Barroso

Public Issue The Basic Procedure – Management gets the approval of the Board. – The firm prepares and files a registration statement with the SEC. – The SEC studies the registration statement during the waiting period. – The firm prepares and files an amended registration statement with the SEC. – If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway. 37Corporate Finance - Pedro Barroso

The Process of a Public Offering 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 38Corporate Finance - Pedro Barroso

An Example of a Tombstone 39Corporate Finance - Pedro Barroso

Alternative Issue Methods There are two kinds of public issues: – General cash offer (IPOs, SEOs) – Rights offer (SEOs) Almost all debt is sold in general cash offerings 40Corporate Finance - Pedro Barroso

Cash Offer There are three methods for issuing securities for cash: – Firm Commitment – Best Efforts – Dutch Auction There are two methods for selecting an underwriter – Competitive – Negotiated 41Corporate Finance - Pedro Barroso

Firm Commitment Underwriting The issuing firm sells the entire issue to the underwriting syndicate The syndicate then resells the issue to the public The underwriter (fee) makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold The syndicate bears the risk of not being able to sell the entire issue for more than the cost This is the most common type of underwriting in the United States 42Corporate Finance - Pedro Barroso

Best Efforts Underwriting Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price The company bears the risk of the issue not being sold The offer may be pulled if there is not enough interest at the offer price. The company does not get the capital, and they have still incurred substantial flotation costs This type of underwriting is not as common as it used to be 43Corporate Finance - Pedro Barroso

Dutch Auction Underwriting Underwriter accepts a series of bids that include number of shares and price per share The price that everyone pays is the highest price that will result in all shares being sold There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid The Treasury has used Dutch auctions for years Google was the first large Dutch auction IPO 44Corporate Finance - Pedro Barroso

IPO Underpricing May be difficult to price an IPO because there is not a current market price available Private companies tend to have more asymmetric information than companies that are already publicly traded Underwriters want to ensure that, on average, their clients earn a good return on IPOs Underpricing causes the issuer to “leave money on the table” 45Corporate Finance - Pedro Barroso

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-equity ratio due to the specter of financial distress, the stock price will fall. – Falling Earnings 46Corporate Finance - Pedro Barroso

Cost of New Issues 1.Spread or underwriting discount 2.Other direct expenses 3.Indirect expenses 4.Abnormal returns 5.Underpricing 6.Green Shoe Option 47Corporate Finance - Pedro Barroso

Costs of Equity Public Offerings Proceeds Direct CostsUnderpricing (in millions)SEOsIPOsIPOs %15.36%18.18% %11.63%10.02% %9.81%17.91% %9.21%29.57% %8.65%39.20% %8.34%45.36% %7.67%37.10% %6.72%17.72% 500 and up3.64%5.15%12.19% 48Corporate Finance - Pedro Barroso

Private Placements Private placements avoid the costly procedures associated with the registration requirements that are a part of public issues The SEC restricts private placement issues to 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 49Corporate Finance - Pedro Barroso

Rights 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 50Corporate Finance - Pedro Barroso

Mechanics of Rights Offerings The management of the firm must decide: – The exercise price (the price existing shareholders must 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 51Corporate Finance - Pedro Barroso

Rights Offering Example Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price What is the new market value of the firm? What is the ex-rights price? What is the value of a right? 52Corporate Finance - Pedro Barroso

What is the New Market Value of the Firm? There are 200,000 outstanding shares at $25 each There will be 10,000 new shares issued at a $20 subscription price 53Corporate Finance - Pedro Barroso

What Is the Ex-Rights Price? There are 210,000 outstanding shares of a firm with a market value of $5,200,000. Thus the value of an ex-rights share is Thus, the value of a right is: $ = $25 – $ = $ $5,200, ,000 shares 54Corporate Finance - Pedro Barroso

The Rights Puzzle Over 90% of new issues are underwritten, even though rights offerings are much cheaper A few explanations: – Underwriters increase the stock price. There is not much evidence for this, but it sounds good – The underwriter provides a form of insurance to the issuing firm in a firm-commitment underwriting – The proceeds from underwriting may be available sooner than the proceeds from a rights offering No single explanation is entirely convincing 55Corporate Finance - Pedro Barroso

Shelf Registration Permits a corporation to register an offering that it reasonably expects to sell within the next two years. Not all companies are allowed shelf registration. Qualifications include: – The firm must be rated investment grade. – They cannot have recently defaulted on debt. – The market capitalization must be > $75 m. – No recent SEC violations. 56Corporate Finance - Pedro Barroso

Private Equity Market The previous sections of this chapter assumed that a company is big enough, successful enough, and old enough to raise capital in the public equity market For start-up firms and firms in financial trouble, the public equity market is often not available 57Corporate Finance - Pedro Barroso

Venture Capital The limited partnership is the dominant form of intermediation in this market There are four types of suppliers of venture capital: 1.Old-line wealthy families 2.Private partnerships and corporations 3.Large industrial or financial corporations have established venture-capital subsidiaries. 4.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. 58Corporate Finance - Pedro Barroso

Public Issue of Bonds The general procedure is similar to the issuance of stock, as described in the previous chapter. The indenture, which is specific to bonds, is a written agreement between the borrower and a trust company. The indenture usually lists: – Amount of Issue, Date of Issue, Maturity – Denomination (Par value) – Annual Coupon, Dates of Coupon Payments – Security – Sinking Funds – Call Provisions – Covenants 59Corporate Finance - Pedro Barroso

Direct Placement Compared to Public Issues A directly placed long-term loan avoids the cost of registration with the SEC Direct placement is likely to have more restrictive covenants In the event of default, it is easier to “work out” a private placement 60Corporate Finance - Pedro Barroso

Long-Term Syndicated Bank Loans Large money-center banks frequently have more demand for loans than they have supply Small regional banks are often in the opposite situation As a result, a larger money center bank may arrange a loan with a firm or country and then sell portions of the loan to a syndicate of other banks A syndicated loan may be publicly traded 61Corporate Finance - Pedro Barroso

Corporate Financing Decisions Leasing 62Corporate Finance - Pedro Barroso

Types of Leases A lease is a contractual agreement between a lessee and lessor The lessor owns the asset and for a fee allows the lessee to use the asset 63Corporate Finance - Pedro Barroso

Buying versus Leasing BuyLease Firm U buys asset and uses asset; financed by debt and equity Lessor buys asset, Firm U leases it Manufacturer of asset Equity shareholders Firm U 1.Uses asset 2.Owns asset Creditors Manufacturer of asset Lessor 1. Owns asset 2. Does not use asset Equity shareholders Creditors Lessee (Firm U) 1. Uses asset 2. Does not own asset 64Corporate Finance - Pedro Barroso

Operating Leases Usually not fully amortized Usually require the lessor to maintain and insure the asset Lessee enjoys a cancellation option 65Corporate Finance - Pedro Barroso

Financial Leases The exact opposite of an operating lease 1.Do not provide for maintenance or service by the lessor 2.Financial leases are fully amortized 3.The lessee usually has a right to renew the lease at expiry 4.Generally, financial leases cannot be cancelled 66Corporate Finance - Pedro Barroso

Sale and Lease-Back A particular type of financial lease Occurs when a company sells an asset it already owns to another firm and immediately leases it from them Two sets of cash flows occur: – The lessee receives cash today from the sale – The lessee agrees to make periodic lease payments, thereby retaining the use of the asset 67Corporate Finance - Pedro Barroso