4 Types of questions Your firm needs capital to finance growth. Should you issue debt or equity or obtain a bank loan? If you choose debt, should the bonds be convertible? Callable? If you choose equity, should you use common or preferred stock? How will the stock market react to your decision? In 1998, IBM announced that it would repurchase $2.5 billion in stock. How should it structure the stock repurchase? IBM’s price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response?
5 Raising capital Sources of funds Internal financing Internally generated cashflows (retained earnings) Debt (borrowing) Bonds and commercial paper Bank debt (loan commitments, lines of credit) Leases New equity Common or preferred stock Rights offering
6 Sources of funds, U.S. corporations, 1979 – 1997
8 Capital structure, U.S. corporations 1979 – 1997
9 Common Stock Book Value vs. Market Value Book value is a backward looking measure. It tells us how much capital the firm has raised from shareholders in the past. It does not measure the value that shareholders place on those shares today. The market value of the firm is forward looking, it depends on the future dividends that shareholders expect to receive.
10 Common Stock Example - Heinz Book Value vs. Market Value (4/2003) Total Shares outstanding = 351 million
11 Common Stock Example - Heinz Book Value vs. Market Value (4/03) Total Shares outstanding = 351 million
12 Preferred Stock Preferred Stock - Stock that takes priority over common stock in regards to dividends. Net Worth - Book value of common shareholder ’ s equity plus preferred stock. Floating-Rate Preferred - Preferred stock paying dividends that vary with short term interest rates.
13 Raising capital: Borrowing Terminology Convertible, callable bonds and preferred stock Zero-coupon, or pure-discount, bonds Junk bonds Secured debt vs. unsecured debt (debentures) Priority / seniority Senior debt (60% recovery in bankruptcy) Subordinated or junior debt (< 30% recovery in bankruptcy)
14 Corporate Debt Debt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company. “ Default Risk ” is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily. “ Bond Ratings ” are issued on debt instruments to help investors assess the default risk of a firm.
15 Corporate Debt Prime Rate - Benchmark interest rate charged by banks. Funded Debt - Debt with more than 1 year remaining to maturity. Sinking Fund - Fund established to retire debt before maturity. Callable Bond - Bond that may be repurchased by firm before maturity at specified call price.
16 Corporate Debt Subordinate Debt - Debt that may be repaid in bankruptcy only after senior debt is repaid. Secured Debt - Debt that has first claim on specified collateral in the event of default. Investment Grade - Bonds rated Baa or above by Moody ’ s or BBB or above by S&P. Junk Bond - Bond with a rating below Baa or BBB.
20 Corporate Debt Eurodollars - Dollars held on deposit in a bank outside the United States. Eurobond - Bond that is marketed internationally. Private Placement - Sale of securities to a limited number of investors without a public offering. Protective Covenants - Restriction on a firm to protect bondholders. Lease - Long-term rental agreement.
21 Corporate Debt Warrant - Right to buy shares from a company at a stipulated price before a set date. Convertible Bond - Bond that the holder may exchange for a specified amount of another security. Convertibles are a combined security, consisting of both a bond and a call option.
23 Financing decisions What is the goal? How can financing decisions create value?
24 Capital structure decisions Observations Pecking order Firms prefer internal to external financing. If financing is external, firms prefer debt to equity. Target capital structure? Mean reversion in leverage ratios and systematic differences across industries.
29 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. Spread - Difference between public offer price and price paid by underwriter. Prospectus - Formal summary that provides information on an issue of securities. Underpricing - Issuing securities at an offering price set below the true value of the security.
30 Direct costs of a public offering, 1990 – 1994
33 General Cash Offers Seasoned Offering - Sale of securities by a firm that is already publicly traded. 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.
35 Rights Issue Rights Issue - Issue of securities offered only to current stockholders. Example - Lafarge Corp needs to raise € 1.28billion of new equity. The market price is € 60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at € 41 per share. If we assume 100% subscription, what is the value of each right?
36 Rights Issue Example - Lafarge Corp needs to raise €1.28billion of new equity. The market price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer at €41 per share. If we assume 100% subscription, what is the value of each right?
37 Price impact How do stock prices react to security offerings? Debt issues? Seasoned equity offerings?
40 Stock price reaction Observations Stock prices react negatively to stock issues Stock prices react positively to bank loans, but very little to public debt issues Leverage-increasing transactions are good news, but leverage-decreasing transactions are bad news Why?
41 Payout policy Questions How do firms payout cash? What are the advantages and disadvantages of each method? How much cash should a firm hold?