Week 1: Raising Capital â Equity
Week 1: Raising Capital – Equity 1. 2. 3. 4. 5.
Overview of Financing Policy Raising Equity Capital Initial Public Offerings (IPOs) Seasoned Equity Offerings (SEOs) Regulatory Environment
What is Corporate Finance? Three key decisions: • Investment (or capital budgeting) policy • Financing policy • Payout policy
Objective of Corporate Finance: Maximise shareholder value/ firm value (these should be equivalent) 1. Overview of Financing Policy • Firms primarily use retained earnings and debt to finance a project and equity only as a last resort. This is known as the “pecking order”. • Why? Information asymmetry – equity issues signal to investors • Equity is the last to be paid back, it has a ‘residual claim’, and is the most risky but it has the highest return. • Hybrid securities combine equity and debt. External Financing Choices 1. Retained Earnings 2. Straight Debt 3. Convertible Debt: Convertible bond-‐ A bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. 4. External Common Equity 5. Straight Preferred Stock 6. Convertible Preferred 2. Raising equity capital Key Characteristics of Equity Finance: -‐ Permanent contribution
-‐ Full voting rights -‐ Residual claim Advantages: • A company is not require to pay dividends to shareholders (in contrast to interest on debt) • No obligation to redeem (in contrast debt must be repaid at maturity) • Raising equity by issuing shares lowers the interest rate a company must pay on debt because a higher proportion of equity in a capital structure lowers the risk of financial difficulty Disadvantages: • Dilution of shareholder ownership • Transaction costs of raising funds Ways to raise equity: Unlisted Firms • Private equity financing -‐ VC • IPO Listed firms • Private placement: the sale of securities to a relatively small number of select investors as a way of raising capital. • Rights issues • Dividend reinvestment plan Private Equity • Venture Capital: sources include family, friends, “business angels”, private equity fund managers • Exit strategies – sale or IPO Public Equity • IPOs • Seasoned Equity Offerings (SEOs) 3. Initial Public Offerings (IPOs) Underwriters • Investment banks act as intermediaries between a company selling securities (debt & equity) and the investing public • The underwriter contracts to purchase all shares for which applications have not been received by the closing date of the issue. The underwriter then charges a fee (usually a percentage of the amount raised by the issue. • Underwriting represents a real cost to the original shareholders, who are effectively selling assets to the new shareholders for less than their fair value. The difference in value is referred to as ‘money left on the table’. Valuing IPOs: Preliminary Valuation • Two approaches: -‐ Discounted cash flow analysis -‐ Comparable firms analysis Final Valuation • Fixed Pricing • Book-‐building • Open auction
Direct costs: Underwriters-‐ spread Lawyers accountants etc. Indirect costs: Underpricing Underpricing Issuing securities at an offer price set below the true value of the security (captured by first-‐ day closing price). Evidence suggests that on average new issues initially trade at a price above the issue price so they are ‘underpriced.’ Explanations of Underpricing • Winner’s curse (information asymmetry) –uninformed investors will participate only if, on average, IPOs are underpriced sufficiently to compensate them • Investment banking conflicts (Investment banks arrange for underpricing as a way to benefit themselves and their clients) • Litigation insurance: reduce the risk of being sued • Ownership dispersion -‐ ensure more diversified ownership for greater liquidity and job security • Signalling – leaving a good taste, Setting a low price so that potential investors subscribe triggering others to follow Explanation of Long-‐run Underperformance • Divergence of opinion hypothesis (optimistic and pessimistic investors opinions converge as more information is released) • Window of opportunity (IPOs usually take place in periods of high demand) 4. Seasoned Equity Offerings (SEOs) Types • Rights issues or DRP Existing shareholders • General Offer Public • Private Placement Financial institutes Private Placements
Ownership will always dilute while wealth may not (if the placement was made at a premium wealth may not decrease) Rights Issues
Rights issues notations
Subscription price (S) Pro-‐rata entitlement (1:N) M is the market price of the share cum-‐ rights X is the theoretical price of the share ex-‐rights R is the value of the right
R+S=X Ownership will stay the same in a rights issue if all SH take up the offer. Why share price may not fall to the theoretical ex-‐rights price X on the ex-‐rights date? -‐ New information on the stock -‐ General movement in share prices -‐ Transaction costs/taxes -‐ The option characteristic of the right (a rights issue is equivalent to a European call option whose value depend on many factors)
Overview of Financing Policy Raising Equity Capital Initial Public Offerings (IPOs) Seasoned Equity Offerings (SEOs) Regulatory Environment
What is Corporate Finance? Three key decisions: • Investment (or capital budgeting) policy • Financing policy • Payout policy
Objective of Corporate Finance: Maximise shareholder value/ firm value (these should be equivalent) 1. Overview of Financing Policy • Firms primarily use retained earnings and debt to finance a project and equity only as a last resort. This is known as the “pecking order”. • Why? Information asymmetry – equity issues signal to investors • Equity is the last to be paid back, it has a ‘residual claim’, and is the most risky but it has the highest return. • Hybrid securities combine equity and debt. External Financing Choices 1. Retained Earnings 2. Straight Debt 3. Convertible Debt: Convertible bond-‐ A bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. 4. External Common Equity 5. Straight Preferred Stock 6. Convertible Preferred 2. Raising equity capital Key Characteristics of Equity Finance: -‐ Permanent contribution
-‐ Full voting rights -‐ Residual claim Advantages: • A company is not require to pay dividends to shareholders (in contrast to interest on debt) • No obligation to redeem (in contrast debt must be repaid at maturity) • Raising equity by issuing shares lowers the interest rate a company must pay on debt because a higher proportion of equity in a capital structure lowers the risk of financial difficulty Disadvantages: • Dilution of shareholder ownership • Transaction costs of raising funds Ways to raise equity: Unlisted Firms • Private equity financing -‐ VC • IPO Listed firms • Private placement: the sale of securities to a relatively small number of select investors as a way of raising capital. • Rights issues • Dividend reinvestment plan Private Equity • Venture Capital: sources include family, friends, “business angels”, private equity fund managers • Exit strategies – sale or IPO Public Equity • IPOs • Seasoned Equity Offerings (SEOs) 3. Initial Public Offerings (IPOs) Underwriters • Investment banks act as intermediaries between a company selling securities (debt & equity) and the investing public • The underwriter contracts to purchase all shares for which applications have not been received by the closing date of the issue. The underwriter then charges a fee (usually a percentage of the amount raised by the issue. • Underwriting represents a real cost to the original shareholders, who are effectively selling assets to the new shareholders for less than their fair value. The difference in value is referred to as ‘money left on the table’. Valuing IPOs: Preliminary Valuation • Two approaches: -‐ Discounted cash flow analysis -‐ Comparable firms analysis Final Valuation • Fixed Pricing • Book-‐building • Open auction
Direct costs: Underwriters-‐ spread Lawyers accountants etc. Indirect costs: Underpricing Underpricing Issuing securities at an offer price set below the true value of the security (captured by first-‐ day closing price). Evidence suggests that on average new issues initially trade at a price above the issue price so they are ‘underpriced.’ Explanations of Underpricing • Winner’s curse (information asymmetry) –uninformed investors will participate only if, on average, IPOs are underpriced sufficiently to compensate them • Investment banking conflicts (Investment banks arrange for underpricing as a way to benefit themselves and their clients) • Litigation insurance: reduce the risk of being sued • Ownership dispersion -‐ ensure more diversified ownership for greater liquidity and job security • Signalling – leaving a good taste, Setting a low price so that potential investors subscribe triggering others to follow Explanation of Long-‐run Underperformance • Divergence of opinion hypothesis (optimistic and pessimistic investors opinions converge as more information is released) • Window of opportunity (IPOs usually take place in periods of high demand) 4. Seasoned Equity Offerings (SEOs) Types • Rights issues or DRP Existing shareholders • General Offer Public • Private Placement Financial institutes Private Placements
Ownership will always dilute while wealth may not (if the placement was made at a premium wealth may not decrease) Rights Issues
Rights issues notations
Subscription price (S) Pro-‐rata entitlement (1:N) M is the market price of the share cum-‐ rights X is the theoretical price of the share ex-‐rights R is the value of the right
R+S=X Ownership will stay the same in a rights issue if all SH take up the offer. Why share price may not fall to the theoretical ex-‐rights price X on the ex-‐rights date? -‐ New information on the stock -‐ General movement in share prices -‐ Transaction costs/taxes -‐ The option characteristic of the right (a rights issue is equivalent to a European call option whose value depend on many factors)
