Copyright © 2003 McGraw Hill Ryerson Limited 14-1 prepared by: Carol Edwards BA, MBA, CFA...

copyright © 2003 McGraw Hill Ryerson Limited

14-114-1

prepared by:Carol EdwardsBA, MBA, CFA

Instructor, FinanceBritish Columbia Institute of Technology

Fundamentals

of Corporate

Finance

Second Canadian Edition


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Chapter 14How Corporations Issue Securities

Chapter Outline Venture Capital The Initial Public Offering The Underwriters Listing on the Stock Market Rights Issues and General Cash Offers

by Public Companies The Private Placement


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Introduction• Better Mousetraps Need Money

The introduction to Chapter 14 tells you about a few companies which made their founders very rich.

These stories illustrate an important concept: The most important asset of a new firm may be a

good idea. But that is not all its needs …

To get to really large and successfula firm needs lots of capital!


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Introduction• Better Mousetraps Need Money

To get a firm off the ground, an entrepreneur may rely on personal savings, funds from family and friends, and bank loans.

But this is unlikely to be enough to build a successful enterprise.

Companies constantly need funding to survive, grow and prosper.

This chapter will introduce you to the main phases a firm may go through in its ongoing search for money.


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Venture Capital• Early Stage Sources of Funds

Venture capital is money invested to finance a new firm.

Venture capitalists are investors who are prepared to back an untried company in return for a share of the profits.

Venture capital is provided by venture capital firms, financial and investment institutions, such as banks and pension funds, and by government institutions.

An angel investor is a wealthy individual who invests in early-stage ventures.


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Venture capitalists know that the success of a business depends on the efforts its owner-managers put in.

Thus they look for the following in a potential investment:Have the owner-managers staked their

savings in the company to signal their faith in the business?

Do the owner-managers have strong incentives to work hard?


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Venture capitalists rarely provide all the funding a firm needs up front.

Instead, they advance the funding to the firm in stages, as it reaches, and successfully passes, major checkpoints.Thus the firm may receive a million dollars as

first stage financing.If it reaches agreed upon goals, then the

venture capitalist would advance second stage financing, and so on.


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The Initial Public Offering• IPO’s

If a start-up is very successful, the firm may need to raise a considerable amount of capital to fund its continued growth.

Usually, it needs more capital than can be comfortably provided by a small number of individuals or a venture capitalists.

The firm can tap a wider source of capital by selling shares to the public to raise the necessary funds.


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An Initial Public Offering (IPO) is a firm’s first offering of stock to the general public.

An IPO is called:A primary offering if new shares are sold to

raise additional cash for the company.A secondary offering if the company’s

founders and the venture capitalist cash in on some of the gains by selling their shares.


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A secondary offering involves the sale of shares from early investors to new investors.

The cash raised from the sale of these shares goes to the early investors.It does not flow to the company.

IPO’s frequently involve both primary and secondary offerings.


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Some of the biggest secondary offerings have involved governments selling off stock in nationalized enterprises.

For example, in 1996, the Canadian government received $2.2 billion from the biggest IPO in Canadian history.84 million shares of the Canadian National

Railway were sold in the stock market.


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The Initial Public Offering•Arranging a Public Issue

Once a firm decides to go public, the first task is to select the underwriters.

An underwriter is a firm which:Buys an issue of securities from a company

and resells it to the public.Also provides the issuing company with

procedural and financial advice, shepherding it through the public issue process.


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The Initial Public Offering•Underwriting

Underwriters make their money on the spread when they resell the company’s shares.That is, they buy the securities at one price

and hope to resell at a higher price.The difference between the buying and

selling price (the spread) is their profit on the transaction.


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The Initial Public Offering•Underwriting vs Best Efforts

Buying shares and reselling them can be risky business. If markets turn against the underwriter, they

can be left holding a lot of unsold “inventory” and have to take losses to unload it.

In risky cases, an underwriter may prefer a best efforts deal. Here the underwriter agrees, for a commission,

to sell as much of the issue as possible, but does not guarantee to sell the entire issue.


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The Initial Public Offering•Prospectus Requirement

In Canada, a firm going public must provide potential investors with a prospectus.

A prospectus is a formal summary that provides information on an issue of securities.

One of the key functions of a prospectus is to warn investors about the risks involved in investment in the firm.


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The Initial Public Offering•Pricing the Issue

The issuing company and the underwriters must set a price for the new securities they are about to offer.

This is done using: Discounted cash flow calculations, like those

you saw in Chapter 5.An analysis of the price-earnings ratios of the

shares of the firm’s principal competitors.


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The Initial Public Offering•Underpricing

The issuing company wants to get the highest possible price for its shares.

The underwriter is more cautious:After all, they will be left holding the unsold

securities if the public perceives them as being too expensive!

As a result, underwriters typically try to underprice the IPO


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The Initial Public Offering•Underpricing

As a consequence of underpricing, it is common to see stock prices increase substantially from the issue price in the days following the IPO.

Underpricing represents a cost to the existing owners of the shares:New investors are allowed to buy ownership

in the firm at a bargain basement price.


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The Initial Public Offering•Who are the Underwriters?

There are several hundred investment banks, securities dealers and brokers involved in underwriting in Canada.

However, the market for larger issues is dominated by the major investment dealers.These companies specialize in underwriting

new issues, dealing in securities and arranging mergers.

You can find a list of these firms in Table 14.4 on page 419 of your text.


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The Initial Public Offering•Listing on the Stock Market

When a firm decides on an IPO of its shares, it must also decide where its newly issued shares should be traded.The firm can seek a listing on a stock

exchange or it can have its securities trade over-the-counter (OTC).

Stock exchanges are organized facilities with a centralized physical location.

OTC markets exist in cyber-space and consist of a network of dealers who trade with each other electronically.


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The Initial Public Offering• Listing on the Stock Market

If a firm wishes to list its shares on an exchange, it will have to meet that exchange’s requirements for listing and pay the requisite listing fee.

You can see the major listing requirements for the Toronto Stock Exchange in Table 14.5 on page 421 of your text.

Larger, more prestigious exchanges tend to have stricter listing requirements and higher listing fees.


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Rights Issues vs General Cash Offers

• Raising Funds After the IPO A company’s IPO is seldom its last offering of

securities. In Chapter 13, we saw that internally generated

cash flow is usually insufficient to meet a firm’s needs for funds.

Established companies make up this shortfall by issuing more equity or debt.

An additional offering of stock by a company whose stock is already publicly traded is called a seasoned offering.


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• Raising Funds After the IPO Public companies can issue securities by

making a general cash offer to investors at large or by making a rights issue.

A rights issue is an issue of securities which is offered only to existing shareholders.

In a rights issue, the company offers it shareholders the right to buy more shares at an “attractive” subscription price, which is significantly below the market value of the shares.


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•Rights Issues By directly offering a new share issue to its

shareholders, a company hopes to save on issuing and underwriting expenses.

For shareholders, a rights issue allows them to retain their proportional shareholding and thus their voting position on the company’s major business decisions. If you owned 10% of the company’s shares before

the issue and you exercise your rights, then you will own 10% of the company’s shares after the issue.


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•Rights Issues Obviously, shareholders will only exercise

their rights if the subscription price stays below the market price of the shares.

If the market price falls, the rights issue can fail because shareholders do not exercise their rights to buy the new shares.

To protect against this, the firm can negotiate a standby agreement.

In a standby agreement, an underwriter stands ready, for a fee, to purchase any unsold shares.


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•General Cash Offers When a public company makes a

general cash offer, the sale of its securities is open to all investors.

The company essentially follows the same procedure as it did with its IPO.

It must hire an underwriter and arrange for the issue to be sold under a firm commitment arrangement or a best-efforts basis.


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•General Cash Offers Whenever a firm makes a cash offer, it

incurs substantial administrative costs plus the underwriter’s compensation.

These issue costs are largely fixed costs, which means that there are huge economies of scale in issuing securities.Costs can absorb 15% of a $1 million (US)

seasoned issue, but less than 4% of a $550 million issue.

The costs are similar in Canada.


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•Market Reaction to Stock Issues Because stock issues usually throw a sizable

number of new shares onto the market, it is widely believed that they must temporarily depress the stock price. This belief in downward price pressure implies that

the stock price is temporarily depressed below its true value.

Knowing what you do about efficient markets, do you think thisreasoning makes sense?


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•Market Reaction to Stock Issues This view is contrary to the notion of market

efficiency. If the price of the stock falls below its true

value just because of increased supply, then the stock would offer a higher return than comparable stocks.

Investors ought to flock to such an attractive investment and, with their buying pressure, bid up the share price!


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•Market Reaction to Stock Issues Economists who have studied new issues of

common stock have generally found that the announcement of the issue does result in a decline in the stock price.

This decline is about 3% in the US.

You know the explanation is notexcess supply, so what accounts

for this price drop?


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• Market Reaction to Stock Issues Savvy investors understand that management

tries to avoid issuing stock if they believe it is undervalued. Selling undervalued stock would give new investors

a good deal at the expense of existing investors. Thus management should choose to forgo the

issue rather than sell the shares at too low a price.

However, what if the position were reversed and the managers knew the stock was overvalued?


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•Market Reaction to Stock Issues If the shares were overpriced,

management would be tempted to sell them to new investors even if they were only going to put the money in the bank!

Investors are not stupid … they know that managers are more likely to issue stock when they think it is overvalued.

Therefore, investors mark the price of the stock down because they believe it to be overpriced.


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The Private Placement• Private Sales of Securities

A private placement is the sale of securities to a limited number of investors without a public offering.

Private placements avoid many of the costs associated with a public offering and are less expensive to arrange.

This may not be important for large issues where costs are a small proportion of the amount of money raised.

However, avoiding such costs is very important to companies making smaller issues.


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The main advantage of a private placement is reduced costs.

Other advantages:The issue can be custom tailored. It is much easier to change the terms of the

contract when only a few investors are involved. The main disadvantage is that the investor

cannot easily resell the security. This is not as important to large institutions

which invest for the long-term.


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Private placements are very popular for the issue of corporate debt by small- to medium-sized firms. These are the firms which face the highest

costs in public issues and which may require specialized, flexible loan arrangements.

However, even large firms use private placements on occasion.


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The advantages of private placements come at a cost. Lenders in private placements have to be

compensated for the risks they take and for the extra research and negotiation they must do.

They also have to be compensated for holding an asset which cannot be easily resold.

These factors are reflected in the cost of capital for the issuing firm. A private placement will, on average, have a yield

which is 1/2% above that on a public issue.


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Summary of Chapter 14 Venture capitalists specialize in providing new

equity capital to help firms grow from start-up until they are ready to “go public”.

Most venture capital financing is done in stages to keep the firm on a short leash and force it to prove, at several crucial points, that it is worthy of additional investment.

An IPO is the first sale of shares to the public. This sale is usually managed by an underwriting firm,

which purchases the issue for resale to investors. Underwriters also provide procedural and financial

advice to the issuing firm.


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Summary of Chapter 14 For a small firm, coming to market for the first time,

the underwriters can also provide a much needed “seal of approval”.

The costs of an issue can be significant as a percent of the amount of money raised, especially for a small issue.

The direct costs include the preparation of a prospectus, legal and administrative fees and the underwriter’s fees.

The indirect cost is the underpricing of the issue. That is, shares are typically sold to the public at less

than their true value, so that the underwriter can be assured of a successful placement.


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Summary of Chapter 14 A firm can use a rights issue to sell its shares to

existing shareholders. It can use a general cash offer to sell its shares

to the public. Or, the firm can use a private placement and

sell its securities to a small group of institutional investors.

A private placement is particularly suited to small, risky or unusual firms and is very popular in debt issues.

Copyright © 2003 McGraw Hill Ryerson Limited 14-1 prepared by: Carol Edwards BA, MBA, CFA...

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Transcript of Copyright © 2003 McGraw Hill Ryerson Limited 14-1 prepared by: Carol Edwards BA, MBA, CFA...