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A. Enlarge Cash Pie
Maximization of shareholders’ equity value
Maximization of cash flow pie
Marketing the rights of the future cash flows generated by its current and prospective projects
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(A)Tax factors in financing
Uneven tax treatment of various components of financial cost Debt vs. Equity financing Personal taxes vs. Corporate taxes
Zero-coupon bond Supply side: Low cost Demand side: meet future commitments
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(B)Financial innovations
Appeals to a special niche in the market
Low cost
Repackage mortgage into complex derivative securities
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( C )Increasing liquidity
Investors are willing to accept lower returns on more liquid assets Approaches to increase liquidity Going public Standardizing their claims Underwriting new public issues Buying insurance for a bond issue Listed on organized exchanges
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(D)Reducing transaction costs
Reduce transaction costs
increase new proceeds
Approaches to reduce transaction costs Use of investment bankers to underwrite new issues Shelf registration Extendible notes Secured debt leasing
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(E)Bridging the credibility gap (reduce the costs of information asymmetries)
Management overprice issues vs. market responseHigh risk asset issues Large gap
Large discount Low net proceedsS.Myers’ pecking order theory R/E Debt and convertibles Common stock
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(F)Managing financial conflicts
Three sources of conflicts related to financial policy Separation of ownership and control Stockholder-Manager Conflicts Separation of stockholders and bondholders Stockholders-Bondholders Conflicts Separation of investors and non-investors Non-investors Stakeholder Conflicts
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(F)Managing financial conflicts
Stockholder-Manager Conflicts Agency costs Free cash flow paid out to shareholders
cash-flow in excess of that required to undertake all economically sound investments
Managers have a greater incentive to shirk their responsibilities as their equity interest falls
Incentive approach
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(F)Managing financial conflicts
Stockholders-Bondholders Conflicts Bondholders have prior but fixed claims Stockholder have limit liability for unlimited
claims on remaining assets i.e. put option Stockholders Bondholders
Risky project Rating downgrade
Transfer assets Bond covenants
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(F)Managing financial conflicts
Non-investor stakeholder Conflicts Implicit commitment of service and parts,
durability to customers Safe work environment or lifetime employment
to employees Advertising to distributors
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B. Venture Capital
(A)The special features of ventures
Its large appetite for cash
Growth options Increasing the profitability of existing product lines Expanding into profitable new products or markets
Difficult to establish its value Expected future cash flows
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(B)Financing ventures
Bank loans Advantages
Face-to-face negotiation Flexibility Less information asymmetry Provision of continuous access to funds
Disadvantages Bank debt is still debt Increase the probability of financial distress Growth options make poor collateral
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(B)Financing ventures
Private placements Private place securities Difficult to sell prior to maturity Restrictive covenants
Convertible securities Convertible bonds or preferred stock Fixed income Conversion feature
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(B)Financing ventures
Venture Capitalists Private equity, closer relationship, more
control, high rate of return Strict contract: modest salaries for managers
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( C )VC Contracting
Risk-return analysis of venture The future cash-flows are unknown
(both in amount and timing) The appropriate discount rate is unknown Any two parties analyzing the same deal will
disagree about the future cash-flow, or the appropriate discount rate to apply, or both.
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( C )VC Contracting
Deal-making --- venture capital contract Allocating cash-flows
Determined by initial investment, required rate of return
Allocating risks Required rate of return usually is higher than the
true expected return on the venture capital portfolio
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( C )VC Contracting
The value of the option to abandon The option to re-value a project The option to increase capital committed
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C. IPO (Initial public offering)
(A)Rights v.s Underwritten OfferingsRights offerings Each stockholder receives options (warrants) to buy the
newly issued securities One right is issued for each share held Must be registered with the SEC Inexpensive (underwritten offering expenses are from 3
to 30 times higher than the costs of right-offering) Unpopular ( 20%, why? Underwritten offering provide
monitoring companies and guarantees to investors)
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(A)Rights v.s Underwritten Offerings
Underwritten offering Underwriting syndicate is a synthetic put,
leading underwriter Typical underwriting process
Laddering Investment bankers’ contributions
Handle most of the paperwork details Marketing Take risk to both of its capital and reputation
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(B) Best efforts vs. Firm commitment contracts
Best effort contract The underwriter acts only as a marketing agent
for the firm The underwriter does not agree to purchase the
issue at a pre-determined price The issuer gets the net proceeds, but without
any guarantee of the final amount from the investment banker
To investor Call option : price restriction in oversubscribe Put option : under-subscribed
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(B) Best efforts vs. Firm commitment contracts
Firm commitment contract The underwriter agree to purchase the whole
issue The underwriter resale the issue to the public at
a specific price The prohibition against raising prices for an
oversubscribed issue means that the company gives a free call option to potential stockholders
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( C ) Negotiation contract vs. Competitive Bid
Negotiation contract Higher total flotation costs Lower variance of issue cost Managers’ favorite
Stable Valuable proprietary information
Effectiveness in monitoring
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( C ) Negotiation Contract vs. Competitive Bid
Competitive bid contract Lower total flotation costs Higher variance of issue cost Issuers bear all of the price risk No third party is certifying for investors the
value of the shares
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(D)Shelf vs. Traditional Registration
Traditional registration The issuing firm, its investment banker, its
auditing firm and its law firm all participate in filing the required registration statement with the SEC
The offering can only proceed when the registration statement becomes effective
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(D)Shelf vs. Traditional Registration
Shelf registration A recent development It allows companies to register their securities,
“put them on the shelf” and then issue the securities whenever they choose
After the securities are registered, management can offer and sell them for up two years on a continuous basis
(E)Under-pricingTABLE 7 Presented below is a summary of estimates of the underpricing of new securities atThe Underpricing of issuance by type of offering. Underpricing is measured by the average percentage New Swcurity issues change from offer prices to aftermarket price. Full citations for all studies mentioned
can be found in the reference section at the end of this issue.
Sample Sample Estimated Type of Offering Study Period Size Underp r i ci n gInitial Public Equity Offering Ibottson(1974) 1960-1969 120 11.40%Initial Public Equity Offering Ibottson/Jaffe(1975) 1960-1970 2650 16.80%Initial Public Equity Offering Ritter(1984) 1960-1982 5162 18.80%
1977-1982 1082 26.50%1980-1981 325 48.40%
Initial Public Equity Offering: Ritter(1985) 1977-1982 Firm Commitment 664 14.80% Best Efforts 364 47.80%Initial Public Equity Offering: Chalk/Peavy(1985) 1974-1982 440 13.80% Firm Commitment 415 10.60% Best Efforts 82 52.00%Equity Carve-Outs Schipper/Smith(1986) 1965-1983 36 0.19%Seasoned New Equity Offering Smith(1977) 1971-1975 328 0.60%Seasoned New Equity Offering: Bhagat/Frost(1986) 1973-1980 552 -0.30% Negotiated 479 -0.25% Competitive Bid 73 -0.65%Primary Debt Issue Weinstein(1978) 1962-1974 412 0.05%
Sorensen(1982) 1974-1980 900 0.50%Smith(1986) 1977-1982 132 1.60%
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(E)Under-pricing
Information asymmetry Uninformed investors would earn
systematically below normal returns. Recognizing their disadvantaged position in this bidding process, uninformed investors will response by bidding for IPO only if the offer price is lower than the after-market price
The greater price uncertainty is, the greater is the under-pricing
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(E)Under-pricing
Other explanations Regulations require underwriters to set the
offering price below the expected value Underwriters collude to exploit inexperienced
issuers and to favor investors Under-priced new issues “leave a good taste”
with investors so that future underwriting from the same issuer can be sold at attractive prices.
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(E)Under-pricing
“Firm commitment” underwriting spreads do not cover all of the risks, so that the underwriter under-prices new issues to compensate
The issuing corporation and underwriter perceive that under-pricing constitutes a form of insurance against legal suit
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D. International cross-listing
(A)International cross-listing (a)Types
. Direct share listing
. Depository receipt(DR)Negotiable certificate that
represent a foreign company’s publicly traded equity or debt.
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E. Enlarge cash pie --- International cross-listing
(b) Participants. Listing company. Investment bank. Custodian bank. Exchange
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E. Enlarge cash pie --- international cross-listing
(c) Why do firms cross-list?. Market segmentation. Investor recognition. Liquidity. Commitment to reveal
information
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E. Debt Financing
(A) Bank loan
Bank loans may provide a possible solution to the problem of “information asymmetry” that attends all public securities offerings Banks have better information to price their
loans Cost of borrowing vs. Cost of securities
offering (Long-term relationship)
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Corporate Policy
Inside debt-holders are in a better position to monitor the firm after the debt is issued Restrictive covenants Easy to renegotiate Easy to evaluate and monitor issuer though
deposit accounts
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Corporate Policy
There may be an advantage to maintaining confidence about the firm’s investment opportunities Develop a new product Develop a new market strategy
Avoid the costly and time-consuming process of registering issues with the SEC Small borrowing
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Corporate Policy
Positive market response to announcements of bank loans Provide a credible “seal of approval” to equity
investors and other claimants of the firm
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(B). Convertibles --- Corporate Policy
Rationale for the use of convertibles: the relative insensitivity of their value to the risk of the issue company Easier for bond issuer and purchaser to agree
on the value of bond It protests the bondholder against the adverse
consequences of management policy that increase the risk of the company
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(C) Junk Bond --- Corporate Policy
Optimal debt capacity The firm’s tax-paying status larger tax shields, less debt capacity Risk of the firm’s assets bankruptcy cost Composition of its assets assets in place
The ideal junk bond issuer is a firm that can take full advantage of the interest rate shields, that does not have a potential for severe bankruptcy costs.and that has a total market value that is largely attribute to assets in place
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Corporate Policy
Financial synergies of junk bond The reintegration of financial and industrial
resources and interests ---Investment banks The reintegration of ownership and control ---Competition Increased capital access for smaller companies
---Size and term flexibility and spread
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Corporate Policy
The democratization of capital ---Managers and employees
Increased industrial competitiveness ---Financing high-growth, innovative companies that are
smaller and higher operating risk, e.g. communications, semiconductors
---Restructuring ownership and strategy of low growth companies through LBO and re-capitalization, e.g. textile
---Recovering equity through workouts and turnarounds of distressed companies e.g. mining
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(D). LYON --- Financial Synergies
LYON is a variant of the convertible that value is relatively insensitive to the risk of the issuing firm Company risk value of bond
Reduce disagreement (information asymmetry) between management and potential investors
Increase cash pie
e.g. Smaller, high-growth companies with volatile earning
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Financial Synergies
LYON is a zero-coupon, fixed-income component with an equity call option Zero-coupon and convertible features reduce
transaction cost
increase cash pie
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Financial Synergies
LYON gives investors the right to put the notes back to the company Put back to companies reduce the exposure
of investor’s principal to a drop in the issuer’s principal to a drop in the issuer’s credit standing
Put option accounted for a large portion of the value of LYON
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