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Corporate Finance
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Chapter 20: Raising Capital
How securities are issued and the role of investment banks
Costs of issuing securities
Pecking order theory of financial choices
20.1 Initial Public Offerings (IPO)
IPO: Selling stock to the public for the first time
Underwriter Firm (investment bank) 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.
What is the incentive of an investment banker to choose a fair price for a new security issue? Pricing a new security is extremely difficult Investment banker has better information and ability to choose fair price than
anyone else If investment banker on average prices issues too high, buyers in the future
will not want to buy from that banker If investment banker on average prices issues too low, issuers in the future will
not want to use that investment banker Reputation of investment banker should provide them with an incentive to
price issues accurately Do investment bankers on average price IPOs fairly?
Answer- NO!
Underpricing
Fact:
For U.S. IPOs conducted between 1960 and 2007, the average first day return is 18%.
0 20 40 60 80 100
return (percent)
Denmark
CanadaNetherlands
Spain
TurkeyFrance
Australia
NorwayHong Kong
UK
USAItaly
Japan
SingaporeSweden
Taiwan
GermanySwitzerland
Korea
BrazilIndia
China
256 %
Number of Offerings and Average First-day Returns on Korean
IPOs, 1980 - 2013
Underpricing (continued)
How should issuers feel about this underpricing?
Explanations for underpricing:
i. makes issue easier to sell
ii. low price affects the price path in the future
iii. winners curse
These arguments could well justify some degree of underpricing, but its not clear
that they can fully account for it.
Example of winners curse:
Underwriter needs to sell 1 million shares
Two types of investors: informed and uninformed
Uninformed investors:
willing to buy 1 million shares at a fair price
assess true value of the shares at: $10 with prob.=.5
$12 with prob.=.5
Informed investors:
know if the shares are worth $10 or $12
willing to order 1 million shares if offer price is less than the true value
Suppose underwriter offers shares at $11
Claim: If the uninformed purchase shares for $11, on average they will lose $$
Case 1: True value is $12
Informed investors order 1 mil. shares, Uninformed investors order 1 mil. shares
Each set of investors are allocated 500,000 shares (pro-rata rule)
Informed and uninformed investors both make $500,000 each.
Case 2: True value is $10
Informed investors order 0 shares, Uninformed order 1 million shares
Uninformed investors lose $1 million.
Expected profit to uninformed: .5(500,000) + (.5)(-1,000,000)=-250,000
Basic lesson:
At what price P will the entire issue sell? Choose P so that:
Another example of winners curse:
Suppose that you decide to apply for every new issue of common stock.
You have no difficulties in getting stock in the issues that no informed investor
wants.
You receive less stock than you wanted when the issue is attractive (undervalued),
since the underwriters do not have enough stock to go around.
The result is that you will be a loser in the IPO market. To be a winner, you should
play the game only if the issues are attractive.
Uninformed investors are exposed to the winners curse, and the underwriters
know this and underprice on average to attract the uninformed.
20.2 Seasoned Equity Offerings
Seasoned issue
Selling additional shares when some shares are already publicly traded
Fact: market reaction to seasoned equity issues is negative on average
Why?-A possible explanation based on asymmetric information
Firms that know they are undervalued by the market are hesitant to sell equity
too cheaply
Firms that know they are overvalued by the market are very eager to sell
equity at an inflated price
Example
Company A Company B
Market believes shares worth
$90 with probability .5
Market believes shares worth
$90 with probability .5
Market believes shares worth
$70 with probability .5
Market believes shares worth
$70 with probability .5
Market expected value of
shares = $80 = share price
Market expected value of
shares = $80= share price
Manager knows shares really
worth $90
Manager knows shares really
worth $70
Observations:
Market realizes that a firm that issues equity is worth less than their current price Market will only pay $70 per share to firms that announce they want to sell equity May be no credible way for Company A to convince market that shares are really
worth $90 Anticipating this market reaction, company A will probably choose to either use debt
or else to pass up investment projects
Implications
1. Explains preference for debt over equity when accessing external capital
markets
2. Same argument implies preference for retained earnings over new debt
issues
3. Explains why profitable firms have low debt. They can finance investment
entirely from retained earnings
4. Indicates that there is value to having financial slack- cash, marketable
securities, unused bank lines of credit.
5. Missing out on positive NPV projects because of external financing
problems can be quite expensive.
Some additional thoughts:
We would expect market reaction to announcements to be most negative when value of the security depends on information known only to management
Seasoned equity -3% reaction on average
Convertibles -2% reaction on average
Public bonds 0% reaction on average
Bank loans +2% reaction on average
Empirical evidence on repurchases:
Positive stock price reactions of 8% to 17% at the announcement that firm will repurchase shares with tender offer.
Positive stock price reactions of 2% to 3% at the announcement that firm will repurchase shares in open market.
Why the difference? Tender offers to repurchase shares are on average larger.
Pecking order theory of financial choices
Most firms seem to finance investments as follows:
1. Use retained earnings whenever possible.
2. Set dividend policy so that retained earnings cover anticipated investment
3. If firm has excessive internal cash, payoff debt first, then repurchase shares
4. If firm has insufficient internal cash, use the debt markets first equity only
as a last resort
Patterns in Real World Financing
Aggregate figures for U.S. Corporations in 1999
Gross capital expenditures $860 billion
Increases in net working capital $207 billion
Total spending $1,067 billion
Internal cash flow $751 billion
Net external financing $1,067 $751 = $316 billion
Net new debt financing $469 billion
Net new equity financing -$153 billion
Total $316 billion
This seems to be highly consistent with the pecking order theory of financial
choices.
20.3 Costs of new issues
1. Underwriter spread
2. Other direct expenses
3. Indirect expenses
4. Incorrect pricing of the issue
a. for SEOs, this is selling stock for less than true value
b. for IPOs this is the IPO underpricing
5. Green-shoe provision or overallotment option
Gives investment bankers right to buy additional shares
(typically 15% of offer) at offer price
What do we know about these costs?
1. Economies of scale in security issuance costs:
Costs are larger for smaller issues
2. Direct cost estimates (spread + other direct costs): 1990-1994 issues
IPOs: 5-11%, SEOs: 3-7%
3. For IPOs, underpricing is a larger cost than direct costs
Many firms going public do not consider this a cost
Total costs of going public can be substantial
20.4 Debt offerings
Public bonds: same basic procedure as issuing equity
--engage an investment banker
Notes: underwriting costs are smaller than for equity issues
asymmetric information problems are also smaller
Private placement: selling debt to a small group of investors, often by direct
negotiation
-- accounts for of all new corporate debt
-- typical buyers: insurance companies, pension funds
Why issue privately placed debt rather than public debt?
Why issue public debt rather than privately placed debt?
20.5 Venture capital
Venture capital is a private equity market
Why do small firms use venture capital?
-raising public equity would be prohibitively expensive
-firms need to be monitored by investors
Who supplies venture capital?
1. Wealthy families
2. Venture capital corporations and partnerships
3. Venture capital subsidiaries of large public companies
4. Informal investors- angels
Stages of venture capital financing
1. Seed-money stage
2. Start-up stage
3. First-round financing
4. Second-round financing
5. Third-round financing- mezzanine financing
6. Fourth round financing- bridge financing
Note: most venture-capital backed projects never make it past the early stages
Why use stage financing?
Issues in structuring venture capital deals
It can be difficult to get entrepreneur and venture capitalist to
agree on the relevant numbers
Deal must be structured so that entrepreneur has incentive to
make project a success
-venture capitalist insists that entrepreneur places a large fraction of
his/her wealth in the project
Why do successful ventures eventually go public?
Firm needs more capital than venture capitalist can provide
Public shares are more liquid, therefore investors demand a lower return on
public shares
Entrepreneur/venture capitalist want to realize their gains