Chapter Sixteen
Issuing Securities to the Public
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Chapter Organisation
16.1 The Public Issue
16.2 The Cash Offer
16.3 New Equity Sales and the Value of the Firm
16.4 The Costs of Issuing Securities
16.5 Rights
16.6 Dilution
16.7 Issuing Long-term Debt
Summary and Conclusions
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Chapter Objectives
• Outline the advantages and disadvantages of public
company listing.
• Discuss the process of underwriting and the
associated costs.
• Identify the costs associated with issuing securities.
• Explain the process of a rights issue and calculate
the value of a right.
• Discuss the dilution effect of new issues.
• Understand the reasons for recent growth in the
corporate debt market.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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The Public Issue
• The regulation for the raising of funds in Australia is
through the Corporations Act 2001, administered by
ASIC. Main areas of regulations are:
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prospectus provisions
restrictions on allotment of shares
securities-hawking provisions
accounts and audit provisions
provisions relating to the sale of prescribed interests
debenture provisions
takeover provisions
provisions licensing persons engaged in securities industry.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Issuing Securities to the Public
1. Analyse funding needs and how they can be met.
2. Approval from board of directors for a public issue.
3. Outside expert opinions sought for support of
issue.
4. Pricing, time-tabling, prospectus prepared,
marketing.
5. Prospectus filed with ASIC and ASX.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Issuing Securities to the Public
(continued)
6. Underwriting agreement executed.
7. Prospectus registered.
8. Public announcement of offering.
9. Funds received.
10. Shares allotted, holdings registered.
11. Shares listed for trading on ASX.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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New Issues
• Flotation is the initial offering of securities to the
public.
• When the company is going to the market for the
first time it is called a primary issue.
• Primary issues are used to:
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convert from a private company to a public company
spin-off a portion of the business of a listed company
form a new public company
privatise a public organisation or demutualise a mutual
society.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Advantages of Public Company
Listing
• Access to additional capital.
• Increased negotiability of capital.
• Growth not limited by cash resources.
• Enhancement of corporate image.
• Can attract and retain key personnel.
• Gain independence from a spin-off.
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Disadvantages of Public
Company Listing
• Dilution of control of existing owners.
• Additional responsibilities of directors.
• Greater disclosure of information.
• Explicit costs.
• Insider trading implications.
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Secondary Issues
• Secondary issues—the term used for all issues by
a company subsequent to its listing.
• The principal forms of secondary issues are:
– Private placements—sale of securities to selected clients
of a sharebroker and/or large institutional investors (e.g.
life insurance companies and superannuation funds).
– Rights issues—issue of shares made to all existing
shareholders, who are entitled to take up the new shares
in proportion to their present holdings.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Underwriting
• Underwriters are investment firms that act as
intermediaries between a company selling securities
and the investing public.
• Roles of the underwriter:
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pricing the issue
marketing the issue
engaging sub-underwriters
placing the shortfall.
• Sub-underwriters are a group of underwriters formed
to reduce the risk and to help to sell an issue.
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Underwriting
• Firm underwriting
– A guarantee that funds will be made available to a company
at a specific time on agreed terms and conditions.
• Standby underwriting
– Where the bidding company has insufficient cash in a
successful bid or if cash is offered as an alternative to a
share bid.
• Best efforts underwriting
– Underwriter must use ‘best efforts’ to sell the securities at the
agreed offering rate
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Underwriting Fees
• The underwriter’s fee is a reflection of the:
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size of the issue
issue price
general market conditions
market attitude towards shares
time period required for underwriting.
• Fees also include brokerage and management fees
• Recent fees for initial equity issues of industrial
companies have ranged from 3 per cent to 5 per cent
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The Offering Price
• Equity issues are priced primarily by reference to the
prevailing market price. For example:
– Private placements of ordinary shares are typically made at
90-100 per cent of market price.
– Rights issues are typically priced at 60−90 per cent of
market price.
– Dividend reinvestment offers are typically priced at 90−95
per cent of market price.
Copyright  2007 McGraw-Hill Australia Pty Ltd
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The Offering Price
• Determining the correct offering price for an initial
public offering is difficult.
• If the issue is priced too high, it may be unsuccessful
and have to be withdrawn.
• If the issue is priced too low (called underpricing), the
issuer’s existing shareholders lose out by selling their
shares for less than they are worth. Underpricing is a
fairly common occurrence.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Average Initial Returns by Month for SECregistered Initial Public Offerings: 1960−2003
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Underpricing
• Tends to be higher for small, young, risky firms (helps
attract investors).
• More pronounced in emerging markets.
• Relatively few buyers get the initial high average
returns observed in IPOs. Reasons include:
– A significant fraction of IPOs experience price drops.
– Informed investors quickly subscribe for underpriced issues,
crowding out uninformed investors. But uninformed investors
get all the shares they want in less profitable issues.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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New Equity Sales and Firm Value
• Shares prices tend to decline after a new equity issue
announcement, but rise following a debt announcement.
• Why?
– Management has superior information about firm value and
knows when the firm is overvalued → sell equity
– Excessive debt usage
– Substantial issue costs.
• Management needs to understand the signals that an
equity issue sends.
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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The Cost of Issuing Securities
Underwriter’s commission
This consists of direct fees paid by the issuer to the
underwriting syndicate.
Other direct expenses
These are direct costs, incurred by the issuer, that are
not part of the compensation to underwriters. These
costs include filing fees, legal fees, and taxes—all
reported on the prospectus.
Indirect expenses
These costs are not reported on the prospectus and
include the costs of management time spent working on
the new issue.
Abnormal returns
In a seasoned issue of shares, the price drops on
average by 3 per cent upon the announcement of the
issue.
Underpricing
For initial public offerings, losses arise from selling the
shares below the correct value.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Rights Offerings—Basic
Concepts
• Rights offering—issue of ordinary shares to existing
shareholders.
• Allows current shareholders to avoid the dilution
that can occur with a new share issue.
• ‘Rights’ are given to the shareholders specifying:
– number of shares that can be purchased (e.g. 1 for 10)
– purchase price
– time frame.
• Shareholders can either exercise their rights or sell
them. They neither win nor lose either way.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Rights Offerings—Basic
Concepts
• Subscription price
– The dollar cost of one of the shares to be issued,
generally less than the current market price
• Ex-rights date
– Beginning of the period when shares are sold without a
recently declared right, normally four trading days before
the holder-of-record date. The share price will drop by the
value of the right.
• Holder-of-record date
– Date on which existing shareholders are designated as
the recipients of share rights.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Ex-rights Share Prices
Rights-on
Announcement
date
30 September
Ex rights
Ex-rights
date
13 October
Record
date
15 October
Rights-on
price $20.00
$3.33 =Value of a right
Ex-rights
price $16.67
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Theoretical Rights Price
M S
n

 nr 
Where:
n  number of shares held to obtain a right
M  market price
S  subscripti on or issue price of the rights issue
r  number of additional shares offered
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Example—Rights Issue
Lemon Co. currently has 5 million shares on issue
with a market price of $8 each. To finance new
projects, the company needs to raise an additional
$6 million. To raise the finance, the company
makes a rights issue at a subscription price of
$6 per share.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Example—Rights Issue (cont’d)
• The number of new shares to be sold:
funds to be raised

subscripti on price
$6 000 000

$6
 1 000 000 shares
• The holder of one right is entitled to subscribe to one new
share at $6 per share.
• To issue 1 million shares, the company would have to issue
1 million rights.
• The company has 5 million shares on issue, which means
that for every 5 shares held, a shareholder is entitled to
receive one right (1-for-5 rights issue).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Example—Rights Issue (cont’d)
• Calculate the theoretical rights price:
M S 
n

 nr 
 $8  $6 
5

 5 1 
 $1.67
• If an outsider buys a right, it will cost $1.67.
• The right can be exercised at a subscription price of $6.
• Total cost of a new share = $1.67 + $6 = $7.67.
Copyright  2007 McGraw-Hill Australia Pty Ltd
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The Value of Rights
Initial position
Terms of offer
After issue
No. of shares
Share price
Value of firm
Subscription price
No. new shares issued
No. of shares
Value of firm
Share price
Value of right per share
Value of a right
5 million
$8
$40 million
$6
1 million
6 million
$46 million
$7.67
$0.33*
$1.65**
* $8.00 – 7.67 = 0.33
** $0.33 × 5 = $1.65
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PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Types of Equity Capital Raised
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Dilution
• Loss in existing shareholders’ value in terms of
either ownership, market value, book value or EPS.
• Types of dilution
– Dilution of proportionate ownership—a shareholder’s
reduction in proportionate ownership due to less-thanproportionate purchase of new shares.
– Dilution of market value—loss in share value due to use
of proceeds to invest in negative NPV projects.
– Dilution of book value and earnings per share (EPS)—
reduction in EPS due to sale of additional shares. This
has no economic consequences.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
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Corporate Debt
• The late 1980s saw a major growth in the
Australian corporate debt market due to:
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the substantial cutback in the level of government
borrowing
the fall in interest rates from extremely high levels
the flight to quality
the shortage of government bonds
the attractiveness of raising funds in the domestic market
relative to that of the euromarket.
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Long-term Debt
• There are two basic forms of direct private longterm financing: term loans and private placement.
• Term loans are direct business loans of, typically,
one to five years.
• Private placements are usually long-term loans
provided directly by a limited number of investors.
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Long-term Debt (continued)
• Differences between direct, private long-term
financing and public issues of debt include:
– direct loans avoid ASIC registration costs
– direct placement is likely to have more restrictive covenants
– term loans and private placements are easier to renegotiate
than public issues.
• The costs of distributing debentures are lower in the
private market but the interest rates are usually
higher.
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Summary and Conclusions
• Flotation is the initial public offering of securities and
can undertaken with the help of underwriters.
• Public company listing has its advantages and
disadvantages.
• The direct and indirect costs of going public can be
substantial but once a firm is public it can raise
additional capital with much greater ease.
• Rights offerings are cheaper than general cash
offers.
• The general procedures followed in a public issue of
debt are the same as those for shares.
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