14- 1
B40.2302 Class #7
 BM6 chapters 15.2-15.6, 16.1-16.4, 17
15.2-15.6: security issue process
 16.1-16.4: dividend policy (MM irrelevance)
 17: debt policy (MM irrelevance)

 Based on slides created by Matthew Will
 Modified 10/25/2001 by Jeffrey Wurgler
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
How Corporations Issue Securities
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter
15.2-15.6
©The McGraw-Hill Companies, Inc., 2000
14- 3
Topics Covered
 The Initial Public Offering
 The Underwriters
 Underpricing and “The Winner’s Curse”
 General Cash Offers
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 4
Initial Public Offering
Initial Public Offering (IPO) - First offering of stock
to the general public.
Two kinds of public offerings:
Primary offering – new shares are sold to raise cash for the
company
Secondary offering – existing shares (owned by VCs or firm
founders) are sold, no new cash goes to company
A single offering may include both of these
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 5
Initial Public Offering
Some benefits/motivations:
-
Additional source of capital
Increase debt capacity (give “breathing room” for debt)
Stock prices give measure of performance
Allows managers to be compensated with options, or have
incentives otherwise directly tied to shareholder value
- Potentially more information about firm (analyst following),
makes borrowing cheaper
- ?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 6
Initial Public Offering
Arranging an IPO: First steps…
Select Underwriter
- provides procedural, financial advice
- ultimately buys issue from company (at “issue price”)
- ultimately sells it to public (at “offer price”)
Prepare Registration Statement – for approval of SEC (in
accord with Securities Act of 1933). Formal summary that
provides information on an issue of securities.
Prepare Prospectus – Streamlined version of registration
statement, for consideration by potential investors
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 7
Initial Public Offering
Arranging an IPO: Trying to set price…
Road show – Talks organized to introduce company to
potential investors, before the IPO.
Bookbuilding – Underwriter builds “book” full of
indications of interest (quantity, price at which
investors may be willing to buy). List of likely
orders. Useful to set offer price.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 8
Initial Public Offering
Arranging an IPO: Selling the shares …
Best efforts offering: IPO method in which underwriter
promises to sell as much as possible, give best effort, not
commit to selling all of issue. Or…
Firm commitment offering: Method in which
underwriter buys the whole issue, bears all risk.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 9
Initial Public Offering
Arranging an IPO: Selling the shares …
Syndicate: Group of underwriters formed to sell a
particular issue
Spread - Difference between public “offer price” and price
paid by underwriter (“issue price”). Biggest part of
underwriter compensation.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 10
Top Underwriters
Top U.S.Underwriters in 1997
($bil of total issues)
Merrill Lynch
Saloman Smith Barney
Morgan Stanley
Goldman Sachs
140
137
Lehman Brothers
JP Morgan
Credit Suisse First Bos ton
121
104
68
Bear Stearns
Donaldson Lufkin Jenrette
58
46
Chase
All Underwrit ers
Irwin/McGraw Hill
$208
167
33
1,293
©The McGraw-Hill Companies, Inc., 2000
14- 11
Top Underwriters
Top Intl.Underwriters in 1997
($bil of total issues)
Merrill Lynch
Goldman Sachs
SBC Warburg
Deutsche Morgan
Credit Suisse First Bos ton
32
29
29
27
JP Morgan
Morgan Stanley
24
23
ABN AMRO Hoare
Lehman Brothers
22
18
Paribas
18
All Underwrit ers
Irwin/McGraw Hill
$37
496
©The McGraw-Hill Companies, Inc., 2000
14- 12
Tombstone
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 13
IPO Costs
Three basic IPO costs:
1.
Administrative costs: for preparing registration, legal
counsel, preparing and printing prospectus, etc.
2.
Spread
3.
Underpricing: Difference between what stock is offered
at and what it’s really worth


Irwin/McGraw Hill
Can be measured, roughly, as end-of-first-trading-day
price minus offer price
A hidden cost, but usually the biggest cost!
©The McGraw-Hill Companies, Inc., 2000
14- 14
IPO Costs
Average costs on U.S. IPOs between 1990-1994
Value of Issues
($mil)
Irwin/McGraw Hill
Direct
Costs (%)
Avg First Day
Total
Return (%) Costs (%)
2 - 9.99
16.96
16.36
33.32
10 - 19.99
11.63
9.65
21.28
20 - 39.99
9.7
12.48
22.18
40 - 59.99
8.72
13.65
22.37
60 - 79.99
8.2
11.31
19.51
80 - 99.99
7.91
8.91
16.82
100 - 199.99
7.06
7.16
14.22
200 - 499.99
6.53
5.70
12.23
500 and up
5.72
7.53
13.25
All Issues
11.00
12.05
23.05
©The McGraw-Hill Companies, Inc., 2000
14- 15
IPO Costs
Why is there underpricing? Several arguments.
- Best one: “Winner’s curse”
Suppose you apply for every IPO. You will have no problem
getting lots of shares in the bad firms (the ones no one
wants), but when the issue is attractive, there will not be
enough to go around, and you will receive less than you
wanted of the good firms. (This is the “winner’s curse” – if
you win an auction, you are likely to have paid too much!)
So you would lose on average. You therefore need IPOs to
be underpriced on average, or else you will not play the
game.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 16
Public issues after the IPO
Seasoned Offering (SEO)– An equity issue by a firm after its IPO
General Cash Offer



Sale of securities open to all investors by an already public company.
Used for virtually all U.S. equity and debt issues
Same procedure as IPO: register with SEC, sell issue to underwriter, who
sells issue to public
Shelf Registration - A procedure (created by SEC “Rule 415” that
allows firms to file one registration statement for several issues of
the same security.



Covers financing plans up to 2 years ahead
Speeds up issue process; don’t have to issue all at once
Usually used for relatively “garden variety” issues, not complex issues
where underwriter’s “stamp of approval” may have value
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 17
Public issues after the IPO: Costs
Direct costs (spread + administrative costs) of issues after the IPO:
$2M < Issue size < $9.9M
IPOs: 17%, SEOs: 13%, Convertible debt: 8%, Bonds: 5%
$40M < Issue size < $59.9M
IPOs: 8%, SEOs: 6%, Convertible debt: 4%, Bonds: 2%
$500M < Issue size < $+++
IPOs: 6%, SEOs: 3%, Convertible debt: 2%, Bonds: 1%
(Notice economies of scale)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 18
Public issues after the IPO: Costs
Gross underwriter spreads of selected issues, 1998
Type
Company
Issue amount,
millions of dollars
Underwriter's
spread, percent
IPO
IPO
IPO
IPO
IPO
Hypertension Diagnostics, Inc.
Actuate Software Corp.
Enterprise Product Partners
EquantNY
Conoco
9.3
33.0
264.0
282.2
4403.5
8.49
7.00
6.36
5.25
3.99
SEO
SEO
SEO
SEO
SEO
SEO
Coulter Pharmaceuticals
Stillwater Mining
Metronet Commuications Corp.
Staples, Inc.
Safeway, Inc.
Media One Group
60.0
61.5
232.6
446.6
1125.0
1511.3
5.48
5.00
5.00
3.25
2.75
2.74
100
200
300
400
490
0.18
0.88
0.63
0.75
3.00
1500
0.15
Debt:
2-year notes
30-year debentures
6-year notes
15-year subordinated notes
Convertible zero-coupon
bonds
10-year notes
Irwin/McGraw Hill
General Motors Acceptance Corp.
Bausch & Lornb, Inc.
Ararnark Corp.
B anque Paribas
Aspect Telecommunications
Federal Home Loan Mortgage Corp.
©The McGraw-Hill Companies, Inc., 2000
14- 19
Private Placements
 Don’t require registration with SEC
 Therefore less costly
 Usually restricted to dozen or less “knowledgeable
investors”
 Investors cannot easily resell security
 “Rule 144A”: SEC rule relaxing restrictions on who
can buy and trade unregistered securities. Allows
“qualified institutional buyers” to trade among
themselves.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 20
Rights Issue
Rights Issue - Issue of securities offered only to
current stockholders, as opposed to general public
offer.
Rights issues are not common in U.S., but are
common in Europe, usually used for seasoned
equity issues (SEOs)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
The Dividend Controversy
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter
16.1-16.4
©The McGraw-Hill Companies, Inc., 2000
14- 22
Topics Covered
 What Do We Mean by Dividend Policy?
 How Dividends Are Paid
 How Do Companies Decide on Dividend
Payments?
 Dividend Policy is Irrelevant in MM world
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 23
What is Dividend Policy?
• Want to view dividend policy in isolation
• Accounting fact: Flow of funds constraint
Inflow of cash into company
= Outflow of cash from company
Earnings + Stock sales + bond sales
= Investment + dividends + interest
• If hold fixed investment and borrowing decisions, change dividends  stock
sales have got to change
• So DP is trade-off between changing # of shares (repurchasing, or selling new
shares) and changing dividends (increasing/decreasing)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 24
Types of Dividends
Cash Dividend
Regular Cash Dividend
 Special Cash Dividend

Cash Dividend - Payment of cash by the firm
to its shareholders.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 25
Types of Dividends
Stock split/Stock dividend
Just increases # of shares, but assets, profits, and
total value are unaffected
 So just reduces value per share in proportion

Stock Dividend - Payment of shares by the
firm to its shareholders.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 26
Dividend payment process
Record Date - Person who owns stock on this
date will receive the dividend.
Cum Dividend – “with dividend” – share
whose buyer is eligible to receive declared
dividend
Ex Dividend – share whose buyer is not
eligible to receive declared dividend
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 27
Types of Dividends
Stock Repurchase – 3 ways
Buy shares on the market
 Tender offer
 Private negotiation (“Greenmail”)

Tax on repurchase: only capital gain
Tax on cash dividend: as ordinary income
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 28
Stock Repurchase Volume
U.S. Stock Repurchases 1985-1997
140
$ Billions
120
100
80
60
40
20
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
0
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 29
The Dividend Decision: Lintner
Lintner’s “Stylized Facts”
1. Firms have long-run target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run,
sustainable earnings.
4. Managers are particularly reluctant to make dividend
changes that might have to be reversed.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 30
The Dividend Decision: Lintner
 Dividend targets vary from firm to firm:
DIV1  target dividend
 target ratio  EPS1
 Dividend change equals:
DIV1 - DIV0  target change
 target ratio  EPS1 - DIV0
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 31
The Dividend Decision: Lintner
 Managers (say Lintner) smooth dividends
Even if earnings are high now, may be low later, so if
want to avoid having to reverse dividend later, only want
to move partway to target payment.
 Final Lintner model:

DIV1 - DIV0  adjustment rate  target change
 adjustment rate  target ratio  EPS1 - DIV0 
0 < Adjustment rate < 1
 Model seems to work pretty well in the data

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 32
M&M Dividend irrelevance
 Modigliani & Miller dividend proposition
Dividend policy is irrelevant in perfect capital
markets
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 33
M&M Dividend irrelevance
 Interpretations
If company’s investment policy is fixed, its NPV is fixed.
The pattern of dividend payments doesn’t affect NPV
 In perfect capital market, investors don’t care how they get
their money, so long as they get it. They can get it through
stock price changes or dividends
 Since investors do not need dividends to convert shares to
cash, they will not pay higher prices for firms with higher
dividend payouts.
 You cannot help or hurt your stockholders by changing
dividends
 Repurchases have exactly same effect as dividends. Flow of
funds identity says if you cancel dividend, you have to buy
shares. If you increase dividend, have to sell shares.

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 34
M&M Dividend irrelevance
 Some key assumptions:




Investment policy held constant
No transaction costs (e.g. repurchasing premium for
company, cost of mailing dividend checks)
Dividends and capital gains taxed at same rate
…
 If you claim dividends do matter, one or more of
these assumptions must be violated. That is the
power of the theorem: it clarifies how dividends
could matter.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 35
M&M Dividend irrelevance
Example - Assume Rational Demiconductor has $1,000 cash, and requires
$1,000 for investment, but decides to declare a $1,000 dividend. Given the
following information (left side), show that the dividend doesn’t affect the
value of the firm assuming that the investment policy is held constant (and
therefore new shares are issued to pay for the required investment).
Original
Cash
1,000
Asset Value 9,000
New Proj NPV 2,000
Total Value 12,000
# of Shares 1,000
price/share
$12
Irwin/McGraw Hill
Pmt Date
0
9,000
2,000
11,000
1,000
$11
Post Pmt, Post Issue
1,000 (91 shs @ $11)
9,000
2,000
12,000
1,091
$11
©The McGraw-Hill Companies, Inc., 2000
14- 36
M&M Dividend irrelevance
Example - Assume Rational Demiconductor has $1,000 cash, and had earmarked
$1,000 for investment, but learns project is a loser (NPV<0), so plans to
distribute cash by repurchase. Given the following information (left side),
show that the repurchase itself doesn’t affect the value of the firm.
(New) Original
Cash
1,000
Asset Value 9,000
New Proj NPV
0
Total Value 10,000
# of Shares 1,000
price/share
$10
Irwin/McGraw Hill
Post-repurchase
0 (repurchase 100 shares at $10)
9,000
0
9,000
900
$10
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Does Debt Policy Matter?
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 17
©The McGraw-Hill Companies, Inc., 2000
14- 38
Topics Covered
 Leverage is Irrelevant in MM World
 How Leverage Affects Returns and Risk in
MM World
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 39
M&M Debt Policy Proposition I
 Modigliani & Miller debt policy proposition:
The market value of a company is independent of its
capital structure.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 40
M&M Debt Policy Irrelevance
 Interpretations:
Firm value is determined by real assets and growth
opportunities, not by security choice
 The total amount of pizza is unaffected by how it is
sliced

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 41
M&M Debt Policy Irrelevance
 Some key assumptions:
No taxes
 Investment policy fixed
 Bankruptcy is not costly
 Efficient capital markets, no transaction costs
 Symmetric information
…

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 42
M&M Debt Policy Irrelevance
 The proof:

Imagine two firms, firm U is unlevered (all
equity) and firm L is levered. Have same profits.

So VU = EU and VL = EL + DL

Which do you prefer to invest in?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 43
M&M Debt Policy Irrelevance
 Suppose buy 1% of U:
Dollar investment
.01*VU
Dollar return
.01*Profits
 Or could buy 1% of L’s debt and equity:
Debt
Equity
Total
Dollar investment
.01*DL
.01*EL
.01*(DL+EL )
= .01*VL
Dollar return
.01*Interest
.01*(Profits – Interest)
.01*Profits
 Same dollar payoffs, must have same dollar cost: VU = VL
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 44
M&M Debt Policy Irrelevance
Another way to see it …
 Suppose buy 1% of L’s equity:
Dollar investment
.01*EL
= .01*(VL - DL)
Dollar return
.01*(Profits-Interest)
 Or could borrow 1% of DL on own account, buy 1% of
U’s equity:
Dollar investment
Borrowing -.01*DL
Equity
.01*VU
Total
.01*(VU - DL )
Dollar return
-.01*Interest
.01*Profits
.01*(Profits-Interest)
 Same dollar payoffs, must have same dollar cost: VU = VL
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 45
M&M Debt Policy Irrelevance
Some implications
 Argument can be extended to full range of capital
structure choices, not just D/E ratio






Debt maturity structure (long-term vs. short-term) irrelevant
Secured/unsecured debt choice irrelevant
Convertible/nonconvertible debt irrelevant
Preferred/common stock irrelevant
… Financial managers irrelevant? This course irrelevant?
… Don’t be discouraged, few of the assumptions hold in practice
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 46
M&M Debt Policy Irrelevance
Example – “Macbeth Spot Removers” – 100% Equity
Data
Number of shares
Price per share
Market Value of Equity
1,000
$10
$ 10,000
Outcomes
Operating Income
Earnings per share
Return on shares (%)
Irwin/McGraw Hill
A
B
C
D
$500 1,000 1,500 2,000
$.50 1.00 1.50 2.00
5 % 10
15
20
“Expected
outcome”
©The McGraw-Hill Companies, Inc., 2000
14- 47
M&M Debt Policy Irrelevance
Example
Now
suppose
50% debt
50% equity
Data
Number of shares
500
Price per share
$10
Market Value of Equity
$ 5,000
Market val ue of Debt
$ 5,000
Outcomes
A
Irwin/McGraw Hill
B
C
D
Operating Income
$500 1,000 1,500 2,000
Interest
$500 500
500
Equity earnings
$0
500
1,000 1,500
Earnings per share
$0
1
2
3
Return on shares (%)
0%
10
20
30
500
©The McGraw-Hill Companies, Inc., 2000
14- 48
M&M Debt Policy Irrelevance
Example - Macbeth’s
- 100% Equity
- Debt replicated by investors
(say they borrow $10 and invest $20
in two unlevered Macbeth shares…
… same payoff as levered equity!)
A
B
C
D
Earnings on two shares
$1.00 2.00 3.00 4.00
LESS : Interest @ 10%
$1.00 1.00 1.00 1.00
Net earnings on investment
$0
1.00 2.00 3.00
Return on $10 net investment (%)
0%
10
Irwin/McGraw Hill
20
30
©The McGraw-Hill Companies, Inc., 2000
14- 49
M&M Debt Policy Irrelevance
Macbeth continued
Expected earnings per share ($)
Price per share ($)
Expected return per share (%)
Irwin/McGraw Hill
Current Structure : Proposed Structure :
100% Equity
50% Debt, 50% Equity
1.50
2.00
10
15
10
20
©The McGraw-Hill Companies, Inc., 2000
14- 50
M&M Debt Policy Irrelevance
We know that…
expected operating income
Expected return on assets  rA 
market val ue of all securities
and also that…
 D
  E

rA  
 rD   
 rE 
DE
 DE

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 51
M&M Debt Policy Proposition II
Rearranging …
D
rE  rA  rA  rD 
E
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 52
M&M Debt Policy Irrelevance
D
rE  rA  rA  rD 
E
Macbeth continued
Check Prop. II for Macbeth. For 100% equity firm…
expected operating income
market val ue of all securities
1,500

 .15
10,000
rE  rA 
For 50% equity,
50% debt firm…
Irwin/McGraw Hill
5000
.15  .10
rE  .15 
5000
 .20 or 20%
©The McGraw-Hill Companies, Inc., 2000
14- 53
M&M Debt Policy Irrelevance
r
rE
rA
rD
Risk free debt
Irwin/McGraw Hill
Risky debt
D
E
©The McGraw-Hill Companies, Inc., 2000
14- 54
M&M Debt Policy Irrelevance
Macbeth continued
Leverage increases the risk of Macbeth shares…
Operating
$500
100% equity : Earnings per share ($)
.50
50 % debt,
50% equity :
Irwin/McGraw Hill
Income
$1,500
1.50
Return on shares (%)
5
15
Earnings per share ($)
0
2
Return on shares (%)
0
20
©The McGraw-Hill Companies, Inc., 2000
14- 55
M&M Debt Policy Irrelevance
 D
  E

BA  
 BD   
 BE 
DE
 DE

D
BE  BA  BA  BD 
E
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000