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 DE DE 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 DE DE D BE BA BA BD E Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000