Issuing Securities
and the Role of
Investment
Banking
19
Corporate Financial Management 3e
Emery Finnerty Stowe
© Prentice Hall, 2004
Raising Long-Term Funds
Externally
Main sources:



Common stock
Preferred stock
Debt
Flotation or issue costs


Fixed costs
Variable costs
Issue Methods


Public offerings
Private placement
Public Offerings
General cash offers
Securities are offered to investors at large.
 Underwriters are often used.

Rights offering

New common stock is sold to existing
stockholders.
General Cash Offers
Decide what to issue:
Amount of capital to be raised
 Type of security

Obtain required approvals.
File a registration statement:
Must be approved by the SEC prior to the
actual sale
 Preliminary prospectus
 Red herring

General Cash Offers
Determine initial pricing and file an
amended registration statement.
Close the offering.
Primary and Secondary Offerings
In a primary offering, the firm sells newly
issued shares to investors.
In a secondary offering, insiders and large
institutional shareholders sell shares they
hold in a registered public offering.
Role of the Underwriters
Investment bankers



An intermediary between the issuer and the purchaser.
Provide advice regarding type of security, terms, and price.
Helps prepare documentation.
Underwriting





A form of insurance.
Risk bearing.
Fixed.
Best effort.
Overallotment (Greenshoe).
Syndicated offering process
Role of the Underwriters
Underwriters compensation

Gross underwriting spread
Management fee (15% to 20%)
 Underwriting fee (15% to 20%)
 Selling concession (60% to 70%)

Other out-of-pocket expenses
Legal fees
 Accounting fees
 Printing costs

Flotation Costs
Include both the gross underwriting spread
and the out-of-pocket expenses.
Economies of scale
Vary by security type: Holding issue size
constant,
Common stock has highest flotation cost.
 Bonds have the lowest flotation costs.
 Flotation costs of preferred stock are in
between.

Negotiated versus Competitive
Offerings
In a negotiated offering, the issuer


selects one or more firms to manage the offering.
works closely with them in designing and pricing the
issue.
In a competitive offering, the issuer


specifies the type and amount of security to be sold.
selects the investment banker through a competitive
bidding process.
Shelf Registration
Since November 1983, the SEC allows
firms to register an inventory of securities
of a particular type for up to two years.
Issue can then sell securities at any time
within this time period.
Rule gives firms financial flexibility and
reduces flotation costs.
Private Placements
Securities are sold directly to institutional
investors.
Exempt from registration requirements.
Securities have restrictions:
Limited number of investors may buy the
securities.
 Restrictions on resale.

Advantages of Private
Placements
Lower issuance costs.
Issue can be placed quickly.
Greater flexibility of issue size.
Greater flexibility of security arrangements.
More favorable share price reaction than a
public offering.
Lower cost of resolving financial distress.
Disadvantages of Private
Placements
Higher yield required by investors.
More stringent covenants and restrictive
terms.
Largest Buyers of Private
Placements
John Hancock Life Insurance
Teachers Insurance &
Annuity Association
Prudential Insurance
Hartford Investment
Management Company
Metropolitan Life
Citigroup Global Investments
American General
Investment Management
New York Life Investment
Management
AIG/SunAmerica
Investments
Principal Capital
Management
Cigna Investment
Management
ING Investment
Management
Provident Investment
Management
Nationwide Insurance
Companies
Main Features of Common Stock
Features specified in the corporate charter
Perpetual security
Not redeemable
May or may not have a par value
Charter specifies the number of authorized shares:


Outstanding shares
Treasury shares
Multiple classes of common stock
Rights and Privileges of
Common Stock
Dividend rights
Voting rights
Cumulative
 Noncumulative
 Voting by proxy

Liquidation rights
Preemptive rights
Public Offering of Common
Stock
Cost of offering
Gross underwriting spread
 Out-of-pocket expenses
 Market impact

A firm’s share price often declines upon the
announcement of a public offering.

Managers sell new shares when shares are
overpriced.
Rights Offerings
Firm issues one right per share outstanding.
Rights are options on newly issued shares:
subscription price
 subscription period

Rights are issued in-the-money.
Rights offerings are frequently
underwritten.
Rights Offerings
Advantages



Allows shareholders to retain their proportionate
ownership in the firm.
Protects existing shareholders from loss of wealth
resulting from a public offering.
Beneficial if firm does not have broad ownership.
Disadvantages


Takes longer to complete.
Cannot sell large blocks of new shares to institutional
shareholders.
Rights Offering
Stansfield Enterprises currently has 1,000,000
shares outstanding trading at $10 per share.
The firm announces a rights offering.
Current shareholders are allowed to buy one
additional share for every share they currently
own at a subscription price of $9.50 per share.
Shareholders who do not wish to exercise their
rights may sell them.
It sounds like a good deal, an opportunity to buy a
$10 stock for $9.50.
Is it that good of a deal?
Value of a Right
What is the value of one right?
To determine this, let’s look at the value of the
firm after the rights offering.
There will be 2,000,000 shares outstanding and
the firm will have raised additional equity of
$9,500,000
The new share price will be $9.75
$10,000,000 old equity  $9,500,000 new equity
$9.75 per share 
2,000,000 shares
The Value of a Right
A shareholder who chooses to exercise his
rights starts with one $10 share, pulls $9.50
out of his wallet and finishes the day with 2
shares of a $9.75 stock for a total portfolio
value of:
$9.75 × 2 = $19.50.
The Value of a Right
If he does nothing, he goes to bed with one
share of a $9.75 stock and $9.50 in his
wallet.
Total = $19.25
Doing nothing will cost him $0.25
The Value of a Right
He can avoid that loss by exercising the
right with $9.50 in cash and then selling the
extra share for $9.75
So, we can be pretty sure that he won’t sell
his right for less than $0.25
Value of a Right
Can he sell his rights for more than $0.25?
Consider an outsider. Would he pay $0.26 for a
right?
 This right will allow him to buy a $9.75 stock
for $9.50 plus the cost of one right.
 Any rational outsider will pay at most $0.25

The Value of a Right
Clearly if the least a seller will take is $0.25
and the most a buyer will pay is $0.25 it’s a
pretty good bet that the rights will have a
market-clearing price will be $0.25
Calculating the ex-rights Price
Consider the value of our shareholder who sells
his rights.
He wakes up in the morning with a $10 stock.
Sells the right stapled to it for $0.25
Goes to bed with a $9.75 stock and $0.25 in the
drawer of his nightstand.
The ex-rights price is $9.75. If it was anything
else there would be an arbitrage opportunity.
Rights Offering
Now suppose Stansfield Enterprises currently has
1,000,000 shares outstanding trading at $10 per
share.
The firm announces a rights offering.
Current shareholders are allowed to buy one
additional share for every two shares they
currently own at a subscription price of $9.50 per
share.
Shareholders who do not wish to exercise their
rights may sell them.
Value of a Right
What is the value of one right?
To determine this, let’s look at the value of the
firm after the rights offering.
There will be 1,500,000 shares outstanding and
the firm will have raised additional equity of
$4,750,000.
The new share price will be $9.83.
$10,000,000 old equity  $4,750,000 new equity
$9.83 per share 
1,500,000 shares
The Value of a Right
A shareholder who chooses to exercise his
rights starts with two $10 shares, pulls
$9.50 out of his wallet and finishes the day
with 3 shares of a $9.83 stock for a total
portfolio value of:
$9.83 × 3 = $29.50.
The Value of a Right
If he does nothing, he goes to bed with two
shares of a $9.83 stock and $9.50 in his
wallet. Total = $29.16
Doing nothing will cost him $0.33.
The Value of a Right
He can avoid that loss by exercising the
right with $9.50 in cash and then selling the
extra share for $9.83.
So, we can be pretty sure that he won’t sell
his right for less than $0.33.
Value of a Right
Can he sell his rights for more than $0.33?
Consider an outsider. Would he pay $0.34 for a
right?
 This right will allow him to buy a $9.83 stock
for $9.50 plus the cost of one right.
 Any rational outsider will pay at most $0.33.

The Value of a Right
Clearly if the least a seller will take is $0.33
and the most a buyer will pay is $0.33, it’s a
pretty good bet that the rights will have a
market-clearing price will be $0.33
Calculating the ex-rights Price
The ex-rights price is
$9.83.
If it was anything else
there would be an
arbitrage opportunity.
PE  PR  R
PE  S
PR  S
R
or R 
N
N 1
Dividend Reinvestment Plans
(DRiPs)
A DRiP allows each shareholder to use the
dividends received to purchase additional
shares of the firm.
Purchase price is often below market price
(5% discount).
Resemble rights offerings.
Lower transaction costs for purchaser than
open market purchase.
Going Public
A firm “goes public” when it offers common stock
to the public for the first time in its life.

Initial Public Offering (IPO)
Subsequent issues of common stock are called
“seasoned” issues.
Underwriters try to price the IPO issue at 10% to
15% below the expected trading price.
For Sale, but not on Ebay
3,500,000 shares
Ebay, Inc.
Common stock
Par value $0.01 per share
Initial Public
Offering Price
Per share
$18.00
Underwriting
Discount
$1.26
Proceeds to
Company
$16.74
Going Private
A small group of investors purchase the
entire common equity of a publicly traded
firm.
Firm is no longer subject to reporting
requirements.
Substantial transaction cost involved in
going public and private.
Advantages of Going Public
Raise new capital
Achieve liquidity and diversification for
current shareholders
Create a negotiable instrument
Increase the firm’s equity financing
flexibility
Enhance the firm’s image
Disadvantages of Going Public
Disclosure requirements
Accountability to public shareholders
Market pressure to perform short-term
Pressure to pay dividends
Dilution of ownership interest
Expense of going public
Higher estate valuation
Features of Preferred Stock
Hybrid securities:
Claims senior to common stock, junior to debt.
 Dividends must be paid to preferred before they
can be paid to common.

Usually have a par or stated value.
Dividend rate is usually specified.
Redemption provisions:
Optional
 Mandatory

Financing with Preferred Stock
Why do firms issue preferred stock?
Sinking fund preferred is like debt:
The “interest payments” are not tax-deductible,
but
 This is offset by the fact that missing a
scheduled payment does not lead to bankruptcy.

Financing with Preferred Stock
Preferred stock dividends also qualify for the 70%
dividends-received deduction when the preferred
shareholder is another corporation.
Because of this, preferred-stock yields are usually
lower than the yields of comparable debt
instruments.
Plus, if the firm is not paying taxes currently due
to poor operating results, the forgone interest tax
deduction is not an issue.
Financing with Preferred Stock
Utility companies have been the heaviest
issuers of fixed-rate preferred stock.
Regulated utilities can pass the cost of
preferred dividends through to their
customers.