Finance 7330
Advanced Corporate Finance
Information and Financial
Decisions
Lecture 11
Fall 2010
Issues in Raising Capital
• What securities to issue
• Changes in Ownership and Control
• Alternative Marketing Options
AT&T Stock Issue
• February 28, 1988, AT&T announces a $1
billion new common stock issue
• Value of AT&T dropped by $2 billion!
Market Reaction to Security Offer
Announcements
»
•
•
•
•
•
Industrial
Common Stock
Preferred Stock
Convertible Preferred
Straight Debt
Convertible Debt
-3.14%
-0.19%*
-1.44%
-0.26%*
-2.07%
* Means not statistically significant
Utility
-0.75%
0.08%*
-1.38%
-0.13%*
Explanations
•
•
•
•
EPS Dilution
Price Pressure
Optimal Capital Structure
Information Asymmetry
– Implied Cash Flow Change
– Leverage Change
• Unanticipated Announcements
EPS Dilution
• Suppose earn $1 million and have
200,000 shares, and the P/E ratio is 15.
Then: EPS = $5.00
Price = $75.
What happens if you issue 50,000
new shares?
What happens to EPS?
EPS Dilution
• Suppose earn $1 million and have
200,000 shares, and the P/E ratio is 15.
Then: EPS = $5.00
Price = $75.
EPS = $1million/1,500,000 = 6.67%
What happens if you issue 50,000
new shares?
EPS = $1 million /1,550,000 = 6.45%
EPS Dilution
• Ignores the additional income earned by
the new capital
• If the new capital is as productive as the
old capital then
Total Earnings will increase by
.0667*50,000*75 = $250,000
Thus Earnings = $1,250,000
EPS = $1,250,000/250,000 =
Price Pressure
Demand and Supply
Optimal Capital Structure
Leverage versus firm value
Information Asymmetry
• Managers who have better information
about the future of the firm than do outside
stockholders, try to time the issues to take
advantage of stockholders.
• Stockholders recognize this and thus
react, in general, negatively to
announcements of new security offerings.
Conv. Bond Sale to retire
debt
Common/preferred E.O.
Preferred/debt E.O.
Common sale to retire
debt
Call of convertible bonds
Call of convertible
preferred
Calls of Nonconvertible
bonds
Convertible preferred
sale
Convertible debt sale
Investment decrease
Dividend decrease
Debt/Debt E.O.
Preferred sale
Debt sale
Common repurchase
financed with debt
Debt/Common E.O.
Preferred/common E.O.
Debt/preferred E.O.
Income bond/preferred
Dividend
increase
Investment
increase
Common Stock
repurchase
(+16.2%)
Issue Common
Stock
(-1.6%)
The two Basic Effects
• Cash Flow implications of a security
offering
• Leverage effect of a security offering
Cash Flow In
Leverage
Decreasing
(-) (-)
Cash Flow In
Leverage
Neutral
(-) (0)
Cash Flow Neutral
Cash Flow out
Leverage
Decreasing
(0) (-)
Leverage
Decreasing
(+) (-)
Cash flow Neutral
Cash Flow Out
Leverage
Neutral
Leverage
Neutral
Cash Flow In
Leverage
Increasing
(-)
(+)
Cash Flow Neutral
Cash Flow Out
Leverage
Increasing
(0) (+)
Leverage
Increasing
(+) (+)
(0)
(0)
(+)
(0)
Evidence
• Optimal Capital Structure Theory
– No evidence from announcement effects
• Cash Flow Changes Implied
– Negative returns when issued
– Positive Returns when retired
•
•
•
•
Leverage Changes
Announcement Anticipation
Ownership changes
Price Pressure – No evidence
Organizational Changes
• Mergers (Target 20% versus Bidder
0.2%*)
• Spin off (3.4%)
• Go Private (30%)
• Vol. Liquidation (33%)
• Proxy Fight (1.1%)
In general, Organizational Restructuring
seems to be good for stockholders
Ownership Changes
• Tender Offer (Target 30%, Bidder 0.8%*)
• Large Block Acquisitions from outside
stockholder (2.6%)
• Secondary Distributions of management
holdings (-2.9%, -0.8%)
• Targeted Share Repurchase (-4.8%)
Transactions that decrease ownership
concentration decreases stock price, whereas
increasing ownership concentration tends to
increase stock price
Marketing Securities Issues
• Rights Offering
• Underwriting
– Firm commitment
– Best Efforts
• Private Placement
Why Underwritten Offering
• Costs 3 to 30 times what a nonunderwritten offering would cost
• Comprises 80% of offerings
Why?
Why Underwritten Offering
• Costs 3 to 30 times what a nonunderwritten offering would cost
• Comprises 80% of offerings
Why?
Reputation Effect
For Underwritten Offerings,
• Negotiated versus competitive bids
– In Negotiated Bid: Firm negotiates the
conditions of the sale directly with the
underwriter
– In competitive Bid: Firm structures the deal
and lets underwriter bid for the deal.
• Negotiated much more expensive but are
chosen in an overwhelming number of
cases
• Why?
Why Negotiated rather than
Competitive Bids?
• Variance of issuing costs higher for
competitive bids
• With negotiated bids can share
confidential information with underwriters
that you might not want to make public
• The underwriter bridges the gap of
mistrust between the market and the firm
Thus you expect that equity offerings will be
done mostly with negotiated bids, but
bonds done more with competitive bids.
Initial Public Offerings (IPO’s)
• What is the right price?
– Stock price behavior? (15% underpricing) i.e.
there is an immediate run-up of 15% from the
initial offering price
– An attempt to resolve the Uncertainty
• Best Efforts versus Firm Commitment
– With firm commitment the investment bank
buys the securities directly, whereas in best
effort it simply acts as agent for the firm
– Underpricing Much larger in Best Efforts
where uncertainly is likely to be largest
Overall Message
• We can think of the firm’s dealing with
outside investors in a similar way to that of
a used car dealer.
• Put into place mechanisms that try to
mitigate the impact of the information
advantage the firm has over the outside
investors
Summary
• Security Issues: Reveals information that
managers know regarding the future of the
firm. This information is that reflected
price stockprice changes
• Organizational Change: Changes in the
organization that gives more transparency
and allows better measure of performance
is rewarded on the market
•
Summary
• Ownership Changes: Increased
ownership concentration rewarded on the
market. Allows for improved monitoring
and control
• Marketing: Firms use underwriting as a
means to assure outsiders that they will
not take advantage of them.
Innovation in Financial Markets
Overall Principle: All securities in an efficient (and
complete) market sell at a price equal to the Present
Value of the payments to the security holders.
That is, from an Issuer's point of view, the security
issuance itself is a zero NPV. From the purchasers’
point of view, the Purchase is at a zero NPV as well.
So, in order to get $1 million from security holders they
must expect to receive (in PV terms) an amount equal to
$1 million in expected cash flow and option values.
So why do we see innovative securities
being issued by firms?
Markets are not efficient.
Markets are not complete
Resolve a conflict of interest among claimants to the
firm's cash flow.
"Tax or Regulatory arbitrage“
Encourage an efficient productive process.
Markets are not efficient.
The investing public can be manipulated and
consistently taken advantage of.
Seems unlikely
We have systems in place which are designed to protect
investors
Resolve a conflict of interest among claimants to the
firm's cash flow.
1. Resolve the conflict of interest between outsiders and
insiders.
Information conflict
Agency Problem
2. Resolve the Conflict of Interest between bondholders
and stockholders.
Risk Shifting (Overinvestment)
Underinvestment
3. Non-investors Implicit Claims
Customers
Employees
Suppliers and distributors
Financial Innovations
• Firm designs a security that appeals to a
special niche
– Likely to be temporary
• “Investment Banks have been purchasing
Mortgages and repackaging them into
complex derivatives securities which offer
unique risk-return combinations”
Tax or Regulatory arbitrage“
Tax Factors: The Corporate Tax Benefit
The Personal Tax Penalty
Zero Coupon Bonds: (Sold to tax exempt institutions)
Lehman Bros. ECAPS
Accreted value of a zero-coupon
bond (old analysis)
Time to
Maturity
10
9
8
7
6
Value
463
500
540
583
630
Interest
Earned
37
40
43
47
IRS
Interest
53.7
53.7
53.7
53.7
ECAPS
• 60 year maturity
• Carry routine payments
• Interest can be deferred in times of
financial distress
• Yet can get tax exemption
How do you characterize Debt?
• Unconditional promise to pay a fixed
amount on demand or at a given time in
the future
• Holders must be able to force payments
• Holders cannot participate in management
• Are stockholders separate from holders of
the issue
• Is instrument treated as debt for non-tax
purposes
Permitting a more efficient productive process.
The problem is that we have a long-term security that
could get in the way of efficient production
This is a particular problem for growth companies
Growth Companies
Large appetite for Cash
Must have Growth Opportunities
Difficult to determine Value
Based on Expectations
Makes the credibility problem more severe
Absence of Hard Assets makes it difficult to
resolve Bondholders’ claims
Bank Loans
Custom Tailor Provisions
Can be renegotiated easily
Venture Capitalists
Take active Role in Management
Shift Risk to Managers
Resolves the credibility problem
Provide managers incentives to do well
Stage Financing
Convertible Preferred Stock
Private Placements
Bank Loans and Venture Capital are expensive
Allows private information to be shared
Renegotiation Possible
Complication: Not liquid requiring restrictions
Convertible Securities
Summary
In order to increase stockholders’ wealth, a
security issue must do something other
than simply act as a source of Funds
There are agency, and information problems
which must be resolved in any issue
This is particularly severe for growth firms
The Security must be able to resolve these
issues to be successful