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Chapter Nineteen
Issuing Securities
to the
Corporate
Finance
Ross Westerfield Jaffe
Public


19
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Executive Summary
• Issuing securities involves the corporation in a
number of decisions.
• This chapter looks at how corporations issue
securities to the investing public.
• The basic procedure for selling debt and equity
securities are essentially the same. This chapter
focuses on equity.
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Chapter Outline
19.1 The Public Issue
19.2 The Basic Procedure for a New Issue
19.3 The Cash Offer
19.4 The Announcement of New Equity and the
Value of the Firm
19.5 The Cost of Issuing Securities
19.6 Rights
19.7 The Private Equity Market
19.8 Summary and Conclusions
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19.1 The Public Issue
• Regulation of the securities market in Canada is carried
out by provincial commissions.
• In the U.S., regulation is handled by a federal body
(SEC).
• The regulators’ goal is to promote the efficient flow of
information about securities and the smooth functioning
of securities’ markets.
• All companies listed on the TSE come under the
jurisdiction of the Ontario Securities Commission
(OSC).
• Other provinces have similar legislation and regulating
bodies
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19.2 The Basic Procedure for a New Issue
Steps involved in issuing securities to the public:
1. Management obtains approval from the board of directors.
2. The firm prepares a preliminary prospectus to the OSC.
3. The OSC studies the preliminary prospectus and notifies
the company of any changes required.
4. Once the revised, final prospectus meets with the OSC’s
approval, a price is determined and a full-fledged selling
effort gets under way.
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19.3 The Cash Offer
• Underwriters are usually involved in a cash offer.
• Underwriters perform the following services:
– Formulating the method used to issue the securities.
– Pricing and selling the new securities.
• The difference between underwriter’s buying price
and the offering price is called the spread.
• Because underwriting involves risk, underwriters
combine to form an underwriting group called a
syndicate
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19.3 The Cash Offer (cont.)
Types of Underwriting: two types of underwriting are
involved in a cash offer.
1. Regular Underwriting
• firm commitment underwriting
• best efforts underwriting
2. Bought Deal
• In a bought deal, the issuer sells the entire issue
to one investment dealer or to a group.
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19.3 The Cash Offer (cont.)
• The selling period: while the issue is being sold to the public,
the underwriting group agrees not to sell securities for less
than the offering price until the syndicate dissolves.
• The overallotment option: known as the Green Shoe
provision gives members of the underwriting group the
option to purchase additional shares at the offering price less
fees and commissions.
• Investment Dealers:
– In 2000, RBC Dominion Securities was the leading underwriter by
revenue.
– TD securities was the first ranked by assets.
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19.3 The Cash Offer (cont.)
The offering price:
• Determining the correct offering price is an underwriter’s
hardest task.
• The issuing firm faces a potential cost if the offering price
is set too high or too low.
Underpricing:
• Underpricing is a common occurrence and it clearly helps
new shareholders earn a higher return on the shares they
buy.
• In the case of an IPO, underpricing reduces the proceeds
received by the original owners.
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19.4 The Announcement of New Equity
and the Value of the Firm
• The market value of existing equity drops on the
announcement of a new issue of common stock.
• Reasons include
– Managerial Information
Since the managers are the insiders, perhaps they are
selling new stock because they think it is overpriced.
– Debt Capacity
If the market infers that the managers are issuing new
equity to reduce their debt-to-equity ratio due to the
specter of financial distress the stock price will fall.
– Falling Earnings
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19.5 The Cost of Issuing Securities
1.
2.
3.
4.
5.
6.
Spread or underwriting discount
Other direct expenses
Indirect expenses
Abnormal returns
Underpricing
Green Shoe option
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The Costs of Public Offerings
Costs of Going Public in Canada: 1984--97
Fees
6.00 %
Underpricing
7.88 %
TOTAL
13.88 %
•The above figures understate the total cost because
they ignore indirect expenses or the overallotment
option.
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19.6 Rights
• An issue of common stock offered to existing
shareholders is called a rights offering.
• Prior to the 1980 Bank Act, chartered banks were
required to raise equity exclusively through rights
offerings.
• If a preemptive right is contained in the firm’s
articles of incorporation, the firm must offer any
new issue of common stock first to existing
shareholders.
• This allows shareholders to maintain their
percentage ownership if they so desire.
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Mechanics of Rights Offerings
• The management of the firm must decide:
– The exercise price (the price existing shareholders must
pay for new shares).
– How many rights will be required to purchase one new
share of stock.
• These rights have value:
– Shareholders can either exercise their rights or sell their
rights.
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Rights Offering Example
• Popular Delusions, Inc. is proposing a rights
offering. There are 200,000 shares outstanding
trading at $25 each. There will be 10,000 new
shares issued at a $20 subscription price.
• What is the new market value of the firm?
• What is the ex-rights price?
• What is the value of a right?
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Rights Offering Example
• What is the new market value of the firm?
• There are 200,000 outstanding shares at $25
each.There will be 10,000 new shares issued at a
$20 subscription price.
$25
$20
$5,200,000  200,000 shares 
 10,000 shares 
share
shares
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Rights Offering Example
• What is the ex-rights price?
• There are 110,000 outstanding shares of a firm
with a market value of $5,200,000.
• Thus the value of an ex-rights share is:
$5,200,000
 $24.7619
210,000 shares
• Thus the value of a right is
$0.2381 = $25 – $24.7619
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Theoretical Value of a Right
The theoretical value of a right during the rights-on
period is:
R0 = (M0 – S) / (N +1)
Where,
M0 = Common share price during the rights-on period
S = Subscription price
N = Number of rights required to buy one new share
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Value of a Right after Ex-Rights Date
• When the stock goes ex-rights, its price drops by the
value of one right.
Me = M0 – R0
Re = (Me – S) / N
Where,
Me is the common share price during the ex-rights
period.
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Cost of Rights Offerings
• Until the early 1980s, rights offerings were the most
popular method of raising new equity in Canada for
seasoned issuers because of lower flotation costs.
• In the late 1980s and early 1990s, with the rise of
POP, bought deals replaced rights offers as the
prevalent form of equity issue.
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19.7 The Private Equity Market
• The previous sections of this chapter assumed that a
company is big enough, successful enough, and old
enough to raise capital in the public equity market.
• There are many firms that have not reached this
stage and cannot use the public equity market.
• For start-up firms and firms in financial trouble, the
public equity market is often not available.
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Private Placements
• Avoid the costly procedures associated with the
registration requirements that are a part of public
issues.
• The OSC and SEC restrict private placement issues
of no more than a couple of dozen knowledgeable
investors including institutions such as insurance
companies and pension funds.
• The biggest drawback is that the securities cannot
be easily resold.
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Venture Capital
•
•
The limited partnership is the dominant form of
intermediation in this market.
There are five types of suppliers of venture capital:
1. Old-line wealthy families.
2. Private partnerships and corporations.
3. Large industrial or financial corporations with
established venture-capital subsidiaries.
4. The federal government (through crown-related firms).
5. Individuals, typically with incomes in excess of
$100,000 and net worth over $1,000,000. Often these
“angels” have substantial business experience and are
able to tolerate high risks.
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Stages of Financing
1. Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
2. Start-Up
Funds are likely to pay for marketing and product refinement.
3. First-Round Financing
Additional money to begin sales and manufacturing.
4. Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling
its product but still losing money.
5. Third-Round Financing
Financing for a firm that is at least breaking even and contemplating
expansion; a.k.a. mezzanine financing.
6. Fourth-Round Financing
Financing for a firm that is likely to go public within six months; a.k.a.
bridge financing.
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19.10 Summary and Conclusions
• Larger issues have proportionately much lower
costs of issuing equity than small ones.
• Firm-commitment underwriting is far more
prevalent for large issues than is best-effort
underwriting. Smaller issues probably use best
effort because of the greater uncertainty.
• Rights offering are cheaper than general cash offers.
• Shelf registration is a new method of issuing new
debt and equity.
• Venture capitalists are an increasingly important
influence in start-up firms and subsequent
financing.
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