16-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by...

16-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Sixteen

Issuing Securities to the Public


16.1 The Public Issue

16.2 The Cash Offer

16.3 New Equity Sales and the Value of the Firm

16.4 The Costs of Issuing Securities

16.5 Rights

16.6 Dilution

16.7 Issuing Long-term Debt

Summary and Conclusions

Chapter Organisation


Chapter Objectives• Outline the advantages and disadvantages of public

company listing.• Discuss the process of underwriting and the

associated costs.• Identify the costs associated with issuing securities.• Explain the process of a rights issue and calculate

the value of a right.• Discuss the dilution effect of new issues.• Understand the reasons for recent growth in the

corporate debt market.


The Public Issue• The regulation for the raising of funds in Australia is

through the Corporations Act 2001, administered by ASIC. Main areas of regulations are:– prospectus provisions– restrictions on allotment of shares– securities-hawking provisions– accounts and audit provisions– provisions relating to the sale of prescribed interests– debenture provisions– takeover provisions– provisions licensing persons engaged in securities industry.


Issuing Securities to the Public1. Analyse funding needs and how they can be met.

2. Approval from board of directors for a public issue.

3. Outside expert opinions sought for support of issue.

4. Pricing, time-tabling, prospectus prepared, marketing.

5. Prospectus filed with ASIC and ASX.


Issuing Securities to the Public (continued)6. Underwriting agreement executed.

7. Prospectus registered.

8. Public announcement of offering.

9. Funds received.

10.Shares allotted, holdings registered.

11.Shares listed for trading on ASX.


New Issues• Flotation is the initial offering of securities to the

public.

• When the company is going to the market for the first time it is called a primary issue.

• Primary issues are used to:– convert from a private company to a public company– spin-off a portion of the business of a listed company– form a new public company– privatise a public organisation or demutualise a mutual

society.


Advantages of Public Company Listing• Access to additional capital.

• Increased negotiability of capital.

• Growth not limited by cash resources.

• Enhancement of corporate image.

• Can attract and retain key personnel.

• Gain independence from a spin-off.


Disadvantages of Public Company Listing• Dilution of control of existing owners.

• Additional responsibilities of directors.

• Greater disclosure of information.

• Explicit costs.

• Insider trading implications.


Secondary Issues• Secondary issues—the term used for all issues by

a company subsequent to its listing.

• The principal forms of secondary issues are:

– Private placements—sale of securities to selected clients of a sharebroker and/or large institutional investors (e.g. life insurance companies and superannuation funds).

– Rights issues—issue of shares made to all existing shareholders, who are entitled to take up the new shares in proportion to their present holdings.


Underwriting• Underwriters are investment firms that act as

intermediaries between a company selling securities and the investing public.

• Roles of the underwriter:– pricing the issue– marketing the issue– engaging sub-underwriters– placing the shortfall.

• Sub-underwriters are a group of underwriters formed to reduce the risk and to help to sell an issue.


Underwriting• Firm underwriting

– A guarantee that funds will be made available to a company at a specific time on agreed terms and conditions.

• Standby underwriting– Where the bidding company has insufficient cash in a

successful bid or if cash is offered as an alternative to a share bid.

• Best efforts underwriting– Underwriter must use ‘best efforts’ to sell the securities at

the agreed offering rate


Underwriting Fees• The underwriter’s fee is a reflection of the:

– size of the issue– issue price– general market conditions– market attitude towards shares– time period required for underwriting.

• Fees also include brokerage and management fees

• Recent fees for initial equity issues of industrial companies have ranged from 3 per cent to 5 per cent


The Offering Price• Equity issues are priced primarily by reference to the

prevailing market price. For example:

– Private placements of ordinary shares are typically made at 90-100 per cent of market price.

– Rights issues are typically priced at 60−90 per cent of market price.

– Dividend reinvestment offers are typically priced at 90−95 per cent of market price.


The Offering Price• Determining the correct offering price for an initial

public offering is difficult.

• If the issue is priced too high, it may be unsuccessful and have to be withdrawn.

• If the issue is priced too low (called underpricing), the issuer’s existing shareholders lose out by selling their shares for less than they are worth. Underpricing is a fairly common occurrence.


Average Initial Returns by Month for SEC-registered Initial Public Offerings: 1960−2003


Underpricing• Tends to be higher for small, young, risky firms (helps

attract investors).

• More pronounced in emerging markets.

• Relatively few buyers get the initial high average returns observed in IPOs. Reasons include:– A significant fraction of IPOs experience price drops.– Informed investors quickly subscribe for underpriced issues,

crowding out uninformed investors. But uninformed investors get all the shares they want in less profitable issues.


New Equity Sales and Firm Value• Shares prices tend to decline after a new equity issue

announcement, but rise following a debt announcement.

• Why?– Management has superior information about firm value and

knows when the firm is overvalued → sell equity– Excessive debt usage– Substantial issue costs.

• Management needs to understand the signals that an equity issue sends.


The Cost of Issuing Securities

Underwriter’s commission This consists of direct fees paid by the issuer to the underwriting syndicate.

Other direct expenses These are direct costs, incurred by the issuer, that are not part of the compensation to underwriters. These costs include filing fees, legal fees, and taxes—all reported on the prospectus.

Indirect expenses These costs are not reported on the prospectus and include the costs of management time spent working on the new issue.

Abnormal returns In a seasoned issue of shares, the price drops on average by 3 per cent upon the announcement of the issue.

Underpricing For initial public offerings, losses arise from selling the shares below the correct value.


Rights Offerings—Basic Concepts

• Rights offering—issue of ordinary shares to existing shareholders.

• Allows current shareholders to avoid the dilution that can occur with a new share issue.

• ‘Rights’ are given to the shareholders specifying:– number of shares that can be purchased (e.g. 1 for 10)– purchase price– time frame.

• Shareholders can either exercise their rights or sell them. They neither win nor lose either way.


Rights Offerings—Basic Concepts• Subscription price

– The dollar cost of one of the shares to be issued, generally less than the current market price

• Ex-rights date– Beginning of the period when shares are sold without a

recently declared right, normally four trading days before the holder-of-record date. The share price will drop by the value of the right.

• Holder-of-record date– Date on which existing shareholders are designated as

the recipients of share rights.


Ex-rights Share Prices

Rights-on Ex rights

Announcementdate date date

Ex-rights Record

30 September 13 October 15 October

Rights-on price $20.00

Ex-rights price $16.67

$3.33 =Value of a right


Theoretical Rights Price

rn

SMn

offered shares additional ofnumber

issue rights theof price issueor on subscripti

pricemarket

right aobtain toheld shares ofnumber

r

S

M

n

Where:


Example—Rights Issue

Lemon Co. currently has 5 million shares on issue with a market price of $8 each. To finance new projects, the company needs to raise an additional $6 million. To raise the finance, the company makes a rights issue at a subscription price of $6 per share.


Example—Rights Issue (cont’d)• The number of new shares to be sold:

• The holder of one right is entitled to subscribe to one new share at $6 per share.

• To issue 1 million shares, the company would have to issue 1 million rights.

• The company has 5 million shares on issue, which means that for every 5 shares held, a shareholder is entitled to receive one right (1-for-5 rights issue).

shares 000 000 1 $6

000 000 $6

priceon subscripti

raised be tofunds


Example—Rights Issue (cont’d)• Calculate the theoretical rights price:

• If an outsider buys a right, it will cost $1.67.

• The right can be exercised at a subscription price of $6.

• Total cost of a new share = $1.67 + $6 = $7.67.

$1.67

1 5

$6 $8 5

rn

SMn


The Value of Rights

* $8.00 – 7.67 = 0.33** $0.33 × 5 = $1.65


Types of Equity Capital Raised


Dilution• Loss in existing shareholders’ value in terms of

either ownership, market value, book value or EPS.

• Types of dilution– Dilution of proportionate ownership—a shareholder’s

reduction in proportionate ownership due to less-than-proportionate purchase of new shares.

– Dilution of market value—loss in share value due to use of proceeds to invest in negative NPV projects.

– Dilution of book value and earnings per share (EPS)—reduction in EPS due to sale of additional shares. This has no economic consequences.


Corporate Debt• The late 1980s saw a major growth in the

Australian corporate debt market due to:– the substantial cutback in the level of government

borrowing– the fall in interest rates from extremely high levels– the flight to quality– the shortage of government bonds– the attractiveness of raising funds in the domestic market

relative to that of the euromarket.


Long-term Debt• There are two basic forms of direct private long-

term financing: term loans and private placement.

• Term loans are direct business loans of, typically, one to five years.

• Private placements are usually long-term loans provided directly by a limited number of investors.


Long-term Debt (continued)• Differences between direct, private long-term

financing and public issues of debt include:– direct loans avoid ASIC registration costs– direct placement is likely to have more restrictive covenants– term loans and private placements are easier to renegotiate

than public issues.

• The costs of distributing debentures are lower in the private market but the interest rates are usually higher.


Summary and Conclusions• Flotation is the initial public offering of securities and

can undertaken with the help of underwriters. • Public company listing has its advantages and

disadvantages.• The direct and indirect costs of going public can be

substantial but once a firm is public it can raise additional capital with much greater ease.

• Rights offerings are cheaper than general cash offers.

• The general procedures followed in a public issue of debt are the same as those for shares.

16-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by...

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Transcript of 16-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by...