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Initial public offerings (IPO)Types of stockGoing public and listingSecurities regulationInvestment banking

CHAPTER 19Investment Banking: Common Stocks

Schematic

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How are start-up firms usually financed?

Founder’s resourcesAngelsVenture capital funds

Most capital in fund is provided by institutional investors (limited partners)

Managers of fund are called venture capitalists (general partners)

Venture capitalists (VCs) sit on boards of companies they fund

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In a private placement, such as to angels or VCs, securities are sold to a few investors rather than to the public at large.

In a public offering, securities are offered to the public and must be registered with SEC.

Differentiate between a privateplacement and a public offering.

(More...)

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Privately placed stock is not registered, so sales must be to “accredited” (high net worth and officers) investors.Send out “offering memorandum” with

20-30 pages of data and information, prepared by securities lawyers.

Buyers certify that they meet net worth/income requirements and they will not sell to unqualified investors.

Limited unaccredited investors o.k.

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Current stockholders can diversify holdings.

Liquidity is increased. Owners can sell some shares.

Easier to raise capital in the future.Going public establishes a value for

the firm.Makes it more feasible to use stock

as employee incentives.

Advantages of Going Public

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Must file numerous reports.Operating data must be disclosed.Officers must disclose holdings.Special “deals” to insiders will be

more difficult to undertake.A small new issue will not be

actively traded, so price may not

reflect true value.

Disadvantages of Going Public

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The advantages of public ownership would be recognized by key employees, who would most likely have stock or stock options. They would know what their stock and options were worth, and would like the liquidity.

How would the decision to go publicaffect key employees?

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A firm goes public through an IPO when the stock is offered to the public for the first time.

Later offers are called Secondary offerings (not identical to Secondary Market)

Selling stock to the public would make the company publicly held.

Insert: How an IPO is done.

When is a stock sale an initial public offering (IPO)?

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What criteria are important in choosing an investment banker?

Reputation and experience in this industry

Existing mix of institutional and retail (i.e., individual) clients

Support in the post-IPO secondary market

Reputation of analyst covering the stockFinancial strength

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What is “book building?” Investment banker asks investors to

indicate how many shares they plan to buy, and records this in a “book”.

Investment banker hopes for oversubscribed issue. (Green Shoe Clause)

Based on demand, investment banker sets final offer price on evening before IPO. (See Accenture article)

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Since the firm is going public, there is no established price.

The banker would examine market data on similar companies.

Price set to place the firm’s P/E, M/B, price/margin ratios in line with publicly traded firms in the same industry, with similar risk and growth characteristics.

Describe how an IPO would be priced.

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On the basis of all relevant factors, banker would determine a ballpark equilibrium price.

The offering price would be set somewhat lower to increase demand and to insure that the issue will sell out.

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There is an inherent conflict of interest, because the banker has an incentive to set a low priceto make brokerage customers happy.to make it easy to sell the issue.

Firm would like price to be high.However, the original owners generally sell

only a small part of their stock, so if price increases, they benefit.

Later offerings easier if first goes well.Controversy over “spinning”

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Gross proceeds: $15 million.But, flotation costs of IPO would be

about 18% or $2.7 million.(See insert)

The firm would net about $12.3 million from the sale.

Suppose a firm issued 1.5 million shares at $10 per share. What would be the approximate flotation costs on

the issue?

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What are typical first-day returns?

For 75% of IPOs, price goes up on first day.

Average first-day return is 14.1%.About 10% of IPOs have first-day

returns greater than 30%.For some companies, the first-day

return is well over 100%.

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What are the long-term returns to investors in IPOs?

Two-year return following IPO is lower than for comparable non-IPO firms.

On average, the IPO offer price is too low, and the first-day run-up is too high.

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What are the direct costs of an IPO?

Underwriter usually charges a 7% spread between offer price and proceeds to issuer.

Direct costs to lawyers, printers, accountants, etc. can be over $400,000.

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If the firm were already publicly owned, the flotation costs would be much less (about 9%) because a market price for the stock would already have been established.

What would be the flotation costson the issue if the firm were already

publicly owned?

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What are equity carve-outs?

A special IPO in which a parent company creates a new public company by selling stock in a subsidiary to outside investors.

Parent usually retains controlling interest in new public company.

What is the purpose of an equity carve-out?

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How are investment banks involved in non-IPO issuances?

Shelf registration (SEC Rule 415), in which issues are registered but the entire issue is not sold at once, but partial sales occur over a period of time.

Public and private debt issuesSeasoned equity offerings (public

and private placements)

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A listed stock is traded on an organized exchange (NYSE, American, Pacific Coast, etc.)

Transition between exchangesIt’s unlikely that a small firm’s stock

would be listed. Small firms trade in the OTC market.

What’s listing? Would a small firm likely be listed?

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A rights offering occurs when current shareholders get the first right to buy new shares.

Prevents dilution of current holdersWould not make sense for a firm

that is going public. If current stockholders wanted to buy shares, they wouldn’t go public.

What is a rights (or privileged or preemptive) offering? Why would

a firm use a rights offering?

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WAYS TO SELL COMMON STOCK

Rights offeringPrivate PlacementPublic offering

IPOSecondary

Dividend Reinvestment Plan.Employee Purchase Plan

ESOP, Stock options, etc.

Slide 15-38

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The reverse of going public.E.G. In an LBO, the firm’s managers

team up with a small group of outside investors with equity capital and purchase all of the publicly held shares of the firm.

The new equity holders usually use a large amount of debt financing.

Called a leveraged buyout or MBO.

What is meant by going private?

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Leverage Buyout (LBO) Steps:

Repurchase by Management and associated groups

Funds provided by management and associated groups & HEAVY DEBT

Change operations/incentives and/or sell some assets

Later go public again, at tidy profit

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Gives managers greater incentives and more flexibility in running the company.

Removes pressure to report high earnings in the short run.

After several years as a private firm, owners typically go public again. Firm is presumably operating efficiently and sells for more.

Advantages of Going Private

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LBO firms are normally leveraged to the hilt, so it’s difficult to raise new capital.

A difficult period that could normally be weathered might bankrupt the company.

Disadvantages of Going Private

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Would be likely to use an investment banker.

Would use a negotiated deal rather than a competitive bid.

Would a company that is going public be likely to sell its new stock by itself

or through an investment banker?

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C om p etitive

U n d erwritten B est E ffort

N eg otiated

In vestm en t B an k in g D eal

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The competitive bid process is only feasible for large, well-established firms, on large issues, and even here, the use of bids is rare for equity issues.

It would cost investment bankers too much to learn enough about the company to make an intelligent bid carrying out “due diligence”.

Why would companies that are goingpublic not use a competitive bid?

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Most offerings are underwritten.In very small, very risky deals, the

investment banker may insist on a best efforts basis.

If a company goes public, in anegotiated deal would it be on an

underwritten or best efforts basis?

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The investment bankers are exposed to more risk on underwritten deals, and they will charge a price for assuming this risk. (Don’t overstate)

If the firm absolutely has to have the money to meet a commitment, and hence it needs a guaranteed price, it will use an underwritten sale.

Would there be a difference in costs between a best efforts and an

underwritten offering?

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REGULATION OF SECURITY OFFERINGS

Securities Act of 1933Sale of new securities

Securities Act of 1934regulation of outstanding securitiesEstablishes SEC

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REGULATION OF SECURITY OFFERINGS

Registration statementThe disclosure document filed with the

SEC in order to register a new security issue.

Prospectus:Part 1 of the registration statement.

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CONTENTS OF PROSPECTUS

Prospectusnature and history of companyuse of proceedscertified financial statementsnames of management and holdingscompetitive conditionsrisk factorslegal opinionsdescription of security being offered

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REGULATION OF SECURITY OFFERINGS

Red HerringThe preliminary prospectus. Contains

red lettered statement that registration statement has not yet become effective

Tombstone

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REGULATION OF SECURITIES

SHELF REGISTRATION (Rule 415)A procedure whereby a company is

permitted to register securities it plans to sell over the next two years. These securities then can be sold piecemeal whenever the company chooses.

Blue Sky lawsState laws regulating the offering and

sale of securities.

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A p p roval

S top O rd er A p p roval

A m en d ed s ta tem en t

C om m en t letter

R eg is tra tion s ta tem en t

Registration Process

40Days

20 days

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NO LIQUIDITYPROBABILITY DISTRIBUTION OF

RETURNSSOURCES OF FUNDS

HIGH INCOME INDIVIDUALSPARTNERSHIPS INCLUDING PENSION

FUNDS, INSURANCE FUNDS, UNIVERSITY ENDOWMENTS, ETC.

STAGED FINANCINGRule 144A

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Prob. Distribution of Returns for single VC investment

Prob.

Return

0%

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Bonds vs. term loansTypes of loansCalls and sinking fundsBond ratingsAdvantages/disadvantages of LT

debt

CHAPTER 19Investment Banking: Long-Term Debt

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BondsNot amortizedSold to public through investment

bankers; can be traded fairly easilyUsed by larger companies

Term loansAmortizedDirectly placed with institutionsNot traded after placementShorter maturity than bonds

Bonds vs. Term Loans

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SpeedFlexibility

Can tailor termsCan be renegotiated if problems

arise“Story loans.” Easier for small

companies to sell one lender a “story”Lower issue costs

Advantages of Term Loans

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A BOND RATHER THAN A LOAN WILL BE CHOSEN IF:

WELL KNOWNSTRONGNOT IN A GREAT HURRYDON’T EXPECT TO CHANGE TERMSLIKELY TO REISSUE

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ORDER OF INTEREST RATES LEVELS:

JUNK BONDSJUNIORSENIOR

BANK LOANSBOND ISSUES

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Maturity matchingMatch maturity of assets and debt

Information asymmetriesFirms with strong future prospects will

issue short-term debt

How do companies manage the maturity structure of their debt?

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Mortgage bond, because real property is pledged as collateral. Probably first mortgage, but could be second mortgage bonds secured by the same building.

Suppose a company issues a bond using a building as collateral. What

type of bond would this be?

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Yes. Debentures are not secured by specific assets. Therefore, bondholders face more risk in debentures than in secured bonds, so higher interest rates must be set on debentures.

If the company had issued debentures instead of mortgage bonds, would the

interest rate be affected?

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An indenture is the formal agreement between the issuer and investors. Trustee is assigned.

Designed to insure that issuer does nothing to cause the quality of bonds to deteriorate after bonds are sold.

(More...)

What’s a bond’s indenture?

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An indenture contains restrictive covenants that constrain the issuer’s actions. Included are:Refunding or call conditions.Sinking fund requirements.Levels at which key financial

ratios must be maintained.Earnings level necessary before

dividends can be paid.

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Permits the issuer to refund if rates decline. That helps the issuer but investors must reinvest at low rates.

Borrowers (issuers) are willing to pay MORE, and lenders require more, on callable bonds, i.e., rd is higher. (About 20 to 70 bp)

Most bonds have a deferred call and then a declining call premium.

How does adding a call provision affect a bond?

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CALLABLE BONDS AS OPTIONS

BONDHOLDERBUYS STRAIGHT

BONDWRITES CALL

OPTION

The compensation (“premium”) for the written call is a higher interest rate

BOND ISSUERISSUES STRAIGHT

BONDBUYS BACK CALL

OPTION

To pay, (i.e. to get the bondholder to accept, he pays a higher interest rate

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By delaying the call, the company guarantees investors the promised interest rate for at least a specified period, so if the issue were immediately callable the interest rate would be higher. (Shorter mat. date)

What would be the effect on the coupon rate if the bonds were made

callable immediately?

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Provision to pay off a loan over its life rather than all at maturity.

Similar to amortization on a term loan.Reduces risk to investor and shortens

average maturity.But can hurt investors if rates decline

after issuance; i.e. premium bonds called at par.

What’s a sinking fund?

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SINKING FUND AS PUT OPTION

BONDHOLDERBuys straight bondBuys put option

To pay for this put, he accepts a lower interest rate

ISSUERIssues straight

bondsells put option

Since the buyer is given the puts as part of the package, he accepts lower Rate

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Because a sinking fund protects bondholders, it lowers the required rate at the time of issue.

Would a sinking fund provision raise or lower the interest rate required on

bonds?

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Sinking funds are generally handled in one of two ways, at firm’s option.Randomly call a specified number

of bonds at par each year for sinking fund purposes.

Buy the required bonds on the open market.

Which method would be used?

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Call bonds ( at par) if rd < coupon rate, but fill sinking fund requirement by buying bonds in the market if rd >

coupon rate

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Sinking funds are more common on long-term issues (20-30 years) than on short-term issues like 5 years.

Sinking fund payments are usually made out of operating cash flows.

Sinking fund unlikely on a 5-year bond for a construction project.

Why might investors require a sinking fund? Would a sinking fund make

sense for, e.g, a 5-year bond to fund a construction project?

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Tax treatment of zero coupon bond

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N I/YR PV PMT FV

5 12 0 1,000INPUT

OUTPUT -567.43

Issue price = 1000/(1.12^5)=$567.43, or 56.743% of par. (Assumes annual compounding.)

What would the issue price be if the company uses 5-year, $1,000 par, zero

coupon bonds that yield 12%?

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$10,000,000/0.56743 = $17,623,319.

What face amount of zeros would be required to raise $10 million?

How would this be shown on the balance sheet?

Cash $10 mill. Bonds $17.6 mill.Disc. (7.6 mill.)Net bonds $10.0 mill.

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Show the cash flows for a 12% coupon bond. (T=.40 for firm, .28 for investor)

0 1 2 3 4 5

InvestorCash Flow-1000 120 120 120 120 1120Taxes* -33.6 -33.6 -33.6 -33.6 -33.6After tax -1000 86.4 86.4 86.4 86.4 1086.4cash flows:

IRR = 8.64%

*Tax = .28(120);

**After Tax

12%

Comparison:

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Show the cash flows for a 12% coupon bond. (T=.40 for firm, .28 for investor)

0 1 2 3 4 5

ISSUERCash Flow 1000 -120 -120 -120 -120 - 1120Int. Tax Shield**48** 48 48 48 48

After Tax 1000 -72 -72 -72 -72 1072

**interest tax shield= .40(120); IRR=7.20% **After Tax

12%

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Show the zero bond’s accruedvalue and cash flows on a time line.

0 1 2 3 4 5

AccruedValue 567.43 635.52 711.78 797.20 892.86 1000.00“Interest” 68.09 76.26 85.42 95.66 107.14After taxcash flows:Inves. -576.43 -19.07 -21.35 -23.92 -26.78 970.00Firm 567.43 27.24 30.50 34.17 38.26 -957.14

T = 40% for firm, 28% for investor.

12%

Comparison:

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Found as the IRRs of the after-tax cash flow streams in the previous slide: 8.6% and 7.2%

Alternatively, can be found as the before-tax value times (1-T): Investor: 12%(0.72) = 8.6%. HDC: 12%(0.6) = 7.2%.

What is the after-tax YTM to a T=28% investor and the after-tax cost to the

firm?

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At year 3, the accrued value is $797.20, so the call is a 1.05($797.20) = $837.06.

The call premium is $837.06 - $797.20 = $39.86, and like the accrued interest, it is taxable income.

What is the after-tax return to a T = 28% investor if the zeros were called

after three years with a 5% call premium?

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Zero Coupon Bond

0 1 2 312%

AccruedValue 576.43 635.52 711.78 797.20“Interest” 68.09 76.26 85.42Call premium 39.86Taxes (28%) -19.07 -21.35 -35.08Cash flow -576.43 -19.07 -21.35 801.98

IRR = After tax YTC =9.45%.

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Regular Coupon Bond

0 1 2 312%

Bond cost -1000.00Call price 1060.00Interest 120.00 120.00 120.00Taxes (28%) -33.60 -33.60 -50.40Cash flow -1000.00 86.40 86.40 1129.60

IRR = After tax YTC = 9.95%.(Higher because of higher call premium.)

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A lower bond rating would:make it more costly to issue new debt decrease the market value of the

outstanding debt.A higher rating would:

make it less costly to issue new debtincrease the market value of the existing

debt.

RATINGS: How would a change in the company’s bond rating affect things?

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Ratings serve as an indicator of the probability of default.

Corporations pay rating agencies to have debt rated prior to sale. WHY?

Investment bankers require bonds be rated as a condition for selling new bonds. Purchasers want this.

Additional Points Concerning Bond Ratings

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If interest rates have fallen since the bond was issued, the firm can replace the current issue with a new, lower coupon rate bond.

However, there are costs involved in refunding a bond issue. For example,The call premium.Flotation costs on the new issue.

Under what conditions would a firm exercise a bond call provision?

(More...)

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The NPV of refunding compares the interest savings benefit with the costs of the refunding. A positive NPV indicates that refunding today would increase the value of the firm.

However, if interest rates are expected to fall further, it may be better to delay refunding until some time in the future.

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Target capital structureLife of asset being financedInterest rate levels and yield curveComparative costs of diff. securitiesRestrictive covenantsNeed for reserve borrowing capacityAvailability of good collateral

What are some factors that influence the use of debt?

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Junk bondsProject financingSecuritizationBonds redeemable at par (putable

bonds)SWAPS

Describe the following items:

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A junk bond is high-risk, high-yield bond frequently issued as part of the financing packages for a merger or a leveraged buyout, or else issued by a troubled company. A junk bond is any bond rated BB or below.

Project financings are used to finance a specific large capital project. Sponsors provide the equity capital, while the rest of the project’s capital is supplied by lenders and/or lessors who do not have recourse.

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PROJECT FINANCING BALANCE SHEET

PROJECT DEBT EQUITY

Sometimes called: Off-balance sheet financing, sometimes SPE’s

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Securitization is the process whereby financial instruments that were previously illiquid are converted to a form that creates greater liquidity.

Bonds backed by mortgages, auto loans, credit card loans (asset-backed)

Putable bonds (redeemable at par at the holder’s option) protect the holder against a rise in interest rates or a lowering of credit quality.

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POISON PUTSBondholder may put if unfriendly takeover

SWAPS (may soon be traded on organized exchanges)INTEREST RATE SWAPS

• Example

CURRENCY SWAPSMYRIAD OF OTHER SWAPS

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What’s a “dividend reinvestmentplan (DRIP)”?

Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more stock rather than cash.

There are two types of plans:Open marketNew stock

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Open Market Purchase Plan

Dollars to be reinvested are turned over to trustee, who buys shares on the open market.

Brokerage costs are reduced by volume purchases.

Convenient, easy way to invest, thus useful for investors.

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New Stock Plan

Firm issues new stock to DRIP enrollees, keeps money and uses it to buy assets.

No fees are charged, plus sells stock at discount of 5% from market price, which is about equal to flotation costs of underwritten stock offering.

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Optional investments sometimes possible, up to $150,000 or so.

Firms that need new equity capital use new stock plans.

Firms with no need for new equity capital use open market purchase plans.

Most NYSE listed companies have a DRIP. Useful for investors.

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Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years.

Set a target capital structure.Estimate annual equity needs.Set target payout based on the

residual model.Generally, some dividend growth rate

emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

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Dividend Payout Ratios forSelected Industries

Industry Payout ratioBanking 38.29Computer Software Services 13.70Drug 38.06Electric Utilities (Eastern U. S.) 67.09Internet n/aSemiconductors 24.91Steel 51.96Tobacco 55.00Water utilities 67.35*None of the internet companies included in the Value Line Investment Survey paid a dividend.

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Stock Repurchases

Reasons for repurchases:As an alternative to distributing cash as

dividends.To dispose of one-time cash from an

asset sale.To make a large capital structure

change.

Repurchases: Buying own stock back from stockholders.

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Advantages of Repurchases

Stockholders can tender or not. Helps avoid setting a high dividend that

cannot be maintained. Repurchased stock can be used in takeovers

or resold to raise cash as needed. Income received is capital gains rather than

higher-taxed dividends. Stockholders may take as a positive signal--

management thinks stock is undervalued.

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Disadvantages of Repurchases

May be viewed as a negative signal (firm has poor investment opportunities).

IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.

Selling stockholders may not be well informed, hence be treated unfairly.

Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

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Stock Dividends vs. Stock Splits

Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned.

Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

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Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.”

Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.

But splits/stock dividends may get us to an “optimal price range.”

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When should a firm consider splitting its stock?

There’s a widespread belief that the optimal price range for stocks is $20 to $80.

Stock splits can be used to keep the price in the optimal range.

Stock splits generally occur when management is confident, so are interpreted as positive signals.

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Interest Rate Swap

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Interest Rate Swap

IntermediaryCompany A (AAA) Company B (BBB)

Direct fixedrate lender

Direct floatingrate lender

10% 6-monthLibor +.75%

10.10% 10.20%

6-month Libor

6-monthlibor

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THE END!

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Initial Public OfferingsInvestment Banking and RegulationThe Maturity Structure of DebtRefunding OperationsThe Risk Structure of Debt

CHAPTER 19Initial Public Offerings, Investment

Banking, and Financial Restructuring

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The Securities and Exchange Commission (SEC) regulates:Interstate public offerings.National stock exchanges.Trading by corporate insiders.The corporate proxy process.

The Federal Reserve Board controls margin requirements.

What agencies regulatesecurities markets?

(More...)

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States control the issuance of securities within their boundaries.

The securities industry, through the exchanges and the National Association of Securities Dealers (NASD), takes actions to ensure the integrity and credibility of the trading system.

Why is it important that securities markets be tightly regulated?

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How are start-up firms usually financed?

Founder’s resourcesAngelsVenture capital funds

Most capital in fund is provided by institutional investors

Managers of fund are called venture capitalists

Venture capitalists (VCs) sit on boards of companies they fund

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In a private placement, such as to angels or VCs, securities are sold to a few investors rather than to the public at large.

In a public offering, securities are offered to the public and must be registered with SEC.

Differentiate between a privateplacement and a public offering.

(More...)

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Privately placed stock is not registered, so sales must be to “accredited” (high net worth) investors.Send out “offering memorandum” with

20-30 pages of data and information, prepared by securities lawyers.

Buyers certify that they meet net worth/income requirements and they will not sell to unqualified investors.

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Advantages of going publicCurrent stockholders can diversify.Liquidity is increased.Easier to raise capital in the future.Going public establishes firm value.Makes it more feasible to use stock as

employee incentives.Increases customer recognition.

Why would a company considergoing public?

(More...)

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Disadvantages of Going PublicMust file numerous reports.Operating data must be disclosed.Officers must disclose holdings.Special “deals” to insiders will be

more difficult to undertake.A small new issue may not be

actively traded, so market-determined price may not reflect true value.

Managing investor relations is time-consuming.

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What are the steps of an IPO?

Select investment bankerFile registration document (S-1) with

SECChoose price range for preliminary (or

“red herring”) prospectusGo on roadshowSet final offer price in final prospectus

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What criteria are important in choosing an investment banker?

Reputation and experience in this industry

Existing mix of institutional and retail (i.e., individual) clients

Support in the post-IPO secondary marketReputation of analyst covering the

stock

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A negotiated deal.The competitive bid process is only

feasible for large issues by major firms. Even here, the use of bids is rare for equity issues.

It would cost investment bankers too much to learn enough about the company to make an intelligent bid.

Would companies going public use a negotiated deal or a competitive bid?

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Most offerings are underwritten. In very small, risky deals, the

investment banker may insist on a best efforts basis.

On an underwritten deal, the price is not set until Investor interest is assessed.Oral commitments are obtained.

Would the sale be on anunderwritten or best efforts basis?

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Since the firm is going public, there is no established price.

Banker and company project the company’s future earnings and free cash flows

The banker would examine market data on similar companies.

Describe how an IPO would be priced.

(More...)

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Price set to place the firm’s P/E and M/B ratios in line with publicly traded firms in the same industry having similar risk and growth prospects.

On the basis of all relevant factors, the investment banker would determine a ballpark price, and specify a range (such as $10 to $12) in the preliminary prospectus.

(More...)

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What is a roadshow?

Senior management team, investment banker, and lawyer visit potential institutional investors

Usually travel to ten to twenty cities in a two-week period, making three to five presentations each day.

Management can’t say anything that is not in prospectus, because company is in “quiet period.”

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What is “book building?”

Investment banker asks investors to indicate how many shares they plan to buy, and records this in a “book”.

Investment banker hopes for oversubscribed issue.

Based on demand, investment banker sets final offer price on evening before IPO.

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What are typical first-day returns?

For 75% of IPOs, price goes up on first day.

Average first-day return is 14.1%.About 10% of IPOs have first-day

returns greater than 30%.For some companies, the first-day

return is well over 100%.

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There is an inherent conflict of interest, because the banker has an incentive to set a low price:to make brokerage customers happy.to make it easy to sell the issue.

Firm would like price to be high.Note that original owners generally sell

only a small part of their stock, so if price increases, they benefit.

Later offerings easier if first goes well.

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What are the long-term returns to investors in IPOs?

Two-year return following IPO is lower than for comparable non-IPO firms.

On average, the IPO offer price is too low, and the first-day run-up is too high.

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What are the direct costs of an IPO?

Underwriter usually charges a 7% spread between offer price and proceeds to issuer.

Direct costs to lawyers, printers, accountants, etc. can be over $400,000.

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What are the indirect costs of an IPO?

Money left on the table(End of price on first day - Offer price) x

Number of shares

Typical IPO raises about $70 million, and leaves $9 million on table.

Preparing for IPO consumes most of management’s attention during the pre-IPO months.

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If firm issues 7 million shares at $10, what are net proceeds if spread is 7%?

Gross proceeds = 7 x $10 million = $70 millionUnderwriting fee = 7% x $70 million

= $4.9 millionNet proceeds = $70 - $4.9

= $65.1 million

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What are equity carve-outs?

A special IPO in which a parent company creates a new public company by selling stock in a subsidiary to outside investors.

Parent usually retains controlling interest in new public company.

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How are investment banks involved in non-IPO issuances?

Shelf registration (SEC Rule 415), in which issues are registered but the entire issue is not sold at once, but partial sales occur over a period of time.

Public and private debt issuesSeasoned equity offerings (public

and private placements)

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A rights offering occurs when current shareholders get the first right to buy new shares.

Shareholders can either exercise the right and buy new shares, or sell the right to someone else.

Wealth of shareholders doesn’t change whether they exercise right or sell it.

What is a rights offering?

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Going private is the reverse of going public.

Typically, the firm’s managers team up with a small group of outside investors and purchase all of the publicly held shares of the firm.

The new equity holders usually use a large amount of debt financing, so such transactions are called leveraged buyouts (LBOs).

What is meant by going private?

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Gives managers greater incentives and more flexibility in running the company.

Removes pressure to report high earnings in the short run.

After several years as a private firm, owners typically go public again. Firm is presumably operating more efficiently and sells for more.

Advantages of Going Private

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Firms that have recently gone private are normally leveraged to the hilt, so it’s difficult to raise new capital.

A difficult period that normally could be weathered might bankrupt the company.

Disadvantages of Going Private

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Maturity matchingMatch maturity of assets and debt

Information asymmetriesFirms with strong future prospects will

issue short-term debt

How do companies manage the maturity structure of their debt?

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If interest rates have fallen since the bond was issued, the firm can replace the current issue with a new, lower coupon rate bond.

However, there are costs involved in refunding a bond issue. For example,The call premium.Flotation costs on the new issue.

Under what conditions would a firm exercise a bond call provision?

(More...)

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The NPV of refunding compares the interest savings benefit with the costs of the refunding. A positive NPV indicates that refunding today would increase the value of the firm.

However, it interest rates are expected to fall further, it may be better to delay refunding until some time in the future.

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Managing Debt Risk with Project Financing

Project financings are used to finance a specific large capital project.

Sponsors provide the equity capital, while the rest of the project’s capital is supplied by lenders and/or lessors.

Interest is paid from project’s cash flows, and borrowers don’t have recourse.

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Managing Debt Risk with Securitization

Securitization is the process whereby financial instruments that were previously illiquid are converted to a form that creates greater liquidity.

Examples are bonds backed by mortgages, auto loans, credit card loans (asset-backed), and so on.

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REMEMBER!

9/11

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