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Finance 7330

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 .

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Finance 7330

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  1. Finance 7330 Advanced Corporate Finance Information and Financial Decisions Lecture 11 Fall 2010

  2. Issues in Raising Capital • What securities to issue • Changes in Ownership and Control • Alternative Marketing Options

  3. 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!

  4. Market Reaction to Security Offer Announcements • Industrial Utility • Common Stock -3.14% -0.75% • Preferred Stock -0.19%*0.08%* • Convertible Preferred -1.44% -1.38% • Straight Debt -0.26%* -0.13%* • Convertible Debt -2.07% * Means not statistically significant

  5. Explanations • EPS Dilution • Price Pressure • Optimal Capital Structure • Information Asymmetry • Implied Cash Flow Change • Leverage Change • Unanticipated Announcements

  6. 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?

  7. 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%

  8. 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 =

  9. Price Pressure Demand and Supply

  10. Optimal Capital Structure Leverage versus firm value

  11. 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.

  12. The two Basic Effects • Cash Flow implications of a security offering • Leverage effect of a security offering

  13. 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

  14. 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

  15. 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

  16. Marketing Securities Issues • Rights Offering • Underwriting • Firm commitment • Best Efforts • Private Placement

  17. Why Underwritten Offering • Costs 3 to 30 times what a non-underwritten offering would cost • Comprises 80% of offerings Why?

  18. Why Underwritten Offering • Costs 3 to 30 times what a non-underwritten offering would cost • Comprises 80% of offerings Why? Reputation Effect

  19. 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?

  20. 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.

  21. 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

  22. 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

  23. 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

  24. 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.

  25. 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.

  26. 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.

  27. 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

  28. 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

  29. 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”

  30. 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

  31. Accreted value of a zero-coupon bond (old analysis) Time to Value Interest IRS Maturity Earned Interest 10 463 37 53.7 9 500 40 53.7 8 540 43 53.7 7 583 47 53.7 6 630

  32. ECAPS • 60 year maturity • Carry routine payments • Interest can be deferred in times of financial distress • Yet can get tax exemption

  33. 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

  34. 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

  35. 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

  36. 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

  37. Private Placements Bank Loans and Venture Capital are expensive Allows private information to be shared Renegotiation Possible Complication: Not liquid requiring restrictions Convertible Securities

  38. 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

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