Session 5 Long-Term Financing

Document Sample
Session 5 Long-Term Financing Powered By Docstoc
					Session 5: Long-Term Financing

    C15.0008 Corporate Finance
              Topics
                Outline
• Characteristics of debt
• Warrants and convertibles
• IPOs and SEOs
                                  Feedback

                                       Pace of the course

                     14


                     12


                     10
Number of students




                     8
                                                                    Pace
                     6


                     4

                     2


                     0
                          1   2    3           4        5   6   7
                          Level of content

                     14


                     12


                     10
Number of students




                     8
                                                          Level
                     6


                     4


                     2


                     0
                          1   2   3     4     5   6   7
                                      Scale
                             Effectiveness

                     9

                     8

                     7
Number of students




                     6

                     5
                                                          Effectiveness
                     4

                     3

                     2

                     1

                     0
                         1    2   3     4     5   6   7
                                      Scale
                Key Points
•   Office Hours
•   Exam points
•   Book vs. Classes
•   Tangents
•   Real life examples
      Characteristics of Debt
• A contractual obligation to make/receive a
  pre-specified set of payments (interest and
  principal)
• No ownership rights
• No control rights
            Debt Covenants
The debt contract (bond indenture) often
contains provisions restricting the actions of
the debtor (firm)
• Amount and seniority of additional debt
• Dividend payments
• Assets sales
• Financial ratios (technical default triggers)
         Interest Payments
• Deductible as an expense at the corporate
  level (for tax purposes)
• Taxable to the recipient as ordinary
  income
• Failure to pay triggers default
               Debt Features
•   Maturity
•   Sinking funds
•   Callability
•   Convertibility
•   Fixed or floating rate
•   Priority/seniority
•   Security/collateralization
•   Rating
      Announcement Effects
• Managers will try to issue equity when
  they think their stock is overvalued
• However, the market knows this,
  announcement of new equity issuance is
  treated as bad news -> Stock price drops
• Similar issue with debt, but to a lesser
  extent because debt is less risky.
• This gives rise to a pecking order.
       Financing Implications
The pecking order theory suggests that
financing sources are used in the following
order:
(1) retained earnings (internal cash flow)
(2) debt
(3) external equity
What increases as we go from (1) to (3)?
       Some other securities
• Preferred stock
• Warrants
• Convertibles
           Preferred Stock
• A kind of equity
• ―Preference‖ over common stock in terms
  of dividend payment and bankruptcy
• Stated Value
• Cumulative/non-cumulative dividends
• Tax Code quirks, regulation for utilities,
  bankruptcy avoidance
             Preferred Stock
Combines the features of debt and equity

 Like debt                 Like equity
 • Pays a fixed dividend   • Dividend payments
 • No voting rights          non-deductible
 • Sinking funds,          • Missed payment does
   callability,              not trigger bankruptcy
   convertibility          • Perpetual
                  Warrants
A warrant is a security issued by the firm
that gives the holder the right to buy shares
of common stock from the company at a
fixed price for a given period of time, i.e., it is
a call option issued by the firm.
            Warrants vs. Calls
• Call—a contract (bet) between 2 individuals, the
  writer and the buyer
• Warrant
  – The firm receives the premium (price)
  – When exercised
     • The firm receives the exercise price
     • The firm provides (issues) the shares
  – Often long maturity
  – Often sold as a package with bonds where warrants
    are detachable after sale
            Traded Warrants



•   NYSE traded
•   Exercise price: 19.23
•   Expiration: 3/19/09
•   American
            The Dilution Effect
A warrant is worth less than the corresponding call
option (on an identical firm without warrants) because
warrant exercise dilutes ownership.
Example: all equity firm, V = $51 million, n = 1 million ,
S = $51/share
Call (at expiration): E = 45  C = 51-45 = $6
Warrants (at expiration): E = 45, nW = 500,000
     V = 51 + 45 (0.5) = $73.5 million
     n = 1,500,000  S = $49/share
                                   W = 49-45 = $4
          Warrant Valuation
• Gain from exercising call:
                      S-E
• Gain from exercising warrant:
             [ n / (n+nW) ] (S-E)

              Price of warrant:
             W = [ n / (n+nW) ] C
           Convertible Bonds
A convertible bond is a bond that can be converted
into common stock
An example:
• Straight debt (10-year): rB = 10%
• Equity: S = $25/share, rS = 16%
• Convertible (10-year)
   – interest rate: 6% (annual coupons)
   – $1,000 par convertible at maturity to 20
     shares
                Terminology
•   Conversion ratio: 20 shares per $1000
•   Conversion price: $1000/20 = $50/share
•   Conversion premium: 50/25 – 1 = 100%
•   Conversion value: 20 x St (at any point in
    time)
           Convertible Payoffs
Payoff at maturity of $1000 face value

  Payoff


   1000




               S=0     S=50   Stock price
        Convertible Valuation
A convertible bond equals a bond plus warrants.
               Conv = Bond + 20 W

Bond: 10-year, 6%, rB = 10%  B = $754
Warrant:W = [n/(n+nW )] C(E=50, S=25, t=10,
  =50%, rf=4%) = [100/(100+3)] $12.67

Conv = $754 + 20($12.30) = $1,000
          Initial Public Offering
Initial public offering (IPO)—the first sale of
common stock to the public
• Facilitated by an investment bank
• Regulated by and registered with the SEC
• Audited financials/prospectus
• Road shows/marketing
                        Why?
• Why go public?
  –   Diversification
  –   Liquidity
  –   Access to capital
  –   Establish market value
• Why not?
  –   Reporting/auditing costs
  –   Disclosure rules
  –   Potential loss of control
  –   The costs associated with an IPO
                  How?
• In the U.S., the principle way of going
  public is via an IPO using book-building
• Internationally, firms also seem to be
  moving towards the book-building method
• More recently in the U.S. a few firms have
  used an auction method for their IPOs,
  e.g., Google
Book-Building: The Mechanics

• Investment bank distributes prospectus with offer size
  and price range (may be updated)
• Based on information from institutional investors, the
  investment bank sets a size and offer price in
  negotiation with the issuer
• The bank buys the issue from the firm (at a discount
  to reflect underwriting fees) and resells it at the offer
  price to investors selected by the bank (best efforts
  vs. firm commitment)
• The bank may have the option to increase the issue
  size/buy more shares (greenshoe option)
• The bank supports the price in the after-market
       Auction: The Mechanics
• Investment bank distributes prospectus with offer size
  and price range (may be updated)
• ―Certified‖ investors can submit bids (price and quantity)
  online during a predetermined period
• Dutch auction—issue is priced at or below the highest
  price for which there is sufficient demand to sell the
  entire issue and allocated using price priority
                  IPO Costs
• Direct costs, e.g., fees for underwriters and
  lawyers (~7% of capital raised, lower for
  auctions)
• Indirect costs, i.e., underpricing
   – Underpricing is the offering price relative to
     the price in the secondary market thereafter
   – Underpricing is a cost to the original owners
• Recent IPOs
  IPOs: The NASDAQ Bubble
                   First-Day   3-Year Abnormal
Period      #/yr   Return      Return
1990-94     326    11.2%       -7.2%
1995-98     438    18.1%       -32.3%
1999-2000   401    65.0%       -34.3%
2001        80     14.0%       NA
        Seasoned Offerings
Seasoned offering—subsequent (to an IPO)
offering of stock that is already publicly
traded
• Rights issue vs. public offering
• Shelf registration
  Costs of Seasoned Offerings
• Direct costs (~3-5% of capital raised)
• Information effect on stock price, i.e., on average
  price drops 3% upon announcement
   – What is the effect on earnings per share?
   – What happens when there is an excess supply of a
     stock?
   – What kind of announcement effects are at work?
• A small amount of issue underpricing
                        200
                              400
                                    600
                                          800
                                                1000
                                                       1200




                    0
            19
               70
            19
               72
            19
               74
            19
               76
            19
               78
            19
               80
            19
               82
            19
               84
            19
               86




# of IPOs
            19
               88
            19
               90
            19
               92
# of SEOS   19
               94
            19
               96
            19
               98
            20
               00
            20
               02
            20
               04
                                                              IPOs and SEOs occur together
               Exam points
•   Tax treatment on debt vs equity
•   Announcement effects
•   Pecking order theory
•   Warrants and convertibles
•   IPO underpricing