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WACC and the Target Capital Structure
WACC and the Target Capital Structure
• Every firm sets a target for its capital structure (for its
debt/equity ratio).
• A hidden assumption in our analysis so far was that the
firm is at a position in which it follows its target ratio.
• Shares and bonds are trading on a daily basis, therefore,
the debt/equity ratio is also changing daily.
• If the capital structure deviates significantly from its target
the firm will issue more shares or bonds (or repurchase
them in the market) to meet the target ratio.
• If the firm wishes to compute its WACC in order to pursue
a new investment and its capital structure is different than
its target, the firm should use the target weights instead of
the current weights in evaluating WACC.
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Lecture 11: Raising Capital
Lecture 11: Raising Capital
Objectives
Objectives
• Introduce “Venture Capital”
• Explain the process and terms associated with a new issue.
• Distinguish between initial public offerings (IPO) and
seasoned equity offerings (SEO)
• Identify the costs of issuing securities
• Describe the IPO underpricing phenomena
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Early Stage Financing and Venture Capital
Early Stage Financing and Venture Capital
• A firm at an early stage might seek funds from the venture
capital market
• A venture capital will typically finance new, high-risk
ventures.
• There are individual venture capitalists (“angels”) and
venture capital firms that pool funds from various sources
and invest them in a portfolio of companies
• Venture capital firms often specialize in different stages of
the firm. For example, supplying “seed money”.
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Choosing a Venture Capitalist
Choosing a Venture Capitalist
• Financial strength – for next rounds of investment
• Style – how involved will the venture capital be in day-to-day
operations and decisions
• References – has the venture capitalist been successful in the
past with similar firms?
• Contacts – with customers, suppliers, other industry contacts
• Exit terms – how and under what terms the venture capitalist
will “cash out”?
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The Basic Procedures for a New Issue to the Public
The Basic Procedures for a New Issue to the Public
• Obtain an approval from the board of directors
• Prepare and distribute preliminary prospectus to the
Ontario Securities Commission (OSC) and to potential
investors. In the US: Security Exchange Committee (SEC)
• Revise prospectus to obtain the OSC approval
• Once the final prospectus is approved by the OSC, a price
is determined and selling efforts get under way
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A Tombstone Ad
A Tombstone Ad
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The Cash Offer -- Terminology
The Cash Offer Terminology
• Underwriter
– A single underwriter or a syndicate buys the securities and sells
them to the public.
– Underwriter bears risk in the offering, and must be compensated
• Spread- the difference between what the Underwriter pays and the
offering price of the securities.
• Bought Deal – the issuer sells the entire issue to a single investment
dealer or group
• Selling period- Underwriting group agrees not to sell securities for
less than the offering price until the syndicate dissolves.
• Overallotment option- (Green Shoe provision) allows underwriting
group to purchase additional shares at the offering price net of fees
and commissions.
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Role of Underwriters
Role of Underwriters
• If the public issue of securities is a cash offer, underwriters
are usually involved
• Underwriters (syndicates) perform the following services
for corporate issuers:
- Formulating the method used to issue the securities
- Pricing the new securities
- Selling the new securities
• The difference between the underwriter’s buying and the
offering price is called the spread or discount which is the
basic compensation received by underwriters
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Types of Underwriting
Types of Underwriting
• Regular: The purchase of securities from the issuing
company by an investment bank for resale to the public
• Firm Commitment: Underwriter buys the entire issue
assuming full financial responsibility for any unsold shares
• Best Efforts: Underwriter sells as much of the issue as
possible at the agreed-on offering price, but can return any
unsold shares to the issuer without financial responsibility
• Bought Deal: One underwriter buys securities from an
issuing firm and sells them directly to a small number of
investors
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The Offer Price and Underpricing
The Offer Price and Underpricing
• Determining the correct offering price is the most difficult thing
that an underwriter must do
- if the offer price is too high, shares might not be sold and the
issue has to be withdrawn
- if the offer price is too low, existing shareholders sell their
shares for less than they are worth
• Underpricing – the difference between the offer price and the
true value (can be measured by the first day of trading return).
Underpricing is fairly common and imposes costs on the
existing shareholders and is an indirect cost of issuing new
securities
Much of the underpricing occurs in small, speculative issues
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Empirical Studies of Underpricing
Empirical Studies of Underpricing
Sample Sample Period Average Underpricing
120 US IPOs, selected monthly 1960-69 11.4%
5,000 US IPOs 1960-82 18.8
1026 US IPOs 01/1980 - 03/1982 (hot market) 48.4
Remainder 1977-1982 16.3
Subset of established firms 10.0
1188 US IPOs 1983-1987
74 reverse LBO 2.0
1,114 IPO control sample 7.8
1,078 US IPOs 1981-1985 6.2
1,526 US IPOs 1975-1984 14.3
100 Canadian IPOs 1971-1983 9.0-11.5
116 Canadian IPOs 1984-1987 4.3
299 Canadian IPOs 1984-1995 7.8
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Average Initial Returns by Month for US IPOs: 1960 9 98
-- 1
Average Initial Returns by Month for US IPOs: 1960 198
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Why Does Underpricing Exist?
Why Does Underpricing Exist?
• The number showed previously are averages. In many
cases investors loose money on new issues. On average
they must be compensated otherwise they will not buy
shares in IPOs.
• Many successful issues are often oversubscribed. In this
case investors will receive only a small fraction of the
amount they requested in successful offerings and all of the
amount they requested in unsuccessful issues (winner’s
curse).
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Initial Public Offerings (IPO)
Initial Public Offerings (IPO)
• IPO: A company’s first equity issue made available to the public
• Pricing IPOs is difficult because the firm has no previous records
• Firms that disclose favorable accounting information sell at
higher prices (BV of assets in particular).
Also correlated with higher prices:
• Use of auditors and underwriters with good reputations
• Entrepreneurial ownership retention
• Use of proceeds for risky investment
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The Costs of Issuing Securities
The Costs of Issuing Securities
• Spread: offer price – the price received by the issuer
• Other Direct Expenses: filing fees, legal fees, taxes
• Indirect Expenses: cost of management’s time spent
• Abnormal Returns: stock prices drop after the issue (SEOs)
• Underpricing: shares sold at price below market (IPOs)
• Overallotment: underwriters have the right to buy
additional shares at the offer price to cover excess demand
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The Costs of Issuing Securities
The Costs of Issuing Securities
• Common stock underwriting costs as a percentage of proceeds:
– Small issues: 15% for a $1m deal
– Large issues: 4% for a $500m deal
– See page 506 for more details
• Issue costs for debt (lower administration costs, lower risk)
– Large issues: less than 1%
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Market Reaction to Stock Issues
Market Reaction to Stock Issues
• Empirical Evidence: Prices drop 3% on the announcement of a
seasoned equity offerings (SEO). (but firms issue to finance +
NPV projects!)
• Possible reasons:
- Information asymmetry: mangers tend to issue equity when the
firm is overvalued. So issuing is bad news!
- Debt usage: equity issues might indicate that the firm has too
much debt or little liquidity. Why would you let other people
share the gains on you positive NPV projects?
- Issue costs (also called flotation costs): previously discussed
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Assigned Reading and Questions
Assigned Reading and Questions
• Finish Ch. 15
• Questions 1,2,3,4 p.521-522
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