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Chapter 18Chapter 18 Issuing Capital and the Investment Banking Process

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction• Firms finance assets with capital– Retained earnings– Debt– Equity

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Sources of Capital for New and Small Firms

• Debt– Borrowing from friends and relatives– Bank loans– Venture capitalists

• Equity– Venture capitalists

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Debt Financing

• Bank Loans– New and small firms rely on banks– Availability of small-business loans was heavily

affected by the 2008 financial crisis

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Bank Loans

• Small Business Loans

– Risky for commercial banks

– Banks use small-business scoring models

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Bank Loans

• Mid-market firms

– Sales between $5 million and $100 million per year

– Rely on banks for funding

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Credit Process Flow Chart

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Loan Commitments

• Loan commitment agreements specify

– maximum loan amount

– interest rate terms

– length of loan

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Fixed versus Floating Rate Loans– Interest rates for variable-rate loans change over

the life of the loan

– Floating rate loans are set at a fixed spread over a prevailing benchmark rate

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Small Business Administration• Created to help small businesses

• Basic loan guarantee program– for qualified new firms that cannot get reasonable long-term financing from other financial institutions

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Equity Financing and Expertise• New and high-risk firms use venture capital (VC)

for financing– Professionally managed– VC firm takes an equity stake in the firm financed– VC firms are actively involved in the business

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Venture Capital Firms

Institutional venture capital firm types:

– Venture capital limited partnerships

– Financial venture capital firms

– Corporate venture capital firms

– Small Business Investment Companies

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Angel Venture Capitalists• Majority of VC equity investments from

wealthy individuals (angels), not institutions

• Angel VCs want– High return– Easy exit

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The Choice to Go Public• Choice made when firm’s capital needs

exceed its ability to raise capital

• Initial public offering (IPO) of firm’s stock– Equity is publicly traded in stock markets for the

first time

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The Choice to Go Public

• Benefits of being a public firm– Access to a larger pool of equity capital– Stock market provides a market value for the

firm’s stock

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The Choice to Go Public

Benefits of being a public firm

– Firm’s managers can be rewarded with firm’s stock

– Original owners can diversify their holdings

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The Choice to Go PublicDisadvantages of being a public firm– Costs of an IPO– Public disclosure of information required — may

be valuable to competitors– Shareholders demand a great deal of information

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Public Firms’ Capital Sources

• Debt Financing– Commercial Paper• Unsecured, short-term promissory note• Used to raise short-term cash, often working capital

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Commercial Paper• Trading process– Can be sold directly to investors or through broker

dealer – Firm’s credit rating critical because commercial

paper is unsecured debt

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Long-Term DebtCorporate bonds

• Minimum denomination on publicly traded bonds is $1,000

• Most coupon-paying bonds pay interest semiannually

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Trading Process for Corporate Bonds

• Initial sale made by public offering or private placement to institutional investors– Large firms use large investment banks– Smaller firms use small regional investment banks

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Trading Process for Corporate Bonds

• Investment banks– Firm commitment underwriting

• Entire issue bought by bank at fixed price (discount from par) and resold at higher price

• Issuing firm has price guarantee – investment bank has risk

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Firm Commitment Underwriting Corporate Bond Issue

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Trading Process for Corporate Bonds

• Competitive sale — highest bid from group of underwriters wins

• Negotiated sale — issuing firm negotiates with single investment bank

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Trading Process for Corporate Bonds

Best efforts underwriting – Underwriter does not buy issue but instead acts as

a placing or distribution agent for a fee– Price risk remains with issuing firm

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Equity Financing

• Majority of both the board of directors and the firm’s existing stockholders must approve any new stock issue

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The Trading Process for Corporate Equity

• Primary market– IPO– Seasoned offering is when the firm already has

publicly-traded shares

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Primary Market Stock Transaction

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The Securities and Exchange Commission (SEC) must approve any new issues to the public

The Trading Process for Corporate Equity

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The Trading Process for Corporate Equity

• Stock issues – Firm commitment underwriting– Best-efforts basis

• Registration statement– Full disclosure of firm information, risks,

management background and securities to be issued

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• Prospectus– Red herring prospectus is preliminary version of

the public offering prospectus– Official prospectus describes issue• Shelf registration allows multiple stock issues for two

years under one registration

The Trading Process for Corporate Equity

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