Fundamentals of Corporate Finance/3e,ch17

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

17-1

Chapter Seventeen

Issuing Securities to the Public


17-2

17.1 The Public Issue

17.2 The Cash Offer

17.3 New Equity Sales and the Value of the Firm

17.4 The Costs of Issuing Securities

17.5 Rights

17.6 Dilution

17.7 Issuing Long-term Debt

17.8 Summary and Conclusions

Chapter Organisation


17-3

Chapter Objectives• Outline the advantages and disadvantages of public company

listing.• Discuss the process of underwriting and the associated costs.• Identify the costs associated with issuing securities.• Explain the process of a rights issue and calculate the value

of a right.• Discuss the dilution effect of new issues.• Understand the reasons for recent growth in the corporate

debt market.


17-4


• Analyse funding needs and how they can be met.

• Approval from board of directors for a public issue.

• Outside expert opinions sought for support of issue.

• Pricing, time-tabling, prospectus prepared, marketing.

• Prospectus filed with ASIC and ASX.


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• Underwriting agreement executed.

• Prospectus registered.

• Public announcement of offering.

• Funds received.

• Shares allotted, holdings registered.

• Shares listed for trading on ASX.


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New Issues

• Flotation is the initial offering of securities to the public.

• Primary issues used to:– convert from a private company to a public company– spin-off a portion of the business of a listed company– form a new public company– privatise a public organisation, or demutualise a mutual

society.


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Advantages of Public Company Listing

• Access to additional capital.

• Increased negotiability of capital.

• Growth not limited by cash resources.

• Enhancement of corporate image.

• Can attract and retain key personnel.

• Gain independence from a spin-off.


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Disadvantages of Public Company Listing

• Dilution of control of existing owners.

• Additional responsibilities of directors.

• Greater disclosure of information.

• Explicit costs.

• Insider trading implications.


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Secondary Issues

• Private placements—securities are offered and sold to a limited number of investors who are often the current major investors in the business.

• Rights issues—issue of shares made to all existing shareholders, who are entitled to take up the new shares in proportion to their present holdings.

• Terms are determined by:– amount of funds required by the company– the market price of the company’s securities– general economic conditions– desire to benefit shareholders– nature of the company’s shareholders.


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Underwriting

• Firm underwritingA guarantee that funds will be made available to a company at a specific time on agreed terms and conditions.

• Standby underwritingWhere the bidding company has insufficient cash in a successful bid or if cash is offered as an alternative to a share bid.

• Best efforts underwritingUnderwriter must use ‘best efforts’ to sell the securities at the agreed offering rate.


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Underwriting

• Role of underwriter– pricing the issue– marketing the issue– engaging sub-underwriters– placing the shortfall

• Sub-underwriter– A group of underwriters formed to reduce the risk and to

help to sell an issue.


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Underwriting Fees

• The underwriter’s fee is a reflection of the:– size of the issue– issue price– general market conditions– market attitude towards shares– time period required for underwriting.

• Fees also include brokerage and management fees.


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Average Initial Returns

Source: Ibbotson, Sindelar and Ritter (1988)


17-14

New Equity Sales—Research Findings

• Shares prices tend to decline after a new equity issue announcement, but rise following a debt announcement.

• Why?– Management has superior information about firm value

and knows when the firm is overvalued → sell equity.– Excessive debt usage.– Substantial issue costs.– Management needs to understand the signals that an

equity issue sends.


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The Cost of Issuing Securities

Underwriter’s commission This consists of direct fees paid by the issuer to the underwriting syndicate.

Other direct expenses These are direct costs, incurred by the issuer, that are not part of the compensation to underwriters. These costs include filing fees, legal fees, and taxes—all reported on the prospectus.

Indirect expenses These costs are not reported on the prospectus and include the costs of management time spent working on the new issue.

Abnormal returns In a seasoned issue of shares, the price drops on average by 3 per cent upon the announcement of the issue.

Underpricing For initial public offerings, losses arise from selling the shares below the correct value.


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Rights Offerings—Basic Concepts

• Rights offeringIssue of ordinary shares to existing shareholders.

• Allows current shareholders to avoid the dilution that can occur with a new share issue.

• ‘Rights’ are given to the shareholders specifying:– number of shares that can be purchased– purchase price– time frame.

• Shareholders can either exercise their rights or sell them. They neither win nor lose either way.


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Rights Offerings—Basic Concepts

• Subscription priceThe dollar cost of one of the shares to be issued, generally less than the current market price.

• Ex-rights dateBeginning of the period when shares are sold without a recently declared right, normally four trading days before the holder-of-record date. The share price will drop by the value of the right.

• Holder-of-record dateDate on which existing shareholders are designated as the recipients of share rights.


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Ex-rights Share PricesRights-on Ex rights

Announcementdate date date

Ex-rights Record

30 September 13 October 15 October

Rights-on price $20.00Ex-rights price $16.67

$3.33 =Value of a right


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Theoretical Rights Price

rn

SMn

offered shares additional ofnumber

issue rights theof price issueor on subscripti

pricemarket

right aobtain toheld shares ofnumber

r

S

M

n

Where:


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Example—Rights Issue

Lemon Co. currently has 5 million shares on issue with a market price of $8 each. To finance new projects, the company needs to raise an additional $6 million. To raise the finance, the company makes a rights issue at a subscription price of $6 per share.


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Example—Rights Issue (continued)

• The number of new shares to be sold:

• The holder of one right is entitled to subscribe to one new share at $6 per share.

• To issue 1 million shares, the company would have to issue 1 million rights.

• The company has 5 million shares on issue, which means that for every 5 shares held, a shareholder is entitled to receive one right (1-for-5 rights issue).

shares 000 000 1 $6

000 000 $6

priceon subscripti

raised be tofunds


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Example—Rights Issue (continued)

• Calculate the theoretical rights price:

• If an outsider buys a right, it will cost $1.67.• The right can be exercised at a subscription price of $6.• Total cost of a new share = $1.67 + $6 = $7.67.

$1.67

1 5

$6 $8 5

rn

SMn


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The Value of Rights

*$8.00 – 7.67 = 0.33**$0.33 × 5 = $1.65


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New Issues and Dilution

• Dilution– Loss in existing shareholders’ value in terms of either

ownership, market value, book value or EPS.

• Types of dilution– Dilution of proportionate ownership—a shareholder’s reduction

in proportionate ownership due to less-than-proportionate purchase of new shares.

– Dilution of market value—loss in share value due to use of proceeds to invest in negative NPV projects.

– Dilution of book value and earnings per share (EPS) —reduction in EPS due to sale of additional shares. This has no economic consequences.


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Corporate Debt

The late 1980s saw a major growth in the Australian corporate debt market due to:

– the substantial cutback in the level of government borrowing

– the fall in interest rates from extremely high levels– the flight to quality– the shortage of government bonds– the attractiveness of raising funds in the domestic market

relative to that of the euromarket.


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Long-term Debt

Differences between direct, private long-term financing and public issues of debt include:

– direct loans avoid ASIC registration costs– direct loans have more restrictive covenants– term loans and private placements are easier to

renegotiate than public issues– private placements are dominated by life insurance

companies and pension funds, whereas commercial banks dominate the term-loan market.

Economy & Finance

Fundamentals of Corporate Finance/3e,ch17