Today

1
Today

• Raising capital
• Overview
• Financing patterns and the stock markets
  reaction
• Reading
• Brealey and Myers, Chapter 14 and 15

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Road map
Part 1. Valuation Part 2. Risk and return
Part 3. Financing and payout decisions
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Balance sheet
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Types of questions

• Your firm needs capital to finance growth. Should
  you issue debt or equity or obtain a bank loan?
  If you choose debt, should the bonds be
  convertible? Callable? If you choose equity,
  should you use common or preferred stock? How
  will the stock market react to your decision?
• In 1998, IBM announced that it would repurchase
  2.5 billion in stock. How should it structure
  the stock repurchase? IBMs price jumped 7 after
  the announcement. Why? How would the market have
  reacted if IBM increased dividends instead?
  Suppose Intel made the same announcement. Would
  we expect the same price response?

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Raising capital

• Sources of funds
• Internal financing
• Internally generated cashflows (retained
  earnings)
• Debt (borrowing)
• Bonds and commercial paper
• Bank debt (loan commitments, lines of credit)
• Leases
• New equity
• Common or preferred stock
• Rights offering

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Sources of funds, U.S. corporations, 1979 1997
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Sources of funds, International 1990 1994
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Capital structure, U.S. corporations 1979 1997
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Common Stock

• Book Value vs. Market Value
• Book value is a backward looking measure. It
  tells us how much capital the firm has raised
  from shareholders in the past. It does not
  measure the value that shareholders place on
  those shares today.
• The market value of the firm is forward looking,
  it depends on the future dividends that
  shareholders expect to receive.

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Common Stock

• Example - Heinz Book Value vs. Market Value
  (4/2003)
• Total Shares outstanding 351 million

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Common Stock

• Example - Heinz Book Value vs. Market Value
  (4/03)
• Total Shares outstanding 351 million

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Preferred Stock

• Preferred Stock - Stock that takes priority over
  common stock in regards to dividends.
• Net Worth - Book value of common shareholders
  equity plus preferred stock.
• Floating-Rate Preferred - Preferred stock paying
  dividends that vary with short term interest
  rates.

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Raising capital Borrowing

• Terminology
• Convertible, callable bonds and preferred stock
• Zero-coupon, or pure-discount, bonds
• Junk bonds
• Secured debt vs. unsecured debt (debentures)
• Priority / seniority
• Senior debt (60 recovery in bankruptcy)
• Subordinated or junior debt (lt 30 recovery in
  bankruptcy)

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Corporate Debt

• Debt has the unique feature of allowing the
  borrowers to walk away from their obligation to
  pay, in exchange for the assets of the company.
• Default Risk is the term used to describe the
  likelihood that a firm will walk away from its
  obligation, either voluntarily or involuntarily.
• Bond Ratingsare issued on debt instruments to
  help investors assess the default risk of a firm.

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Corporate Debt

• Prime Rate - Benchmark interest rate charged by
  banks.
• Funded Debt - Debt with more than 1 year
  remaining to maturity.
• Sinking Fund - Fund established to retire debt
  before maturity.
• Callable Bond - Bond that may be repurchased by
  firm before maturity at specified call price.

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Corporate Debt

• Subordinate Debt - Debt that may be repaid in
  bankruptcy only after senior debt is repaid.
• Secured Debt - Debt that has first claim on
  specified collateral in the event of default.
• Investment Grade - Bonds rated Baa or above by
  Moodys or BBB or above by SP.
• Junk Bond - Bond with a rating below Baa or BBB.

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Bond Rating
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Bond Rating
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Bond Ratings
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Corporate Debt

• Eurodollars - Dollars held on deposit in a bank
  outside the United States.
• Eurobond - Bond that is marketed internationally.
• Private Placement - Sale of securities to a
  limited number of investors without a public
  offering.
• Protective Covenants - Restriction on a firm to
  protect bondholders.
• Lease - Long-term rental agreement.

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Corporate Debt

• Warrant - Right to buy shares from a company at a
  stipulated price before a set date.
• Convertible Bond - Bond that the holder may
  exchange for a specified amount of another
  security.
• Convertibles are a combined security, consisting
  of both a bond and a call option.

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Financial Markets
Money
Primary Markets
OTC Markets
Secondary Markets
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Financing decisions
What is the goal? How can financing decisions
create value?
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Capital structure decisions

• Observations
• Pecking order
• Firms prefer internal to external financing. If
  financing is external, firms prefer debt to
  equity.
• Target capital structure?
• Mean reversion in leverage ratios and systematic
  differences across industries.

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Capital structure, 1997
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how corporations issue securities?
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The process

• Mechanics
• Underwriters
• Firm commitment vs. best efforts
• Rights offerings

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The Top Managing Underwriters
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Initial Offering

• Initial Public Offering (IPO) - First offering of
  stock to the general public.
• Underwriter - Firm that buys an issue of
  securities from a company and resells it to the
  public.
• Spread - Difference between public offer price
  and price paid by underwriter.
• Prospectus - Formal summary that provides
  information on an issue of securities.
• Underpricing - Issuing securities at an offering
  price set below the true value of the security.

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Direct costs of a public offering, 1990 1994
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International comparison of underpricing
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Average Initial IPO Returns
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General Cash Offers

• Seasoned Offering - Sale of securities by a firm
  that is already publicly traded.
• Shelf Registration - A procedure that allows
  firms to file one registration statement for
  several issues of the same security.
• Private Placement - Sale of securities to a
  limited number of investors without a public
  offering.

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Underwriting Spreads (2003)
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Rights Issue

• Rights Issue - Issue of securities offered only
  to current stockholders.
• Example - Lafarge Corp needs to raise
  1.28billion of new equity. The market price is
  60/sh. Lafarge decides to raise additional funds
  via a 4 for 17 rights offer at 41 per share. If
  we assume 100 subscription, what is the value of
  each right?

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Rights Issue
Example - Lafarge Corp needs to raise
1.28billion of new equity. The market price is
60/sh. Lafarge decides to raise additional funds
via a 4 for 17 rights offer at 41 per share. If
we assume 100 subscription, what is the value of
each right?
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Price impact

• How do stock prices react to security offerings?
• Debt issues?
• Seasoned equity offerings?

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Stock price reaction
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Stock price reaction
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Stock price reaction

• Observations
• Stock prices react negatively to stock issues
• Stock prices react positively to bank loans, but
  very little to public debt issues
• Leverage-increasing transactions are good news,
  but leverage-decreasing transactions are bad news
  
• Why?

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Payout policy

• Questions
• How do firms payout cash?
• What are the advantages and disadvantages of each
  method?
• How much cash should a firm hold?

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SP 500, earnings and dividends
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SP 500, dividends and repurchases
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Stock Price Reaction