Chapter 14: How Firms Issue Securities

1
Topic Raising Capital
Objectives

• Explain the process and terms associated with a
  new issue
• Identify costs of issuing securities
• Describe the IPO underpricing problem
• Explain how a rights offer works

2
The Basic Procedures for a New Issue

• Obtain approval from the board of directors
• Prepare and distribute preliminary prospectus to
  the OSC and to potential investors
• Revise prospectus to obtain the OSC approval
• Once final prospectus approved by the OSC, a
  price is determined and selling efforts get under
  way

3
Securities Registration

• Prompt Offering Prospectus System (POP)
• - accessible only by large companies. Issuers
  file annual and interim financial statements
  regardless of whether they issue securities in a
  given year for at least 36 months and comply with
  disclosure requirements. Firms can the issue
  securities with only a short prospectus.
• Multi-Jurisdictional Disclosure System (MJDS)
• - large issuers are allowed to issue in the
  US under disclosure documents satisfactory to
  regulators in Canada and vice versa.

4
The Cash Offer

• Additional stock is sold to the public through a
  general cash offer, and 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 underwriters buying
  and the offering price is called the spread or
  discount which is the basic compensation received
  by underwriters

5
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, 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

6
The Offer Price and Underpricing

• Determining the correct offering price is the
  most difficult thing 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  be sold and the issue has to be withdrawn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 offer price is set below the
  true value is fairly common and imposes costs
  on the existing shareholders and is an indirect
  cost of issuing new securities

7
Initial Public Offerings (IPO)

• IPO A companys 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
• Use of auditors and underwriters with good
  reputations
• Entrepreneurial ownership retention
• Use of proceeds for risky investment
• Much of the underpricing occurs in small,
  speculative issues
• Winners curse explains IPO underpricing

8
The Costs of Issuing Securities

• Spread offer price price received by the
  issuer
• Other Direct Expenses filing fees, legal fees,
  taxes
• Indirect Expenses cost of managers 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

9
Market Reaction to Stock Issues

• Empirical Evidence Prices drop 3 on the
  announcement of a stock offering (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

10
Rights Offering

• In general, the firm can choose offering the
  issue to existing shareholders or to the public.
  However, if a preemptive right is contained in
  the firms articles of incorporation, the new
  shares must be offered to existing shareholders
  first (dilution concern).
• Rights offering offer additional shares to
  existing shareholders
• Mechanism
• Each existing shareholder receives one right per
  share owned
• One new share can be purchased for the
  subscription price plus a stated number of rights

11
How Rights Issues Work

• Air Canada has one million common shares
  outstanding, with a market value of 7 per share.
  The firm wants to raise 2.5 million in new
  equity trough a rights offering. Suppose the
  subscription price is set at 5.
• How many shares will have to be sold?
• How many rights will be required to buy a share?
• What is the value of a right?
• How can an investor who owns no shares of Air
  Canada buy one share?

12
a) In order to raise 2.5 million at a
subscription price of 5 per share, the firm will
have to issue 2,500,000/5 500,000
shares b) Since each shareholder gets one right
per share owned, the firm will issue one million
rights. So the number of rights required to buy a
share will be 1,000,000/500,000 2
13
Initial Position
c)
(1)
shares
1,000,000
(2)
Market price per share
7
(3)
Value of firm (1)x(2)
7,000,000
Terms of Offer
(4)
Subscription Price
5
(5)
rights issued (1)
1,000,000
(6)
of rights for a new share (b)
2
Position After the Offer
(7)
shares (1) 500,000
1,500,000
(8)
Value of Firm (3) 2.5M)
9,500,000
(9)
Share Price (8)/(7)
6.33
(10)
Value of a right (2)-(9)
0.67
d) The investor needs to buy the required number
of rights from an Air Canada shareholder at a
price of 2x.671.33. with a subscription price
of 5, the total cost to the investor will be 5
1.33 6.33, which is the market price of the
new stock.
14
Q1, Chapter 15, Rights Offering

• Bajor mining Co. is proposing a rights offering.
  Presently, there are
• 250,000 shares outstanding at 60 each. There
  will be 50,000 new shares offered at 40 each.
• What is the new value of the company?
• How many rights are associated with one of the
  new shares?
• What is the value of a right?

15
Q1, Chapter 15, Rights Offering
16
Topic Raising Capital
Objectives

• Demonstrate that shareholder wealth is unaffected
  by a rights issue
• Distinguish between a rights issue and general
  cash offer
• Understand different kinds of dilution
• Explain the differences between private
  placements and public issues

17
How Rights Issues Work

• Some Concepts
• - rights-on price stock price when a buyer of
  the stock would
• receive the rights (i.e. before the rights
  expire)
• - ex-rights price stock price when a buyer of
  the stock would not
• receive the rights (i.e. after the rights
  have expired)
• - subscription price
• - number of rights required to purchase one
  share (N)
• Question
• Will shareholder wealth be affected by the
  subscription price in a rights issue?
• How about in a general cash offer?

18
Pricing a Rights Issue

• The formula for the ex-rights share price is
• Ex-rights price N ? rights-on price
  subscription price / (N1)
• 2 x 7 5 / 3
  6.33
• The value of a right can be calculated as either
• Value of one right rights-on price ?
  subscription price/(N1)
• 7 -
  5 /3 .67 or
• Value of one right ex-rights
  price ? subscription price/N
• 
  6.33 - 5 / 2 .67

19
Example Derivations
Suppose a firm starts with a specfic no of shares
at a certain price and wants to raise new equity
via a rights offering
a)What is the initial value of the firm? b)What
is the new value of the firm after the
offer? c)What is the value of a right?
20
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21
Example A

• In 1994 Pandora Inc. makes a rights issue at a
  subscription price of 5 a share. One new share
  can be purchased for every four shares held.
  Before the issue there were 10 million shares
  outstanding and the share price was 6.
• A) What is the total amount of new money raised?
• B) What is the expected stock price after the
  rights are issued?
• C) And the value of a right?

22
a) Note that the of shares issued is
10,000,000/4 2,500,000, and the subscription
price is 5, so the total amount of money raised
is 5 per share x 2,500,000 shares
12,500,000 b) ex-rights price 4 x 6 5
/ 5 5.8 c) value of one right 6-5 / 5
.2 The rights-on value of one share is the
ex-rights price value of one right 6, same
as original price. So no loss in wealth
23
Example B

• Suppose that Pandora had decided to issue the
  new stock at 4 instead of 5 a share.
• How many new shares would it have needed to raise
  the same sum of money? Recalculate the answers to
  the previous problem.
• Show that Pandoras shareholders are just as well
  off if it issues the shares at 4 rather than the
  5 previously assumed.

24
of new shares Funds to be raised /
Subscription price
12,500,000 / 4 3,125,000 of rights needed to
buy a share 10,000,000 / 3,125,000
3.2 ex-rights price 3.2 x 6 4 / 4.2
5.52 value of one right 6-4 / 4.2
.48 The rights-on value of one share is the
ex-rights price value of one right 6, same
as original price. So no loss in wealth. Note
comparing examples AB we see that the
subscription price does not affect shareholder
wealth!
25
General Cash Offer vs. Rights Issue

• Open to different investors
• General cash offer shares sold to retail and
  institutional investors through investment
  dealers
• Rights issue existing shareholders are informed
  how many rights are needed to buy an extra share
  at the subscription price
• The relevance of issue prices
• General cash offer the issue price determines
  amount raised
• Rights issue subscription price is not
  important, because can adjust the of rights
  required to buy one share
• Flotation costs are lower for rights issues than
  for standard issues (simpler underwriting
  arrangements)
• Puzzle??

26
Dilution

• Dilution Loss in existing shareholders value
  when new securities are issued.
• There are several kinds of dilution
• Dilution of proportionate ownership (represents
  of votes and claim on dividends) true in cash
  offers, but can be avoided with a rights
  offering. Value of shares unaffected
• Dilution of market value market price per share
  falls. Only occurs if firm finances negative NPV
  projects (important)
• Dilution of book value per share and EPS (not
  important)

27
Private Placements of Debt

• Private placements Loans, usually long term in
  nature, provided directly by a limited number of
  investors
• Differences from public issue of debt
• Registration costs are lower (no prospectus, no
  OSC registration
• Often more restrictive covenants
• Easy to renegotiate in case of default (few
  lenders)
• Life insurance companies and pension funds are
  the major suppliers
• Issue costs are lower (few buyers, no underwriter)