corporate finance and market efficiency
DESCRIPTION
TRANSCRIPT
1
Chapter 13 Corporate Financing and Market Efficiency
1. Can Financing Decisions Create Value?
2. A Description of Efficient Capital Markets
3. The Different Types of Efficiency
4. The Evidence
5. Implications for Corporate Finance
2
Can Financing Decisions Create Value?
Example: Suppose Jays Electronics is thinking about relocating its plant to Mexico where labor costs are lower. In the hope that it can stay in Ontario, the company has submitted an application to the province to guarantee a five-year bank term loan for $2 million. With a provincial guarantee, a chartered bank has offered to make the loan (interest payments are paid at the end of each year) at an interest rate of 5 percent. This is an attractive rate because the normal cost of debt capital for Jays Electronics is 10%. What it the NPV of this potential financing transaction?
3
What Sort of Financing Decisions?
• Typical financing decisions include:– How much debt and equity to sell– When (or if) to pay dividends– When to sell debt and equity
• Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions.
4
How to Create Value through Financing
1. Fool Investors Empirical evidence suggests that it is hard to fool
investors consistently.2. Reduce Costs or Increase Subsidies
Certain forms of financing have tax advantages or carry other subsidies.
3. Create a New Security Sometimes a firm can find a previously-unsatisfied
clientele and issue new securities at favorable prices. In the long-run, this value creation is relatively small,
however.
5
A Description of Efficient Capital Markets
• An efficient capital market is one in which stock prices fully reflect available information.
• The EMH has implications for investors and firms.
– Since information is reflected in security prices quickly, knowing information when it is released does an investor no good.
– Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.
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Ex: How Does an Efficient Market Work?
Suppose the F-stop Camera Corporation (FCC) is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has a positive NPV.
Consider the share of FCC. One of the determinant of the share’s price is the probability that FCC will be the company to develop the new auto-focusing system first. In an efficient market we would expect the price of the shares of FCC to rise if this probability increases.
Now, suppose a well-known engineer is hired by FCC to help develop the new auto-focusing system. Assuming an efficient market, what do you think will happen to FCC’s share price when this is announced?
7
The Different Types of Efficiency
• Weak Form– Security prices reflect all information found in past
prices and volume.
• Semi-Strong Form– Security prices reflect all publicly available
information.
• Strong Form– Security prices reflect all information—public and
private.
8
Weak Form Market Efficiency• Security prices reflect all information found in
past prices and volume.
• Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
• Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.
9
Testing Random Walk Theory
• The movement of stock prices from day to day DO NOT reflect any pattern.
• Statistically speaking, the movement of stock prices is random (skewed positive over the long term).
10
Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
Month
Leve
l
12
Random Walk Theory
S&P 500 Five Year Trend?or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
Leve
l
13
Random Walk Theory
14
Random Walk Theory
Ret
urn
in w
eek
t + 1
, (%
)
Return in week t, (%)
S&P Composite(correlation = -.07)
15
Efficient Market Theory
Last Month
This Month
Next Month
$90
70
50
Microsoft Stock Price
Cycles disappear
once identified
Actual price as soon as upswing is recognized
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Why Technical Analysis FailsSt
ock
Pric
e
Time
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away.
SellSell
Buy
Buy
17
Semi-Strong Form Market Efficiency
• Security prices reflect all publicly available information.
• Publicly available information includes:– Historical price and volume information
– Published accounting statements.
– Information found in annual reports.
18
Event Studies: How Tests Are Structured
Event studies are one type of test of the semi-strong form of market efficiency.This form of the EMH implies that prices should
reflect all publicly available information. To test this, event studies examine prices and
returns over time—particularly around the arrival of new information.
Test for evidence of underreaction, overreaction, early reaction, delayed reaction around the event.
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How Tests Are Structured (cont.)
• Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day.
• The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day:
AR= R – Rm
• The abnormal return can be calculated using the Market Model approach:
AR= R – ( + Rm)
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+)
announcement
Efficient market response to “good news”
Overreaction to “good news” with reversion
Delayed response to
“good news”
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+)
announcement
Efficient market response to “bad news”
Overreaction to “bad news” with reversion
Delayed response to “bad news”
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Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032-0.244-0.483
-3.619
-5.015-5.411-5.183
-4.898-4.563-4.747-4.685-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
Cum
ulat
ive
abno
rmal
retu
rns
(%)
Efficient market response to “bad news”
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997)
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Event Studies: Takeover Announcement
-16-11-6-149
141924293439
Days Relative to annoncement date
Cum
ulat
ive
Abn
orm
al R
etur
n (%
)Announcement Date
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Event Study Results• Over the years, event study methodology has been
applied to a large number of events including:– Dividend increases and decreases– Earnings announcements– Mergers – Capital spending– New issues of stock
• The studies generally support the view that the market is semistrong-form efficient.
• In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements.
25
The Record of Mutual Funds
• If the market is semistrong-form efficient, then no matter what publicly available information mutual-fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.
• We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.
26
Efficient Market Theory
-40
-30
-20
-10
0
10
20
30
40
1962
1977
1992
Ret
urn
(%)
FundsMarket
Average Annual Return on 1493 Mutual Funds and the Market Index
27
Strong Form Market Efficiency
• Security prices reflect all information—public and private.
• Strong form efficiency incorporates weak and semi-strong form efficiency.
• Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.
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Insider Trading
Officers, directors, and major shareholders of a firm are considered insiders who may have non-public important information. The SEC, the Ontario Securities Commission (and its counterparts in other provinces) prohibited the trade of securities based on pieces of information that have not yet become news.To enforce regulation, the OSC and the SEC require insiders to reveal any trading they might do in their own company’s share.
29
Relationship among Three Different Information Sets
All informationrelevant to a stock
Information setof publicly available
information
Informationset of
past prices
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What the EMH Does NOT Say• If EMH holds there should be no upward trend in
stock price.• If EMH holds, investors can not earn any return• If EMH holds, investors can throw darts to select
stocks.• If EMH holds, stock prices should not go up over time.• If EMH holds, daily fluctuations should not exist as
prices reflect the fundamental value of the firm.• EMH can not hold because there are not enough
active traders.
31
Views Contrary to Market Efficiency• Stock Market Crash of 1987, Dot.com bubble.
– The NYSE dropped between 20-percent and 25-percent Monday following a weekend during which little surprising information was released.
– Nasdaq fell 72% during a two year period.• Temporal Anomalies
– Turn of the year, —month, —week.• Speculative Bubbles
– Sometimes a crowd of investors can behave as a single squirrel.
• Size– Small cap stocks seem to outperform large cap stocks.
• Value versus Growth– Value stock-price stocks outperform growth stocks.
32
Efficient Market Theory2000 Dot.Com Boom
883,1208.092.
6.154)( 2000 March
gr
DivindexPV
589,8074.092.6.154)( 2002October
grDivindexPV
33
Why Doesn’t Everybody Believe the EMH?
• There are optical illusions, mirages, and apparent patterns in charts of stock market returns.
• The truth is less interesting.• There is some evidence against market
efficiency:– Seasonality– Small versus Large stocks– Value versus Growth stocks
• The tests of market efficiency are weak.
34
Implications for Corporate FinanceThe EMH has three implications for corporate finance:
1. The price of a company’s stock cannot be affected by a change in accounting.
2. Financial managers cannot “time” issues of stocks and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds as it desires without depressing prices.
• There is conflicting empirical evidence on all three points.
35
Efficient Market Theory
0
5
10
15
20
First Second Third Fourth Fifth
Ave
rage
Ret
urn
(%)
IPOMatched Stocks
IPO Non-Excess Returns
Year After Offering
36
Practice Questions: q8Which statements contradicts EMH (specify type)A. Tax-exempt municipal bonds offer lower pretax returns than
taxable government bonds.B. Managers make superior returns on their purchases of their
company’s stock.C. There is a positive relation between the return on the market in
one quarter and the change in aggregate profits in the next quarter.
D. There is disputed evidence that stocks which have appreciated unusually in the recent past continue to do so in the future.
E. The stock of an acquired firm tends to appreciate in the period before the merger announcement.
F. Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earning announcement.
G. Very risky stock on average give higher returns than safe stocks.
37
Chapter 14: Corporate Financing
• Common Stock• Preferred Stock• Corporate Long-Term Debt: The Basics• Patterns of Long-Term Financing
38
Example: Western Redwood Corp.• Formed in 1976 with 10,000 shares issued and sold for $1
per share.• By 2004, the company had retained $100,000.
Western Redwood Corporation Equity Accounts, 2004
Common stock(10,000 shares outstanding)
$ 10,000
Retain earnings 100,000
Total shareholders’ equity $ 110,000
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Example: Western Redwood Corp.• Issues 100,000 shares at $20 per share at 2004
Western Redwood Corporation Equity Accounts, 2004
Common stock(10,000 shares outstanding)
$ 210,000
Retain earnings 100,000
Total shareholders’ equity $ 310,000
40
Market Value and Book Value
• Market Value is the price of the stock multiplied by the number of shares outstanding. – Also known as Market Capitalization
• Book Value– The sum of par value, (contributed surplus –
value in access of par upon issue), accumulated retained earnings, and adjustments to equity is the common equity of the firm, usually referred to as the book value of the firm.
41
Enbridge Inc., 2003
42
Enbridge Inc., 2003
43
Enbridge Inc., 2003
44
Enbridge Inc., 2003
45
Authorized vs. Issued Common Stock
• The articles of incorporation must state the number of shares of common stock the corporation is authorized to issue.
• The board of directors, after a vote of the shareholders, may amend the articles of incorporation to increase the number of shares.– Authorizing a large number of shares may worry
investors about dilution because authorized shares can be issued later with the approval of the board of directors but without a vote of the shareholders.
46
Enbridge Inc., 2003
47
Shareholders’ Rights
• The right to elect the directors of the corporation by vote constitutes the most important control device of shareholders.
• Directors are elected each year at an annual meeting by a vote of the holders of a majority of shares who are present and entitled to vote. – The exact mechanism varies across
companies.• The important difference is whether shares are to
be voted cumulatively or voted straight.
48
Cumulative versus Straight Voting
• The effect of cumulative voting is to permit minority participation.– Under cumulative voting, if there are N directors up
for election, then 1/(N+1) percent of the stock plus one share will guarantee you a seat.
– With cumulative voting, the more seats that are up for election at one time, the easier it is to win one.
• Straight voting works like a U.S. political election.– Shareholders have as many votes as shares and
each position on the board has its own election.– A tendency to freeze out minority shareholders.
49
Cumulative vs. Straight Voting: Example 1
• Imagine a firm with two shareholders: Mr. MacDonald and Ms. Laurier. – Mr. MacDonald owns 60% of the firm ( = 600
shares) and Ms. Laurier 40% ( = 400 shares).– There are three seats up for election on the
board.
50
Cumulative vs. Straight Voting: Example 2
There are 2 million shares outstanding. How many shares do you need to own to be certain that you can elect at least one director under: a) straight voting? b) cumulative voting?
51
Proxy Voting• A proxy is the legal grant of authority by a shareholder to
someone else to vote his or her shares.• For convenience, the actual voting in large public
corporations is usually done by proxy.• If shareholders are not satisfied with management, an
outside group of shareholders can try to obtain as many votes as possible via proxy.
• Proxy battles are often led by large pension funds like the Ontario Teachers’ Pension Board or the British Columbia Investment Management Corporation.
52
Dividends
• Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. – A corporation cannot default on an undeclared
dividend.• The payment of dividends by the corporation is not a
business expense. – Therefore, they are not tax-deductible.
• Dividends (of Canadian corporations) received by individual shareholders are partially sheltered by a dividend tax credit.
• Canadian corporations do not pay taxes on dividends for amounts they receive from Canadian corporations.
53
Classes of Shares
• When more than one class of share exists, they are usually created with unequal voting rights.
• Many companies issue dual classes of common stock. The reason has to do with control of the firm.– Firms going public with dual classes of shares in
Canada are often family controlled.• Lease, McConnell, and Mikkelson found the market
prices of U.S. stocks with superior voting rights to be about 5-percent higher than the prices of otherwise-identical stocks with inferior voting rights.
54
Corporate Long-Term Debt: The Basics
• Interest versus Dividends• Is It Debt or Equity?• Basic Features of Long-Term Debt• Different Types of Debt• Repayment• Seniority• Security • Indenture
55
Interest versus Dividends• Debt is not an ownership interest in the firm. Creditors
do not usually have voting power.• The device used by creditors to protect themselves is
the loan contract (i.e., indenture).• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully tax-deductible. Dividends are paid out of after-tax dollars.
• Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm.– One of the costs of issuing debt is the possibility of
financial failure.
56
Is It Debt or Equity?
• Some securities blur the line between debt and equity.
• Corporations are very adept at creating hybrid securities that look like equity but are called debt. – Obviously, the distinction is important for tax
purposes.– A corporation that succeeds in creating a debt
security that is really equity obtains the tax benefits of debt while eliminating its bankruptcy costs.
57
Basic Features of Long-Term Debt
• The bond indenture usually lists– Amount of Issue (typically denominated with a $1000 face
value), Date of Issue, Maturity– Denomination (Par value)– Coupon, typically semiannual– Security– Sinking Funds– Call Provisions– Covenants
• Features that may change over time– Rating– Yield-to-Maturity– Market Price
58
Enbridge Inc., 2003
59
Back to Preferred Shares
• A preferred share represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy.
• Preferred shares have a stated liquidating value. For example, CIBC “$2.25 preferred” translates into a dividend yield of 9% of the stated $25 value.
• Preferred dividends are either cumulative or noncumulative.• Firms may have an incentive to delay preferred dividends,
since preferred shareholders receive no interest on the cumulated dividends.
• Preferred shares have a lower yield than debt.
60
Tax loophole in Canada
• Corporate investors are exempt from income taxes on dividends they would be willing to pay a premium for these shares (compared to similar debt instruments); as a consequence, yields are low.
• Low taxed companies may therefore prefer to issue these shares compared to debt (i.e., for these companies the debt tax shield is of limited usage).
61
Tax loophole in CanadaZero Tax Ltd., a corporation not paying any income taxes, can issue preferred shares attractive to Full Tax Ltd., a second corporation taxable at a combined federal and provincial rate of 45%. Zero Tax is seeking $1000 in financing through either debt or preferred stock. Zero Tax can issue either debt with a 10% coupon or preferred stock with a 6.7% dividend.
Preferred (6.7%) Debt (10%)Issuer: Zero Tax Ltd.Preferred dividend/interest paid $67.00 $100.00Dividend tax at 40% 26.80 0.00Tax deduction on interest 0.00 0.00Total financing cost $93.80 $100.00After-tax cost 9.38% 10.00%Purchaser: Full Tax Ltd.Before-tax income $67.00 $100.00Tax 0.00 45.00After-tax income $67.00 $55.00After-tax yield 6.70% 5.50%
62
Other Reasons for Preferred Shares
– Regulatory firms can pass the tax disadvantage to their customers.
– Firms issuing preferred shares can avoid the threat of bankruptcy while at the same time not surrender control (no voting rights on preferred shares).
63
Patterns of Long-Term Financing
• For Canadian firms, internally generated cash flow dominates as a source of financing.
• Firms usually spend more than they generate internally—the gap is financed by new sales of debt and equity.
• Net new issues of equity are dwarfed by new sales of debt.
• This is consistent with the pecking order hypothesis.• Leverage ratios for Canadian firms are considerably
higher than they were in the 1960s.
64
The Long-Term Financial GapSources of Cash Flow
(100%)
Internal cash flow (retained earnings plus depreciation)
68.3%
Long-term debt and
equity 31.7%
Uses of Cash Flow (100%)
Capital spending
Net working
capital plus other uses
Internal cash flow
External cash flow
Financial deficit
65
Chapter 15 How Corporations Issue Securities
• Issuing securities involves the corporation in a number of decisions.
• This chapter looks at how corporations issue securities to the investing public.
• The basic procedure for selling debt and equity securities are essentially the same. This chapter focuses on equity.
66
Topics Covered
• Venture Capital• The Initial Public Offering• Other New-Issue Procedures• Security Sales by Public Companies
– Rights Issue• Private Placements and Public Issues
67
Venture Capital• The limited partnership is the dominant form of intermediation
in this market.• There are five types of suppliers of venture capital:
1. Old-line wealthy families.2. Private partnerships and corporations.3. Large industrial or financial corporations with established
venture-capital subsidiaries.4. The federal government (through crown-related firms).5. Individuals, typically with incomes in excess of $100,000
and net worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.
68
Stages of Financing1. Seed-Money Stage:
Small amount of money to prove a concept or develop a product.2. Start-Up
Funds are likely to pay for marketing and product refinement.3. First-Round Financing
Additional money to begin sales and manufacturing.4. Second-Round Financing
Funds earmarked for working capital for a firm that is currently selling its product but still losing money.
5. Third-Round FinancingFinancing for a firm that is at least breaking even and
contemplating expansion; a.k.a. mezzanine financing.6. Fourth-Round Financing
Financing for a firm that is likely to go public within six months; a.k.a. bridge financing.
69
U.S. Venture Capital Investments
3.7 4.2 7.6 11.5 14.821.2
54.4
106.2
40.7
21.2 18.4
0
20
40
60
80
100
120
$ B
illio
ns
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
70
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.
Offering price – The price of a share at IPO.Spread - Difference between public offer price and
price paid by underwriter.Prospectus - Formal summary that provides
information on an issue of securities.
71
The Top Managing Underwriters
UnderwriterValue of Issues
($billion) Number of issuesCitigroup 543 1872Morgan Stanley 395 1365Merrill Lynch 380 1914Lehman Brothers 354 1264J.P. Morgan 354 1417
72
The Public Issue in Canada• Regulation of the securities market in Canada is
carried out by provincial commissions.• In the U.S., regulation is handled by a federal body
(SEC).• The regulators’ goal is to promote the efficient flow
of information about securities and the smooth functioning of securities’ markets.
• All companies listed on the TSX come under the jurisdiction of the Ontario Securities Commission (OSC).
• Other provinces have similar legislation and regulating bodies.
• The Canadian Securities Administration (CSA) coordinates regulation.
73
New Issue Procedure
Steps involved in issuing securities to the public:
1. Management obtains approval from the board of directors.
2. The firm prepares a preliminary prospectus to the OSC.3. The OSC studies the preliminary prospectus and
notifies the company of any changes required.4. Once the revised, final prospectus meets with the
OSC’s approval, a price is determined and a full-fledged selling effort gets under way.
74
The Process of Raising Capital
Steps in Public Offering Time
1. Pre-underwriting conferences2. Registration statements 3. Pricing the issue4. Public offering and sale 5. Market stabilization
Several months 20-day waiting period
Usually on the 20th day After the 20th day
30 days after offering
75
• The overallotment option: known as the Green Shoe provision gives members of the underwriting group the option to purchase additional shares at the offering price less fees and commissions. The option has a short maturity and is limited to about 10% of original number of shares issued.
• Investment Dealers:– In 2003, RBC Dominion Securities was the leading
underwriter by revenue.
76
Underwriting Spreads US (2003)Type Company
Issue Amount ($ millions)
Underwriter's spread
Common Stock:IPO Buffalo Wild Wings 45 7.0%IPO Carter's Inc. 119 7.0%IPO Genitope Corp. 41 7.0%IPO International Steel Group 462 6.5%IPO Ipass 98 7.0%
Seasoned General Cable Corp. 41 5.5%Seasoned Big 5 sporting Goods Corp. 94 5.0%Seasoned Red Robin Goods Corp. 92 5.3%Seasoned Gibraltar Steel 102 5.0%Seasoned Interstate hotels 47 5.3%
Debt (cupon rate, type, maturity) :4.85% Fixed Rate Notes, 2011 Raytheon 500 0.6%4.85% Notes, 2015 Procter & Gamble 150 0.5%6.3% Notes, 2018 Eastman Chemical 248 0.8%5.9% Senior Notes, 2008 Bausch & Lomb 50 1.0%6.25% Convertible Senior Debentures, 2033 General Motors 4,000 1.8%
77
Average Initial IPO Returns
0 20 40 60 80 100return (percent)
CanadaNetherlandsSpainFranceAustraliaHing KongUKUSAItalyGermanyJapanSingaporeSwedenTaiwanMexicoSwitzerlandIndiaGreeceKoreaBrazilChina
257 %
78
Initial Offering USAverage Expenses on 1767 IPOs from 1990-1994
Value of Issues($mil)
DirectCosts (%)
Avg First DayReturn (%)
TotalCosts (%)
2 - 9.99 16.96 16.3610 - 19.99 11.63 9.6520 - 39.99 9.7 12.4840 - 59.99 8.72 13.6560 - 79.99 8.2 11.3180 - 99.99 7.91 8.91
100 - 199.99 7.06 7.16200 - 499.99 6.53 5.70
500 and up 5.72 7.53
All Issues 11.00 12.05
25 1618 1518 1817 9516 3514 1412 7811 1010 36
18 69
.
.
.
.
.
.
.
.
.
.
79
The Costs of Public OfferingsCosts of Going Public in Canada: 1984-97 Fees 6.00 % Underpricing 7.88 % TOTAL 13.88 %
• The above figures understate the total cost because they ignore indirect expenses or the overallotment option.
80
From CNN.COM (Aug 18, 2004)
Google plans to price the shares in a rare auction-style IPO. The deal promises to put more shares in the hands of ordinary investors rather than wealthy investment banking clients. The auction is also widely seen as a slap at Wall Street and the clubby culture that contributed to investigations into improper IPO trading activities at the height of the dot-com bubble.
81
General Cash Offers
Seasoned Offering - Sale of securities by a firm that is already publicly traded.
General Cash Offer - Sale of securities open to all investors by an already public company.
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.
82
Private Placements
• Avoid the costly procedures associated with the registration requirements that are a part of public issues.
• The OSC and SEC restrict private placement issues of no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds.
• The biggest drawback is that the securities cannot be easily resold.
83
Market Reaction to SEO
Suppose that the CFO of a restaurant chain is strongly optimistic about its prospect. From her point of view, the company’s stock price is too low. Yet the company wants to issue shares to finance expansion into another county. What is she to do?
84
The Announcement of New Equity and the Value of the Firm
• The market value of existing equity drops on the announcement of a new issue of common stock.
• Reasons include– Managerial Information
Since the managers are the insiders, perhaps they are selling new stock because they think it is overpriced.
– Debt CapacityIf the market infers that the managers are issuing new
equity to reduce their debt-to-equity ratio due to the specter of financial distress the stock price will fall.
– Falling Earnings
85
Rights• An issue of common stock offered to existing
shareholders is called a rights offering.• Prior to the 1980 Bank Act, chartered banks were
required to raise equity exclusively through rights offerings.
• If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new issue of common stock first to existing shareholders.
• This allows shareholders to maintain their percentage ownership if they so desire.
86
Mechanics of Rights Offerings
• The management of the firm must decide:– The exercise (subscription) price (the price
existing shareholders pay for new shares).– How many rights will be required to purchase
one new share of stock.• These rights have value:
– Shareholders can either exercise their rights or sell their rights.
87
Rights Offering Example
National Power has 1 million shares outstanding. Each share sells for $20. The company wants to raise $5 million in new equity. Suppose the exercise (subscription) price is set at $10 per share. Find
1. Market value of company after rights issue.2. Number of new shares.3. Number of rights needed to buy a share. 4. The value of the share after the rights offering.5. The value of a right.6. The cost of a new share to an “outside” investor.
88
Time Line
P=$20
N=1mP=$16.67
N=1m
P=$16.67
N=1.5m
Rights announcement
Ex Right Date Right Expiration Date
P=$16.67
N=1m
R=$3.33
Right Issue Date
89
Theoretical Value of a Right
The theoretical value of a right during the rights-on period is:
R0 = (M0 – S) / (N +1)
Where,M0 = Common share price during the rights-on period
S = Subscription priceN = Number of rights required to buy one new share
90
Value of a Right after Ex-Rights Date
When the stock goes ex-rights, its price drops by the value of one right.
Me = M0 – R0
Re = (Me – S) / N
Where,Me is the common share price during the ex-rights period.
91
Self Practice
Yoma Inc. is attempting to raise $5,000,000 in new equity with a rights offering. The subscription price will be $40 per share. The stock currently sells for $50 per share and there are 250,000 shares outstanding.
a. How many new shares will Yoma issue?b. How many rights will be required to buy one share?c. At what price will the stock sell when it goes ex‑rights if
the total value of all stock increases by the amount of the new funds?
d. What is the theoretical value of 1 right?