Fundamentals of corproate finance 3e chapter 17

Chapter Seventeen Issuing Securities to the Public Copyright  2004 McGraw-Hill Australia Pty Ltd 17-1 Chapter Organisation 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-2 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-3 Issuing Securities to the Public • 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-4 Issuing Securities to the Public • Underwriting agreement executed • Prospectus registered • Public announcement of offering • Funds received • Shares allotted, holdings registered • Shares listed for trading on ASX Copyright  2004 McGraw-Hill Australia Pty Ltd 17-5 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-6 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-7 Disadvantages of Public Company Listing • Dilution of control of existing owners • Additional responsibilities of directors • Greater disclosure of information • Explicit costs • Insider trading implications Copyright  2004 McGraw-Hill Australia Pty Ltd 17-8 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-9 Underwriting • Firm underwriting A guarantee that funds will be made available to a company at a specific time on agreed terms and conditions • Standby underwriting Where the bidding company has insufficient cash in a successful bid or if cash is offered as an alternative to a share bid • Best efforts underwriting Underwriter must use ‘best efforts’ to sell the securities at the agreed offering rate Copyright  2004 McGraw-Hill Australia Pty Ltd 17-10 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-12 Average Initial Returns Source: Ibbotson, Sindelar and Ritter (1988) Copyright  2004 McGraw-Hill Australia Pty Ltd 17-13 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-14 The Cost of Issuing Securities Copyright  2004 McGraw-Hill Australia Pty Ltd 17-15 Rights Offerings—Basic Concepts • Rights offering Issue 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-16 Rights Offerings—Basic Concepts • Subscription price The dollar cost of one of the shares to be issued, generally less than the current market price • Ex-rights date Beginning 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 date Date on which existing shareholders are designated as the recipients of share rights Copyright  2004 McGraw-Hill Australia Pty Ltd 17-17 Ex-rights Share Prices Rights-on Announcement date 30 September Rights-on price $20.00 Ex-rights price $16.67 Ex rights Ex-rights date 13 October Record date 15 October $3.33 =Value of a right Copyright  2004 McGraw-Hill Australia Pty Ltd 17-18 Theoretical Rights Price M −S n   n+r  Where: n = number of shares held to obtain a right M = market price S = subscription or issue price of the rights issue r = number of additional shares offered Copyright  2004 McGraw-Hill Australia Pty Ltd 17-19 Example—Rights Issue Lemon Co currently has 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-20 Example—Rights Issue (continued) • The number of new shares to be sold: funds to be raised = subscription price $6 000 000 = $6 = 000 000 shares • • • The holder of one right is entitled to subscribe to one new share at $6 per share To issue million shares, the company would have to issue million rights The company has million shares on issue, which means that for every shares held, a shareholder is entitled to receive one right (1-for-5 rights issue) Copyright  2004 McGraw-Hill Australia Pty Ltd 17-21 Example—Rights Issue (continued) • Calculate the theoretical rights price: M −S  =n    n +r  $8 −$6  =5    +1  =$1.67 • • • 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-22 The Value of Rights *$8.00 – 7.67 = 0.33 **$0.33 × = $1.65 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-23 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-thanproportionate 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-24 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-25 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 17-26 .. .Chapter Organisation 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... McGraw-Hill Australia Pty Ltd 17- 7 Disadvantages of Public Company Listing • Dilution of control of existing owners • Additional responsibilities of directors • Greater disclosure of information • Explicit... McGraw-Hill Australia Pty Ltd 17- 14 The Cost of Issuing Securities Copyright  2004 McGraw-Hill Australia Pty Ltd 17- 15 Rights Offerings—Basic Concepts • Rights offering Issue of ordinary shares to existing