Slide 20.16 IPO Underpricing
The underpricing (there is a large increase above the offer price the first day
of trading) of IPOs is very common. The record year is still 1999,
with an average first day return of almost 70%.
Lecture Tip: An article in the Red Herring supplemental issue “Going Public
2000” discusses the issue of IPO underpricing. The title of the
article is “Leaving Money on the Table, Why banks are pricing
IPOs so far below what the public market seems willing to pay.” It
illustrates that underpricing is not just an academic issue. As the
article says, “The difference … between the offer price and the
first-day close could have gone to the issuing company rather than
to the chosen few investors lucky enough to be given IPO shares to
flip for a big one-day take.”
The author points out that a more accurate measure of “money left on the
table” might be the difference between the offer price and the
opening price. In 1999, five IPO’s left over $1 billion on the table
using this measurement. When you consider that the underwriters
generally earn a 7% spread based on the offer price, they are
losing a substantial chunk of money as well.
The author argues that the wild swings are at least partially due to the
unpredictability of online traders. He uses the example of
Andover.net to illustrate his point. The shares of Andover.net were
sold at a Dutch auction that was open to all investors large or
small. Each investor tendered a secret bid. The winning bids were
tallied and all winners paid the lowest accepted price.
Theoretically, there should not have been a price jump because all
investors who were interested could place a bid. If they were
willing to pay enough, they would receive the stock. The Dutch
auction led to an offer price of $18 per share, but it opened trading
at $48 and closed at $63.38.
The other main argument that the author gives is that the underwriter does
not want to face a lawsuit for overpricing an issue. His final
comment about “leaving money on the table” puts a different light
on the whole process: “Everybody wins. The issuer gets its money
and the publicity that comes from a huge first-trade gain, and the
initial investors get a fat profit. As for the bank, it earns its fees,
keeps its customers happy, and, perhaps most importantly, steers
clear of the lawyers.”
.A Underpricing: A Possible Explanation
Many possible explanations exist, but there is no consensus. Two
points, however, are worth noting. First, when the issue price is too
low, the issue is often oversubscribed. Second, and more simply, is
the issue of risk. Ethics Note: Traditionally, IPOs have been
reserved for the syndicates’ best customers, but the investment
bankers have to be careful how they allocate those shares. In July,
2004, Piper Jaffray was fined $2.4 million for selling shares of
“hot” IPOs to the executives of firms that they had either recently
done business with or with whom they were trying to gain
business.
Lecture Tip: How good is the long-run performance of IPO firms? Not
overwhelmingly good. In addition to the growing academic
research, there is a good bit of institutional research suggesting
that holding on to IPO stocks is a risky proposition. A quick glance
at Hoover’s IPO Central, under IPO Performance, shows that a
substantial number of firms have prices today that are lower than
the offer price.
20.1. The Announcement of New Equity and the Value of the Firm
Slide 20.17 The Announcement of New Equity and the Value of the Firm
Stock prices tend to decline when a company announces a seasoned equity
offering. Why? Much of the decline may be due to the private
information known by management (called asymmetric
information) and the signals that the choice to issue equity sends to
the market.
Managerial information concerning value of the stock – expectation that
managers will issue equity only when they believe the current price
is too high
Debt capacity – expectation that a firm will issue debt as long as it can afford
to (allows stockholders to benefit more from good projects);
consequently, a stock issue indicates that management believes that
the firm is too highly leveraged
Issue costs – selling securities carries a high cost. See next section.
20.2. The Cost of New Issues
Slide 20.18 The Cost of New Issues
The cost of issuing securities can be broken down into the following main
categories:
-Gross spread (or underwriting discount)
-Other direct expenses – filing fees, legal fees, etc.
-Indirect expenses – opportunity costs, such as management time spent
working on the issue
-Abnormal returns – seasoned stock issue, the reduction in price when the
announcement is made
-Underpricing – IPOs
-Green Shoe option – additional allotment of shares sold at offer price
Slide 20.19 The Costs of Equity Public Offerings
Four clear patterns emerge:
-There are substantial economies of scale
-Selling debt is less costly
-An IPO is more expensive than a seasoned offering
-Straight bonds are cheaper to float than convertible bonds
.A The Costs of Going Public: A Case Study
20.7. Rights
Slide 20.20 Rights
Privileged subscription – issue of common stock offered to
existing stockholders. Offer terms are evidenced by warrants or
rights. Rights are often traded on exchanges or over the counter.
.A The Mechanics of a Rights Offering
Slide 20.21 Mechanics of Rights Offerings
Early stages are the same as for a general cash offer, i.e., obtain approval from
directors, file a registration statement, etc. The difference is in the
sale of the securities. Current shareholders get rights to buy new
shares. They can subscribe (buy) the entitled shares, sell the rights
or do nothing.
.B Subscription Price
The price that existing shareholders are allowed to pay for a share
of stock. (In the context of options, this is similar to an exercise
price.)
.C Number of Rights Needed to Purchase as Share
Number of new shares = funds to be raised / subscription price
Shareholders get one right for each share already owned.
Number of rights needed to buy a share = # of old shares / # of new shares
Example: Suppose a firm with 200,000 shares outstanding wants to raise $1
million through a rights offering. Each current shareholder gets one
right per share held. The following table illustrates how the
subscription price, number of new shares to be issued, and the
number of rights needed to buy a share are related, ignoring
flotation costs.
Subscription Price # of new shares # of rights required
$25 40,000 5
$20 50,000 4
$10 100,000 2
$5 200,000 1
A right has value if the subscription price is below the share price. How much
a right is worth depends on how many rights it takes to buy a share
and the difference between the stock price and the
subscription price. If it takes N rights to buy one share, the value of one right
is equal to
(initial stock price – subscription price) / (N + 1)
.D Effect of Rights Offering on Price of Stock
Slide 20.22 Rights Offering Example
Slide 20.23 What is the new market value of the firm?
Slide 20.24 –
Slide 20.25 What Is the Ex-Rights Price?
When a privileged subscription is used, the firm sets a holder-of-record date.
The stock sells rights-on, or cum rights, until two business days
before the holder-of-record date. After that, the stock sells without
the rights or ex rights.
Note: The PowerPoint slides illustrate calculations via total market
values; however, the following equation can also be used.
ex rights price = (1 / (N+1))(N*initial stock price + subscription price)
Example: Suppose the above firm decides on a subscription price of $20, with
50,000 shares to be issued. Assume the shares outstanding
currently sell for $35. Using the valuation formula and letting N =
4, a right is worth (35 – 20)/(4+1) = $3. The expected ex rights
price is (1/5)(4*35 + 20) = $32
Lecture Tip: You may wish to link the stock behavior associated with the ex
rights date to that of the ex dividend date. Point out that a time
line could be drawn that applies to stocks trading ex rights as well
as stocks trading ex dividend. Both dividend and rights
declarations involve setting an ex date, which is two days before
the record date. In both situations, the share price reacts on the ex
date to reflect the value of the right or dividend that would not be
received if the shares were purchased after the ex date.
.E Effects on Shareholders
Absent taxes and transaction costs, shareholder wealth is not differentially
affected whether they exercise or sell their rights, nor does it
matter what subscription price the firm sets as long as it is below
the market price.
.F The Underwriting Arrangements
Standby underwriting – firm makes a rights offering and the
underwriter makes a commitment to “take up” (purchase) any
unsubscribed shares. In return, the underwriter receives a standby
fee. In addition, shareholders are usually given oversubscription
privileges (the right to purchase unsubscribed shares at the
subscription price).
20.8. The Rights Puzzle
Slide 20.26 The Rights Puzzle
A pure rights offering is typically cheaper than underwriting or a rights offer
with standby underwriting. However, the vast majority of offerings
in the U.S. are underwritten. A few possible explanations exist:
-underwriter increases stock price (not likely)
-underwriter provides guaranteed price (i.e., insurance)
-underwriters certify the price to the market
-proceeds are available sooner
None of the explanations are very convincing.
20.9. Dilution
Slide 20.27 Dilution
.A Dilution of Proportionate Ownership
This occurs when the firm sells stock through a general cash offer and new
stock is sold to people who previously weren’t stockholders. For
many large, publicly held firms this simply isn’t an issue, since
there are many different stockholders to begin with. For some
firms with a few large stockholders it may be of concern.
.B Stock Price Dilution
A stock’s market value will fall if the NPV of the project being
financed is negative and rise if the NPV is positive.
.C Book Value
Whenever a stock’s book value is greater than its market value,
selling new stock will result in accounting dilution. However, the
change in book value is essentially irrelevant.
.D Earnings per Share
A project with big growth in earnings over time may reduce EPS
initially, even if the NPV is positive.
.E Conclusion
Recall, the goal of the firm is to maximize market value (or price
per share). Dilution of the other variables is irrelevant to
stockholders.
20.10. Shelf Registration
Slide 20.28 Shelf Registration
Shelf registration – SEC Rule 415 allows a company to register all securities
that it expects to issue within the next two years in one registration
statement. The firm can then issue the securities in smaller
increments, as funds are needed during the two-year period. Both
debt and equity can be registered using Rule 415.
Qualifications:
-Securities must be investment grade
-No debt defaults in the last three years
-Market value of outstanding stock must be greater than $150 million
-No violations of the Securities Act of 1934 within the last three years
20.11. Issuing Long-Term Debt
Slide 20.29 Issuing Long-Term Debt
The general process for public issuance is the same as that for
stocks.
Direct financing:
Term loans – direct business loans.
Private placements – similar to term loans, but with longer
maturities.
Direct financing may have more restrictive covenants, but is less
costly and easier to negotiate.
Slide 20.30 Quick Quiz