Chapter 15 – Raising Capital
1. IPOs and Underpricing
A. Underpricing: The 1999 – 2000 Experience
The number of IPOs and the average return on IPOs during 1999
and 2000 was enormous compared to past periods. 1999 set a
record with just under $65 billion raised. 2000 beat this record with
just over $65 billion raised.
B. Evidence on Underpricing
The underpricing (there is a large increase above the offer price the
first day of trading) of IPOs is very common. Empirical evidence
suggests that it has gotten worse in recent years. As Table 15.2
points out, the average underpricing has been higher from 2000 to
2007, even with a down market, than any other period in time. The
record year, though, is still 1999 with an average first day return of
almost 70 percent.
Real-World 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 IPOs 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.
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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.”
Lecture Tip: More recent evidence (see “Underpricing, Overhang,
and the Cost of Going Public to Preexisting Shareholders” by
Dolvin and Jordan in the 2007 issue of Journal of Business
Finance and Accounting) suggests that underpricing has little
impact on owners, as very few preexisting shares are sold in IPOs.
C. Why Does Underpricing Exist?
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 have either recently done business
with or with whom they were trying to gain business.
2. New Equity Sales 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.
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-Managerial information concerning value of the stock –
expectation that managers will issue equity only when they believe
the current price is too high
-Debt usage – 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 – equity is more expensive to issue than debt from a
straight flotation cost perspective
3. The Costs of Issuing Securities
A. The Costs of Selling Stock to the Public
The cost of issuing securities can be broken down into the
following main categories:
-Spread
-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
Other conclusions:
-There are substantial economies of scale
-Best efforts cost more (may be why firm commitment is the
standard)
-The cost of underpricing may be greater than the direct
issuance costs
-An IPO is more expensive than a seasoned offering
B. The Costs of Going Public: A Case Study
This section describes a real IPO and the attendant costs. The
important conclusion is that, while $97.5 million was raised by
selling shares, the issuing firm received only about $86 million
after the spread and other fees were paid.
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Real-World Tip: There is an excellent article in the June 2000
issue of The Journal of Finance by Chen and Ritter, called the
“Seven Percent Solution.” This article addresses the issue of the
spread earned by investment bankers for IPOs and what factors
impact the choice of lead underwriter. One interesting result was
that even though over 90% of the issues studied had a seven
percent spread, it did not appear to be illegal collusion.
Companies that are looking for an investment banker are
apparently not very price-sensitive. They are more concerned with
underwriter reputation and the services that they will receive. A
low spread is perceived as lower quality and does not attract
business – in fact, it may drive it away.
4. 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
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. Number of Rights Needed to Purchase a 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
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$5 200,000 1
C. The Value of a Right
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. Ex Rights
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.
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. The Underwriting Arrangements
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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.
F. 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.
5. Dilution
A. Dilution of Proportionate Ownership
This occurs when the firm sells stock through a general cash offer
and new stock is sold to persons 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. Dilution of Value: Book versus Market Values
A stock’s market value will fall if the NPV of the project being
financed is negative and rise if the NPV is positive. Whenever a
stock’s book value is greater than its market value, selling new
stock will result in accounting dilution (but not necessarily result in
market value dilution)
6. Issuing Long-Term Debt
The process for issuing long-term debt is similar to issuing stock
except that the registration statement must include the bond
indenture.
Most corporate debt is privately placed. Term loans are direct
business loans with one to five years’ maturity, usually amortized.
Private placements are similar to term loans, except for longer
terms. Commercial banks, insurance companies, and other
intermediaries often grant both types of loans.
Differences between private placements and public issues:
-No SEC registration is required for a private placement
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-Direct placements may have more restrictive covenants
-Private placements are easier to renegotiate, if necessary
-Issuance costs are generally lower on private placements,
although the coupon rate is generally higher
It is much cheaper to issue debt than equity.
Real-World Tip: Corporate issuers continued to exploit the
relatively low level of long-term interest rates in 1996 and 1997. In
December 1996, IBM issued 100-year bonds with a face value of
$850 million. As evidence of the low required return, note that the
yield on these bonds is only one-tenth of one percent higher than
on similar 30-year IBM bonds. In all, approximately
$3.6 billion worth of 100-year bonds were issued between
November 1995 and December 1996. Previous “century bond”
issuers include Walt Disney Company, Coca-Cola, and Yale
University.
7. 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 stock must be greater than $150 million
-No violations of the Securities Act of 1934 within the last
three years
8. Summary and Conclusions
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