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Chapter 11 Raising Long-Term Financing
Chapter Overview
The Opening Focus discusses the IPO of Financial Engine’s Inc., which provides financial advice
day trading began. This positioned the firm for success in the next few years.
Opening Focus Discussion Questions
1. Who benefited the most from the IPO of Financial Engine Inc.?
2. Is Financial Engine Inc. served well when it appears its shares were underpriced by 44%? Is
such underpricing a rarity?
This chapter looks at long-term financing instruments, including:
11-1 The Basic Choices in Long-Term Financing
Technology
1. Smart Concepts animations provide a step-by-step explanation about the marginal costs and
marginal benefits of raising external funds..
3. Smart Practices Video features Frank Popoff, retired chairman of the board of Dow Chemi-
cal, as he looks at foreign bonds and their role in corporate finance.
5. Smart Practices Video features Jay Ritter of the University of Florida as he looks at IPO un-
derpricing, which occurs worldwide.
Lecture Guide
This chapter surveys global financing instruments, going into detail about investment banking and
initial public offerings.
Chapter 11 Raising Long-Term Financing 299
Common Stock and Long-term Debt
Most companies finance first through internal financing.
• Student Interaction: Ask students why internal financing is preferred.
Some reasons for this may include:
11-1 The Basic Choices in Long-term Financing
The concepts in this section go back to Chapter 1: that the goal of the firm is to maximize
11-1a The Need to Fund a Financial Deficit
While firms prefer internal financing to external financing, firms may need to enter the finan-
11-1b The Choice Between Internal and External Financing
The firm’s dividend decision and capital structure decisions are part of the financing deci-
Are the transactions costs worth the benefits of additional investment?
11-1c Raising Capital from Financial Intermediaries or on Capital Markets
There are global differences in raising capital. In general, banks play a larger role in fi-
nancing foreign companies than domestic companies.
The banking system has changed substantially since Glass-Steagall was essentially repealed.
The Gramm-Leach-Bliley Act of 11/99 was a landmark financial services reform law. It repealed
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11-1d Expanding Role of Securities Markets in Corporate Finance
Annual Global Securities Issuance: Patterns
11-2 Investment Banking and the Public Sale of Securities
Firms generally do not sell new stock directly to the public (although there are exceptions
Figure 11.1 Prospectus of Financial Engines Common Stock
Note that investment banks are not investors – they are advisors in the issue process. In-
vestment banks competed with commercial banks – in some transactions IBs accepted credit risk,
traditionally a mainstream banking function, by providing short-term loans to firms to help with
Chapter 11 Raising Long-Term Financing 301
11-2a Conflicts of Interest Facing Investment Banks
11-2b Legal Rules Governing Public Security Sales in the United States
A number of regulatory changes impacted the securities industry. One was the Employee
Retirement Income Security Act (ERISA), requiring pension fund managers to follow a “prudent
man” rule in making investment decisions for the fund. This meant that fund managers were no
Basic Disclosure Documents
Public issues must be registered with the SEC; however, the SEC does not certify that the infor-
mation that the company provides is correct. It simply verifies that all the required information
was submitted. Rights offerings used to be more common among U.S. firms.
Shelf Registration
Shelf registration has made debt issuances easier and less costly for U.S. firms.
11-3 The U.S. Market for Initial Public Offerings
11-3a Patterns Observed in the U.S. IPO Markets
There are a number of possible explanations for “hot markets” and for the fact that there tends to be
more underpricing of IPOs (higher first day gains) in hot markets.
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• Perhaps there are changes in firm risk. If “everyone” is doing an IPO, then the riskier and
harder to price companies may be in the market. When there is more risk, and when it is hard-
er to evaluate the risk of a company, there will be more underpricing.
Table 11-3 Number of U.S. IPO Offerings, Initial Returns and Gross Proceeds
IPOs can raise large amounts of cash. For example, in 1998, DoubleClick, an online advertising
network, planned on selling 2.5 million shares at $12-$14 per share. Because of the high demand
11-3b Advantages and Disadvantages of an IPO
An IPO or a secondary offering after an IPO can be very profitable for a company’s found-
ers. For example, eBay’s founder received close to $130 million from the sale of 790,000 of his
37.6 million shares of stock in eBay’s secondary offering in April 1999. (The company did its IPO
in September 1998.) In another example, 20-year-old Christopher Klaus founded Internet Services
Systems in 1994. The firm went public in 1998, giving Klaus a $160 million fortune in his remain-
ing 26% ownership of the company. Not just owners can become rich. Over 2,000 Microsoft em-
ployees have become millionaires through exercising employee stock options.
Some of the benefits include:
• New capital available for the company.
Chapter 11 Raising Long-Term Financing 303
11-3c Specialized IPOs, ECOs, Spin-offs, Reverse LBOs and Tracking Stocks
Equity carve-outs (ECOs) do not necessarily increase stock price for the parent company.
A 2002 McKinsey analysis of 200 equity carve-outs in the U.S. and Europe over the previous 12
years showed that only 10% of the equity carve-outs raised the parents’ company share price by
more than 12%. The study found that during the two years following the carve-out, most parent
11-3d The Investment Performance of IPOs
At the peak of the IPO boom, many companies⎯in particular Internet companies⎯had a huge
first day “pop,” in other words a large increase in price on the opening day of trading. The IPO
“boom” began in September 1998 with a 606% first day gain for theglobe.com. One of the highest
A Wall Street Journal article on June 13, 2001, “Analysts’ Links to IPOs Mean Losses for In-
vestors” stated that investors lost an average of over 53% when they followed the advice of an ana-
lyst working for a Wall Street firm that led or co-managed that stock’s IPO. Investors lost only
4.24% when they took the advice of analysts working for firms with no underwriting connection to
the IPO.
A Business Week article on February 5, 2001, “Do Top Women Execs = Stronger IPOs?”,
quoted a University of Michigan study that found having more top managers who are female meant
higher stock prices and earnings per share after an IPO. When executive teams were at least 10%
female, stock prices were almost 5% higher than for companies with no top women managers.
Earnings per share for companies with at least 10% female management were 56% higher than for
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There is a new verb in the English language – to NASDAQ. This verb came into use in 2002,
11-4 Seasoned Equity Offerings
This is a good place to remind students that new equity issues are relatively rare. Most American
companies get most of their external financing from debt issues. Net equity issues are negative in
most years. This is because:
• When one company purchases another with cash, the stock of the acquired company is re-
Figure 11.2 Factors That Affect SEO Issuance Decisions
11.4a Stock Price Reactions to Seasoned Equity Offerings
11-4b Rights Offerings
11-4c U.S. Private Placements
Concerning public vs. private placements, the instructor can note that private debt placements
may have less restrictive covenants and fewer transactions costs than public placements, but may
carry a higher coupon interest rate to compensate for the lack of liquidity for investors in a private
issue.
11-5 International Common Stock Offerings
There are many similarities between U.S. and international equity issues. Accounting differences
can be an issue, however, more foreign firms are adopting GAAP standards. This is required of
Chapter 11 Raising Long-Term Financing 305
11-5a Non-U.S. Initial Public Offerings
Many of the same anomalies of U.S. IPOs are common to international firms:
11-b International Common-Stock Issues
American Depository Receipts
ADRs are a relatively new investment, increasing in popularity. They provide an easy way
11-5c Share Issue Privatizations
More countries are privatizing previously government-owned industries. The most im-
Long-term Financing Summary
This slide summarizes the main points of this chapter.
Ch. 11 Resource Articles
“Performance Differences Between IPOs in New Industries versus IPOs in Established Industries,”
Managerial Finance, 2009. This article reports the results of a study between the IPOs of estab-
“A Credit Crunch Imperils the Economy,” Wall Street Journal, November 6, 2001. This is an op-
ed piece saying that cutting interest rates is not necessarily spurring new investment. The money
isn’t reaching capital-hungry business because Treasury regulators are cracking down on loans. It
states that credit rationing, not interest rates is the real problem with the economy.
low as zero.
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“Chicago Merc’s IPO Hits Market this Week,” Wall Street Journal, December 1, 2002. This arti-
cle looks at the Chicago Mercantile Exchange’s IPO, the first major market that has gone public in
Enrichment Exercises
Activities for students:
1. Download a company prospectus from the SEC’s Edgar site (www.sec.gov or
www.FreeEdgar.com). Choose one of the following sections: risk factors, use of proceeds,
3. Dutch Auctions
One of the hardest parts of an IPO is appropriately pricing the stock. One suggestion for IPOs
is a Dutch auction. In a Dutch auction, investors are given a range of prices, and then bid on
how many shares they would be willing to buy at a specified price. The company then sorts
the offers in descending order. The price that is high enough to get the deal done – sell the re-
quired number of shares – is the price that is chosen for the IPO. Try this in class. For a class
4. Equity Carve-Outs
Why can equity carve outs and spin offs potentially create value for shareholders? The discus-
sion can bring out potential reasons such as:
Chapter 11 Raising Long-Term Financing 307
• The carved out firm is more of a “pure play” company and can be more easily valued by
the market. For example, investors may be better able to evaluate the new company’s
growth opportunities when they are separate from the parent company.
5. IPOS – Money on the Table
In spite of the large amounts of money left on the table, neither the companies nor the invest-
ment bankers were really unhappy about this situation. Lead students in a discussion of why
this might be. This is potentially because:
• The company’s stock price often was priced higher than they initially expected, which
meant they netted more funds from the IPO than anticipated.
• Firms generally floated only a small percent of the total shares outstanding, so they could
lowed at the time of the IPO. Optimistic investors can buy shares; pessimistic ones can’t short
sell until there is a more established aftermarket. This could result in a short run overvaluation
of the shares and greater long-run underperformance. Some of the proxies for uncertainty in
IPOs include:
• Bid-ask spread. This reflects dealers’ order processing and inventory holding costs.
Spreads increase when there is more uncertainty about valuation.
6. Give students a list of companies that went public 2-5 years ago. Ask them to download stock
price data for those companies, either individually or as a group project. (Yahoo finance is a
good source of stock price data that is easily downloadable into an Excel spreadsheet.) Stu-
dents can also download market index values for the same period from Yahoo, and compare
the IPO stock returns to the market returns. What was the average company and stock market
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return in the year (or several years) following the IPO. Did the IPO under perform the market?
If so, by how much?
7. The Wall Street Journal has an excellent, free videotape (about 15 minutes long) detailing the
8. Additional discussion questions for students:
1. What is the cost of internal financing? (The cost applied to internal financing is the also
the cost of equity for the firm. It is technically slightly less than the cost of new equity fi-
nancing because of transactions costs associated with new equity issues, although often this
differential is ignored because new equity issues are a relatively rare event.
2. Why do firms prefer internal financing in spite of its higher cost? There are a number of
possible explanations for this, including the fact that it is easy to use – it’s there without
Answers to Concept Review Questions
1. A financial intermediary (FI) is an institution that raises capital by issuing liabilities against
itself—for example, in the form of demand or savings deposits, or by shares in a mutual fund
or pension fund. The intermediary then pools the funds raised and uses these to make loans to
borrowers or, where allowed, to make equity investments in non-financial firms. Borrowers re-
2. The U.S. shows trend toward securitization, the repackaging of loans and other bank-based
credit products into securities that can be re-sold to public investors. U.S. issuers account for a
3. Bulge bracket firms are the largest Investment Banks ( IBs) providing a wide range of services.
Bulge-bracket firms generally occupy the lead or co-lead manager’s position in large new secu-
Chapter 11 Raising Long-Term Financing 309
4. The guiding principle behind legislation is full disclosure – that the firm must disclose all rele-
vant financial, accounting and legal information to potential investors, so that the company and
5. In a shelf registration, firms file a document asking to issue a certain amount of securities over
6. IPO financing is cyclical. There are “hot” and “cold” markets when IPO activity peaks and
then wanes. Industries may for a time be the “hot” industry, for example, tech firms in the late
7. The benefits of going public include: raising new capital for the company, providing publicly
traded stocks that can be used in acquiring other companies, having listed stock that can be
8. In an equity carve-out, only part of the company’s equity is sold. This is sometimes called a
partial IPO. The parent company maintains control of the company typically, but gets the ben-
9. Underpricing refers to the fact that IPO shares typically rise on the first day of trading, indicat-
ing that they could have been priced higher to begin with. An unsophisticated investor who in-
10. Underpricing adds to the cost of going public because the company must issue more shares at a