FM03 - Long Term Financing

8/2/2019 FM03 - Long Term Financing

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Copyright 2012 Pearson Prentice Hall. All rights reserved.

Edited by Olivier Greusard

Part III:

Long Term Financing(Chapters 14 and 15)

FM 03 Corporate Finance

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Raising Equity Capital(Chapter 14)


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Chapter 14 Outline

14.1 Equity Financing for Private Companies

14.2 Taking Your Firm Public: The InitialPublic Offering

14.3 IPO Puzzles

14.4 Raising Additional Capital: TheSeasoned Equity Offering


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Copyright 2012 Pearson Prentice Hall. All rights reserved.Edited by Olivier Greusard

14.1 Equity Financing forPrivate Companies

Sources of Funding:A private company can seek funding from

several potential sources: Angel Investors Venture Capital Firms Institutional Investors Corporate Investors


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14.1 Equity Financingfor Private Companies

Angel Investors:Individual investors who buy equity in small

private firms

The first round of outside private equityfinancing is often obtained from angels


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Venture Capital Firms:Specialize in raising money to invest in the

private equity of young firms

In return, venture capitalists often demand agreat deal of control of the company


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Figure 14.2 Venture CapitalFunding in the United States


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Institutional Investors:Pension funds, insurance companies, and

foundations May invest directly May invest indirectly by becoming limited partners in

venture capital firms

Corporate Investors:

Many established corporations purchase equityin younger, private companies

corporate strategic objectives desire for investment returns


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Securities and ValuationWhen a company decides to sell equity to

outside investors for the first time, it is typicalto issue preferred stock rather than commonstock to raise capital

It is called convertible preferred stock if the ownercan convert it into common stock at a future date


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Example 14.1 Funding andOwnership

Problem: You founded your own firm two years ago. You initially

contributed $100,000 of your money and, in return received1,500,000 shares of stock. Since then, you have sold an

additional 500,000 shares to angel investors. You are nowconsidering raising even more capital from a venturecapitalist (VC).


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Problem (contd): This VC would invest $6 million and would receive 3 million

newly issued shares. What is the post-money valuation?Assuming that this is the VCs first investment in your

company, what percentage of the firm will she end upowning? What percentage will you own? What is the valueof your shares?


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Solution:

Plan: After this funding round, there will be a total of 5,000,000

shares outstanding:

Your shares 1,500,000

Angel investors shares 500,000

Newly issued shares 3,000,000

Total 5,000,000


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Plan (contd): The VC is paying $6,000,000/3,000,000=$2/

share.

The post-money valuation will be the totalnumber of shares multiplied by the price paid bythe VC.

The percentage of the firm owned by the VC isher shares divided by the total number of shares.

Your percentage will be your shares divided bythe total shares and the value of your shares willbe the number of shares you own multiplied bythe price the VC paid.


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Execute: There are 5,000,000 shares and the VC paid $2

per share. Therefore, the post-money valuation

would be 5,000,000($2) = $10 million. Because she is buying 3,000,000 shares, and

there will be 5,000,000 total shares outstandingafter the funding round, the VC will end upowning 3,000,000/5,000,000=60% of the firm.

You will own 1,500,000/5,000,000=30% of thefirm, and the post-money valuation of your sharesis 1,500,000($2) = $3,000,000.


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Evaluate: Funding your firm with new equity capital, be it from an

angel or venture capitalist, involves a tradeoffyou mustgive-up part of the ownership of the firm in return for the

money you need to grow. The higher is the price you can negotiate per share, the

smaller is the percentage of your firm you have to give upfor a given amount of capital.


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Exiting an Investment in a PrivateCompany

Acquisition Public Offering


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14.2 Taking Your Firm Public:The Initial Public Offering

The process of selling stock to the publicfor the first time is called an initial publicoffering (IPO)


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Advantages and Disadvantages of GoingPublic

Advantages:

Greater liquidity

Better access to capitalDisadvantages:

Equity holders more dispersed Must satisfy requirements of public companies


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IPOs include both Primary and Secondaryofferings

Underwriters and the SyndicateUnderwriter: an investment banking firm that

manages the offering and designs its structure Lead Underwriter

Syndicate: other underwriters that help marketand sell the issue


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Table 14.2 International IPOUnderwriter Ranking Report for 2007


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Figure 14.3The Cover Pageof RealNetworksIPO Prospectus


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ValuationUnderwriters work with the company to come

up with a price Estimate the future cash flows and compute the

present value

Use market multiples approachRoad ShowBook Building


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Example 14.2 Valuing an IPOUsing Comparables

Problem: Wagner, Inc., is a private company that designs,

manufactures, and distributes branded consumer products.During the most recent fiscal year, Wagner had revenues of

$325 million and earnings of $15 million. Wagner has filed aregistration statement with the SEC for its IPO.


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Problem (cont'd): Before the stock is offered, Wagners investment bankers

would like to estimate the value of the company usingcomparable companies. The investment bankers have

assembled the following information based on data for othercompanies in the same industry that have recently gonepublic. In each case, the ratios are based on the IPO price.


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Example 14.2 Valuing an IPO UsingComparables

Problem (cont'd)

After the IPO, Wagner will have 20 million sharesoutstanding. Estimate the IPO price for Wagner using theprice/earnings ratio and the price/revenues ratio.


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Solution:

Plan: If the IPO price of Wagner is based on a price/earnings ratio

that is similar to those for recent IPOs, then this ratio willequal the average of recent deals. Thus, to compute the IPOprice based on the P/E ratio, we will first take the averageP/E ratio from the comparison group and multiply it byWagners total earnings. This will give us a total value ofequity for Wagner. To get the per share IPO price, we need

to divide the total equity value by the number of sharesoutstanding after the IPO (20 million). The approach will bethe same for the price-to-revenues ratio.


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Execute: The average P/E ratio for recent deals is 21.2. Given

earnings of $15 million, we estimate the total market valueof Wagners stock to be ($15 million)(21.2) = $318 million.

With 20 million shares outstanding, the price per shareshould be $318 million / 20 million = $15.90.

Similarly, if Wagners IPO price implies a price/revenuesratio equal to the recent average of 0.9, then using itsrevenues of $325 million, the total market value of Wagner

will be ($325 million)(0.9) = $292.5 million, or ($292.5/20)= $14.63/share


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Pricing the Deal and Managing RiskFirm Commitment IPO: the underwriter

guarantees that it will sell all of the stock at theoffer price

Over-allotment allocation, or Greenshoeprovision: allows the underwriter to issue morestock, amounting to 15% of the original offersize, at the IPO offer price


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Other IPO TypesBest-Efforts Basis: the underwriter does not

guarantee that the stock will be sold, butinstead tries to sell the stock for the bestpossible price

Auction IPO: The company or its investmentbankers auction off the shares, allowing themarket to determine the price of the stock


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Table 14.3 Bids Received to PurchaseShares in a Hypothetical Auction IPO


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Figure 14.4 Aggregating the Shares Soughtin the Hypothetical Auction IPO


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Example 14.3Auction IPO Pricing

Problem: Fleming Educational Software, Inc., is selling 500,000

shares of stock in an auction IPO. At the end of the biddingperiod, Flemings investment bank has received the

following bids:

What will the offer price of the shares be?


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Solution:

Plan: First, we must compute the total number of shares

demanded at or above any given price. Then, we pick thelowest price that will allow us to sell the full issue (500,000shares).


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Execute: Convert the table of bids into a table of cumulative demand:


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Execute (cont'd): For example, the company has received bids for a

total of 125,000 shares at $7.75 per share orhigher (25,000 + 100,000 = 125,000).

Fleming is offering a total of 500,000 shares. Thewinning auction price would be $7.00 per share,because investors have placed orders for a totalof 500,000 shares at a price of $7.00 or higher.All investors who placed bids of at least this pricewill be able to buy the stock for $7.00 per share,even if their initial bid was higher.


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Execute (cont'd): In this example, the cumulative demand at the winning

price exactly equals the supply. If total demand at this pricewere greater than supply, all auction participants who bid

prices higher than the winning price would receive their fullbid (at the winning price). Shares would be awarded on apro rata basis to bidders who bid exactly the winning price.


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Evaluate: While the auction IPO does not provide the certainty of the

firm commitment, it has the advantage of using the marketto determine the offer price. It also reduces the

underwriters role, and consequently, fees.


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Table 14.4Summary of IPO Methods


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14.3 IPO Puzzles

Four IPO puzzles:Underpricing of IPOsHot and Cold IPO marketsHigh underwriting costsPoor long-run performance of IPOs


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14.3 IPO Puzzles

Underpriced IPOsOn average, between 1960 and 2003, the price

in the U.S. aftermarket was 18.3% higher atthe end of the first day of trading

Who wins and who loses because of underpricing?


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14.3 IPO Puzzles

Hot and Cold IPO MarketsIt appears that the number of IPOs is not solely

driven by the demand for capital.

Sometimes firms and investors seem to favorIPOs; at other times firms appear to rely onalternative sources of capital


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Figure 14.6 Cyclicality of Initial PublicOfferings in the United States, (1980-2009)


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14.3 IPO Puzzles

High Cost of Issuing an IPOIn the U.S., the discount below the issue price

at which the underwriter purchases the sharesfrom the issuing firm is 7% of the issue price.

This fee is large, especially considering theadditional cost to the firm associated withunderpricing.


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14.3 IPO Puzzles

Poor Post-IPO Long-Run StockPerformance

Newly listed firms appear to perform relativelypoorly over the following three to five yearsafter their IPOs

That underperformance might not result fromthe issue of equity itself, but rather from theconditions that motivated the equity issuance

in the first place


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14.4 Raising Additional Capital:The Seasoned Equity Offering

A firms need for outside capital rarelyends at the IPO

Seasoned Equity Offering (SEO): firms returnto the equity markets and offer new shares forsale


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14.4 Raising Additional Capital:The Seasoned Equity Offering

SEO ProcessWhen a firm issues stock using an SEO, it

follows many of the same steps as for an IPO.

Main difference is that the price-setting processis not necessary.

Two kinds of seasoned equity offerings:Cash offerRights offer


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Example 14.4 Raising Moneywith Rights Offers

Problem: You are the CFO of a company that has a market

capitalization of $1 billion. The firm has 100 million sharesoutstanding, so the shares are trading at $10 per share. You

need to raise $200 million and have announced a rightsissue. Each existing shareholder is sent one right for everyshare he or she owns.


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Problem (cont'd): You have not decided how many rights you will require to

purchase a share of new stock. You will require either fourrights to purchase one share at a price of $8 per share, or

five rights to purchase two new shares at a price of $5 pershare. Which approach will raise more money?


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Solution:

Plan: In order to know how much money will be raised, we need

to compute how many total shares would be purchased if

everyone exercises their rights. Then we can multiply it bythe price per share to calculate the total amount raised.

l i i


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Execute: There are 100 million shares, each with one right attached.

In the first case, 4 rights will be needed to purchase a newshare, so 100 million / 4 = 25 million new shares will be

purchased. At a price of $8 per share, that would raise $8 x25 million = $200 million.

l i i


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Execute (contd): In the second case, for every 5 rights, 2 new shares can be

purchased, so there will be 2 x (100 million / 5) = 40 millionnew shares. At a price of $5 per share, that would also raise

$200 million. If all shareholders exercise their rights, bothapproaches will raise the same amount of money.

E l 14 4 R i i M


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Evaluate: In both cases, the value of the firm after the issue

is $1.2 billion. In the first case, there are 125million shares outstanding after the issue, so theprice per share after the issue is $1.2 billion / 125million = $9.60. This price exceeds the issue priceof $8, so the shareholders will exercise theirrights. Because exercising will yield a profit of

($9.60 $8.00)/4 = $0.40 per right, the totalvalue per share to each shareholder is $9.60 +0.40 = $10.00.

E l 14 4 R i i M


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Evaluate (cont'd): In the second case, the number of shares outstanding will

grow to 140 million, resulting in a post-issue stock price of$1.2 billion / 140 million shares = $8.57 per share (also

higher than the issue price). Again, the shareholders willexercise their rights, and receive a total value per share of$8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both casesthe same amount of money is raised and shareholders areequally well off.


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Debt Financing(Chapter 15)


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Chapter Outline

15.1 Corporate Debt 15.2 Bond Covenants 15.3 Repayment Provisions


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15.1 Corporate Debt

Private DebtBank Loans

Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit

Private Placements


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15.1 Corporate Debt

Public DebtThe Prospectus

Indenture A formal contract between a bond issuer and a trust

company, which represents the bondholders interests Original Issue Discount (OID) Bond

A coupon bond issued at a discount


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Figure 15.1 FrontCover of the Offering

Memorandum for theHertz Junk Bond Issue


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15.1 Corporate Debt

Public DebtUnsecured Corporate Debt

Notes Debentures

Secured Corporate Debt Mortgage Bonds Asset-Backed Bonds


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15.1 Corporate Debt

Public DebtSeniority

A bondholders priority, in the event of a default, inclaiming assets not already securing other debt

Subordinated Debenture A debenture issue that has a lower priority claim to the

firms assets than other outstanding debt

Tranches Different classes of securities that comprise a single

bond issuance


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Table 15.2 Hertzs December2005 Junk Bond Issues


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15.1 Corporate Debt

Public DebtInternational Bonds

Domestic Bonds Issued by a local entity and traded in a local market,

but purchased by foreigners Denominated in the local currency

Foreign Bonds Issued by a foreign company in a local market and are

intended for local investors

Denominated in the local currency


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15.1 Corporate Debt


Foreign Bonds Yankee bonds

Foreign bonds issued in the United States Eurobonds

International bonds that are not denominated in thelocal currency of the country in which they are issued


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15.1 Corporate Debt


Global Bonds Combines the features of domestic, foreign, and

Eurobonds, and are offered for sale in several differentmarkets simultaneously

Can be offered for sale in the same currency as thecountry of issuance

bl f b


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Table 15.3 Summary of New DebtIssued as Part of the Hertz LBO


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15.2 Bond Covenants

CovenantsRestrictive clauses in a bond contract that limit

the issuer from taking actions that mayundercut its ability to repay the bonds

Advantages of CovenantsWith more covenants, a firm firms can reduce

its costs of borrowing.

The reduction in the firms borrowing cost can morethan outweigh the cost of the loss of flexibilityassociated with covenants


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15.3 Repayment Provisions

Call ProvisionsCallable Bond

Call Date Call Price Call Premium

Table 15 5 Call Features of


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Table 15.5 Call Features ofHertzs Bonds


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Call Provisions Call Provisions and Bond Prices

Investors will pay less for a callable bond than for anotherwise identical noncallable bond

A firm raising capital by issuing callable bonds insteadof non-callable bonds will either have to pay a highercoupon rate or accept lower proceeds


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Call Provisions Yield to Call

The yield of a callable bond calculated under theassumption that the bond will be called on the earliestcall date

Yield to Worst Quoted by bond traders as the lower of the yield to call

or yield to maturity


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Table 15.6 Bond Calls and Yields

Example 15 1


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Example 15.1Calculating the Yield to Call

Problem: IBM has just issued a callable (at par) five-year, 8% coupon

bond with annual coupon payments. The bond can be calledat par in one year or anytime thereafter on a couponpayment date. It has a price of $103 per $100 face value,implying a yield to maturity of 7.26%. What is the bondsyield to call?

Example 15 1


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Solution:

Plan: The timeline of the promised payments for this bond (if it is

not called) is:

Example 15 1


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Solution:

Plan: (contd) If IBM calls the bond at the first available opportunity, it will

call the bond at year 1. At that time, it will have to pay the

coupon payment for year 1 ($8 per $100 of face value) andthe face value ($100). The timeline of the payments if thebond is called at the first available opportunity (at year 1)is:

Example 15 1


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Solution:

Plan: (contd) To solve the YTC, we use these cash flows, set the price

equal to the bonds current price and solve for the discount

rate.

Example 15.1


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Execute: For the YTC, setting the present value of these payments

equal to the current price gives:

Given: 1 -103 8 100

Solve for: 4.85

Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)

108

103 Solving for the yield to call gives:(1 YTC)

108YTC = 1 4.85%

103

=+

! =

Example 15.1


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Evaluate: The YTM is higher than the YTC because it assumes that you

will continue receiving your coupon payments for 5 years,even though interest rates have dropped below 8%. Whileunder the YTC assumptions, you are repaid the face valuesooner, you are deprived of the extra 4 years of couponpayments, so your total return is lower.

3 i i


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Sinking FundA company makes regular payments into a

fund administered by a trustee over the life ofthe bond.

These payments are then used to repurchasebonds, usually at par.

Balloon Payment

A large payment that must be made on thematurity date of a bond when the sinking fundpayments are not sufficient to retire the entirebond issue.

15 3 R P i i


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Convertible ProvisionsConvertible BondsConversion Ratio

15 3 R t P i i


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Convertible ProvisionsConvertible Bond Pricing

Consider a convertible bond with a $1000 face valueand a conversion ratio of 20

If you converted the bond into stock on its maturitydate, you would receive 20 shares

If you did not convert, you would receive $1000 Conversion Price

By converting the bond you essentially paid $1000 for20 shares, implying a conversion price per share of$1,000/20 = $50.

15 3 R t P i i


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Convertible ProvisionsConvertible Bond Pricing

Straight (Plain-Vanilla) Bond A non-callable, non-convertible bond

Convertible Bonds and Stock Prices When a firms stock price is much higher than the

conversion price, conversion is very likely and theconvertible bonds price is close to the price of theconverted shares

Figure 15.2


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Figure 15.2Convertible Bond Value

15 3 R t P i i


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Convertible ProvisionsCombining Features

Companies have flexibility in setting the features of thebonds they issue

Leveraged Buyout (LBO) When a group of private investors purchases all the

equity of a public corporation and finances thepurchase primarily with debt.

Table 15.7 RealNetworks 2003


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Table 15.7 RealNetworks 2003Convertible Debt Issue

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