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Topics Covered

The Initial Public Offering

The Underwriters

Underpricing and The Winners Curse

General Cash Offers

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Initial Public Offering

Initial Public Offering (IPO)- First offering of stock

to the general public.

Two kinds of public offerings:

Primary offeringnew shares are sold to raise cash for the

company

Secondary offeringexisting shares (owned by VCs or firmfounders) are sold, no new cash goes to company

A single offering may include both of these

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Initial Public Offering

Some benefits/motivations:

- Additional source of capital

- Increase debt capacity (give breathing room for debt)- Stock prices give measure of performance

- Allows managers to be compensated with options, or have

incentives otherwise directly tied to shareholder value

- Potentially more information about firm (analyst following),

makes borrowing cheaper

- ?

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Initial Public Offering

Arranging an IPO: First steps

Select Underwriter

- provides procedural, financial advice

- ultimately buys issue from company (at issue price)- ultimately sells it to public (at offer price)

Prepare Registration Statementfor approval of SEC (inaccord with Securities Act of 1933). Formal summary that

provides information on an issue of securities.

Prepare ProspectusStreamlined version of registrationstatement, for consideration by potential investors

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Initial Public Offering

Arranging an IPO: Trying to set price

Road showTalks organized to introduce company to

potential investors, before the IPO.

BookbuildingUnderwriter builds book full of

indications of interest (quantity, price at which

investors may be willing to buy). List of likelyorders. Useful to set offer price.

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Initial Public Offering

Arranging an IPO: Selling the shares

Best efforts offering: IPO method in which underwriter

promises to sell as much as possible, give best effort,

not commit to selling all of issue. Or

Firm commitment offering: Method in which

underwriter buys the whole issue, bears all risk.

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Initial Public Offering

Arranging an IPO: Selling the shares

Syndicate: Group of underwriters formed to sell a

particular issue

Spread- Difference between public offer price and

price paid by underwriter (issue price). Biggest part

of underwriter compensation.

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Top Underwriters

1,293ersUnderwritAll

33Chase

46JenretteLufkinDonaldson

58StearnsBear68tonFirst BosSuisseCredit

104MorganJP

121BrothersLehman

137SachsGoldman140StanleyMorgan

167BarneySmithSaloman

$208LynchMerrill

issues)totalof($bil

1997inrsUnderwriteU.S.Top

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Top Underwriters

496ersUnderwritAll

18Paribas

18BrothersLehman

22HoareAMROABN23StanleyMorgan

24MorganJP

27tonFirst BosSuisseCredit

29MorganDeutsche29WarburgSBC

32SachsGoldman

$37LynchMerrill

i ssues)totalof($bil

1997inrsUnderwriteInt l .Top

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Tombstone

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IPO Costs

Average costs on U.S. IPOs between 1990-1994

05.2312.0511.00IssuesAll

25.137.535.72upand500

23.125.706.53499.99-20022.147.167.06199.99-100

82.168.917.9199.99-80

51.1911.318.279.99-60

37.2213.658.7259.99-40

18.2212.489.739.99-20

28.219.6511.6319.99-10

32.3316.3616.969.99-2

(%)Costs

Total

(%)Return

First DayAvg

(%)Costs

Direct

($mil)

IssuesofValue

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IPO Costs

Why is there underpricing? Several arguments.

- Best one: Winners curse

Suppose you apply for every IPO. You will have noproblem getting lots of shares in the bad firms (the ones no

one wants), but when the issue is attractive, there will not

be enough to go around, and you will receive less than you

wanted of the good firms. (This is the winners curse if

you win an auction, you are likely to have paid too much!)

So you would lose on average. You therefore need IPOs to

be underpriced on average, or else you will not play the

game.

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Public issues after the IPO

Seasoned Offering(SEO)An equity issue by a firm after its IPO

General Cash Offer Sale of securities open to all investors by an already public company.

Used for virtually all U.S. equity and debt issues

Same procedure as IPO: register with SEC, sell issue to underwriter, whosells issue to public

Shelf Registration- A procedure (created by SEC Rule 415 thatallows firms to file one registration statement for several issues of

the same security. Covers financing plans up to 2 years ahead

Speeds up issue process; dont have to issue all at once

Usually used for relatively garden variety issues, not complex issueswhere underwriters stamp of approval may have value

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Public issues after the IPO: Costs

Direct costs (spread + administrative costs) of issues after the IPO:

$2M < Issue size < $9.9M

IPOs: 17%, SEOs: 13%, Convertible debt: 8%, Bonds: 5%

$40M < Issue size < $59.9M

IPOs: 8%, SEOs: 6%, Convertible debt: 4%, Bonds: 2%

$500M < Issue size < $+++IPOs: 6%, SEOs: 3%, Convertible debt: 2%, Bonds: 1%

(Notice economies of scale)

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Public issues after the IPO: CostsGross underwriter spreads of selected issues, 1998

Issue amount, Underwr i ter ' s

Type Company mil l ions of dollars spread, percent

IPO Hypertension Diagnostics, Inc. 9.3 8.49

IPO Actuate Software Corp. 33.0 7.00

IPO Enterprise Product Partners 264.0 6.36

IPO EquantNY 282.2 5.25

IPO Conoco 4403.5 3.99

SEO Coulter Pharmaceuticals 60.0 5.48

SEO Stillwater Mining 61.5 5.00

SEO Metronet Commuications Corp. 232.6 5.00

SEO Staples, Inc. 446.6 3.25

SEO Safeway, Inc. 1125.0 2.75

SEO Media One Group 1511.3 2.74

Debt:

2-year notes General Motors Acceptance Corp. 100 0.18

30-year debentures Bausch & Lornb, Inc. 200 0.88

6-year notes Ararnark Corp. 300 0.63

15-year subordinated notes B anque Paribas 400 0.75

Convertible zero-coupon Aspect Telecommunications 490 3.00

bonds

10-year notes Federal Home Loan Mortgage Corp. 1500 0.15

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Private Placements

Dont require registration with SEC

Therefore less costly

Usually restricted to dozen or less knowledgeable

investors Investors cannot easily resell security

Rule 144A: SEC rule relaxing restrictions on who

can buy and trade unregistered securities. Allows

qualified institutional buyers to trade among

themselves.

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The Dividend Controversy

Principles of Corporate Finance

Brealey and Myers Sixth Edition

Slides by

Matthew Will,

Jeffrey Wurgler

Chapter

16.1-16.4The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

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Topics Covered

What Do We Mean by Dividend Policy?

How Dividends Are Paid

How Do Companies Decide on Dividend

Payments?

Dividend Policy is Irrelevant in MM world

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Types of Dividends

Cash Dividend Regular Cash Dividend

Special Cash Dividend

Cash Dividend- Payment of cash by the firm

to its shareholders.

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Types of Dividends

Stock split/Stock dividend Just increases # of shares, but assets, profits, and

total value are unaffected

So just reduces valueper share in proportion

Stock Dividend- Payment of shares by thefirm to its shareholders.

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Dividend payment process

Cum Dividendwith dividend sharewhose buyer is eligible to receive declared

dividend

Ex Dividendshare whose buyer is not

eligible to receive declared dividend

Record Date- Person who owns stock on thisdate will receive the dividend.

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Types of Dividends

Stock Repurchase3 ways Buy shares on the market

Tender offer

Private negotiation (Greenmail)

Tax on repurchase: only capital gainTax on cash dividend: as ordinary income

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Stock Repurchase Volume

0

20

40

60

80

100

120

140

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

$Billions

U.S. Stock Repurchases 1985-1997

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The Dividend Decision: Lintner

1. Firms have long-run target dividend payout ratios.

2. Managers focus more on dividend changes than on

absolute levels.

3. Dividends changes follow shifts in long-run,

sustainable earnings.

4. Managers are particularly reluctant to make dividendchanges that might have to be reversed.

Lintners Stylized Facts

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The Dividend Decision: Lintner

Dividend targets vary from firm to firm:

Dividend change equals:

1

1

EPSratiotarget

dividendtargetDIV

01

01

DIV-EPSratiotarget

changetargetDIV-DIV

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The Dividend Decision: Lintner

Managers (say Lintner) smooth dividends Even if earnings are high now, may be low later, so if

want to avoid having to reverse dividend later, only wantto move partway to target payment.

Final Lintner model:

0 < Adjustment rate < 1

Model seems to work pretty well in the data

01

01

DIV-EPSratiotargetrateadjustment

changetargetrateadjustmentDIV-DIV

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M&M Dividend irrelevance

Modigliani & Miller dividend proposition

Dividend policy is irrelevant in perfect capital

markets

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M&M Dividend irrelevance

Interpretations

If companys investment policy is fixed, its NPV is fixed.The pattern of dividend payments doesnt affect NPV

In perfect capital market, investors dont care how they gettheir money, so long as they get it. They can get it through

stock price changes or dividends Since investors do not need dividends to convert shares to

cash, they will not pay higher prices for firms with higherdividend payouts.

You cannot help or hurt your stockholders by changingdividends

Repurchases have exactlysame effect as dividends. Flow offunds identity says if you cancel dividend, you have to buyshares. If you increase dividend, have to sell shares.

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M&M Dividend irrelevance

Some key assumptions:

Investment policy held constant

No transaction costs (e.g. repurchasing premium forcompany, cost of mailing dividend checks)

Dividends and capital gains taxed at same rate

If you claim dividends domatter, one or more ofthese assumptions must be violated. Thatis the

power of the theorem: it clarifies how dividendscouldmatter.

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M&M Dividend irrelevance

Example- Assume Rational Demiconductor has $1,000 cash, and had

earmarked $1,000 for investment, but learns project is a loser (NPV

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Does Debt Policy Matter?

Principles of Corporate Finance

Brealey and Myers Sixth Edition

Slides by

Matthew Will,

Jeffrey Wurgler

Chapter 17

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Topics Covered

Leverage is Irrelevant in MM World

How Leverage Affects Returns and Risk in

MM World

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M&M Debt Policy Proposition I

Modigliani & Miller debt policy proposition:

The market value of a company is independent of its

capital structure.

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M&M Debt Policy Irrelevance

Some key assumptions:No taxes

Investment policy fixed

Bankruptcy is not costlyEfficient capital markets, no transaction costs

Symmetric information

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M&M Debt Policy Irrelevance

The proof:

Imagine two firms, firm U is unlevered (all

equity) and firm L is levered. Have same profits.

So VU= EU and VL= EL + DL

Which do you prefer to invest in?

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M&M Debt Policy Irrelevance

Suppose buy 1% of U:Dollar investment Dollar return

.01*VU .01*Profits

Or could buy 1% of Ls debt and equity:Dollar investment Dollar return

Debt .01*DL .01*Interest

Equity .01*EL .01*(ProfitsInterest)

Total .01*(DL

+EL

) .01*Profits

= .01*VL

Same dollar payoffs, must have same dollar cost: VU= VL

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M&M Debt Policy Irrelevance

Another way to see it Suppose buy 1% of Ls equity:

Dollar investment Dollar return

.01*EL .01*(Profits-Interest)

= .01*(VL- DL)

Or could borrow 1% of DLon own account, buy 1% ofUs equity:

Dollar investment Dollar return

Borrowing -.01*DL

-.01*Interest

Equity .01*VU .01*Profits

Total .01*(VU - DL ) .01*(Profits-Interest)

Same dollar payoffs, must have same dollar cost: VU= VL

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M&M Debt Policy Irrelevance

Some implications

Argument can be extended to full range of capital

structure choices, not just D/E ratio

Debt maturity structure (long-term vs. short-term) irrelevant

Secured/unsecured debt choice irrelevant

Convertible/nonconvertible debt irrelevant

Preferred/common stock irrelevant

Financial managers irrelevant? This course irrelevant?

Dont be discouraged, few of the assumptions hold in practice

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Example

Now

suppose

50% debt

50% equity

M&M Debt Policy Irrelevance

3020100%(%)sharesonReturn

321$0shareperEarnings

500,11,000500$0earningsEquity

500500500$500Interest000,21,5001,000$500IncomeOperating

CBA

Outcomes

5,000$DebtofueMarket val

5,000$EquityofValueMarket

$10shareperPrice

500sharesofNumber

Data

D

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Example- Macbeths - 100% Equity

- Debt replicated by investors

(say they borrow $10 and invest $20

in two unlevered Macbeth shares

same payoff as levered equity!)

3020100%(%)investmentnet$10onReturn

3.002.001.000$investmentonearningsNet

1.001.001.00$1.0010%@Interest:LESS

4.003.002.00$1.00sharestwoonEarnings

DCBA

M&M Debt Policy Irrelevance

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M&M Debt Policy Irrelevance

2015(%)shareperreturnExpected

1010($)shareperPrice

2.001.50($)shareperearningsExpectedEquity50%Debt,50%

:StructureProposed

Equity100%

:StructureCurrent

Macbeth continued

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M&M Debt Policy Irrelevance

securitiesallofuemarket val

incomeoperatingexpectedrassetsonreturnExpected A

EDA r

EDEr

EDDr

We know that

and also that

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M&M Debt Policy Proposition II

DAAE

rrE

Drr

Rearranging

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M&M Debt Policy Irrelevance

15.000,10

500,1

securitiesallofuemarket val

incomeoperatingexpected

rr AE

DAAE rrE

Drr

20%or20.

10.15.5000500015.

Er

Macbeth continued

Check Prop. II for Macbeth. For 100% equity firm

For 50% equity,

50% debt firm

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r

D

E

rD

rE

M&M Debt Policy Irrelevance

rA

Risk free debt Risky debt

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M&M Debt Policy Irrelevance

200(%)sharesonReturn

20($)shareperEarnings:equity50%

debt,%50155(%)sharesonReturn

1.50.50($)shareperEarnings:equity100%$1,500

Income

$500

Operating

Macbeth continued

Leverage increases the risk of Macbeth shares

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