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