4. Financing Decisions and the Enterprise Value

Question 1

I. Refer the main points regarding Equity Financing Instruments.

Answer 1

A set of fundamental rights is associated with it (pro rata- the share of capital detained):
- Ownership: a (residual) claim/rights over cash-flows and assets
- Management and control rights, (voting right, and control over the cash-flows generated by the company)
- Right to dividends
- Preference rights in future stock issues (A right to buy a number of shares to keep the proportion I had before the company issued new stocks).

Question 2

I. How can shares be classified?

Answer 2

1. Ordinary or Common Shares
2. Special Shares (privileged)
3. Preferred Stock

Question 3

I. Explain what are ordinary or common shares.

Answer 3

In Ordinary/Common shares, the voting rights are proportional to cash-flow claiming rights, one share represents one right of voting.

Therefore, shareholders are not given any preference in dividend distribution or in asset allocation, in case of bankruptcy, but detain control rights by appointing managers.

Question 4

I. Explain what are special shares.

Answer 4

Special Shares (privileged) are shares offering non-proportional voting rights with respect to cash-flows (state owned golden shares)

Note: They may have the exclusive right to decide upon certain matters like choosing the manager.

Question 5

I. Explain what are Preferred stocks.

Answer 5

In Preferred stocks:
- Dividend right may be cumulative or convertible into ordinary shares;
- No voting right (or with voting rights with a lesser proportion than cash-flow claiming rights)
- There are usually higher (non-proportional) dividend payments, and higher claim to assets in the event of liquidation.

Question 6

I. Name other equity instruments.

Answer 6

1. Warrants
2. Trading stocks
3. Contingent Value Rights (CVR)

Question 7

I. Describe what are warrants.

Answer 7

Warrants are call options over company shares, it is a way to generate equity by selling options over the shares of a company.

• Only the company can sell the warrant.
• When a warrant is exercised the number of shares will increase, and that will decrease the price of the shares.

Question 8

I. Describe what are tracking stocks.

Answer 8

In tracking stocks:
- Dividends are a function of earnings of one (or more) specific investment.

This allows investors to “buy” only that part of the company, making it appropriate for big corporations.

Ex: H owns 100% shares of A&B. The dividends of H will be based only on the performance of company B.

Question 9

I. Describe what are Contingent Value Rights (CVR)

Answer 9

A CVR is a derivative whose value is based on some future event.

Question 10

II. What are the main sources of equity financing?

Answer 10

1. Retained earnings
2. Four(4) F’s
3. Equity Crowdfunding
4. Venture Capital (and Private Equity - PE)
5. Initial Public Offering (IPO)
6. Seasoned Equity Offering (SEO)

Question 11

II. Point the main elements about Retained Earnings.

Answer 11

Retained earnings (non distribution of dividends) is an alternative source of
financing.

Reasons to use this source:
- Financing of new investment projects;
- Existence of market frictions: taxes and transaction costs;
- Share placement risks;
- Capital dilution;
- Lower cost of capital.

Question 12

II. Describe some problems regarding retained earnings.

Answer 12

It is a factor of aggravated risks/costs of agency, in a company with a relevant separation between ownership and control (with consequent information asymmetry).

Note: the cost of retained earnings is usually lower than the cost of new share capital

Question 13

II. The four (4) F’s are for…

Answer 13

Founder, Family, Friends and Fools

Question 14

III. In what consists Equity Crowdfunding?

Answer 14

• Consists in selling shares to a crowd
• In return the crowd receives the possibility of owning money with an increase of share prices
• Platforms of crowdfunding: Crowdcube, Seedrs, Syndicate Room, Venture Founders and Crowdbank
• Other types of crowdfunding: Donation, Reward and Lending based (peer-to-peer lending)

Question 15

III. What is an Initial Public Offering-IPO ?

Answer 15

IPO’s happen when the company shares are sold for the first time to the public, in the capital markets.
It can involve:
- Issuing new shares
- Issuing existing shares held by present shareholders.

Note: Only the issue of new shares will be resulting in an increase in share capital (equity).

Question 16

II. What happens after the IPO?

Answer 16

After the IPO, all shares may
be traded in the secondary market.

However, since the proportion of shares that shareholders keep on an IPO is representative of their trust on the company
usually they usually sell no more than 25%.

Note: Sometimes, they agree not to sell their shares during a specific period of time after the IPO, so that it doesn’t have a negative impact on share price.

Question 17

II. Name the several phases of an IPO.

Answer 17

1. Find the support of an investment bank.
   - In this case reputation works as a guarantee regarding the quality of the offer (if an IPO goes wrong, investment banks’ reputation may be injured).
2. Company valuation, price determination, nº of shares to sell and method of
   sale
   - 3 Methods of sale: Fixed price (shares are distributed pro-rata of shared demanded), Bookbuilding (Only the minimum and maximum prices of the offer are
   established), Auction (the final price is the highest possible given by investors).
3. Register of preliminary prospect of the offer through the regulator (CMVM-portugal)
4. Roadshow- the company and the manager present the operation to investors, to stimulate their interest in buying shares.
5. Final registration and definition of the offering price.
   - to determine the price is a very difficult task because there is no historical data.
   Problems: Overpricing (disappointment of new investors), underpricing (Opportunity costs for existing shareholders).
6. Distribution of shares.
   - Fixed price: shares are distributed pro-rata of shared demanded.
   - Bookbuilding: shares are distributed by the lead manager.
   - Auction: share distribution is not a problem.
7. Start of trading.
   - Usually, shareholders accept not to sell the shares detained before the IPO and not included in the offer, during a period of 6 months to one year (lockup period).
8. The day after.

Question 18

II. Point 5 advantages and 5 disadvantages of market listing.

Answer 18

Advantages of IPO’S:
- Access to alternative sources of financing
- Risk diversification
- Allows changes in ownership structure
- Independent and objective valuation of the company by the market
- Induces the company to adopt better corporate governance practices

Disadvantages of IPO’s:
- Greenshoe: agreement that grants the underwriter the right to sell more shares than originally planned, it’s an option given to the lead manager to increase the number of shares offered (if market share price after an IPO is higher than offering price)
- Agency costs
- Underpricing
- Issuing costs
- Loss of control

Question 19

II. Explain the Underpricing problem of IPO’S.

Answer 19

Underpricing is the Opportunity cost resulting from a first day closing market price higher than offering price.
- Underpricing makes shareholders “leave too much money on the table” with an IPO
- There is no single explanation for this problem, it is persistent and costly for shareholders

Question 20

II. Name some explanations for underpricing.

Answer 20

Possible explanations for underpricing

• Winner’s curse: Underpricing arises from a need to ensure small (not informed) investors do not
  abandon the IPO market (because they are unable to distinguish good from bad IPOs)
• Signalling: Good companies are prepared to incur in a high cost by defining an offering price below actual share value, to open the door to more
  favorable future offers
• Cascade Effect : Investors tend to invest in securities with a great demand;
  so the decision for a price below actual share value will attract significant buying
  orders
• Compensate investors for information costs
• Looking for a greater ownership dispersion
• Motivate the lead manager to act in the interest of the company.

Question 21

II. Explain what is a Seasoned Equity Offering (SEO).

Answer 21

A seasoned equity offering (SEO) occurs when new shares are issued by listed companies.

Question 22

II. SEO may take 3 forms, explain them.

Answer 22

SEO 3 forms

• General Cash Offers: New shares are offered to the general public, for a price very close to present market price
• Private Placement: Shares are sold directly to one or a small number of investors, and the terms of the offer are negotiated between the parties
• Rights Offerings: Present shareholders have preference (call option) in buying the new shares, pro-rata of shares held, and shareholders can either exercise or trade the option

Question 23

II. Describe General Cash Offers.

Answer 23

In General Cash Offers shares are offered on a lead manager firm commitment or best effort basis.
- There is a reference price, so usually the value of the SEO is 3% lower than the market price.
- If P>V: it benefits present shareholders
- If P<V: it benefits new shareholders

Question 24

II. Describe Private Placement.

Answer 24

Advantages:
-Lower intermediation costs and issuing costs
- Terms of offer may change to comply with requirements of investors

Disadvantages:
- Smaller number of potential but relevant investors, who may want to influence
management

Question 25

II. Describe Rights Offerings.

Answer 25

A call option is granted to present shareholders, pro-rata of shares already held.
- Investors can either exercise or trade the option
- By exercising, they keep their relative position in ownership structure
- Due to the call option, if
P<V it does not
go against shareholders’ interests

Question 26

III. Identify the main cost of capital models.

Answer 26

Main models to assess cost of capital:
- CAPM
- CAPM + Dimension
- Fama & French three factors model
- Carhart´s 4 factors model
- Ross´s arbritrage pricing theory (APT)
- Cost of new external equity (increase of share capital)