Chapter 10.5 Flashcards
General Cash Offer by a Public Company
T of F: The need for funding ends when a company goes public
False
Why does the need for funding not end when a company goes public?
Most companies continually make new investments in real assets and working capital. If they don’t generate enough cash from operations to fund these investments, their managers must raise capital from outside the firm
Managers of every business want to fund the business at the _______ possible cost
Lowest
If a public firm is financially sound, what is the lowest-cost source of external funds?
Often a general cash offer, also referred to as a registered public offering
What is a general cash offer (also referred to as a registered public offering)?
A sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public
How are general cash offers similar to IPOs?
There are some similarities between their procedures
What are the 5 steps in the procedure of a general cash offer?
- Type of security and amount to be raised
- Approvals
- Registration statement
- Offer price
- Closing
What is the first step of the general cash offer procedure and what happens at this step?
Type of Security and Amount to Be Raised: Management decides how much money the firm needs to raise and what type of security to issue, such as debt, common stock, or preferred stock
What is the second step of the general cash offer procedure and what happens at this step?
Approvals: obtained from the board of directors to issue securities. If the size of a stock issue exceeds the previously authorized # of shares of common/preferred stock, approval from stockholders is required as well
What is the third step of the general cash offer procedure and what happens at this step?
Registration statement: issuer files a registration statement + satisfies all of the securities laws enforced by the SEC. For a debt issue, the registration statement must contain a bond indenture which specifies the details of the issue
What is the fourth step of the general cash offer procedure and what happens at this step?
Offer price: after assessing demand, the underwriter and the issuer agree on an offer price
What is the fifth step of the general cash offer procedure and what happens at this step?
Closing: At closing of firm-commitment offering, issuer delivers the securities to the underwriter, and the underwriter pays for them, net of its fees. The securities are then sold to investors
What impacts does the issuer having flexibility in the method of sale and the way the securities are registered have?
Both of these factors can affect the issuer’s funding cost
In a general cash offer, between what 2 basis’ does management have to decide to sell the securities on?
Either on a
1. Competitive basis
OR
2. Negotiated basis
What happens when management decides on a competitive sale?
The issuer specifies the type and number of securities it wants to sell and hires an investment banking firm to do the origination work
What happens once the origination work is completed in a competitive sale?
The issuer invites underwriters to bid competitively to buy the issue.
What happens in the bid that follows a competitive sale?
The investment banking firm that offers the highest price for the securities wins the bid. The winning underwriter then pays for the securities and makes them available to investors at the offer price
What happens when management decides on a negotiated sale?
- The issuer selects the underwriter at the beginning of the origination process.
- At that time, the scope of work is defined, and the issuer negotiates the origination and underwriter’s fees to be charged.
- The issuer and underwriter then work closely to design the issue and determine the most favourable time to take the securities to market
In a negotiated sale, after the most favourable time to take securities to market is determined, what happens?
An assessment of demand: price is set + underwriter pays the issuer for the securities and sells them to individual investors
Which method of sale (competitive or negotiated) results in the lower funding cost for the issuing firm?
This question has been hotly debated, and the results from empirical studies are mixed
What is the argument for competitive bidding resulting in a lower funding cost for the issuing firm?
Argument is straightforward: competition keeps everyone honest. The greater the number of bidders, the greater the competition for the security issue, and the lower the cost to the issuer
What is argued for negotiated sales resulting in higher funding costs for the issuing firm compared to competitive sales?
Negotiated sales lack competition and therefore should be the more costly method of sale
What do supporters of negotiated sales argue?
In negotiated sale, the investment bankers works closely with the issuer and thus has intimate knowledge of the firm and its problems. As a result, the investment banker is in a better position to reduce uncertainty surrounding the issue and tell the firm’s story to potential investors resulting in a lower issue costs
How do supporters of negotiated sales argue that negotiated sales involve potential competition?
The potential competitors= the other investment banks that weren’t chosen to underwrite the current issue but would like to underwrite the firm’s next issue. These investment bankers won’t hesitate to tell issuer’s CFO how much better they could’ve done than the underwriter that was chosen. Therefore threat of potential competition provides many of the same benefits as direct competition
In the end, what does the better method of sale depend on?
The complexity of the sale and the market conditions at the time of sale. Also depends on the type of securities being offered.
What type of sales do most experts believe are the less costly method for debt issues that are vanilla bonds ?
Competitive sales are the less costly method of selling so-called vanilla bonds when market conditions are stable
What are vanilla bonds?
Bonds with no unusual features. Their terms + conditions are standardized and well-known to market participants, and they lack complex features.
How are vanilla bond securities like commodities?
Because market participants understand the risks of investing in them and are comfortable buying them
When there are complex circumstances to explain or when market conditions are unstable what sales method prove the less costly method of sale for debt issues?
Negotiated sale allows the underwriter to better manage uncertainty and explain the firm’s situation which results in the lower funding cost
For equity securities, what type of sales generally provide the lowest-cost method of sale?
Negotiated sales
Why do negotiated sales generally provide the lowest-cost method of sale for equity securities?
Equity by nature tend to be complex, and for the same reasons as complex debt issues, complexities are better handled when sales are negotiated. Thus it’s no surprise that virtually all equity issues, including IPO, involve negotiated sales
What is shelf registration?
A type of SEC registration that allows firms to register to sell securities over a 2 year period and, during that time, take securities “off the shelf” and sell them as needed
Since Nov 1983, how many large corporations has the SEC given the option of using shelf registration and why?
2000 large corps, the preparation of an SEC registration is a costly undertaking
How are the costs associated with selling securities “off the shelf” reduced?
Because only a single registration statement is required. A shelf registration statement can cover multiple securities, and there isn’t a penalty if authorized securities aren’t issued
In addition to reducing costs, what 2 important benefits do corporations gain from shelf registration?
- The greater flexibility in bringing securities to market
- Allows firms to periodically sell small amounts of securities
How does shelf registration allow greater flexibility in bringing securities to market for corporations?
Securities can be taken off the shelf and sold within minutes. Thus, firms can sell their securities when market conditions are more favourable
How is shelf registration allowing firms to periodically sell small amounts of securities a benefit to corporations?
Sell small amounts of securities, raising money as it’s actually needed rather than banking a large amount of money from a single security sale and spending it over time
What is a common misconception about the cost of raising money through a general cash offer?
That it’s inexpensive—when in reality, despite being a wholesale market transaction, the costs can still be significant.
Between the total costs for common stock, preferred stock, and corporate bond, issuing which is the most and least costly?
Most: issuing common stock is the most costly alternative
Least: issuing corporate bonds (nonconvertible)
What is considered a large security issue?
$500 million and over
For large security issues ($500 million or more) how do the total issuance costs of common stock compare to corporate bonds?
Common stock costs about 3.63% of the amount raised, while corporate bonds cost only about 0.65%, making bonds significantly cheaper to issue at that scale.
Why is issuing equity more expensive than issuing debt?
Because equity issues involve greater underwriting risk, higher sales commissions, and more administrative expenses to bring the securities to market.
How do economies of scale affect the cost of issuing common stock?
Smaller equity issues (under $10 million) cost about 13.63% of the amount raised, while larger issues ($500 million and over) cost only 3.63%, showing significant economies of scale in underwriting spreads and out-of-pocket expenses.
T or F: the cost of an IPO is significantly higher than the cost of a general cash offer of equity
Yes, even when the cost of underpricing for the IPO isn’t included in the total
How do the total direct costs of a large ($500M+) equity IPO compare to a general cash offer of the same size, and why?
An IPO costs 5.51%, while a general cash offer costs 3.63%, due to the greater underwriting risk and higher distribution costs associated with IPOs.
