Raising capital: equity Flashcards
What is Pecking Order Perspective and why?
• Most public firms tend to finance their projects first with
retained earnings, then with debt, and only finally with
equity (as a last resort)
• Why? “Information Asymmetry”
Suppose that managers have more information about the firm
than outside investors
→ Managers prefer to issue equity when equity is overvalued
→ Equity issues signal to investors that equity is overvalued
→ Stock price declines at equity issue announcement
→ Managers avoid issuing equity
e.gStock price reaction to issues: straight debt (little or no
effect), convertible debt (-2%), equity (-3%)
What are the Different Options to Raise Equity?
- For unlisted firms
1. Private Equity Financing
• “Angel” Finance
• Venture Capital
2. Initial Public Offering (IPO)
• Listing shares first time - For listed firms
1. Private placement
• To small group of investors
2. Rights issue
• To existing shareholders
3. Dividend reinvestment plan
• To existing shareholders (offered
to reinvest dividend to apply for
new shares
For private equity
- “Angel” Finance
• Informal market for direct equity finance provided by a small
number of high net worth individuals - Venture Capital
• A venture capitalist is an active financial intermediary, providing financing to early-stage and high-potential start-up companies mainly in high tech industries
• It organizes and manages funds mostly raised from investors (such as pension funds and endowments/foundations) typically for about 5-7 years
• Typically staged financing; significant control over company decisions - Successful exit strategies – trade sale or IPO
For public equity
firms with larger needs for capital
- Initial Public Offering (IPOs)
- Seasoned Equity Offerings (SEOs)
Definition: The sale of shares in an already publicly traded company
Alternate SEO types: private placements, rights issues, DRPs
Advantages of going public
• Access to additional capital • Allow venture capitalists to cash out • Current stockholders can diversify • Liquidity is increased (shares can be rapidly sold with little impact on the stock price) • Going public establishes firm value • Makes it more feasible to use stock as employee incentives • Increases customer recognition
Disadvantages of going public
• IPO creates substantial fees
– Legal, accounting, investment banking fees are often
10% of funds raised in the offering
• Greater degree of disclosure and scrutiny
• Dilution of control of existing owners
• Special “deals” to insiders will be more difficult to undertake
• Managing investor relations is time-consuming
Typical Procedure for an IPO
• Step1. Appointment of an underwriter
• Step2. Undertakes the due diligence process and prepare the preliminary初步 prospectus
• Step3. Institutional marketing program commences
(including IPO road shows)
• Step 4. Exposure period: lodge the final prospectus with
the Australian Securities and Investment Commission
(ASIC) and lodge listing application with ASX
• Step 5. Marketing and offer period
• Step 6. Offer closes, shares allocated, trading commences
Underwriter
DfInvestment banks that act as intermediaries between a
company selling securities and the investing public
• roles include formulating the method used to issue and marketing the securities& pricing and selling the new securities
• Firm commitment contract vs. Best efforts contract
• Sometimes, underwriters form an underwriting group
(syndicate)
Valuing IPOs (preliminary valuation)
Since the firm is going public, no established price
• Two common valuation methods
- Discounted cash flow (DCF) analysis
- Comparable firms analysis
• On the basis of all relevant factors, the investment banker would specify a range (e.g., $28-$35 in the case of Facebook) in the preliminary prospectus
Valuing IPOs – Procedures
- Fixed Pricing – traditional method (common in Australia)
• Price is set, prospectus sent out and offers are received
• Subject to market movement - high risk of under-subscription - Book-building – most IPOs in the US
• Underwriters ask institutional investors to indicate quantities they would purchase at what price, and records this in a “book”
• Lower under-subscription risk (reducing price uncertainty), but significant costs & possible investment banking conflicts - Open auction (a Dutch auction)
• Investors are invited to submit their bids, and the securities are then sold to successful bidders (e.g., Google’s IPO in 2004)
Costs of IPOs – Direct Costs
• Underwriters receive payment in the form of a spread (the difference between the underwriters’ buying price and the offering price), usually 7%
• Direct administrative costs to management, lawyers,
accountants& fees for registering the new
securities, etc. can be over 1% of the proceeds
Costs of IPOs – Indirect Costs
Underpricing
• Issuing securities at an offering price set below the actual market value of the security
- underpricing%= (first day closing price- offer price)/OP
• e.g., LinkedIn’s IPO offer price = $45, but its first-day
closing = $94.25, which is about 110% first-day return
• The average underpricing among nearly 12,000 U.S. IPOs from 1960 to 2008 = 16.9%
• The economic consequence of underpricing is significant for the original owners of the firm:
Money left on the table = (First-day closing price - Offer
price) x Number of shares which is the money issuing firm missed because of underpricng
Explanation of underpricing
- Winner’s curse (information asymmetry)
• underpriced shares are more likely to be bought by informed investors which leaves the uninformed investors negative expected return. In order to encourage uninformed investors into IPO market, price are usually underpriced.
• Evidence: more information freely available about the issuer → less underpricing - Investment Banking Conflicts
• Investment banks arrange for underpricing as a way to benefit themselves and their other clients(know the fact of underpricing and make profit)
• Evidence for: Higher IPO commissions or higher underwriter’s stake in the IPO → less underpricing
• Evidence against: Investment banks also underprice themselves when listing - Litigation Insurance
• If investors can gain from underpriced shares, issuer and underwriter are less likely to be sued for material misstatements and omissions made in connection with the IPO
• Evidence against: underpricing happens even in other countries with laxer regulatory schemes - Signaling
•Investors who benefit from underpricing will be more likely to participate on the next share issuing. (signal of good quality shares)
• Easier to subsequently raise funds at higher prices
Reason for long- run underperformance
“Clientele effects”
• Only optimistic investors buy into an IPO, but their optimism will disappear as more information about the firm is released
“Window of opportunity”
• Management times the issue (taking advantage of high demand for
IPOs by the market – hot markets)
• A decline in demand for IPOs (cold markets) after hot markets
are generally correlated with a reduction in equity prices after IPOs
What are the alternative types of SEOs?
- 2rights issues and DRP(existing shareholders)
3. placement(financial institutions)
