FM03 - Long Term Financing

FM 03 Corporate Finance
Part III: Long Term Financing

(Chapters 14 and 15)
Copyright 2012 Pearson Prentice Hall. All rights reserved. Edited by Olivier Greusard
Raising Equity Capital

(Chapter 14)
Chapter 14 Outline
14.1 Equity Financing for Private Companies 14.2 Taking Your Firm Public: The Initial Public Offering 14.3 IPO Puzzles 14.4 Raising Additional Capital: The Seasoned Equity Offering
14.1 Equity Financing for Private Companies

Sources of Funding:
A private company can seek funding from several potential sources:
Angel Investors Venture Capital Firms Institutional Investors Corporate Investors

Angel Investors:
Individual investors who buy equity in small private firms The first round of outside private equity financing is often obtained from angels

Venture Capital Firms:
Specialize in raising money to invest in the private equity of young firms In return, venture capitalists often demand a great deal of control of the company
Figure 14.2 Venture Capital Funding in the United States

Institutional Investors:
Pension funds, insurance companies, and foundations
May invest directly May invest indirectly by becoming limited partners in venture capital firms
Corporate Investors:
Many established corporations purchase equity in younger, private companies
corporate strategic objectives desire for investment returns

Securities and Valuation
When a company decides to sell equity to outside investors for the first time, it is typical to issue preferred stock rather than common stock to raise capital
It is called convertible preferred stock if the owner can convert it into common stock at a future date
Example 14.1 Funding and Ownership

Problem:
You founded your own firm two years ago. You initially contributed $100,000 of your money and, in return received 1,500,000 shares of stock. Since then, you have sold an additional 500,000 shares to angel investors. You are now considering raising even more capital from a venture capitalist (VC).

Problem (cont d):
This VC would invest $6 million and would receive 3 million newly issued shares. What is the post-money valuation? Assuming that this is the VC s first investment in your company, what percentage of the firm will she end up owning? What percentage will you own? What is the value of your shares?

Solution: Plan:
After this funding round, there will be a total of 5,000,000 shares outstanding: Your shares 1,500,000 Angel investors shares 500,000 Newly issued shares 3,000,000 Total 5,000,000
Example 14.1 Funding and Ownership Plan (cont d):

The VC is paying $6,000,000/3,000,000=$2/ share. The post-money valuation will be the total number of shares multiplied by the price paid by the VC. The percentage of the firm owned by the VC is her shares divided by the total number of shares. Your percentage will be your shares divided by the total shares and the value of your shares will be the number of shares you own multiplied by the price the VC paid.
Example 14.1 Funding and Ownership Execute:

There are 5,000,000 shares and the VC paid $2 per share. Therefore, the post-money valuation would be 5,000,000($2) = $10 million. Because she is buying 3,000,000 shares, and there will be 5,000,000 total shares outstanding after the funding round, the VC will end up owning 3,000,000/5,000,000=60% of the firm. You will own 1,500,000/5,000,000=30% of the firm, and the post-money valuation of your shares is 1,500,000($2) = $3,000,000.

Evaluate:
Funding your firm with new equity capital, be it from an angel or venture capitalist, involves a tradeoffyou must give-up part of the ownership of the firm in return for the money you need to grow. The higher is the price you can negotiate per share, the smaller is the percentage of your firm you have to give up for a given amount of capital.

Exiting an Investment in a Private Company
Acquisition Public Offering
14.2 Taking Your Firm Public: The Initial Public Offering

The process of selling stock to the public for the first time is called an initial public offering (IPO)

Advantages and Disadvantages of Going Public
Advantages:
Greater liquidity Better access to capital
Disadvantages:
Equity holders more dispersed Must satisfy requirements of public companies

IPOs include both Primary and Secondary offerings Underwriters and the Syndicate
Underwriter: an investment banking firm that manages the offering and designs its structure
Lead Underwriter
Syndicate: other underwriters that help market and sell the issue
Table 14.2 International IPO Underwriter Ranking Report for 2007
Figure 14.3 The Cover Page of RealNetworks IPO Prospectus

Valuation
Underwriters work with the company to come up with a price
Estimate the future cash flows and compute the present value Use market multiples approach
Road Show Book Building
Example 14.2 Valuing an IPO Using Comparables

Problem:
Wagner, Inc., is a private company that designs, manufactures, and distributes branded consumer products. During the most recent fiscal year, Wagner had revenues of $325 million and earnings of $15 million. Wagner has filed a registration statement with the SEC for its IPO.

Problem (cont'd):
Before the stock is offered, Wagner s investment bankers would like to estimate the value of the company using comparable companies. The investment bankers have assembled the following information based on data for other companies in the same industry that have recently gone public. In each case, the ratios are based on the IPO price.

Problem (cont'd)
After the IPO, Wagner will have 20 million shares outstanding. Estimate the IPO price for Wagner using the price/earnings ratio and the price/revenues ratio.

Solution: Plan:
If the IPO price of Wagner is based on a price/earnings ratio that is similar to those for recent IPOs, then this ratio will equal the average of recent deals. Thus, to compute the IPO price based on the P/E ratio, we will first take the average P/E ratio from the comparison group and multiply it by Wagner s total earnings. This will give us a total value of equity for Wagner. To get the per share IPO price, we need to divide the total equity value by the number of shares outstanding after the IPO (20 million). The approach will be the same for the price-to-revenues ratio.

Execute:
The average P/E ratio for recent deals is 21.2. Given earnings of $15 million, we estimate the total market value of Wagner s stock to be ($15 million)(21.2) = $318 million. With 20 million shares outstanding, the price per share should be $318 million / 20 million = $15.90. Similarly, if Wagner s IPO price implies a price/revenues ratio equal to the recent average of 0.9, then using its revenues of $325 million, the total market value of Wagner will be ($325 million)(0.9) = $292.5 million, or ($292.5/20) = $14.63/share
14.2 Taking Your Firm Public: The Initial Public Offering Pricing the Deal and Managing Risk
Firm Commitment IPO: the underwriter guarantees that it will sell all of the stock at the offer price Over-allotment allocation, or Greenshoe provision: allows the underwriter to issue more stock, amounting to 15% of the original offer size, at the IPO offer price
14.2 Taking Your Firm Public: The Initial Public Offering Other IPO Types
Best-Efforts Basis: the underwriter does not guarantee that the stock will be sold, but instead tries to sell the stock for the best possible price Auction IPO: The company or its investment bankers auction off the shares, allowing the market to determine the price of the stock
Table 14.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO
Figure 14.4 Aggregating the Shares Sought in the Hypothetical Auction IPO
Example 14.3 Auction IPO Pricing

Problem:
Fleming Educational Software, Inc., is selling 500,000 shares of stock in an auction IPO. At the end of the bidding period, Fleming s investment bank has received the following bids:
What will the offer price of the shares be?


Solution: Plan:
First, we must compute the total number of shares demanded at or above any given price. Then, we pick the lowest price that will allow us to sell the full issue (500,000 shares).

Execute:
Convert the table of bids into a table of cumulative demand:
Example 14.3 Auction IPO Pricing Execute (cont'd):

For example, the company has received bids for a total of 125,000 shares at $7.75 per share or higher (25,000 + 100,000 = 125,000). Fleming is offering a total of 500,000 shares. The winning auction price would be $7.00 per share, because investors have placed orders for a total of 500,000 shares at a price of $7.00 or higher. All investors who placed bids of at least this price will be able to buy the stock for $7.00 per share, even if their initial bid was higher.

Execute (cont'd):
In this example, the cumulative demand at the winning price exactly equals the supply. If total demand at this price were greater than supply, all auction participants who bid prices higher than the winning price would receive their full bid (at the winning price). Shares would be awarded on a pro rata basis to bidders who bid exactly the winning price.

Evaluate:
While the auction IPO does not provide the certainty of the firm commitment, it has the advantage of using the market to determine the offer price. It also reduces the underwriter s role, and consequently, fees.
Table 14.4 Summary of IPO Methods
14.3 IPO Puzzles

Four IPO puzzles:
Underpricing of IPOs Hot and Cold IPO markets High underwriting costs Poor long-run performance of IPOs
14.3 IPO Puzzles

Underpriced IPOs
On average, between 1960 and 2003, the price in the U.S. aftermarket was 18.3% higher at the end of the first day of trading
Who wins and who loses because of underpricing?
14.3 IPO Puzzles

Hot and Cold IPO Markets
It appears that the number of IPOs is not solely driven by the demand for capital. Sometimes firms and investors seem to favor IPOs; at other times firms appear to rely on alternative sources of capital
Figure 14.6 Cyclicality of Initial Public Offerings in the United States, (1980-2009)
14.3 IPO Puzzles

High Cost of Issuing an IPO
In the U.S., the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price. This fee is large, especially considering the additional cost to the firm associated with underpricing.
14.3 IPO Puzzles

Poor Post-IPO Long-Run Stock Performance
Newly listed firms appear to perform relatively poorly over the following three to five years after their IPOs That underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place
14.4 Raising Additional Capital: The Seasoned Equity Offering A firm s need for outside capital rarely ends at the IPO
Seasoned Equity Offering (SEO): firms return to the equity markets and offer new shares for sale
14.4 Raising Additional Capital: The Seasoned Equity Offering SEO Process
When a firm issues stock using an SEO, it follows many of the same steps as for an IPO. Main difference is that the price-setting process is not necessary.
Two kinds of seasoned equity offerings:

Cash offer Rights offer
Example 14.4 Raising Money with Rights Offers

Problem:
You are the CFO of a company that has a market capitalization of $1 billion. The firm has 100 million shares outstanding, so the shares are trading at $10 per share. You need to raise $200 million and have announced a rights issue. Each existing shareholder is sent one right for every share he or she owns.

Problem (cont'd):
You have not decided how many rights you will require to purchase a share of new stock. You will require either four rights to purchase one share at a price of $8 per share, or five rights to purchase two new shares at a price of $5 per share. Which approach will raise more money?

Solution: Plan:
In order to know how much money will be raised, we need to compute how many total shares would be purchased if everyone exercises their rights. Then we can multiply it by the price per share to calculate the total amount raised.

Execute:
There are 100 million shares, each with one right attached. In the first case, 4 rights will be needed to purchase a new share, so 100 million / 4 = 25 million new shares will be purchased. At a price of $8 per share, that would raise $8 x 25 million = $200 million.

Execute (cont d):
In the second case, for every 5 rights, 2 new shares can be purchased, so there will be 2 x (100 million / 5) = 40 million new shares. At a price of $5 per share, that would also raise $200 million. If all shareholders exercise their rights, both approaches will raise the same amount of money.
Example 14.4 Raising Money with Rights Offers Evaluate:

In both cases, the value of the firm after the issue is $1.2 billion. In the first case, there are 125 million shares outstanding after the issue, so the price per share after the issue is $1.2 billion / 125 million = $9.60. This price exceeds the issue price of $8, so the shareholders will exercise their rights. Because exercising will yield a profit of ($9.60 $8.00)/4 = $0.40 per right, the total value per share to each shareholder is $9.60 + 0.40 = $10.00.

Evaluate (cont'd):
In the second case, the number of shares outstanding will grow to 140 million, resulting in a post-issue stock price of $1.2 billion / 140 million shares = $8.57 per share (also higher than the issue price). Again, the shareholders will exercise their rights, and receive a total value per share of $8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both cases the same amount of money is raised and shareholders are equally well off.
Debt Financing
(Chapter 15)
Chapter Outline
15.1 Corporate Debt 15.2 Bond Covenants 15.3 Repayment Provisions
15.1 Corporate Debt

Private Debt
Bank Loans
Term Loan Syndicated Bank Loan Revolving Line of Credit Asset-Backed Line of Credit
Private Placements
15.1 Corporate Debt

Public Debt
The Prospectus
Indenture
A formal contract between a bond issuer and a trust company, which represents the bondholders interests
Original Issue Discount (OID) Bond

A coupon bond issued at a discount
Figure 15.1 Front Cover of the Offering Memorandum for the Hertz Junk Bond Issue
15.1 Corporate Debt

Public Debt
Unsecured Corporate Debt
Notes Debentures
Secured Corporate Debt

Mortgage Bonds Asset-Backed Bonds
15.1 Corporate Debt

Public Debt
Seniority
A bondholder s priority, in the event of a default, in claiming assets not already securing other debt Subordinated Debenture
A debenture issue that has a lower priority claim to the firm s assets than other outstanding debt
Tranches
Different classes of securities that comprise a single bond issuance
Table 15.2 Hertz s December 2005 Junk Bond Issues
15.1 Corporate Debt

Public Debt
International Bonds
Domestic Bonds
Issued by a local entity and traded in a local market, but purchased by foreigners Denominated in the local currency
Foreign Bonds
Issued by a foreign company in a local market and are intended for local investors Denominated in the local currency
15.1 Corporate Debt

Public Debt
International Bonds
Foreign Bonds
Yankee bonds Foreign bonds issued in the United States
Eurobonds
International bonds that are not denominated in the local currency of the country in which they are issued
15.1 Corporate Debt

Public Debt
International Bonds
Global Bonds
Combines the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously Can be offered for sale in the same currency as the country of issuance
Table 15.3 Summary of New Debt Issued as Part of the Hertz LBO
15.2 Bond Covenants

Covenants
Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds
Advantages of Covenants
With more covenants, a firm firms can reduce its costs of borrowing.
The reduction in the firm s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants
Table 15.4 Typical Bond Covenants
15.3 Repayment Provisions

Call Provisions
Callable Bond
Call Date Call Price Call Premium
Table 15.5 Call Features of Hertz s Bonds

Call Provisions
Call Provisions and Bond Prices
Investors will pay less for a callable bond than for an otherwise identical noncallable bond A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a higher coupon rate or accept lower proceeds

Call Provisions
Yield to Call
The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date
Yield to Worst
Quoted by bond traders as the lower of the yield to call or yield to maturity
Table 15.6 Bond Calls and Yields
Example 15.1 Calculating the Yield to Call

Problem:
IBM has just issued a callable (at par) five-year, 8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond s yield to call?

Solution: Plan:
The timeline of the promised payments for this bond (if it is not called) is:

Solution: Plan: (cont d)
If IBM calls the bond at the first available opportunity, it will call the bond at year 1. At that time, it will have to pay the coupon payment for year 1 ($8 per $100 of face value) and the face value ($100). The timeline of the payments if the bond is called at the first available opportunity (at year 1) is:

Solution: Plan: (cont d)
To solve the YTC, we use these cash flows, set the price equal to the bond s current price and solve for the discount rate.

Execute:
For the YTC, setting the present value of these payments equal to the current price gives:
103 =
108 Solving for the yield to call gives: (1 + YTC) 108 YTC = ! 1 = 4.85% 103
Given: Solve for:
1 4.85
-103
100
Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)


Evaluate:
The YTM is higher than the YTC because it assumes that you will continue receiving your coupon payments for 5 years, even though interest rates have dropped below 8%. While under the YTC assumptions, you are repaid the face value sooner, you are deprived of the extra 4 years of coupon payments, so your total return is lower.

Sinking Fund
A company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par.
Balloon Payment
A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue.

Convertible Provisions
Convertible Bonds Conversion Ratio

Convertible Bond Pricing
Consider a convertible bond with a $1000 face value and a conversion ratio of 20 If you converted the bond into stock on its maturity date, you would receive 20 shares
If you did not convert, you would receive $1000
Conversion Price
By converting the bond you essentially paid $1000 for 20 shares, implying a conversion price per share of $1,000/20 = $50.

Convertible Bond Pricing
Straight (Plain-Vanilla) Bond
A non-callable, non-convertible bond
Convertible Bonds and Stock Prices

When a firm s stock price is much higher than the conversion price, conversion is very likely and the convertible bond s price is close to the price of the converted shares
Figure 15.2 Convertible Bond Value

Combining Features
Companies have flexibility in setting the features of the bonds they issue
Leveraged Buyout (LBO)

When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt.
Table 15.7 RealNetworks 2003 Convertible Debt Issue

FM03 - Long Term Financing

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FM 03 Corporate Finance

Part III: Long Term Financing

Raising Equity Capital

14.1 Equity Financing for Private Companies

14.1 Equity Financing for Private Companies

14.1 Equity Financing for Private Companies

Figure 14.2 Venture Capital Funding in the United States

14.1 Equity Financing for Private Companies

14.1 Equity Financing for Private Companies

Example 14.1 Funding and Ownership

Example 14.1 Funding and Ownership

Example 14.1 Funding and Ownership

Example 14.1 Funding and Ownership Plan (cont d):

Example 14.1 Funding and Ownership Execute:

Example 14.1 Funding and Ownership

14.1 Equity Financing for Private Companies

14.2 Taking Your Firm Public: The Initial Public Offering

14.2 Taking Your Firm Public: The Initial Public Offering

14.2 Taking Your Firm Public: The Initial Public Offering

Table 14.2 International IPO Underwriter Ranking Report for 2007

Figure 14.3 The Cover Page of RealNetworks IPO Prospectus

14.2 Taking Your Firm Public: The Initial Public Offering

Road Show Book Building

Example 14.2 Valuing an IPO Using Comparables

Example 14.2 Valuing an IPO Using Comparables

Example 14.2 Valuing an IPO Using Comparables

Example 14.2 Valuing an IPO Using Comparables

Example 14.2 Valuing an IPO Using Comparables

Table 14.3 Bids Received to Purchase Shares in a Hypothetical Auction IPO

Example 14.3 Auction IPO Pricing

What will the offer price of the shares be?

Example 14.3 Auction IPO Pricing

Example 14.3 Auction IPO Pricing

Example 14.3 Auction IPO Pricing Execute (cont'd):

Example 14.3 Auction IPO Pricing

Example 14.3 Auction IPO Pricing

Table 14.4 Summary of IPO Methods

14.3 IPO Puzzles

14.3 IPO Puzzles

14.3 IPO Puzzles

14.3 IPO Puzzles

14.3 IPO Puzzles

Two kinds of seasoned equity offerings:

Example 14.4 Raising Money with Rights Offers

Example 14.4 Raising Money with Rights Offers

Example 14.4 Raising Money with Rights Offers

Example 14.4 Raising Money with Rights Offers

Example 14.4 Raising Money with Rights Offers

Example 14.4 Raising Money with Rights Offers Evaluate:

Example 14.4 Raising Money with Rights Offers

15.1 Corporate Debt

15.1 Corporate Debt

Original Issue Discount (OID) Bond

15.1 Corporate Debt

Secured Corporate Debt

15.1 Corporate Debt

Table 15.2 Hertz s December 2005 Junk Bond Issues

15.1 Corporate Debt

15.1 Corporate Debt

15.1 Corporate Debt

15.2 Bond Covenants

Table 15.4 Typical Bond Covenants

15.3 Repayment Provisions