Long-Term FinancingEquity

Financial Decisions Revisited

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Section 1An Introduction to Equity

Financing

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What is Equity? Several definitions are available

depending on the form of equity;a. in accounting equation it’s the

difference between assets and liabilities;

b. on the company statements the amount injected by shareholders to the business plus any retained earnings;

c. a security which entitles it’s holder the right of ownership;

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Superiors of Equity Financing

Equity financing is not required to be repaid;

Unlike debt financing no installments are intended which otherwise can be used in future growth;

Lower debt leverages improves company’s future borrowing options;

There is no restrictions on company’s activities which may possibly prevent it from taking advantage of new opportunities;

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Drawbacks of Equity Financing

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Taking on equity investment ends up intransferring some part of ownership rightsto investors;

If there is a surge in earnings, you have to share a portion of your earnings with the equity investor.Over time, distribution of profits to other owners mayoutgrow what you would have repaid on a loan;

Your business may be subject to potential conflictsderiving from different business visions or perspectives

Decisive Factors If company is experiencing creditworthinessproblem or currently overleveraged ✔

If sharing decision-making is not convenient ✖

If you rather share ownership/equity than have to repay a bank loan ✔

If business’s profitability forecasts are hope rising ✖

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SECTION 2Raising Equity Capital

Stages of Attracting Equity Capital

Private companies may submit stocks and have shareholders. However their shares are not traded in market or exposed to SEC regulations. The ways of attracting equity capital are;

a. angel investors-for many start-ups, the first round of outside private equity financing is often obtained from angels. Frequently, these investors are friends or acquaintances of the entrepreneur. These investors may have substantial influence in the business decisions of the firm. Angels may also bring expertise to the firm that the entrepreneur lacks;

• venture capitalists-a venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms.Typically they invest companies which are in growth stage;

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How to Raise Equity Capitalinstitutional investors-pension funds, insurance companies,endowments, and foundations manage large quantities of money. They may invest directly in privatefirms, or they may invest indirectly by becoming limited partners in venture capital or private equity firms;

corporate investors-are established corporations which purchase equity in younger, private companies;

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How to Raise Equity CapitalIPO

The process of selling stock to the public for the first time;

The two advantages that going public offers are greater liquidity and better access to capital;

However there are disadvantages of offering shares to public such as;a. there will be significantly greater public regulation, accountability and

scrutiny. The legal requirements the company faces will be greater, and the company will also be subject to the rules of the stock exchange on which its shares are listed;

b. a wider circle of investors with more exacting requirements will hold shares;c. there will be additional costs involved in making share issues, including

brokerage commissions and underwriting fees;

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The Mechanism of IPO A company about to issue new securities in order to raise finance might decide to have the issue underwritten;

Underwriters are financial institutions which agree to buy at the issue price any securities which are not subscribed for by the investing public;

The shares that are sold in the IPO may either be new shares that raise new capital, known as a primary offering, or existing shares that are sold by current

shareholders, known as a secondary offering; 12

The Mechanism of IPO Underwriters typically act in two ways;a. best effort basis-the underwriter does not guarantee

that the stock will be sold, but instead tries to sell the stock for the best possible price;

b. firm commitment IPO-more commonly underwriter guarantees that it will sell all of the stock at the offer price. The underwriter purchases the entire issue and then resells it at the offer price. If the entire issue does not sell out, the remaining shares must be sold at a lower price and the underwriter must take the loss;

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Seasonal OfferingRight Issue

The offer of new shares to existing shareholders in the proportion of shares currently held by these shareholders;

Price of share is lower than normal market price;

It follows many of the same steps as for IPO but the main difference is a market price for the stock already exists, so the price-setting

process is not necessary;

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Seasonal OfferingsRight Issue

The main features of right issue are;a.cheaper than IPO;b. may offset the future negative effect of stock dilution***;c. typically has negative effect on stock prices because it’s perceived as a signal of financial distress by investors;d.companies with good financial health also may apply right issue for financing different projects;e. enable current shareholders to maintain their proportionate stake in the company;

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Dilution IllustrationCurrently company has 10 shareholders and each one holds 1 shares(10%)of company. Company issues additional 20 shares which are bought by one person. Now new shareholder owns 66% of company while the old shareholders only possess 3% of company.

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SECTION 3Types of Shares

General Framework of Common Stocks

Carries voting right; Higher yield is almost guaranteed over the time as a result of company’s growth; Even if dividend is not paid holders may earn through capitalappreciation; Common stocks are liquid so these can be sold and purchase at fair price easily and quickly; Common stock holders get the payment last; There is a difficulty to control because

you’re also dependent of decisions of others; 17

Dual-Class Common Stock Two share classes may be issued depending on the

voting rights and dividend payments;

Each type of share targets different investor segments;

a. Class A-inferior voting privilages but stronger claim to dividends. This type of shares are typically offered to general public;

b. Class B- may have superior voting rights but instead weak claim to dividends. Generally offered to family members, founders or executives;

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Preferred Stocks Represent some degree of ownership but voting right is not inherent to them;

Receives fixed dividend;

Participating Preferred Stock Participating Preferred Stock where the holder is allowed to participate in increasing dividends if the common stockholders receive increasing dividends;

Paid before than common stock holders in case of bankruptcy;

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Types of Preferred Stock Cumulative Preferred Stock-if company can’t afford to dividend

payment then the appropriate amount is accumulated in arrears and represents the amount that is owed by company to investor. Common stock holders can not be paid until the position of cumulative preferred stock holders is closed;

Non-cumulative Preferred Stock-sometimes referred as straight shares. If company opts out dividend distribution then it is not owed to the investor;

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Types of Preferred Stock Convertible Preferred Stock-includes the provision to convert or exchange preferred stocks to common stocks at a fixed price;

Redeemable Preferred Stock-a type of preferred stock that enables the issuer to buy back the stock at a certain price and retire it, thereby converting the stock to treasury stock;

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SECTION 4Price of Equity and Dividend

Policy

Price Terminology Par Value or Face Value-which appears on the face of

share. It’s typically $1 or less which ensures that shares will not be sold below that price;

Issue Price-the price which is quoted by company when the shares are introduced to markets. Businesses apply for the assistance of professional organizations for determining the issue price;

Market Price-the price which is shares are commonly traded in Stock Exchanges;

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Factors Influencing Stock Prices

Company specific news-announcement of dividends, introduction of a new product or a product recall, securing a new large contract, anticipated takeover or merger a change of management accounting errors or scandals;

Industry performance-for example competitor’s performance;

Economic factors-interest rates,inflation,economic shocks,political uncertainties;

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Dividends as a Passive Residual

The firm uses earnings plus the additional financing that the increased equity can support to finance any expected positive-NPV projects;

Any unused earnings are paid out in the form of dividends. This describes a passive dividend policy;

Can the payment of cash dividends affect Can the payment of cash dividends affect shareholder wealth?shareholder wealth?

If so, what dividend-payout ratio will maximize If so, what dividend-payout ratio will maximize shareholder wealth?shareholder wealth?

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Factors Influencing Dividend Policy

• Funding Needs of the Firm• Liquidity• Ability to Borrow• Restrictions in Debt Contracts

(protective covenants)• Control

Issues to ConsiderIssues to Consider

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Stock Dividends Stock DividendStock Dividend -A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend;

Companies may decide to distribute stock to shareholders of record if the company's availability

of liquid cash is in short supply;27

B/S Changes for the Stock Dividend

$800,000 ($5 x 20,000 new shares) transferred (on paper) “out of” retained earnings;

$100,000 transferred “into” common stock account;

$700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital;

“Total shareholders’ equity” remains unchanged at $10 million; $40 sales price

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Stock DividendsBefore 5% Stock DividendBefore 5% Stock Dividend

Common stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 5% Stock DividendAfter 5% Stock DividendCommon stock ($5 par; 420,000 shares420,000 shares) $ 2,100,000$ 2,100,000Additional paid-in capitalAdditional paid-in capital 1,700,000 1,700,000Retained earningsRetained earnings 6,200,000 6,200,000 Total shareholders’ equity $10,000,000

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Stock Dividends, EPS, and Total Earnings

Assume that investor SP owns 10,000 shares and the firm Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share;earned $2.50 per share;

Total earnings = $2.50 x 10,000 = $25,000; After the 5% dividend, investor SP owns 10,500 shares 10,500 shares

and the same proportionate earnings of $25,000; EPS is then reduced to $2.38 per share because of the

stock dividend ($25,000 / 10,500 shares = $2.38 EPS$2.38 EPS);

After a stock dividend, what happens to EPS and After a stock dividend, what happens to EPS and total earnings of individual investors?total earnings of individual investors?

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Stock Dividends and Stock Splits

Similar economic consequences as a 100% stock dividend;

Primarily used to move the stock into a more popular Primarily used to move the stock into a more popular trading range and increase share demand;trading range and increase share demand;

Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact the How does this impact the shareholdersshareholders’’ equity accounts?; equity accounts?;

Stock SplitStock Split -- An increase in the number of shares outstanding by reducing the par value of

the stock.

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Stock SplitsBefore 2-for-1 Stock SplitBefore 2-for-1 Stock Split

Common stock ($5 par; 400,000 shares400,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

After 2-for-1 Stock SplitAfter 2-for-1 Stock SplitCommon stock ($2.50 par; 800,000 shares800,000 shares) $ 2,000,000$ 2,000,000Additional paid-in capitalAdditional paid-in capital 1,000,000 1,000,000Retained earningsRetained earnings 7,000,000 7,000,000 Total shareholders’ equity $10,000,000

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Stock Repurchase

Reasons for stock repurchase: Available for management stock-option plans; Available for the acquisition of other companies; “Go private” by repurchasing all shares from outside

stockholders; To permanently retire the shares;

Stock RepurchaseStock Repurchase -- The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.

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Repurchasing as Part of Dividend Policy

AssumeAssume::– Earnings after taxes $ 800,000– Number of common Number of common

shares outstanding shares outstanding 400,000 400,000– Earnings per share Earnings per share $ 2 $ 2– Current market price

per share $ 31– Expected dividend per share $ 1– Expected total dividendsExpected total dividends to be to be

paid outpaid out $ 400,000 $ 400,000

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Repurchasing as Part of Dividend Policy

If dividend is paid, shareholders receiveIf dividend is paid, shareholders receive::– Expected dividend per share $ 1– Market price per share Market price per share $ 30$ 30– Total valueTotal value $ 31 $ 31

If shares repurchased, shareholders receiveIf shares repurchased, shareholders receive::– Dividend per share $ 0– Market price per share* $ 31– Total valueTotal value $ 31 $ 31* Shares repurchased = $400,000 / $31 = 12,903 Original P/E ratio = $30$30/$2 = 15 “New” EPS = $800,000 / 387,097 = $2.07 “New” market price = $2.07 x 15 = $31 35

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SECTION 5Role of Shares in Company

Management

Two methods of voting: (1) in person or (2) by proxy

ProxyProxy -- A legal document giving one person authority to act for another.

Voting Rights

SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings;

Most shareholders, if satisfied with company performance, sign proxies in behalf of management;

Shareholders are generally geographically widely dispersed;

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Voting Procedures

Majority-rule voting Majority-rule voting - a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory statutory votingvoting;

Cumulative voting Cumulative voting - a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors;

The board of directors are elected under either:

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Voting Procedures Example

Under majority-rule votingUnder majority-rule voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position;

Under cumulative votingUnder cumulative voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire;

You are a shareholder of You are a shareholder of FunFinMan, Inc. FunFinMan, Inc. You You own 100 shares and there are 9 director own 100 shares and there are 9 director

positions to be filled.positions to be filled.

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Minimum Votes to Elect a Director -- Cumulative

For example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001 voting shares30,001 voting shares.

(100,000 shares) x (3 directors) 10

Total number ofvoting shares

Specific number ofdirectors sought

Total number of directors to be elected + 1

X

+ 1

+ 1 = 30,001 shares30,001 shares

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Thank You

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