Session 5: Long-Term Financing

C15.0008 Corporate Finance Topics

Outline

• Characteristics of debt

• Warrants and convertibles

• IPOs and SEOs

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Key Points

• Office Hours

• Exam points

• Book vs. Classes

• Tangents

• Real life examples

Characteristics of Debt

• A contractual obligation to make/receive a pre-specified set of payments (interest and principal)

• No ownership rights

• No control rights

Debt Covenants

The debt contract (bond indenture) often contains provisions restricting the actions of the debtor (firm)

• Amount and seniority of additional debt

• Dividend payments

• Assets sales

• Financial ratios (technical default triggers)

Interest Payments

• Deductible as an expense at the corporate level (for tax purposes)

• Taxable to the recipient as ordinary income

• Failure to pay triggers default

Debt Features

• Maturity• Sinking funds• Callability• Convertibility• Fixed or floating rate• Priority/seniority• Security/collateralization• Rating

Announcement Effects

• Managers will try to issue equity when they think their stock is overvalued

• However, the market knows this, announcement of new equity issuance is treated as bad news -> Stock price drops

• Similar issue with debt, but to a lesser extent because debt is less risky.

• This gives rise to a pecking order.

Financing Implications

The pecking order theory suggests that financing sources are used in the following order:

(1) retained earnings (internal cash flow)

(2) debt

(3) external equity

What increases as we go from (1) to (3)?

Some other securities

• Preferred stock

• Warrants

• Convertibles

Preferred Stock

• A kind of equity

• “Preference” over common stock in terms of dividend payment and bankruptcy

• Stated Value

• Cumulative/non-cumulative dividends

• Tax Code quirks, regulation for utilities, bankruptcy avoidance

Preferred Stock

Combines the features of debt and equity

Like debt• Pays a fixed dividend• No voting rights• Sinking funds,

callability, convertibility

Like equity• Dividend payments

non-deductible• Missed payment does

not trigger bankruptcy• Perpetual

Warrants

A warrant is a security issued by the firm that gives the holder the right to buy shares of common stock from the company at a fixed price for a given period of time, i.e., it is a call option issued by the firm.

Warrants vs. Calls

• Call—a contract (bet) between 2 individuals, the writer and the buyer

• Warrant– The firm receives the premium (price)– When exercised

• The firm receives the exercise price• The firm provides (issues) the shares

– Often long maturity– Often sold as a package with bonds where warrants

are detachable after sale

Traded Warrants

• NYSE traded

• Exercise price: 19.23

• Expiration: 3/19/09

• American

The Dilution Effect

A warrant is worth less than the corresponding call option (on an identical firm without warrants) because warrant exercise dilutes ownership.

Example: all equity firm, V = $51 million, n = 1 million , S = $51/share

Call (at expiration): E = 45 C = 51-45 = $6

Warrants (at expiration): E = 45, nW = 500,000V = 51 + 45 (0.5) = $73.5 millionn = 1,500,000 S = $49/share

W = 49-45 = $4

Warrant Valuation

• Gain from exercising call:

S-E

• Gain from exercising warrant:

[ n / (n+nW) ] (S-E)

Price of warrant:

W = [ n / (n+nW) ] C

Convertible Bonds

A convertible bond is a bond that can be converted into common stock

An example:• Straight debt (10-year): rB = 10%• Equity: S = $25/share, rS = 16%• Convertible (10-year)

– interest rate: 6% (annual coupons)– $1,000 par convertible at maturity to 20

shares

Terminology

• Conversion ratio: 20 shares per $1000

• Conversion price: $1000/20 = $50/share

• Conversion premium: 50/25 – 1 = 100%

• Conversion value: 20 x St (at any point in time)

Convertible Payoffs

Payoff at maturity of $1000 face value

Payoff

Stock priceS=0 S=50

1000

Convertible Valuation

A convertible bond equals a bond plus warrants.

Conv = Bond + 20 W

Bond: 10-year, 6%, rB = 10% B = $754

Warrant:W = [n/(n+nW)] C(E=50, S=25, t=10, =50%, rf=4%) = [100/(100+3)] $12.67

Conv = $754 + 20($12.30) = $1,000

Initial Public Offering

Initial public offering (IPO)—the first sale of common stock to the public

• Facilitated by an investment bank

• Regulated by and registered with the SEC

• Audited financials/prospectus

• Road shows/marketing

Why?

• Why go public?– Diversification– Liquidity– Access to capital– Establish market value

• Why not?– Reporting/auditing costs– Disclosure rules– Potential loss of control– The costs associated with an IPO

How?

• In the U.S., the principle way of going public is via an IPO using book-building

• Internationally, firms also seem to be moving towards the book-building method

• More recently in the U.S. a few firms have used an auction method for their IPOs, e.g., Google

Book-Building: The Mechanics

• Investment bank distributes prospectus with offer size and price range (may be updated)

• Based on information from institutional investors, the investment bank sets a size and offer price in negotiation with the issuer

• The bank buys the issue from the firm (at a discount to reflect underwriting fees) and resells it at the offer price to investors selected by the bank (best efforts vs. firm commitment)

• The bank may have the option to increase the issue size/buy more shares (greenshoe option)

• The bank supports the price in the after-market

Auction: The Mechanics

• Investment bank distributes prospectus with offer size and price range (may be updated)

• “Certified” investors can submit bids (price and quantity) online during a predetermined period

• Dutch auction—issue is priced at or below the highest price for which there is sufficient demand to sell the entire issue and allocated using price priority

IPO Costs

• Direct costs, e.g., fees for underwriters and lawyers (~7% of capital raised, lower for auctions)

• Indirect costs, i.e., underpricing– Underpricing is the offering price relative to

the price in the secondary market thereafter– Underpricing is a cost to the original owners

• Recent IPOs

IPOs: The NASDAQ Bubble

First-Day 3-Year Abnormal

Period #/yr Return Return

1990-94 326 11.2% -7.2%

1995-98 438 18.1% -32.3%

1999-2000 401 65.0% -34.3%

2001 80 14.0% NA

Seasoned Offerings

Seasoned offering—subsequent (to an IPO) offering of stock that is already publicly traded

• Rights issue vs. public offering

• Shelf registration

Costs of Seasoned Offerings

• Direct costs (~3-5% of capital raised)• Information effect on stock price, i.e., on average

price drops 3% upon announcement– What is the effect on earnings per share?– What happens when there is an excess supply of a

stock?– What kind of announcement effects are at work?

• A small amount of issue underpricing

IPOs and SEOs occur together

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Exam points

• Tax treatment on debt vs equity

• Announcement effects

• Pecking order theory

• Warrants and convertibles

• IPO underpricing