Topic 1: An Overview of Corporate Financing: Dpto. Economía de La Empresa - Universidad Carlos III de Madrid 1

Topic 1: An Overview of
Corporate Financing
Chp. 14 , 15 y 25 BREALEY, R.A. y MYERS, S.C. (2003): Principles of corporate

financing". 7th ed. McGraw Hill.
Chp. 2 y 3 GRINBALTT Y TITMAN (2003) Financial markets and corporate strategy
McGraw Hill.
Chp. 14 ROSS, WESTERFIELD Y JAFFE (2000) Corporate Finance
Dpto. Economa de la Empresa Universidad Carlos III de Madrid 1

Overview of Corporate Financing
Outline:
1. Introduction: the main decisions of the firm

1.1 Capital budgeting
1.2 Financing decisions
2. Financial instruments
2.1 Financial markets
2.2 Equity and Debt
3. Issuing securities and subscription rights

Some notation
V: market value of the firm; Payout: percentage of net earnings paid as
E: market value of equity; dividends;
BVE: book value of equity; Div: dividends;
F: face value (or nominal value) of debt P: market price of shares;
or of equity; Pe: share price at issue;
rE: required rate of return of equity Pd: estimated price of shares after issue;
(discount rate);
a: number of shares listed;
ROE: return on equity;
q: number of new shares issued;
B: market value of debt;
N: number of susbcription rights needed
rC: coupon rate of debt; to acquire a new share(N = a/q);
ac: accrued coupon; PV: present value.
rD: required rate of return on debt
(discount rate);
NE: net earnings / net income / net
benefit;
EBIT: earnings before interest and
taxes;
EBT: earnings before taxes;

1. Introduction: the main decisions of the firm
1.1 Capital budgeting
1.2 Financing decisions

1. Introduction: What do firms do?
Cash flow scheme between the firm and financial markets:

(1) External funds obtained from investors
(2) Funds invested in the firm
(3) Internal funds generated by the operational activities of the firm
(4) Internal funds reinvested in the firm
(5) Funds that remunerate investors
(1)
(2)
Operating CFO Capital

activities
(3) markets
(4)
(5)

Two main financial decisions
Which project to invest in? Capital budgeting decision
Based on what? NPV !!!
It is not simple:
Investments generate income in the future;
Income is estimated (it is uncertain);
The CFO needs to determine the present value of the uncertain future
income.
How to finance investments? Financing decisions

Use equity, debt, internal funds? In what proportions?
Decide on the capital structure (D/E or D/V) of the firm.

Classifying the financing sources
Internal funds: Advantages of using internal funds:

Retained earnings 1. Availability: they do not require
External funds: authorization from investors or
Shares Shares, bonds and issuing new securities
Common shares commercial paper 2. They do not affect the control

are all securities structure of the firm
Preferred shares and they require to
Convertibles issue a title.
Debt Disadvantages of using internal
Bonds funds:
Bank loans 1. They are not free cash. These
Leasings are funds that will not be
distributed to shareholders, so
Commercial paper their reinvestment should offer
Lines of credit an adequate return.
Suppliers 2. The willingness not to lose
control of the company should
not lead the company to pass
up profitable investment
opportunities.

2. Financial instruments
2.2 Equity and Debt

Physical or virtual space where funds are transferred from

agents with excess funds to agents with a deficit of funds, according
to pre-specified rules.
Financial markets fulfill several objectives:
Finance economies;
Maximize the flow of funds;
Provide prices for different assets.

Financial markets can be classified (segmented) in different

ways:
1. According to the moment in the life of the financial instrument;

Primary market (issues), and Secondary market (transactions)
2. According to the maturity of the financial instrument;
Long term and short term markets
3. According to the organization of the markets;
Stock market (electronic), and outcry market (hand-waving)
4. According to the moment when the transaction occurs;
Spot market, Derivatives market, Futures market
5. According to where the issue takes place.
Domestic market, international market

2.2 Shares
Shares are tradable financial securities.
Shares may be physical securities (paper is now rare) or electronic
registries.
Title of ownership in the company
Shareholders have the following rights:

Entitled to receive dividends if the firm distributes them;
Preferential right to acquire new issues of shares if the share

carries a subscription right;
Voting rights (not the preferred shares)
Choice of the managerial team; Firms statutory changes; Board

changes; Major issues (e.g. mergers).
May be entitled to the liquidation value of the firm:
Residual claimants (last in terms of priority);
Limited liability (if liquidation value is not enough to cover debts,

shareholders are not required to cover the shortfall).

2.2 Shares Voting systems
Accumulated voting system: managers are voted for at the same time, and shareholders
may give all their votes to a single candidate. This system increases the power of small
shareholders: it is more likely that they can elect some of their preferred candidates.
Majority voting system: managers are voted for one by one (sequentially), and therefore
the elected candidate will be the one chosen by the majority shareholder. Minority
shareholders have no chance to make their candidate win if the majority shareholder
choses someone else.
Example: A company has to elect 4 candidates. There are only two shareholders in this
company, a majority shareholder with 79 shares and a minority shareholder with 21 shares
(# total shares is 100).
With the accumulated system
Candidates 1 2 3 4 5
Accumulated voting system: With majority system

Minority shh. 21 0 0 0 0 0
Majority shh. 0 20 20 20 19 0
Majority voting system:
Minority shh. 21 0 0 0 0 0
Majority shh. 0 79 79 79 79 0
Departamento de Economa de la Empresa Universidad Carlos III de Madrid 12

2.2 Types of shares
Shares can be classified:
According to their rights:

Common shares: dividends, liquidation, voting, preferential right to
acquire new shares.
Preferred shares: higher dividends and preferential treatment
Convertible securities: Securities with an embedded option to be
converted into shares.
When new equity is being issued:
Old shares (pre-existing shares)
New shares
According to their historic performance:
Blue chips: shares from companies with big capitalization and
liquidity that have done very well in the past
Speculative shares: from high risk companies with low capitalization

2.2 Types of shares
Common shares
Common shares issues: used to start a company or to increase the

capital of a company
Share Nominal Value VS Share price
Issued shares are registered at their Nominal Value (or Face Value)
Share price:
Issue at par value: the share price is equal to the nominal value
Issue above par value (or at premium): share price at issue is

greater than its nominal value
Issue below par value (or at a discount): share price is below face
value

2.2 Types of shares
Preferred shares
They are similar to common shares but they include in addition:

preferential treatment of dividend payments and liquidation rights:
preferred shareholders are paid prior to common shareholders (but still
after debt in liquidation)
preferred shares do not always have voting rights (only when preferential
treatment of dividends are cancelled)
Fiscal aspects:
Contrary to debt, dividend payments are not deductible
Fiscal advantage to some investors: companies that hold preferred
shares from other companies do have the right to deduct a certain
percentage of those dividends

2.2 Types of shares
Convertible securities
They may be converted into shares, either by decision of its holder

or of the issuing company, or both
They do not carry the same rights as shares, instead, they may
include some options like:
Rights issues: entitle the owner to acquire a pre-determined
number of shares at a fixed price on or until a pre-determined

date.
Warrants: long-term call options to buy underlying shares of the
issuer at a pre-specified price.

Convertible bonds: bonds which may be converted into shares.

2.2 Shares
Some definitions:
Authorized equity: maximum number of shares that can be issued

(determined by shareholders or the companies statutes)
Shares issued: shares that are held by shareholders
Own shares: shares of the firm that have been repurchased by the firm, so
not in the market.
Earnings before Interest and Taxes (EBIT): income before interest and tax
expenses
Net earnings (NE) or Net income: income after interest and tax expenses
Dividends (Div): share of the net earnings distributed to shareholders

2.2 Shares
Some definitions (cont):
Retained earnings: The part of the net earnings (income) that is not
distributed as dividends.
Earnings per share (EPS): Net earnings / number of shares
Payout Ratio: proportion of earnings distributed as dividends
Book value of equity (BVE): accounting value of equity
Return on Equity (ROE): Earnings generated by every dollar/euro of
equity (book value)
Market Capitalization: share price x number of shares issued (=
market value of equity).
Remark: market value of equity can be different from book value of equity!!

2.2 Shares Some relationships
ROE:
NEt
ROE =
BVEt 1
Dividendos (Divt):
Divt = Payout * NEt
Retained earningst:
Retained Earningst = NEt * (1 Payout ) = NEt Divt

Book Value of Equity (BVEt):
BVEt = BVEt 1 + (1 Payout ) * NEt = BVEt 1 + NEt Divt

2.2 Shares Example 1
The authorized equity of What is the number of
company GA is 100,000 shares issued?
shares. The book value of How many shares are there
equity is as follows: circulating?
Common shares 40,000
How many more shares can
with face value 0,5/share the firm issue without
Issuance premiums 10,000 permission from the
Retained earnings 30,000 shareholders?
Own capital 80,000 Suppose the firm issues
Own shares (2,000 shr.) 10,000 shares at 2 per
5,000 share. What items in the
Book value of equity 75,000 balance sheet (ownership
interests) would change?

2.2 Shares Example 2
Fill in the following table (the bold values are given):
Year t = 1 Year t = 2
BVEt-1 10 10,8
ROE 0,2 0,2
Payout 0,6 0,6
NEt 2 2,16
Divt 1,2 1,296
Retained Earningst 0,8 0,864

2.3 Debt - Definition of debt contract
Debt instruments (usually defined as fixed income investments), are
contracts that specify the obligation to pay interests periodically and repay
the principal at a pre-determined date (maturity date).
Debt does not constitute a title of ownership, therefore lenders do not have
voting rights.
Debt can be tradable (e.g. bonds) or not tradable (bank loans).
Debt is usually risky: there is a chance that: debt value > asset value and
hence the firm defaults on its debt obligations
But, treasury bonds are usually considered free of risk
Debt brings seniority rights upon bankruptcy and liquidation: debt-holders

are paid before shareholders and senior debt-holders are paid before junior
debt-holders
Collateral: inventories and equipment can be used to secure debt in case of
default
Debt may bring covenants: to protect creditors and restrict the borrower
from taking certain actions (e.g. max. amount of dividends).
Debt brings a tax advantage as interest payments are tax deductible
(dividends are not tax deductible).

2.3 Debt - Tax savings advantage
Example:
Assume two firms with the same marginal revenue, one of the firms has debt
and the other one has not:
Firm A: Only Firm B: Debt

shares & shares
200 EBIT 200
0 Current Liabilities (interest) 100
200 Gross Profit (EBT) 100

70 Taxes 35
130 Net Earnings 65
100 Dividends 0
30 Retained earnings 65

2.3 Debt The trade-off theory of debt
Debt has a fundamental trade-off:
Benefit: Interests paid on debt are tax deductible

Cost: The obligation to make interest payments periodically may bring the
company into financial distress.
The trade-off theory of debt says that:
The optimal debt level in a company should balance the benefits of

borrowing: the tax advantages; against the costs of holding debt: the
expected costs of financial distress

2.3 Debt Types and financing sources
Bonds: Fixed income security, tradable. Different types of bonds according to
their characteristics: issuer (corporate treasury), maturity, covenants,
embedded options, rating, etc.
Bank loans: they are not considered securities because they are not tradable
(not easily). The bank specifies the quantity lent and the interest rate
Revolver: there is no fixed schedule, money can be withdrawn and returned
as the company wishes
Non-revolver: the company does not return the loan, but it extends it instead.
Commercial paper: short-term (1 to 6 months), tradable, usually with an implied
fixed rate.
Leasings: Financing contract to rent (or lease) fixed assets. Formally the
contract is set up as a rent, however it has an embedded call option to acquire
the asset.
Credit Line: a credit that will be given in the future but the money is not
borrowed yet. The bank specifies the quantity lent but not the interest rate,
which can vary when the company decides to withdraw part or all of the money .
The interest is paid only on the amount withdrawn so it varies.
Accounts payable: Short term debt resulting from the purchase of inventories
or fixed assets from suppliers. It is part of the working capital. It is not debt in the
financial sense (it pays no interests and its maturity is often defined by the
industry or sector).

2.3 Debt Characteristics
1. Issuing contract
A bond represents a financial contract between the issuer and the buyer, defining all
the characteristics in terms of debt principal, coupons, maturity, guarantees, etc.)
Public issue: Highly standardized in order to increase their liquidity in the market.
Has a secondary market and it is typical for big issues. It is very hard to
renegotiate as all current debt-holders must agree to changes.
Private issue: It may be sold to a single buyer, there is more liberty to define the
characteristics (tailor made) easily renegotiable and it is usually cheaper than a
public issue.
2. Bearer or registered
With bearer bonds the bondholder is not known to the firm. Whoever holds the
bond is entitled to the coupons and principal.
Registered bonds (more common): the firm knows the names of the holders of
the bonds it issued.

3. Coupons
Zero coupon. The bond pays no coupons, it is usually issued at a discount and it is
repaid at par.
Fixed rate: the coupon rate is fixed for the life of the bond, the value of the
coupons is fixed and known from the issue.
Floating rate coupons. The coupon rate is variable and it is linked to a market rate
(e.g. Euribor, Libor, etc). Usually the spread is fixed but changes in the indexed
market rate change the value of the coupons.
4. Amortization
Perpetual. The debt principal is never repaid, only coupons are paid.
Balloon payment. The debt principal is entirely amortized at the maturity date.
Amortizable loan. The debt principal is amortized during the life of the bond:
Constant payment (increasing amortization, decreasing interests);
Constant amortization;
Defined by the issuer (decreasing, increasing, etc.).
Deferred: these bonds allow the issuer not to pay interests during a certain period
of time (for ex. 5 years), or to pay them with other bonds (PIK: payment-in-kind)

5. Maturity
Date at which the principal and interests will be fully paid: expiration date
of the bond.
The maturity of bonds may be modified after the issue by exercising the
convertibility, put, or call options:

Converting debt to shares
Redeemable bonds or callable bonds include a call option that
allows the company buy the bond back before the maturity date at a
pre-specified price (the company enjoys a rescue covenant).
When the bond carries a call option, its holder has a short position on the
bond and the company has a long position.
When does a company want to rescue / redeem its bonds?
When their market value is above the strike price
Why do companies enjoy rescue covenants:
Brings flexibility to the company in terms of money availability
If interest rates decrease then it is best to redeem current bonds and
issue new ones with a lower coupon.

5. Maturity (cont)
What is the effect of rescue covenants on investors:
It brings uncertainty to bondholders
If interest rates decrease, investors are happy because they are
receiving better coupon rates for their bonds and thus their price
increase. But if the bond is redeemable and the option is exercised by
the company, the investor loses the possibility of making a gain.
Then, the investor requires a lower price for a redeemable bond.
This type of bonds is more and more common, specially in more uncertain
times.
Puttable bonds or retractable bonds give the option to the
bondholder to sell the bond back to the company, before its maturity
at a pre-specified price (called strike price). In this case:
Bondholder enjoy a long position on the bond
The issuer enjoys a short position on the bond
What is the effect on investors?
Very valuable!
If the price of the bond decreases, they will exercise the option to sell

5. Maturity (cont)
What is the effect on the company?
Bad effect because it may be forced to buy the bonds at the

detriment of using that money to undertake investments
Puttable bonds are more expensive than normal bonds
Puttable bonds usually have lower coupon rates because part
of the gains come from the put option that they carry.
6. Price
Bond prices are usually expressed in relationship with their face value
(principal)
A bond with face value 100 that is listed at 97,75, is listed at a discount
A bond with face value 100 that is listed at 100,75, is listed at a premium
A bond with face value 100 that is listed at 100, is listed at par

6. Price (cont.)
The value of a bond is expressed:
net of coupons (clean price) means that the price of a bond today
excludes the interests generated by the current coupon (accrued
interest)
Thus, the value of the bond is separated in two parts, the clean price
reflected in the bond market, and the accrued interest reflected
separately:
Value of the bond = clean price + accrued interest (coupon)
In this way, changes in the bonds price reflect changes in the

fundamental value of the issuer, and not changes in the interest accrued.
Example: A bond that is sold in the first trimester of the year, is

entitled to receive th of the annual coupon payment. This is also
called the dirty price.

Example: Compute the value, the corresponding accrued coupon and the price of
a bond on the 1st October 2010 that will mature the 31/12/2014, has a nominal
value F of 100, an annual coupon rate of 7% (rC) to be paid at the end of the
year and a required rate of return of 8.5% (rD).
Determine the value of the bond (dirty price, quoted in Europe, price buyer
pays):
rC F r F r F r F r F+F
B= t1
+ C t 2 + C t3 + C t 4 + C
(1 + rD ) (1 + rD ) (1 + rD ) (1 + rD ) (1 + rD )t5
7 7 7 7 107
B= + + + + = 100,03
(1 + 8,5%)3 /12 (1 + 8,5%)15 /12 (1 + 8,5%) 27 /12 (1 + 8,5%)39 /12 (1 + 8,5%)51/12
Determine the accrued coupon:

The coupon payments are for 12 months made in December each year
The last coupon payment made: 9 months (from Dec. 31st 2009 to Oct. 1st 2010)
period since last payment 9
ac = rC F = 7 = 5,25
overall period of the coupon payments 12
Determine the clean price of the bond (quoted in the US):

Listed price = B ac = 100,03 5,25 = 94,78

6. Yield
Zero coupon bonds do not give any coupons ever. These bonds are usually
sold at a discount of their face value. Compute the yield of a zero coupon bond
with face value F=1000 euros on the 15/06/2009 that matures the 15/12/2009
and price at issue of 977 euros:
Effective annual yield (rD) = ((1,000 / 977 )^(12 / 6)) -1 = 4.76%
Coupon bonds give interests regularly (coupons): consider a coupon bond with
a 5% coupon that is paid on March 15th every year, face value = 1000 euros,
actual date is 15/03/2000, and maturity 15/03/2003 and price 992.5 euros.
Effective annual yield (rD ) = 5.28%
992.5 = 50 / (1 + rD ) + 50 / (1 + rD )^2 + 1050 / (1 + rD )^3

7. Collateral
Protects debtholders in case of bankruptcy: they can seize the collateral
The more collateral the firm provides, the lower will be the interest rate of debt (lower risk).
Unsecured debt:
Simple bonds (long term)
Commercial paper (short term)
Secured debt: debt may be guaranteed in different ways.
Debt may be secured with a mortgage, the bondholder has proprietary rights on a
real estate asset in case of default;
Debt may be backed by securities: the portfolio of titles the firm has secures debt.
E.g. Holding companies can obtain debt backed by the shares they own on their
subsidiary companies;
Debt may be backed with fixed assets or inventories of a company: naturally, the
more tangible and liquid the assets of the firm are, the higher is the collateral value
they have for securing debt;
Governments sometimes may provide guarantees for some debt issues (e.g. deposit
insurance);

8. Seniority
Rules that define the access to funds, whenever the firm is in distress or
when it goes through liquidation.
Debtholders have priority over shareholders.
Debt can be senior or junior. Senior debt has priority over junior debt.
Only if senior debtors are paid in full will junior debtors receive any
funds.
The higher is the seniority of debtholders the lower is their expected

return (lower risk). Junior debt charges higher interests because it is also
riskier (lower expected recover rate in liquidation).

2.3 Debt and Equity Recap
Basic differences between debt and equity
Stocks Debt
Payment Residual Contractual
Tax Treatment Not Deductible Deductible
Priority in Liquidation No Yes
Maturity No Date Usually Defined
Ownership/Control Yes, before Only upon

bankruptcy bankruptcy

3. Issuing securities and subscription rights

3.1 Issuing securities
The firm obtains funds (financing) by selling (issuing and placing)

securities (shares, bonds).
New securities are issued in the Primary Market.
When investors trade their securities, by selling or buying more, this
does not affect the funds the firm has available for investing:
Securities are traded in the Secondary Market.
The issue of securities can be:
Private: it targets a limited and specific group of investors;
Public: if targets all investors

3.1 Issuing securities a private issue
The issue is targeted to a group of investors, presumably sophisticated
investors.
Advantages:
Save of time and lower issuance costs: If it is a small number of investors or it is
a small issue the firm does not have to report it to the market regulator or
register the issue.
Strategic reasons: given the amount and nature of the information required for
the public issue (included in the prospectus) the firm may be unwilling to do a
public issue in order to keep this information private. Firms in highly competitive
or growth sectors tend to make more private issues (placements).
Costs:
Low liquidity: following the issue it is hard to trade these securities because
there is no secondary market. Investors have to find buyers for their securities.
As such, private issues often target long-term investors.
Less information and higher expected returns: with a private issue, the investor
has to collect and analyze the information about the firm, therefore incurring
higher costs and requiring a compensation for it.
In the case of debt issues, a private issue pays higher interests relatively
to a public issue.

3.1 Issuing securities a public issue
Issue is targeted to all investors.
Benefits:
Increases the available information and allows a more efficient pricing:
Less risk for investors. If its a debt issue, the coupon rate is lower because there are less asymmetries of
information.
More pressure for the firm to define ambitious objectives and to accomplish them (increase in efficiency).
Possibility to obtain more funds because a larger number of investors is being
targeted;
Recognition effect: it increases the credibility of the firm with suppliers, clients,
employees...
Costs:
Higher direct issuance costs:
Prepare and deliver more information to the market;
Hire the services of an investment bank;
Administrative and legal costs with the registry of the issue.
Indirect costs can also be significant:
Underwriters (investment bank) pressure to lower the issuance price;
If the placement is incomplete there are also reputational costs.
Possibility of loss of control;
Time spent with preparing the issue: considerably longer than with a private issue;
Release of strategic information that may benefit competitors.

3.1 Issuing securities legal aspects of public issue
Not all firms are allowed to make a public issue (e.g. in Spain only
SA firms have tradable securities);
Public issues are regulated:

The issue is communicated and registered with the market regulator
(with some special issues firms are exempt from this requirement);
Firms have to prepare a prospectus detailing all the characteristics of
the issue, the rights and obligations awarded with the securities and
financial information of the firm and its future prospects;
The firm needs to have its accounts audited;
The firm has minimum capital requirements
The firm needs to have positive net profits in the previous two years,
positive net profits in 3 out of the past 5 years sufficient to pay out as
dividends 5% of the equity raised.

3.1 Issuing securities types of public issues
Direct: the firm prepares the issue by itself (most regulators require that the
firm hires the services of an investment bank to insure that all legal
requirements are respected).
Indirect: the firm hires the services of an investment bank to make the issue.
Three different types of issuing contract can be made:
Best efforts: the investment bank compromises to make its best efforts to place
the entire issue, however it offers no guarantees.
Standby underwriting: the investment bank compromises to buy all the securities
that were not purchased by investors.
Firm commitment underwriting: the investment bank buys the entire issue and
then it will sell it in the market.
In the last two types of issuing contract it is common that a syndicate of banks is
formed to place the issue and it has a leader underwriter. Investment banks do
this to divide the risks of a failed issue.
Initial public offering (IPO): the firm makes a public issue of a given type of
security for the first time. Objective is to raise funds.
Public offering: the firm is already public, it has already issued a similar
security.

3.1 Issuing securities issuing public debt
Example of a debt issue:
When deciding to issue debt privately or through a public issue the firm
must take into account:
Public issue: higher direct issuance costs but a lower coupon rate;
Private issue: lower direct issuance costs but a higher coupon rate
(riskier bonds due to asymmetries of information and lower liquidity);
Hard to value other aspects (e.g. Recognition effects, increased
efficiency) because they are firm and sector specific.
Example: The firm Alfa is looking to issue bonds with a 20 year maturity to
raise 20 Million (VN). Its presented with two alternatives:
Public issue: Issuance costs representing 1% of the amount issued and
investors require a coupon rate of 7% (rC1) paid annually;
Private issue: Issuance costs representing 0.25% of the amount issued
and investors require a coupon rate of 7.1% (rC2) paid annually;
Assume that the opportunity cost of det (rD) is 7% (i.e. lowest coupon).
What is the best option for the firm?

3.1 Issuing securities issuing public debt
Solution: (talk about Face value at end of period???))
Total costs of the public issue:
Direct issuance costs = Amount issued * issuance costs = 20,000,000 * 1%
=200,000
Indirect costs = present value of the coupon rate:
20
VN * rC VN * rC VN * rC VN * rC
VA(dc) = +
(1 + rC ) (1 + rC ) 2
+ ... + =
(1 + rC ) 20 i =1 (1 + rC ) i
1 1 1 1
VA(dc) = VN rC
20
= 1 . 4 M
0.07 0.07(1 + 0.07) 20 = 14,831,619.9

r
D rD (1 + rD )
Total costs of the private issue:
Direct issuance costs = Amount issued * issuance costs = 20,000,000 * 0.25 %
=50,000
Indirect costs:
1 1 1 1

VA(dc) = VN rC
20
= 1 . 42 M
= 15,043,500.2
20
rD rD (1 + rD ) 0.07 0.07(1 + 0.07)
Since 15,031,619.9 < 15,093,500.2, public is cheaper than private in this case.

3.1 Initial public offering (IPO) - Undericing
What is underpricing in an IPO?
In an IPO the price is usually set based on the estimated future profits of
the firm (discounted cash-flows) or on the valuations of similar or
competitor firms
In the first day of trading, the price rises significantly relative to the IPO
issuance price;
Extreme case: Netscape shares were issued at $28 and at the end of
the first day they closed at $58,25 (underpriced by 108%);
Underpricing represents a high cost for firms and for the old shareholders
who forgo funds;
Equity offering underpricing is common in all markets and it is explained by
several reasons:
Underwriters pressure: reducing issuance prices benefits insurers
because it reduces the likelihood that they might have to take up unsold
shares.
Leaving a good taste: the likelihood of having further successful issues
increases if investors make profits out of the IPO.

3.1 IPO Costs of an IPO
Example of costs in an IPO:
When Microsoft went public in 1986 the underwriters bought a total of 2,8 M shares
at $19.69 each and sold them for $21.
The firm paid 0.5 M dollars on legal and administrative expenses.
A few hours into trading, the price rose to $35. Calculate:
a) the direct issuance costs;
b) the underpricing costs;
c) the total costs as a proportion of the market value of equity.
Solution:
A. The underwriter margin was 21- 19,69 = 1,31 * 2,8 M = 3,7 M$
The legal and administrative costs were 0,5 M$

Therefore, the direct costs are = 4,2 M $ (3,7+0,5)
B. The underpricing costs were = ($35 $21)*2,8 M = 39,2 M$
C. The total costs were = 39,2 +4,2 = 43,4 M$
The market value was 2,8 M * $35 = 98 M$

43,4 M / 98 M = 0,44
The total costs of the IPO absorbed 44% of the market value of equity.

3.1 Public offering (PO)
Main characteristics:
Following an IPO, firms might need more funds and thereby issue more
shares or bonds.
After an IPO, there are other differences between public issues:
Single issue: the firm prepares and makes a single issue.
Seasoned issues: with a single registry and prospect the firm plans
several issues (very advantageous: lower costs for several issues, short
notice).
Open issue: issue that targets all investors.
Rights issue: issue limited to existing shareholders. With rights issues,
the firm offers its shareholders options to buy new shares at an
attractive price.

3.2 Public offering (PO) with subscription rights
Equity issues with subscription rights
When new shares are issued, existing shareholders are diluted.

Dilution represents a reduction in the ownership of existing shareholders.
Example: a company has 100 shares owned by two shareholders, with 50%
ownership each. The company issues 25 more shares to new investors,
now each previous shareholder has 50 shares of the 125 in total, that is
40% ownership.
Research shows that when new issues of shares are announced, share
prices go down (by around 3%)
Dilution also implies sometimes that the share price after the issue is lower
than before, which means that old shareholders lose some of their value.
How is this (dilution) problem solved?

With subscription rights: when new shares are issued, preexisting
shareholders have the right to buy first if they own subscription rights, of
they can sell the rights if they dont want any new shares.

3.2 Rights issues
Let us define:
P: price of the old shares before the issue;
Pe: issuance price of the new shares;
Pd: price of all shares after the issue;
a: # of old shares;
q: # of new shares being issued;
N = a/q.
A subscription right is a call option (option to buy) offered to current

shareholders.
It is offered one right per share and each right allows to acquire 1/N new
shares at the issuance price (with N rights investors can buy one share).
The options (rights) can be exercised during the issuance period and the
exercise price is the issuance price.
Subscription rights prevent the dilution of the value of old shareholders.

3.2 Rights issues
Example:
A firm has 900,000 shares issued (a) which are trading at 10 each (P). In
order to finance a project the firm wants to issue 100,000 new shares (q)
with a rights issue and an issuing price of 8 per shares (Pe).
A. How much financing will the firm raise?
B. What is the price after the issue (Pd)?
C. What is the loss for old shareholders?
D. What is the value of each right?
A. Amount raised= q*Pe =100,000*8= 800,000

B. Determining Pd :
Total number of shares after the issue= 900,000+100,000=1,000,000
Price following the issue (Pd )=(900,000*10+800,000)/1,000,000=9.8
C. Loss of value for old shareholders (dilution effect):

Before, their value was= 900,000*10=9,000,000, after the issue
=900,000*9.8=8,820,000;
Loss=180,000 (or 900,000*(9.8-10) because Pe <Pd <P).

3.2 Rights issues
Example (cont.):
D. Value of each right:
The right to acquire for 8 a share that trades in the market for 9.8 is
worth 1.8. Therefore, the right to acquire a new share is worth 1.8;
Because a=900,000 and q=100,000, N=9. The issuance conditions are 1
new share for 9 of the old ones;
Because N=9, one investor needs 9 rights to acquire a new share.
Therefore, the value of the right attributed to each old share is given by
=1.8/N=0.2.

3.2 Rights issues
Example (cont.):
Consider an old shareholder with 4,900 shares:
The value of his portfolio before the issue was 4,900 10 = 49,000 ,
after the issue is = 4,900 9.8 = 48,020 which implies a loss of
980, but
The shareholder has 4,900 rights, and their value must be added to its
portfolio. Total value of the portfolio after the

issue=48,020+0.24,900=49,000.
How many rights must he exercise to keep his (firm) portfolio value?
If he incorporates to his portfolio 980/9.8=100 shares (exericise 900

rights), the value of his portfolio will be= 5,0009.8=49,000;
To buy the 100 shares the investor needs 800, and he obtains these
funds by selling the rights he does not intend to exercise. (4,900-

900)0.2=800.
Conclusion: Issuing shares with an issuance price lower than the market
price does not harm the shareholder value when there are subscription
rights.

Topic 1: An Overview of Corporate Financing: Dpto. Economía de La Empresa - Universidad Carlos III de Madrid 1

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Topic 1: An Overview of Corporate Financing: Dpto. Economía de La Empresa - Universidad Carlos III de Madrid 1

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Topic 1: An Overview of

Chp. 14 , 15 y 25 BREALEY, R.A. y MYERS, S.C. (2003): Principles of corporate

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 1

1. Introduction: the main decisions of the firm

3. Issuing securities and subscription rights

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 2

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 3

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 4

Cash flow scheme between the firm and financial markets:

Operating CFO Capital

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 5

How to finance investments? Financing decisions

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 6

Internal funds: Advantages of using internal funds:

Common shares commercial paper 2. They do not affect the control

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 7

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 8

Physical or virtual space where funds are transferred from

Financial markets fulfill several objectives:

Maximize the flow of funds;

Provide prices for different assets.

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 9

Financial markets can be classified (segmented) in different

1. According to the moment in the life of the financial instrument;

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 10

Shareholders have the following rights:

Preferential right to acquire new issues of shares if the share

Choice of the managerial team; Firms statutory changes; Board

Residual claimants (last in terms of priority);

Limited liability (if liquidation value is not enough to cover debts,

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 11

Accumulated voting system: With majority system

Departamento de Economa de la Empresa Universidad Carlos III de Madrid 12

According to their rights:

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 13

Common shares issues: used to start a company or to increase the

Share Nominal Value VS Share price

Issue above par value (or at premium): share price at issue is

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 14

They are similar to common shares but they include in addition:

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 15

They may be converted into shares, either by decision of its holder

number of shares at a fixed price on or until a pre-determined

issuer at a pre-specified price.

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 16

Authorized equity: maximum number of shares that can be issued

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 17

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 18

Divt = Payout * NEt

Retained Earningst = NEt * (1 Payout ) = NEt Divt

BVEt = BVEt 1 + (1 Payout ) * NEt = BVEt 1 + NEt Divt

Departamento de Economa de la Empresa Universidad Carlos III de Madrid 19

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 20

Fill in the following table (the bold values are given):

ROE 0,2 0,2

Payout 0,6 0,6

Divt 1,2 1,296

Retained Earningst 0,8 0,864

Departamento de Economa de la Empresa Universidad Carlos III de Madrid 21

Debt brings seniority rights upon bankruptcy and liquidation: debt-holders

Dpto. Economa de la Empresa Universidad Carlos III de Madrid 22

Firm A: Only Firm B: Debt

200 Gross Profit (EBT) 100

A. Amount raised= qPe =100,0008= 800,000