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S I Li

Long Term Financing – Debt and Equity Common Shareholders -Firm owners and residual claimants -Face limited liability -Shareholder rights: -Cash flow rights  receive dividends -Control rights  voting rights Value of Common Stock -Book value – sum of retained earnings, contributed surplus, and share capital -Retained earnings – the percentage of net earnings not paid out as dividends -Contributed surplus – total assets minus the sum of total liabilities -Share capital – portion of a company’s equity that has been obtained by trading stock to a shareholder for cash or an equivalent item of capital value -Market value – current market price Value of all equity firm = Total cash dividends payable next of the equity -Market-to- year book ratio – measure of financial success of the firm -If >1 than the firm is growing -If <1 than the firm is undervalued or there is a problem S = net income * (P/E) Features -Authorized (number of shares you’re allowed to issue) vs. outstanding (number of shares you issue) -Shares may have different classes of common stock: -Different voting rights -Dividends: -Corporations cannot default on undeclared dividends -Dividends are not seen as a business expense -Some investors pay taxes on dividends received -Only debt holders can put the company into bankruptcy Straight Debt Distinctions -Debt is not ownership in the firm -Types of debt: -Debentures (unsecured) -The written agreement between the corporate debt issuer and lender is called the indenture Preferred Shares Total cost = ρF + (1-T c c old λ + E – (E/5) (T c -Senior to 1−(1+ri) −5 common stock, junior to debt -Shares have a stated liquidating value on them and typically have a stated dividend per share amount -If dividends Total benefit = (F – E)λR f1-T c + F(C old C new)(1-Tc) have been deferred: 1−(1+ri) −n - Common ri shareholders must also forego PB= Par dividends -Preferred valuen shareholders may be granted voting and other rights (rare) -Convertible preferred shares – can be exchanged for common shares in the future -Sinking funds – a fund formed by periodically setting aside money for the gradual repayment of debt -Canadian corporations do not pay tax on preferred share dividends -Most preferred shares are purchased by corporations How Firms Raise Equity -Publicly via a general cash offering made to all investors: -Public pay cash for shares -Sold through an underwriter -Publicly via a rights offering available only to existing shareholders -Existing shareholders get “right” to buy more shares at a slight discount -May or may not use underwriter -Direct placement – selling a new issue not by offering it for sale publicly, but by placing it with one of several institutional investors -Privately via private placement or with venture capital Procedure for a New Issue 1. Management obtains approval from BOD to issue securities 2. Prepare prospectus for securities commission and potential investors 3. After approval, issue is priced – seasoned offerings are priced close to current market value 4. Securities are offered for sale – the underwriter brings securities to market -Prospectus – a disclosure document that describes a financial security for potential buyers In the Prospectus -Preliminary prospectus -Contains details so as to provide a full disclosure of all material facts -No sales allowed until final is accepted -Red Herring – used to solicit interest – used as marketing document to see if there is enough interest for the company -Don’t include the price of the share -Final prospectus -Includes price to public, commissions, and net proceeds to issuer (money from public – underwriter fees) -When final is accepted, issue is “blue skied” Decreasing Regulatory Drag -Prompt offering prospectus system: -Takes 5 days as opposed to 20 -Large existing firms that make regular disclosures to OSC are waived from requirements Bought Deals -Issuer accepts a fixed bid from a single dealer for a specific issue of securities -Once-only deal and does not imply an ongoing relationship between the issuer and the dealer -Issuer accepts a specific price from a dealer -Fast and most popular The General Cash Offer -Underwriters help firms issue new securities – their compensation is called the “spread” or the difference between the underwriter’s buying price and the selling price -Underwriters have 4 main functions: -Origination – the mechanics of producing the issue -Distribution – selling the issue -Risk bearing – the amount of risk borne depends on the underwriting agreement -Certification – quality control Syndicates -Investment dealers usually join forces and form a “syndicate” -Banking group agreement: members authorize financing group to negotiate on their behalf and agree in advance as to individual participation -Risk spread across all members -Banking group names appear on Tombstone (advertisement announcing new issue) -Selling Group Agreement – buy issue from banking group at specified discount with no liability beyond order Investment Dealing Arrangements -Negotiated bid – issuing firm negotiates terms with the investment banker -Competitive bid – issuer structures the offering and secures bid -Regular underwriting – underwriters buy securities from firm and sells them to public for purchase price plus spread -Firm commitment – like regular underwriting but without an out clause -Best efforts – no firm commitment. The Cost of Issuing Securities “Floatation Costs” -Spread – the difference between the price the issuer receives and the offer price -Other direct expenses – these are costs incurred by the issuer, that are not part of the compensation to underwriters -Indirect expenses – these costs are not reported on the prospectus (cannot quantify) -Abnormal returns – price drop in trading stock upon announcement of seasoned issue -Underpricing – arises in IPOs – loss that arises from selling shares for less than they are worth -Overallotment (green shoe) option – covers excess demand for issue (cannot quantify) Why do Stock Prices Drop When Firms Issue New Equity? SEO -Seasoned offering -Information asymmetry: firm is issuing new stock now because common stock is overvalued -OVERVALUED: Market price > intrinsic value -Company issues equity (sells) -Interpret from issuing equity as a BAD signal > selling stock which will drive the price down -UNDERVALUED: Market price < intrinsic value -Company buys back stock = repurchase -Interpret share repurchase as a GOOD signal > will drive the market price up -Issuing equity will cause stock price to fall -Company will use debt to magnify good news -Company will use equity when there is bad news 1. Debt is leverage. Leverage = Debt/Equity. Has a magnifying role -Makes good results better -Makes bad results worse 2. If good results ahead, existing shareholders do not want to share good results with new shareholders -Ex. Do not want to dilute -So do not issue equity  issue debt instead The Initial Public Offering 1. Firm contracts underwriter to bring IPO to market 2. Prospectus is produced 3. Stock price is set (usually underpriced) 4. Issue is listed Performance of IPOs -Look at the difference between the offering price and the price shortly after offering -Why underprice? -Underwriter incentives -Leave investors with a “good taste in their mouths” -Signalling -Asymmetrically informed investors -Only good firms can afford underpricing cost: use underpricing to signal to the market that the firm is good -Reduce cost of capital to increase number of uninformed investors -Underprice: Offering price < price after offering -When investor is uninformed, they do a lower offering price -In IPO, informed investors make money and uninformed investors lose money Three Empirical Conclusions on Underwriting Costs -There are substantial economies of scale in issuing securities -For smaller issues, the cost of underpricing may exceed direct issue costs -It costs more to float an IPO than a seasoned offering Pricing a New Issue (Simplified) -First step is to calculate va
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