CFS Session 2 Equity Financing

Section 2: Equity Financing
Dr. Owen Williams, CFA

Corporate Financing Strategies
INVESTMENTS | BODIE, KANE, MARCUS

Lecture Outline
• Introduction
• Externally-Generated Equity
• Raising Equity Capital
• Internally-Generated Equity
2
Introduction
• Three methods to finance company via firm

equity:
1. Increase outstanding equity shares
2. Produce and retain earnings from operations
3. Sell Assets
3 Introduction
Lecture Outline
• Introduction
• Common Equity
• Preferred Equity
• Private Equity
4
Role of External Equity
1. Finance a portion of firm’s capital needs

2. Guarantee for creditors financing the other
portion of firm’s capital
3. Increases odds of firm resisting in a period of
difficulty
5 Externally-Generated Equity
Common Stock
Authorized Shares
Maximum number of shares that may be issued
Issued Shares
Authorized shares sold to investors
Outstanding Shares
Issued shares held by public
Treasury Stock
Issued shares repurchased by company, held in its
treasury, but not yet retired
Common Stock
Par Value Retained Earnings

Recorded price of Earnings not paid out as
security on certificate dividends
Additional Paid-In Capital

Difference between sales price of stock and par
Founder’s Stock
Original shares given to entrepreneurs
Common Stock
Book Value vs. Market Value

• Book value is a backward looking measure
• Tells us how much capital the firm has raised from
shareholders in the past
• Does not measure the value that shareholders place on
those shares today
• The market value of the firm is forward looking
• Depends on earnings outlook and the future dividends
that shareholders expect to receive
Common Stock
Book Value for FedEx (2/28/18)
31.8
$19,250.80
Common Stock
Market Value for FedEx (2/28/18)
From above, total Shares outstanding = 267 million
Market price on NYSE $250/share

# shares x 267
Market value $66.75 billion
Example: Common Stock
Suppose that FedEx raised more capital by selling an additional 75M
shares. FedEx market price is $250. Update the balance sheet:
Common shares ($0.10 par value per share)
Additional paid-in capital
Retained earnings
Treasury shares at cost
Net common equity
Authorized shares (mln) 800
Issued shares, of which
Outstanding shares
Treasury shares 51
Suppose that FedEx raised more capital by selling an additional 75M
shares. FedEx market price is $250. Update the balance sheet:
Common shares ($0.10 par value per share) $31.8 + 7.5 = 39.3
Additional paid-in capital 3,085 + 18,742.5 = 21,827.5
Retained earnings 23,710
Treasury shares at cost (7,567)
Net common equity $38,009.80
Issued shares, of which 318 + 75 = 393
Outstanding shares 267 + 75 = 342
Treasury shares 51
A year after the above equity sale, FedEx did a 100M share buy-back,
through a debt issue, to take advantage of share price drop to $175.
Update the balance sheet:
Common shares ($0.10 par value per share)
Additional paid-in capital
Retained earnings
Treasury shares at cost
Net common equity
Issued shares, of which
Outstanding shares
Treasury shares
A year after the above equity sale, FedEx did a 100M share buy-back,
through a debt issue, to take advantage of share price drop to $175.
Update the balance sheet:
Common shares ($0.10 par value per share) $39.3
Additional paid-in capital 21,827.5
Retained earnings 23,710
Treasury shares at cost (7,567+17,500=25,067)
Net common equity $20,509.80
Issued shares, of which 393
Outstanding shares 342 – 100 = 242
Treasury shares 51 + 100 = 151
Hooters has had one stock issue in which it sold 50,000 shares to
investors at €25 per share. Complete the balance sheet:
Common shares (€1 par value)

Additional Paid-In Capital
Retained Earnings
Net Common Equity €3,500,000
Hooters has had one stock issue in which it sold 50,000 shares to
investors at €25 per share. Complete the balance sheet:
Common shares (€1 par value) €50,000

Additional Paid-In Capital €1,200,000
Retained Earnings €2,250,000
Net Common Equity €3,500,000
Common Stock
Holding of common equity in U.S. (2017)
Pension funds
Other (1.3%) (12.3%)
Household
sector (39.0%) Mutual funds,
etc. (29.9%)
Insurance
Rest of world companies
(15.5%) (2.0%)
Common Stock
Costs for Firm Issuing Common Shares

1. Shareholders are entitled to whatever profits remain
after creditors & taxes paid
2. Surrender control over major company decisions
3. Shareholders have right to vote at Annual General
Meeting
Preferred Stock
• Part of equity capital but having the features of debt
securities
• Net worth = common shares + preferred shares
• Flavours:
• Callable Preferred Stock
• Convertible Preferred Stock
• Cumulative Preferred Stock
• Participatory Preferred Shares
Preferred Stock, a Hybrid Security
Factor Common Stock Preferred Stock
Limited to redemption
Upside Potential Unlimited
value*
Downside risk $0 $0, but less likely
Price volatility High More moderate

At management Higher dividend yield,
Dividends
discretion Paid before common
Voting rights Yes No, generally
Claim on assets Lowest Above common
Preferred Stock, a Hybrid Security
Factor Bonds Preferred Stock
Limited to redemption
Upside Potential none
value*
Downside risk $0 $0, but more likely
Price volatility Low More moderate

Higher yield,
Interest or Dividends Obligatory
But payment deferrable
Voting rights No No, generally
Claim on assets Highest Below all bonds
Why Issue Preferred Shares?
1. Firms receive greater funding from preferred shares
compared to common shares
2. Equity financing without diluting voting rights of
common shareholders
3. Dividends non-binding for firm
4. Firms retains a call option
5. Relative to debt issue, firms maintain lower
debt/equity ratio
6. Preferred shares can held firm defend against hostile
take-over
A Preferred Stock Scheme
I. A European subsidiary of Google may issue
preferred shares to raise funds
II. Google Europe then lends funds to Google
III. For Google, the loan is tax deductible
IV. For Google Europe, dividends paid to shareholders
are offset by interest received from Google
Tax minimization works best when parent & subsidiary

are in different tax localities
Example: Preferred Stock
Consider two possible sources of financing:
1. A callable preferred share that will sell for $1000, pays a 6%
dividend, and is callable at a premium of 5%
2. A convertible preferred share that will sell for $1000, paying a 3%
dividend and that is convertible into common shares at a ratio of 1:4
The firm’s common share now trade at $250. Which preferred share is
the cheaper source of financing if, after 1-year, the common stock is:
i. $375
ii. $200
Assume both preferred shares rise +10% in case i. and fall -10% in case ii.
Stock prices appreciate
Callable
The firm sold the shares for $1000 and in 1-year they are $1100. The
call is exercised, the firm buys-back at $1050. A $60 dividend was
also paid. Total cost = (1050-1000) + 60 = $110 or 11%
Convertible Conversion has no

value
Cost to convert each share today: $1000 / 4 = $250
Cost to convert each share Yr. 1: $1100 / 4 = $275 Conversion has $100
Firm must sell common shares which are now in value
worth $375 at $275 cost $100. The firm also paid $30 in dividend.
Total cost = (375-275) + 30 = $130 or 13%
Stock prices depreciate
Callable
The firm sold the shares for $1000 and in 1-year they are $900. The
call is worthless for the firm. A $60 dividend was paid.
Total cost = $60 or 6%
Convertible Conversion has no

value
Cost to convert each share today: $1000 / 4 = $250
Cost to convert each share Yr. 1: $900 / 4 = $225 Conversion has no
Investors will not convert for common shares value: 200 < 225
The firm paid $30 in dividend.

Total cost = $30 or 3%
Private Equity
• Private Equity Market

• Venture Equity
• Non-Venture Equity
• Characteristics of private placements

• Avoids cost of registration with exchange
• Most issues involve debt securities
• Securities difficult to resell
Venture Capitalist (VC)
• Private financing for new, non-public, and often high
risk businesses in exchange for stock
• Usually involves active participation by VC
• Ultimate goal: take company public (IPO)
Advantages of VC Financing
1. Capital to expand company
2. Guidance and expertise
3. No obligation to repay VC
4. Regulated entities
Negative Realities of VC Financing For Firms
1. VC deals are hard to find
2. Very expensive for firms
• VC’s demand typically 40% equity stake
• VC’s get voting convertible preferred stock
3. Dilution of ownership & control
• VC’s demand seats on board of directors and/or senior
management
4. Funds released progressively
5. Early redemption
Firm Checklist in Choosing VC
• Financial strength
• Compatible management style
• Obtain and check references
• Contacts
• Exit strategy
Private Equity
Suppliers of Venture Capital

1. Wealthy families (must tolerate high risk)
2. Private partnerships
3. Subsidiaries of large financial corporations
4. Individuals (angels)
Business Angels
• Characteristics of Angel Investors
- Individual or high net worth investors
- Family/friends
- Angel syndicate
- Typical investment $25k to $500k
• Like VC’s, angels may share advice
• Early financing of start-ups has become more
dependent on angel investors in recent years
Business Angels
• “Patient capital” -- often 8-10 year for ROI
• Profit / exit strategy
• Trade sale
• MBO
• Purchase of shares
• IPO
Business Angels
Advantages of Angel Investing Disadvantages of Angel Investing

Financing much less risky than Loss of complete control as an
taking loans owner
Angels bring business acumen, Angel provides less structural
vertical expertise, director service, support than an investing company
and financial experience
Credibility from being associated Angels rarely make follow on the
with the investor investments
Contacts for potential customers, Pressure to generate substantial
employees, investment bankers, etc returns for the angel
Private Equity Fundraisers
Subsidiaries of Financial Corps
International Business Angel Networks
Private Equity: Financing Stages
First-Round
Seed Money Start-Up
Financing
Bridge Mezzanine Second-Round

Financing Financing Financing
Private Equity Funding By Stage
Crowdfunding
Two Main Types of Crowdfunding:
1. Loans to companies (P2P lending)
2. Equity crowdfunding (financement participatif)
• Neither bank nor market financing

• Rapid growth recently (deregulation; internet/social networks)
• Loan maturities 3-months to 5-years ; fixed rate
Lecture Outline
• Introduction
42

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Section 2: Equity Financing

Dr. Owen Williams, CFA

INVESTMENTS | BODIE, KANE, MARCUS

• Three methods to finance company via firm

1. Finance a portion of firm’s capital needs

Par Value Retained Earnings

Additional Paid-In Capital

Book Value vs. Market Value

Market price on NYSE $250/share

Common shares (€1 par value)

Common shares (€1 par value) €50,000

Costs for Firm Issuing Common Shares

Downside risk $0 $0, but less likely

Price volatility High More moderate

Claim on assets Lowest Above common

Price volatility Low More moderate

Claim on assets Highest Below all bonds

Tax minimization works best when parent & subsidiary

Convertible Conversion has no

Convertible Conversion has no

The firm paid $30 in dividend.

• Private Equity Market

• Characteristics of private placements

Suppliers of Venture Capital

Advantages of Angel Investing Disadvantages of Angel Investing

Bridge Mezzanine Second-Round

• Neither bank nor market financing

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