IB 2360: FINANCE2

CORPORATE FINANCE

Spring Term 2019

Week 4

Onur Tosun

Before we start…

• Last time:
• Cost of financial distress
• How to decide on debt vs equity
• Related theories
• Relation between leverage and firm characteristics
• Agency problems
• Debt and agency cost relation
• Strategies for firms in financial distress

• Today…
• Long-term financing alternatives: Equity and Debt financing
• Fundamentals of IPO
• Bonds and Bond ratings

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 Ch19: Equity Financing

• There are two ways of external funding:

• Issuing securities  Equity financing
• Borrowing funds and public issue of debt  Debt financing
Equity financing

Initial Public
Cash Offers
Offerings (IPO)
Public Investment
Placement Banks
Seasoned New
Equity Financing Rights Offers
Insurance Firms, Issues
Private
Mutual Funds,
Placement
Pension Funds

Traditional Stock Exchanges – Raising Capital

The concept of share ownership
in UK dates back to 1553 when
the famous seafaring adventurer
Sebastian Cabot founded the first
joint stock company

“ The Mysterie and Companie

of the Merchant Adventurers
for the Discoverie of Regions,
Dominions, Islands and Places
Unkwowen”
The company was created to defray the
cost of an expedition to discover the
Northeast passage which Elizabethans
believed led to the Orient and Indies

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 Jonathan’s Coffee House

Amsterdam stock exchange founded 1602 to trade Dutch East India stock

Globally listed companies in London Stock Exchange

Number of companies:
60 +
40-59
20-39
1-19

Source: London Stock Exchange statistics. Based on country of primary business.

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Ch19: Equity Financing

• Public placement:
• The public sale of shares are done via investment banks.

• If it is going to be the first time for a firm being listed in the stock
market (IPO), it will be done by “Cash Offers”.
• The equity is offered to all investors in the market via cash.
• But first, the shares are purchased by investment banks at the day
of public offering.

Ch19: Equity Financing

• Public placement:
• Banks act as underwriters, and they buy all the shares from the
company directly.
• But at a lower price then the offering price because they take the
risk of not being able to sell all shares.
• Offering price – underwriter’s price = spread (discount)
• Then, they either offer the shares:
• with a fixed price to the public  Firm commitment
• Or via uniform price auction  Dutch auction underwriting

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Ch19: Equity Financing

• Public placement:
• Example: Bidder Quantity Price (£)
• A firm wants to sell 400 A 100 shares 16
shares to public. The bids B 100 shares 14
are given in the table. C 100 shares 12

Which investor gets how D 200 shares 12

E 200 shares 10
many shares and at what
price?
All get 400/(100+100+100+200)=80% at £12 per share except bidder E.

http://www.youtube.com/watch?v=XZGvhRHvaao

Ch19: Equity Financing

• Issues with public placement:
• Underpricing: It is the case with most IPOs. The firm sets an offer price.
Market opens and the firm’s shares trade at the offer price. When market
closes, the shares usually have a higher price. The difference is called
“money left on the table”. Although the closing price is higher, it is still
usually less than the true value of that firm. That difference is called
“underpricing”:

• Why?
• Overvaluation: As we discussed earlier, issuing shares may signal that the
CEO has some private information and the firm might be in fact overvalued.
Following “Adverse Selection Theory”, investors pay less than the actual
value for the firm’s share.

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Ch19: Equity Financing

• Issues with public placement:

• Fear of financial distress: As we mentioned earlier, issuing shares
may also signal that firm might be in financial distress and thus, the
firm prefers to issue equity than costly debt. Consequently,
investors choose to pay less than the true value of the firm when
buying the shares.
• Overpricing: Opposite to underpricing scenario, the firm might fear
that it will set offering price too low and too much money will be
left on the table in the first day of public offering. Hence, it decides
on a higher offering price. But due to the reasons mentioned above,
investors may not even trade on the offering price, pushing the
closing price even lower. This phenomenon is called “Overpricing”

Ch19: Equity Financing

• OK… But who gets the money left on the table in the case of
underpricing???
• The firm?

• Banks involved?

• Investors?
• Even though there is a loss of value through underpricing,
the initial return of IPOs in the first day of offering is usually
quite high.

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Ch19: Equity Financing

Weighted average of initial IPO returns (in %) across countries…

Source: Ljunqvist (2006)

Ch19: Equity Financing

• Issues with public placement:

• Examples: Facebook IPO (2012) vs Twitter IPO (2013)
• Facebook IPO (2012): A Story of failure and overpricing

– Facebook got too greedy and didn’t want to

leave any penny on the table; so, it decided
on a high offering price of $38 per share on
NASDAQ.
– After NASDAQ opened, trading price jumped
to $42.5 ; but by noon, it started to fall even
below the offering price.

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Ch19: Equity Financing

• Facebook IPO (2012): A Story of failure and overpricing

– Underwriters (Banks) started to buy

the shares at $38 in order to keep
the closing price above the offering
price and prevent a huge loss.
– The closing price was $38.23. After
a week from IPO, the share price of
Facebook was even worse: $26.81

Ch19: Equity Financing

• Twitter IPO (2013): A Story of success and underpricing

– After the Facebook failure, Twitter agreed on

a more conservative offering price of $26 per
share on NYSE.
– NYSE opened, trading price jumped to $45.1 .
Throughout the day, trading price fluctuated
but never fell drastically.
– When NYSE closed on November 7th, the
closing price per share of Twitter was $44.9
– After one week, the share price was still
high: $41.75

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Ch19: Equity Financing

• Public placement:
• Rights Offers: It is still a public placement of firm’s shares. But this
time, the firm’s shares are already traded in the stock market.
• When the company decides to issue more new shares, it contacts to
investment banks. The announcement of these seasoned new shares
are made in public; BUT, underwriters contact only the “current”
shareholders of the firm.
• The shares are offered at a price to the existing shareholders only for a
limited period of time. If they decide to increase their ownership within
the firm, they buy some of these seasoned new shares.
• The unsold shares expire at the end of the offer period and stay within
the firm.

Ch19: Equity Financing

• Private placement:

• Not all firms are big and well-known enough to be accepted in the
public stock markets and also attract investors in those markets.
• Therefore, some firms choose to issue their shares via private
placement.
• They contact to some private equity firms which will act as
underwriters.
• Those underwriters sell the shares to institutional investors,
insurance firms, mutual fund and pension fund companies.

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Break…

• After the break:

• Long-term financing alternatives: Debt financing
• Bonds and Bond ratings

So far…

• Long-term financing alternatives: Equity financing

• Ways to issue equity
• Fundamentals of IPO

10
Ch20: Debt Financing

• The other alternative of external funding is “debt financing”.

Long Term
(Funded)
Public
Short Term
(Unfunded)
Bonds
Long Term
(Funded)
Debt Private
Financing Short Term
(Unfunded)
Line of Credit
Bank Loans Revolving
Loan
Commitment
Non-
Revolving

Ch20: Debt Financing

• Bank Loans:
• It is still quite common way of external financing method by firms
across countries.

Source: Beck et al. (2008)

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Ch20: Debt Financing

• Bank Loans:
• Line of credit: For a short-term, bank agrees to lend money to firm.
The maximum amount of funding is determined but not the interest
rate; so, bank may charge any interest rate it wants at any time.
Thus, firm has the flexibility to decline the funding.
• Loan commitment: A similar contract where the interest rate is pre-
determined, is called loan commitment.
• If the firm can pay down the loan and borrow more during the term
of contract, this will be a revolving loan commitment.
• The case where the fund flow is restricted will be a non-revolving
loan commitment.

Ch20: Debt Financing

• Corporate Bonds:
• The logic is quite similar to issuing shares. Company appoints a
“trust company” to manage the bonds issued to investors. Then,
bonds are offered with a face value (principle value) and an interest
rate for a term of maturity.
• To protect bondholders in case of a default by the company, the
firm should show a property it owns as collateral.
• Also some of the borrowing firm’s actions are limited by protective
covenants to secure the bondholders against the risk of default. The
covenants are divided into negative and positive covenants.

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Ch20: Debt Financing
• Corporate Bonds:
• Protective covenants:
• Limits on merging with another firm
• Limits on dividend payments to shareholders by the borrowing firm
• Limits on pledging any assets to other lenders
• Limits on leasing and selling of its assets without permission
• Limits on issuing any additional long term debt
• Requirement of keeping the working capital above a minimum level
• Requirement of disclosure of the periodic financial statements to lenders
• As another feature of bonds, the firm can call the entire bond issue at a
predetermined price over a specified period under call provision. The
difference between the call price and face value is call premium.

Ch20: Debt Financing

• Corporate Bonds: Example

• What is the amount of bonds issued??? What is the term to maturity???

• What is the structure of the coupon payments; how many payments will be
made till maturity???
• If it was a callable bond in 3 years, how much the call price at least should be???

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Ch20: Debt Financing

• Corporate Bonds:
• Bond Refunding: Some companies prefer to issue callable bonds, so
that they can purchase their bonds back and issue new bonds
simultaneously instead.
• It is preferred when they have a superior knowledge of what the
future interest rates will be or due to some tax advantages.
• On the other hand, the potential bondholders would only invest in
those callable bonds if the call premium and coupon payments are
high enough.

Ch20: Debt Financing

• Bond Refunding: Example

• The British firm TTB wants to issue perpetual callable bonds of
£1,000 face value and a call price of £1200 for the first year. The
current market interest rate is 8%. There is equal chance of the
rates will either fall to 6% or increase to 12% next year. The firm will
call the bonds if the interest rate falls because it can engage in
cheaper investments. If the bond sells at par, what should the
coupon rate be to attract investors?
• In case of interest rate = 6 %, the bondholders receive the call price
and C (the coupon payment)  £1,200 + C
• In case of interest rate = 12%, the bondholders receive the regular
bond price and C (the coupon payment)  ( C / 12% ) + C

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Ch20: Debt Financing

• Bond Refunding: Example

• Since there is equal chance for each case to happen, the present
value with coupons should be:
£1,000 = { ( £1,200 + C ) * 0.5 + [ ( C / 12%) + C ] * 0.5 } / ( 1 + 8%)
• Rearranging the equation for C gives:
C = £92.90  Coupon rate is 92.90 / 1000 = 9.29%

Ch20: Debt Financing

• Corporate Bonds:
• Similar to shares, firms can issue bonds either via public or private
placement. Compared to public placement, with private placement,
firms issue bonds:
• to a limited number of institutional investors such as insurance
companies and pension funds
• for a longer term to maturity (more than 15 years)
• With more strict covenants.

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Ch20: Debt Financing

• Corporate Bond Ratings:

• OK, but how do the potential debtholders (bondholders) decide on
which company to lend money (to invest) ?  bond ratings

Ch20: Debt Financing

• Corporate Bond Ratings:

• http://www.standardandpoors.com/home/en/eu
• https://www.moodys.com/
• How reliable are the rating agencies ???
• 2008 financial crisis !!!
• Let’s see what Warren Buffett has to say on Credit Rating Agencies
• https://www.youtube.com/watch?v=P88bbG8Du58

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Ch20: Debt Financing
• Corporate Bond Ratings: EU Junk Bonds 2005-2011

Summary…

• Long-term financing alternatives: Equity financing

• Ways to issue equity
• Fundamentals of IPO
• Long-term financing alternatives: Debt financing
• Bonds and bond ratings

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Next time…

• READING WEEK
 NO SEMINAR !!!
 NO LECTURE !!!

• Week6:
• Basics of derivatives: Options
• Combination of Options
• Option Valuation

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