4.

Financing Decisions and the Enterprise Value

- Equity Instruments -

MIF / MIM | Corporate Finance / Financial Management | 2022/2023

Summary

I. Equity Financing Instruments

II. Sources of Equity Financing

III. Cost of Equity

2
I. Equity Financing Instruments

• Represented by shares;

• May eventually be traded in secondary capital markets (conditional to a

previous IPO);

• A set of fundamental rights is associated with it (pro rata the share of

capital detained):

• Ownership, that is, a (residual) claim/rights over cash-flows and assets;

• Management and control rights, i.e., voting right in management decisions,

that is, control rights over the cash-flows generated by the company;

• Right to dividends;

• Preference rights in future stock issues.

3
I. Equity Financing Instruments

q Classes of shares

• Ordinary or Common Shares

• Voting rights are proportional to cash-flow claiming rights;

• Shareholders are not given any preference in dividend distribution or in asset

allocation, in case of bankruptcy, but detain control rights by appointing managers;

• Because, in most cases, it is necessary 50% of votes in the shareholders meeting to

elect managers, minority shareholders are in disadvantage;

• Shareholders return take the form of dividends and capital gains; neither of these are
accounted for as costs of the company, not providing thus a tax benefit.

4
I. Equity Financing Instruments

q Classes of shares

• Special Shares (privileged)

• Shares offering non-proportional voting rights with respect to cash-flows;

• e.g., state owned golden shares

• Preferred Stock

• Priority dividend and priority asset claims (in case of bankruptcy) facing common
stock;
• Dividend right may be cumulative or convertible into ordinary shares;
• No voting right (or with voting rights with a lesser proportion than cash-flow claiming
rights) [class B shares in US]
• Equity financing instrument or hybrid financing instrument?

5
I. Equity Financing Instruments

q Other equity instruments

• Warrants

• Call options over company shares;

• An interesting instrument for young companies with great growth potential;

• Tracking stocks

• Dividend are a function of earnings of one (or more) specific investment;

• It allows investors to “buy” only that part of the company in which they bet;

• Appropriate for big corporations (conglomerates)

• Contingent Value Rights (CVR)

• Derivative whose value is based on some future event

6
II. Sources of Equity Financing

q 1. Retained earnings

• Not all equity financing requires an increase in share capital (rights issue);

• Retained earnings (non distribution of dividends) is an alternative source of

financing;

• Reasons usually advanced for profit retention:

• Financing of new investment projects;

• Existence of market frictions: taxes and transaction costs;

• Share placement risks;

• Capital dilution;

• Lower cost of capital.

7
II. Sources of Equity Financing

q 1. Retained earnings

• However, it is a factor of aggravated risks/costs of agency, namely in

company with a relevant separation between ownership and control (with
consequent information asymmetry);

• It is generally understood that benefits driven by retained earnings

(prevention of market frictions) compensate agency costs; therefore, the cost
of retained earnings is lower than the cost of new share capital.

8
II. Sources of Equity Financing

q 2. Four F’s

• Founder

• Family

• Friends, and…

• Fools.

q 3. Equity Crowdfunding

• Internet platforms such Crowdcube, Seedrs, Syndicate Room, Venture

Founders and Crowdbnk.

• Other types of crowdfunding: Donation, Reward and Lending based (peer-to-

peer lending)

9
II. Sources of Equity Financing

q 4. Venture Capital (and Private Equity - PE)

• How do private equity companies raise capital for their investments?

Investors (Limited Partners)

Pension funds, Banks, Insurance Companies, Mutual Funds, ...

Management Company (General Partners)

q Capital (~99%)
q Small percentage of capital (~1%)
q Capacity of management
Venture Capital Fund / PE Fund
(Limited Partnership)

Banks Loans (~ 70%)

(In case of levered operations - PE)

Company X Company Y Company W

10
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• It happens when the company shares are sold for the first time to the public,
in the capital markets;

• The offer may involve:

• New shares issued by the company, resulting in an increase in share capital, and/or
• Existing shares held by present shareholders, not resulting in any change in share
capital;

• After the IPO, all shares (either they have been object of the offer or not) may
be traded in the secondary market, and their price will fluctuate according to
the movements of demand and supply, as they were a financial commodity.

11
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• The several phases of an IPO
1. Find the support of an investment bank

• Major activities of an investment bank

• Advising through the whole process;
• Marketing of the operation;
• Underwriting (or not) of the shares [Firm Commitment or Best Effort];
• In case of underwriting, shares not sold will be taken by the underwriter;
• Determination of the offer final price and number of shares to offer;
• Distribution of shares;
• Markey making after the IPO;
• Follow-up of the company by analysts:

• Reputation works as a guarantee of quality of the offer.

12
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• The several phases of an IPO
2. Company valuation, price determination and number of shares to sell and method of
sale:

• Methods of sale

• Fixed price – the final price of the offer is decided when the offer is registered
(phase 3);

• Bookbuilding – Only the minimum and maximum prices of the offer are
established. The final price is decided one day before the actual offer, after the
lead manager appraises demand by investors (phase 4)

• Auction - Investors inform their interest and the final price is the highest possible
so that all shares are sold– single price [Dutch auction]. (Ex.: Google)

13
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• The several phases of an IPO
3. Register of preliminary prospect of the offer through the regulator

• SEC – United States

• CMVM – Portugal

• FSA – UK

4. Roadshow

• The company and the lead manager present the operation to investors
(institutional) in order to stimulate their interest in buying shares;

• According to opinions and buying intentions (not committed) expressed by

investors, the company and the lead manager decide on the final price of the offer.

14
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• The several phases of an IPO
5. Final registration and definition of the price of the offering price

• To determine the offering price is a difficult task for the lead manager and a critical
issue for the company; there are no historical data to consider:

• Overpricing – may lead to a failure or may disappoint investors ex-post;

• Underpricing – shareholders bear an opportunity cost;

• Underpricing is one of the most studied phenomena in IPOs.

6. Distribution of shares

• Fixed price – shares are distributed pro-rata of shared demanded;

• Bookbuilding – shares are distributed by the lead manager;

• Auction – share distribution is not a problem.

15
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• The several phases of an IPO
7. Start of trading

• First day closing market price represents the first valuation of the shares by the
market;

• Usually, shareholders accept not to sell the shares detained before the IPO and not
included in the offer, during a period of 6 months to one year [lockup period];

8. The day after

• The lead manager becomes commonly responsible for:

• Prevent shares market price fall below the offering price;

• Market making;

• Follow-up of the company by analysts [research].

16
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Advantages of market listing
• Access to alternative sources of financing;

• Prestige;

• Risk diversification;

• Favours exit strategies of venture capital companies or initial reference shareholders;

• Allows changes in ownership structure;

• Independent and objective valuation of the company by the market;

• Activates the market for corporate control;

• Induces the company to adopt better corporate governance practices.

17
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Disadvantages of market listing
• Issuing costs;

• Listing fees;

• Market information costs;

• Additional auditing costs;

• Agency costs;

• Loss of confidentiality;

• Loss of control;

• Legal risks;

• Greenshoe;

• Underpricing.

18
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Greenshoe
• Option given to the lead manager to increase the number of shares offered, usually,
15% (option expires, commonly, 30 days after the IPO);

• If market share price after the IPO is higher than offering price, the lead manager
exercises the option;

• May also be used to maintain the market share price after the IPO close to the
offering price.

19
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Underpricing
• Opportunity cost resulting from a first day closing market price higher than offering
price;
• This problem has been first mentioned by Ibbotson (1975) and then widely confirmed;
• Underpricing makes shareholders “leave too much money on the table” with an IPO;
• There is no single explanation for underpricing. It is persistent and costly for
shareholders.

• Lead managers loose commission with underpricing but the benefit from:

• A lesser selling effort and lower underwriting risk (in case of firm commitment);

• Lower market making costs, after the IPO;

• Possibility of allocating a larger number of shares to the best clients, when

underpricing is more significant (in case of bookbuilding);

• Higher benefits from exercising the greenshoe option.

20
 II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Underpricing

Russia
Argentine
Austria
Canada
Danmark
Chile
Norway
Holland
France
Turkey
Spain
Portugal
Nigeria
Belgium
Israel
Mexico
Hong-Kong
UK
Finland
USA
Italy
Source: Ross, Australia
Westerfield and Jaffe,
Corporate Finance (9 th 0 10 20 30 40 50 60 70 80 90 100
Edition) Average return first day after the IPO (%)

21
 II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Underpricing

New Zealand
Indonesia
Phillipine
Iran
s
Poland
Ireland
Cyprus
Greece
Germany
Sweden
Singapore
Switze
South Africarl
Bulgaria
Thailand
Taiwan
Japan
Brazil
South Korea
Malasia
India
Source: Ross, China
Westerfield and Jaffe,
Corporate Finance (9 th 0 10 20 30 40 50 60 70 80 90 165
Edition) Average return first day after the IPO (%)

22
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Underpricing
• Possible explanations
• Winner’s curse
• Underpricing arises from a need to ensure small (not informed) investors do not
abandon the IPO market;
• Signalling
• Good companies are prepared to incur in a high cost by defining an offering
price below actual share value, in order to open the door to future more
favourable offers;
• Cascade effect
• Investors tend to invest in securities with a great demand;
• The decision for a price below actual share value will attract significant buying
orders by investors and ensure the success of the IPO.
• Compensate investors for information costs
• In bookbuilding price is a function of demand, then investors will be cautious in
their demand for shares, except when lead manager allocates more
(underpriced) shares to more interested investors.

23
II. Sources of Equity Financing

q 5. Initial Public Offering – IPO

• Underpricing
• Possible explanations
• Looking for a greater ownership dispersion
• Avoiding the formation of shareholders blocks;
• Increase market liquidity;
• Motivate the lead manager to act in the interest of the company
• High price might imply direct (underwriting) or indirect (reputation) costs for the
lead manager;
• Low price facilitates the sale and attracts clients to the bank;
• Market inefficiency
• Markets are irrational and tend to overprice shares in first day after IPO;
• Evidence shows that first day gains are absorbed within one year after IPO;
• Windows of opportunity: companies use IPO when investors are more optimistic.
This optimism is reflected on first day shares market price.

24
II. Sources of Equity Financing

q 6. Seasoned Equity Offering – SEO

• New shares issues by listed companies [seasoned equity issues] may take
three forms:
• General Cash Offers
• Very much used by American companies;
• New shares are offered to the general public, for a price very close to present
market price;
• Private Placement
• Shares are sold directly to one or a small number of investors;
• The terms of the offer (number and price of shares) are negotiated between the
parties;
• Rights Offerings
• Present shareholders have preference (a call option) in buying the new shares,
pro-rata of shares held;

• Shareholders can either exercise or trade the option.

25
II. Sources of Equity Financing

q 6. Seasoned Equity Offering – SEO

• General Cash Offers
• Shares are offered to the general public on a lead manager firm commitment or best
effort basis;
• Unlike in IPOs, there is a reference price (market price). The price of new share is
commonly 3% lower than previous days closing market price;
• When shares are over-valued (P > V) the issue of new shares benefits present
shareholders at the expense of new shareholders;
• When shares are under-valued (P < V) there is a wealth transfer from old to new
shareholders;
• Very much used in the USA.
• Private Placement
• Advantages
• Lower intermediation costs (lead manager) and issuing costs (legal and
administrative);
• Terms of offer may change to comply with requirements of investors;
• Disadvantages
• Smaller number of potential but relevant investors, who may want to influence
management.
26
II. Sources of Equity Financing

q 6. Seasoned Equity Offering – SEO

• Rights Offerings
• A call option is granted to present shareholders, pro-rata of shares presently held;
• The option may by either exercised or traded;
• Present shareholders can keep their relative position in ownership structure;
• Because of the call option, the offering price being lower than market price does not
go against shareholders interests;
• This solution is popular in Europe and Asia, not so much in the USA (puzzling!).
• In practice:
• A right (call option) is allocated to every share outstanding before the offer;
• A shareholder holding x rights (x = old shares / new shares), can buy a new share
for a lower price;
• Rights can be traded;
• Anyone who neither exercise the rights nor trades them will loose wealth.

27
II. Sources of Equity Financing

q 6. Seasoned Equity Offering – SEO

• Rights Offerings
• Underwriting rights of new shares
• Anytime a company decides to increase its share capital, the present shareholders
possess a legal right of preference in the underwriting of the new shares;
• Shareholders may renounce to this preference right through a majority decision in
the shareholders meeting (waving of rights);
• If they do not do this, we will be in presence of an issue of new shares reserved to
shareholders (a rights issue);
• In practice, because shareholders did not renounce to their legal preference rights,
they hold a call option over the new shares, probably issued at an attractive price.

28
II. Sources of Equity Financing

q 6. Seasoned Equity Offering – SEO

• Rights Offerings
• Underwriting rights of new shares
• The existence of these underwriting rights and, above all, the possibility to trade
them, separately from the original shares, will make sure that present
shareholders are not financially jeopardized, whatever the price established for the
new shares;
• Shareholders may then opt for one of the following paths:
• Exercise the rights and buy the new shares;
• Sell the rights and become this way compensated for the decrease in the
market price of their shares, as a consequence of the increase in share capital.
• The market price reduction is a rational adjustment, due to the fact that the price
of the new shares is commonly lower than the present market price of old shares
(in order to make the offer more attractive).

29
III. Cost of Equity

q CAPM
• ke = Rf + ß(Rm – Rf )
Percentage Points Added
Market Value (000,000)
to CAPM Estimate
>$12,400 0
$5,250 to $12,400 0.3
q CAPM + Dimension $2,600 to $5,250 0.6
$1,650 to $2,600 0.8
• ke = Rf + ß(Rm – Rf ) + dimension premium $700 to $1,650 1.2
$450 to $700 1.3
$250 to $450 1.9
$100 to $250 2.4

q Fama & French three factors model $50 to $100 3.5

<$50 9.2

• ke = Rf + ß1(Rm – Rf ) + ß2.RSMB + ß3.RHML Source: Ibbotson Associates

• SMB - "small (market capitalization) minus big“

• HML - "high (book-to-price ratio) minus low"

30
III. Cost of Equity

q Carhart´s four factors model

• ke = Rf + ß1(Rm – Rf ) + ß2.RSMB + ß3.RHML + ß4. RWML

• WML - “winner minus loser“ – momentum factor

q Ross´s arbritrage pricing theory (APT)

• ke = Rf + ß1.RP1 + ß2.RP2 +…+ ßk.RPk

• RPk – risk premium associated to factor k

• bk – asset sensitivity to factor k

q Cost of new external equity (increase of share capital)

• ke / (1 - issuing costs*)

* Direct costs / amount of issue

31
Further Readings

• Ross, Westerfield and Jaffe; Corporate Finance, McGraw-Hill Irwin, 9th edition
(2010) – Chapter 20

32