Session 5: Long-Term Financing C Corporate Finance Topics

Outline Characteristics of debt Warrants and convertibles IPOs and SEOs

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Key Points Office Hours Exam points Book vs. Classes Tangents Real life examples

Characteristics of Debt A contractual obligation to make/receive a pre-specified set of payments (interest and principal) No ownership rights No control rights

Debt Covenants The debt contract (bond indenture) often contains provisions restricting the actions of the debtor (firm) Amount and seniority of additional debt Dividend payments Assets sales Financial ratios (technical default triggers)

Interest Payments Deductible as an expense at the corporate level (for tax purposes) Taxable to the recipient as ordinary income Failure to pay triggers default

Debt Features Maturity Sinking funds Callability Convertibility Fixed or floating rate Priority/seniority Security/collateralization Rating

Announcement Effects Managers will try to issue equity when they think their stock is overvalued However, the market knows this, announcement of new equity issuance is treated as bad news -> Stock price drops Similar issue with debt, but to a lesser extent because debt is less risky. This gives rise to a pecking order.

Financing Implications The pecking order theory suggests that financing sources are used in the following order: (1) retained earnings (internal cash flow) (2) debt (3) external equity What increases as we go from (1) to (3)?

Some other securities Preferred stock Warrants Convertibles

Preferred Stock A kind of equity “Preference” over common stock in terms of dividend payment and bankruptcy Stated Value Cumulative/non-cumulative dividends Tax Code quirks, regulation for utilities, bankruptcy avoidance

Preferred Stock Combines the features of debt and equity Like debt Pays a fixed dividend No voting rights Sinking funds, callability, convertibility Like equity Dividend payments non-deductible Missed payment does not trigger bankruptcy Perpetual

Warrants A warrant is a security issued by the firm that gives the holder the right to buy shares of common stock from the company at a fixed price for a given period of time, i.e., it is a call option issued by the firm.

Warrants vs. Calls Call—a contract (bet) between 2 individuals, the writer and the buyer Warrant –The firm receives the premium (price) –When exercised The firm receives the exercise price The firm provides (issues) the shares –Often long maturity –Often sold as a package with bonds where warrants are detachable after sale

Traded Warrants NYSE traded Exercise price: Expiration: 3/19/09 American

The Dilution Effect A warrant is worth less than the corresponding call option (on an identical firm without warrants) because warrant exercise dilutes ownership. Example: all equity firm, V = $51 million, n = 1 million, S = $51/share Call (at expiration): E = 45  C = = $6 Warrants (at expiration): E = 45, n W = 500,000 V = (0.5) = $73.5 million n = 1,500,000  S = $49/share W = = $4

Warrant Valuation Gain from exercising call: S-E Gain from exercising warrant: [ n / (n+n W ) ] (S-E) Price of warrant: W = [ n / (n+n W ) ] C

Convertible Bonds A convertible bond is a bond that can be converted into common stock An example: Straight debt (10-year): r B = 10% Equity: S = $25/share, r S = 16% Convertible (10-year) –interest rate: 6% (annual coupons) –$1,000 par convertible at maturity to 20 shares

Terminology Conversion ratio: 20 shares per $1000 Conversion price: $1000/20 = $50/share Conversion premium: 50/25 – 1 = 100% Conversion value: 20 x S t (at any point in time)

Convertible Payoffs Payoff at maturity of $1000 face value Payoff Stock price S=0S=

Convertible Valuation A convertible bond equals a bond plus warrants. Conv = Bond + 20 W Bond: 10-year, 6%, r B = 10%  B = $754 Warrant:W = [n/(n+n W )] C(E=50, S=25, t=10,  =50%, r f =4%) = [100/(100+3)] $12.67 Conv = $ ($12.30) = $1,000

Initial Public Offering Initial public offering (IPO)—the first sale of common stock to the public Facilitated by an investment bank Regulated by and registered with the SEC Audited financials/prospectus Road shows/marketing

Why? Why go public? –Diversification –Liquidity –Access to capital –Establish market value Why not? –Reporting/auditing costs –Disclosure rules –Potential loss of control –The costs associated with an IPO

How? In the U.S., the principle way of going public is via an IPO using book-building Internationally, firms also seem to be moving towards the book-building method More recently in the U.S. a few firms have used an auction method for their IPOs, e.g., Google

Book-Building: The Mechanics Investment bank distributes prospectus with offer size and price range (may be updated) Based on information from institutional investors, the investment bank sets a size and offer price in negotiation with the issuer The bank buys the issue from the firm (at a discount to reflect underwriting fees) and resells it at the offer price to investors selected by the bank (best efforts vs. firm commitment) The bank may have the option to increase the issue size/buy more shares (greenshoe option) The bank supports the price in the after-market

Auction: The Mechanics Investment bank distributes prospectus with offer size and price range (may be updated) “Certified” investors can submit bids (price and quantity) online during a predetermined period Dutch auction—issue is priced at or below the highest price for which there is sufficient demand to sell the entire issue and allocated using price priority

IPO Costs Direct costs, e.g., fees for underwriters and lawyers (~7% of capital raised, lower for auctions) Indirect costs, i.e., underpricing –Underpricing is the offering price relative to the price in the secondary market thereafter –Underpricing is a cost to the original owners Recent IPOs

IPOs: The NASDAQ Bubble First-Day3-Year Abnormal Period#/yrReturnReturn %-7.2% %-32.3% %-34.3% %NA

Seasoned Offerings Seasoned offering—subsequent (to an IPO) offering of stock that is already publicly traded Rights issue vs. public offering Shelf registration

Costs of Seasoned Offerings Direct costs (~3-5% of capital raised) Information effect on stock price, i.e., on average price drops 3% upon announcement –What is the effect on earnings per share? –What happens when there is an excess supply of a stock? –What kind of announcement effects are at work? A small amount of issue underpricing

IPOs and SEOs occur together

Exam points Tax treatment on debt vs equity Announcement effects Pecking order theory Warrants and convertibles IPO underpricing