16-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Sixteen Issuing Securities to the Public

16-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 16.1The Public Issue 16.2 The Cash Offer 16.3 New Equity Sales and the Value of the Firm 16.4 The Costs of Issuing Securities 16.5 Rights 16.6 Dilution 16.7 Issuing Long-term Debt Summary and Conclusions Chapter Organisation

16-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Outline the advantages and disadvantages of public company listing. Discuss the process of underwriting and the associated costs. Identify the costs associated with issuing securities. Explain the process of a rights issue and calculate the value of a right. Discuss the dilution effect of new issues. Understand the reasons for recent growth in the corporate debt market.

16-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Public Issue The regulation for the raising of funds in Australia is through the Corporations Act 2001, administered by ASIC. Main areas of regulations are: –prospectus provisions –restrictions on allotment of shares –securities-hawking provisions –accounts and audit provisions –provisions relating to the sale of prescribed interests –debenture provisions –takeover provisions –provisions licensing persons engaged in securities industry.

16-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Issuing Securities to the Public 1.Analyse funding needs and how they can be met. 2.Approval from board of directors for a public issue. 3.Outside expert opinions sought for support of issue. 4.Pricing, time-tabling, prospectus prepared, marketing. 5.Prospectus filed with ASIC and ASX.

16-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Issuing Securities to the Public (continued) 6.Underwriting agreement executed. 7.Prospectus registered. 8.Public announcement of offering. 9.Funds received. 10.Shares allotted, holdings registered. 11.Shares listed for trading on ASX.

16-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan New Issues Flotation is the initial offering of securities to the public. When the company is going to the market for the first time it is called a primary issue. Primary issues are used to: –convert from a private company to a public company –spin-off a portion of the business of a listed company –form a new public company –privatise a public organisation or demutualise a mutual society.

16-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Advantages of Public Company Listing Access to additional capital. Increased negotiability of capital. Growth not limited by cash resources. Enhancement of corporate image. Can attract and retain key personnel. Gain independence from a spin-off.

16-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Disadvantages of Public Company Listing Dilution of control of existing owners. Additional responsibilities of directors. Greater disclosure of information. Explicit costs. Insider trading implications.

16-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Secondary Issues Secondary issues—the term used for all issues by a company subsequent to its listing. The principal forms of secondary issues are: –Private placements—sale of securities to selected clients of a sharebroker and/or large institutional investors (e.g. life insurance companies and superannuation funds). –Rights issues—issue of shares made to all existing shareholders, who are entitled to take up the new shares in proportion to their present holdings.

16-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Underwriting Underwriters are investment firms that act as intermediaries between a company selling securities and the investing public. Roles of the underwriter: –pricing the issue –marketing the issue –engaging sub-underwriters –placing the shortfall. Sub-underwriters are a group of underwriters formed to reduce the risk and to help to sell an issue.

16-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Underwriting Firm underwriting –A guarantee that funds will be made available to a company at a specific time on agreed terms and conditions. Standby underwriting –Where the bidding company has insufficient cash in a successful bid or if cash is offered as an alternative to a share bid. Best efforts underwriting –Underwriter must use ‘best efforts’ to sell the securities at the agreed offering rate

16-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Underwriting Fees The underwriter’s fee is a reflection of the: –size of the issue –issue price –general market conditions –market attitude towards shares –time period required for underwriting. Fees also include brokerage and management fees Recent fees for initial equity issues of industrial companies have ranged from 3 per cent to 5 per cent

16-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Offering Price Equity issues are priced primarily by reference to the prevailing market price. For example: –Private placements of ordinary shares are typically made at per cent of market price. –Rights issues are typically priced at 60−90 per cent of market price. –Dividend reinvestment offers are typically priced at 90−95 per cent of market price.

16-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Offering Price Determining the correct offering price for an initial public offering is difficult. If the issue is priced too high, it may be unsuccessful and have to be withdrawn. If the issue is priced too low (called underpricing), the issuer’s existing shareholders lose out by selling their shares for less than they are worth. Underpricing is a fairly common occurrence.

16-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Average Initial Returns by Month for SEC- registered Initial Public Offerings: 1960−2003

16-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Underpricing Tends to be higher for small, young, risky firms (helps attract investors). More pronounced in emerging markets. Relatively few buyers get the initial high average returns observed in IPOs. Reasons include: –A significant fraction of IPOs experience price drops. –Informed investors quickly subscribe for underpriced issues, crowding out uninformed investors. But uninformed investors get all the shares they want in less profitable issues.

16-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan New Equity Sales and Firm Value Shares prices tend to decline after a new equity issue announcement, but rise following a debt announcement. Why? –Management has superior information about firm value and knows when the firm is overvalued → sell equity –Excessive debt usage –Substantial issue costs. Management needs to understand the signals that an equity issue sends.

16-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Cost of Issuing Securities

16-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Rights Offerings—Basic Concepts Rights offering—issue of ordinary shares to existing shareholders. Allows current shareholders to avoid the dilution that can occur with a new share issue. ‘Rights’ are given to the shareholders specifying: –number of shares that can be purchased (e.g. 1 for 10) –purchase price –time frame. Shareholders can either exercise their rights or sell them. They neither win nor lose either way.

16-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Rights Offerings—Basic Concepts Subscription price –The dollar cost of one of the shares to be issued, generally less than the current market price Ex-rights date –Beginning of the period when shares are sold without a recently declared right, normally four trading days before the holder-of-record date. The share price will drop by the value of the right. Holder-of-record date –Date on which existing shareholders are designated as the recipients of share rights.

16-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ex-rights Share Prices Rights-onEx rights Announcement date Ex-rightsRecord 30 September13 October15 October Rights-on price $20.00 Ex-rights price $16.67 $3.33 =Value of a right

16-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Theoretical Rights Price Where:

16-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Rights Issue Lemon Co. currently has 5 million shares on issue with a market price of $8 each. To finance new projects, the company needs to raise an additional $6 million. To raise the finance, the company makes a rights issue at a subscription price of $6 per share.

16-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Rights Issue (cont’d) The number of new shares to be sold: The holder of one right is entitled to subscribe to one new share at $6 per share. To issue 1 million shares, the company would have to issue 1 million rights. The company has 5 million shares on issue, which means that for every 5 shares held, a shareholder is entitled to receive one right (1-for-5 rights issue).

16-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Rights Issue (cont’d) Calculate the theoretical rights price: If an outsider buys a right, it will cost $1.67. The right can be exercised at a subscription price of $6. Total cost of a new share = $ $6 = $7.67.

16-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Value of Rights * $8.00 – 7.67 = 0.33 ** $0.33 × 5 = $1.65

16-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Types of Equity Capital Raised

16-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Dilution Loss in existing shareholders’ value in terms of either ownership, market value, book value or EPS. Types of dilution –Dilution of proportionate ownership—a shareholder’s reduction in proportionate ownership due to less-than- proportionate purchase of new shares. –Dilution of market value—loss in share value due to use of proceeds to invest in negative NPV projects. –Dilution of book value and earnings per share (EPS)— reduction in EPS due to sale of additional shares. This has no economic consequences.

16-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Corporate Debt The late 1980s saw a major growth in the Australian corporate debt market due to: –the substantial cutback in the level of government borrowing –the fall in interest rates from extremely high levels –the flight to quality –the shortage of government bonds –the attractiveness of raising funds in the domestic market relative to that of the euromarket.

16-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Long-term Debt There are two basic forms of direct private long- term financing: term loans and private placement. Term loans are direct business loans of, typically, one to five years. Private placements are usually long-term loans provided directly by a limited number of investors.

16-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Long-term Debt (continued) Differences between direct, private long-term financing and public issues of debt include: –direct loans avoid ASIC registration costs –direct placement is likely to have more restrictive covenants –term loans and private placements are easier to renegotiate than public issues. The costs of distributing debentures are lower in the private market but the interest rates are usually higher.

16-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Flotation is the initial public offering of securities and can undertaken with the help of underwriters. Public company listing has its advantages and disadvantages. The direct and indirect costs of going public can be substantial but once a firm is public it can raise additional capital with much greater ease. Rights offerings are cheaper than general cash offers. The general procedures followed in a public issue of debt are the same as those for shares.