1. C15.0008 Corporate Finance Topics
Long-Term Financing
C Corporate Finance Topics

2. Outline Characteristics of debt Warrants and convertibles
IPOs and SEOs

3. Feedback

4. Level of content

5. Effectiveness

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

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

9. 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)

10. 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

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

12. 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.

13. 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)?

14. Some other securities
Preferred stock
Warrants
Convertibles

15. 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

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

17. 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.
Warrant is equivalent to an employee stock option!

18. 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

19. Traded Warrants NYSE traded Exercise price: 19.23 Expiration: 3/19/09
American
Few traded warrants (<<100 on NYSE, AMEX, NASDAQ)

20. 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, nW = 500,000 V = (0.5) = $73.5 million n = 1,500,000  S = $49/share W = = $4
In second firm stock price does not fall to $49 (from $51) at expiration; it never got to $51 in the first place
Warrants (and employee stock options) have value (just like any other claim on the firm): V = S + W = 51 =

21. Warrant Valuation Gain from exercising call: S-E
Gain from exercising warrant:
[ n / (n+nW) ] (S-E)
Price of warrant:
W = [ n / (n+nW) ] C
Be careful! This is much more subtle than it looks.
Warrants and call options on the same firm must sell at the same price (they have the same payoff)
The C above is the call option on a hypothetical firm that is identical except for the fact that it does not have any warrants.
Advanced questions:
What happens to the stock price when a firm issues warrants (at a fair price) and uses to proceeds to scale up? Nothing, the stock price is unaffected.
What happens to the value of existing call options (corresponding to warrants)? The value falls. Why? Stock price volatility goes down. In the bad state the stockholders get the warrant proceeds but pay nothing in the future. In the good state, the stockholders have to give away some of the upside to the warrant holders.

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

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

24. Convertible Payoffs Payoff at maturity of $1000 face value Payoff 1000
Stock price
S=0
S=50

25. Convertible Valuation
A convertible bond equals a bond plus warrants.
Conv = Bond + 20 W
Bond: 10-year, 6%, rB = 10%  B = $754
Warrant:W = [n/(n+nW)] C(E=50, S=25, t=10, =50%, rf=4%) = [100/(100+3)] $12.67
Conv = $ ($12.30) = $1,000
Annual coupon bond
Dilution effect assumed (it depends on number of convertibles relative to shares outstanding)

26. 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

27. Why? Why go public? Why not? 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
Public firms also go private—LBOs, MBOs, private equity/buyout funds

28. 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

29. 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
How do underwriters use the greenshoe option?
Allocate more than 100% of issue (up to 100+greenshoe)
If price rises exercise option to fill allocation
If price starts to fall, do not exercise option and buy back shares in the open market to fill allocation

30. 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
Example: issue size 100 shares
Bids P n cum.
16 30
Priced at <=$17
Bids above $17 receive full bid
Bids at $17 receive 50% allocation
Why auctions?
Eliminate underpricing
Make allocation of shares fairer

31. 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

32. IPOs: The NASDAQ Bubble
First-Day 3-Year Abnormal
Period #/yr Return Return
% -7.2%
% -32.3%
% -34.3%
% NA
# of issues flat (until bubble bursts)
Underpricing rose dramatically at the peak
Future underperformance?

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

34. 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

35. IPOs and SEOs occur together
Less dramatic than IPOs, but a similar pattern

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