Session 5: Long-Term Financing

1. Session 5: Long-Term Financing C15.0008 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.

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

19. Traded Warrants • NYSE traded • Exercise price: 19.23 • Expiration: 3/19/09 • American

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 = 51-45 = $6 Warrants (at expiration): E = 45, nW = 500,000 V = 51 + 45 (0.5) = $73.5 million n = 1,500,000  S = $49/share W = 49-45 = $4

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

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 = $754 + 20($12.30) = $1,000

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? • 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

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

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

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#/yrReturnReturn 1990-94 326 11.2% -7.2% 1995-98 438 18.1% -32.3% 1999-2000 401 65.0% -34.3% 2001 80 14.0% NA

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

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