15

9-1

RAISING CAPITAL
CHAPTER

ADAPTED BY STAFF AT UNISWA

Brealey, Myers, and Allen

Principles of Corporate Finance
12th Edition
 9-2

Topics Covered

 Firm Life Cycle

 Venture Capital
 The Initial Public Offering
 Alternative Issue Procedures for IPOs
 Security Sales by Public Companies
Rights Issue
 Private Placements and Public Issues
 9-3

Key Concepts and Skills

 Understand the venture capital market and its role in
financing new businesses
 Understand how equity and debt securities are sold to the
public
 Understand initial public offerings and the costs of going
public
 Understand rights issues
 9-4
Industry Life-Cycle Stages:
Strategic Implications
 Industry life cycle
refers to the stages of introduction, growth,
maturity, and decline that typically occur over
the life of an industry
 9-5

Stages of the Industry Life Cycle

Exhibit 5.12
 9-6

QUESTION

The most likely time to pursue a harvest strategy is

in a situation of

A. High growth
B. Strong competitive advantage
C. Mergers and acquisitions
D. Decline in the market life cycle
 9-7

Strategies in the Introduction Stage

 Introduction stage
the first stage of the industry life cycle,
characterized by (1) new products that are not
known to customers, (2) poorly defined market
segments, (3) unspecified product features, (4)
low sales growth, (5) rapid technological
change, (6) operating losses, and (7) a need for
financial support.
 9-8

Industry Life-Cycle Strategies

For the Introduction Stage:

 Develop product and get users to try it
 Generate exposure so product becomes
“standard”
 9-9

Industry Life-Cycle Strategies

 Growth stage
The second stage of the product life cycle,
characterized by (1) strong increases in sales;
(2) growing competition; (3) developing brand
recognition; and (4) a need for financing
complementary value-chain activities such as
marketing, sales,
customer service, and
research and
 9 - 10

Industry Life-Cycle Strategies

For the Growth Stage:

 Brand recognition
 Differentiated products
 Financial resources to support value-chain
activities
 9 - 11

Industry Life-Cycle Strategies

 Maturity stage
The third stage of the product life cycle,
characterized by (1) slowing demand growth, (2)
saturated markets, (3) direct competition, (4)
price competition, and (5) strategic emphasis on
efficient operations.
 Reverse positioning, breakaway positioning
 9 - 12

Industry Life-Cycle Strategies

 Decline stage
The fourth stage of the product life cycle,
characterized by (1) falling sales and profits, (2)
increasing price competition, and (3) industry
consolidation.
 9 - 13

Strategies in the Decline Stage

For the Decline Stage

 Maintaining
 Harvesting
 Exiting the market
 Consolidation
 9 - 14
CORPORATE & FINANCIAL STRATEGY

 Financial strategy must be tied to the overall Corporate

Strategy.
 Total risk = Business risk + Financial Risk
 Therefore, the total systematic risk (Equity Beta) of the
firm’s equity has two parts:
Systematic risk of the assets, A, (Business risk) – the equity risk
that comes from the nature of the firm’s operating activities. E.g
Technology, markets, customers
Level of leverage, D/E, (Financial risk) – the equity risk that
comes from the financial policy (i.e. capital structure) of the firm.
 9 - 15
Balancing business and financial risk

HIGH

correct not good

BUSINESS RISK
LOW
LOW sub optimal HIGH
correct

FINANCIAL RISK
 9 - 16
BUSINESS & FINANCIAL RISK & SOURCES OF FUNDING IN THE PLC MATRIX

GROWTH LAUNCH

Business risk high Business risk v. high

Financial risk low Financial risk v. low

Equity Equity
(growth investors) (venture capital)

MATURITY
DECLINE
Business risk medium
Financial risk medium Business risk low
Financial risk high
Debt and equity
(retained earnings) Debt
 9 - 17
Venture Capital

Steps to obtaining venture funding:

Prepare a business
plan

Receive first-stage
financing

Receive subsequent
staged financing
 9 - 18
Venture Capital

Venture Capital
Money invested to finance a new firm

Success of new firm dependent on managers

Restrictions placed on management by venture
capital company
Funds usually dispersed in stages after certain
level of success
 9 - 19
Venture Capital

First Stage Market Value Balance Sheet ($mil)

Assets Liabilities and Equity
Cash from new equity 1.0 New equity from venture capital 1.0
Other assets 1.0 Your original equity 1.0
Value 2.0 Value 2.0

Debt First stage

Assets Value

Value Equity
 9 - 20

Venture Capital

Second Stage Market Value Balance Sheet ($mil)

Assets Liabilitie s and Equity
Cash from new equity 4.0 New equity from 2nd stage 4.0
Fixed assets 1.0 Equity from 1st stage 5.0
Other assets 9.0 Your original equity 5.0
Value 14.0 Value 14.0
 9 - 21
Venture Capital

 Private financing for relatively new businesses in exchange for

shares.
 Usually entails some hands-on guidance
 The ultimate goal is usually to take the company public and the VC
will benefit from the capital raised in the IPO.
 Many VC firms are formed from a group of investors that pool
capital and then have partners in the firm decide which companies
will receive financing.
 Some large corporations have a VC division.
 9 - 22

Venture Capital

 To limit the risk faced by venture capitalists, finance is usually

provided in stages. At each stage, enough money is provided to
reach the next stage only.
 First stage financing:
 Also known as “seed money” or “ground floor financing”
 Provides enough money to get a prototype built and a manufacturing plan
completed.
 Second stage financing:
 Also known as mezzanine level financing
 This might represent a substantial investment which is needed to start
manufacturing, marketing and distribution
 Different venture capital firms may specialise in different stages.
U.S. Venture Capital Investments
9 - 23
 9 - 24

Characteristics of Debt Capital

 No ownership interest:
Entitled to periodic interest payments
(usually semi-annual).
Tax deductible from the company’s
perspective.
Repayable on a future date (due date).
Unpaid debt is a liability, which if not paid
may cause insolvency.
24
Differ in terms of security pledged, term,
 9 - 25

Types of Long-term Debt

 Bonds – public issue of long-term debt

 Private issues
Term loans
• Direct business loans from commercial banks, insurance companies,
etc.
• Maturities 1 – 5 years
• Repayable during life of the loan
Private placements
• Similar to term loans with longer maturity
Easier to renegotiate than public issues
Lower costs than public issues
 9 - 26

Bond Indenture (Trust deed) Bond Types

•Registered vs. bearer form • Zeroes

• Secured vs. unsecured • Floaters
• Repayment • Securitised
• Call provision • Others
• Call premium - Income bonds
• Call protection/deferred calls - Convertibles
• Protective covenants - Put bonds
- Negative covenants - LYON’s
- Positive covenants
 9 - 27
Zero Coupon Bonds: Example
 South African Tax deduction is based on the
implicit interest.
 At 15% discount rate and matures in 5 years

Year Beginning value Ending Value Implicit

Interest
1 1000/(1.15)5 = 497 1000/(1.15)4 = 572 75

2 1000/(1.15)4 = 572 1000/(1.15)3 = 658 86

3 1000/(1.15)3 = 658 1000/(1.15)2 = 756 98

4 1000/(1.15)2 = 756 1000/(1.15)1 = 870 114

5 1000/(1.15)1 = 870 1000/(1.15)0 = 130

1000
Total 503
interest
 9 - 28

Zero Coupon Bonds : Example

Suppose this firm wants to raise R10 million, how many zeros must
be
issued?
No of zeros = Amount to be raised
Issue Price
= 10 000 000/ 497
= 20 121 bonds

At maturity how much will this firm pay?

= No of zeros x Par value
= 20121 x 1000
= 20 121 000

28
 9 - 29
Characteristics of Equity Capital

 Ownership rights:
Participate in periodic distributions of residual
profits (dividends).
Participate in residual assets on liquidation.
Corporate democracy
• “one share, one vote”
 classes of shares
 proxy voting and proxy fights
 Participate in the control of the company (elect
directors).
29
 Vote on major issues affecting the company.
 9 - 30

Selling Securities to the Public

1. Obtain Approval from Board of Directors

2. Prepare necessary documentation
3. File documents with JSE Listings Committee
4. 21 days later, insert in the press either
 A Pre-Listing Statements
 A Prospectus (Offer for Sale)
5. Hold offer to sell shares open for 3 weeks
 9 - 31
Alternative Issue Methods 1

BACKDOOR
PUBLIC PRIVATE
LISTING

IPO or Offer for Preferential Private An Intro- Reverse

Cash Shell
Subscription Offer Placing duction Takeover
 9 - 32
Alternative Issue Methods 2

 Public
 IPO Public invited to subscribe New capital raised
 Preferential Offer Some investors favoured New capital raised
in IPO
 Private
 Private Placing Market either existing or New capital may or
newly created shares may not be raised
 An Introduction List existing shares - No new capital
raised
adequate spread of
shareholders
 Backdoor Listing
 Reverse Take-over Existing listed co. takes New capital may or
over co. seeking a listing may not be raised
 Cash Shell Co. seeking a listing buys New capital may or
a listed cash shell into may not be raised
which it transfers its assets
 9 - 33
Dilution

 Dilution is a loss in value for existing

shareholders
Percentage ownership – shares sold to the
general public without a rights offering
Market value – firm accepts negative NPV
projects
Book value and EPS – occurs when
market-to-book value is less than one
 9 - 34
Rights Offerings: Basic Concepts

 Issue of ordinary shares offered to existing shareholders – “right of

first refusal”
 Allows current shareholders to avoid the dilution that can occur
with a new share issue
 “Rights” are given to the shareholders
Specify number of shares that can be purchased
Specify purchase price
Specify time frame
 Rights may be traded OTC or on an exchange.
 Used to prevent Dilution of ownership
 9 - 35
Figure 15.2 : Ex-rights share prices
 9 - 36
The Value of a Right
 The price specified in a rights offering is generally
less than the current market price
 The share price will adjust based on the number
of new shares issued
 The value of the right is the difference between
the old share price and the “new” share price
 9 - 37
Right offering equations

# of new shares = Amount to be raised/ Subscription price /share

Ratio of rights offer or Number rights needed to buy a share:

No rights needed (N) = Old shares / New shares

N = the ratio of the rights offer

Value of a right = cum rights share price – subscription price of new shares
N+1

Ex-rights price = 1 x [(N x cum rights share price) + subscription price of shares]
N+1

Or Ex-rights price = cum rights share price – value of a right

 9 - 38

Rights Offering Example 1

 Suppose a company wants to raise R10 million.

 The subscription price is R20 and the current share price is R25.
 The firm currently has 5 000 000 shares outstanding.
How many shares have to be issued?
How many rights will it take to purchase one
share?
What is the value of a right?
 9 - 39

Solution

 No of shares = 10m / E20 = 500 000 new shares

 Ratio of the offer = 5 000000 / 500000 = 10
 For every 10 currently held shares you can buy 1
new share
 Value of a right = (25 - 20) /(10+1) = 0,45
 Ex rights price = 25 – 0,45 = 24,55
 9 - 40

More on Rights Offerings

 Ex-rights – the price of the stock will drop by the value of the right
on the day that the stock no longer carries the “right”
 Standby underwriting – underwriter agrees to buy any shares that
are not purchased through the rights offering
 Shareholders can either exercise their rights or sell them – they
are not hurt by the rights offering either way
 Rights offerings are generally cheaper, yet they are much less
common than general cash offers in the U.S. The reverse is true in
South Africa.
 9 - 41

Rights Offer Example 2

 A company wants to raise R20 million.

 The subscription price is R40 and the current
stock price is R50.
 The firm currently has 5 000 000 shares in issue.
How many shares have to be issued?
How many rights will it take to purchase one
share?
What is the value of a right?
 9 - 42

Rights Offer Example 3

 National Power earns R2 million after taxes and has 1 million shares in
issue. The company wants to fund their planned expansions through
the use of a rights offer. They require R5 million. Although the current
market price per share is R20ps, the new shares will be sold for R10 per
share.
 1. How many shares must they sell at this price to raise the R5 million?
 2. As an existing shareholder, how many rights do you need to own in
order to buy one of the new shares?
 3. What will the new price of the shares be after the rights issue?
 9 - 43

Rights Offer Example 3

 Number of new shares = funds to be raised/subscription costs
 =5 000 000/10
 =500 000 new shares
 If National Power shareholders receive one right for every share they own, NP will need
to issue 1 000 000 rights (since there are 1 000 000 shares).

 Number of rights needed to buy a new share

 = old shares/new shares
 =1 000 000/ 500 000
 =2 rights
 Therefore, you need 2 rights to buy ONE new share
 9 - 44

Rights Offer Example 3

Original price = R20 Number of shares = 1 000 000

Original market value = 20 000 000
New shares = R10 Number of shares = 500 000
New market value = 20 000 000 + 5 000 000
= R25 000 000
New number of shares = 1 500 000
Therefore new share price will = 25 000 000/1 500 000
=R16.67
The value of the right is therefore R3.33 (R20 – R16.67)
If an existing shareholder does not want to exercise this right, he can sell it to
an outsider. Therefore the price at which he will sell each right is R3.33.
 9 - 45
Rights Offer Example 3

 If:
 P0 is the price of the original share (which carries the right),
 PS is the subscription price of the new share,
 PX is the price of the new shares (after rights are exercised),
 N is the number of rights to buy ONE share, and
 R is the value of a right:
 9 - 46
Rights Issue Example 4
Example - Ivanhoe Mines needs C$1.2 billion of new equity. Market price
C$24.73. Ivanhoe Mines decides to raise additional funds by offering the right to
buy 3 new shares for 20 at C$13.93 per share. With 100% subscription, what is
value of each right?

 Current market value = 20 × C$24.73 = C$494.60

 Total shares = 20 + 3 = 23
 Amount of new funds = 3 × C$13.93 = C$41.79
 New share price = (41.79 + 494.60) / 23 = C$23.32
 Value of a right = C$23.32 - C$13.93 = C$9.39
 9 - 47
Rights Issue
Example - Lafarge Corp needs to raise €1.28billion of new equity. The market
price is €60/sh. Lafarge decides to raise additional funds via a 4 for 17 rights offer
at €41 per share. If we assume 100% subscription, what is the value of each right?

 Current market value = 17 × €60 = €1,020

 Total shares = 17 + 4 = 21
 Amount of funds = 1,020 + (4x41) = €1,184
 New share price = (1,184) / 21 = €56.38
 Value of a right = 56.38 – 41 = €15.38
 9 - 48

Initial Offering

Initial Public Offering (IPO) - First offering of stock to the

general public
Underwriter - Firm that buys an issue of securities from a
company and resells it to the public
Spread - Difference between public offer price and price paid
by underwriter
Prospectus - Formal summary that provides information on
an issue of securities
Underpricing - Issuing securities at an offering price set
below the true value of the security
 9 - 49
Motives For An IPO
 9 - 50
Underwriter Spread

Spread - the difference between the public offer price

and the price paid by underwriter

Example
Assume the issuing company incurs $1 million in expenses to
sell 3 million shares at $40 each to an underwriter; the
underwriter sells the shares at $43 each. What is the spread for
this deal?

3 million × ( $ 43 − $ 40 )=$ 9 million

 9 - 51
Underwriting Arrangements

 Firm Commitment - Underwriters buy the securities

from the firm and then resell them to the public
 Best Efforts Commitment - Underwriters agree to sell
as much of the issue as possible but do not guarantee
the sale of the entire issue
 Flotation Costs - The costs incurred when a firm
issues new securities to the public
What are some of the specific costs incurred when
a firm issues new securities?
 9 - 52
Underwriters

 Services provided by underwriters

Formulate method used to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter
 Syndicate – group of investment bankers that
market the securities and share the risk
associated with selling the issue
 Spread – difference between what the syndicate
pays the company and what the security sells for
in the market
 9 - 53

Dutch Auction Underwriting

 Underwriter accepts a series of bids that include

number of shares and price per share
 The price that everyone pays is the highest price
that will result in all shares being sold
 There is an incentive to bid high to make sure you
get in on the auction but knowing that you will
probably pay a lower price than you bid
 Google was the first large Dutch auction IPO
 9 - 54
Green Shoes and Lockups

 Green Shoe provision

Allows syndicate to purchase an additional 15% of the issue
from the issuer
Allows the issue to be oversubscribed
Provides some protection for the lead underwriter as they
perform their price stabilization function
 Lockup agreements
Restriction on insiders that prevents them from selling their
shares of an IPO for a specified time period often 180 days or
more
The stock price tends to drop when the lockup period
expires due to market anticipation of additional shares
hitting the street
 9 - 55

Underwriting Arrangements
Example
How much will a firm receive in net funding from a firm commitment
underwriting of 250,000 shares priced to the public at $40 if a 10%
underwriting spread has been added to the price paid by the underwriter?
Additionally, the firm pays $600,000 in legal fees.

Cost to public = $40

Net to issuer = $40/1.10 = $36.36
Therefore, the spread was $3.64 per share
Net to issuer = 250,000 × $36.36 = $9,090,000
Less: Legal fees 600,000
$8,490,000
 9 - 56
IPO Underpricing

 Initial Public Offering – IPO

 May be difficult to price an IPO because there isn’t
a current market price available
 Additional asymmetric information associated
with companies going public
 Underwriters want to ensure that their clients earn
a good return on IPOs on average
 Underpricing causes the issuer to “leave money
on the table”
 9 - 57

Underpricing of an IPO - Example

Example
Assume the issuer incurs $1 million in other expenses to sell 3
million shares at $40 each to an underwriter and the underwriter
sells the shares at $43 each. By the end of the first day’s
trading, the issuing company’s stock price had risen to $70.
What is the total cost of underpricing?

Cost of underpricing:
3 million($70 − $43) = $81 million
 9 - 58
The Top Managing Underwriters
January – June 2014
 Average Initial IPO Returns 9 - 59

Russia Argentina
Austria Canada
Denmark Chile
Norway Netherlands
Turkey Spain
Egypt France
Mexico Portugal
Nigeria Poland
Belgium Israel
Mauritius Italy
Hong Kong U.K.
U.S. Finland
South Africa Philippines Series1
New Zealand Cyprus
Ireland Australia
Pakistan Iran
Germany Tunisia
Indonesia Singapore
Sweden Switzerland
Brazil Morocco
Sri Lanka Thailand
Bulgaria Taiwan
Japan Greece
Malaysia Korea
India China
Jordan Saudi Arabia
0 50 100 150 200 250
Return (percent)
 9 - 60
IPO Proceeds

IPO Proceeds and First Day Returns

 9 - 61
Security Sales by Public Companies
General Cash Offer - Sale of securities open to all investors by an already
public company
Seasoned Offering - Sale of securities by a firm that is already publicly
traded
Shelf Registration - A procedure that allows firms to file one
registration statement for several issues of the same security

International Security Issues- Sale of securities in other countries

Eurobond – Bonds underwritten by a group of international banks and
offered simultaneously to investors in a number of countries
Global bonds – Bonds where one part is sold internationally in the
eurobond market and the remainder sold in the company’s domestic
market
 9 - 62
Underwriting Spreads
 9 - 63
Total Direct Costs of Raising Capital
 9 - 64
New Equity Issues and Price

 Share prices tend to decline when new equity is issued

 Possible explanations for this phenomenon
Signaling and managerial information
Signaling and debt usage
Issue costs
 Since the drop in price can be significant and much of the
drop may be attributable to negative signals, it is important
for management to understand the signals that are being
sent and try to reduce the effect when possible.
 9 - 65
Issuance Costs

 Spread
 Other direct expenses – legal fees, filing fees, etc.
 Indirect expenses – opportunity costs, i.e., management time
spent working on issue
 Abnormal returns – price drop on existing stock
 Underpricing – below market issue price on IPOs
 Green Shoe option – cost of additional shares that the syndicate
can purchase after the issue has gone to market
 9 - 66
Example: Costs of Listing
Telkom IPO Expenses [R3,9bn raised in Feb 2003] R
JSE listing and inspection fee 620 000
US Securities and Exchange Commission registration fee 607 663
NASD filing fee 275 000
New York Stock Exchange listing fee 1 969 872
Printing and engraving expenses 27 000 000
Legal fees and expenses 93 000 000
Accounting fees and expenses 60 000 000
Financial advisory fees 27 000 000
Other fees and expenses 10 000 000
Total (5,7% of capital raised) 220 471 663
 9 - 67
Quick Quiz

 What is venture capital and what types of firms receive it?

 What are some of the important services provided by
underwriters?
 What is IPO underpricing and why might it persist?
 What are some of the costs associated with issuing
securities?
 What is a rights offering and how do you value a right?
 What are some of the characteristics of private placement
debt?