FIn201 chapters 1-6

Young firms often require what type of capital to finance their growth?

Venture capital

Venture capital provides entrepreneurs with ________ to grow their firms.

Financing

Why do firms issue securities?

To further finance their growth

Steps to obtaining venture funding:

1. Prepare a business plan

2. Receive first-stage financing

3. Receive subsequent staged financing

Suppose a Venture Capital firm offers to purchase 1 million of your firm’s shares for $1 each, which will give them 50% ownership in the firm. What value are they placing on your firm?

Value of the Firm = $1,000,000/ .50 = $2,000,000

Angel Investors

Investors who finance companies in their earliest stages of growth

Corporate Venturers

Corporations that offer venture assistance to finance young, promising companies

Private Equity Investing

Investors who offer funds to finance firms that do not trade on public stock exchanges such as the NYSE or NASDAQ

Types of Venture Investors

Angel Investor

Corporate Ventures

Private Equity Investing

Venture Capital Management

Venture Capitalist are not passive investors

When a firm requires more capital than private investors can provide,

it can choose to go public through an Initial Public Offering (IPO)

Primary Offering

when new shares are sold to raise additional cash for the company

Secondary Offering

when the company’s founders and venture capitalists cash in on some of their gains by selling shares

Benefits of Going Public

Ability to raise new capital

Stock price provides performance measure

Information more widely available

Diversified sources of finance

Reduced borrowing costs

Steps to issue a new public security:

1. SEC Registration

2. Select Underwriter / Undertake Roadshow

3. Set final issue price for public

Prospectus

a formal summary that provides information on an issue of securities

IPO Flowchart

1. Underwriter provides advice to firm

2. Underwriter pays firm for a number of shares

3. Firm provides shares to underwriter to be resold

4. Underwriter offers shares to investors

5. Investors purchase shares from underwriter

Spread

the difference between the public offer price and the price paid by underwriter

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?

Public Offer Price: $43 per share

Price Paid to Firm: $40 per share

Total Shares: 3 million shares

Total Spread = 3 million x ($43 - $40) = $9 million

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

Underwriting Arrangements: Capital To Firm 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 x $36.36 = $9,090,000

less: legal fees - 600,000

= $8,490,000

Underpricing:

Issuing securities at an offering price set below the true value of the security

Underpricing of an IPO

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?

3 million ($70 - $43) = $81 million

Flotation Costs:

The costs incurred when a firm issues new securities to the public

After an IPO, successful firms may issue additional equity or debt through what are known as Seasoned Offerings. What are the two main types?

• Rights Issue (offered only to current stockholders)

• General Cash Offer (open to all investors by an already-public company)

Rights issue

Issue of securities offered only to current stockholders

General Cash Offer

Sale of securities open to all investors by an already-public company

Rights Issue Example

An investor exercises his right to buy one additional share at $20 for every five shares held. How much should each share be worth after the rights issue if they previously sold for $50 each?

Pre-Right Issue: 5 shares ( $50 each) = $250

Post-Right Issue: 5 shares ($50 each) = $250 + 1 share ($20 each) = 20

$250 + $20 =$270

share price = $270/6 = $45 each

Shelf Registration

A procedure that allows firms to file one registration statement for several issues of the same security

Benefits of Shelf Registration:

1. Security issuance without excessive costs

2. Security issuance on very short notice

3. Timed issuance to capitalize on favorable market conditions

4. Additional underwriter competition

In order to avoid registering with the SEC,

a company can issue a security privately

Private Placement:

The sale of securities to a limited number of investors without a public offering

Private Placements-Advantages

Do not have to register with SEC

Private placements cost less than public issues

Contracts can be customized for each investor

Private Placements Disadvantages

Difficult for investors to resell security

Lenders often require higher return to compensate for higher risk

• Private placements typically yield .5% higher than public issue

Firms have three broad sources of cash

Internally generated funds, New equity issues, New debt issues

Competition in financial markets is fiercer than product markets

Few protected niches, securities sell for their true value

Why Internal funds? Managers prefer to reinvest internal funds for a number of reasons:

Cost of issuing securities, New equity announcement implications

What happens when the firm cannot finance all of its activities from plowed-back funds?

Financial Deficit, New Equity Issues, New Debt Issues

Most corporations are too large to be owned by one investor;

therefore they issue stock to many investors

Dow is owned by 650,000 different investors. If it has 1.167 billion shares outstanding, how much of Dow does an investor who holds one share own?

The investor owns: 1/1,167,000,000 , or 0.000000085% of Dow

Treasury stock

Stock that has been repurchased by the company and held in its treasury

Issued shares

Shares that have been issued by the company

Outstanding Shares

Shares that have been issued by the company and are held by investors

Authorized Share Capital

The maximum number of shares that the company is permitted to issue without additional shareholder approval

When a firm issues new equity,

it records each new share in its books at par value

Additional Paid-in Capital (APIC)

The difference between the issue price and the par value of a stock

Retained Earnings (RE)

Earnings not paid out as dividends

Suppose a firm has recently issued 10 million new shares at $15 per share; the par value of each is $1.50. What is the value of additional paid-in capital (APIC)?

APIC = (10,000,000 x $15) - (10,000,000 x $1.50)

APIC = $135,000,000

Net Common Equity

Represents the total amount contributed directly by shareholders when the firm issued new stock, and contributed indirectly when it plowed back part of its earnings

Equation for Net Common Equity

Net Common Equity = Par Value + Additional Paid-in Capital + Retained Earnings - Share Repurchases

A corporation is owned by

its common stockholders

Owners are entitled to

Profits, Control of the firm

Shareholders exercise control over the firm by

voting for its board of directors

Majority Voting

Voting system in which each director is voted on separately

Cumulative Voting

Voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors

Proxy Contest

Takeover attempt in which outsiders compete with management for shareholders’ votes

A shareholder owning 100 shares of stock is voting for the board of directors who are elected by cumulative voting. How many votes did the shareholder cast for Director 'A' if four directors are to be elected and the shareholder cast his/her maximum number of votes for 'A'?

Total votes = number of shares owned x total number of directors to be elected

number of shares owned = 100

number if directors to be elected = 4

100 × 4 = 400

Preferred Stock Equation

net worth = common equity + preferred equity

Preferred Stock Advantages:

Dividends, Tax Advantages

Preferred Stock Potential Disadvantages:

Interest rate fluctuations, Floating Rate Preferred

Corporate Debt; When issuing debt, companies promise to make payments and repay principal.

But they have limited liability; debt is not always repaid

Interest rate fluctuations

Coupon vs. Zero-coupon, Bonds, Prime Rate, LIBOR

Funded Debt

Debt with more than 1 year remaining to maturity

Unfunded Debt

debt due in less than one year

Sinking Fund

A fund established to retire debt before maturity

Callable Bond

A bond that may be repurchased by a firm before maturity at a specified call price

Seniority

Subordinated Debt

Security

Secured Debt

Currency and Country of Origin

Eurodollars, Eurobond

Protective Covenants

Restrictions on a firm to protect bondholders

Leases

Long-term rental agreements

Debt Characteristics

Interest rate fluctuations

funded and unfunded debt

sinking fund

callable bond

seniority

security

currency and country of origin

public vs private placements

protective covenants

leases

Convertible Securities; Give investors the option

to alter their investments if they so choose

Convertible securities

warrant

convertible bond

Warrant

the right to buy shares from a company at a stipulated price before a set date

Convertible Bond

A bond that the holder may exchange for a specified amount of another security

An investor owns a bond selling for $1,000. This bond can be converted to 20 shares of stock that are currently selling for $55 per share. Should the investor convert his bond into shares?

value of investment without conversion = $1,000

value of investment WITH conversion = (20 x $55) = $1,100

yes investor should convert his bond into shares

Debt policies should address debt structure and general repayment terms,

including maximum repayment terms, debt service patterns (such as equal payments or equal principal amortization), and the use of variable or fixed-rate interest.

Debt is

anything owed by one party to another. Examples of debt include amounts owed on credit cards, car loans, and mortgages

What are the two main types of debt, and what are examples of each?

Secured debt (example: a mortgage)

Unsecured debt (example: a credit card)

There are various debt management strategies followed by creditors.

Banks sanction only that amount of loan to a person which they can easily repay in the form of EMIs (Equated Monthly Installments)

According to basic capital structure theory, does changing a firm's capital structure affect its value to shareholders?

No, a company's choice of capital structure does not increase the value of the firm

What does Modigliani and Miller's (MM) Irrelevance Proposition state about firm value?

The value of a firm does not depend on its capital structure

What are the core assumptions of MM's irrelevance proposition?

• "Well-functioning" capital markets

• Efficient capital markets

• No taxes (therefore no distortion)

• Ignore costs of financial distress

MM’s Irrelevance Proposition Example:

An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value?

Before reconstructing:

Value(firm) = Value(equity) + Value(debt) = $10,000,000 +$0

AfterRestructuring:

Shares outstanding = 600,000 Value(equity) = $600,000

Value(firm) = $6,000,000 + $4,000,000 = $10,000,000

Ceteris paribus, borrowing will increase earnings per share.

However, this isn’t a source of value to shareholders

Shareholders can easily replicate

a firm’s borrowing on their own if they choose

Debt financing DOES NOT affect the

operating risk of the firm

Debt financing DOES affect the

financial risk of the firm

Debt increases financial risk and causes

shareholders to demand higher rates of return

Debt financing advantage:

the interest that a firm pays on debt is tax deductible

Interest tax shield

Annual tax shield = Tc x (r(debt)xD)

perpetual tax shield

PVtax sheild = annual tax shield/ r(debt)

PVtax sheild = Tc x (r(debt)x D)/r(debt) = TcD

Perpetual Tax Shield Example

What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $12 million at an interest rate of 4% and a tax rate of 35%

PV tax shield = Tc x D = (.35)x (12,000,000)

Pv tax shield = $4,200,000

When accounting for taxes, how is the total value of a levered firm calculated?

value of levered firm = Value if all equity financed + PVtax shield

WACC takes into account the required after-tax rate of return

WACC = (1-Tc) x r(debt) x (D/D+E) + r(equity) x (E/D+E)

Taxes and WACC: Example What is the expected rate of return to shareholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?

WACC = (1-Tc) x r(debt) x (D/D+E) + r(equity) x (E/D+E)

WACC= 15% =0.15

(1-Tc) = (1-35)= 65% = 0.65

r(debt) = 10% = 0.10

(D/D+E)= 60% = 0.60

(E/D+E) = 40% = 0.40

r(equity) = ?

0.15 = (0.65) x 0.10 x (0.60) + r(equity) x (0.40)

r(equity) = 27.75%

How do investors factor potential financial distress into the market value of a firm?

Overall Market Value = Value if all equity financed + PVtax shield - PVcosts of financial distress