FIN 340 12/2

Class Update and Agenda

The professor initiates the session by engaging with the students about their break experiences and comments on the poor weather conditions upon returning to Chicago from Miami. The agenda outlines the plan for the subsequent weeks, highlighting:

  • Two remaining topics: Raising Capital (discussed today and the following Thursday) and Mergers and Acquisitions (next Tuesday).
  • A review session scheduled for the Thursday after next, followed by the final exam the week after.

Recap of Previous Topics

Before diving into the current topic, the professor summarizes previous lessons:

  • Tools for evaluating business opportunities such as Net Present Value (NPV), Internal Rate of Return (IRR), and the Profitability Index.
  • Focus on NPV as the most common method employed by businesses to assess potential investment opportunities.
Explanation of NPV
  • NPV: The formula compares the cost of an investment against the expected future benefits. The investment cost is represented as Cash Flow Zero (CF0), which is typically a large negative amount reflecting initial outlays. Future cash flows (CF1, CF2) are discounted to present value using a discount rate. The cash flows' present values are compared to CF0:
    • extNPV=CF<em>0+CF</em>1(1+r)1+CF2(1+r)2ext{NPV} = CF<em>0 + \frac{CF</em>1}{(1+r)^1} + \frac{CF_2}{(1+r)^2}
    • Where CF represents cash flows and r signifies the discount rate.
  • Cash flows are analyzed for different periods. The components for estimating Free Cash Flows include:
    1. Operating Cash Flow
    2. Change in Net Working Capital
    3. Capital Expenditures
Discount Rate Considerations
  • The discount rate varies among firms, being calculated as the Weighted Average Cost of Capital (WACC), which integrates both the cost of debt and equity:
    • extWACC=DVr<em>d+EVr</em>eext{WACC} = \frac{D}{V} r<em>d + \frac{E}{V} r</em>e, where D is debt, V is the total capitalization (debt + equity), rd is the cost of debt, and re is the cost of equity.

Main Topic: Raising Capital

  • The current topic focuses on how firms raise capital for investments. The core method of raising capital discussed is through Initial Public Offerings (IPOs).
    • IPO Definition: An IPO is when a private company offers its shares to the public for the first time to generate capital, allowing direct involvement in the stock market.
Importance and Function of IPOs

  1. Reasons for Conducting an IPO:

    • To raise funds for expansion, pay debts, or pursue growth opportunities.
    • Provides liquidity for owners, employees, and early investors to cash out shares.

  2. The Role of Investment Banks in IPOs:

    • Expertise in pricing, marketing, and offering shares to the public.
    • Structured as a syndicate, a group of investment banks, is often involved for larger IPOs.
Process of Underwriting
  • The professor explains the underwriting process, which includes:
    • Preparing and filing the registration statement with the SEC (containing financial histories, business models, and risks).
    • SEC conducts a review over approximately twenty days.
    • Setting and pricing the IPO, conducting roadshows to gauge interest among potential investors.
Types of Underwriting

The session lays out three main types of underwriting:

  1. Firm Commitment:

    • The most common type; investment banks buy the entire stock issue from the company and assume the risk of selling it themselves.
    • They guarantee the total proceeds to the issuing firm regardless of their success in selling shares.
    • Morning trading institutions or mutual funds typically invest.

  2. Best Effort Underwriting:

    • Here, investment banks act merely as agents and do not take on risk beyond utilizing their best efforts to sell. Unsold stocks revert to the issuing company.
    • Investment banks earn commissions rather than profit from stock reselling.

  3. Dutch Auction Underwriting:

    • Engaged by companies like Google, this process involves collecting bids from investors. The price is then set at a level where the required number of shares can be sold.
    • Investors indicate the number of shares they wish to purchase and the maximum price they are willing to pay, facilitating a price-discovery mechanism.
Example of Dutch Auction
  • The professor provides an example with five bidders willing to buy shares at different prices. The auction is designed to find a price that satisfies the total number of shares to be sold:
    • If an issuer needs to sell 400 shares, the price point that accommodates all stakeholders is chosen,
    • Share allocations are calculated proportionally.

Roles of Underwriting Banks

  • Banks, such as Goldman Sachs and Morgan Stanley, play key roles, including issue pricing, determining security types to offer, and advising clients. They may apply