© 2009 Cengage Learning/South-Western

RaisingLong-Term Financing

Chapter 11

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Common Stock and Long-Term Debt

Long-Term Financing

Common stock

Preferred stock

Long-term debt

The dominant source for new financing for corporations across the world is internally

generated cash flows.

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Corporations face four key decisions continually:

• How much capital to raise?• How much of this is to be raised externally?• Should external funds be raised via capital

markets or via financial intermediaries?• What proportion of the external funding should be

common stock, preferred stock, or long-term debt?Internal financing: cash flow from operations minus

cash dividends. Amount not fixed: firm can vary dividends and capital structure.

Corporations are almost always net dissavers.

Basic Choices In Long-Term Financing

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Factors that affect the choice of financing:

• Management’s decision to build up or reduce working capital over time;

• Dividend policy is not fixed, so firm can draw from retained earnings for capital source, and

• Raising capital externally entails higher legal and transaction costs than raising capital internally.

Marginal benefits of raising capital externally: ability to raise greater sums of money per

dollar spent to acquire financing.

Marginal costs of raising capital externally: transaction, legal and other costs usually

decline per dollar of capital raised.

Internal Versus External Financing

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Financial intermediaries (banks) play a more important role for non-US corporations.

Laws that influenced the role financial intermediaries played in the U.S.:

McFadden Act of 1927 prohibited interstate

banking.

In July 1994, Congress passed a bill to allow interstate banking.

Glass-Steagall Act (1933) mandated separation of

investment and commercial banking.

Gramm-Leach-Bliley Act (1999) repealed the Glass-

Steagall Act.

Financial Intermediaries

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The McFadden Act of 1927 prohibited interstate banking.

• America’s long history of distrusting concentrated, private economic power has dramatically influenced U.S. financial regulations.

• In response to public opinion, policymakers discouraged the growth of large intermediaries (especially commercial banks), in part, by imposing on them severe geographical restrictions.

• Existing restrictions were codified into national law when Congress passed the McFadden Act in 1927, which prohibited interstate banking.

• After numerous failed attempts to repeal the McFadden Act over the years, Congress finally approved a bill allowing full interstate branch banking in July 1994.

McFadden Act of 1927

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Glass-Steagall Act (1933) mandated separation of investment and commercial

banking.• The Glass-Steagall Act was passed in 1933 in response to

perceived banking abuses during the Great Depression.

• This legislation mandated the separation of investment and commercial banking:- Commercial banks were prohibited from underwriting

corporate security issues, providing security brokerage services to their customers, or even owning voting equity securities on their own account.

- Banking’s corporate financing role was thus restricted to making commercial loans and to providing closely related services, such as leasing.

Glass-Steagall Act (1933)

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Gramm-Leach-Bliley Act (1999) repealed the Glass-Steagall Act.

• Congress passed the Gramm-Leach-Bliley Act in November 1999.

• This act allows commercial banks, securities firms, and insurance companies to join together in a new financial holding company structure, also defined by the act.

• However, the act still prohibits nonfinancial companies from owning commercial banks.

Gramm-Leach-Bliley Act (1999)

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Securitization repackages loans and other traditional bank-based credit products into securities.

• The total value of primary issues around the world in 2006 was a record $7.29 trillion.

• Worldwide security offerings were $1.82 trillion in 1997 and less than $400 billion as recently as 1988.

• The eighteen-fold increase in the value of security market financing between 1988 and 2006 was not matched by a remotely comparable increase in world trade, investment, or economic activity.

• Instead, it is a reflection of the power of the trend toward the “securitization” of corporate finance.

The Expanding Role of Securities Markets

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Securities 1990 2000 2006

Worldwide offerings (equity & debt)

$504 billion $3,268 billion $7,290 billion

U.S. Issuers worldwide

$313

billion

$1,958

billion

$3,980

billion

Annual Global Securities Issuance: Patterns

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U.S. issuers account for two-thirds of total public issue volume.

Major global trend is shift toward securitization and diminishing reliance on traditional intermediaries

(banks) for external financing.

Debt issues are over three-fourths of US total every year. Equity issues play small financing role

everywhereAmerica’s IPO market is usually the world’s largest and

most liquid source of equity capital for small, rapidly growing firms, and most observers consider it a key national asset. During, 2006, however, the United

States trailed both Britain and China in the value of IPOs.

Annual Global Securities Issuance: Patterns

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Employ an investment bank to advise and handle offering;

Approach Private vs. public capital market;

A firm needing external capital faces the following choices:

Negotiate privately with investment banks or solicit competitive bids from the banks, or

Issue shares to existing stockholders or general cash offering.

Investment Banking And the Public Sale of Securities

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Source: B.E. Tunick, C. O’Leary, M. Burns, “The face-Off”, Investment Dealers Digest (January 12, 2004), pp. 32-61

Lead Underwriter Proceeds ($ Billion)

Number of issues

Disclosed fees ($ millions)

1. Citigroup 542,749 1,872 1,799

2. Morgan Stanley 394,780 1,365 1,203

3. Merrill Lynch 380,319 1,914 1,028

4. Lehman Brothers 354,259 1,266 643

5. J.P. Morgan Chase 353,911 1,418 1,035

6. CSFB 338,768 1,249 923

7. Deutsche Bank 317,428 1,257 638

8. UBS 293,310 1,147 1,008

Industry Total 5,327,491 19,729 15,461

Compare this 2003 table with the 2006 table on the next slide.

Global Investment Banking League TableFor 2003 in $ Billions

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Source: Dan Freed, “League Table Roundup: Debt was a deluge, while US equities poured it on late,” Investment Dealers’ Digest (January 8, 2007).

Global Investment Banking League TableFor 2006 in $ Billions

Compare this 2006 table with the 2003 table on the previous slide.

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Conflicts of Interest

• Investment banks cannot “solve” these conflicts of interest.

• Instead, they must price new security issues to strike a balance between the revenue maximization goal of the issuing firms and the profit maximization objective of their investing clients.

Banks provide advice and underwriting services to

companies that want to issue those securities for the highest possible price.

Banks sell these securities to their own clients who want to purchase securities at bargain

prices.

Research analysts working for the investment banks produce reports that are supposed to advise clients on whether the

securities are fairly priced.

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Two basic laws governing public issues:

Securities act of 1933

Prescribed security issuance procedures, set

basic principle of full disclosure

Securities and exchange

commission act of 1934

Set up SEC, gave it broad regulatory, rule-making

powers

Securities laws mandate disclosure of all relevant corporate information to potential

investors.

Investment banks play key disclosure role by performing due diligence.

Legal RulesGoverning U.S. Public Security Sales

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Registration Statement is filed with the Securities and Exchange Commission

Offering only becomes effective with SEC’s final approval.

Principal disclosure document:Registration Statement

Offering can be primary, secondary, or mixed.

• Sell newly issued shares• Raise new capital for the firm

• Existing shareholders sell their shares.• No new capital for the firm

Basic Disclosure Documents

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SEC introduced rule 415: shelf registration

• Qualifying issuers (more than $150 million in outstanding stock) file a “master registration statement”, summarizing planned financing for the next two years.

• The company can offer securities for sale (off the shelf) over subsequent two years.

• Shelf registration popular with issuers; very flexible.Most qualifying debt issues are shelf

registered.Very few equity issues use shelf: IB

certification needed.

Shelf Registration

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US IPO market larger than rest of world’s combined.

IPOs account for 30-45% of all new equity raised each year.

IPO market is highly cyclical: biggest IPO boom ever between 1991 and March 2000.

During, 2006, however, the United States trailed both Britain and China in the value of

IPOs.

NYSE and NASDAQ now compete for IPOs.

The U.S. Initial Public Offering Market

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Market prone to industry “fads”: semiconductors, biotech mid-1980s; Internet

after 1995.

Institutional investors most important IPO investors: allocated 50-75% IPO shares.

The U.S. Initial Public Offering Market

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$580,16816.6%7,7281975-2006

220,87022.91,0792000-2006

295,15320.94,1451990-99

623,0916.82,3921980-89

$1,1245.7%1121975-79

Gross proceeds ($ Millions)

Average first day returns

(%)

Number of offerings

Period

Initial returns were very high during internet boom: 69.0% in 1999 and 55.5% in 2000.

The U.S. Initial Public Offering Market

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IPOs can raise large amounts of new capital for growth.

Publicly traded stock serve as currency for acquisitions.

Listed stock (options) can be used to attract top managers.

Entrepreneurs enjoy personal wealth and liquidity.

IPOs serve as advertising for firms and their products/services.

Advantages Of IPOs

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High financial costs, with no guarantee of success: Cash expenses of an IPO often

approach $1 million.Managerial costs of planning and executing

IPO.

Firms need to focus on stock price and deal with shareholders.

In public firms, severe constraints are placed on managerial discretion.

• Have to disclose operating and sensitive data publicly

• Must follow public company governance rules set by SEC

Disadvantages Of IPOs

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Equity carve-out

• Parent sells minority stake in subsidiary to public through IPO.

• Raises cash for parent, allows better monitoring of subsidiary

Spin-off

• Parent distributes all of a subsidiary’s stock to shareholders.

• Full spin-off creates independent new company.

Reverse LBO• Company goes public again after

LBO.• Successful LBOs create value, so

high returns to second IPO.

Tracking stock

• Stock mirrors performance of division, but not legally or operationally separate from parent.

Specialized IPOs

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Patterns observed in IPO offerings:

• IPO underpricing: in US, the share prices rise on average 15% above the offer price in the first day of trading.

• Large IPOs typically underpriced less than smaller offerings.

• Early research on long-run performance of IPOs shows IPOs underperform compared to shares of comparable-sized firms.

• New research challenges these findings.

Investment Performance Of IPOs

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Figure 11.2 The Long-Run Performance of U.S. IPOs and SEOs vs. Matching Firms That Did Not Issue New Equity

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Figure 11.2 The Long-Run Performance of U.S. IPOs and SEOs vs. Matching Firms That Did Not Issue New Equity (cont.)

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SEOs infrequent for most U.S. and non-U.S. firms.

Reason Negative market reaction when SEOs are announced

SEO announcements convey negative info:

• Managers may consider stock over-valued.• SEOs could reveal that cash flows will be lower

than expected.

Short-term and long-term performance of SEOs: prices fall on announcement; under-

perform over 1,3 and 5 years.

Seasoned Equity Offerings (SEO)

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Sale of a security directly to one or a group of accredited investors

Accredited investors in private placements are financially sophisticated.

Corporations, institutional investors, wealthy individuals, pension and mutual funds,

venture capitalists are among accredited investors.

Rule 144A allows limited trading of PP amongqualified institutional investors.

U.S. Private Placements

Institutions with assets exceeding $100 million.

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Two types

Domestic stock offering

International, or cross-border, issues

Total number of non-U.S. IPOs exceeds U.S. total, but total value (except privatizations)

usually much smaller.

All markets show significant IPO underpricing.

Most markets show poor long-term returns for IPOs, SEOs.

International Common Stock Offerings

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Dollar-denominated claims issued by U.S. banks

Represent ownership of shares of a foreign company’s stock held on deposit in the

issuing firm’s home country.

Sponsored ADR

• The issuing foreign company pays all legal and financial costs of creating and trading the security.

• Issuing firm is not involved with the issue of ADRs.

Unsponsored ADR

American Depositary Receipts (ADRs)

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Fig. 11-3 American Depositary Receipts (ADRs)

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SIPs have raised almost $1.5 trillion since 1980. The 15 largest (and 27 of the 28 largest) share offerings in

history are all either SIP or rights offerings by partially privatized companies.

Share Issue Privatizations

A government executing a share issue privatization (SIP) sells all or part of its ownership in a state-owned

enterprise to private investors via a public share offering.

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Fig. 11-4 Annual Privatization Revenues for Divesting Governments Worldwide, 1988–2006 (in $U.S. Billions)

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Share Issue Privatizations

The World’s Largest Share Offerings

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Raising Long-Term Financing

• Long-term financing instruments: common and preferred stock, debt

• Financial intermediaries: institutions that raise funds by selling claims on themselves

• Volume of security issues surged eight-fold in 11 years.

• Firms wanting to raise capital externally must make a series of decisions: debt or equity, use an investment bank or not.