Long term financing ipo

Chapter 14
Raising
Equity Capital

© Pearson Education Limited 2015 14-2
Chapter 14 Outline
14.1 Equity Financing for Private Companies
14.2 Taking Your Firm Public: The Initial
Public Offering
14.3 IPO Puzzles
14.4 Raising Additional Capital: The Seasoned
Equity Offering

Learning Objectives
• Contrast the different ways to raise equity
capital for a private company
• Understand the process of taking a
company public
• Gain insight into puzzles associated with
initial public offerings
• Explain how to raise additional equity
capital once the company is public

14.1 Equity Financing for Private
Companies
• Sources of Funding:
– A private company can seek funding from
several potential sources:
• Angel Investors
• Venture Capital Firms
• Institutional Investors
• Corporate Investors

Companies
• Angel Investors:
– Individual investors who buy equity in small
private firms
– The first round of outside private equity
financing is often obtained from angels

Companies
• Venture Capital Firms:
– Specialize in raising money to invest in the
private equity of young firms
– In return, venture capitalists often demand a
great deal of control of the company

Figure 14.1 Most Active U.S. Venture Capital
Firms in 2012 (by Number of Deals Completed

Figure 14.2 Venture Capital Funding in
the United States

Companies
• Institutional Investors:
– Pension funds, insurance companies,
endowments, and foundations
• May invest directly
• May invest indirectly by becoming limited partners in
venture capital firms

Companies
• Corporate Investors:
– Many established corporations purchase equity
in younger, private companies
• corporate strategic objectives
• desire for investment returns
– Also called corporate partner, strategic partner,
strategic investor

Companies
• Securities and Valuation
– When a company decides to sell equity to
outside investors for the first time, it is typical to
issue preferred stock rather than common stock
to raise capital
• It is called convertible preferred stock if the owner can
convert it into common stock at a future date

Example 14.1 Funding and
Ownership
Problem:
• You founded your own firm two years ago. You initially
contributed $100,000 of your money and, in return received
1,500,000 shares of stock. Since then, you have sold an
additional 500,000 shares to angel investors. You are now
considering raising even more capital from a venture
capitalist (VC).

Ownership
Problem (cont’d):
• This VC would invest $6 million and would receive 3 million
newly issued shares. What is the post-money valuation?
Assuming that this is the VC’s first investment in your
company, what percentage of the firm will she end up
owning? What percentage will you own? What is the value of
your shares?

Ownership
Solution:
Plan:
• After this funding round, there will be a total of 5,000,000
shares outstanding:
Your shares 1,500,000
Angel investors’ shares 500,000
Newly issued shares 3,000,000
Total 5,000,000

Ownership
Plan (cont’d):
• The VC is paying $6,000,000/3,000,000=$2/share.
• The post-money valuation will be the total number of shares
multiplied by the price paid by the VC.
• The percentage of the firm owned by the VC is her shares
divided by the total number of shares.
• Your percentage will be your shares divided by the total
shares and the value of your shares will be the number of
shares you own multiplied by the price the VC paid.

Ownership
Execute:
• There are 5,000,000 shares and the VC paid $2 per share.
Therefore, the post-money valuation would be 5,000,000($2)
= $10 million.
• Because she is buying 3,000,000 shares, and there will be
5,000,000 total shares outstanding after the funding round,
the VC will end up owning 3,000,000/5,000,000=60% of the
firm.
• You will own 1,500,000/5,000,000=30% of the firm, and the
post-money valuation of your shares is 1,500,000($2) =
$3,000,000.

Ownership
Evaluate:
• Funding your firm with new equity capital, be it from an
angel or venture capitalist, involves a tradeoff—you must
give-up part of the ownership of the firm in return for the
money you need to grow.
• The higher is the price you can negotiate per share, the
smaller is the percentage of your firm you have to give up for
a given amount of capital.

Example 14.1a Funding and
Ownership
Problem:
• You founded your own firm three years ago. You initially
contributed $500,000 of your money and, in return received
100,000 shares of stock. Since then, you have sold an
additional 50,000 shares to angel investors. You are now
considering raising even more capital from a venture
capitalist (VC).

Ownership
Problem (cont’d):
• This VC would invest $15 million and would receive
1,000,000 newly issued shares. What is the post-money
valuation? Assuming that this is the VC’s first investment in
your company, what percentage of the firm will he end up
your shares?

Ownership
Solution:
Plan:
shares outstanding:
Your shares 500,000
Total 1,550,000

Ownership
Plan (cont’d):
• The VC is paying $15,000,000/1,000,000=$15/share. The
post-money valuation will be the total number of shares
multiplied by the price paid by the VC. The percentage of the
firm owned by the VC is his shares divided by the total
number of shares. Your percentage will be your shares
divided by the total shares and the value of your shares will
be the number of shares you own multiplied by the price the
VC paid.

Ownership
Execute:
Therefore, the post-money valuation would be
1,550,000($15) = $23,250,000.
• Because he is buying 1,000,000 shares, and there will be
1,550,000 total shares outstanding after the funding round,
the VC will end up owning 1,000,000/1,550,000=64.5% of
the firm.
• You will own 500,000/1,550,000=32.3% of the firm, and the
post-money valuation of your shares is 500,000($15) =
$7,500,000.

Ownership
Evaluate:
• Funding your firm with new equity capital, be it from an
angel or venture capitalist, involves a tradeoff—you must
give-up part of the ownership of the firm in return for the
money you need to grow. The higher is the price you can
negotiate per share, the smaller is the percentage of your
firm you have to give up for a given amount of capital.

Example 14.1b Funding and
Ownership
Problem:
• You founded a drug discovery company 5 years ago. You
initially contributed $50,000 of your money and, in return
received 500,000 shares of stock. You have also sold
500,000 shares to angel investors to bring the drugs through
animal studies. You now need more funding from VCs to clear
the drugs through clinical trials.

Ownership
Problem (cont’d):
• The VC would invest $100 million and would receive
100,000,000 newly issued shares. What is the post-money
valuation? Assuming that this is the VC’s first investment in
your company, what percentage of the firm will she end up
your shares?

Ownership
Solution:
Plan:
shares outstanding:
Your shares 500,000
Total 101,000,000

Ownership
Plan (cont’d):
• The VC is paying $100,000,000/100,000,000=$1/share. The
post-money valuation will be the total number of shares
multiplied by the price paid by the VC. The percentage of the
firm owned by the VC is her shares divided by the total
number of shares. Your percentage will be your shares
divided by the total shares and the value of your shares will
be the number of shares you own multiplied by the price the
VC paid.

Ownership
Execute:
Therefore, the post-money valuation would be
101,000,000($1) = $101 million.
• Because she is buying 100,000,000 shares, and there will be
101,000,000 total shares outstanding after the funding
round, the VC will end up owning
100,000,000/101,000,000=99% of the firm.
• You will own 500,000/101,000,000=0.00495% of the firm,
and the post-money valuation of your shares is 500,000($1)
= $500,000.

Ownership
Evaluate:
• Funding your firm with new equity capital involves a tradeoff
—you must give-up part (or basically all, in this case) of the
ownership of the firm in return for the money you need to
grow.
• Pharmaceuticals require a huge investment of money and it
may have been a better option to sell the rights to your drug
to a large pharmaceutical company.

Companies
• Exiting an Investment in a Private Company
• Acquisition
• Public Offering

14.2 Taking Your Firm Public: The
Initial Public Offering
• The process of selling stock to the public for
the first time is called an initial public
offering (IPO)

Table 14.1
Largest Global
IPOs

• Advantages and Disadvantages of Going
Public
– Advantages:
• Greater liquidity
• Better access to capital
– Disadvantages:
• Equity holders more dispersed
• Must satisfy requirements of public companies

• IPOs include both Primary and Secondary
offerings
• Underwriters and the Syndicate
– Underwriter: an investment banking firm that
manages the offering and designs its structure
• Lead Underwriter
– Syndicate: other underwriters that help market
and sell the issue

Table 14.2
International
IPO
Underwriter
Ranking
Report for
2012

• SEC Filings
– Registration Statement
• preliminary prospectus or red herring
– Final Prospectus

Figure 14.3
The Cover Page of
RealNetworks’ IPO
Prospectus

• Valuation
– Underwriters work with the company to come up
with a price
• Estimate the future cash flows and compute the
present value
• Use market multiples approach
– Road Show
– Book Building

Example 14.2 Valuing an IPO Using
Comparables
Problem:
• Wagner, Inc., is a private company that designs,
manufactures, and distributes branded consumer products.
During the most recent fiscal year, Wagner had revenues of
$325 million and earnings of $15 million. Wagner has filed a
registration statement with the SEC for its IPO.

Comparables
Problem (cont'd):
• Before the stock is offered, Wagner’s investment bankers
would like to estimate the value of the company using
comparable companies. The investment bankers have
assembled the following information based on data for other
companies in the same industry that have recently gone
public. In each case, the ratios are based on the IPO price.

Comparables
Problem (cont'd)
• After the IPO, Wagner will have 20 million shares
outstanding. Estimate the IPO price for Wagner using the
price/earnings ratio and the price/revenues ratio.

Comparables
Solution:
Plan:
• If the IPO price of Wagner is based on a price/earnings ratio
that is similar to those for recent IPOs, then this ratio will
equal the average of recent deals. Thus, to compute the IPO
price based on the P/E ratio, we will first take the average
P/E ratio from the comparison group and multiply it by
Wagner’s total earnings. This will give us a total value of
equity for Wagner. To get the per share IPO price, we need
to divide the total equity value by the number of shares
outstanding after the IPO (20 million). The approach will be
the same for the price-to-revenues ratio.

Comparables
Execute:
• The average P/E ratio for recent deals is 21.2. Given earnings
of $15 million, we estimate the total market value of
Wagner’s stock to be ($15 million)(21.2) = $318 million.
With 20 million shares outstanding, the price per share
should be $318 million / 20 million = $15.90.
• Similarly, if Wagner’s IPO price implies a price/revenues ratio
equal to the recent average of 0.9, then using its revenues of
$325 million, the total market value of Wagner will be ($325
million)(0.9) = $292.5 million, or ($292.5/20)= $14.63/share

Comparables
Evaluate:
• As we found in Chapter 10, using multiples for valuation
always produces a range of estimates—you should not expect
to get the same value from different ratios. Based on these
estimates, the underwriters will probably establish an initial
price range for Wagner stock of $13 to $17 per share to take
on the road show.

Example 14.2a Valuing an IPO Using
Comparables
Problem:
• Wagner, Inc., is a private company that designs,
manufactures, and distributes branded consumer products.
During the most recent fiscal year, Wagner had revenues of
$200 million and earnings of $15 million. Wagner has filed a

Comparables
Problem (cont'd):
• Before the stock is offered, Wagner’s investment bankers
would like to estimate the value of the company using
comparable companies. The investment bankers have
assembled the following information based on data for other
companies in the same industry that have recently gone
public. In each case, the ratios are based on the IPO price.

Comparables
Problem (cont'd)
• After the IPO, Wagner will have 30 million shares
outstanding. Estimate the IPO price for Wagner using the
Company Price/Earnings Price/Revenues
Ray Products Corp. 17.5× 2.1×
Byce-Frasier Inc. 14.4× 2.3×
Fashion Industries Group 14.9× 1.3×
Recreation International 13.3× 2.7×
Average 15.0× 2.1×

Comparables
Solution:
Plan:
• If the IPO price of Wagner is based on a price/earnings ratio
that is similar to those for recent IPOs, then this ratio will
equal the average of recent deals. Thus, to compute the IPO
price based on the P/E ratio, we will first take the average
P/E ratio from the comparison group and multiply it by
Wagner’s total earnings. This will give us a total value of
equity for Wagner. To get the per share IPO price, we need
to divide the total equity value by the number of shares
the same for the price-to-revenues ratio.

Comparables
Execute:
of $25 million, we estimate the total market value of
Wagner’s stock to be ($25 million)(15.0) = $375 million.
With 30 million shares outstanding, the price per share
should be $375 million / 30 million = $12.50.
• Similarly, if Wagner’s IPO price implies a price/revenues ratio
equal to the recent average of 2.1, then using its revenues of
$200 million, the total market value of Wagner will be ($200
million)(2.1) = $420 million, or ($420/30)= $14.00/share

Comparables
Evaluate:
price range for Wagner stock of $12 to $15 per share to take
on the road show.

Example 14.2b Valuing an IPO Using
Comparables
Problem:
• Gen Probe, Inc. is a medical diagnostics company that
designs and manufactures tests for HIV. During the most
recent fiscal year, Gen Probe had revenues of $150 million
and earnings of $10 million. Gen Probe has filed a

Comparables
Problem (cont'd):
• Before the stock is offered, Gen Probe’s investment bankers
try to estimate the value of the company. They gather
information by comparing Gen Probe to other medical
diagnostic companies that have offered an IPO. The ratios
are based on the IPO price.

Comparables
Problem (cont'd)
• After the IPO, Gen Probe will have 10 million shares
outstanding. Estimate the IPO price for Gen Probe using the
Bayer/Versant 14.2× 1.3×
Roche Diagnostics, Inc. 18.2× 0.8×
Beckdon Dickinson, Inc. 28.3× 0.7×
3rd
Wave Technologies 12.5× 0.5×
Average 18.3× 0.825×

Comparables
Solution:
Plan:
• If the IPO price of Gen Probe is based on a price/earnings
ratio that is similar to those for recent IPOs, then this ratio
will equal the average of recent deals. Thus, to compute the
IPO price based on the P/E ratio, we will first take the
average P/E ratio from the comparison group and multiply it
by Gen Probe total earnings. This will give us a total value of
equity for Gen Probe. To get the per share IPO price, we
need to divide the total equity value by the number of shares
the same for price-to-revenues.

Comparables
Execute:
of $10 million, we estimate the total market value of Gen
Probe’s stock will be ($10 million)(18.3) = $183 million. With
10 million shares outstanding, the price per share should be
$183 million / 10 million = $18.30.
• Similarly, if Gen Probe’s IPO price implies a price/revenues
ratio equal to the recent average of 0.825, then using its
revenues of $150 million, the total market value of Gen Probe
will be ($150 million)(0.825) = $123.8 million, or
(123.8/10)=$12.38/share

Comparables
Evaluate:
price range for Gen Probe stock of $10 to $15 per share to
take on the road show.

Example 14.2c Valuing an IPO Using
Comparables
Problem:
• Gen Probe, Inc. is a medical diagnostics company that
designs and manufactures tests for HIV. During the most
recent fiscal year, Gen Probe had revenues of $400 million
and earnings of $30 million. Gen Probe has filed a

Comparables
Problem (cont'd):
• Before the stock is offered, Gen Probe’s investment bankers
try to estimate the value of the company. They gather
information by comparing Gen Probe to other medical
diagnostic companies that have offered an IPO. The ratios
are based on the IPO price.

Comparables
Problem (cont'd)
• After the IPO, Gen Probe will have 25 million shares
outstanding. Estimate the IPO price for Gen Probe using the
Bayer/Versant 14.2× 1.3×
Roche Diagnostics, Inc. 18.2× 0.8×
Beckdon Dickinson, Inc. 28.3× 0.7×
3rd
Wave Technologies 12.5× 0.5×
Average 18.3× 0.825×

Comparables
Solution:
Plan:
• If the IPO price of Gen Probe is based on a price/earnings
ratio that is similar to those for recent IPOs, then this ratio
will equal the average of recent deals. Thus, to compute the
IPO price based on the P/E ratio, we will first take the
average P/E ratio from the comparison group and multiply it
by Gen Probe total earnings. This will give us a total value of
equity for Gen Probe. To get the per share IPO price, we
need to divide the total equity value by the number of shares
the same for price-to-revenues.

Comparables
Execute:
of $30 million, we estimate the total market value of Gen
Probe’s stock will be ($30 million)(18.3) = $549 million. With
25 million shares outstanding, the price per share should be
$549million / 25 million = $21.96.
• Similarly, if Gen Probe’s IPO price implies a price/revenues
ratio equal to the recent average of 0.825, then using its
revenues of $400 million, the total market value of Gen Probe
will be ($400 million)(0.825) = $330 million, or
(330/25)=$13.20/share

Comparables
Evaluate:
price range for Gen Probe stock of $13 to $22 per share to
take on the road show.

• Pricing the Deal and Managing Risk
– Firm Commitment IPO: the underwriter
guarantees that it will sell all of the stock at the
offer price
• Spread
• Lockup
– Over-allotment allocation, or greenshoe
provision: allows the underwriter to issue more
stock, amounting to 15% of the original offer
size, at the IPO offer price

• Other IPO Types
– Best-Efforts Basis: the underwriter does not
guarantee that the stock will be sold, but instead
tries to sell the stock for the best possible price
– Auction IPO: The company or its investment
bankers auction off the shares, allowing the
market to determine the price of the stock

Table 14.3 Bids Received to Purchase
Shares in a Hypothetical Auction IPO

Figure 14.4 Aggregating the Shares Sought
in the Hypothetical Auction IPO

Example 14.3 Auction IPO Pricing
Problem:
• Fleming Educational Software, Inc., is selling 500,000 shares
of stock in an auction IPO. At the end of the bidding period,
Fleming’s investment bank has received the following bids:
• What will the offer price of the shares be?

Solution:
Plan:
• First, we must compute the total number of shares
demanded at or above any given price. Then, we pick the
lowest price that will allow us to sell the full issue (500,000
shares).

Execute:
• Convert the table of bids into a table of cumulative demand:

Execute (cont'd):
• For example, the company has received bids for a total of
125,000 shares at $7.75 per share or higher (25,000 +
100,000 = 125,000).
• Fleming is offering a total of 500,000 shares. The winning
auction price would be $7.00 per share, because investors
have placed orders for a total of 500,000 shares at a price of
$7.00 or higher. All investors who placed bids of at least this
price will be able to buy the stock for $7.00 per share, even if
their initial bid was higher.

Execute (cont'd):
• In this example, the cumulative demand at the winning price
exactly equals the supply. If total demand at this price were
greater than supply, all auction participants who bid prices
higher than the winning price would receive their full bid (at
the winning price). Shares would be awarded on a pro rata
basis to bidders who bid exactly the winning price.

Evaluate:
• Although the auction IPO does not provide the certainty of
the firm commitment, it has the advantage of using the
market to determine the offer price. It also reduces the
underwriter’s role, and consequently, fees.

Example 14.3a Auction IPO Pricing
Problem:
• Fleming Educational Software, Inc., is selling 1,000,000
shares of stock in an auction IPO. At the end of the bidding
period, Fleming’s investment bank has received the following
bids:
Price ($) Number of Shares Bid
20.00 250,000
19.50 225,000
19.00 175,000
18.50 200,000
18.00 150,000
17.50 125,000
17.00 75,000

Solution:
Plan:
lowest price that will allow us to sell the full issue (1,000,000
shares).

Execute:
Price ($) Cumulative Demand
20.00 250,000
19.50 475,000
19.00 650,000
18.50 850,000
18.00 1,000,000
17.50 1,125,000
17.00 1,200,000

Execute (cont'd):
• For example, the company has received bids for a total of
725,000 shares at $19.50 per share or higher (250,000 +
225,000 = 475,000).
• Fleming is offering a total of 1,000,000 shares. The winning
auction price would be $18.00 per share, because investors
have placed orders for a total of 1,000,000 shares at a price
of $18.00 or higher. All investors who placed bids of at least
this price will be able to buy the stock for $18.00 per share,
even if their initial bid was higher.

Execute (cont'd):

Evaluate:
• While the auction IPO does not provide the certainty of the
firm commitment, it has the advantage of using the market
to determine the offer price. It also reduces the underwriter’s
role, and consequently, fees.

Example 14.3b Auction IPO Pricing
Problem:
• Stryker Endoscopy, Inc., is selling 700,000 shares of stock in
an auction IPO. At the end of the bidding period, Stryker
Endoscopy’s investment bank has received the following bids:
9.00 125,000
8.75 150,000
8.50 75,000
8.25 100,000
8.00 150,000
7.75 100,000
7.50 125,000

Solution:
Plan:
lowest price that will allow us to sell the full issue (700,000
shares).

Execute:
9.00 125,000
8.75 275,000
8.50 350,000
8.25 450,000
8.00 600,000
7.75 700,000
7.50 825,000

Execute (cont'd):
• Stryker Endoscopy is offering a total of 700,000 shares. The
winning auction price would be $7.75 per share, because
investors have placed orders for a total of 700,000 shares at
a price of $7.75 or higher. All investors who placed bids of at
least this price will be able to buy the stock for $7.75 per
share, even if their initial bid was higher.

Execute (cont'd):

Evaluate:

Example 14.3c Auction IPO Pricing
Problem:
• Stryker Endoscopy, Inc., is selling 1,000,000 shares of stock
in an auction IPO. At the end of the bidding period, Stryker
Endoscopy’s investment bank has received the following bids:
16.00 45,000
15.75 100,000
15.50 150,000
15.25 110,000
15.00 170,000
14.75 250,000
14.50 225,000

Solution:
Plan:
lowest price that will allow us to sell the full issue (1,000,000
shares).

Execute:
16.00 45,000
15.75 145,000
15.50 295,000
15.25 405,000
15.00 575,000
14.75 825,000
14.50 1,050,000

Execute (cont'd):
• Stryker Endoscopy is offering a total of 1,000,000 shares.
The winning auction price would be $14.50 per share,
because investors have placed orders for a total of 1,050,000
shares at a price of $14.50 or higher. All investors who
placed bids of at least this price will be able to buy the stock
for $14.50 per share, even if their initial bid was higher.

Execute (cont'd):
was greater than supply, so all auction participants who bid
prices higher than the winning price receive their full bid (at
the winning price). Shares are awarded on a pro rata basis to
bidders who bid exactly the winning price.

Evaluate:

Table 14.4 Summary of IPO Methods

14.3 IPO Puzzles
• Four IPO puzzles:
– Underpricing of IPOs
– “Hot” and “Cold” IPO markets
– High underwriting costs
– Poor long-run performance of IPOs

14.3 IPO Puzzles
• Underpriced IPOs
– On average, between 1980 and 2012, the price
in the U.S. aftermarket was 18% higher at the
end of the first day of trading
• Who wins and who loses because of underpricing?

Figure 14.5
International
Comparison of
First-Day IPO
Returns

14.3 IPO Puzzles
• “Hot” and “Cold” IPO Markets
– It appears that the number of IPOs is not solely
driven by the demand for capital
– Sometimes firms and investors seem to favor
IPOs; at other times firms appear to rely on
alternative sources of capital

Figure 14.6 Cyclicality of Initial Public
Offerings in the United States, (1975-2011)

14.3 IPO Puzzles
• High Cost of Issuing an IPO
– In the U.S., the discount below the issue price at
which the underwriter purchases the shares
from the issuing firm is 7% of the issue price
– This fee is large, especially considering the
additional cost to the firm associated with
underpricing

Figure 14.7 Relative Costs of Issuing
Securities

14.3 IPO Puzzles
• Poor Post-IPO Long-Run Stock Performance
– Newly listed firms appear to perform relatively
poorly over the following three to five years after
their IPOs
– That underperformance might not result from
the issue of equity itself, but rather from the
conditions that motivated the equity issuance in
the first place

14.4 Raising Additional Capital: The
Seasoned Equity Offering
• A firm’s need for outside capital rarely ends
at the IPO
– Seasoned Equity Offering (SEO): firms return to
the equity markets and offer new shares for sale

• SEO Process
– When a firm issues stock using an SEO, it
follows many of the same steps as for an IPO
– Main difference is that the price-setting process
is not necessary
• Tombstones

Figure 14.8
Tombstone
Advertisement for
a RealNetworks
SEO

• Two kinds of seasoned equity offerings:
– Cash offer
– Rights offer

Example 14.4 Raising Money with
Rights Offers
Problem:
• You are the CFO of a company that has a market
capitalization of $1 billion. The firm has 100 million shares
outstanding, so the shares are trading at $10 per share. You
need to raise $200 million and have announced a rights
issue. Each existing shareholder is sent one right for every
share he or she owns.

Rights Offers
Problem (cont'd):
• You have not decided how many rights you will require to
purchase a share of new stock. You will require either four
rights to purchase one share at a price of $8 per share, or
five rights to purchase two new shares at a price of $5 per
share. Which approach will raise more money?

Rights Offers
Solution:
Plan:
• In order to know how much money will be raised, we need to
compute how many total shares would be purchased if
everyone exercises their rights. Then we can multiply it by
the price per share to calculate the total amount raised.

Rights Offers
Execute:
• There are 100 million shares, each with one right attached.
In the first case, 4 rights will be needed to purchase a new
share, so 100 million / 4 = 25 million new shares will be
purchased. At a price of $8 per share, that would raise $8 x
25 million = $200 million.

Rights Offers
Execute (cont’d):
• In the second case, for every 5 rights, 2 new shares can be
purchased, so there will be 2 x (100 million / 5) = 40 million
new shares. At a price of $5 per share, that would also raise
$200 million. If all shareholders exercise their rights, both
approaches will raise the same amount of money.

Rights Offers
Evaluate:
• In both cases, the value of the firm after the issue is $1.2
billion. In the first case, there are 125 million shares
outstanding after the issue, so the price per share after the
issue is $1.2 billion / 125 million = $9.60. This price exceeds
the issue price of $8, so the shareholders will exercise their
rights. Because exercising will yield a profit of ($9.60 –
$8.00)/4 = $0.40 per right, the total value per share to each
shareholder is $9.60 + 0.40 = $10.00.

Rights Offers
Evaluate (cont'd):
• In the second case, the number of shares outstanding will
grow to 140 million, resulting in a post-issue stock price of
$1.2 billion / 140 million shares = $8.57 per share (also
higher than the issue price). Again, the shareholders will
exercise their rights, and receive a total value per share of
$8.57 + 2($8.57 - $5.00)/5 = $10.00. Thus, in both cases
the same amount of money is raised and shareholders are
equally well off.

Example 14.4a Raising Money with
Rights Offers
Problem:

Rights Offers
Problem (cont'd):
purchase a share of new stock. You will require either five
ten rights to purchase three new shares at a price of $6.67
per share. Which approach will raise more money?

Rights Offers
Solution:
Plan:

Rights Offers
Execute:
purchased. At a price of $10 per share, that would raise $10
x 50 million = $500 million.

Rights Offers
Execute (cont’d):
new shares. At a price of $6.67 per share, that would also
raise $500 million. If all shareholders exercise their rights,
both approaches will raise the same amount of money.

Rights Offers
Evaluate:
issue is $5.5 billion / 300 million = $18.33. This price
exceeds the issue price of $10, so the shareholders will
exercise their rights. Because exercising will yield a profit of
($18.33 – $10.00)/5 = $1.67 per right, the total value per
share to each shareholder is $18.33 + 1.67 = $20.00.

Rights Offers
Evaluate (cont'd):
$16.92 + 3($16.92 - $6.67)/10 = $20.00. Thus, in both
cases the same amount of money is raised and shareholders
are equally well off.

Example 14.4b Raising Money with
Rights Offers
Problem:

Rights Offers
Problem (cont'd):
purchase a share of new stock. You will require either two
five rights to purchase two new shares at a price of $6.25 per
share. Which approach will raise more money?

Rights Offers
Solution:
Plan:

Rights Offers
Execute:
purchased. At a price of $5 per share, that would raise $5 x
50 million = $250 million.

Rights Offers
Execute (cont’d):
new shares. At a price of $6.25 per share, that would also
raise $250 million. If all shareholders exercise their rights,
both approaches will raise the same amount of money.

Rights Offers
Evaluate:
issue is $5.25 billion / 150 million = $35. This price exceeds
the issue price of $5, so the shareholders will exercise their
rights. Because exercising will yield a profit of ($35.00 –
$5.00)/2 = $15 per right, the total value per share to each
shareholder is $35.00 + 15.00 = $50.00.

Rights Offers
Evaluate (cont'd):
$37.50 + 2($37.50 - $6.25)/5 = $50.00. Thus, in both cases
the same amount of money is raised and shareholders are
equally well off.

• Researchers have found that, on average,
the market greets the news of an SEO with
a price decline (about 1.5%)
– Often the value lost can be a significant fraction
of the new money raised
– Adverse selection (the lemons problem)

Figure 14.9 Price Reaction to an SEO
Announcement

• SEO Costs
– In addition to the price drop when the SEO is
announced, the firm must pay direct costs as
well. Underwriting fees amount to 5% of the
proceeds of the issue

Chapter Quiz
1. What are the main sources of funding for private
companies to raise outside equity capital?
2. What is a venture capital firm?
3. What services does the underwriter provide in a
traditional IPO?
4. Explain the mechanics of an auction IPO.

Chapter Quiz (cont’d)
5. List and discuss four characteristics about IPOs
that are puzzling.
6. For each of the characteristics, identify its
relevance to financial managers.
7. What is the difference between a cash offer and a
rights offer for a seasoned equity offering?
8. What is the typical stock price reaction to an
SEO?

Long term financing ipo

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