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  1. 1. <ul><li>Regulation and Investment Banking </li></ul><ul><li>Public versus Private Ownership </li></ul><ul><li>Procedures for Selling New Common Stock </li></ul><ul><li>Factors Influencing Long- Term Financing Decisions </li></ul><ul><li>Refunding Operations </li></ul>CHAPTER 13 Investment Banking and Financial Restructuring
  2. 2. <ul><li>1. Represents ownership. </li></ul><ul><li>2. Ownership implies control. </li></ul><ul><li>3. Stockholders elect directors. </li></ul><ul><li>4. Directors elect management. </li></ul><ul><li>5. Assumed goal of management: Maximize the stock price. </li></ul>Facts about common stock:
  3. 3. <ul><li>Should management work primarily to maximize stock price or be equally concerned about employees, customers, suppliers, and “the public?” </li></ul><ul><li>In an enterprise economy, management works for stockholders , subject to constraints (environmental, fair hiring, etc.) and competition . </li></ul>Social/Ethical question:
  4. 4. <ul><li>No required fixed payments. </li></ul><ul><li>No maturity date. </li></ul><ul><li>Strengthens balance sheet and improves coverage ratio. </li></ul><ul><li>Common stock, can at times, be sold easier than debt </li></ul>Advantages of financing with common stock:
  5. 5. <ul><li>Current shareholders may lose some control . </li></ul><ul><li>Future earnings must be shared with new stockholders. Dilution . </li></ul><ul><li>Higher flotation costs than debt. </li></ul><ul><li>Higher component cost of capital . </li></ul><ul><li>Sale of new common stock may be perceived by investors as a negative signal . </li></ul><ul><li>Too little debt may encourage a takeover bid. </li></ul>Disadvantages of stock financing:
  6. 6. <ul><li>Classified stock has special provisions . </li></ul><ul><li>Could classify existing stock as founder’s shares , with sole voting rights but dividend restrictions for a number of years. Keep control . </li></ul><ul><li>New publicly sold shares might be called “Class A” shares, with voting restrictions but full dividend rights. </li></ul>What’s classified stock? How might a firm use classified stock?
  7. 7. What agencies regulate securities markets? <ul><li>The Securities and Exchange Commission (SEC) regulates: </li></ul><ul><ul><li>Interstate public offerings </li></ul></ul><ul><ul><li>Must register securities at least 20 days before they are publicly offered </li></ul></ul><ul><ul><li>Registration statements and prospectuses </li></ul></ul><ul><ul><li>National stock exchanges </li></ul></ul><ul><ul><li>Trading by corporate insiders </li></ul></ul><ul><ul><li>The corporate proxy process </li></ul></ul>(More)
  8. 8. <ul><li>The Federal Reserve Board controls margin requirements. </li></ul><ul><li>States control the issuance of securities within their boundaries. “Blue Sky” laws </li></ul><ul><li>The securities industry, through the National Association of Securities Dealers (NASD), takes actions to ensure the integrity and credibility of the trading system. </li></ul>
  9. 9. Why is important that securities markets be tightly regulated? <ul><li>Investors receive accurate information </li></ul><ul><li>No one artificially manipulates the market of a given stock </li></ul><ul><li>Corporate insiders do not take advantage of their position to profit in their companies’ stock at the expense of other stockholders. </li></ul>
  10. 10. What are some of the decisions faced by firms needing external financing? (Investment Banking Process) <ul><li>Stage 1 Decisions </li></ul><ul><ul><li>Amount to be raised </li></ul></ul><ul><ul><li>Type(s) of securities to be used </li></ul></ul><ul><ul><li>Competitive bid versus negotiated deal </li></ul></ul><ul><ul><li>Selection of an investment banker </li></ul></ul>(More)
  11. 11. <ul><li>Stage II Decisions </li></ul><ul><ul><li>Reevaluating the initial decisions </li></ul></ul><ul><ul><li>Best efforts versus an underwritten deal </li></ul></ul><ul><ul><li>Banker’s compensation and other expenses </li></ul></ul><ul><ul><li>Setting the offering price </li></ul></ul><ul><li>Selling Procedures </li></ul><ul><ul><li>“Green Shoe Provision” </li></ul></ul><ul><li>Shelf Registration </li></ul>
  12. 12. Shelf Registration <ul><li>SEC Rule 415 - must have $150 million in stock outstanding (market value) </li></ul><ul><li>Master Registration for up to two years </li></ul><ul><li>Advantages: </li></ul><ul><ul><li>Lower floatation costs </li></ul></ul><ul><ul><li>More control over the timing of the sale </li></ul></ul><ul><ul><li>Can make underwriters compete for the business </li></ul></ul><ul><ul><li>Securities can be issued in “dribs and drabs” </li></ul></ul>
  13. 13. <ul><li>A firm goes public through an IPO when the stock is offered to the public for the first time. </li></ul>When is a stock sale an initial public offering (IPO)?
  14. 14. <ul><li>Current stockholders can diversify holdings. </li></ul><ul><li>Liquidity is increased. </li></ul><ul><li>Easier to raise capital in the future. </li></ul><ul><li>Going public establishes a value for the firm. </li></ul><ul><li>Makes it more feasible to use stock as employee incentives. </li></ul>Advantages of going public:
  15. 15. <ul><li>Must file numerous reports. </li></ul><ul><li>Operating data must be disclosed. </li></ul><ul><li>Officers must disclose holdings. </li></ul><ul><li>Special “deals” to insiders will be more difficult to undertake. </li></ul><ul><li>A small new issue will not be actively traded, so market-determined price may not reflect true value. </li></ul>Disadvantages of going public:
  16. 16. <ul><li>If key employees own stock or options, they would know the true worth of these securities. </li></ul><ul><li>Stock can be sold much more easily </li></ul><ul><li>It becomes easier to create employee incentive plans. </li></ul>How would the decision to go public affect key employees?
  17. 17. <ul><li>Yes, but investment bankers possibly might not like it. Might send negative signal to potential purchasers. </li></ul><ul><li>Still, it’s quite common for founding stockholders to sell some shares to diversify their personal holdings. </li></ul>Could the founding stockholders sell some of their own shares when the firm goes public?
  18. 18. <ul><li>A listed stock is traded on an organized exchange. </li></ul><ul><li>Today, even some larger firms are choosing to remain unlisted. </li></ul><ul><li>Publicity from listing on a major exchange </li></ul><ul><li>It’s unlikely that a small firm’s stock would be listed. Small firms trade in the OTC market. </li></ul>What is meant by “listing?” Would a small firm likely be listed?
  19. 19. How Can New Shares be Sold? <ul><li>Pro Rata Basis to Existing Shareholders - Preemptive Rights Offering </li></ul><ul><li>Through Investment Bankers to the General Public </li></ul><ul><li>To a Single Buyer (or small number of buyers) in a Private Placement </li></ul><ul><li>To Employees through Employee Stock Ownership Plans (ESOP) </li></ul><ul><li>Through a Dividend Reinvestment Plan </li></ul>
  20. 20. <ul><li>A rights offering occurs when current shareholders get the first right to buy new shares. </li></ul><ul><li>Would not make sense for a firm that is going public. If current stockholders wanted to buy shares, they wouldn’t go public. </li></ul>What is a rights offering? Would it make sense for a small firm that is going public to use a rights offering?
  21. 21. Preemptive Rights <ul><li>If a firm sells to existing stockholders, the stock floatation is called a rights offering. </li></ul><ul><li>Preemptive rights </li></ul><ul><ul><li>protect stockholders’ power of control </li></ul></ul><ul><ul><li>protect against dilution of value </li></ul></ul> M o - S N + 1 R = Value of one right
  22. 22. <ul><li>Private placement : Securities are sold to a few investors rather than to the public at large. </li></ul><ul><li>Public offering : Securities are offered to the public through investment bankers. (Note that a Private Placement could also utilize investment bankers.) </li></ul><ul><li>(More...) </li></ul>Differentiate between a private placement and a public offering.
  23. 23. <ul><li>Privately placed stock is not registered , so sales must be to “sophisticated” (high net worth) investors. </li></ul><ul><li>Send out “offering memorandum” with 20-30 pages of data and information, prepared by securities lawyers. </li></ul><ul><li>Buyers certify that they meet net worth/income requirements and they will not sell to unqualified investors. </li></ul>
  24. 24. Advantages and Disadvantages of Private Placement <ul><li>Advantages: </li></ul><ul><ul><li>Lower Floatation costs </li></ul></ul><ul><ul><li>Greater speed - don’t go through SEC </li></ul></ul><ul><ul><li>Institutions with $100 million or more can buy or sell private placement securities (Rule 144A of SEC) </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Lack of liquidity </li></ul></ul><ul><ul><li>Lack of valuation </li></ul></ul><ul><ul><li>If debt, might have higher interest rates </li></ul></ul>
  25. 25. <ul><li>Would use an investment banker. </li></ul><ul><li>Would use a negotiated deal rather than a competitive bid. </li></ul>Would a company that is going public be likely to sell its new stock by itself or through an investment banker?
  26. 26. <ul><li>The competitive bid process is only feasible for large, well-established firms, on large issues, and even here, the use of bids is rare for equity issues. </li></ul><ul><li>It would cost investment bankers too much to learn enough about the company to make an intelligent bid. </li></ul>Would companies that are going public use a negotiated deal or a competitive bid?
  27. 27. <ul><li>Most offerings are underwritten. </li></ul><ul><li>In very small, very risky deals, the investment banker may insist on a best efforts basis. </li></ul><ul><li>On an underwritten deal, the price is not set until: </li></ul><ul><ul><li>Investor interest is assessed </li></ul></ul><ul><ul><li>Oral commitments are obtained </li></ul></ul>If a company goes public as a negotiated deal, would it be on an underwritten or best efforts basis?
  28. 28. <ul><li>Since the firm is going public, there is no established price. </li></ul><ul><li>The banker would examine market data on similar companies. </li></ul><ul><li>Price set to place the firm’s P/E and M/B ratios in line with publicly traded firms in the same industry, with similar risk and growth prospects. (More...) </li></ul>Describe how an IPO would be priced.
  29. 29. <ul><li>On the basis of all relevant factors, banker would determine a ballpark equilibrium price . </li></ul><ul><li>The offering price would be set somewhat lower to increase demand and to insure that the issue will sell out. (More...) </li></ul>
  30. 30. <ul><li>There is an inherent conflict of interest, because the banker has an incentive to set a low price </li></ul><ul><ul><li>to make brokerage customers happy </li></ul></ul><ul><ul><li>to make it easy to sell the issue </li></ul></ul><ul><li>Firm would like price to be high. </li></ul><ul><li>Note that original owners generally sell only a small part of their stock, so if price increases, they benefit. </li></ul><ul><li>Later offerings easier if first goes well. </li></ul>
  31. 31. <ul><li>NO! Boston Chicken had an IPO recently. Stock was issued at $20 and rose to $48.50 the first day! They are now in Chapter 11 bankruptcy! </li></ul>Do investment bankers always “ get it right” in pricing IPOs?
  32. 32. <ul><li>Gross proceeds: $15 million. </li></ul><ul><li>But, flotation costs of IPO would be about 18% or $2.7 million. The firm would net about $12.3 million from the sale. </li></ul>Suppose a firm issued 1.5 million shares at $10 per share. What would be the net amount raised if flotation costs on the issue were 18%?
  33. 33. <ul><li>If the firm were already publicly owned, the flotation costs would be much less, about 9% or about $1.4 million, because a market price for the stock would already have been established. </li></ul><ul><li>Now the firm would net about $13.6 million. </li></ul>What would be the net proceeds if the firm were already publicly owned and floatation costs were 9% ?
  34. 34. <ul><li>The investment bankers are exposed to more risk on underwritten deals, and they will charge a price for assuming risk. </li></ul><ul><li>If the firm absolutely has to have the money to meet a commitment, it will want a guaranteed price and will use an underwritten deal. </li></ul><ul><li>Investment banker maintains a secondary market for the shares - especially smaller firms </li></ul>Would there be a difference in costs between a best efforts and an underwritten offering?
  35. 35. Employee Stock Option Plans (ESOPs) <ul><li>A company typically borrows money to buy its own stock and places the stock in the hands of an ESOP trustee, who then allocates the stock ownership to the firm’s employees on the basis of relative salaries. </li></ul><ul><li>Companies can claim a tax credit equal to a percentage of wages, provided that the funds are used to buy newly issued stock for the benefit of employees. </li></ul>
  36. 36. Advantages of ESOPs <ul><li>Tax breaks - firms get a tax credit and they can deduct the interest on the debt used to buy the stock, some of the principal payments on the ESOP -funded debt, and dividends on ESOP-held shares </li></ul><ul><li>Anti-takeover defense </li></ul><ul><li>Pension cost control - eliminate retirement medical benefits </li></ul><ul><li>Productivity enhancement (AVIS) </li></ul>
  37. 37. Disadvantages of ESOPs <ul><li>Balance of power can shift to a raider </li></ul><ul><li>Legal considerations - Department of Labor </li></ul><ul><li>Retiree benefits are tied to the ESOP and hence to the firm’s stock </li></ul><ul><li>Obligation to repurchase stock - Private companies with ESOPs have to repurchase the stock at the current appraised value when employees leave the company or retire. </li></ul>
  38. 38. Equity Carve-Outs <ul><li>Equity Carve-Outs (or Spin-outs) occurs when the parent firm sells about 20 % of the equity in a wholly owned subsidiary. </li></ul><ul><li>A carve-out is a form of corporate securitization, which is the issuance of public securities backed by assets that have been segregated from the remaining assets of the company. </li></ul>
  39. 39. Advantages of Equity Carve-outs <ul><li>Provides a “pure play” on a line of business </li></ul><ul><li>Offers incentives to the subsidiary’s managers </li></ul><ul><li>Easier to measure the cost of capital for the different business units </li></ul><ul><li>Can increase the effectiveness of capital allocation </li></ul>
  40. 40. Disadvantages of Equity Carve-outs <ul><li>Underwriting commissions for a carve-out is larger than for an equity offering by the parent </li></ul><ul><li>Time must be spent marketing the new stock </li></ul><ul><li>Cost of additional reports </li></ul><ul><li>The subsidiary’s board must monitor transactions between the parent and subsidiary to ensure that the subsidiary is not exploited. </li></ul>
  41. 41. <ul><li>Going private is the reverse of going public. </li></ul><ul><li>Typically, the firm’s managers team up with a small group of outside investors with equity capital, and purchase all of the publicly held shares of the firm. </li></ul><ul><li>The new equity holders usually use a large amount of debt financing (sometimes 80 to 90%) to complete the purchase. </li></ul><ul><li>Transaction is called a leveraged buyout (LBO) . </li></ul>What is meant by “going private”?
  42. 42. <ul><li>Administrative cost savings </li></ul><ul><li>Gives managers greater incentives and more flexibility in running the company. </li></ul><ul><li>Removes pressure to report high earnings in the short run. </li></ul><ul><li>Increased shareholder participation </li></ul><ul><li>Increased financial leverage </li></ul><ul><li>After several years as a private firm, owners typically go public again. </li></ul>Advantages of Going Private
  43. 43. <ul><li>LBO firms are normally leveraged to the hilt, so it’s difficult to raise new capital. </li></ul><ul><li>A difficult period that could normally be weathered might bankrupt the company. </li></ul><ul><li>Typically, LBO is an “unstable” arrangement. The firm usually: (1) “goes public,” or (2) is sold to another firm, or (3) goes through another LBO. </li></ul>Disadvantages of Going Private
  44. 44. What factors influence long-term financing decisions? <ul><li>Capital structure considerations </li></ul><ul><li>Maturity matching </li></ul><ul><li>Interest rate levels </li></ul><ul><li>Restrictive covenants </li></ul><ul><li>Amount of financing required </li></ul><ul><li>Availability of collateral </li></ul><ul><li>Current and prospective capital costs </li></ul>
  45. 45. <ul><li>Project financing </li></ul><ul><li>Securitization </li></ul>Describe the following items:
  46. 46. <ul><li>Project financings are used to finance a specific large capital project. Sponsors provide the equity capital, while the rest of the project’s capital is supplied by lenders and/or lessors who do not have recourse. </li></ul>(More...)
  47. 47. <ul><li>Securitization is the process whereby financial instruments that were previously illiquid are converted to a form that creates greater liquidity. Examples are bonds backed by mortgages, auto loans, credit card loans (asset-backed), and so on. </li></ul><ul><li>Asset securitization involves the pooling and repackaging of loans secured by relatively homogeneous, small dollar assets into liquid securities. </li></ul>
  48. 48. <ul><li>If interest rates have fallen since the bond was issued, the firm can replace the current issue with a new, lower coupon rate bond. </li></ul><ul><li>However, there are costs involved in refunding a bond issue. For example, </li></ul><ul><ul><li>The call premium. </li></ul></ul><ul><ul><li>Flotation costs on the new issue. </li></ul></ul>Under what conditions would a firm exercise a bond call provision? (More...)
  49. 49. <ul><li>The NPV of refunding compares the interest savings benefit with the costs of the refunding. A positive NPV indicates that refunding today would increase the value of the firm. </li></ul><ul><li>However, if interest rates are expected to fall further, it may be better to delay refunding until some time in the future. </li></ul><ul><li>Similar to refinancing a home mortgage. </li></ul>
  50. 50. Conclusion <ul><li>Common Stock Financing </li></ul><ul><li>Securities Regulation </li></ul><ul><li>Investment Banking Process </li></ul><ul><li>Going Public </li></ul><ul><li>Rights Offering </li></ul><ul><li>Public vs. Private Placement </li></ul><ul><li>ESOPs </li></ul><ul><li>Going Private </li></ul><ul><li>Refunding </li></ul>