BMAN30111 Advanced Corporate Finance
Overview:
T1 IPO L1-2 PL1-2
T2 Capital Structure I: MM’s Theorems L3-4 PL3-4
Capital Structure II: Trade-off and Pecking Order Theories L5-6 PL5-6
T3 Agency Cost & Corporate Governance L7-10 PL7-10
T4 Option Valuation of Debt and Equity L11-12 PL11-12
T5 Issuance and Valuation of Convertibles L13-14 PL13-14
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,T1 IPO
Reasons to Raise Capital
1. Finance growth
2. Pay off debts
3. For mergers & acquisitions
Debt Capital
- Debt holders have a contract specifying their claims must be met full before equity holders
- Creditors can legally claim company’s assets if company go bankruptcy
- Interest payments are cost and tax-deductible
Equity Capital
- Shareholders are the owner of the firm and have voting rights
- Shareholders have the right to dividend payment (though dividend is not a must)
- Dividend payments are not cost and not tax-deductible
Financing Gap for Intermediate Firms
- Small firm’s equity from own/friend’s money
- Large firm’s equity from IPO, SEO
Business Angel
1. Wealthy individuals, generally with substantial business & entrepreneurial experience
2. Usually invest in equity
3. Not interested in controlling companies
4. Target firms earlier than VC
5. Share expertise
6. Generally are invisible, or visible with other investors e.g. banks, VC
Venture Capitalists
1. Wealthy individuals, generally with substantial business & entrepreneurial experience
2. Provide managerial assistant
3. Usually industry specialized (e.g. Skype)
- Seed Corn: develop business concept
- Start-up: further develop product idea
- Expansion: increase production capacity & working capital
- Management buyout: funding managers making a buy of a large company
- Management buy in: funding for new team of managers from outside the company
- Public to private: funding for returning a company to its unquoted status
2
,Equity Finance at Listing
1. IPO: Firm sells its shares to the market for the very first times
- Primary: news shares available in a public offering
- Secondary: existing shareholders sell their shares in an equity offering
2. SEO: Firm sells further shares to raise more finance
* Empirical: Right issue is most popular used method to raise capital for UK listed companies
Advantages of Going Public
1. New capital for company to finance new investment, make acquisition, refinance etc.
2. Facilitate raising new finance in the future, which may reduce debt overhang problem
3. Investor value liquidity, stock market minimises transaction cost
4. Less asymmetric information, trading on stock market generates a set of information
5. Enhance company image, more financial press attention & credibility to customers & sup
6. Cashing in, IPO can be an efficient exit strategy for VC
7. Diversification of risk for original owners, public firm can tolerate higher risk (ier strategy)
Disadvantages of Going Public
1. Financial cost of IPO (IPO > SEO > CB > Bonds)
- Expensive undertaking cost (average fee around $200 million)
- Underpricing of firm’s stock (on average 15%)
- Increase in legal requirements (e.g. financial statements, corporate governance)
2. Stock-price emphasis
- Management short-termism (focus on short term profit)
- Separation between ownership & control (agency cost)
- Hostile take-over
3. Expose to the market
- More public scrutiny
- More disclosure to product market competitors
(firms in industry with high disclosure cost prefer remaining private)
Empirical Reason for IPO
In all Countries
1. Finance fund growth (via new projects, M&A)
2. Obtain stock liquidity
US & Europe
1. Recognition, Reputation, Credibility
EU: One of the major motivations
US: Less than half of US CFO agrees that IPO improve market perception, hence prestige
2. IPO’s Cost
EU: Less concerned, viewing increased monitoring by outsider is a benefit of IPO (for CG)
US: High concerned about direct cost (underwriting, audit) & indirect cost (public scrutiny)
3
,IPO Process
1. Prepare a detailed prospectus of the company
- Minimum 3 years of audited accounts, major contracts (UK)
- Disclosure of all ownership information at/above 3%(UK) / 5%(US)
2. Strict regulation set by stock exchange
- At least 25% of shares will be public
- Managers must comply with insider dealing regulation
3. Choose & meet with the underwriter, sponsors
- Lead underwriter: the primary investment banking firm responsible for security issuance
- Syndicate: a group of underwriters jointly underwrite & distribute security issuance
Underwriter
a. assist all necessary filing (registration statement, prospectus)
b. value company
c. recommend stock price, capital needs, timetable, marketing strategy
Sponsor sell equity
a. Best effort
- iBank promise best effort to sell firm’s security
- Firm will withdraw issue from market if demand in insufficient
b. Firm-commitment
- iBank agree to underwrite issue (purchase shares from firm and resell to public)
- Receive spread as compensation, difference between buying price & offer price
- Spread is on average 7% for US, smaller for international
4. Valuation of the company (PL01-02)
- Discounted Cash Flow
- Comparable firm’s approach
5. Underwriting Practice
- Road Show
Senior mng & underwriters travel around to promote to largest customers (institutional)
- Book Building (Common in US)
Underwriters measure demand curve through conversation with investors, thus offer price
- Offer for sale
Underwriters set a final price and invite subscription from retail/institutional investor
- Placing (not normally underwritten)
Target institutional investors
6. Auction
4
,Anomalies in IPO: Short-run Underpricing
- First day, first week, or sometime first month of trading
- Shares are offered at a price considerably below first day trading price
Empirical (e.g. Linked In, Royal Mail)
- Underpricing is a world wide phenomenon (UK, US, emerging markets)
- Average first day return (EU 5-50%, non-EU: 5-150%)
Theories
1. Risk Averse Underwriter Hypothesis
- UWR voluntarily underprice to reduce the risk of unsuccessful IPO as they have significant
stakes: most IPO are through firm commitment & their reputation
- However, UWR can adjust their spread to compensate for the risk
- If this is the case, firm commitment IPO should be more underpriced than best effort IPO
2. Winner’s Curse Hypothesis
- Given fixed number of shares, demand will be excessive
- Informed investors will only try to buy underpriced (fairly priced) shares
- Uninformed investors cannot discriminate ex ante & will always demand shares
- UI will be able to buy a fraction of underpriced shares, or all shares that is overpriced
- UI will discount the price they are willing to pay, resulting in a lower share price
- UWR will price stock below the fair price to ensure all issue will be placed
3. Ownership Structure Hypothesis
- Underpricing is used to insure oversubscription of the issue
- Shares allocation can be rationed, managers can discriminate between investors
a. Managerial Entrenchment
b. Reduced likelihood of hostile takeovers (allocate to small investors)
4. Signalling Hypothesis
- Buy at low price, then see an increase, will be a signal of good investment for buyers
- Useful for future SEO, being able to sell at a higher price (SEO likely to follow IPO in few yr)
5. UWR Monopsony Power Hypothesis (Supply side monopoly)
- UWR underprice to reduce marketing effort
- Allocate issues to favoured customers who regularly do business with them
6. Underpricing as a Form of Insurance
- When overprice, investor may perceive information of company are not accurate (win. dre)
5
,Anomalies in IPO: Long-run Underperformance
- 3-5 years after IPO
- Market-adjusted buy and hold return on average, are negative
Theories
1. Agency Cost Based Explanation
- Potential conflict between original owners & new shareholders
Higher equity retention by original shareholders, better long-term performance
- Less monitoring action in those non-VC-backed IPO firms
No VC post-issue monitor service ensuring superior long0term performance
- Finding: no relationship between long-run performance & ownership structure
2. Behavioural & Expectation Based Explanation
- Price support hypt: Price support by UWR is removed, price adjust downwards to their MV
- Divergence of expectation decrease with time, price will adjust downwards
- Investors are over-optimistic about growth prospects during IPO, correct initial overprice
3. Underperformance is a mis-measurement
- Risk-measurement hypt: LRU may due to fail to adjust returns for time-varying system. Risk
- Mis-specified t-stats hypt: Violation of underlying statistical assumptions
- Imperfect benchmark hypt: Imperfect benchmarking may lies behind poor long-run return
Anomalies in IPO: Hot Issue Markets Phenomenon (Cyclicality of IPO)
- The extent of underpricing tends to vary overtime (Usually higher in bullish stock market)
Theories
1. Underpricing will be higher if firms go public in more risky periods
2. Cost of IPO are lower & benefit are greater in certain period, firms accept underpricing
3. When larger no. of firms do IPO at the same time, underprice to attract investors
Anomalies in IPO: Lock-in (Lockup) Agreement
- Lock-in: shareholders agree not to sell a certain % of shares for a specified length after IPO
- Around the expiration date of the agreement, share price of IPO firms fall 1-3% (US)
Theories
1. Signalling hypt: restricting sale impose a cost on insiders, higher quality agree longer lock-in
2. Commitment hypt: Prevent managers from expropriating the minority shareholders
3. Sponsor’s Reputation hypt: Sponsor write lock-in agreement to signal their reputation
6
,T2 Capital Structure
MM Proposition 1 (Capital Structure does not matter)
- Capital structure do not affect the aggregate value of firms
- Total value of firm equals MV of total cash flows generated by assets, not capital structure
- Capital structure is irrelevant
Assumption
1. Perfect Capital Markets
- No tax, transaction cost, issuance cost
- No asymmetric information & agency problems
2. Investors & firms can borrow and lend at the same rate
3. Financing decisions do not change the cash flows generated by investments
4. No arbitrage opportunities
Home-made Leverage
- Investors are indifferent to any changes in capital structure
- They can borrow/lend to ‘undo’ the effect of change in firm’s capital structure
MM Proposition II (Capital Structure does not matter)
- Debt maybe cheaper than equity, but it increases financial risk & cost of equity
- Cost of equity of a levered firms increases in proportion to the debt-equity ration (in $MV)
- Any attempt to raise the firms value by issuing debt will be exactly offset by increase in CoC
- WACC only change when company’s operation change, as it reflects operation performance
MM Proposition III (Capital structure is relevant with corporate taxes)
- Profitable firms should use more debt
- Firms with sufficient EBIT should be 100% debt financed
Determinants of Capital Structure
- MM’s proposition do not hold in real world as the market is imperfect (tax, asymmetric info)
Firm Value with Corporate Tax
- Increase debt relative to equity reduces firm’s corporate tax burden
- Debt Interest Tax Shield reduces the premium for financial risk (1-Tc)
- 𝑃𝑉 𝐷𝐼𝑇𝑆 = 𝑇( 𝐷
- Adjusted Present Value: 𝑉) = 𝑉* + 𝑃𝑉 𝐷𝐼𝑇𝑆 = 𝑉* + 𝑇( 𝐷
Firm Value with Corporate & Personal Tax
- Tax adv. of debt over equity at corporate level might be offset by tax disadv. at individual level
(1234 )(12367 )
- Effective tax advantage of debt: 𝑇 ∗ = 1 −
(12368 )
- Adjusted Present Value: 𝑉) = 𝑉* + 𝑃𝑉 𝐷𝐼𝑇𝑆 = 𝑉* + 𝑇 ∗ 𝐷
Firm Value with Non-Debt Tax Shields
- Borrowing is not the only way to shield income against tax (highly relevant to high growth)
- MM did not consider potential substitutes for debt tax shields (non-debt tax shield)
- Especially for small & high growth firms, with many R&D and capital investment expense
7
, Empirical Evidence on Taxes & Capital Structure
1. Profitability are negatively related to leverage (i.e. lower tax shield, consistent with POT)
2. Firms with high marginal tax rates are more likely to leverage
3. Firms with considerable taxable earnings are more likely to issue debt
4. Leverage responses to tax increases but not tax cuts
5. Low leverage puzzle: ~ 20% of US company can use tax to improve their earning
i.e. may due to financial distress cost, agency cost of debt, financial flexibility
Default & Bankruptcy in PCM
MM’s irrelevant theorem holds with risk debt and costless bankruptcy:
- Limited liabilities and no distress/bankruptcy cost
- Costless transfer of ownership & control of the firm’s shareholders to debt-holders
Cost of Financial Distress
Direct Cost
- Incurred to facilitate an orderly bankruptcy process
1. Mainly costly professional fees (legal & accounting fee)
2. Average direct FD cost is 1-10% of firm’s pre-bankruptcy market value
3. Higher for firms with more complicated operations / larger number of creditors
4. Relatively higher for small firms
Indirect Cost
- Incurred due to potential loss of customers, suppliers, employees, receivables, sales of asset,
delayed liquidation, agency cost
1. Difficult to measure, but can be larger than direct cost
2. Empirical: 10-30% of firm’s value, adjusted for selection bias, up to 45%
Static Trade Off Theory of Optimal Capital Structure
𝑉) = 𝑉* + 𝑃𝑉 𝐷𝐼𝑇𝑆 − 𝑃𝑉(𝐹𝐷𝐶)
- Every firm has an optimal debt level or target leverage
- Firm balance the benefits of debt against the financial distress cost (bankruptcy cost)
Empirical
A majority of firms has a target leverage
Factor affecting decision to issue debt:
- Moderate important for tax saving for US & EU, but investor tax are not important
- FDC is less important than tax saving
- Financial flexibility & credit rating are most important, hence avoiding distress is vital
Regression Evidence
- Moderate evidence to support trade off theory
- UK & US firms adjust their capital structures toward target leverage ratios
- Firms are more likely to increase debt if they are under-leverage relative to the target lev, VV
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