Corporate Financing Decision (FIN 502)

MBA
Kathmandu University School of Management

Rajesh Sharma, PhD

Raising capital
Raising Capital: Later Stage
• Retained Earnings/ Reinvestment

• Bonus Share

• Right Share

• Follow on Public Offering (FPO): Dilutive & Non-Dilutive

• Private Equity (PE)

• Debt Financing
 Raising Capital: Later Stage
• A company’s first public issue of stock is seldom its last. As the firm grows
(expected result: increase in sales and profit), it is likely to make further issues
of debt and equity. Public companies can issue securities either by offering them
to investors at large or by making a rights issue that is limited to existing
stockholders.
NOTE- Any amount ploughed into business for supporting growth
(Although retained earning and bonus share are not a typical topic under “raising capital”, for the sake
of this lecture we understand capital infusion (BOTH internal and external) from VALUATION
perspective and its effect (ANNOUNCEMENT effect) on: Cash flow/ Rate of Return/ Growth/
Number of Shares)

• Growth Strategies:
– Expansion
• Market Penetration and Product expansion: By lowering price in existing market OR
expanding product line (Increase in Production)
• Market Expansion and Product diversification: Entering new market (Increase in Production)
– Acquisitions
• A company purchases another company to expand its operations. A small company may use
this type of strategy to expand its product line and enter new markets.
 Retained Earnings and its effect
• Does NOT fall under traditionally Raising capital definition (In-depth coverage in dividend
payout chapter).

• Retained earnings (RE) is the amount of net income left over for the business after it has paid
out dividends to its shareholders. (Depend on dividend policy: both cash and stock)
• RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

• A growth-focused company may not pay dividends at all or pay very small amounts, as it may
prefer to use the retained earnings to finance expansion activities i.e. expand the existing
business operations, invest to launch a new product, utilized for any possible partnership
(including M&A) that leads to improved business prospects.

Valuation Effect
• Normally, these funds are used for working capital and fixed asset purchases (capital
expenses)
• Paying off debt obligations (Financial Risk: Debt/Equity).
• Affect firms’ growth (g) = “ROE” X “Retention Rate” (Important input in valuation model)
• Number of Shares ??
Raising Capital: Issuing New Equity

• Bonus Share

• Right Share

• Follow on Public Offering (FPO): Dilutive

 Bonus Share and its effect
• A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free
additional shares to existing shareholders.
• When a company issues bonus shares (increases number of outstanding shares), the
shares are paid for out of the cash reserves, and the reserves deplete: Such proceed
supports growth and addresses both dividend as well as investment requirement.

• CASE 1: Bonus issues are given to shareholders when companies are short of cash and
shareholders expect a regular income (Stable dividend theory).
– Pullbacks to a company’s dividend policy result in an adverse effect and signals a weakening company. A
company must consider its future prospects and its earning potential before setting a dividend rate.
– Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their dividend payout by 75%, a
move that saw their share price tank.
• CASE 2: Bonus shares may also be issued to restructure company reserves.

Valuation Effect
• Number of Shares: Issuing bonus shares does not involve cash inflow. It increases the
company’s share capital but not its net assets.
• Effect on Cost of Capital: Affect financial risk through change in Debt/Equity ratio.
• Affordability: Minimize share price.
Right Shares
• An issue of rights to a company's existing shareholders that entitles them to buy
additional shares directly from the company in proportion to their existing holdings,
within a fixed time period.

• In a rights offering, the subscription price at which each share may be purchased in
generally at a discount to the current market price.

• Rights are often transferable, allowing the holder to sell them on the open market.

Rights

• If a preemptive right is contained in the firm’s articles of incorporation, the firm must
offer any new issue of common stock first to existing shareholders.

• This allows shareholders to maintain their percentage ownership if they so desire.

Right Shares: Mechanics
• Early stages are the same as for a general cash offer, i.e., obtain approval from
directors, file a registration statement, etc. The difference is in the sale of the
securities. Current shareholders get rights to buy new shares. They can
subscribe (buy) the entitled shares, sell the rights or do nothing.

• The management of the firm must decide:

– The exercise price (the price existing shareholders must pay for new
shares).
– How many rights will be required to purchase one new share of stock.

• These rights have value:

– Shareholders can either exercise their rights or sell their rights.
Right Shares: Example
• National Power earns $2 million after taxes and has 1 million shares
outstanding. Earnings per share are thus $2, and the stock sells for $20, or 10
times earnings (that is, the price–earnings ratio is 10). To fund a planned
expansion, the company intends to raise $5 million worth of new equity
funds through a rights offering.

• To execute a rights offering, the financial management of National Power will

have to answer the following questions:
– What should the price per share be for the new stock?
– How many shares will have to be sold?
– How many shares will each shareholder be allowed to buy?

• Also, management will probably want to ask this:

– What is likely to be the effect of the rights offering on the per-share value of the existing
stock?
Answers to these questions are highly interrelated.
Right Shares: Example
• The early stages of a rights offering are the same as those for a general cash
offer. The difference between a rights offering, and a general cash offer lies
in how the shares are sold.

• In a rights offer; National Power’s existing shareholders are informed that

they own one right for each share of stock they own. National Power will
then specify how many rights a shareholder needs to buy one additional share
at a specified price.

• To take advantage of the rights offering, shareholders have to exercise the

rights by filling out a subscription form and sending it, along with payment, to
the firm’s subscription agent (the subscription agent is usually a bank).
Shareholders of National Power will actually have several choices:
– Exercise their rights and subscribe for some or all of the entitled shares
– Do nothing and let the rights expire.
Right Shares: Number of Rights
• National Power wants to raise $5 million in new equity. Suppose the subscription price
is set at $10 per share.

• At $10 per share, National Power will have to issue 500,000 new shares.

• To determine how many rights will be needed to buy one new share of stock, we can
divide the number of existing outstanding shares of stock by the number of new
shares:
Right Shares: Number of Rights
• It should be clear that the subscription price, the number of new shares, and
the number of rights needed to buy a new share of stock are interrelated.

• For example, National Power can lower the subscription price. If it does,
more new shares will have to be issued to raise $5 million in new equity.
The Value of Right
• Suppose a shareholder of National Power owns two shares of stock just before the rights offering
is about to expire. Initially, the price of National Power is $20 per share, so the shareholder’s total
holding is worth 2 X $20 = $40. The National Power rights offer gives shareholders with two
rights the opportunity to purchase one additional share for $10.
• New position: 3 shares with total value of $50.
• Price/Share (New) = $50/ 3 = $16.67.
• Hence, the value of right = $20 - $16.67 = $ 3.33
Ex Rights
• The rights offering will have a large impact on the market price of National Power’s stock. Price
will drop by $3.33 on the ex-rights date.
• The standard procedure for issuing rights involves the firm’s setting a holder-of-record date.
Following stock exchange rules, the stock typically goes ex rights two trading days before the
holder-of-record date.
• If the stock is sold before the ex-rights date—“rights on,” “with rights,” or “cum rights”—the
new owner will receive the rights. After the ex-rights date, an investor who purchases the shares
will not receive the rights.
Bonus v/s Right Share
Follow on Public Offering (FPO)
• Follow on Public Offering (FPO):
– A company uses FPO after it has gone through the process of an IPO and
decides to make more of its shares available to the public or to raise capital to
expand or pay off debt.
– The two main types of FPOs:
• Dilutive- new shares are added
• Non-Dilutive- existing private shares (e.g. Promoters, VC/PE) are sold publicly.
Note: The classification is with respect to “capital raising” (new capital that firm receives)

• FPO Schedule: During Undervalue or Overvalue

• FPO Price: Discount Price/ Auction Price/ Market Price (ATM)

– An at-the-market (ATM) offering gives the issuing company the ability to raise
capital as needed. If the company is not satisfied with the available price of shares
on a given day, it can refrain from offering shares.
 Effect of FPO
Valuation Effect
• Dilutive:
– Company’s Board of Directors agrees to increase the share float level or the
number of shares available. This kind of follow-on public offering seeks to raise
money to reduce debt or expand the business. Resulting in an increase in the
number of shares outstanding and change in capital structure.

– Valuation effect: Firm issues FPOs during overvalue but market discounts price
(effect largely depend upon quality of information disclosed not upon the increase
in numbers of shares).
Understand the overall process
Brealey, R. A., Myers, S. C., Allen, F., & Mahanty, P. (2011). Principles of Corporate Finance
(Chapter: How Corporations Issues Securities/ Topic: Market Reaction to Stock Issues)

– Why will investor buy at prevailing market price? (Average of current share price:
30 days/ 12 months)

– Nepal case (Not align with market price BUT 2 times book value/net worth:
unverified source)
 Effect of FPO
Valuation Effect

• Non-Dilutive:
– This approach is useful when directors or substantial shareholders sell-off
privately held shares (VC/PE: that are looking to realize gains from FPO).
– Commonly referred to as a secondary market offering, there is no benefit to the
company or current shareholders (with respect to raising capital/ understand
authorized and issued capital).
– Valuation effect: ??

• The split depends upon the reason for FPO (Plus the agreement with VC and PE): If
additional funds needed to support growth than a firm issues dilutive options.

By paying attention to the identity of the sellers on offerings, one can determine
whether the offering will be dilutive or non-dilutive to their holdings.
IPO v/s FPO
Right Share v/s FPO
Private Equity
• Technically refers to any type of equity investment in an asset in which the
equity is not freely tradable on a public market.

• Long Term in nature.

• Angle Investor v/s Venture Capital v/s Private Equity (Understand the
differences).

• Professional pools of capital that buy all the publicly traded equity of target
companies = “Go Private”

• Usually done with borrowed money

– High degree of leverage

• Aka : Leveraged Buyout

 Private Equity: Why and How?
• Private equity firms mostly buy mature companies that are already established.

• The companies may be deteriorating or not making the profits they should be due to
inefficiency.

• Private equity firms buy these companies and streamline operations to increase revenues.

• Can save poorly-performing companies from bankruptcy and turn them into profitable
enterprises.

• Private equity firms mostly buy 100% (or take control) ownership of the companies in which
they invest.

• The companies are in total control of the firm after the buyout.

• Existing company with existing products and existing cash flows, then restructuring that
company to optimize its financial performance (Understand Exit Strategies for PE)
Private Equity: Structure
 TESLA CASE and their proposal for privatization in August 2018

What was the deal ?

Why was the deal proposed by TESLA (from firm point of view)?
What was the outcome ?
Why do you think the way these deal was concluded (reflect on final outcome) ?
Debt: The Basics
• Long-term debt – loosely, bonds with a maturity of one year or more.

• Short-term debt – less than a year to maturity, also called unfunded debt.

• Bond – strictly speaking, secured debt; but used to describe all long-term
debt.
Debt: The Basics
Private v/s Public

• Another important difference is that more than 50 percent of all debt is

issued privately. There are two basic forms of direct private long-term
financing:
– Term loans are direct business loans. These loans have maturities of between
one year and five years. Most term loans are repayable during the life of the
loan. The lenders include commercial banks, insurance companies, and other
lenders that specialize in corporate finance.
– Private placements are similar to term loans except that the maturity is longer.
The important differences between direct private long-term financing and public
issues of debt are these:
1) Avoid SEC Registration
2) Restrictive Covenants
3) Smaller Number, hence easy to renegotiate incase of default
4) Lower cost
5) Major players are insurance, pension funds, institutional investors
Long-term Debt
• Debt financing is money that you borrow to run your business, as opposed
to equity financing, in which you raise money from investors who are in
return entitled to a share of the profits from your business.

• Debt is not an ownership interest in the firm. Creditors do not have voting
power.

• The corporation’s payment of interest on debt is considered a cost of doing

business and is fully tax-deductible.

• Unpaid debt is a liability of the firm. If it is not paid, the creditors can
legally claim the assets of the firm.
Debt v/s Equity
• Debt • Equity
• Not an ownership interest • Ownership interest
• Creditors do not have • Common stockholders vote for
voting rights the board of directors and
• Interest is considered a other issues
cost of doing business • Dividends are not considered a
and is tax deductible cost of doing business and are
• Creditors have legal not tax deductible
recourse if interest or • Dividends are not a liability of
principal payments are the firm, and stockholders have
missed no legal recourse if dividends
• Excess debt can lead to are not paid
financial distress and • An all-equity firm cannot go
bankruptcy bankrupt
The Bond Indenture
• Contract between the company and the bondholders that includes:
– The basic terms of the bonds

– The total amount of bonds issued

– A description of property used as security, if applicable

– Sinking fund provisions

• (a fund established to retired debt before maturity)

– Call provisions
• (Bond that may be repurchased by a firm before maturity at a specified call price)

– Details of protective covenants

e.g. Terms of Bond Issue, JC Penney
The Covenants
• Covenants
– Debt ratios (existing bond holder limits borrowing)
– Security
• Negative pledge (the processing of giving unsecured debentures equal protection and
when assets are mortgaged).

– Dividends/ Dilution (Convertible bond valuation issue)

– Event risk
– Positive covenants (Positive covenants specify actions that the firm must take. A poison put is a
clause that obligates the borrower to repay the bond in case of an attempt to acquire the firm by another
firm).

* Bond covenants include clauses to protect the bondholders’ interests. They

are also called protective covenants. These are some of the most commonly used
provisions that are normally included in the debt contract.
 Covenants Restrictions 1993 v/s 2007

a Default on other loans, rating changes, or declining net worth

Bond Classifications based on its character

• Registered vs. Bearer Forms (Whether firm keeps details information of owners/ Payment
to whoever possess bond / Associated risk / Money launders)

• Security
– Debentures – Long-term unsecured issues on debt
– Mortgage Bond – Long-term secured debt often containing a claim against a specific
building or property
– Collateral Trust Bond – Bonds secured by common stocks or other securities that are owned
by the borrower
– Equipment Trust Security – Form of secured debt generally used to finance railroad
equipment. The trustee retains ownership of the equipment until the debt is repaid.

• Seniority
Coupon Rate and Associated Factors
• The coupon rate depends on the risk characteristics of the bond when issued.

• Which bonds will have the higher coupon, all else equal?

– Secured debt versus a debenture (Secured is paid first)

– Subordinated debenture versus senior debt (Paid after senior debt)

– A bond with a sinking fund versus one without

(Company has to come up with substantial cash at maturity to retire debt, and this is riskier than systematic
retirement of debt through time)

– A callable bond versus a non-callable bond

( Bondholders bear the risk of the bond being called early, usually when rates are lower. They don’t receive all of the expected
coupons, and they have to reinvest at lower rates)
Types of Bonds: Based on Return
• Floating Rate Bonds
– Coupon rate floats depending on some index value.
– Examples – adjustable rate mortgages and inflation-linked Treasuries.
– There is less price risk with floating rate bonds.
– The coupon floats, so it is less likely to differ substantially from the yield to
maturity.
– Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or
below a specified “floor.”

• Fixed Rate Bonds

– Fixed Interest Rate.
– Significantly affected by fluctuations in interest rates, and therefore has a
significant amount of interest rate risk.
– Although a conservative investment, it is highly susceptible to a loss in value due
to inflation.
Types of Bonds: Others
• Income bonds
(Income bonds – coupon payments depend on level of corporate income)

• Convertible bonds
(Bonds can be converted into shares of common stock at the bondholder's discretion)

• Put bonds
( Bondholder can force the company to buy the bond back prior to maturity)

• There are many other types of provisions that can be added to a bond, and
many bonds have several provisions – it is important to recognize how these
provisions affect required returns.

REQUIRED RETURN in above cases??

Types of Bonds: Others
• Eurobonds: bonds denominated in a particular currency (e.g. USD)and issued
simultaneously in the bond markets of several countries.
– When European and American multinationals are forced to tap into international markets
for capital.
– Issued outside of the borders of the currency’s home country. It doesn’t mean that the bond
is issued in Europe

• Foreign bonds: bonds issued in another nation’s capital market by a foreign

borrower.
– A foreign bond is a bond issued in a domestic market by a foreign entity in the domestic
market's currency as a means of raising capital.

A dollar-denominated Eurobond is free of exchange rate risk for a U.S. investor,

regardless of where it is issued. A foreign bond would be subject to this risk if it is not issued
in the U.S. The reason is that the Eurobond pays interest in U.S. dollars, but the foreign bond
pays interest in the currency of the country in which it was issued.
Types: Innovation in Bond Design
 Patterns of Financing
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)

Capital Internal cash

spending flow (retained
80% earnings plus Internal
depreciation) cash flow
80%
Financial
deficit
Net
working
capital plus Long-term External
other uses debt and cash flow
20% equity 20%

Internally generated cash flow dominates as a source of financing: This preference has increased through time.
• Effect of Debt on firm Valuation:
– Not a straightforward answer
– Depend upon “debt/equity” mix which is determined by firms’ life cycle stage
and type of industry it belongs to.

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Includes
Bankruptcy
Risk

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Next Class: Financial Leverage
and Capital Structure