Corporate Finance

Term III, Sections E & F

Class Notes 6

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2017-March 2018
 Capital Market Instruments

 Equity Shares
 Preference Shares
 Debentures or Bonds
 Convertible and non-convertible debentures may be issued along
with a detachable warrant.
 The warrant gives a right to the debenture holder to obtain
equity shares of the company at a specified period at a price not
exceeding the cap price specified in the warrant.
 Capital Market Instruments

 Convertible Bonds : This method of “delayed” equity

financing gives several advantages to the corporation.

 delayed dilution of common stock and earnings per share (EPS).

 able to offer the bond at a lower coupon rate - less than it would
have to pay on a straight bond as, the more valuable the conversion
feature, the lower the yield that must be offered to sell the issue.
 Corporations with weak credit ratings that also have great
potential for growth. Such companies will be able to sell convertible
debt issues at a near-normal cost, not because of the quality of the
bond but because of the attractiveness of the conversion feature.
 If a large part of the issue is purchased by one buyer, conversion
may shift the voting control of the company away from its original
owners and toward the converters. This could be very real
consideration for the small company, or one just going public.
 Issue of Equity

 Rights Issue : offer new shares to existing shareholders on a

pro rata basis

 Public Issue : offer new shares to the general public

 Private Placement : Offer to a single or a very small number

of investors

 Employee Stock Option Schemes and Sweat Equity shares :

offer new shares to employees/directors
 Issue of Long-term Securities to the Public

• The guidelines for issuing securities in India have been issued by

Securities and Exchange Board of India (SEBI) and are called
the Securities and Exchange Board of India (Disclosure and
Investor Protection) Guidelines, 2000.
 Issue of Long-term Securities to the Public
The major steps involved in issuing securities are as follows:
1. Approval of the board of directors + shareholders' approval +
appraisal of project

2. Appointment of lead merchant banker. (Bank or part thereof

that specializes in providing various financial services such as
accepting bills arising out of trade, underwriting new issues,
and providing advice on acquisitions, mergers, foreign
exchange, portfolio management, etc)

3. Lead merchant banker submits draft offer document and

other documents to SEBI for seeking permission to issue
securities. The offer document or Prospectus should contain all
material information, which shall be true and adequate so as to
enable the investors to make informed decision on the
investments in the issue.
 Issue of Long-term Securities to the Public

4. After SEBI approval of prospectus and permission from ROC

and Stock exchanges obtained, the issue can be opened for
subscription by public by announcing in newspapers, directing
them to deposit money in the specified branches of selected
banks.

5. Later, an allotment of securities has to be made to the

subscribers to the issue. If excess money has been received,
the same has to be refunded to the subscribers
Issue of Long-term Securities to the Public (Other Issues – contd.)

 The issue of securities should be in dematerialized form.

 Dematerialisation or Demat in short is the process through which an investor’s
physical share certificate gets converted to electronic format which is
maintained in an account with the Depository Participant - National Securities
Depository Limited (NSDL) and Central Depository Services (CDSL)

 Differential pricing : public issue of securities convertible at a later date

into equity shares can be made to applicants in the firm allotment category
at a price higher than the price at which securities are offered to the public

 Price Band: Issuer company can mention a price band of 20% (cap in the
price band should not be more than 20% of the floor price) in the offer
document filed with SEBI and actual price can be determined at a later date
before filing the offer document with the Registrar of Companies (ROC).

 The issuer company has the freedom to determine the denomination of

shares for public/rights issues and to change the denomination of existing
shares, but at any given time, there shall be only one denomination for the
shares of a company.
 Issue of Long-term Securities to the Public (Other Issues – contd.)

 A composite issue means an issue of securities by a listed company on a

public cum rights basis through a single offer document wherein the
allotment for both public and rights components are proposed to be made
simultaneously.

 Promoters’ Contribution: shall contribute not be less than 20% of the post
issue capital. Promoters shall bring in the full amount of the promoters’
contribution including premium at least one day prior to the issue opening
date.

 Lock-in Requirements : promoters’ contribution shall be locked in for a

period of 3 years.

 Due Diligence : The lead merchant banker shall exercise due diligence to
satisfy himself about all the aspects of offering, veracity and adequacy of
disclosure in the offer documents. The lead merchant banker will have to
furnish a Due Diligence Certificate.
Issue of Long-term Securities to the Public (Other Issues – contd.)

 Firm Allotment : issuer company can make allotment on a firm

basis in public issues to Indian and Multilateral Development
Financial Institutions, Indian Mutual Funds, Foreign
Institutional Investors including NRIs, Overseas Corporate
Bodies, Employees of the issuer company and Scheduled
banks.

 Green-shoe Option: Option to allot excess subscribed shares to

the extent of 15% to stabilize post-listing price.

 Red Herring Prospectus : It is a prospectus which does not

have details of either price or number of shares being offered
or the amount of issue.
 Issue of Long-term Securities to the Public

Intermediaries in the issue of securities to the public :

 Merchant Banker

 Co-Managers of the issue

 Underwriters

 Brokers

 Bankers to the issue

 Major Contents of the Prospectus

 Capital structure of the company

 Particulars of the proposed issue
 Objects
 Project cost
 Means of financing
 Deployment of funds in the project
 Terms of the present issue
 Terms of payments
 Arrangement and disposal of odd lots1
 Company management and project
1 The scrips of companies which are in demat can be traded in market lot of 1. However, the
securities of companies which are still in the physical form are traded in the market lot of
generally either 50 or 100. Investors having quantities of securities less than the market lot
are required to sell them as "Odd Lots".
 Major Contents of the Prospectus (contd)

 Management discussion and analysis of the financial

condition and results of operations.
 Financials of group companies
 Promise vis-à-vis performance Projections
 Basis for issue price
 Outstanding litigations or defaults
 Disclosure on investor grievances and redressal system
 Types of Public Issues
Issue Type Offer Price Demand Payment Reservations

Price at which the 50 % of the shares

100 % advance
securities are offered Demand for the offered are reserved
payment is required
and would be allotted securities offered is for applications below
Fixed Price Issues to be made by the
is made known in known only after the Rs. 1 lakh and the
investors at the time
advance to the closure of the issue balance for higher
of application.
investors amount applications.

A 20 % price band is 10 % advance

offered by the issuer Demand for the payment is required
50 % of shares
within which securities offered , to be made by the
offered are reserved
investors are allowed and at various prices, QIBs along with the
Book Building for QIBS, 35 % for
to bid and the final is available on a real application, while
Issues small investors and
price is determined by time basis on the BSE other categories of
the balance for all
the issuer only after website during the investors have to pay
other investors.
closure of the bidding period.. 100 % advance along
bidding. with the application.
 Book Building of Securities

• Book building is a systematic process of generating, capturing,

and recording investor demand for shares during an initial
public offering (IPO), or other securities during their issuance
process, in order to support efficient price discovery.

• The price for such securities is assessed for the determination

of the quantum of such securities to be issued.

• A company can undertake book building of 75% or 100% of

the proposed capital issue.
 Book Building of Securities (contd.)
• The "book" is the off-market collation of investor demand by the bookrunner and is
confidential to the bookrunner, issuer, and underwriter. Where shares are acquired, or
transferred via a bookbuild, the transfer occurs off-market, and the transfer is not
guaranteed by an exchange's clearing house. Where an underwriter has been
appointed, the underwriter bears the risk of non-payment by an acquirer or non-
delivery by the seller.
• The key differences between acquiring shares via a bookbuild (conducted off-market)
and trading (conducted on-market) are:
– bids into the book are confidential vs. transparent bid and ask prices on a stock
exchange;
– bidding is by invitation only (only high-net-worth clients of the bookrunner and any
co-managers may bid);
– the bookrunner and the issuer determine the price of the shares to be issued and
the allocations of shares between bidders in their absolute discretion;
– all shares are issued or transferred at the same price whereas on-market
acquisitions provide for multiple trading prices.
• The final issue price is not determined until the end of the process when the book has
closed. After the close of the book building period, the bookrunner evaluates the
collected bids on the basis of certain evaluation criteria and sets the final issue price.
 Qualified Institutional Buyer

In terms of clause 2.2.2B (v) of DIP Guidelines, a 'Qualified Institutional Buyer' shall mean:

a. Public financial institution as defined in section 4A of the Companies Act, 1956;

b. Scheduled commercial banks;
c. Mutual funds;
d. Foreign institutional investor registered with SEBI;
e. Multilateral and bilateral development financial institutions;
f. Venture capital funds registered with SEBI.
g. Foreign Venture capital investors registered with SEBI.
h. State Industrial Development Corporations.
i. Insurance Companies registered with the Insurance Regulatory and Development
Authority (IRDA).
j. Provident Funds with minimum corpus of Rs.25 crores
k. Pension Funds with minimum corpus of Rs. 25 crores)

These entities are not required to be registered with SEBI as QIBs. Any entities falling
under the categories specified above are considered as QIBs for the purpose of
participating in primary issuance process.
 Issue of Debt Instruments
Additional guidelines for offering convertible/non-convertible
debt instruments through an offer document are:

• Credit Rating of Debt Instruments

• Debenture Trustee

• Debenture Redemption Reserve (DRR)

• Creation of Charge
 Euro - Issues

 Since 1992, Indian companies are permitted to issue Global

Depository Receipts (GDR) or American Depository Receipts
(ADR) abroad to raise equity share capital.
 They can also raise debt capital abroad by issuing Foreign
Currency Convertible Bonds (FCCB).

Global Depository Receipt (GDR)

A GDR is a dollar denominated instrument in the form of a
Depository receipt or certificate created by the Overseas
Depository Bank outside India and issued to non-resident investors
against the issue of ordinary shares or Foreign Currency Convertible
Bonds of issuing company in India.
 Features of GDR

 denominated in a foreign currency (say dollar).

 holders have rights to dividend, rights issues and

bonus issues pertaining to the underlying equity
shares of the issuer company.

 holders have no voting rights in the meetings of the

issuer company’s shareholders.

 issuer company does not bear any foreign currency

exchange risk. The same is borne by the holders.
 Creation of GDR

Ind. Co.
INR
Equity
Shares
USD

Domestic Overseas GDR

Depository Body Investor
Custodian

Stock
Exchange
 American Depository Receipt

• American Depository Receipts (ADR) is listed in an American

stock exchange and primarily aims at investors in America.
ADRs and corresponding dividends are denominated in
dollars.

• The accounting statements of the issuer company have to

comply with the stringent requirements of Securities and
Exchange Commission of USA, US GAAP (Generally Accepted
Accounting Principles) and Sarbanes-Oxley Act (SOX)
 External Commercial Borrowings (ECB)

• External commercial borrowing (ECBs) are loans made in foreign

currency to Indian borrowers. They are used widely in India to
facilitate access to foreign money by Indian corporations and PSUs
(public sector undertakings).
• ECBs include commercial bank loans, buyers' credit, suppliers'
credit, securitised instruments such as floating rate notes and
fixed rate bonds etc., credit from official export credit agencies
and commercial borrowings from the private sector window of
multilateral financial Institutions such as International Finance
Corporation (Washington), ADB, AFIC, CDC, etc.
• ECBs cannot be used for investment in stock market or speculation
in real estate.
• The DEA (Department of Economic Affairs), Ministry of Finance,
Government of India along with Reserve Bank of India, monitors
and regulates ECB guidelines and policies.
 External Commercial Borrowings (ECB)

• Most of these loans are provided by foreign commercial banks and other
institutions. During the 2012, contribution of ECBs was between 20 to 35
percent of the total capital flows into India. Large number of Indian corporate
and PSUs have used the ECBs as sources of investment.
• For infrastructure and greenfield projects, funding up to 50% (through ECB) is
allowed. The Reserve Bank of India raised the ECB limit "for non-banking
finance companies (NBFCs) classified as infrastructure finance companies (IFCs)
... from 50 per cent to 75 per cent of owned funds, including outstanding
ECBs". In telecom sector too, up to 50% funding through ECBs is allowed.
• Corporate sectors can mobilize USD 750 million via automatic route, whereas
service sectors and NGO's for microfinance can mobilize USD 200 million and
10 million respectively.[4]
• Borrowers can use 25 per cent of the ECB to repay rupee debt and the
remaining 75 per cent should be used for new projects. A borrower can not
refinance its entire existing rupee loan through ECB. The money raised through
ECB is cheaper given near-zero interest rates in the US and Europe, Indian
companies can repay part of their existing expensive loans from that.
 Foreign Currency Convertible Bonds (FCCB)

 Quasi-debt securities denominated in a foreign currency

 Convertible into equity shares of the issuer company or into

depository receipts on the expiry of a minimum lock-in period. The
exchange rate for the conversion and the conversion price are fixed.

 With put and call options. Investors can exercise the put option after
the expiry of a certain period whereby the investors can receive the
principal and the due interest amounts. The issuer can exercise the
call option and can redeem the bonds by payment of the principal and
the accrued interest.
 Term Loan

• Companies can raise Term loans from financial institutions and banks.

• Term loans are direct business loans.

• Maturity period of loan is usually long term (more than one to around
ten years).

• Loans carry market interest rate and the principal is repaid in

installments after a period of moratorium.
 Venture Capital

 Promoters without any track record of performance but with good project
ideas can approach venture capital funds to raise capital for launching and
developing a business.

 Venture capital (VC) funds invest in long-term equity and debt capital in
risky projects with expectation of high return. The underlying sources of
funds for them are from high net worth individuals, pension funds,
insurance companies, banks, large corporations and others.

 VC funds usually provide financing in stages. At each stage, they invest

enough money to reach the next stage.
 Venture Capital

 For example, they may provide seed capital or first stage financing to build
a prototype. If that is successful, then they may provide second stage
financing to buy plant and machinery for commercial manufacturing and
marketing.

 Some VC funds specialize in certain stages of funding. Some even actively

participate in running the business.

 At present, many VC funds operate in India.

 Initial Offering

Spread - Difference between public offer price and price paid by

underwriter. (applicable to the US)

Underpricing - Issuing securities at an offering price set below the

true value of the security.
 Underwriting Spreads (2001)
Gross underwriter spreads of selected issues, 2001
Issue amount, Underwriter's
Type Company millions of dollars spread, percent

IPO Torch Offshore 80.0 7.000

IPO Alliance Imaging 122.0 7.000
IPO United Surgical Partners 126.0 7.000
IPO Tellium, Inc. 135.0 7.000
IPO Agere Systems 3,600.0 3.900

Seasoned National Golf Propertie, Inc. 29.6 5.126

Seasoned Lifepoint Hospitals 92.8 5.000
Seasoned Valspar Corp. 168.0 4.250
Seasoned Raytheon Co. 343.8 3.745
Seasoned Pepsico, Inc. 534.6 2.000
Seasoned Allegheny Energy, Inc. 598.3 3.005

Debt:
8.3% Subordinated notes,2011 Bank of the West 50.0 0.650
6.875% Medium Term notes, 2006 Maytag Corp. 185.0 0.500
7.75% Notes,2011 Shurgard Storage Centers 250.0 0.650
8.5% Senior notes, 2011 Hilton Hotels 300.0 0.875
5.875% Global bonds, 2021 American Home Products 500.0 0.350
3.5% Convertible Bonds,2031 Cox Communications 685.0 2.250
7.45% Global Bonds,2031 Kellogg 1,100.0 0.875
8.5% Senior notes, 2008 Calpine 1,500.0 1.000
 Rights Issues –1
Rights Issue – Sale of securities on a privileged basis – ie., to existing
owners of securities of the company. The subscription price is usually
lower than the market price

Choices for the investor :

• Exercise the “right”

• Sell the “right”
• Allow the “right” to lapse or expire

Key concepts :
• Record Date
• Rights on
• Ex-rights
 Rights Issues – 2

Ex-Rights Value of share :

Px = ((P0 * N) + S) / (N + 1)
R0 – value of right
Px –ex rights value of share
P0 – market value of share
S – Subscription price
N – number of rights needed to purchase 1 share

Assume :
Px –ex rights value of share
P0 = 100
S = 90
N=4

Px =((100 * 4) + 90)/ (4+1) = 98

 Rights Issues – 3

Value of Rights (pre exercise) :

R0 = P0-Px= P0-((P0 * N) + S) / (N + 1)
= (P0 – S)/(N+1)
Where :
R0 – value of right
P0 – market value of share
S – Subscription price
N – number of rights needed to purchase 1 share

R0 =(100-90)/(4+1) = 2
 Rights Issues – Some Considerations

• There will be differences between the theoretical and market value of

rights due to :
• Transaction costs
• Speculation
• Irregular exercise and sale of rights
• Success of Rights Issues depends on how different the Subscription price is
from the market price
• Too little spread may mean a failure of the issue
• Too few rights needed per new share may mean less funds raised
 Rights Issue Versus Offering

Rights Issue Public Offering

• Principal sales tool is the discount • Major selling tool is the investment
from the current market price banking organization
• Lower flotation cost • Higher flotation cost
• Stock sold at lower price • Stock sold at higher price
• Less dilution • More dilution
• Less distribution • Wider distribution