Chapter 20 - NEW

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Issuing Securities to the

Public
Chapter 20
Executive Summary

• Issuing securities involves the corporation in a number of

decisions.

• This chapter looks at how corporations issue securities to the

investing public.

• The basic procedure for selling debt and equity securities are

essentially the same. This chapter focuses on equity.


The Public Issue
• Regulation of the securities market in the U.S., regulation is
handled by a federal body (SEC).
• The regulators’ goal is to promote the efficient flow of
information about securities and the smooth functioning of
securities’ markets.

• All companies listed in Dhaka, Bangladesh come under the


jurisdiction of the Dhaka Stock Exchange (DSE).
• Listing done under two regulations:
– The Listing Regulations of the Dhaka Stock Exchange Limited
– The Dhaka Stock Exchange (Direct Listing) Regulations 2006
Issuing Methods
• Company can issue securities to primary market as follows:
– Public Issue
– Private Issue (sold to fewer than 35 investors)
– Preferential issue: A private placement of securities by a listed company.
Securities are issued to an identified set of investors which may include
promoters, strategic investors, employees and such groups.
– Right or Bonus issues: Securities are issued to existing shareholders at a
pre-determined price (is called rights)
or
Get an allotment of additional free shares (bonus). Employee get the
bonus share as a incentives and existing shareholder also can get bonus
share.

Read more at:


http://www.fingyan.com/understand-shares-issue-and-its-types/
– There are two kinds of public issues:
General cash offer and rights offer

Cash offers are sold to all interested investors and


Rights offers are sold to existing shareholders.

*Equity is sold by both the cash offer and the rights


offer, though almost all debt is sold by cash offer.
• Public Equity Issue can be in two forms:

– Initial Public Offering (IPO) / Unseasoned offering

– Seasoned Equity offering * (SEO)


* SEO refers to a new issue where the company’s securities have been
previously issued. A seasoned equity offering of common stock may be made
by either a cash offer or a rights offer.
The Basic Procedure for a New Issue
Steps involved in issuing securities to the public:

1. Management obtains approval from the board of directors.


2. The firm prepares a preliminary prospectus to the DSE.
3. The DSE studies the preliminary prospectus and notifies the
company of any changes required.
4. Once the revised, final prospectus meets with the DSE’s
approval, a price is determined and a full-fledged selling
effort gets under way.
The Cash Offer
• Underwriters are usually involved in a cash offer.

• Underwriters perform the following services:

– Formulating the method used to issue the securities.

– Pricing and selling the new securities.

• Investment Banks are financial intermediaries typically working as


Underwriters.
• The difference between underwriter’s buying price and the offering
price is called the spread.
• Because underwriting involves risk, underwriters combine to form
an underwriting group called a syndicate
The Cash Offer: Different methods (cont.)

1. Firm commitment underwriting


– Underwriter buys all the securities for less than
the offering price and bears risk of being unable
to sell them all.
– Earns compensation through spreads
2. Best efforts underwriting
– Acts as agent, receiving commission for each
securities sold
3. Dutch auction (uniform pricing) underwriting
– The underwriter does not set a fixed price, but rather
conducts an auction in which investors bid for the shares.
– It is an attempt to determine a fair market price.
The Cash Offer (cont.)

The offering price:


• Determining the correct offering price is an underwriter’s
hardest task.
• The issuing firm faces a potential cost if the offering price is
set too high or too low.
Underpricing:
• Underpricing is a common occurrence and it clearly helps
new shareholders earn a higher return on the shares they
buy.
• In the case of an IPO, underpricing reduces the proceeds
received by the original owners.
The Announcement of New Equity and the Value of the Firm

• The market value of existing equity drops on the


announcement of a new issue of common stock.
• Reasons include
– Managerial Information
Since the managers are the insiders, perhaps they are selling
new stock because they think it is overpriced.
– Debt Capacity
If the market infers that the managers are issuing new equity to
reduce their debt-to-equity ratio due to the threat of financial
distress the stock price will fall.
– Falling Earnings
due to substantial costs related with issuing new securities.
19-12 Explaining -
Issuing new equity to reduce their debt-to-equity ratio

5
D
%
D $1
0
$10
E
$90+
E new100
$90 95
%

Total
100
Total =
200

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited


Rights
• An issue of common stock offered to existing shareholders is
called a rights offering.
• If a tactical 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.
• Each shareholder is issued an option to buy specified number
of shares at fixed price within a bracket of time.
Mechanics of Rights Offerings
• The management of the firm must decide:
– The process of issuing rights differs from the process of issuing shares

of stock for cash. Existing stockholders are notified that they have been

given one right for each share of stock they own.

* Key terms of right offerings

– The subscription price (the price existing shareholders must pay for

new shares).

– How many rights will be required to purchase one new share of stock?
• A rational shareholder will subscribe to the rights offering only
if the subscription price is below the market price.

• For example, if the stock price at expiration is $13 and the subscription
price is $15, no rational shareholder will subscribe. Why pay $15 for
something worth $13?

• These rights have value:


– Shareholders can either exercise their rights or sell their rights or can
do nothing.
Rights Offering Example

🞂 Popular Delusions, Inc. is proposing a rights offering. There are


200,000 shares outstanding trading at $25 each. There will be
10,000 new shares issued at a $20 subscription price.

1. What is the new market value of the firm?

2. How many “Rights needed” to purchase one new share

3. What is the ex-rights price *?

4. What is the value of a right?

* Ex-rights price is a calculated price for a company's stock shares after


issuing new rights-shares with the assumption that all these newly
issued shares are taken up by the existing shareholders.
Rights Offering Example

1. What is the new market value of the firm?


🞂 There are 200,000 outstanding shares at $25 each. There will be
10,000 new shares issued at a $20 subscription price.

( Old Value + new value)


= 52,00,000 Ans.

2. How many “Rights needed” to purchase one new share

20
SHARE
Ans.
Right offering example
🞂

=52,00,000 / 2,10,000 = $24.76

4. Value of a right is (25 – 24.76) = 0.2381


Rights vs Underwriting

🞂 Rights
Advantages:
🞂 Lowest cost method
🞂 Maintains ownership percentage
🞂 Protects against underpricing.

Disadvantages:
Shareholders may not have capital,
May not be fully subscribed,
Rights vs Underwriting
🞂 Underwriting
Advantages:
🞂 Advice on issue characteristics and pricing from
investment bankers,
🞂 Access to broader market,
🞂 Acts to guarantee price in firm commitment.

Disadvantages:
- Most costly--both direct and other expenses
- Current shareholders may not be able to maintain
ownership percentage
The Private Equity Market

🞂 The previous sections of this chapter assumed that a company is big enough,
successful enough, and old enough to raise capital in the public equity market.

🞂 Private equity is capital that is not listed on a public exchange. Private equity is
composed of funds and investors that directly invest in private companies. Private-
equity firms are formed by investors who want to directly invest in other
companies, rather than buying stock.

🞂 There are many firms that have not reached this stage and cannot use the public
equity market.

🞂 For start-up firms and firms in financial trouble, the public equity market is often
not available.

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