Issuing Securities to the Public

Chapter 20
 The Public Issue
• Regulation of the securities market in the U.S., 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 an incentives and existing shareholder also can get
bonus share.

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 – 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.
19-11 Explaining -
Issuing new equity to reduce their debt-to-equity ratio

5% D $10

E
$90+ new100
95%

D $10
Total = 200
E
$90

Total 100

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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 + New (10,000 * 20)
( Old Value + new value)
= 52,00,000 Ans.

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

share 𝑂𝐿𝐷 𝑆𝐻𝐴𝑅𝐸 2 ,00,000
𝑅𝑖𝑔h𝑡 𝑛𝑒𝑒𝑑𝑒𝑑= 𝑅𝑖𝑔h𝑡 𝑛𝑒𝑒𝑑𝑒𝑑= =¿ 20
𝑁𝐸𝑊 𝑆𝐻𝐴𝑅𝐸 10,000 SHARE
Ans.
 Right offering example
3. What is the ex-right price value?
 There are 2,10,000 (2,00,000+10,000) outstanding
shares of a firm with a market values of 5200,000
(50,00,000+2,00,000)
 The value of ex-right share is-
=52,00,000 / 2,10,000 =
Ex right share $24.76

*Alternative:

𝑃𝑥 (𝐸𝑥 − 𝑟𝑖𝑔h𝑡 𝑝𝑟𝑖𝑐𝑒)=

(20 ∗ 25)+20
(20+1) Px ¿¿ ¿=$ 24.76
4. Value of a right is (25 – 24.76) =
0.2381
 Rights vs Underwriting

Rights Underwriting

Advantages: Advantages:
 Lowest cost method
 Advice on issue characteristics
and pricing from investment
 Maintains ownership bankers,
percentage  Access to broader market,
 Protects against  Acts to guarantee price in firm
underpricing. commitment.
Disadvantages: Disadvantages:
 Shareholders may not have - Most costly-both direct and
other expenses
capital,
- Current shareholders may not
 May not be fully be able to maintain ownership
subscribed, 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.