CORPORATE FINANCE

Session 11

Main textbook for the course : Brealey and Myers, Principles of corporate finance, McGraw-Hill

A. An overview of corporate financing (cont'd) : two exercises

1. Corrections to exercise 1 of chapter 14 :

The authorized capital of the Caker Co. is 100 000 shares. This means the management can arrange to sell up to 100 000 shares to old or new shareholders without calling for a new shareholder's meeting to get the permission.

The current equity data are :

The first line means that 80 000 shares were issued (i.e. sold). In the first line, they are recorded at their par value ; any premium value gotten while selling some of them is recorded in the second line.

Retained earnings are cumulated past profits that were not distributed as dividends.

The common equity is the sum of these three figures.

80 000 shares were issued, but the company bought back 2000 shares, at the market prices prevailing. Here all costed $5 000.

So it is said that 80 000 shares were issued but only 78 000 are still outstanding. The difference is the shares bought back by the company (called here Treasury stock)

So the Net common equity is $80 000 - 5 000 = $75 000.

With no further permission, the company can still issue 20 000 shares, since its entire authorized capital is 100 000 shares.

It can, of course sell them at the best price possible (to raise money).

Suppose it sells 10 000 more shares at $2 per share.

As we saw this issue will be recorded into two parts : the par value will go increase the "Common stock" line (by $5 000), and the complement will go increase the "Additional paid-in capital" (by $15 000).

2. Corrections to exercise 3 of chapter 14 :

a) Debt maturing in more than 1 year is often called funded debt

b) An issue of bonds that is sold simultaneaously in several countries is called a Eurobond

c) If a lender ranks behind the firm's general creditors in the event of default, his or her loan is said to be subordinated

d) Unsecured bonds are usually called (in the US) debentures

e) In many cases, a firm is obliged to make regular contributions to a sinking fund which is then used to repurchase bonds

f) Most bonds give the firm the right to repurchase or call the bonds at specified prices

g) Interest on many bank loans is based on the prime rate of interest (the rate offered to large reliable clients)

h) The interest rate on floating-rate loans is tied to short-term interest rates

i) Where there is a private placement, securities are sold directly to a small group of institutional investors. These securities cannot be resold to individual investors. In the case of a public issue, debt can be freely bought and sold by individual investors.

j) A long-term, noncancelable rental agreement is called a lease

k) A convertible bond can be exchanged for shares of the issuing corporation

l) A warrant gives its owner the right to buy shares in the issuing company at a predetermined exercise price

B. How corporations issue securities (cont'd) :

Details on venture capital funding :

Venture capital developped in the US, mostly in the 80's and 90's.

It is a convenient way for energetic and imaginative entrepreneurs, who have no money and no access to standard financial markets, to find money to finance their project, in exchange for a big chunk of their shares.

In the 90's in the US, only 3 out of ten VC projects were successful, and less than one in ten turned into a star.

A full fledged example :

Three individuals, usually friends (or at least acquaintances), named George and Mildred Marvin, and Chip Norton, have a great idea for a new product P. Their project is to launch a firm to first of all develop prototypes and later go into large scale manufacture and sale.

They can gather altogether $100 000 of their own savings plus some personal bank loans. But they need 10 times that much to start their project.

If they are convincing, they get a Venture Capitalist (say Meriam Venture Partners) to complete the $1 000 000 needed.

And Meriam Venture will accept to value the idea of our entrepreneurs at $ 900 000 !

So before Meriam Venture, the balance sheet of the new firm (let's call it Marvin Enterprises) will be

Assets :

Cash : $100 000

Liabilities :

Funders original equity : $100 000

After Meriam Venture entered into Marvin, the balance sheet of the new firm will be

Assets :

Intangibles (the value of the idea) : $900 000

Some other stuff : $ 100 000 (we suppose in the mean time the $100 000 initial cash has been transformed into some other assets)

Cash : $1 000 000 (the new cash injection by Meriam)

Liabilities :

Funders original equity : $1 000 000 (i.e. Meriam accepted to value the original investment + the idea at $ 1 000 000)

Meriam equity : $ 1 000 000

At this point, Marvin Entreprises has, say, 2 000 000 ordinary shares issued and outstanding. This is the completion of the first round of VC money raising.

Now Marvin team works hard for 18 to 24 months, to develop and prove the viability of the first prototypes.

Suppose it is successful. Before going into full scale manufacturing and sale, let's suppose it now needs to build a pilot plant.

This requires a second round of money raising. A larger one.

Usually it is still undertaken by Venture Capitalists, because the company's project is not ripe enough to turn the standard stock market.

After having found this second round of money (some of it from Meriam, perhaps, and some of it from other VC's) the Balance sheet of Marvin will now look like this :

In other words, the second round VC accept to value the $ 2 000 000 first equity at $ 10 000 000, and therefore to give a value of $ 8 000 000 to the project on top of the $ 2 000 000 already spend. And since they bring $ 4 000 000 new cash, the total value of Marvin becomes (on paper)

$ 14 000 000.

They value the shares at $5 apiece. And the 2nd round of VC buy 800 000 new shares.

Now the shares are :

- founding partners : 1 000 000 shares

- first stage VC : 1 000 000 shares

- second stage VC : 800 000 shares

The founders only control 35,7% of their company.

But in exchange, they have the possibility to finance and develop their project. (They may also get fired by the VC's)

Initial public offering (IPO) : primary and secondary (example cont'd)

Let's keep on with Marvin Entreprises.

The pilot plant turned out to be promissing.

It is now 2 or 3 years after the second round of VC money, and it is time to go full scale.

Here is how an Initial public offering on the stock market is arranged :

Marvin (and its VC partners) have to find an underwriter : a specialized financial firm that will help them prepare a public offering and indeed sell their securities.

A registration statement has to be prepared for the Security and Exchange Commission (SEC), and has to be accepted.

A prospectus for future investors must be prepared.

An introductory price must be determined.

Looking at PER of competitors in the field, a price of $90 per share (way above the par value of $1) may seem fair. Then usually the underwriters suggest a little less : a price of $80 per share is chosen.

The IPO will have a primary part and a secondary part :

• primary part : new shares that will bring money into the firm's till (say here 500 000 shares at $80/share)

• secondary part : shares from the actual owners that will bring money into their pocket, not in the company's till (say here 200 000 for the founders, and 200 000 for the VC's, all at $80/shares)

(see Marvin prospectus pp 406-410 of the text book)

If the sale goes well, and it is to a large extend the role of the underwriter to ensure that, after it the founders will have received

200 000 x $80 = $16 000 000 into their pocket, and their remaining shares into the company will have a market value of

market price of the share x 800 000.

It is common that the share price goes up some, within a few days, right after the IPO. Suppose it goes to $95.

Then the market value of the shares still held by the founders is $95 x 800 000 = $ 76 000 000.

The cost of the underwriters :

Usually underwriters buy all the shares to be sold, at a discount price compared to the issuing price.

Typically, here they will have bought the 900 000 shares at a discount of say $5.

So the public invests : $80 x 900 000 = $72 000 000

of which

• the underwriters gets $5 x 900 000 = $ 4 500 000

• the firm receives in new cash injection $75 x 500 000 = $37.5 mio

• the current stockholders (founders and VC) $75 x 400 000 = $30 mio

From now on Marvin Entreprises is a (small and hopefully promissing) company listed on the stock exchange.

Miscellaneaous :

The private placement

The "tombstone"

C. The dividend controversy, and the structure of capital :

In the last session, we saw that US firms have financed between 2/3 and 3/4 of their new financial needs via internally generated cash. The rest coming from new external sources of financing (equity, debt, and accounts payable).

In theory, it should always be up to the shareholders to choose whether to reinvest into the firm. So the firm should distribute as dividends all its profit, and then issue new securities for its development needs.

They don't do it this way, first of all because retaining earnings is simple and costless, whereas issuing new securities is intricate, costly, and appears to send wrong signals to the markets about the health of the firm.

Secondly we saw that at certain periods firms repurchased a part of their stocks and issued more debts, and at other periods they were more balanced.

Finally we saw that dividends (as well as retained earnings) are taxable, whereas interests on debts are not taxable.

With all these facts in hand, what is the best level of dividends ?

In a fundamental paper of 1961, H. Miller and F. Modigliani showed that in perfect capital markets with no taxes, no cost of issuing securities, and no other imperfections, the capital structure of a firm (i.e. the structure of its long-term liabilities : equity and debts) and the dividends it pays do not matter.

It is called the MM model.

We shall not prove the MM dividend irrelevance (even though it is not all that complicated, see pp 424-425)

Similarly the financial leverage (i.e. the ratio of debt over total equity + debt) does not matter either.

Basically, in a perfect financial market, the value of a firm depends only upon its assets cash generation capabilities.

In a no tax world, let's compare the value of two firms with the same assets. One is entirely equity financed : its asset value is Ve.

So Ve = Ee (the total equity)

The other one is leveraged. Its asset value is Vl.

So Vl = El + Dl (equity + debt)

Since the assets are the same, the profits before interest are the same.

In the first case the cash generation is Depreciation + Profit.

In the second case the cash generation (before interest) is = Depreciation + Interest + (Profit - Interest)

The two profit values are the same. So this confirms that Ve = Vl.

We could also demonstrate the equivalence of investing only in the equity of a leveraged firm, or the equity and the debt of the same firm.

These are various ways to express the MM idea.

We already met the formula : Return of total assets (= Ra) = (D/(D+E))Rdebt + (E/(D+E))Requity

This also stems from the MM theory. So what we stated, in session 7, "an increase in the leverage financing of a firm increases the expected rate of return of its common stock" is a part of MM.

D. How much a firm should borrow :

Miller-Modigliani study a financial market with no taxes, no security issue costs, and no other imperfections.

Things become a bit more complicated when enter the taxes.

We saw that the tax laws are favorable to debts. Here is an example with numbers :

So the tax laws provided a "tax shield" of $28 to the bondholders + stockholders of the firm in the second configuration.

How to treat this ?

In 1976, Merton Miller developped the following theory to take into account tax shield and other imperfections :

It says that a firm's value has 3 additive parts :

1. its value if it is all equity financed

2. plus, the Present Value of the tax shields

3. minus, the Present Value of the cost of bankrupcy or other financial distresses

Miller states : the firm should increase its debt ratio until the marginal tax shield present value increase is offset by the marginal cost of financial distress present value increase.

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Next (and final) session, we shall cover what Corporate Finance knows, and what Corporate Finance doesn't know.