Chapter: 20

Raising Finance

www.bradford.ac.uk/management
 Long Term Financing
• Long-term equity
– Ordinary shares
– Retained profit
– Preference shares

• Long-term debt
– Bank loans
– Bonds or Debentures
– Convertible Bonds
– Leases

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Securities and the Stock Market
• New securities can be sold either by public or
private placements.
There are 2 types of public issue:
• Rights issues
• General cash offer
• Primary Market is the market for the sale of new
securities by corporations. (Initial Public
Offering (IPO) and Seasoned offerings)
• Secondary Markets the markets where previously
issued securities are traded among investors.
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 Underwriting
• Most security issues are underwritten:
• Formulate the method used to issue the shares;
• price the shares;
• sell them.

• Firm commitment Buy the security below its offering

taking
price the risk of not being able to sell It provides
them. a
guarantee that the company receives the funds required.
• Dutch auction
• Best effort
• As the underwriter has access to non-public information relating
to the company the involvement provides some re-assurance
to investors that the company has no major problems yet to be
revealed to investors.
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 Rights Issues
• In the UK firms are required by company law to
offer new issues of shares to existing
shareholders
• Existing shareholders may authorise in general
assembly other types of issues
• Existing shareholders are offered the opportunity
to buy shares in a new issue in proportion to their
existing ownership
• Rights issues imply that managers cannot
arrange to sell shares to outsiders at a discount,
and dilute the interests of existing shareholders.
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 Mechanics of Rights Issues
•The management of the firm must decide:
– How much capital to raise (F).
– The subscription price (the price existing shareholders
must pay for new shares) (Ps), specified as the
prevailing market price less the discount

Subscription price  Ps P0(1 d)

F
Number of shares to be issued  ΔN  Ps
Terms are exp ressed as N/N- the ratio of new
shares to the number of pre-issue shares

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 Fall in Share Price in Rights
• Issue
As rights issues are made at a discount the proportionate
increase in the number of shares is greater than the
proportionate increase in the value of the company.

• This implies that the share price can be expected to fall – the
expected price following this price adjustment is known as the
theoretical ex-rights price (Px)

• Assuming that the announcement of rights issue adds no new

information

• This anticipated fall in share price is a mechanical adjustment,

does not imply a real fall in value.

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 Calculating the Theoretical Ex-Rights Price
and the Value of a Right

V F
0 N 
Px  P0 Ps
N N  NN
 
N N N

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 Rights
• Shareholders can exercise their
rights or sell them to other
investors.
V (R)  Px  Ps  Expected Capital Gain

• A right is a call option

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 Example

XYZ has decided it will need to raise £160m through a

rights issue. After consulting its investment bankers the
company is planning to make the rights issue at a
discount of 20 per cent to the current market price of
£5.00.The company has 100m shares outstanding.

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 Terms of the Rights Issue
Initial Value of Equity (V0) = 100 m x £5.00 = £500m
Funds required = F = £ 160m
Subscription price = PS =£5.00 (1- 0.2) = £4.00
Number of new shares = F / PS =£160m / £4.00 = 40m
Terms = New shares / Old Shares = 40 / 100 = 2 for 5

Ex-rights Price
(Initial Value + New Funds) / (Old shares + New shares) =£4.714
= 3

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 Terms of the Rights Issue

Right  Px - PS
 £4.7143 - £4 
£0.7143

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Rights Issues and Shareholder Wealth
•The mechanical aspect of a rights issues should have a
neutral impact on a shareholder’s wealth
–A capital loss can be anticipated on the
original shares (P0 > Px)
–A capital gain can be anticipated on
the new shares purchased at a discount (Px > Ps)
– The impact of capital gains and
losses for shareholders will be offsetting

N (P0  Px )  N (Px  Ps )
Loss on initial holdings  Gain on new shares
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 Shareholder Exercises the
Rights
Assume shareholder owns 10 shares:
Exercise the right
Initial investment 10 x £ 5.00 =
£50.00
Purchase of four new shares =
£16.00
Overall Investment = £66.00
Value of 14 Shares (at Px = £4.7143) = £66.00
 Shareholder Sells the Rights:
Neutral Impact on Wealth

Initial investment 10 x £ 5.00 =

£50.00

Value of ten share at Px = £ 4.7143 x 10 = £47.143

Sells four rights@£0.7143 = £
2.8572
Overall value £50

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 Deep Discount Issues
• Deep discount issues may avoid the need to underwrite
the issue

• A deep discount issue implies setting a relatively

low subscription price

• This reduces the probability of the share price falling

below the subscription price.

• The larger the discount the greater the incentive for a

shareholder to subscribe to the issue or sell the rights –
this is necessary to avoid the capital loss on existing
holdings of shares

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Underwriting and Deep Discount Rights
Issues
• Disadvantages of not under-written deep
discount issues

– Deep discount issues imply more dilution (a greater

fall in the share price and in EPS) – but this involves
nominal rather than real changes.

– No certification by the under-writers

– Deep discount issues may be mis-interpreted as

indicating
• management’s fear that the share price will fall
• a failure to arrange underwriting
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 Market Reaction To Equity
Issues:
• Event have been used to evaluate the
market’s
studies reaction to the announcement of equity
issues.

• The studies have typically recorded a fall in

share price of about 3 per cent or so.

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 Explanation of Price Reaction: Information
Asymmetry & Adverse Selection

• Managers are better informed than investors.

• Managers will not issue equity if shares

are undervalued.

• Managers issue equity if shares are

will
overvalued
– signal are consequently assumed to
New over valuation
issues
– Market adjusts downwards on the
announcement of a new issue.
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 Explanation of Price Reaction:
Debt usage

• The cost of equity is larger than the cost of

debt.
• Firms issuing equity cannot issue debt.
• The firm has too much debt- Financial
distress
• Thus the market interprets the issuance of
equity as a signal of the BAD health of the
firm.
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 Explanation of Price Reaction:
Issuance Costs
• Flotation Costs:
• Gross spread- the direct fees paid to the underwriter (difference
between the price the issuer gets and the offer price)
• Other direct expenses- fees which are not part
of the compensation to the underwriter (legal fees, taxes)
• Indirect expenses- management time working on the issue.
• Abnormal returns- the price of the shares drop an average of
3% on the announcement of the issue.
• Underpricing- For IPOs losses arise from selling the
shares below its true value.
• Green option- underwriters have the right to
additional
shoe shares at the offer price (overallotment).
buy

Since the market is aware of these costs the share

price will go down
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 Another Explanation of Price Reaction: Price
Pressure Hypothesis
“If the supply of shares increases and demand is unchanged the
market price must fall”??

• In an efficient market assets are priced according to their fair

value, and as long as a new issue of shares is not
associated with a fall in the fair value, there is no reason for
the share price to fall.

• Demand is infinitely elastic at a price equal to fair value – the

number of shares on offer by a single company is relatively
small in relation to the market as a whole and any increase
can be easily absorbed.

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 Dilution
• There is a lot of misconception regarding dilution

• If a company issues shares then the old

shareholders will see their proportional ownership
decrease but this should not impact on the value
of the company

• As long as equity is issued to finance positive

NPV investments there is no reason for dilution to
affect price

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 Issuing Long Term Debt
• More than 50% of all debt is issued privately
– Term loans: direct business loans with maturities of 1-5
years
– Private placements: longer term loans provided directly
by a limited number of investors.
• Differences between private and public financing:
– Private loans avoid the cost of stock
exchange
registration
– Private loans are easier to renegotiate
– The costsof distributing a bond are smaller
in the private market.
– The interest rates are normally higher in private loans
– Private loans tend to have more restrictive covenants
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