Fundamentals of corproate finance 3e chapter 17

Chapter Seventeen
Issuing Securities to the Public

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Chapter Organisation
17.1 The Public Issue
17.2 The Cash Offer
17.3 New Equity Sales and the Value of the Firm
17.4 The Costs of Issuing Securities
17.5 Rights
17.6 Dilution
17.7 Issuing Long-term Debt
17.8 Summary and Conclusions

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Chapter Objectives
•
•
•
•
•

•

Outline the advantages and disadvantages of public company
listing.
Discuss the process of underwriting and the associated costs.
Identify the costs associated with issuing securities.
Explain the process of a rights issue and calculate the value
of a right.
Discuss the dilution effect of new issues.
Understand the reasons for recent growth in the corporate
debt market.

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Issuing Securities to the Public
• Analyse funding needs and how they can be met.
• Approval from board of directors for a public issue.
• Outside expert opinions sought for support of

issue.
• Pricing, time-tabling, prospectus prepared,

marketing.
• Prospectus filed with ASIC and ASX.

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Issuing Securities to the Public
• Underwriting agreement executed.
• Prospectus registered.
• Public announcement of offering.
• Funds received.
• Shares allotted, holdings registered.
• Shares listed for trading on ASX.

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New Issues
• Flotation is the initial offering of securities to the

public.

• Primary issues used to:
–
–
–
–

convert from a private company to a public company
spin-off a portion of the business of a listed company
form a new public company
privatise a public organisation, or demutualise a mutual
society.

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Advantages of Public Company
Listing
•

Access to additional capital.

•

Increased negotiability of capital.

•

Growth not limited by cash resources.

•

Enhancement of corporate image.

•

Can attract and retain key personnel.

•

Gain independence from a spin-off.

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Disadvantages of Public Company
Listing
•

Dilution of control of existing owners.

•

Additional responsibilities of directors.

•

Greater disclosure of information.

•

Explicit costs.

•

Insider trading implications.

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Secondary Issues
•

Private placements—securities are offered and sold to a
limited number of investors who are often the current major
investors in the business.

•

Rights issues—issue of shares made to all existing
shareholders, who are entitled to take up the new shares in
proportion to their present holdings.

•

Terms are determined by:
– amount of funds required by the company
– the market price of the company’s securities

– general economic conditions
– desire to benefit shareholders
– nature of the company’s shareholders.

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Underwriting
• Firm underwriting
A guarantee that funds will be made available to a company
at a specific time on agreed terms and conditions.

• Standby underwriting
Where the bidding company has insufficient cash in a
successful bid or if cash is offered as an alternative to a
share bid.

• Best efforts underwriting
Underwriter must use ‘best efforts’ to sell the securities at the
agreed offering rate.

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Underwriting
• Role of underwriter
–
–
–
–

pricing the issue
marketing the issue
engaging sub-underwriters
placing the shortfall

• Sub-underwriter
–

A group of underwriters formed to reduce the risk and to
help to sell an issue.

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Underwriting Fees
•

The underwriter’s fee is a reflection of the:
– size of the issue
– issue price

– general market conditions
– market attitude towards shares
– time period required for underwriting.

•

Fees also include brokerage and management fees.

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Average Initial Returns

Source: Ibbotson, Sindelar and Ritter (1988)

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New Equity Sales—Research
Findings
•

Shares prices tend to decline after a new equity issue
announcement, but rise following a debt announcement.

•

Why?
– Management has superior information about firm value
and knows when the firm is overvalued → sell equity.
– Excessive debt usage.
– Substantial issue costs.
– Management needs to understand the signals that an
equity issue sends.

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The Cost of Issuing Securities

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Rights Offerings—Basic Concepts
•

Rights offering
Issue of ordinary shares to existing shareholders.

•

Allows current shareholders to avoid the dilution that can
occur with a new share issue.

•

‘Rights’ are given to the shareholders specifying:
– number of shares that can be purchased
– purchase price
– time frame.

•

Shareholders can either exercise their rights or sell them.
They neither win nor lose either way.

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Rights Offerings—Basic Concepts
• Subscription price
The dollar cost of one of the shares to be issued, generally
less than the current market price.

• Ex-rights date

Beginning of the period when shares are sold without a
recently declared right, normally four trading days before the
holder-of-record date. The share price will drop by the value
of the right.

• Holder-of-record date
Date on which existing shareholders are designated as the
recipients of share rights.

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Ex-rights Share Prices
Rights-on

Announcement
date
30 September
Rights-on
price
$20.00
Ex-rights
price
$16.67

Ex rights

Ex-rights
date
13 October

Record
date
15 October

$3.33 =Value of a right

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Theoretical Rights Price
M −S
n

 n+r 
Where:

n = number of shares held to obtain a right
M = market price
S = subscription or issue price of the rights issue
r = number of additional shares offered
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Example—Rights Issue
Lemon Co. currently has 5 million shares on issue
with a market price of $8 each. To finance new
projects, the company needs to raise an additional
$6 million. To raise the finance, the company
makes a rights issue at a subscription price of $6
per share.

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Example—Rights Issue (continued)
•

The number of new shares to be sold:

funds to be raised
=
subscription price
$6 000 000
=
$6
= 1 000 000 shares
•

•
•

The holder of one right is entitled to subscribe to one new
share at $6 per share.
To issue 1 million shares, the company would have to issue
1 million rights.
The company has 5 million shares on issue, which means
that for every 5 shares held, a shareholder is entitled to
receive one right (1-for-5 rights issue).

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Example—Rights Issue (continued)
•

Calculate the theoretical rights price:

M −S 
=n 

 n +r 
$8 −$6 
=5 

 5 +1 

=$1.67
•
•
•

If an outsider buys a right, it will cost $1.67.
The right can be exercised at a subscription price of $6.
Total cost of a new share = $1.67 + $6 = $7.67.

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The Value of Rights

*$8.00 – 7.67 = 0.33
**$0.33 × 5 = $1.65
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New Issues and Dilution
• Dilution
–

Loss in existing shareholders’ value in terms of either

ownership, market value, book value or EPS.

• Types of dilution
–

–
–

Dilution of proportionate ownership—a shareholder’s
reduction in proportionate ownership due to less-thanproportionate purchase of new shares.
Dilution of market value—loss in share value due to use
of proceeds to invest in negative NPV projects.
Dilution of book value and earnings per share (EPS) —
reduction in EPS due to sale of additional shares. This
has no economic consequences.

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Corporate Debt
The late

1980s saw a major growth in the Australian
corporate debt market due to:
–
–
–

–
–

the substantial cutback in the level of government
borrowing
the fall in interest rates from extremely high levels
the flight to quality
the shortage of government bonds
the attractiveness of raising funds in the domestic
market relative to that of the euromarket.

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