Corporate Financial Decision Making (FNCE 20005)

Corporate Financial Decision Making (FNCE 20005)

• Corporate financial decision making involves decisions impacting a business' finances.
• There are three key decisions of corporate finance: investment policy (capital budgeting), financing policy, and payout policy.
• Investment (or capital budgeting) policy determines which investment projects a firm should undertake.
• Financing policy determines the methods a firm uses to obtain funds, such as debt or equity.
• Payout policy determines how a firm returns cash to its owners.
• The goal of corporate finance is to maximize shareholder value and return capital to investors.

Raising Equity Capital

• Equity characteristics include permanent contribution of capital
• Ordinary shares are the most common form of equity
• Ordinary shareholders have full voting rights
• Shareholders hold a residual claim
• Subordinated right to a return on capital
• Subordinated right to a return of capital on liquidation
• Equity is the most risky form of investment

Options for Raising Equity

• Unlisted firms can engage in Private Equity Financing which includes Angel Finance and Venture Capital.
• Listed firms can choose Private placement or Rights issues
• Listed firms may offer Dividend reinvestment plans to existing shareholders

Private Equity Details

• "Angel" Finance is an informal market where high net worth individuals directly finance equity.
• Venture capitalists act as intermediaries to finance early-stage, high-potential start-ups, often in tech.
• Venture capital firms manage funds generally raised from investors like pension funds, typically for 5-7 years.
• Venture Capital is usually staged financing with significant control over company decisions .
• Strategies for exiting venture capital investments include trade sales or IPOs.
• Anthropic, an A.I startup that raised $7.3 billion over the last year.

Public Equity

• Public equity is available to firms with larger capital needs
• Initial Public Offerings (IPOs) refer to a firm's first sale of equity to the public.
• Seasoned Equity Offerings (SEOs) involve the sale of shares by a firm already publicly traded.
• Alternate SEO types are private placements, rights issues, and DRPs
• The primary market involves transactions between the issuing firm and investors.
• The secondary market involves transactions between investors, such as on a stock exchange.

IPOs

• IPOs are a way for firms to raise capital and offer increased customer recognition.
• IPOs provide access to additional capital, allow venture capitalists to cash out, and diversify current stockholders.
• IPOs increase liquidity and establish firm value while enabling stock-based employee incentives.
• IPOs create substantial fees which often involve legal, accounting, and investment banking fees, often 10% of funds raised.
• IPOs can have a greater degree of disclosure and scrutiny
• IPOs may cause dilution of control of existing owners
• Special "deals" to insiders will be more difficult to undertake if firm does an IPO
• Managing investor relations is time-consuming after IPO

The IPO Process

• Step 1: Engage an Investment Banker who will manage the float process,
• The banker also prepares the prospectus and provides underwriting services.
• The prospectus provides a legal document detailing the IPO that is also used to market the float.
• The underwriter guarantees the sale of all issued shares for a fee and purchases any shares that remain unsold.
• Underwriters conduct a marketing roadshow for potential investors.
• Alibaba appointed Credit Suisse, Deutsche Bank, Goldman Sachs, J.P Morgan Chase, Morgan Stanley, and Citigroup as managers

IPO Pricing

Pricing is traditionally set in Australia: A prospectus is sent out, offers are received, but is subject to market movement with a high risk of under-subscription

• US IPOs use book-building: institutional investors indicate quantities they would purchase at what price in a "book."
• Book-building has lower under-subscription risk but has significant costs & possible investment banking conflicts
• Alternatively, an open auction (Dutch auction) may be used
• Investors submit, with Google's IPO in 2004 being an example.

IPO Roadshow & Pricing: Alibaba Example

• During the roadshow, bankers market and gauge investor interest, eliciting non-binding orders through book-building.
• Step 2: In September 2014, Alibaba and its advisors began a two-week marketing pitch before filing with regulators.
• Alibaba stated that their expected subscription price was between $60 and $66 per share.
• Share subscription price was $68 per share
• Trading on NASDAQ began with the shares closing at $93.89 which implies a 38% return
• An estimated $8.3 billion was left on the table
• IPO Costs:
  • Direct Costs: Payments to Underwriters including 7% of proceeds.
  • Indirect Costs: usually about 1% of proceeds.
  • Underpricing Securities: Underpricing is when securities sell below actual market value (captured by first-day closing price)

IPO Underpricing

• Alibaba's underpricing = 38.07%
• Underpricing is issuing securities at an offering price set below the actual market value
• LinkedIn's IPO offer was $45 but its first-day closing price was $94.25, underpricing by about 110%.
• Approximately 12,000 U.S. IPO average underpricing from 1960 to 2008 equaled 16.9%

Indirect IPO Costs

• Leaving money on the table is evident in some of the very biggest IPOs in history.
• The volume IPOs in the US from 2001-2024 averaged 114, in contrast to the 310 average between 1980-2000.
• Underpricing is common on mostly European IPOs, but is common in China

IPO Investment Risks

• Investing in IPOs carries a risk of potential loss (28% chance) despite the prospect of significant returns.

Rationales for Underpricing

• Winner's Curse (information asymmetry): Informed investors can judge whether an IPO is over/under priced. Uninformed Investors, are not.
• It is important to ensure that uninformed investors stay in the market – IPOs need to be significantly underpriced and requires capital constraints on informed investors.
• Market Feedback Hypothesis: Issuers may be uncertain about the true value and use bookbuilding to find determine the true value in the the market.
• Issuers must underprice the issue to induce institutional investors to reveal data and participate.
• Investment banking conflicts: Investment banks arrange for underpricing as a way to benefit themselves and other clients.
• Underpricing reduces an investment bank's own costs.
• Underpricing can develop unethical relationships with clients
• For instance, Salomon Smith Barney offered Bernie Ebbers the opportunity to buy 200k shares in Qwest's IPO.
• In this case, Salomon helped Ebbers earn eleven million dollars by flipping IPO shares.

Reasons For the Under Performance of Some IPOS

• Litigation Insurance: Underpricing ensures that subscribers earn a positive return from their investment, reducing the likelihood of them suing the underwriter after a biased IPO
• Signaling: Underpricing signals the quality of the issue and facilitates raising funds at higher prices.
• IPO statistics show that firms of similar sizer and growth opportunitys will have an affected share price/returns
• "Clientele effects" : Only optimistic investors buys in an IPO, their enthusiasm will disappear as additional information about the firm is released
• "Impresario hypothesis" : Investment bankers attempt to create an atmosphere of demand by initially doing IPOs
• Investors expect to see a reduction in share price as efforts are withdrawn after buying in
• Window of opportunity IPOs manage the issue (taking advantage of high demand for IPOs by the market – hot markets) A decline in demand for IPOs (cold markets) after hot markets are generally correlated with a reduction in equity prices after IPOs

Seasoned Equity Offerings (SEOs)

• Alternative types of SEOs include rights issues or DRP, general offers, and placement.
• Existing shareholders buy Rights, the general public buy General offers, Financial institutions buy Placements
• The choice of method depends upon three factors: costs, time to implement, and transfer of votes and wealth from old to new shareholders.

Season Equity Offerings

• Private Placements: are issues directed towards financial institutions where Daffy Limited has 10m shares +9 m by placing 1 m shares Raises 9m
• Lower issue costs
• Usually does not require a prospectus.
• Is shares issued at a discounted rate

Rights Issues

• A is a share issue to existing shareholders at a fixed price

• Shareholders receive a n entitlement on the pro rata basis

• Subsription price is between 10-30% disount at the time it is announced

• Takes 2-3 months to complete

• A company has a current market share price of $3.50, makes a -for-5 rights with 2.50

• Ex rights price x is = n/n+1 x M + 1/n+1 x S , this $3.3

Implications of the Right Share

• Most issues are renounceable to shareholders may: exercise rights acquire new share or allow the rights ot lapse

ASX

• It is important to follow ASX Listing Rule 7.1 (prohibits a company from issuing 15%)

Regulations and Objectives

• Capital raising by companies in Australia is regulated by Corporations Act, ASX Listing Rules, articles of Association, Consumer Law and Special Legislation.
• Regulations are for investor protection, to require full disclosure and what can be displayed
• The basic rule follows a s.1018. If an offer is made, then securities must be a prospectus

Listings Rules of AXS

• All listed corporations must meet requirements in order to be listed on the ASX
• Continuous disclosure. Companies need to always inform if there si information that may affect chair price
• How rules govern new issues
• Regulations to share maintenance