FNCE 20005: Corporate Financial Decision Making

Corporate Financial Decision Making (FNCE 20005)

• Subject coordinator/lecturer: Dr Chander Shekhar from the University of Melbourne, Faculty of Business and Economics, Department of Finance, and can be contacted via [email protected]
• Office: Room 11.025, The Spot Building
• Study Material: Fundamentals of Corporate Finance (RTKHGWJ), 8e, 2021, lecture notes and tutorial materials

Study Tips

• Skim through lecture slides before class
• Actively participate in your tutorials
• Make full use of consults & OLT
• Read any financial newspaper regularly (FT, WSJ, The Economist etc.)
• Watch business channels as Bloomberg, CNBC etc.

Corporate Financial Decision Making

• Corporate decisions have financial implications that affects the finances of a business
• The three key decisions of corporate finance are investment policy, financing policy, and payout policy
• Investment (or capital budgeting) policy determines which projects a firm should undertake
• Financing policy is how a firm obtains funds (debt or equity)
• Payout policy determines how the firm returns cash to its owners
• The big picture of corporate finance is to "Maximize Shareholder Value"
• Investors get a return on their capital, which flows through investment, payout, and financing policies

Lecture 1 Outline: Equity Capital

• Raising Equity Capital
• Initial Public Offerings (IPOs)
• Seasoned Equity Offerings (SEOs)
• Regulatory Environment

Raising Equity Capital

• Equity characteristics include permanent contribution of capital
• Ordinary shareholders have full voting rights
• There are different forms of equity; the most common being ordinary shares
• Shareholders hold a residual claim with subordinated rights to a return on capital and on liquidation
• Equity is the most risky form of investment

Different options to Raise Equity

• Unlisted Firms options:Private Equity Financing includes "Angel" Finance, and Venture Capital, Initial Public Offering (IPO) and Listing shares first time
• Listed firms options: Private placement to small groups of investors, rights issue to existing shareholders, and the Dividend reinvestment plan (offered to existing shareholders to reinvest dividend to apply for new shares.)

Private Equity

• "Angel" Finance: An informal market for direct equity finance provided by a small number of high-net-worth individuals
• Venture Capital: It is active financial intermediary, providing financing to early-stage and high-potential start-up companies mainly in high tech industries
• Organize and manage funds mostly raised from investors (such as pension funds and endowments/foundations) from 5-7 years.
• Has staged financing; significant control over company decisions
• Exit strategies – trade sale or IPO

Inside the Funding Frenzy at Anthropic - NYT 20/2/2024

• Anthropic, an A.I. start-up, raised $7.3 billion over the last year, since generative A.I. burst onto the scene in late 2022
• Investors have fought for a piece of the developers

Public Equity

• It is available to firms with larger capital needs
• The Initial Public Offering (IPOs) refers to firms selling equity to the public for the first time
• Seasoned Equity Offerings (SEOs) is the sale of shares in an already publicly traded company
• Alternative SEO types are private placements, rights issues, and DRPs
• The primary market is the transaction between the issuing firm and its investors
• The secondary market is the transaction between investors e.g., stock exchange

Initial Public Offerings (IPOs)

• Often have IPO delays due to market volatility, such as car rental start-up, Turo, who delayed its listing in early 2022
• It involves a lengthy process with steps like engaging investment bankers and setting a price and listing

Motives for Going Public (% of CEOs who agreed):

• Creating public shares for future acquisitions (59.4%)
• Establishing a market price/value for the firm (51.2%)
• Enhancing the reputation of the company (49.1%)

Advantages of Going Public

• Access to additional capital
• Allow venture capitalists to cash out
• Enables current stockholders to can diversify
• Increases liquidity, allowing shares to be rapidly sold with little impact on the stock price
• Establishes firm value
• Makes it more feasible to use stock as employee incentives
• Increases Customer recognition

Disadvantages of Going Public

• IPOs create substantial fees, often 10% of funds raised in the offering for legal, accounting, and investment banking
• It creates a greater degree of disclosure and scrutiny requirement
• It leads to dilution of control of existing owners
• Special "deals" to insiders will be more difficult to undertake
• Managing investor relations is time-consuming

Steps of IPOs

• Engage an Investment Banker
• Investment bankers manage the float process, prepare the prospectus, and provide underwriting services
• The prospectus is a legal document detailing the IPO, and is also used to market the float
• The underwriter guarantees, for a fee, that all issued shares will be sold and is liable to purchase any shares that remain unsold at the conclusion of the float
• Investment bankers have a clear incentive to have the shares sold and achieve this with a marketing roadshow for potential investors
• Alibaba appointed a syndicate of banks manage their IPO: Credit Suisse, Deutsche Bank, Goldman Sachs, J.P Morgan Chase, Morgan Stanley and Citigroup

Subscription/issue price

• Fixed Pricing is a traditional method where price is set, the prospectus sent out and offers received, creating a high risk of under-subscription
• With book-building, underwriters ask institutional investors to indicate the quantity of shares they would purchase at what price, and records this in a "book," lowering subscription risk, but creates significant costs & investment banking conflicts
• Open auctions is where investors a invited to submit their bids, and the securities are then sold to successful bidders ( e.g., Google's IPO in 2004)

The Roadshow

• Bankers hit the streets to market the float and attempt to gauge investor interest
• Common to elicit non-binding orders from institutional investors in a process known as book-building
• In early September 2014, Alibaba and its advisors begun a two-week global marketing pitch to woo investors
• Alibaba expected the subscription price to be between $60 and $66 per share
• Roadshows assist in determining the appropriate subscription price for share

Set the Price and List

• The shares are issued in the primary market
• In secondary markets the buyers of shares don't pay the firm, instead they pay the shares seller
• Alibaba announced a subscription price of $68 per share in September 2014 and began trading on the NASDAQ at $93.89
• The close price implied a 38% return to IPO subscribers
• This meant $8.3 billion was left on the table

Costs of IPOs

• Direct costs: Underwriters receive payment in the form of as spread which is usually 7% of the proceeds to the issuer
• Direct administration, lawyers, accountants as well as additional security registration fees can be over 1% of the proceeds

Indirect Costs

• Underpricing (issuing securities at an offering price set below the actual market value of the security)
• LinkedIn IPO offer price was $45 and first-day closing price was $94.25, creating underpricing of about 110%
• The average underpricing among nearly 12,000 U.S. IPOs from 1960 to 2008 = 16.9%

Underpricing

• IPO volume has been very low in the U.S. since 2000
• In 1980-2000, an average of 310 operating companies went public every year
• In 2001-2024, an average of 114 operating companies went public every year
• Leaving money on the table is evident in some of the very biggest IPOs in history (Visa, Airbnb, etc)
• All IPOs are not good investments (28% chance that you will lose money or just break even)

Explanations for Underpricing

• Winner’s curse (information asymmetry) to ensure uninformed investors stay in the market, IPOs need to, on average, be significantly underpriced.
• Market Feedback Hypothesis where initial bookbuilding offers an opportunity to get the issuer an opportunity to find out from the market the “true” value
• Investment banks arrange for underpricing as a way to benefit themselves and their other clients
• Litigation Insurance where potential liability may be faced by issuer and underwriter for biased information, and ensures subscribers earn a positive return from their investment
• Signaling as the CEO knows an IPO is first in multi-stage strategy for expansion, leaving a good impression signals the quality of the issue and raises funds at higher prices

Reasons for long-run underperformance:

• "Clientele effects," where only optimistic investors buy into an IPO, and their optimism will disappear as more information about the firm is released
• "Impresario hypothesis," where investment bankers attempt to create excess demand be initially underpricing IPOs
• "Window of opportunity," where management times the is issue and a decline in demand for IPOs generally correlated with reduction in equity prices after IPOs

Seasoned Equity Offerings (SEOs).

• Alternative Types of SEOs include:general offers, rights issues, and placements

Determinants of Choice of Methods

• Influenced by: costs, time to implement, and transfer of votes/wealth from old to new shareholders

Private Placement

• Issue of new shares to a limited number of investors (usually financial institutions)
• An example situation includes Daffy Limited issuing 1 million shares at $9 each

Private Placements compared to other methods

• Advantages include quicker time to complete, lower issue costs and does not generally require a prospectus
• Disadvantages include share issued at a premium and dilute control of existing shareholders

Rights issue

• New share issue offered to existing shareholders at a fixed subscription price
• Shareholders receive an entitlement to new shares at fixed proportion to of the number of shares already held (on a pro-rata basis)
• Subscription price is usually at discounted 10–30% to of the share price at the time the issue is announced
• It takes around 2–3 months to complete or at least 23 days to renounceable offer

Rights Issue Notable Notations

• S = Subscription price
• 1:N = Pro-rata entitlement
• M = Market price of the share cum-rights
• X = theoretical price of the share ex-rights
• R = Value of the right

Rights Issues Example:

• When shares owned at right expires and money kept

• There is wealth loss

• Voting power loss

• When exercising and being paid to

• No wealth Los

• No power loss There is no voting power loss

• In summary

• Cash will exist for: ex-rights date, and exercise right by paying with shares will get exchanged 1:1 get 1 new share.

• Note that: strategies (1 and 3) are equivalent

• **

Rights issues alternative actions for investors to take:

• Have shares been issued with discount
• Do nothing and the ownership ratio change as there are third party buy rights and acquire new shares
• Shares given third party may not be for cash
• Exercising and acquire new shares and not dilute it by a third party buying up the share

Dividend Reinvestment Plans (DRP)

• DRP gives part or all of dividend to apply for new shares without transaction costs, and is usually at a discount ( 5-10%) to the current market price
• Used as a substantial source of capital for major corporations
• Rationale: Allows the firms to have a high dividend payout while lessening impact on cash outflows
• A DRP is a very small rights issue.

Regulatory Environment:

• Capital raising by companies in Australia are regulated by the listed instruments.
• Corporations act 2001, apply to every single company
• ASX Listing Rules only applys companies which are listed
• Articles of association:company legislation (legal and financial)
• Australian consumer Law
• Special legislan to take action when special laws are in affect that make the companies have regulations

Fund Raising through corporations Act- objectives is

• Prohibition: "full" information disclosure

ASX’s listing rules must be maintained

• Contious dosure companies must IMMEDIATELY notify ASX if there is “ANY INFORMATION LIKE to affect the share price