Raising Equity Capital

Raising Equity Capital

• Equity capital is a permanent contribution to a company, primarily through ordinary shares.
• Ordinary shareholders possess full voting rights, typically one vote per share.
• Shareholders have a residual claim on the company's assets.
• Right to reclaim capital is lower than lenders
• Shareholders are last in line
• Equity investment carries the highest risk.
• An initial public offering (IPO) signifies a firm's first equity capital raise.
• Seasoned equity offerings (SEOs) are subsequent returns to the market for additional equity.

Options to Raise Equity: Unlisted vs. Listed Companies

• Unlisted companies can use private equity financing
• Private equity financing includes angel and venture capital.
• Angel financing happens through high-net-worth individuals.
• Venture capital targets early-stage, high-potential start-ups with active strategic engagement, spanning 3-7 years.
• An IPO is a venture capitalist's successful exit strategy.
• Listed companies use private placement, rights issues, and dividend reinvestment plans to raise equity.
• Private placement involves selling to a small investor group.
• Rights issues are offered to existing shareholders to buy new shares.
• Dividend reinvestment plans allows existing shareholders to reinvest dividends into new shares.

IPO Advantages

• IPOs grant access to additional capital.
• They permit venture capitalists to liquidate their investments.
• Existing stockholders benefit from diversification.
• Increased liquidity allows shares to sell rapidly with minimal stock price impact.
• Value is established.
• Using stock as employee incentive becomes more feasible.
• Customer recognition increases.

IPO Disadvantages

• IPO incurs substantial fees, legal, accounting, and investment banking which often consume 10% of raised capital.
• Stringent disclosure and scrutiny apply.
• Control is diluted among existing owners.
• Insider "deals" are harder to execute.
• Managing investor relations is time intensive.

IPO Process

• The IPO process starts with engaging an investment banker to prepare a prospectus and handle underwriting.
• Investment bankers gauge investor interest to set an appropriate subscription price through a "roadshow".
• After setting the price, shares are issued in the primary market.
• The issuing firm receives funds in this market.
• Shares begin trading on the stock exchange.
• The secondary market involves funds paid to the buyer of the share.

Three Types of Underwriting

• Standby underwriting guarantees full subscription, with the underwriter purchasing unsold shares at closing.
• Risk is minimal, with offering price set after assessing market receptiveness.
• Best efforts underwriting compels the underwriter to use "best efforts" to sell securities at the agreed price, but does not guarantee specified money.
• Dutch auction underwriting lacks a fixed price; shares are sold via investor bids.

Direct IPO Costs

• Underwriting fees, the underwriter's spread, represent the difference between buying and offering prices, typically around 7%.
• Underwriting fees for smaller companies are around 10-12% of gross proceeds.
• Legal fees cover administrative costs for management, lawyers, and accountants.
• Regulatory fees are fees for registering new securities.

Indirect IPO Costs

• Underpricing involves issuing securities below market value, described as "money left on the table".
• One reason for underpricing is the winner's curse, or information asymmetry.
• Companies underprice to mitigate this, ensuring subscription from a broad range of investors.
• Market feedback hypothesis drives issuers to underprice, incentivizing honest feedback from institutional investors.
• Investment banking conflicts, like favoring key clients, can cause underpricing to drive their own spread/benefit the banks
• This ensures shares sell faster.
• Reducing chances of lawsuits can be achieved by ensuring positive return that will limit investor ability to sue if the shares perform poorly
• Underpricing gives investors a good return which brings back the customer
• Investment banks prefer low prices.

Long-Run Underperformance Factors

• "Clientele effects" occur if optimistic IPO investors sell shares upon realizing the company isn't performing well, leading to share price depression.
• The "Impresario Hypothesis" suggests stock prices drop when investment banks withdraw support, revealing the company is not as good as investors initially thought.
• Management exploits high IPO demand during "windows of opportunity."
• Valuations of bad companies tend to settle once the market stops being favorable.

General IPO Comments

• There is a 28% chance of loosing or just breaking even when one invests in IPOs
• IPO activity and investor overpayment tend to rise after strong stock market returns, creating "Hot Issue" markets
• IPOs yield lower long-term returns than non-issuing firms.
• Firms that go public during peaks tend to do worse

Seasoned Equity Offerings (SEO)

• SEO costs are lower than IPO costs.
• Private placements, rights issues, and dividend reinvestment plans are used for SEOs.
• Private placements involve issuing new shares to a few investors, like financial institutions, at discount to incentivize participation.
• Ownership and wealth decrease due to Private Placements, and voting power dilution.
• 15-12 rule: A public company cannot sell >12% of shares without approval.

Rights Issues

• With rights issues, existing shareholders can purchase new shares to maintain ownership percentage.
• Shareholders can exercise shares
• Pro-rata entitlement dictates the number of new shares shareholders can buy.
• Rights resemble warrants more closely.
• The most important difference between a right and an ordinary call option is that rights are issued by the firm, so they more closely resemble warrants
• Ex-rights date is when shares no longer have rights attached.
• Ex-rights prices are lower than cum-rights prices.
• Rights offers are renounceable -> rights can be sold on the exchange

Possible Actions Regarding Rights

• Shareholders may lapse their rights
• Shareholders may trade those rights
• Shareholders may exercise rights to gain new shares

General Comments about Rights Issues

• Rights issues maintain shareholders' ownership and voting power.
• Share price may not always fall to the theoretical ex-rights price due to market information released between the offer and ex-rights dates.
• The theoretical value neglects the option value.

Dividend Reinvestment Plan (DRP)

• A DRP allows shareholders to buy shares at a discount instead of cash dividends.
• Companies maintain cash and pay less dividends
• DRPs lessen the cash flow impact during high dividend payouts.

Capital Raising Regulators

• The Corporations Act and ASX Listing Rules serve to protect investors and guide capital raising activities.
• Articles of Association govern specific companies.
• Australian Consumer Law regulates all companies.
• Special Legislation is for industries.

The Basic Rule

Corporations Act dictates an offer of securities must be accompanied by a prospectus, unless excluded, Hefty penalties for misleading prospectus can be applied.

Accelerated Entitlement Offers

• An accelerated entitlement offers happen in two stages
• Stage 1: offer to institutionalised shareholders
• Stage 2: offer to retail shareholders

Topics in Lecture 2

• Dividends
• Modigliani-Miller’s Dividend Irrelevance Theorem
• Factors Affecting Dividend Policy
• Share Buybacks vs Dividends

Dividends

• While being Discretionary, financial requirements can restrict dividend policy.
• Regular and special dividends exist.
• Interim and final dividends exist.
• Dividends per share (DPS), dividend yield (%), and payout ratio (%) measure dividends.
• An assets must exceed liabilities and payment must be reasonable for dividend approval based on the 2010 Solvency Test.
• Dividends are taxed.

Key Terms

• Announcement date=announcing dividend and payment dates
• Cum-dividend date=last day stock is traded with the right to recieve it
• Ex-dividend date=first day stock is traded without the right to trade it
• Record date=identifying shareholders for mailing checks out on the payment date
• (pcum - pex)/dividend is 1 in perfect markets, and the equation to calculate dividend drop of rate.

Key Formulas

• = PCUM – (Pсим — P)tcg is the equation for cash flow from selling on cum-dividend date
• = PEX - (PEX - P)tcg + Div. (1 – ta) is the equation for cash flow from selling on ex-dividend date
• Equation for a stable market: PCUM - PEX / Div. = 1-ta / 1-tcg

Dividend and Taxes

• Difference in tax rate between dividend and capital gains affects price change and the dollar dividend.
• If dividends and capital gains are taxed equally the Price Change = Dividend
• Price Change is less than Dividend if capital gains taxes are higher than dividend taxes
• Price Change is more than Dividend if dividends taxes are higher than capital gains taxes

M-M Theorem Assumptions

• There are no tax differences to investors between cap gains and taxation
• Flotation and signaling should not be concerns as new stock must immediately replace cash holdings in the case of overpaying.
• They do not use excess cash for bad projects or acquisitions if underpaying.

MM theory implications

• If a firm's policies do not change, the value of its dividends shouldn't either.
• The dividend payout policy isn't relevant for capital markets and is a NPV of 0
• Stockholders can replicate dividends in perfect capital markets by selling holdings of a non-dividend stock
• Stockholders can replicate never having dividends by reinvesting holdings to buy more stock in a company- which translate to getting no dividends

Dividend Policy Factors

• MM model says dividend policy is irrelevant to firm value under perfect market assumptions

MM Model Weaknesses?

• Uncertainty resolution is more clear to investors as investors will take A bird in the hand is better than 2 in the bush, and will resolve uncertainty about market value by selling shares to investors immediately
• Paying dividends and raising equity to replace funds will not change the firm’s riskiness- as it is only investment policy that does
• Higher dividends imply more frequent need for capital which will drive up transaction costs
• Capital raises will be necessary for positive NPV investments in high payout dividend policy settings
• Direct costs like advise and brokerage fees will be incurred
• Value of current shareholders will be diluted

Information Asymmetry

• Good times are coming signaller is high dividend rates
• It implies the dividend ratio is high

Agency Costs

• Empire building managers will misuse high capital due to not being concerned over market value of projects
• High payouts are needed for higher percs, and so shareholder interests will align- causing managers to have to properly justify when they go to the market
• Higher dividend payouts can also be a strong committment

Impact of Taxes

• Deffered CGT is better than immediate- meaning investors will delay tax payment for Capital Gain Tax (CGT)
• Australia utilises the Imputation tax system over the Classic Tax System (USA)
• High dividend payment is favoured as a tax system

Tax Implications, Corporate

• Double tax elimination and credit receipt exists
• Imputation credits are for resident shareholders, so retention could cause issues
• High dividends tend to be favoured in system
• Capital Gains are subject to various reductions as seen in individuals
• Resident tax profits of shareholders has tax credits that dividends undos

Preferences to CGT and Taxation

• Tax on CGT is higher than Taxation=tax on capital
• Dividends subject to less double taxation
• Capital gains realisation is deferred
• Don't get access to AUS tax system
• Must realise the tax preference of your shareholder

High Payouts

• Constantly flucutating dividend that signals special dividend
• Retain flexibilities for the cashflow

Share Buybacks

• Shareholders sell shared, so corporations can repurchase their stock
• There is no longer an off-market tax advantage
• Buy back at a discount and for 10/12 for the 10% of stock at 12 month
• It is not common for firms to have buyback for low capital cashflows as the buybacks will not control them

Advantages to performing highly

• By reducing number of shares
• EPS will increase

Good Signaler

• Buyback stock and share undervalued for the stock

Dividend

• Has its problems
• Buybacks are more irregular
• No dilution from future equities
• Shareholder do not undergo transaction costs
• Don’t lead to a Price Stop

Lecture 3

• Raising debt capital through operations
• Hybrids
• Debt and Lease

Leases

• Lease payments should paid in advance
• And are tax-deductable
• There needs to be memoisation of the 6-row tables

Advantages Of Leasing

• Insurance should be taken against absense
• Payments from leases are useful