Equity Financing Citibank

Equity Financing 06/08/94

Equity Financing

Warning This workbook is the product of, and copyrighted by, Citibank N.A. It is solely for the internal use of Citibank, N.A., and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of the Professional Development Center of Latin America Global Finance and the Citibank Asia Pacific Banking Institute. Please sign your name in the space below.

Table of Contents

TABLE OF CONTENTS

Introduction: Equity Financing Course Overview............................................................................. v Course Objectives...........................................................................vi The Workbook ...............................................................................vii Unit 1: Fundamentals of Equity Introduction ................................................................................... 1-1 Unit Objectives .............................................................................. 1-1 What Is Equity?............................................................................. 1-1 Types of Equity ............................................................................. 1-2 Common Stock .................................................................. 1-2 Preferred Stock .................................................................. 1-3 Equity Markets .............................................................................. 1-5 U.S. Equity Markets............................................................ 1-6 National Markets...................................................... 1-6 Regional Markets..................................................... 1-7 Other Equity Markets.......................................................... 1-8 Equity Market Transactions................................................ 1-8 Initial Public Offering (IPO) ...................................... 1-8 Seasoned Offering................................................... 1-8 Investor-to-investor Transactions ............................ 1-9 Types of Equity Securities.................................................. 1-9 Registered Shares................................................... 1-9 Bearer Shares ....................................................... 1-10 Depository Receipts............................................... 1-10 Purchasers of Equity Securities ....................................... 1-11 Unit Summary ............................................................................. 1-12 Progress Check 1........................................................................ 1-15

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Unit 2: Issuing Equity Securities Introduction ................................................................................... 2-1 Unit Objectives .............................................................................. 2-1 Public Placement .......................................................................... 2-1 Initial Public Offering .......................................................... 2-2 Firm Commitment Offering ...................................... 2-2 Best Efforts Offering ................................................ 2-5 Other Offerings ........................................................ 2-6 Pricing an IPO ......................................................... 2-7 Seasoned Offerings ........................................................... 2-8 General Cash Offering............................................. 2-9 Rights Offering....................................................... 2-13 Private Placement ....................................................................... 2-16 Unit Summary ............................................................................. 2-17 Progress Check 2........................................................................ 2-21 Unit 3: Valuing Equity Securities Introduction ................................................................................... 3-1 Unit Objectives .............................................................................. 3-1 Common Equity ............................................................................ 3-1 Ratio Valuation ................................................................... 3-2 Price / Earnings Ratio .............................................. 3-3 Market / Book Ratio ................................................. 3-4 Dividend Valuation................................................... 3-5 Other Price-to-characteristics Ratios ....................... 3-6 Relative Valuation .............................................................. 3-7 Liquidation Value ..................................................... 3-7 Asset-based Valuation............................................. 3-8 Discounted Cash Flow Valuation ....................................... 3-8 Forecast Cash Flows ............................................... 3-9 Estimate Cost of Capital ........................................ 3-11

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Unit 3: Valuing Equity Securities (Continued) Estimate Residual Value ..................................................3-13 Discount Cash Flows........................................................3-15 Preferred Equity ..........................................................................3-16 Unit Summary .............................................................................3-17 Progress Check 3........................................................................3-19

Appendix Glossary........................................................................................ G-1

Index

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Introduction

INTRODUCTION: EQUITY FINANCING

COURSE OVERVIEW The purpose of this workbook is to provide the student with a broad introduction to the topics relating to equity and its use as a source of capital for companies. Equity financing can be analyzed from the perspective of the issuer as well as from the investor. Both perspectives are considered in this workbook; in many instances they are very much alike. Completion of this workbook provides the student with a working vocabulary of terms used in the equity markets and an understanding of some commonly used methods for both issuing and valuing equity securities. UNIT 1: Fundamentals of Equity Common fundamentals necessary to understand equity market transactions are introduced in Unit One. This includes the markets in which equity securities are traded, a discussion of the participants in the markets, and definitions of the different types of equity securities and their characteristics. This unit does not require any mathematical analysis; the major focus is on introducing and defining key terms.

UNIT 2: Issuing Equity Securities The process of issuing equity securities is detailed in Unit Two. The various steps for bringing an issue to investors in the market are described and discussed. Public offerings are compared and contrasted to private offerings. These two major types of offerings are broken down into the common methods used by issuers. The role of the investment banker is discussed with each method. Also included is a simple example that illustrates the process for placing a price on the shares being offered. The focus of this unit is on key terms and processes, with very little mathematical analysis. The student will learn to distinguish between the different types of offerings and the strengths and weaknesses of each.

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INTRODUCTION

UNIT 3: Valuing Equity Securities We look at different methods for estimating the value of equity securities in the third, and final, unit. The main methods described include ratio valuation, relative valuation, and discounted cash flow valuation. Each method group is demonstrated and discussed, including its relative strengths and weaknesses. There are many calculations to learn in this section. Most of the computations are applications of the general formulas discussed in the Basics of Corporate Finance workbook. It may be helpful to review the calculations presented in that workbook if you are having trouble understanding the calculations presented in Unit Three. A financial calculator is very helpful in solving the types of problems discussed in this section.

This workbook provides the student with a good working vocabulary and understanding of the equity markets and the securities that are traded there. This introduction will prepare the student for further study and application of equity as a financing alternative for companies attempting to raise capital for their operations.

COURSE OBJECTIVES When you complete this workbook, you will be able to:
Recognize the types of equity instruments, the characteristics of the equity markets, and the market participants
Understand the issuing processes for publicly- and privately-placed equity securities
Identify the costs, both direct and indirect, associated with various types of equity issues
Demonstrate various techniques for estimating the value of equity securities

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THE WORKBOOK This self-instruction workbook has been designed to give you complete control over your own learning. The material is divided into workable sections, each containing everything you need to master the content. You can move through the workbook at your own pace, and go back to review ideas that you didn't completely understand the first time. Each unit contains: Unit Objectives –

which point out important elements in the unit that you are expected to learn.

Text –

which is the "heart" of the workbook where the content is presented in detail.

Key Terms –

which also appear in the Glossary. They appear in bold face the first time they appear in the text.

Instructional Mapping –

terms or phrases in the left margin which highlight significant points in the lesson.

✔ Progress Checks –

which help you practice what you have learned and check your progress. Appropriate questions or problems are presented at the end of each unit. You will not be graded on these by anyone else; they are to help you evaluate your progress. Each set of questions is followed by an Answer Key. If you have an incorrect answer, we encourage you to review the corresponding text and then try the question again.

In addition to these unit elements, the workbook includes the:

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Glossary –

which contains all of the key terms used in the workbook.

Index –

which helps you locate the glossary item in the workbook.

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INTRODUCTION

This is a self-instructional course; your progress will not be supervised. We expect you to complete the course to the best of your ability and at your own speed. Now that you know what to expect, you are ready to begin. Please turn to Unit One. Good Luck!

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Unit 1

UNIT 1: FUNDAMENTALS OF EQUITY

INTRODUCTION

The purpose of this unit is to provide the foundation that will help you understand the use of equity as a source of capital and as an investment vehicle. You will be introduced to the concept of equity, the equity markets, and how the markets function.

UNIT OBJECTIVES

When you complete Unit One, you will be able to: n

Define equity

n

Identify the types of equity and the rights associated with each type

n

Recognize how equity markets function: their purpose, the participants, and the types of transactions that occur

n

Identify the three formats for issuing stock certificates

WHAT IS EQUITY? Definition of equity

Equity is one source of capital (funds) a company may use to finance its operations. Many analysts define equity as the net worth of a company: the value of the assets less the value of the liabilities. This definition is based on the accounting equation: Assets

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In other words, the value of the equity of a business is whatever remains after the company satisfies all of the claims of its creditors (residual claim). We will discuss various techniques for estimating this value later in the course.

TYPES OF EQUITY

A company usually issues equity to investors as a security in the form of shares of stock in the company. Each share represents a claim of ownership on the assets of the firm. Publicly-held companies issue two types of equity: common stock and preferred stock. Each type of equity has specific characteristics and functions.

Common Stock One source of equity capital is the common stock security. Common stock represents an ownership claim on the assets of a company. A prospectus is a document that details the ownership rights of common stockholders. The prospectus also specifies the voting rights of the shares. Shareholder rights

An owner of a company's common stock is entitled to share in the profits of that company. This participation usually takes place in two ways: 1. A dividend (distribution of earnings) paid by the company to the share owners 2. An appreciation in the price of the stock (capital gain) generated by the future prospects of the company Common stock has no maturity date; the shareholders are entitled to these earnings for as long as they own the shares and the company is in business. We will discuss returns to common shares and how to value them in more detail later in the course.

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Voting rights

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The common shares of many firms also give shareholders the right to vote. Shareholders vote to determine the directors of the company or to approve broad strategy and policy choices presented by the directors. Usually, each share represents one vote; however, some common shares have no voting rights or they may have multiple voting rights. A recent common stock innovation is super-voting shares that represent a higher number of votes. Companies issue these shares to select investors to ensure that the majority ownership remains with the designated shareholders. To meet different capital needs, a company may issue several types (or classes) of common stock. Each class possesses different rights and voting privileges. Companies use a different letter classification, such as "class A shares," "class B shares," to distinguish shares with different voting powers.

Preemptive purchase of new issues

Owners of common shares also may enjoy a preemptive power, which gives existing shareholders the right to purchase newly-issued shares before they are offered to other investors. This right is usually proportional to the amount of shares currently owned by each investor in order to protect the dilution of value for current stockholders.

Preferred Stock Often called a hybrid (mixed) source of capital, preferred stock is similar to common stock in some respects and to bonds (debt capital) in other respects.

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Shareholder rights

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Like common stockholders, preferred stockholders participate in the earnings of a company. Like bond holders, preferred stockholders receive a regular dividend payment based on the shares' face (par) value. This payment is usually determined when the shares are issued and is generally stated as a percentage of the par value. The dividend may be based on a fixed percentage rate of par or at a floating percentage rate that is tied to some market interest rate. For this reason, many analysts believe that the price of preferred stock behaves like bonds in response to changes in interest rates. The Brazilian market usually sets the dividend on preferred shares to some percentage of the earnings of the company, rather than a percentage of par value. A company must pay a dividend to preferred shareholders before it pays a dividend to the common shareholders, hence the term "preferred." The par value establishes the amount due to the preferred stockholders in the event of liquidation of the company. Thus, preferred stock has a priority claim on both earnings and assets. A company may decide not to pay preferred dividends at certain times (such as periods of financial distress or large internal growth). However, these "passed" dividends must be paid before any common stock dividend may be paid. Financial analysts often consider preferred shares as a liability because shareholders receive their dividends before any earnings distribution to common shareholders. Most accountants classify preferred stock as equity and list it in the equity section of the balance sheet. In this course, we will demonstrate both approaches — preferred stock as equity and as liability.

Voting rights

Preferred stock also may have other ownership provisions. Generally, preferred shareholders do not have voting rights. However, some preferred stocks grant a voting right if the company fails to pay the preferred dividend for a specified period (such as four or eight quarters). This provides incentive for the directors to make great efforts to pay the preferred dividend.

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Buy-back rights

Many newer issues of preferred stock allow for a sinking fund. This entitles the company to retire (buy back from investors) a certain percentage of the preferred shares each year. Some preferred shares may have a call provision that allows the company to repurchase the shares at a set price, usually at a premium over the par value.

Conversion rights

Finally, many preferred stock issues include a conversion feature that allows the shareholders to exchange the preferred stock for common stock at a set rate. This conversion is usually at the option of the shareholder.

EQUITY MARKETS Market participants

An equity (or stock) market is the place where companies issue shares of stock and investors purchase and sell these shares. These markets usually have three types of participants: 1. Investors 2. Issuers 3. Financial intermediaries: brokers and dealers Essentially, investors have capital and need opportunities to invest; issuers need capital. Brokers and dealers are financial intermediaries. Brokers arrange for the issuers and investors to complete a deal; dealers purchase securities from issuers and sell them to investors. While the details in carrying out transactions may be different, most markets provide the same functions for issuers and investors.

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U.S. Equity Markets Listing a stock

In the United States, there are several markets (or exchanges) in which to buy and sell equity securities. A company's stock must be accepted for trading, or "listed," on a particular exchange. This acceptance is based on the ability of the company to meet certain minimum size requirements and also on the amount of capital the company has raised in the public markets.

Regulation of U.S. markets

The Securities and Exchange Commission (SEC), a U.S. Government agency, regulates all of the U.S. stock markets. The SEC specifies rules concerning security registration, fair trading, and information disclosure. The SEC also enforces these rules. U.S. markets fall into two categories: national and regional. Let us examine each of these.

National Markets

The major national markets include the New York Stock Exchange, the American Stock Exchange, and the over-the-counter market. n

New York Stock Exchange The New York Stock Exchange (NYSE) is the oldest, and probably the most famous, stock market in the U.S. The stocks listed on the NYSE are generally from the oldest, largest, and best-known companies in the U.S.

n

American Stock Exchange The American Stock Exchange (AMEX), also located in New York, lists large, stable, and well-known companies; although the requirements to be listed on the AMEX are not as strict as the requirements for the NYSE. Trading of stocks on the NYSE and the AMEX is done by using a centralized, two-way auction system. To participate in this system, a broker must have some affiliation with one of the firms owning a seat on the exchange.

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Over-the-counter Market The other national market is called the over-the-counter (OTC) market. The OTC market is a network of securities dealers connected by telephone and computer (known as the National Association of Securities Dealers Automated Quotation System, or NASDAQ). Trading is completed by negotiation through this computerized system. Generally, companies listed on the OTC market are newer, or smaller, than the companies listed on the NYSE and the AMEX.

Regional Markets

In addition to the national markets, there are several regional stock exchanges. These regional exchanges specialize in smaller, regional companies that operate in areas close to the exchange, although many national companies are listed on regional exchanges. The largest regional exchanges are the Pacific Exchange (San Francisco), the Midwest Exchange (Chicago), the Philadelphia Exchange, the Boston Exchange, and the Cincinnati Exchange. The regional exchanges are linked to the NYSE and AMEX so that participants on the national exchanges also can make trades on the regional exchanges. These regional exchanges employ the same twoway auction system for trading stocks as the NYSE and AMEX. Multiple listings

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A company may have its stocks listed on more than one exchange. It is common for stocks listed on the regional exchanges to be listed on one of the national exchanges as well. However, dual-listed stocks are traded based on the national exchange market prices, even in the regional exchanges.

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Other Equity Markets Exchanges in developed countries

Most developed countries have set up stock exchanges (sometimes referred to as "bourse") that function much like the U.S. markets. The largest exchanges are located in London, Tokyo, and Frankfurt. These exchanges specialize in listing and trading the equity securities of local companies. Like the U.S., most countries have special government agencies to regulate their equity markets. For example, the Japanese Ministry of Finance is responsible for the regulation of the Tokyo stock market.

International exchange

The largest exchange for shares of foreign companies is the International Stock Exchange (ISE) in London. The NYSE and the German exchanges are also important in the trading of foreign equity securities.

Equity Market Transactions There are essentially three types of transactions in the equities market: 1) an initial public offering, 2) a seasoned offering (both 1 and 2 are primary market transactions), and 3) an investor-toinvestor sale of securities. Primary market transactions

Initial Public Offering (IPO)

In an initial public offering, a privately-held company offers shares in the company through the equity markets for the first time. This is often referred to as "taking a company public." Seasoned Offering

A company offers additional shares to investors after the initial public offering. This is called a "seasoned" offering because shares of the company have been listed on an exchange and have been trading for some time.

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IPOs and seasoned offerings are referred to as primary market transactions because companies sell stock directly to investors. We will discuss these primary market transactions in more detail in Unit Two. Secondary market transactions

Investor-to-investor Transactions

The third type of equity market transaction is the sale of a company's stock by one investor to another. The company does not receive or pay any money in this transaction, so it is often referred to as a secondary market transaction. For example, if one investor sells 100 shares of General Motors stock to another investor through an exchange, it is considered a secondary market transaction and has no effect on General Motors' balance sheet.

Types of Equity Securities Equity securities may be issued in one of three forms: 1. Registered shares 2. Bearer shares 3. Depository receipts Registered Shares Recorded list of shareholders

If a company records and maintains a current list of shareholders who own its stock certificates, then the shares are said to be registered. Each transaction involving the shares of a company is reported to the company so that the registration list may be updated. Several countries, including the United States and United Kingdom, require companies to register their shares. Tax collection is the most common reason for this requirement.

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FUNDAMENTALS OF EQUITY

Bearer Shares Possession of stock certificates

Bearer shareholders are not recorded by the issuing company. Possession of the actual stock certificates is the only proof of ownership. Bearer shares are common on most European stock exchanges (except in the United Kingdom).

Depository Receipts

A depository receipt is a negotiable certificate representing a certain number of shares of a company traded on an exchange other than the exchange where the issuer resides. Depository receipts offer advantages to investors and issuers. Advantage to investors

Advantage to issuers

n

Investors can participate in foreign markets without having to be concerned with the regulations of that market or the complexities associated with trading in a foreign currency.

n

Issuers avoid many of the costly and time-consuming regulations found in some countries. Usually, the host country's regulating agency will have only minimum requirements concerning the size of the issuing company and the size of the issue.

Let's look at the process for issuing depository receipts. Process for issuing depository receipts

A bank purchases a large block of shares of a foreign company and holds these shares on deposit in an account. The bank then issues depository receipts that represent a certain number of the foreign shares (such as one depository receipt = one, five, or ten shares) or a percentage of a share (such as four depository receipts = one share) for purchase by investors. The depository receipts are denominated in the currency of the bank and the investors, while the shares are denominated in the local currency of the company issuing them. The depository receipts are listed on a market exchange and traded like any other equity security. Even though the shares are held on deposit at the issuing bank, the bank generally will pass along any rights (including voting rights) associated with the underlying shares. ver. 1.0

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Sponsored / unsponsored depository receipts

Depending on who initiates the issue, depository receipts may be either sponsored or unsponsored. Sponsored depository receipts are issued under an agreement between the foreign company and a depository bank. The bank assumes responsibility for distributing dividend payments, and either the bank and/or the company is responsible for the expenses incurred in handling the depository receipt accounts. Unsponsored depository receipts are issued by a depository bank at the request of investors. The investors are then responsible for the attendant expenses.

American / Global depository receipts

In the U.S. markets, depository receipts are known as American depository receipts (ADRs) or American depository shares (ADSs). Most ADRs trade on the NYSE or AMEX, or they are quoted on NASDAQ. Depository receipts trading in non-U.S. markets are referred to as Global depository receipts (GDRs) or International depository receipts (IDRs).

Purchasers of Equity Securities The investors that purchase equity securities are classified into two groups: institutions and individuals. Institutional investors

Institutional investors include: n

Banks and other depository institutions

n

Mutual funds

n

Pension funds

n

Insurance companies

n

Corporations

Institutional investors buy and sell large blocks of shares, enabling them to negotiate better trading commissions. These large positions, and the frequency with which institutional investors trade, create liquidity in the equity markets for all investors. Large institutional investors are very sophisticated in their investment strategies and may have influence over the management of a company.

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Individual investors

FUNDAMENTALS OF EQUITY

Individual investors usually have much less capital to invest in equity securities. Their actions have considerably less influence over the trading prices of stocks and the decisions that company managers make concerning the underlying companies. Most individual investors do not have the resources to obtain information as easily as institutional investors. Therefore, many individual investors are considerably less sophisticated in their trading strategies. It is common for individual investors to pool their investment capital in a mutual fund or other investment vehicle to capture some of the economies of scale that institutional investors enjoy.

Public and private placement

Many companies will target a certain set of investors when issuing equity securities, depending on their needs. Companies trying to build a broad investor base and name recognition will try to place their securities with individual investors. When a company offers its securities to all participants in the market, it is called a public placement (or a public offering). Companies that wish to avoid some of a government's registration requirements may try to target the institutional investors. Selling securities to a select group of predetermined investors is called a private placement (or a private offering). We will discuss private and public placement in greater detail in Unit Two.

UNIT SUMMARY

In this unit, we defined equity as the net worth of a company: the value of the assets less the value of the liabilities. We explored how companies use equity to raise capital by issuing common and preferred stock.

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Both common and preferred stockholders are entitled to participate in the profits of the issuing company. However, their ownership rights differ. Common stockholders share in the company's profits through distribution of earnings and capital gains. Preferred stockholders must receive their dividend before any common stock dividends can be paid. The par value of preferred shares establishes the basis for the dividend payment and a liquidation value, should the company go out of business. Owners of common stock typically enjoy the right to vote on company directors and policy issues. Preferred stock usually does not carry voting rights except in rare instances when a company has not paid dividends for several periods. We introduced the major equities markets and the institutional and individual investors, brokers and issuers who participate in market transactions. We identified primary market transactions (initial public offerings and seasoned offerings) and secondary market transactions (investor-to-investor trades). The three forms in which equities typically trade are: 1. Registered shares, which are reported to the issuing company and maintained on a continually updated list of shareholders 2. Bearer shares, which require only possession of the actual stock certificates to prove ownership 3. Depository receipts, which are negotiable certificates representing shares of a company traded on an exchange other than the exchange where the issuer resides Now that you have a broad understanding of the fundamentals of equity, you are ready to focus on the issuer's concerns in raising capital through the equities market. More specifically, the process of bringing an equity issue to market will be discussed in Unit Two, Issuing Equity Securities.

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FUNDAMENTALS OF EQUITY

You have completed Unit One, Fundamentals of Equity. Please complete Progress Check 1 that follows and check your answers with the Answer Key. If you answer any questions incorrectly, please review the appropriate text; then continue to Unit Two.

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4 PROGRESS CHECK 1 Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page.

Question 1: Define equity by completing the equation below. Equity = _________________ - _______________

Question 2: Match each market participant with the correct definition. ______ Investor

a) Needs capital

______ Issuer

b) Buys and sells securities

______ Broker

c) Arranges for two parties to complete a deal

______ Dealer

d) Has suitable capital to use for future gains

Question 3: Which type of share generally carries no voting rights for the investor in choosing directors or in determining broad policy decisions for the company? ______ a) Common share ______ b) Preferred share ______ c) Depository receipt

Question 4: Which type of share has a priority claim on the earnings of the company? ______ a) Common share ______ b) Preferred share ______ c) Registered share ______ d) Bearer share

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ANSWER KEY

Question 1: Define equity by completing the equation below. Equity =

Assets – Liabilities

a

In other words, the value of the equity is whatever remains after the company satisfies all the claims of its creditors.

Question 2: Match each market participant with the correct definition. d

Investor

a) Needs capital

a

Issuer

b) Buys and sells securities

c

Broker

c) Arranges for two parties to complete a deal

b

Dealer

d) Has suitable capital to use for future gains

Question 3: Which type of share generally carries no voting rights for the investor in choosing directors or in determining broad policy decisions for the company? b) Preferred share Generally, preferred shares carry no voting privileges, except for some rare occurrences when their dividends have been held in arrears for several consecutive periods.

Question 4: Which type of share has a priority claim on the earnings of the company? b) Preferred share A company must pay a dividend to preferred shareholders before it pays a dividend to the common shareholders.

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PROGRESS CHECK 1 (Continued)

Question 5: An investor just purchased shares of a Venezuelan manufacturing company on the NYSE. In what form would the investor hold these securities? ______ a) Registered shares ______ b) Bearer shares ______ c) American depository receipts

Question 6: The reason an investor invests in a Venezuelan manufacturing company through the NYSE instead of the Venezuelan exchange is to: ______ a) eliminate all risk. ______ b) receive dividends in the investor's own currency. ______ c) gain a better exchange of shares for ADRs. ______ d) participate in the largest exchange in the world.

Question 7: Which type of investor usually has more influence on the managers of a publicly-traded company? ______ a) Institutional investor ______ b) Individual investor

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ANSWER KEY

Question 5: An investor just purchased shares of a Venezuelan manufacturing company on the NYSE. In what form would the investor hold these securities? c) American depository receipts American depository receipts are negotiable certificates, traded on the NYSE and the AMEX, that represent ownership of shares of a foreign company.

Question 6: The reason an investor invests in a Venezuelan manufacturing company through the NYSE instead of the Venezuelan exchange is to: b) receive dividends in the investor's own currency. Even though the investment is denominated in an investor's local currency, and the company is required to meet certain reporting requirements, the investment still has all of the risks inherent in the company. The depository receipt makes investment in the company more convenient for the investor - it does not eliminate all risk.

Question 7: Which type of investor usually has more influence on the managers of a publicly-traded company? a) Institutional investor

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Unit 2

UNIT 2: ISSUING EQUITY SECURITIES

INTRODUCTION

In Unit One, you learned that primary equity market transactions involve the direct sale of stock by a company to investors. In this unit, we describe a company's process for placing its securities publicly and privately in the equity markets. We outline the steps necessary for a company to sell equity to investors and discuss the relative advantages, disadvantages, and costs associated with public and private placement.

UNIT OBJECTIVES

When you complete Unit Two, you will be able to:


Identify the different methods for publicly placing equity securities




Recognize the process for raising equity capital through initial public offerings and seasoned offerings




Differentiate between public placement and private placement




Recognize the direct and indirect costs of equity offerings

PUBLIC PLACEMENT Two types of public placement

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As mentioned in Unit One, in a public placement a company offers its equity securities to all participants in the market. There are two types of primary market transactions a company can use to publicly place its shares: an initial public offering (IPO) and a seasoned offering.

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ISSUING EQUITY SECURITIES

Initial Public Offering If a privately-held company decides to raise capital by selling equity to investors, it does so through an initial public offering. This is often called "taking a company public." There are two major types of IPO: a firm commitment offering and a best efforts offering. These two offerings are distinguished by the role that the investment bank plays in the process of bringing the issue to investors. Bank as underwriter

In a firm commitment offering, the investment bank serves as the underwriter of the issue. The investment bank actually purchases the shares from the issuer at a discount, then resells them to investors. This is called underwriting the issue.

Bank as sales representative

In a best efforts offering, the investment bank agrees to use its "best efforts" to sell the shares; but the bank does not actually purchase the shares from the company. In most cases, the issuer does not choose the type of offering it prefers; the nature of the company and the type of deal dictate which offering will bring the best results. We will describe the process for both types of offerings.

Firm Commitment Offering

There are several steps in the process of issuing a firm commitment IPO. Select investment bank

An issuing company begins the process by selecting an investment bank to manage the underwriting. The company and the underwriter then discuss the financing requirements of the company. The two groups draft a "letter of intent" that outlines the proposed terms of the stock issue and the underwriter's compensation for participating in the issue.

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If the issue is large, or to be placed in several markets, then additional underwriters may be invited to participate. This group of investment banks is called a syndicate; the original investment bank is referred to as the managing underwriter. Draft registration statement

Next, the underwriter assists the issuer in drafting a registration statement. The company submits the registration to the appropriate government regulatory agency for examination and approval. In the United States, the Securities and Exchange Commission (SEC) is the agency responsible for regulating securities markets. In the United Kingdom, the Securities and Investments Board is responsible for regulation; in Japan, the Ministry of Finance is the appropriate agency. The registration statement contains all the information a potential investor needs to make an educated decision about the offering, including:


Description of the business, its operations, and its current capital structure




Terms of the offering and proposed use of the proceeds




Set of audited financial statements




Description of the future prospects of the firm, including potential risks




Background of the management group and current major shareholders in the company




Identity of the underwriter




Disclosure of the underwriting agreements to which the offering company is party

Preparing the statement usually takes about four to eight weeks (depending on the requirements in the country of issue). Most government agencies will take between two and four weeks to approve or reject the potential issue.

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Generate investor interest

Underwriters show the informational section of the registration statement to potential investors in the form of a preliminary prospectus, sometimes referred to as a "red herring." This gives the underwriter an idea of how much investor demand there is for the issue. The preliminary prospectus gives an estimated price per share because the final price is determined just prior to issue. Representatives of the company and the bank may also conduct information meetings with prospective investors to generate interest in the issue. These meetings are often called "road shows" or "dog and pony shows."

Finalize price of issue and number of shares

A day or two after receiving approval from the appropriate regulatory agency, the issuer and the underwriter (or syndicate) meet to finalize the issue — including the number of shares to be issued and the price of the shares. It is not unusual for the number of shares and the price figures to be drastically different from the figures on the preliminary prospectus. The official prospectus is then prepared and sent to the government agency for a routine acceptance.

Underwriter sells stock

After the pricing meeting, the underwriter (or syndicate) sells the stock to investors. This sale takes place a few hours, or perhaps the next morning, after the last meeting between the issuer and the underwriters. The sale occurs quickly because the underwriter has identified potential investors prior to the actual sale. In a firm commitment offering, the underwriter has essentially guaranteed that the issuer will receive the net proceeds (amount received from the sale of the stock less the underwriter's expenses and fees) agreed upon at the pricing meeting. The underwriter prepares a simple, boxed advertisement called a tombstone to be placed in the financial section of an appropriate newspaper. The tombstone is released on the day following the offering to advertise that the stock issue has taken place.

Issuer risk

Substantial proceeds risk exists for the issuer from the time of the registration statement filing to the issue. During that time, market conditions may weaken which can reduce the demand for the new issue. This will affect the amount of capital the company can raise through the offering. ver. 1.0

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Underwriter risk

The underwriter incurs very little risk, because it purchases the shares from the issuer following the price-setting meeting, then sells them — usually within a few hours. In most cases, the underwriter pays the issuer a lower price per share than the underwriter receives from investors. This price difference is called the underwriter spread and is one of the ways an investment bank is compensated for its underwriting services.

Direct costs of the issue

In addition to the underwriting spread, a calculation of the net proceeds of an issue must account for other expenses associated with a firm commitment IPO. Direct costs include legal, printing, and auditing fees charged by the underwriter and its associates. These direct expenses range from about 2% to about 10% of gross proceeds, with an average of about 5%. Economies of scale exist for these expenses — the costs of larger issues are a smaller percentage of the gross proceeds. Investment banks in the United States usually charge underwriting fees ranging from 7% to 10% of the gross proceeds, with an average of about 8.5%. IPOs managed by foreign banks may have slightly higher expenses associated with a lower volume of deals. Best Efforts Offering

In a best efforts offering, the investment bank does not underwrite the issue, although the bank is still often referred to as the underwriter. Instead, the bank agrees to use its "best efforts" to sell the shares. More risk for issuer

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This arrangement exposes the issuer to more risk than the firm commitment. In a best efforts offering, the investment banker essentially acts as an advisor and a marketing agent. The company and the investment bank agree on an issuing price and a minimum and maximum number of shares to be sold. The investment bank tries to generate interest in the issue so that the issuing company can sell enough shares to meet its capital needs. Best efforts offerings are more common with smaller issues.

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Best efforts issuing process

The registration process for best efforts offerings is the same as for the firm commitment offering. Following approval by the appropriate government regulatory agency, the investment bank sets up an escrow account for potential investors. These investors deposit money in the account to reserve their shares.

Direct costs

The investment bank typically charges a commission (between 8% and 11%) on the shares sold in the offering, in addition to the other fees and expenses. This commission is often higher than the spread in a firm commitment offering. In some best efforts agreements, if the minimum number of shares is not sold in the prescribed amount of time, the offering is withdrawn and the investors' money is returned. The issuer does not receive any capital. This arrangement is similar to an all-or-nothing agreement (discussed below), but the minimum number of shares to be sold in the best efforts agreement is much smaller. Other best efforts agreements specify that the investment bank sell as many shares as possible (up to the maximum number specified). Other Offerings

Although firm commitment and best efforts are by far the most common types of IPOs, investment bankers and issuers sometimes use other, less common types as well. All-or-nothing offering

An all-or-nothing offering is a contract specifying that the investment bank will withdraw the offer if it is unable to place (sell) the issue. This is similar to a best efforts offering with a minimum acceptable percentage of shares to be sold. Some variations of the all-or-nothing offering will set a minimum acceptable percentage (such as 90%).

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Open-price offering

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An open-price offering is an arrangement where investors bid on the shares. The investment bank then places the offering with the investors who make the highest bids and work down until enough capital has been raised. Most open-price offerings will specify a minimum bid by investors. Open-price offerings are more common for companies that issue shares in several different markets at the same time. Pricing an IPO

Two pricing approaches

An IPO is often very difficult to price. The investment bank analyzes the potential investor market and attempts to estimate how much investors will be willing to pay for the shares. The investment banks use two approaches to estimate the price at which the share will be offered: 1. Comparable company analysis This approach involves analyzing the past performance of the IPOs of companies with a similar size and industry as the firm planning the IPO. The banks attempt to find pricing benchmarks based on historical data to help set the offering price of the new shares. This approach is very unscientific and often misleading. It is unlikely that there are other companies that may be compared to the company that is issuing the IPO. 2. Discounted cash flow analysis Discounted cash flow analysis is the major alternative to the comparable company analysis. We will present the framework for this analysis in Unit Three. The main idea, however, is to value the company by forecasting future cash flows to be generated by the company and discounting them using an appropriate discount rate.

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This approach is usually more scientific because it attempts to include several relevant variables in the analysis. However, there is no guarantee that it produces better results. Most experienced investment bankers use both methods to help set a range of prices for which shares may be sold. However, the best investment bankers develop a "feel" for the market; they seem to know what investors will buy and how much they are willing to pay. Some evidence exists that investment bankers may deliberately underprice an IPO. By underpricing the issue, investment bankers can limit their exposure to unsold shares. Issuers realize this and will negotiate a higher offer price to maximize their proceeds, while investment bankers will negotiate a lower offer price to limit their risk.

Seasoned Offerings Additional equity offering

Issuing process

Suppose that a company has successfully placed an IPO, and those shares are being traded in the equity market. Now, the company needs more capital and wants to raise it through an additional equity offering called a seasoned offering. The process of issuing additional shares is similar to an initial public offering.











The company chooses an investment bank to manage the offering. The company and investment bank draft a registration statement and file it with the appropriate government agency. The registration process is much easier to complete for a seasoned offering than for an initial offering because the publicly-traded company has already conformed to the requirements for information reporting. Its accounting systems provide the government agency and investors with the appropriate information. The investment bank encourages interest in the issue among potential investors. ver. 1.0

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As with an IPO, the investment bank charges fees for its services, and the company incurs other direct and indirect expenses in placing the issue. There are two types of seasoned offerings: a general cash offering and a rights offering. Let's look at the differences between these two types of offerings and explore the impact of the additional share offering on the current shareholders.

General Cash Offering All potential investors

If a company offers the additional shares to all potential investors (not just current stockholders), the offering is called a general cash offering. The shares are sold to investors using the same methods as for the initial public offering.

Direct costs

Typical general cash offerings incur direct administrative expenses of approximately 1.5% of the offering, and the investment banker's spread averages about 5%. A lower percentage of the total issue amount is charged for larger issues, indicating economies of scale in the costs of issuing the equity.

Indirect costs

An indirect cost of a seasoned offering results from the tendency of the stock price to fall when the offering is announced. This price change may range from 2% to 6% of the total value of the firm. Two theories have been proposed to explain this phenomenon. One theory is that company managers are more likely to issue additional stock when the current stock is overvalued — they try to take advantage of the mispricing in order to maximize the capital raised by the firm. Investors believe that a general cash offering is a signal that the shares are overpriced. Another theory is based on the idea that a stock issue announcement indicates that the company is having cash flow problems and needs to raise capital that doesn't require interest payments. Since equity issues do not require any interest payments (and debt issues do), investors view the stock issue as a sign of problems.

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Whatever the cause for the stock price falling when a general cash offering is announced, a company needs to account for this indirect cost when planning its capital needs. Example

Let's analyze an example that illustrates the economic effects of a general cash offering on the existing shareholders. In this scenario, KWM Corporation has:




2 million shares outstanding A total shareholder value of $80 million A price per share of $40

The firm would like to raise $10 million in equity capital to help fund a new line of business. Without direct / indirect costs

If there were no direct issuance costs or indirect costs resulting from market reaction to the announcement, the firm would simply sell 250,000 new shares on the open market at the market price of $40 to raise the $10 million (250,000 x $40 = $10,000,000). After the issue, the total shareholder value of the firm would be $90 million (2.25 million shares x $40 per share). The wealth of the shareholders would remain constant — each share still would be worth $40.

Real-world example

In the real world, this process is more complicated. Let's continue with KWM Corporation in a more realistic situation. KWM still needs to raise $10 million in equity, but its investment bank will charge a $200,000 fee plus a 5% spread on the issue proceeds. The company also expects the total value of its shares to fall 3% on the day that the issue is announced. How many shares will KWM have to sell to cover the direct and indirect cost of the issue and still have $10 million to fund their new business project?

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Calculate gross proceeds

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The first step is to calculate the gross proceeds needed to cover the direct costs of issuing the equity. To find the gross proceeds, divide the net proceeds desired by 1 minus the spread and add any other direct costs to the total. For this example, the calculation is: Gross proceeds = [(Net proceeds) / (1 – Spread)] + Other direct costs = [($10 million) / (1 – 0.05)] + $200,000 = $10,726,315

KWM Corporation needs to raise gross proceeds of $10,726,315 to cover the direct and indirect cost of the issue and still have $10 million to fund its new project. Determine correct issue price

The next step is to determine the correct issue price. To interest investors in purchasing the shares, the company must offer them at a price that will be their value after the transaction, not at the market price before the issue. The new price will be lower than the current market price, reflecting the direct transaction costs and the indirect costs resulting from market reaction to the issue. To calculate the appropriate issuance price, we begin with this formula: Price x Quantity = Gross proceeds

Since we have already calculated the gross proceeds of the issue ($10,726,315), we need to find the quantity of new shares (N) necessary to meet KWM's needs. Then, we can calculate the price of KWM shares in the market after the issue. The price of the shares is found by dividing the total shareholder value of the company by the total number of shares outstanding.

Price of shares

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In this example, the price is calculated as:

Price of shares

=

(0.97 x $80 million) + ($10,726,315 - 726,315) _______________________________________ (2,000,000 + N)

The 0.97 x $80 million represents the effect of the indirect costs of the issue on the total shareholder value before the issue (recall the 3% loss of shareholder value that is expected to occur when the issue is announced). Gross proceeds of the issue are $10,726,315. Of the gross proceeds, $726,315 will go to the investment bank to pay its fees and expenses. Net proceeds to be added to the firm's value are $10 million. The denominator is the total number of outstanding shares after the offering (2,000,000 + N). N is the number of shares issued in the general cash offering. If we plug the price expression into the original formula, the calculation is: PRICE

x

QUANTITY

= PROCEEDS

(0.97 x $80 million) + $10,726,315 – $726,315 ________________________________________ (2,000,000 + N)

x

N

= $10,726,315

Using algebra to solve for N, we find that the company needs to issue 279,063 new shares to raise the necessary gross proceeds. The price of the new shares (also the market value of the shares after the issue) can be found by plugging 279,063 into the "N" part of the price calculation: (0.97 x $80 million) + $10,726,315 – $726,315 ________________________________________ (2,000,000 + 279,063)

=

$38.44

We can confirm our calculations by dividing the gross proceeds by the number of new shares issued. This tells us that we have issued the correct number of shares at the correct price. $10,726,315 / 279,063

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Assessing total costs

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Now that KWM has determined the gross proceeds, issue price, and number of shares to issue, the company will look at the total cost of the offering. This figure can be important when a company is deciding between different investment banks or alternative sources of capital. The total cost includes both the direct costs charged by the investment banker and the indirect costs resulting from the market reaction to the announcement of the new issue. You can calculate the total cost of the offering by subtracting the value of the firm with the issuance costs from the value of the firm without those costs. Without the transaction costs, the firm value would be the original $80 million plus the gross proceeds. The new firm value is the price per share multiplied by the total number of shares (the original 2,000,000 shares plus the 279,063 new shares offered). The calculation for total cost is: Total cost

= =

($80 million + 10,726,315) – ($38.44 x 2,279,063) $3,118,941

A key point to remember is that investors who purchase the new shares will receive equal value for their investment. They will pay $38.44 per share for shares that are worth $38.44. However, the original shareholders will experience a decrease in value. They hold shares that were worth $40 per share before the issue. Now those same shares are worth $38.44. The amount of that erosion is equal to the issuance costs, both direct and indirect. In our example, those costs are $1.56 per share.

Rights Offering Preserves ownership positions of shareholders

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The second type of seasoned offering is a rights offering, which gives the existing shareholders a preemptive right to buy the new equity securities. Companies allow current shareholders the first right to purchase the new equity so that their holdings are not diluted. Rights offerings are more common in European and other markets than in U.S. markets.

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Example

ISSUING EQUITY SECURITIES

Let's look at an example that illustrates the concept of diluting shares of current stockholders. Consider a company with 4 million outstanding shares of common equity. One particular investor, a mutual fund, owns 200,000 shares of the company, which represents a 5% ownership share in the firm. The company issues 500,000 new shares and the mutual fund is not able to purchase any. Therefore, after the issue, the fund's 200,000 shares represent only a 4.44% ownership in the firm. This is referred to as "dilution of ownership in the firm."

Preserves shareholder earnings

The mutual fund also may experience a dilution of earnings. If the earnings of the company increase in proportion to the new capital added to the firm, then the mutual fund will earn the same rate of return on its investment. If the earnings on the new capital investment do not measure up to prior investment, the mutual fund will earn less on its investment because the new earnings must be spread over more shareholders (500,000 new shares).

Direct costs

The direct costs of a rights offering are usually much less than those of a general cash offering because the existing shareholders are already familiar with the company and its operations. The investment bank may only serve as a standby underwriter in case the shares are not all sold. The direct costs of a rights offering without a standby underwriting facility are usually 0.05% to 0.5% of the issue proceeds. The fee for a standby underwriter is usually a fixed amount and the underwriter agrees to purchase the unsold shares at a small discount. This protects the issuer in the event that the share price falls below the subscription price. Approximately two-thirds of all rights offerings are underwritten. If the issue is not underwritten, the subscription price is set low enough so that the share price is not likely to fall below it. This method is less expensive, but riskier than an underwritten rights offering.

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Indirect costs

The indirect costs for a rights offering are similar to a general cash offering. Most issue announcements are met with a 3% to 4% fall in the share price of the existing shares. Theories explaining price decreases are much the same as for the general cash offering.

Issue process

The process for selling shares in a rights offering is as follows:





The existing shareholders are usually sent one right for each share owned. A certain number of these rights (10 or 20, for example) allows the investor to purchase one additional share at a predetermined subscription price. This method is known as a "New York" rights offering, and is commonly used in the United States. In a "Philadelphia" rights offering, shareholders receive one right for some multiple number of shares owned. Philadelphia rights offerings are common in the United Kingdom.




Investors either redeem the rights or sell them to other investors. The subscription price is usually lower than the price at which the existing shares are trading. This provision gives the rights a stand-alone value, which encourages investors to either exercise the rights or sell them to investors who will exercise them. These rights often trade in public markets, so that current shareholders can either redeem them for the additional shares or sell them in the market and accept the dilution.

Because the company issues the shares for a lower price than the current market price, the market price will fall to somewhere between the old share price and the subscription price. This occurs as the total firm value increases with the new equity capital and the number of outstanding shares also increases.

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PRIVATE PLACEMENT

As an alternative to selling equity in the public markets, a company may place its shares directly with private investors. This method is called a private placement. Participants

The firms that use private placement are usually small, tightly-held companies in the high-growth and high-risk stage of their development. Firms can sell their equity shares only to investors who meet regulatory requirements concerning net worth and investment sophistication. Investors traditionally have been small groups of high net-worth individuals or small venture capital firms. Recently, with the passage of the SEC's Rule 144A in the U.S., institutional investors have begun to participate in the private placement market.

Ownership sold at a discount

Regulations tightly restrict the resale of shares to other investors after purchase. To compensate for the lack of liquidity and higher risk, investors purchase the shares at a lower cost (usually some percentage discount) than if the shares were offered on the public markets. The ownership of the company must be sold at a discount to attract the necessary capital. This is a big disadvantage for the original owners (shareholders) of the firm.

Issue process quicker and less costly

One advantage of private placement for the company is that it can avoid the costly and time-consuming process of registering the offering with the government regulatory agency. Because it is not underwritten, the issue does not require a formal prospectus and other documents. The investment bank's fees and expenses are much less for a private placement than for a public offering, sometimes as much as one-tenth of the cost. The entire procedure is much quicker and less costly than a public offering.

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Transaction volume

Private placement equity is a small percentage of the total value of equity sold in the public markets. Some analysts estimate that private placements make up only 7% of the total dollar value of common stock issues. Because private placement issues are not registered, this is a difficult estimate to make. In the U.S. market, the Securities and Exchange Commission (SEC) Regulation D outlines the regulation of private placement of equity.

SEC Rule 144A

One recent development in the U.S. private placement market is the passing of Rule 144A by the SEC. When compared to the financial reporting requirements for a public offering, this rule is less demanding of issuers — thus resulting in lower issuing costs. The rule specifies that equity shares can be placed only with qualified institutional buyers that meet a minimum requirement of $100 million in investment securities holdings. Rule 144A securities must be nonfungible (not listed on an exchange or quoted on NASDAQ). The rule creates liquidity in the private placement market by allowing the securities to be traded among qualified institutional buyers. Before Rule 144A, privately-placed securities could not be traded for a period of two years following issue. Rule 144A has allowed many foreign companies to raise equity in the U.S. market at a lower cost than they would have incurred with a public listing on one of the exchanges. It also has allowed many institutions with an appetite for foreign equity to purchase those securities.

UNIT SUMMARY

In this unit, you learned about the different ways a company can issue equity securities. A company may offer its securities publicly to all participants in the market or choose to sell its securities privately to a predetermined group of investors. The chart below provides an overview of some of the key features of each method for issuing equity securities.

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ISSUING METHOD

KEY FEATURES

ADVANTAGES

DISADVANTAGES

PUBLIC PLACEMENT Initial Public Offering




Privately-held company "goes public"

1. Firm commitment




Investment banker underwrites




Investment banker guarantees net proceeds




Proceeds unsure from registration to pricing meeting

2. Best efforts




Investment banker as advisor and marketing agent




Investment banker advises on price and encourages investor interest




Greater proceeds risk than firm commitment

Seasoned Offering




Public company issues additional shares




Issue process easier to complete than IPO

1. General cash offering




New shares offered to all investors




Larger pool of investors




Indirect costs of 2-6% decline in firm value

2. Rights offering




New shares limited to current shareholders




Current shareholders can avoid dilution




3-4% decrease in stock price




Sold only to qualified investors




Issue process faster and less costly for company




Company sells ownership at a discount




Investors can purchase shares at lower cost




Limited liquidity

PRIVATE PLACEMENT

We also looked at each step in the process of raising equity capital. In a public placement, companies must:


Select an investment banker




Register with the appropriate government regulatory agency




Generate investor interest in the issue




Set the subscription price prior to selling the equity issue

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For initial public offerings, the underwriter and the company negotiate the issue price. In setting the price of a seasoned offering, companies must account for the effect of the issue announcement on the price of shares currently trading. Private placements with qualified institutional investors offer the advantage of being faster and less costly because the issue is not underwritten and the company does not have to register the issue with a regulatory agency. In the next unit, we will direct our focus from the issuing company to the investor's point of view. We will explore the question, "How do we place a value on a company's equity securities?"

Please check your comprehension of the concepts presented in Unit Two by completing the Progress Check that follows. If you miss any question, we suggest that you review the appropriate text. Then, continue to the third and final unit of this course, Valuing Equity Securities.

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✔ PROGRESS CHECK 2 Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page.

Question 1: The major difference between a firm commitment initial public offering and a best efforts IPO is the: _______a) role of the investment bank in bringing the issue to investors. _______b) underwriting process for each type of offering. _______c) efforts of the investment bank to sell the underwritten shares. _______d) process of registering the offering with the appropriate government regulatory agency.

Question 2: In a rights offering, the first option to purchase the newly-issued shares is granted to: _______a) all investors in the market. _______b) new market investors. _______c) qualified institutional buyers. _______d) the original shareholders.

Question 3: ABC investment bank circulates a preliminary prospectus about a computer company's initial public offering in order to: _______a) register the issue with the regulatory agency. _______b) advertise that the stock offering has taken place. _______c) gauge the strength of investor demand for the issue. _______d) inform investors about the issue's price per share.

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ANSWER KEY

Question 1: The major difference between a firm commitment initial public offering and a best efforts IPO is the: a) role of the investment bank in bringing the issue to investors.

Question 2: In a rights offering, the first option to purchase the newly-issued shares is granted to: d) the original shareholders.

Question 3: ABC investment bank circulates a preliminary prospectus about a computer company's initial public offering in order to: c) gauge the strength of investor demand for the issue. The preliminary prospectus contains no financial information about the issue. Underwriters use the preliminary prospectus at their "road shows" to generate interest in the issue and get an idea about the strength of investor demand.

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PROGRESS CHECK 2 (Continued)

Question 4: A computer company is in the process of a firm commitment IPO. ABC investment bank has completed its information meeting with investors, and the company and the underwriter have received approval for the issue from the regulatory agency. What is the next step in the issuing process? _______a) Hold a pricing meeting _______b) Place a tombstone _______c) Draft a letter of intent _______d) Sell the issue to investors

Question 5: Alpha Corporation just announced a general cash offering to raise additional equity for its operations. Its stock is currently trading at $50 per share. The new issue will trade at: _______a) a price that is higher than $50. _______b) a price that is lower than $50. _______c) exactly $50. _______d) a price that may be higher or lower than the current market price, depending on expectations of future market conditions.

Question 6: The indirect cost associated with a seasoned offering is the result of the: _______a) fees and expenses associated with bringing an equity offering to market. _______b) difference between the price at which the stock is purchased from the company and the price at which it is sold to investors. _______c) tendency of the price of the stock to fall when the offering is announced. _______d) undervaluation of the current stock.

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ANSWER KEY

Question 4: A computer company is in the process of a firm commitment IPO. ABC investment bank has completed its information meeting with investors, and the company and the underwriter have received approval for the issue from the regulatory agency. What is the next step in the issuing process? a) Hold a pricing meeting This meeting is usually held a day or two after the notification of approval by the agency and after the underwriter has determined what can be sold at which price through the "road shows" conducted with investors.

Question 5: Alpha Corporation just announced a general cash offering to raise additional equity for its operations. Its stock is currently trading at $50 per share. The new issue will trade at: b) a price that is lower than $50. The stock price tends to fall when a seasoned offering is announced. In order for investors to purchase the shares, Alpha Corporation must offer them at their value after the announcement, not at the market price before the issue.

Question 6: The indirect cost associated with a seasoned offering is the result of the: c) tendency of the price of the stock to fall when the offering is announced.

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PROGRESS CHECK 2 (Continued)

Question 7: Investors that participate in a private placement: _______a) belong to a small group of average investors that require low-risk investments. _______b) prefer not to be identified by government regulatory agencies. _______c) purchase shares at a lower cost to compensate for low liquidity and higher risk. _______d) cannot trade the securities for a period of two years following the issue.

Question 8: Select four issues regarding the private placement market that are addressed by Rule 144A. _______a) Minimum reporting requirements for issuers _______b) Maximum size for issuers _______c) Restrictions on listing securities on public exchanges _______d) Trading of securities among qualified institutional buyers _______e) Restriction preventing foreign countries from raising equity in the U.S. _______f) Minimum number of years that securities must be held before they may be traded _______g) Minimum size for qualified institutional buyers

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ANSWER KEY

Question 7: Investors that participate in a private placement: c) purchase shares at a lower cost to compensate for low liquidity and higher risk.

Question 8: Select four issues regarding the private placement market that are addressed by Rule 144A. a) Minimum reporting requirements for issuers c) Restrictions on listing securities on public exchanges d) Trading of securities among qualified institutional buyers g) Minimum size for qualified institutional buyers

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Unit 3

UNIT 3: VALUING EQUITY SECURITIES

INTRODUCTION

Having issued securities on the equities markets, companies must track the value of their stock. Investors also need to estimate the value of equity securities to make educated investment decisions. A variety of techniques are available for estimating the value of equity securities. In this unit, we demonstrate the most commonly used methods for estimating the value of equity and discuss their relative strengths and weaknesses. We also introduce some methods used in estimating the value of preferred shares.

UNIT OBJECTIVES

When you complete Unit Three, you will be able to:


Recognize the advantages and disadvantages of common valuing methods




Calculate the value of equity securities using ratio valuation methods




Complete a sample analysis using the discounted cash flow valuation technique

COMMON EQUITY Three valuing methods

There are three standard methods for estimating the value of common equity. They are: 1. Ratio valuation 2. Relative valuation 3. Discounted cash flow valuation

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Preferred method

VALUING EQUITY SECURITIES

Most investment analysts consider the discounted cash flow method to be the best method for estimating the value of a company or for estimating the value created by a potential project. By focusing on cash flows rather than net income or other values, the analyst eliminates the bias incurred by various accounting conventions. Discounted cash flow analysis also attempts to account for risk, whereas other methods do not. We will come back to a discussion of discounted cash flow analysis after we look at the two alternative methodologies. Many managers, especially those without a strong analytical background, still use ratio and relative valuation methods. While not as comprehensive as discounting cash flows, these methods can be good "first-cut" types of analyses (a quick, back-of-the-envelope calculation) that will give you a beginning point for comparison. Let's begin with ratio valuation.

Ratio Valuation Data easy to obtain

Using price-to-characteristics ratios to estimate the value of common stock is very popular. You can find the data needed to calculate ratios in the financial statements of the company, which are published in the annual report. Most of the calculations are simple and straightforward. We will describe the following ratios:


Price / earnings ratio




Market / book ratio




Dividend valuation




Other price-to-characteristics ratios

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Price / Earnings Ratio

The price / earnings ratio gives information about the value the market attaches to the earnings of a company. The formula for calculating the price / earnings (P/E) ratio is: P/E = (Market price per share) / (Earnings per share)

Description and uses of P/E ratio

The P/E ratio shows how much investors are paying for each dollar of income generated by the firm. High P/E ratios indicate that investors are very optimistic about the future prospects of the company. They are willing to pay more for the current earnings of the firm because they feel that the future earnings will be even higher. Likewise, lower P/E ratios indicate less optimism for the company by investors. Analysts often use P/E ratios to compare companies as potential investment opportunities. It is appropriate to compare companies within the same industry because of their similar structure and operations. For example, analysts would compare the P/E ratios of Ford Motor Company and General Motors as part of their analysis. They would not compare the P/E ratio of Ford with the P/E ratio of IBM.

Disadvantage of P/E ratio

The problem with using P/E ratios to make investment decisions is that the analysis is short-sighted. For example, some investors believe that by choosing companies with lower P/E ratios, they are getting a bargain. If two similar companies are being considered and one has a P/E ratio of 8, and the other has a P/E ratio of 12, investors probably will choose the company with a P/E of 8 because they will pay less for each dollar of income generated by the company. However, the company with a P/E of 12 may still be a better investment because of its future earnings potential. The P/E ratio is based on the most recent earnings figure, not the future earnings potential; therefore, it can be short-sighted when used as the only investment criterion.

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VALUING EQUITY SECURITIES

Market / Book Ratio

The market / book ratio relates the market price of the shares with the book value of the company on a per share basis. The formula is: Market / Book = (Market price per share) / (Book price per share)

Description and uses of market / book ratio

This ratio describes how much investors are paying for the company divided by the value of the company according to accounting methods. In other words, the market / book ratio gives a multiple of the market price of the company in relation to its book value. Some investors consider the book value as the floor for the market price of the company. They feel that if the market value ever falls below the book value, the company can sell off its assets at book value to maintain its price. Those investors may also argue that low market / book ratios indicate the company is a safer investment; but the book value may not be the price the company could get by selling off its assets.

Disadvantage of market / book

The market / book ratio is even less useful as a stand-alone tool than the P/E ratio. Problems occur even when comparing companies in the same industry. Most accounting conventions require that assets be carried at their historical cost on the books. It can be difficult to find a company with similar operations and similar assets to serve an appropriate point of comparison. Companies with older, less-costly assets will have lower market / book ratios than similar companies with newer, more modern assets (all other factors being equal). However, some less-sophisticated investors continue to use the market / book ratio as a major investment decision-making tool. The sophisticated analyst uses the information from this ratio as part of a more thorough analysis.

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Dividend Valuation Firm value based on dividend payments

If a company pays a regular dividend, analysts can estimate the firm value based on those dividend payments using the dividend valuation ratio. There are two ways to estimate the value, depending on whether we assume that the dividends paid on the common stock are a perpetuity or a growing perpetuity. The ratio for estimating the value of common stock as a perpetuity is: V

=

D/R

Where: V = Value of common stock D = Recent dividend payment R = Estimated discount rate

The growing perpetuity formula is: V

=

D1 / (R – G)

Where: V = Value of common stock D1 = Expected dividend in the next period, calculated as D1 = D x (1 + G) R = Estimated discount rate G = Estimated dividend growth rate

Notice that both ratios require an estimated discount rate. That rate is the investor's required rate of return or the earnings an investor expects to make on an equity investment. Disadvantages

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If a company does not pay dividends, or if our assumptions concerning future dividends do not fit a perpetuity, then this method is of little value. For example, if a company is very erratic in its dividend payments, then the assumption of a dividend perpetuity may not be valid.

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Other Price-to-characteristics Ratios Additional methods to analyze a company

There may be other price-to-characteristics ratios that can help the analyst understand a company or industry. For example:


A price-to-revenues ratio may provide insight into how much investors are paying for the revenues being generated by the company.




The price-to-EBITD (Earnings Before Interest, Taxes, and Depreciation) ratio shows how much value market investors place on the earnings (without interest payments, taxes, and depreciation) of the company.




The price-to-cash flow ratio relates the price of the firm to the cash flow generated by the firm.

The calculation of these ratios is similar to the P/E ratio (price per share divided by EBITD or cash flow). Ratio based on operating statistic

Many analysts develop ratios that correspond to some type of operating statistic of the company or industry. For example, analysts studying the computer software industry, or other service-type industries, often want to evaluate how efficiently a company's employees are generating revenues or earnings. Since ratios focusing on fixed assets provide little information (these companies do not have many fixed assets), they use ratios that divide a company's revenues or earnings by the number of employees. Sometimes they are even more specific and relate revenues to the number of programmers (or another specific type of employee important in that industry). This allows a comparison between firms of different sizes competing in the same industry and tells the analyst which firms are using their employees to generate revenues (or earnings) most efficiently. Every industry has corresponding measures that analysts use to understand how well companies are performing.

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Relative Valuation Data difficult to obtain

Relative valuation methods provide information about a company relative to other companies in the same industry. Most of these valuation methods provide an estimate of the entire firm value. By dividing the firm value by the number of shares outstanding, the analyst can find per share value estimates. These methods of valuation often require that the analyst be very familiar with the operations of a particular company and its industry. The information needed to make these kinds of estimates is usually not readily available to most investors. In this section, we describe:


Liquidation value




Asset-based valuation

Liquidation Value Description and uses

If a company sells all of its assets and uses the proceeds to pay its creditors, the liquidation value is the amount left to distribute to shareholders. Analysts often consider the liquidation value to be the floor price of the stock. If the stock price falls below this value, investors are better off having the company liquidated. Corporate raiders often use liquidation value as a criterion to evaluate potential takeovers. They may notice that a stock price is less than the liquidation value on a per share basis and will make an offer for all of the stock of the company. The raider then gains control, sells off the assets, and pays the creditors. The value remaining represents the raider's gain (less the original investment).

Disadvantages

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However, it may be very difficult to estimate the liquidation value of a company. This is especially true if there is little or no market for the assets of the company. The analyst must have a thorough understanding of the company and its industry to make an accurate estimate of the company's liquidation value.

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Asset-based Valuation Description and uses

Some analysts may want to value the individual assets of a company at a market price according to the cash flow generated by the asset groups. They often use the asset-based valuation method for companies with several different operations. For example, consider a media company that owns television stations, radio stations, some newspaper publishers, and a book publisher. The market most likely will value earnings from each business at a different P/E ratio. An analyst with access to a breakdown of the cash flow generated by each unit may discover that one unit is undervalued. This unit will be worth more to other investors as either a stand-alone entity or as part of another company. Spin-offs, mergers, and acquisitions are often motivated by this type of asset valuation.

Discounted Cash Flow Valuation The discounted cash flow method involves a more detailed analysis than ratio and relative valuation methods. It requires the investor or analyst to make several assumptions about the future prospects of the company being analyzed. We will briefly describe the four-step process: Four-step process

1) Forecast cash flows

2) Estimate cost of capital 3) Estimate residual value 4) Discount cash flows

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Forecast Cash Flows Project cash flows based on assumptions

The first step in discounting cash flow is to develop a set of projected cash flows for an appropriate time frame based on certain assumptions. Usually the analysts' sense of the accuracy of their estimates and assumptions will dictate the time frame used for the analysis. That may be somewhere between three and twenty-five years.

Example

Figure 3.1 is an example of how assumptions for five years may be organized for XYZ Corporation. ASSUMPTIONS: Year

1 i

2 i

3 i

4 i

5 i

4.00%

4.00%

4.00%

4.00%

4.00%

(A)

Sales Growth

(B)

Profit Margin Incremental Net

12.00%

12.00%

12.00%

12.00%

12.00%

(C)

Cash Income Tax

35.00%

35.00%

35.00%

35.00%

35.00%

(D)

Incremental Working Capital Investment

13.00%

13.00%

13.00%

13.00%

13.00%

(E)

Fixed Asset Investment (% of Sales Increase)

18.00%

18.00%

18.00%

18.00%

18.00%

Figure 3.1: Assumptions for Forecasting Cash Flows

Begin with most recent sales figure

The most common procedure for estimating cash flows begins with the most recent sales figure. The analyst then estimates future sales based on an assumed revenue growth rate (A). Next, the analyst makes assumptions about the projected profit margin of the firm (B) and estimates a future cash tax rate (C). The analyst also makes assumptions about the company's future investment in working (D) and fixed (E) capital assets. An analyst with access to this information will use the company's actual projected figures. Analysts outside the firm will make an estimate based on the investment rates as percentages of incremental sales. Having completed the set of assumptions, the analyst is ready to forecast future cash flows for XYZ Corporation. Based on the assumptions in Figure 3.1, estimated cash flows for each of the five years are shown in Figure 3.2.

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ESTIMATES: Year (Figures in Millions)

1 i

2 i

3 i

4 i

5 i

$104.00

$108.16

$112.49

$116.99

$121.67

12.48

12.98

13.50

14.04

14.60

Cash Income Taxes

4.37

4.54

4.72

4.91

5.11

EBIAT

8.11

8.44

8.77

9.12

9.49

Fixed Capital Investment

0.72

0.75

0.78

0.81

0.84

Working Capital Investment

0.52

0.54

0.56

0.58

0.61

Free Cash Flow

6.87

7.15

7.43

7.73

8.04

Sales Operating Profit

Figure 3.2: Five-year Cash Flow Forecast

Use assumptions to estimate cash flow

Let's look at how the analyst in the example used the assumptions to calculate the cash flow for Year 1. Sales for the past year (Year 0) totaled $100 million. Sales

= Sales for Year 0 (1 + Forecast growth rate) = $100 million x (1.04) = $104 million

Operating Profit

= Sales x Expected profit margin = $104 million x 0.12 = $12.48 million

Income Tax

= Operating profit x Tax rate = $12.48 million x 0.35 = $4.37 million

EBIAT (Earnings before interest after taxes)

= Operating profit – Taxes = $12.48 million – $4.37 million = $8.11 million

If analysts do not have access to exact figures from the company's fixed capital and working capital investment plans, they must make estimates. As mentioned earlier, a common method is to assume a certain investment rate based on the incremental increase in sales. Analysts usually base their assumptions on a careful study of the company's past investment patterns.

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In our example, the Year 1 sales increase is $4 million ($104 million $100 million). The analyst expects the firm to invest 13% of each year's sales increase in working capital and 18% in fixed capital assets. This is the investment net of depreciation. The calculations for investments in Year 1 are: Fixed Capital Investment = Incremental sales increase x Fixed asset investment rate = $4 million x 0.18 = $0.72 million Working Capital Investment = Incremental sales increase x Working capital investment rate =

$4 million x 0.13

=

$0.52 million

Now we calculate the cash flow. Projected Cash Flow =

EBIAT – (Fixed + Working capital investment)

=

$8.11 million – ($0.72 million + $0.52 million)

=

$6.87 million

The estimated cash flow for XYZ Corporation for Year 1 is $6.87 million.

Estimate Cost of Capital Find the discount rate

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The next step in the discounted cash flow valuation is to estimate the cost of capital for the firm. This is the required rate of return that the firm must earn for its investors to properly reward them for the risk they take by investing in the company. It is the rate that will be used to discount the projected cash flows to calculate the present value of the company.

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Weighted average cost of capital

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The best method for estimating the cost of capital is by using the weighted average cost of capital. This method accounts for each source of capital (debt, preferred stock, and common equity) and the cost associated with its use. The formula for calculating the weighted average cost of capital is:

ka = Wd kd (1 - T) + Wp kp + We ke Where: ka

=

Weighted average cost of capital

Wd

=

Percentage of capital using debt

kd T

=

Cost of debt

=

Marginal tax rate of company

Wp

=

Percentage of capital using preferred stock

kp We

=

Cost of preferred stock

=

Percentage of capital using equity

ke

=

Cost of equity

Debt

The formula multiplies the cost of each source of capital by its relative weight in the capital structure of the firm. It adjusts the cost of debt for the tax-deductibility of interest payments by multiplying k by one minus the tax rate. Analysts estimate the cost of debt as the interest rate that the company will pay on new debt.

Preferred stock

Preferred dividends are divided by the price of the preferred shares to calculate the cost of preferred shares. This gives an estimate of the rate of return that preferred shareholders are earning on their investment.

Common equity

To estimate the cost of common equity, many analysts use the capital asset pricing model. Another method commonly used is dividend valuation. For a more in-depth discussion on the weighted-average cost of capital and the capital asset pricing model, consult any corporate finance textbook.

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Example

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To continue our example of XYZ Corporation, suppose that the cost of debt is 6.0%, the cost of preferred stock is 8.5%, and the cost of common equity is 13.0%. The expected capital structure is 40% debt, 10% preferred equity, and 50% common stock. The cash tax rate is expected to be 35%. You can estimate the weighted average cost of capital as follows: ka

=

Wd kd (1 - T) + Wp kp + We ke

ka

=

(0.40)(0.06)(1 - 0.35) + (0.10)(0.085) + (0.50)(0.13)

ka

=

0.0891 or 8.91%

The required rate of return for investors (discount rate) is 8.91%. Estimate Residual Value

The third step in the discounted cash flow valuation is to calculate the residual value. Residual value is the estimated value of the company at the end of the forecasted periods. Based on liquidation value

There are several methods that can be used to make this estimate. If the analyst knows that the company will be terminated at the end of the forecast, the analyst may want to use an estimated liquidation value of the assets or an estimated price at which the company may reasonably be sold at that time.

Based on returns matching cost of capital

If the analyst expects that the company will continue to operate and generate cash flows for the investors, the analyst will want to make a different estimate. One method is to assume that the company will continue to earn a rate of return that matches the cost of capital invested in the company. Under this assumption, the value of the company is:

Residual value = (EBIAT) / ka Where: ka = Weighted average cost of capital

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The convention is to use the earnings before interest after taxes (EBIAT) for the last forecasted year, divided by the average cost of capital (discount rate) for that year. By using this method, the analyst makes the implicit assumption that the company is not creating (or destroying) any value for the shareholders of the company. All investors (debt, preferred, and common) are earning their expected rates of return by investing in the company. Based on returns above cost of capital

Some companies may anticipate that they will continue earning returns above their cost of capital after the forecast period. In these cases, a growing perpetuity method may be appropriate for estimating the residual value. The formula for placing value on a growing perpetuity is:

Residual value = [EBIAT x (1 + g)] / (ka - g) Where: g = Expected growth rate ka = Weighted average cost of capital

One important thing to remember when using this method is that the cost of capital must be larger than the expected growth rate. Example

We want to estimate the residual value of XYZ Corporation at the end of five years. Let's assume that the residual value is a perpetuity of $9.49 million (Year 5 earnings before interest after tax). We can use our formula to estimate the residual value with a weighted average cost of capital of 8.91%. Residual value

= =

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($9.49 million) / (0.0891) $106.51 million

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Discount Cash Flows

The final step is to discount the projected cash flows, including the residual value, to a present value using the weighted average cost of capital (discount rate). In Figure 3.3, we discount the cash flows of XYZ Corporation and calculate the firm's present value:

Year

Cash Flow (Millions)

Present Value Factor*

Present Value (Millions)

1

6.87

1/(1.0891)1

6.31

7.15

1/(1.0891)2

6.03

7.43

1/(1.0891)3

5.75

7.73

1/(1.0891)4

5.49

8.04

1/(1.0891)5

5.25

106.51

1/(1.0891)5

69.51

Total Firm Value

98.34

2 3 4 5 Residual Value

* Present Value Factor = 1 / (1 + Weighted Average Cost of Capital)T

T = Year

Figure 3.3: Present Value of XYZ Corporation

Find value of common equity

This discounting process gives us the total present value of the company — based on our earlier assumptions concerning growth, investment, and cost of capital. To find the value of the common equity, we deduct the value of the debt and the value of the preferred stock. In our example, the company has approximately $35 million in debt and $8 million in preferred stock on its books. Thus, the value of the common equity is $55.34 million ($98.34 million – $43 million). If the company has 2.5 million shares of common stock outstanding, we can divide the value of the equity by the number of shares to get the firm value on a per share basis ($55.34 million / 2.5 million = $22.14 per share).

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For further details about any of the steps, or for more comparisons between discounted cash flow valuation and other methods, consult any corporate finance textbook.

PREFERRED EQUITY Perpetuity method

The most common method for estimating the value of preferred shares is to use a perpetuity method. The dividend paid on each share is considered a perpetuity. We can estimate the value of the preferred shares by dividing the dividend by the investors' required rate of return. The formula is:

Value = Dividend / Discount rate

Example

If we know that a company pays a yearly dividend of $6.25 on its preferred shares and that an investor can earn an 8.5% rate of return on investments with similar risk, then we can estimate the value of the preferred shares. Value

= =

$6.25 / 0.085 $73.53

This means that an investor with a required rate of return of 8.5% would be willing to pay $73.53 for a preferred share that pays a $6.25 yearly dividend. Estimating cost of preferred shares

Analysts use this same relationship to estimate the cost of preferred shares when trying to find the weighted average cost of capital. The analyst will have access to the dividend and price per share information, and will solve the equation for the discount rate (which represents the cost of the preferred stock to the company).

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For example, suppose that a company has preferred shares that are currently selling for $43.50 and pay a yearly dividend of $4.80. The cost of the preferred shares can then be estimated. Discount rate

= = =

Dividend / Share price $4.80 / $43.50 0.1103 or 11.03%

UNIT SUMMARY

In this unit you were introduced to a variety of methods investors and financial analysts use to estimate the value of common and preferred equity. To value common equity, you learned several quick analysis calculations that give the analyst a beginning point for comparison. These include: Ratio Valuation


Price / earnings ratio




Market / book ratio




Dividend value




Other price-to-characteristics ratios

Relative Valuation

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Liquidation value




Asset-based valuation

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For a more sophisticated analysis, analysts use the discounted cash flow method. Following a simple example, we looked at each of the four steps in this process: 1. Forecast cash flow 2. Estimate cost of capital 3. Estimate residual value 4. Discount cash flows You also learned a commonly-used perpetuity method for estimating the value of preferred shares.

Congratulations! You have completed the final unit of Equity Financing. You should now have a better understanding of equity as viewed by the issuer as well as the investor. You have learned to recognize types of equity instruments and characteristics of equity markets and the market participants. You also were introduced to issuing processes for publicly- and privately-placed equity securities, direct and indirect costs associated with various types of equity issues, and various techniques for estimating the value of equity securities. This will prepare you for further study and application of equity as a financing alternative for companies attempting to raise capital for their operations. Now you are ready to complete the final Progress Check. If you answer any questions incorrectly, please reread the appropriate text.

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✔ PROGRESS CHECK 3 Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page.

Question 1: JB Company has 5.4 million shares outstanding at a market price of $27.50. Last year, JB Company had earnings of $11.6 million. What is the P/E ratio for JB Company? ____________________________

Question 2: Which of the following is a disadvantage of using P/E ratios to make investment decisions? _____a) The information needed to calculate this ratio is not readily available. _____b) It is difficult to find companies with similar earnings for comparison. _____c) Accounting conventions require the company to carry its assets at their historical cost. _____d) The analysis overlooks the company's future earnings potential.

Question 3: Some investors believe that low market / book ratios indicate the company is a safer investment. This may not be true if the: _____a) ratio is used to compare two companies within the same industry. _____b) market value is higher than the book value. _____c) book value does not represent the price a company would get from a sale of its assets. _____d) company does not pay a dividend.

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ANSWER KEY

Question 1: JB Company has 5.4 million shares outstanding at a market price of $27.50. Last year, JB Company had earnings of $11.6 million. What is the P/E ratio for JB Company? 12.80 times P/E ratio

= = =

(Price per share) / (Earnings per share) ($27.50) / ($11.6 million / 5.4 million shares) 12.80

Question 2: Which of the following is a disadvantage of using P/E ratios to make investment decisions? d) The analysis overlooks the company's future earnings potential. P/E ratios are based on a company's most recent earnings figure. This is a disadvantage, as the analysis may be short-sighted.

Question 3: Some investors believe that low market / book ratios indicate the company is a safer investment. This may not be true if the: c) book value does not represent the price a company would get from a sale of its assets.

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PROGRESS CHECK 3 (Continued)

Question 4: TSM Incorporated pays an annual dividend of $6.50 to its common shareholders. What is the value of these common shares to an investor with a required rate of return of 11%? $____________________________

Question 5: If a company sells off its assets and uses the proceeds to pay its creditors, the amount left to distribute to shareholders is the: _____a) free cash flow. _____b) residual value. _____c) asset-based value. _____d) liquidation value.

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ANSWER KEY

Question 4: TSM Incorporated pays an annual dividend of $6.50 to its common shareholders. What is the value of these common shares to an investor with a required rate of return of 11%? $59.09 V = = =

D/R $6.50 / 0.11 $59.09

Question 5: If a company sells off its assets and uses the proceeds to pay its creditors, the amount left to distribute to shareholders is the: d) liquidation value.

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PROGRESS CHECK 3 (Continued)

Question 6: The following assumptions and calculations were made concerning Alpha Manufacturing Inc. Use the data to answer the question below. ASSUMPTIONS Year

1

Sales Growth

5.00%

Profit Margin Incremental Net

2 4.00%

3 3.00%

4 3.00%

5 2.00%

9.00%

9.00%

9.50%

9.50%

10.00%

Cash Income Tax

35.00%

35.00%

35.00%

35.00%

35.00%

Incremental Working Capital Investment

11.00%

11.00%

10.00%

10.00%

10.00%

Fixed Asset Investment (% of Sales Increase)

15.00%

15.00%

14.00%

14.00%

14.00%

1

2

3

4

5

$105.00

$109.20

$112.48

$115.85

$118.17

ESTIMATES Year (Figures in Millions) Sales Operating Profit

9.45

9.83

10.69

11.01

11.82

Cash Income Taxes

3.31

3.44

3.74

3.85

4.14

EBIAT

4.14

6.39

6.95

7.15

7.68

Fixed Capital Investment

0.75

0.63

0.46

0.47

0.32

Working Capital Investment

0.52

0.54

0.56

0.58

0.61

Free Cash Flow

4.84

5.30

6.16

6.34

7.12

If the weighted average cost of capital is 11.40%, and the residual value is estimated to be $67.37 million, calculate the total firm value for Alpha Manufacturing: __________________________________________ Year

Cash Flow (Millions)

Present Value Factor

Present Value (Millions)

1

__________

__________

__________

2

__________

__________

__________

3

__________

__________

__________

4

__________

__________

__________

5

__________

__________

__________

__________

__________

__________

Total Firm Value

__________

Residual Value

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VALUING EQUITY SECURITIES

ANSWER KEY

Question 6: The following assumptions and calculations were made concerning Alpha Manufacturing Inc. Use the data to answer the question below. $60.62 million

Year

Cash Flow (Millions)

Present Value Factor

Present Value (Millions)

1

4.84

1/(1.114)1

4.35

2

5.30

1/(1.114)2

4.27

3

6.16

1/(1.114)3

4.46

4

6.34

1/(1.114)4

4.12

5

7.12

1/(1.114)5

4.15

67.37

1/(1.114)5

39.27

Total Firm Value

60.62

Residual Value

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Appendices

APPENDIX

GLOSSARY All-or-nothing Offering

A method of issuing securities in which the investment bank will withdraw the offering if all of the securities (or a high percentage) are not purchased by investors

Asset-based Valuation

Valuation method in which a company is broken down into distinct components or asset groups, with each component or group being valued individually. Total firm value is the sum of the values of each component.

Bearer Shares

Shares of stock where the only record of ownership is the possession of the stock certificate

Best Efforts Offering

Method of initial public offering in which investment banker serves as a marketing agent to encourage investors to purchase the shares

Broker

An intermediary arranging the meeting of sellers and buyers to complete a sale of securities

Common Stock

A certificate representing an ownership claim on the assets and earnings of a company

Comparable Company Analysis

A method of valuing equity securities by analyzing the past performance of companies with characteristics similar to the issuing company

Cost of Capital

The required rate of return expected by each provider of capital to a company. The cost of capital is often estimated by using a weighted average, based on the proportion of capital provided by each source.

Dealer

An intermediary that purchases securities from investors and sells them to investors

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GLOSSARY

Depository Receipt

A negotiable certificate representing a certain number of shares in a company traded on an exchange other than the exchange where the issuer is located

Dilution

The lowering of value of existing shares when new shares are issued

Direct Cost

An expense directly related to the issuing of a security to investors; includes administrative, legal, and printing expenses as well as the underwriting spread

Discounted Cash Flow Valuation

A method of valuing equity securities by forecasting future cash flows expected to be generated by the company, and discounting these cash flows to a present value

Dividend

The distribution of the earnings of a company to its shareholders

Dividend Valuation

The method of valuing a company by treating its dividend payments as either a perpetuity or a growing perpetuity

Equity

The net worth of a company; i.e., the value of the assets less the value of the liabilities of a company

Firm Commitment Offering

Method of completing an initial public offering in which the investment banker serves as an underwriter for the issue

General Cash Offering

A type of seasoned offering in which all potential investors are given the opportunity to purchase the newly-issued securities

Indirect Cost

The expenses incurred as a result of the offering of securities for sale in the open market; most often occurs in the form of a fall in the price of the securities already trading in the market

Initial Public Offering (IPO)

The first entry of a company into the public equity markets by offering shares of stock in the company to investors

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GLOSSARY

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Institutional Investor

Investors with extremely large amounts of capital to invest; includes mutual funds, pension funds, insurance companies and corporations

Investor

An entity with capital available for the purchase of marketable securities

Issuer

An entity in need of capital, offering marketable securities for sale

Liquidation Value

Value of a company based on the assumed sale of all assets at market prices

Market-tobook Ratio

The market price per share divided by the book price per share of a company

Open-price Offering

A method of issuing securities in which the investors bid on the price to be paid for the securities. The shares are sold to highest bidders first, working down until all of the shares are sold.

Over-thecounter (OTC) Market

A network of securities dealers connected by telephone and computer specializing in the trading of marketable securities

Preferred Stock

A certificate representing an ownership claim on the assets and earnings of a company. Preferred stock has a priority claim over common stock.

Price-tocharacteristics Ratios

Ratios that relate the market price of a company to certain measures specific to the industry in which the company is operating

Price-toearnings (P/E) Ratio

The market price per share divided by the earnings per share of a company

Primary Market Transaction

The sale of a company's shares by the issuer directly to investors (includes initial public offerings and seasoned offerings)

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GLOSSARY

Private Placement

The selling of shares to a pre-selected, small group of investors by the company issuing the shares

Public Placement

The offering of shares for purchase by any investor participating in the market

Qualified Institutional Buyer (QIB)

An investor meeting certain requirements concerning size and trading practices, as outlined in the SEC Rule 144A

Registered Shares

Shares of stock whose ownership identity and records are kept by the issuing company, usually for tax collection purposes

Registration Statement

A document filed with a government regulatory agency and circulated among potential investors that summarizes the background and details of a company and its potential stock offering

Relative Valuation

A method of valuing equity securities in which information in a company is compared to companies similar in products or operations to the analyzed company

Residual Value

The estimated value of a company at the end of a forecasted period. Residual value is an important component of the discounted cash flow valuation.

Rights Offering

A type of seasoned offering in which existing shareholders are issued certificates representing the right to purchase the newly issued shares

Road Show

An informational meeting of potential investors organized by the investment banker managing the offering; provides investors with important information concerning the company's background, operations, and future prospects. Also called "dog and pony show."

Rule 144A

SEC rule governing the sale of privately-placed securities to qualified institutional buyers, and the secondary trading of the securities among the qualified buyers

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GLOSSARY

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Seasoned Offering

The offering of additional shares of stock to investors by a company with shares already trading on a public stock exchange

Secondary Market Transaction

The sale and purchase of shares of a company by two investors, independent of the issuing company

Securities and Exchange Commission (SEC)

The U.S. government regulatory agency responsible for overseeing the issuing and trading of securities in the U.S. markets

Stock Exchange

A centralized location where the shares of many companies are bought and sold by investors

Tombstone

An advertisement placed in a financial journal or newspaper announcing the completion of a securities offering

Underwriter Spread

The difference between the price an underwriter pays the issuer for the securities and the price that the underwriter sells the securities to investors; one means of compensation for the underwriter's services

Underwriting

The practice by an investment bank of directly purchasing the securities of an issuer, then reselling them to interested investors. The bank which completes the underwriting is known as the underwriter.

Voting Rights

The ability of the shareholders of a company to participate in the election of certain officers and to choose broad policy decisions for the company

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GLOSSARY

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Index

INDEX A All-or-nothing Offering Asset-based Valuation

2-6 3-8

B Bearer Shares Best Efforts Broker

1-9, 1-10, 1-13 2-2, 2-5, 2-6 1-5, 1-6, 1-13

C Common Stock Comparable Company Analysis Cost of Capital

1-2—1-5, 1-13, 2-17, 3-2, 3-5, 3-13, 3-15 2-7 3-8, 3-11—3-16, 3-18

D Dealer Depository Receipt Dilution Direct Cost Discounted Cash Flow Valuation Dividend Dividend Valuation

1-5, 1-7 1-9, 1-10, 1-11, 1-13 1-3, 2-14, 2-15, 2-18 2-11, 2-13, 2-14, 3-18 3-1, 3-11, 3-13, 3-16 1-2, 1-4, 1-11, 1-13, 3-5, 3-16, 3-17 3-2, 3-5, 3-12

E Equity F Firm Commitment

1-1, 1-2, 1-4—1-6, 1-8—1-13, 2-1, 2-2, 2-8—2 11, 2-13—2-19, 3-1, 3-5, 3-12, 3-13, 3-15, 3-17, 3-18

2-2, 2-4—2-6, 2-18

G General Cash Offering I Indirect Cost Initial Public Offering (IPO) Institutional Investor Investor

2-9, 2-10, 2-12, 2-14, 2-15

Issuer

2-1, 2-9—2-12, 2-14, 2-15, 3-18 1-8, 1-9, 1-13, 2-1, 2-2, 2-5—2-9, 2-18, 2-19 1-11, 1-12, 2-16, 2-19 1-2, 1-3, 1-5, 1-8—1-13, 2-1—2-9, 2-11, 2-13—2-19, 3-3—3-8, 3-11, 3-13, 3-14, 3-16—3-18 1-5, 1-10, 1-13, 2-2—2-6, 2-8, 2-14, 2-17, 3-18

L Liquidation Value

1-13, 3-7, 3-13

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INDEX

M Market-to-book Ratio

3-2, 3-4

O Open-price Offering Over-the-counter (OTC) Market

2-7 1-6, 1-7

P Preferred Stock Price-to-characteristics Ratios Price-to-earnings Ratio Primary Market Transaction Private Placement Public Placement

1-2, 1-3, 1-4, 1-5, 1-12, 1-13, 3-12, 3-13, 3-15, 3-16 3-2, 3-6, 3-17 3-2—3-4, 3-6, 3-8 1-8, 1-9, 1-13, 2-1 1-12, 2-1, 2-16—2-19 1-12, 2-1, 2-18

Q Qualified Institutional Buyer

2-17

R Registered Shares Registration Statement Relative Valuation Residual Value Rights Offering Road Show Rule 144A

1-9, 1-13 2-3, 2-4, 2-8 3-1, 3-2, 3-7, 3-8, 3-17 3-8, 3-13—3-15, 3-18 2-9, 2-13—2-15, 2-18 2-4 2-16, 2-17

S Seasoned Offering Secondary Market Transaction Securities and Exchange Commission (SEC) Stock Exchange

1-8, 1-9, 1-13, 2-1, 2-8, 2-9, 2-13, 2-18, 2-19 1-9, 1-13 1-6, 2-3, 2-16, 2-17 1-7, 1-8, 1-10

T Tombstone

2-4

U Underwriter Spread Underwriting

2-5 2-2, 2-3, 2-5, 2-14

V Voting rights

1-2, 1-3, 1-4, 1-10, 1-13

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