1. Chapter 13
Corporate Financing and Market Efficiency
1. Can Financing Decisions Create Value?
2. A Description of Efficient Capital Markets
3. The Different Types of Efficiency
4. The Evidence
5. Implications for Corporate Finance
1

2. Can Financing Decisions Create Value?
Example: Suppose Jays Electronics is thinking about
relocating its plant to Mexico where labor costs are
lower. In the hope that it can stay in Ontario, the
company has submitted an application to the province to
guarantee a five-year bank term loan for $2 million. With
a provincial guarantee, a chartered bank has offered to
make the loan (interest payments are paid at the end of
each year) at an interest rate of 5 percent. This is an
attractive rate because the normal cost of debt capital for
Jays Electronics is 10%. What it the NPV of this potential
financing transaction?
2

3. What Sort of Financing Decisions?
• Typical financing decisions include:
– How much debt and equity to sell
– When (or if) to pay dividends
– When to sell debt and equity
• Just as we can use NPV criteria to evaluate
investment decisions, we can use NPV to
evaluate financing decisions.
3

4. How to Create Value through Financing
1. Fool Investors
• Empirical evidence suggests that it is hard to
fool investors consistently.
2. Reduce Costs or Increase Subsidies
• Certain forms of financing have tax advantages
or carry other subsidies.
3. Create a New Security
• Sometimes a firm can find a previouslyunsatisfied clientele and issue new securities at
favorable prices.
• In the long-run, this value creation is relatively
small, however.
4

5. A Description of Efficient Capital Markets
• An efficient capital market is one in which stock
prices fully reflect available information.
• The EMH has implications for investors and
firms.
– Since information is reflected in security
prices quickly, knowing information when it is
released does an investor no good.
– Firms should expect to receive the fair value
for securities that they sell. Firms cannot profit
from fooling investors in an efficient market.
5

6. Ex: How Does an Efficient Market Work?
Suppose the F-stop Camera Corporation (FCC) is
attempting to develop a camera that will double the
speed of the auto-focusing system now available. FCC
believes this research has a positive NPV.
Consider the share of FCC. One of the determinant of the
share’s price is the probability that FCC will be the
company to develop the new auto-focusing system first.
In an efficient market we would expect the price of the
shares of FCC to rise if this probability increases.
Now, suppose a well-known engineer is hired by FCC to
help develop the new auto-focusing system. Assuming
an efficient market, what do you think will happen to
FCC’s share price when this is announced?
6

7. The Different Types of Efficiency
• Weak Form
– Security prices reflect all information found in
past prices and volume.
• Semi-Strong Form
– Security prices reflect all publicly available
information.
• Strong Form
– Security prices reflect all information—public
and private.
7

8. Weak Form Market Efficiency
• Security prices reflect all information found in
past prices and volume.
• Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error
t
• Since stock prices only respond to new
information, which by definition arrives
randomly, stock prices are said to follow a
random walk.
8

9. Testing Random Walk Theory
• The movement of stock prices from day to
day DO NOT reflect any pattern.
• Statistically speaking, the movement of
stock prices is random (skewed positive over the
long term).
9

10. Random Walk Theory
Coin Toss Game
Heads
Heads
$106.09
$103.00
$100.43
Tails
$100.00
Heads
Tails
$100.43
$97.50
$95.06
Tails
10

11. Random Walk Theory
Level
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
130
80
Month
11

12. Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
Level
230
180
130
80
Month
12

13. Random Walk Theory
13

14. Random Walk Theory
S&P Composite
Return in week t + 1, (%)
(correlation = -.07)
Return in week t, (%)
14

15. Efficient Market Theory
Microsoft
Stock Price
$90
Actual price as soon as upswing is
recognized
70
50
Cycles
disappear
once
identified
Last
Month
This
Month
15
Next
Month

16. Stock Price
Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Sell
Sell
Buy
Buy
If it were possible to make
big money simply by
finding “the pattern” in the
stock price movements,
everyone would do it and
the profits would be
competed away.
16
Time

17. Semi-Strong Form Market Efficiency
• Security prices reflect all publicly
available information.
• Publicly available information
includes:
– Historical price and volume information
– Published accounting statements.
– Information found in annual reports.
17

18. Event Studies: How Tests Are Structured
• Event studies are one type of test of the semistrong form of market efficiency.
This form of the EMH implies that prices should
reflect all publicly available information.
• To test this, event studies examine prices and
returns over time—particularly around the arrival
of new information.
• Test for evidence of underreaction, overreaction,
early reaction, delayed reaction around the
event.
18

19. How Tests Are Structured (cont.)
• Returns are adjusted to determine if they are
abnormal by taking into account what the rest of
the market did that day.
• The Abnormal Return on a given stock for a
particular day can be calculated by subtracting
the market’s return on the same day (RM) from
the actual return (R) on the stock for that day:
AR= R – Rm
• The abnormal return can be calculated using the
Market Model approach:
AR= R – (α + βRm)
19

20. Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
Overreaction to “good
news” with reversion
Delayed
response to
“good news”
Efficient market
response to “good news”
-30
-20
-10
0
+10
+20
Days before (-) and
after (+) announcement
20
+30

21. Reaction of Stock Price to New Information
in Efficient and Inefficient Markets
Stock
Price
Efficient market
response to “bad news”
-30
-20
-10
Overreaction to “bad
news” with reversion
Delayed
response to
“bad news”
0
+10
+20
+30
Days before (-) and
after (+) announcement
21

22. Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
4
6
8
Efficient market
response to “bad news”
-2
-3
-3.619
-4
-5
-4.49
-4.563
-4.747-4.685
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal
22
of Investing (Spring 1997)

23. Event Studies: Takeover Announcement
Cumulative Abnormal Return
(%)
Announcement Date
39
34
29
24
19
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
23

24. Event Study Results
• Over the years, event study methodology has been
applied to a large number of events including:
– Dividend increases and decreases
– Earnings announcements
– Mergers
– Capital spending
– New issues of stock
• The studies generally support the view that the market
is semistrong-form efficient.
• In fact, the studies suggest that markets may even have
some foresight into the future—in other words, news
tends to leak out in advance of public announcements.
24

25. The Record of Mutual Funds
• If the market is semistrong-form efficient, then
no matter what publicly available information
mutual-fund managers rely on to pick stocks,
their average returns should be the same as
those of the average investor in the market as a
whole.
• We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.
25

26. Efficient Market Theory
Average Annual Return on 1493 Mutual Funds and the
Market Index
40
30
10
0
-10
Funds
Market
-20
-30
26
19
92
19
77
-40
19
62
Return (%)
20

27. Strong Form Market Efficiency
• Security prices reflect all information—public and
private.
• Strong form efficiency incorporates weak and
semi-strong form efficiency.
• Strong form efficiency says that anything
pertinent to the stock and known to at least one
investor is already incorporated into the
security’s price.
27

28. Insider Trading
Officers, directors, and major shareholders of a
firm are considered insiders who may have nonpublic important information. The SEC, the
Ontario Securities Commission (and its
counterparts in other provinces) prohibited the
trade of securities based on pieces of
information that have not yet become news.
To enforce regulation, the OSC and the SEC
require insiders to reveal any trading they might
do in their own company’s share.
28

29. Relationship among Three Different
Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices
29

30. What the EMH Does NOT Say
• If EMH holds there should be no upward trend in
stock price.
• If EMH holds, investors can not earn any return
• If EMH holds, investors can throw darts to select
stocks.
• If EMH holds, stock prices should not go up over
time.
• If EMH holds, daily fluctuations should not exist
as prices reflect the fundamental value of the
firm.
• EMH can not hold because there are not enough
30
active traders.

31. Views Contrary to Market Efficiency
• Stock Market Crash of 1987, Dot.com bubble.
– The NYSE dropped between 20-percent and 25-percent
Monday following a weekend during which little
surprising information was released.
– Nasdaq fell 72% during a two year period.
• Temporal Anomalies
– Turn of the year, —month, —week.
• Speculative Bubbles
– Sometimes a crowd of investors can behave as a single
squirrel.
• Size
– Small cap stocks seem to outperform large cap stocks.
• Value versus Growth
31
– Value stock-price stocks outperform growth stocks.

32. Efficient Market Theory
2000 Dot.Com Boom
PV (index ) March 2000
Div
154.6
=
=
= 12,883
r − g .092 − .08
PV (index )October 2002
Div
154.6
=
=
= 8,589
r − g .092 − .074
32

33. Why Doesn’t Everybody Believe the EMH?
• There are optical illusions, mirages, and
apparent patterns in charts of stock market
returns.
• The truth is less interesting.
• There is some evidence against market
efficiency:
– Seasonality
– Small versus Large stocks
– Value versus Growth stocks
• The tests of market efficiency are weak.
33

34. Implications for Corporate Finance
The EMH has three implications for corporate finance:
1. The price of a company’s stock cannot be
affected by a change in accounting.
2. Financial managers cannot “time” issues of
stocks and bonds using publicly available
information.
3. A firm can sell as many shares of stocks or
bonds as it desires without depressing prices.
•
There is conflicting empirical evidence on all three
points.
34

35. Efficient Market Theory
IPO Non-Excess Returns
Average Return (%)
20
IPO
Matched Stocks
15
10
5
0
First
Second
Third
Fourth
Fifth
35
Year After
Offering

36. Practice Questions: q8
Which statements contradicts EMH (specify type)
A. Tax-exempt municipal bonds offer lower pretax returns
than taxable government bonds.
B. Managers make superior returns on their purchases of
their company’s stock.
C. There is a positive relation between the return on the
market in one quarter and the change in aggregate
profits in the next quarter.
D. There is disputed evidence that stocks which have
appreciated unusually in the recent past continue to do
so in the future.
E. The stock of an acquired firm tends to appreciate in
the period before the merger announcement.
F. Stocks of companies with unexpectedly high earnings
appear to offer high returns for several months after
the earning announcement.
G. Very risky stock on average give higher returns than
36
safe stocks.

37. Chapter 14: Corporate Financing
•
•
•
•
Common Stock
Preferred Stock
Corporate Long-Term Debt: The Basics
Patterns of Long-Term Financing
37

38. Example: Western Redwood Corp.
• Formed in 1976 with 10,000 shares issued and sold for $1
per share.
• By 2004, the company had retained $100,000.
Western Redwood Corporation Equity Accounts, 2004
Common stock
(10,000 shares outstanding)
Retain earnings
Total shareholders’ equity
$ 10,000
100,000
$ 110,000
38

39. Example: Western Redwood Corp.
• Issues 100,000 shares at $20 per share at 2004
Western Redwood Corporation Equity Accounts, 2004
Common stock
(10,000 shares outstanding)
Retain earnings
Total shareholders’ equity
$ 210,000
100,000
$ 310,000
39

40. Market Value and Book Value
• Market Value is the price of the stock multiplied
by the number of shares outstanding.
– Also known as Market Capitalization
• Book Value
– The sum of par value, (contributed surplus –
value in access of par upon issue),
accumulated retained earnings, and
adjustments to equity is the common equity of
the firm, usually referred to as the book value
of the firm.
40

41. Enbridge Inc., 2003
41

42. Enbridge Inc., 2003
42

43. Enbridge Inc., 2003
43

44. Enbridge Inc., 2003
44

45. Authorized vs. Issued Common Stock
• The articles of incorporation must state the
number of shares of common stock the
corporation is authorized to issue.
• The board of directors, after a vote of the
shareholders, may amend the articles of
incorporation to increase the number of shares.
– Authorizing a large number of shares may
worry investors about dilution because
authorized shares can be issued later with the
approval of the board of directors but without
a vote of the shareholders.
45

46. Enbridge Inc., 2003
46

47. Shareholders’ Rights
• The right to elect the directors of the corporation
by vote constitutes the most important control
device of shareholders.
• Directors are elected each year at an annual
meeting by a vote of the holders of a majority of
shares who are present and entitled to vote.
– The exact mechanism varies across
companies.
• The important difference is whether shares are
to be voted cumulatively or voted straight.
47

48. Cumulative versus Straight Voting
• The effect of cumulative voting is to permit minority
participation.
– Under cumulative voting, if there are N directors up
for election, then 1/(N+1) percent of the stock plus
one share will guarantee you a seat.
– With cumulative voting, the more seats that are up for
election at one time, the easier it is to win one.
• Straight voting works like a U.S. political election.
– Shareholders have as many votes as shares and
each position on the board has its own election.
– A tendency to freeze out minority shareholders.
48

49. Cumulative vs. Straight Voting: Example 1
• Imagine a firm with two shareholders:
Mr. MacDonald and Ms. Laurier.
– Mr. MacDonald owns 60% of the firm ( = 600
shares) and Ms. Laurier 40% ( = 400 shares).
– There are three seats up for election on the
board.
49

50. Cumulative vs. Straight Voting: Example 2
There are 2 million shares outstanding. How
many shares do you need to own to be certain
that you can elect at least one director under:
a) straight voting? b) cumulative voting?
50

51. Proxy Voting
• A proxy is the legal grant of authority by a shareholder to
someone else to vote his or her shares.
• For convenience, the actual voting in large public
corporations is usually done by proxy.
• If shareholders are not satisfied with management, an
outside group of shareholders can try to obtain as many
votes as possible via proxy.
• Proxy battles are often led by large pension funds like
the Ontario Teachers’ Pension Board or the British
Columbia Investment Management Corporation.
51

52. Dividends
• Unless a dividend is declared by the board of directors of
a corporation, it is not a liability of the corporation.
– A corporation cannot default on an undeclared
dividend.
• The payment of dividends by the corporation is not a
business expense.
– Therefore, they are not tax-deductible.
• Dividends (of Canadian corporations) received by
individual shareholders are partially sheltered by a
dividend tax credit.
• Canadian corporations do not pay taxes on dividends for
amounts they receive from Canadian corporations.
52

53. Classes of Shares
• When more than one class of share exists, they
are usually created with unequal voting rights.
• Many companies issue dual classes of common
stock. The reason has to do with control of the
firm.
– Firms going public with dual classes of shares
in Canada are often family controlled.
• Lease, McConnell, and Mikkelson found the
market prices of U.S. stocks with superior voting
rights to be about 5-percent higher than the
prices of otherwise-identical stocks with inferior
voting rights.
53

54. Corporate Long-Term Debt: The Basics
•
•
•
•
•
•
•
•
Interest versus Dividends
Is It Debt or Equity?
Basic Features of Long-Term Debt
Different Types of Debt
Repayment
Seniority
Security
Indenture
54

55. Interest versus Dividends
• Debt is not an ownership interest in the firm. Creditors
do not usually have voting power.
• The device used by creditors to protect themselves is
the loan contract (i.e., indenture).
• The corporation’s payment of interest on debt is
considered a cost of doing business and is fully taxdeductible. Dividends are paid out of after-tax dollars.
• Unpaid debt is a liability of the firm. If it is not paid, the
creditors can legally claim the assets of the firm.
– One of the costs of issuing debt is the possibility of
financial failure.
55

56. Is It Debt or Equity?
• Some securities blur the line between debt and
equity.
• Corporations are very adept at creating hybrid
securities that look like equity but are called
debt.
– Obviously, the distinction is important for tax
purposes.
– A corporation that succeeds in creating a debt
security that is really equity obtains the tax
benefits of debt while eliminating its
56
bankruptcy costs.

57. Basic Features of Long-Term Debt
• The bond indenture usually lists
– Amount of Issue (typically denominated with a $1000
face value), Date of Issue, Maturity
– Denomination (Par value)
– Coupon, typically semiannual
– Security
– Sinking Funds
– Call Provisions
– Covenants
• Features that may change over time
– Rating
– Yield-to-Maturity
57
– Market Price

58. Enbridge Inc., 2003
58

59. Back to Preferred Shares
• A preferred share represents equity of a corporation, but
is different from common stock because it has
preference over common in the payments of dividends
and in the assets of the corporation in the event of
bankruptcy.
• Preferred shares have a stated liquidating value.
For example, CIBC “$2.25 preferred” translates into a
dividend yield of 9% of the stated $25 value.
• Preferred dividends are either cumulative or
noncumulative.
• Firms may have an incentive to delay preferred
dividends, since preferred shareholders receive no
interest on the cumulated dividends.
59
• Preferred shares have a lower yield than debt.

60. Tax loophole in Canada
•
•
Corporate investors are exempt from income
taxes on dividends  they would be willing to
pay a premium for these shares (compared to
similar debt instruments); as a consequence,
yields are low.
Low taxed companies may therefore prefer to
issue these shares compared to debt (i.e., for
these companies the debt tax shield is of
limited usage).
60

61. Tax loophole in Canada
Zero Tax Ltd., a corporation not paying any income taxes, can issue
preferred shares attractive to Full Tax Ltd., a second corporation taxable at
a combined federal and provincial rate of 45%. Zero Tax is seeking $1000
in financing through either debt or preferred stock. Zero Tax can issue
either debt with a 10% coupon or preferred stock with a 6.7% dividend.
Preferred (6.7%)
Issuer: Zero Tax Ltd.
Preferred dividend/interest paid
Dividend tax at 40%
Tax deduction on interest
Total financing cost
After-tax cost
Purchaser: Full Tax Ltd.
Before-tax income
Tax
After-tax income
After-tax yield
Debt (10%)
$67.00
26.80
0.00
$93.80
9.38%
$100.00
0.00
0.00
$100.00
10.00%
$67.00
0.00
$67.00
6.70%
$100.00
45.00
$55.00
61 5.50%

62. Other Reasons for Preferred Shares
– Regulatory firms can pass the tax
disadvantage to their customers.
– Firms issuing preferred shares can avoid the
threat of bankruptcy while at the same time
not surrender control (no voting rights on
preferred shares).
62

63. Patterns of Long-Term Financing
• For Canadian firms, internally generated cash
flow dominates as a source of financing.
• Firms usually spend more than they generate
internally—the gap is financed by new sales of
debt and equity.
• Net new issues of equity are dwarfed by new
sales of debt.
• This is consistent with the pecking order
hypothesis.
• Leverage ratios for Canadian firms are
63
considerably higher than they were in the 1960s.

64. The Long-Term Financial Gap
Uses of Cash Flow
(100%)
Sources of Cash Flow
(100%)
Capital
spending
Internal cash
flow (retained
earnings plus
depreciation)
68.3%
Net
working
capital plus
other uses
Internal
cash flow
Financial
deficit
Long-term
debt and
equity 31.7%
64
External
cash flow

65. Chapter 15
How Corporations Issue Securities
• Issuing securities involves the corporation
in a number of decisions.
• This chapter looks at how corporations
issue securities to the investing public.
• The basic procedure for selling debt and
equity securities are essentially the same.
This chapter focuses on equity.
65

66. Topics Covered
•
•
•
•
Venture Capital
The Initial Public Offering
Other New-Issue Procedures
Security Sales by Public Companies
– Rights Issue
• Private Placements and Public Issues
66

67. Venture Capital
•
•
The limited partnership is the dominant form of
intermediation in this market.
There are five types of suppliers of venture capital:
1. Old-line wealthy families.
2. Private partnerships and corporations.
3. Large industrial or financial corporations with
established venture-capital subsidiaries.
4. The federal government (through crown-related
firms).
5. Individuals, typically with incomes in excess of
$100,000 and net worth over $1,000,000. Often
these “angels” have substantial business experience
and are able to tolerate high risks.
67

68. Stages of Financing
1.
2.
3.
4.
5.
6.
Seed-Money Stage:
Small amount of money to prove a concept or develop a product.
Start-Up
Funds are likely to pay for marketing and product refinement.
First-Round Financing
Additional money to begin sales and manufacturing.
Second-Round Financing
Funds earmarked for working capital for a firm that is currently
selling its product but still losing money.
Third-Round Financing
Financing for a firm that is at least breaking even and
contemplating expansion; a.k.a. mezzanine financing.
Fourth-Round Financing
Financing for a firm that is likely to go public within six months;
a.k.a. bridge financing.
68

69. U.S. Venture Capital Investments
120
106.2
80
54.4
60
40.7
21.2
18.4
2003
2001
2000
1999
21.2
1998
1997
11.5
1996
7.6
1995
0
3.7
4.2
1994
20
14.8
2002
40
1993
$ Billions
100
69

70. Initial Offering
Initial Public Offering (IPO) - First offering of
stock to the general public.
Underwriter - Firm that buys an issue of securities
from a company and resells it to the public.
Offering price – The price of a share at IPO.
Spread - Difference between public offer price and
price paid by underwriter.
Prospectus - Formal summary that provides
information on an issue of securities.
70

71. The Top Managing Underwriters
Underwriter
Citigroup
Morgan Stanley
Merrill Lynch
Lehman Brothers
J.P. Morgan
Value of Issues
($billion)
543
395
380
354
354
Number of issues
1872
1365
1914
1264
1417
71

72. The Public Issue in Canada
• Regulation of the securities market in Canada is
carried out by provincial commissions.
• In the U.S., regulation is handled by a federal body
(SEC).
• The regulators’ goal is to promote the efficient flow
of information about securities and the smooth
functioning of securities’ markets.
• All companies listed on the TSX come under the
jurisdiction of the Ontario Securities Commission
(OSC).
• Other provinces have similar legislation and
regulating bodies.
• The Canadian Securities Administration (CSA)
coordinates regulation.
72

73. New Issue Procedure
Steps involved in issuing securities to the public:
1. Management obtains approval from the board of
directors.
2. The firm prepares a preliminary prospectus to the OSC.
3. The OSC studies the preliminary prospectus and
notifies the company of any changes required.
4. Once the revised, final prospectus meets with the
OSC’s approval, a price is determined and a fullfledged selling effort gets under way.
73

74. The Process of Raising Capital
Steps in Public Offering
Time
1. Pre-underwriting conferences
Several months
2. Registration statements
20-day waiting period
3. Pricing the issue
Usually on the 20th day
4. Public offering and sale
After the 20th day
5. Market stabilization
30 days after offering
74

75. • The overallotment option: known as the Green Shoe
provision gives members of the underwriting group the
option to purchase additional shares at the offering
price less fees and commissions. The option has a
short maturity and is limited to about 10% of original
number of shares issued.
• Investment Dealers:
– In 2003, RBC Dominion Securities was the leading
underwriter by revenue.
75

76. Underwriting Spreads US (2003)
Issue Amount
($ millions)
Underwriter's
spread
Type
Common Stock:
IPO
IPO
IPO
IPO
IPO
Company
Buffalo Wild Wings
Carter's Inc.
Genitope Corp.
International Steel Group
Ipass
45
119
41
462
98
7.0%
7.0%
7.0%
6.5%
7.0%
Seasoned
Seasoned
Seasoned
Seasoned
Seasoned
General Cable Corp.
Big 5 sporting Goods Corp.
Red Robin Goods Corp.
Gibraltar Steel
Interstate hotels
41
94
92
102
47
5.5%
5.0%
5.3%
5.0%
5.3%
Raytheon
Procter & Gamble
Eastman Chemical
Bausch & Lomb
500
150
248
50
0.6%
0.5%
0.8%
1.0%
4,000
1.8%
Debt (cupon rate, type,
maturity) :
4.85% Fixed Rate Notes,
2011
4.85% Notes, 2015
6.3% Notes, 2018
5.9% Senior Notes, 2008
6.25% Convertible Senior
Debentures, 2033
General Motors
76

77. Average Initial IPO Returns
Canada
Netherlands
Spain
France
Australia
Hing Kong
UK
USA
Italy
Germany
Japan
Singapore
Sweden
Taiwan
Mexico
Switzerland
India
Greece
Korea
Brazil
China
257 %
0
20
40
60
80
100
return (percent)
77

78. Initial Offering US
Average Expenses on 1767 IPOs from 1990-1994
Value of Issues
Direct Avg First Day
Total
($mil)
Costs (%)
Return (%) Costs (%)
2 - 9.99
16.96
16.36
25 16
.
10 - 19.99
11.63
9.65
18.
15
20 - 39.99
9.7
12.48
18.
18
40 - 59.99
8.72
13.65
17.95
60 - 79.99
8.2
11.31
16.35
80 - 99.99
7.91
8.91
14.
14
100 - 199.99
7.06
7.16
12.78
200 - 499.99
6.53
5.70
11 10
.
500 and up
5.72
7.53
10.36
All Issues
11.00
12.05
18.69
78

79. The Costs of Public Offerings
Costs of Going Public in Canada: 198497
Fees
6.00 %
Underpricing
7.88 %
TOTAL
13.88 %
• The above figures understate the total cost
because they ignore indirect expenses or
the overallotment option.
79

80. From CNN.COM (Aug 18, 2004)
Google plans to price the shares in a rare
auction-style IPO. The deal promises to
put more shares in the hands of ordinary
investors rather than wealthy investment
banking clients. The auction is also widely
seen as a slap at Wall Street and the
clubby culture that contributed to
investigations into improper IPO trading
activities at the height of the dot-com
bubble.
80

81. General Cash Offers
Seasoned Offering - Sale of securities by a firm
that is already publicly traded.
General Cash Offer - Sale of securities open to all
investors by an already public company.
Shelf Registration - A procedure that allows firms
to file one registration statement for several
issues of the same security.
Private Placement - Sale of securities to a limited
number of investors without a public offering.
81

82. Private Placements
• Avoid the costly procedures associated with the
registration requirements that are a part of public
issues.
• The OSC and SEC restrict private placement
issues of no more than a couple of dozen
knowledgeable investors including institutions
such as insurance companies and pension
funds.
• The biggest drawback is that the securities
cannot be easily resold.
82

83. Market Reaction to SEO
Suppose that the CFO of a restaurant chain is
strongly optimistic about its prospect. From her
point of view, the company’s stock price is too
low. Yet the company wants to issue shares to
finance expansion into another county. What is
she to do?
83

84. The Announcement of New Equity and the
Value of the Firm
• The market value of existing equity drops on the
announcement of a new issue of common stock.
• Reasons include
– Managerial Information
Since the managers are the insiders, perhaps they
are selling new stock because they think it is
overpriced.
– Debt Capacity
If the market infers that the managers are issuing
new equity to reduce their debt-to-equity ratio due
to the specter of financial distress the stock price
will fall.
84
– Falling Earnings

85. Rights
• An issue of common stock offered to existing
shareholders is called a rights offering.
• Prior to the 1980 Bank Act, chartered banks
were required to raise equity exclusively through
rights offerings.
• If a preemptive right is contained in the firm’s
articles of incorporation, the firm must offer any
new issue of common stock first to existing
shareholders.
• This allows shareholders to maintain their
percentage ownership if they so desire.
85

86. Mechanics of Rights Offerings
• The management of the firm must decide:
– The exercise (subscription) price (the price
existing shareholders pay for new shares).
– How many rights will be required to purchase
one new share of stock.
• These rights have value:
– Shareholders can either exercise their rights
or sell their rights.
86

87. Rights Offering Example
1.
2.
3.
4.
5.
6.
National Power has 1 million shares outstanding. Each
share sells for $20. The company wants to raise $5
million in new equity. Suppose the exercise
(subscription) price is set at $10 per share. Find
Market value of company after rights issue.
Number of new shares.
Number of rights needed to buy a share.
The value of the share after the rights offering.
The value of a right.
The cost of a new share to an “outside” investor.
87

88. Time Line
Ex Right Date
Right Issue Date
P=$20
P=$16.67
P=$16.67
P=$16.67
N=1m
N=1m
N=1m
N=1.5m
Rights
announcement
Right Expiration
Date
R=$3.33
88

89. Theoretical Value of a Right
The theoretical value of a right during the rightson period is:
R0 = (M0 – S) / (N +1)
Where,
M0 = Common share price during the rights-on
period
S = Subscription price
N = Number of rights required to buy one new
share
89

90. Value of a Right after Ex-Rights Date
When the stock goes ex-rights, its price
drops by the value of one right.
Me = M 0 – R 0
Re = (Me – S) / N
Where,
Me is the common share price during the
ex-rights period.
90

91. Self Practice
Yoma Inc. is attempting to raise $5,000,000 in new
equity with a rights offering. The subscription price will
be $40 per share. The stock currently sells for $50 per
share and there are 250,000 shares outstanding.
a. How many new shares will Yoma issue?
b. How many rights will be required to buy one share?
c. At what price will the stock sell when it goes ex‑rights if
the total value of all stock increases by the amount of the
new funds?
d. What is the theoretical value of 1 right?
91