Raising capital

Class 14

Financial Management, 15.414

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Today

Raising capital

• Overview

• Financing patterns and the stock market’s reaction

Reading

• Brealey and Myers, Chapter 14 and 15

 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Road map

Part 1. Valuation

Part 2. Risk and return

Part 3. Financing and payout decisions

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Balance sheet

Net Assets Debt and Equity

Net Working Long-Term Debt

Capital

Fixed Assets
Shareholders’
1. Tangible
2. Intangible Equity

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Types of questions

Your firm needs capital to finance growth. Should you issue debt
or equity or obtain a bank loan? If you choose debt, should the
bonds be convertible? Callable? If you choose equity, should you
use common or preferred stock? How will the stock market react
to your decision?

In 1998, IBM announced that it would repurchase $2.5 billion in

stock. How should it structure the stock repurchase? IBM’s price
jumped 7% after the announcement. Why? How would the
market have reacted if IBM increased dividends instead?
Suppose Intel made the same announcement. Would we expect
the same price response?

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Raising capital

Sources of funds

Internal financing
Internally generated cashflows (retained earnings)

Debt (borrowing)
Bonds and commercial paper
Bank debt (loan commitments, lines of credit)
Private placements
Leases

New equity
Common or preferred stock

Rights offering

Private placements

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Sources of funds, U.S. corporations, 1979 – 1997

120
Internal Debt Equity
100

80
% of total financing

60

40

20

0
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
-20

-40

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Sources of funds, International 1990 – 1994

90

Internal Debt Equity

80

70

% of total financing

60

50

40

30

20

10

US Japan UK Canada France

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Capital structure, U.S. corporations 1979 – 1997

50

Book values Mkt values

40

Debt / (Debt + Equity)

30

20

10

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Capital structure, International 1991

90%
Liab/TA (Bk) Liab/TA (Mkt) D/(D+E) (Bk) D/(D+E) (Mkt)
80%

70%

60%

50%

40%

30%

20%

10%

0%
US Japan UK Canada France Germany

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Raising capital

Terminology

Convertible, callable bonds and preferred stock

Zero-coupon, or pure-discount, bonds

Junk bonds

Secured debt vs. unsecured debt (debentures)

Priority / seniority
Senior debt (60% recovery in bankruptcy)

Subordinated or junior debt (< 30% recovery in bankruptcy)

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Bond ratings

Moody’s and Standard and Poor’s

Moody’s Standard and Poor’s

Aaa AAA
Aa AA Investment
A A grade
Baa BBB

Ba BB
B B
Caa CCC Junk bonds
Ca CC
C C

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Bond ratings

Default probabilities for S&P ratings

Percent defaulting within …

Original rating 1 year 5 years 10 years

AAA 0.00 0.06 0.06
AA 0.00 0.67 0.74
A 0.00 0.22 0.64
BBB 0.03 1.64 2.80
BB 0.37 8.32 16.37
B 1.47 21.95 33.01
CCC 2.28 35.42 47.46

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Bond ratings
Adjusted Key Industrial Financial Ratios
U.S. Industrial Long Term Debt
Three-Year (1998 to 2000) Medians
Source: Standard and Poor’s

AAA AA A BBB BB B CCC

EBIT int. cov. (x) 21.4 10.1 6.1 3.7 2.1 0.8 0.1
EBITDA int. cov. (x) 26.5 12.9 9.1 5.8 3.4 1.8 1.3
Free oper. cash flow/total debt (%) 84.2 25.2 15.0 8.5 2.6 (3.2) (12.9)
FFO/total debt (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6
Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0
Operating income/sales (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9
Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8
Total debt/capital (incl. STD) (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7
Companies 8 29 136 218 273 281 22

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Financing decisions

What is the goal?

How can financing decisions create value?

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Capital structure decisions

Observations

Pecking order
Firms prefer internal to external financing. If financing is
external, firms prefer debt to equity.

Target capital structure

Mean reversion in leverage ratios and systematic differences
across industries.

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Capital structure, 1997

Industry Debt / (Debt + Equity)

High leverage
Building construction 60.2%
Hotels and lodging 55.4
Air transport 38.8
Primary metals 29.1
Paper 28.2
Low leverage
Drugs and chemicals 4.8
Electronics 9.1
Management services 12.3
Computers 9.6
Health services 15.2

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

2: The process

Mechanics

Underwriters

Firm commitment vs. best efforts

Rights offerings

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Direct costs of a public offering, 1990 – 1994

IPOs SEOs
Proceeds Gross Other Total Gross Other Total
($ mill) spread costs direct spread costs direct
2 – 10
9.05%
7.91%
16.96%
7.72%
5.56%
13.28%
10 – 20
7.24
4.39
11.63
6.23
2.49
8.72
20 – 40
7.01
2.69
9.70
5.60
1.33
6.93
40 – 60
6.96
1.76
8.72
5.05
0.82
5.87
60 – 80 6.74
1.46
8.20
4.57
0.61
5.18
80 – 99 6.47
1.44
7.91
4.25
0.48
4.73
100 – 200 6.03
1.03
7.06
3.85
0.37
4.22
200 – 500 5.69
0.86
6.53
3.26
0.21
3.47
500 + 5.21 0.51

5.72


3.03 0.12

3.15

Average 7.31 3.69 11.00 5.44 1.67 7.11

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Underpricing of IPOs, 1960 – 1997

100%

80%

60%

40%

20%

0%
6001 6307 6701 7007 7401 7707 8101 8407 8801 9107 9501 9807

-20%
Date (YearMonth)

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

International comparison of underpricing

Average Initial
Country Data Source(s) Sample Size Years
Return (%)
Australia Lee et al. 11.9 266 1976-89
Belgium Rogiers et al. 10.1 28 1984-90
Brazil Aggarwal et al. 78.5 62 1979-90
Canada Jog & Riding; Jog & Srivastava 5.4 258 1971-92
Chile Aggarwal et al. 16.3 19 1982-90
Finland Keloharju 9.6 85 1984-92
Husson & Jacquillat; Leleux & Muzyka; 4.2 187 1983-92
France
Palliard & Belletante
Germany Ljungqvist 10.9 170 1978-92
Hong Kong McGuinness 17.6 80 1980-90
Italy Cherubini & Ratti 27.1 75 1985-91
Japan Fukuda; Dawson & Hiraki; Hebner & Hiraki 32.5 472 1970-91
Korea Dhatt et al. 78.1 347 1980-90
Malaysia Isa 80.3 132 1980-91
Mexico Aggarwal et al. 33.0 37 1987-90
Netherlands Wessels; Eijgenhuijsen & Buijs 7.2 72 1982-91
New Zealand Vos & Cheung 28.8 149 1979-91
Portugal Alpalhao 54.4 62 1986-87
Singapore Koh & Walter 27.0 66 1973-87
Spain Rahnema et al. 35.0 71 1985-90
Sweden Ridder; Rydqvist 39.0 213 1970-91
Switzerland Kunz & Aggarwal 35.8 42 1983-89
Taiwan Chen 45.0 168 1971-90
Thailand Wethyavivorn & Koo-smith 58.1 32 1988-89
U.K. Dimson; Levis 12.0 2133 1959-90

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

3: Price impact

How do stock prices react to security offerings?

Debt issues?

Seasoned equity offerings?

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Stock price reaction

Type of issuer
Type of security Industrial Utility
Common stock* -3.14% -0.75%
Preferred stock -0.19 0.08
Convertible preferred -1.44 -1.38
Straight debt -0.26 -0.13
Convertible bonds -2.07 --
Private placements of debt -0.91 --
Bank loan agreements 1.93 --

*Approximately 30% of issue size

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Stock price reaction

Loan Private Public straight

Stated purpose agreement placement bonds
Repay debt 1.14% 0.51% -0.35%
Cap expenditure 1.20 -0.23 0.55
General purpose 4.67 0.26 0.07
Repay bank loans 3.10 -2.07 -1.63
No purpose given 1.74 -- 0.69

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Stock price reaction

Security Security Announce

Transaction issued retired return
Leverage increasing
Stock repurchase Debt Common 21.9%
Exchange offer Debt Common 14.0
Exchange offer Preferred Common 8.3

No leverage effect
Exchange offer Debt Debt 0.3

Leverage decreasing
Call exercise Common Debt –2.1
Exchange offer Common Preferred –2.6
Exchange offer Preferred Debt –7.7
Exchange offer Common Debt –9.9

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

Stock price reaction

Observations

Stock prices react negatively to stock issues

Stock prices react positively to bank loans, but very little to

public debt issues

Leverage-increasing transactions are good news, but leverage-

decreasing transactions are bad news

Why?

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Payout policy

Questions

How do firms payout cash?

What are the advantages and disadvantages of each method?

How much cash should a firm hold?

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

S&P 500, earnings and dividends

$50 1.0

$40 0.8
Payout ratio (right
scale)
$30 0.6

$20 0.4

Earnings
$10 0.2
Dividends

$0 0.0
1946 1956 1967 1978 1988 1999

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 MIT SLOAN SCHOOL OF MANAGEMENT

15.414 Class 14

S&P 500, dividends and repurchases

$300
(millions)
Dividends Repurchases
$240

$180

$120

$60

$0

71 74 77 80 83 86 89 92 95
98

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 MIT SLOAN SCHOOL OF MANAGEMENT
15.414 Class 14

Stock price reaction

Announcement
Event return
Increases
Repurchase: open market 3.6%
Repurchase: tender offer 16.2
Dividend increase 0.9
Dividend initiation 3.7
Special dividend 2.1

Decreases
Dividend omission -7.0%
Dividend decrease -3.6

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