Week 7

1) Private Equity Issuance

• consists of investors and funds that make direct investments into private companies

• venture capital

2) Public Equity Issuance

• Initial Public Offerings (IPO)

  • Firms offer shares to the public for the first time

• Seasoned Equity Offerings (SEO)

  • Public firms issue additional shares

• Public equity issuance becomes less popular in recent years

• Public equity issuance (e.g., IPO) is expensive for firms because firms are usually underpriced when going public

  • IPO underpricing arises because of information asymmetries & agency conflicts between various parties (firms, underwriters & investors)

Private firms want to go public because they want to:

• raise capital

• take advantage of market timing

Other interesting reasons for IPOs:

• allows firms to use their publicly-traded shares (instead of cash) to pay for future acquisitions

• allows firms to have verifiable market valuation, and thus gain credibility to customers, suppliers, analysts & investors

IPO = a company’s first share issue to the public

(private —> public)

i) 1980-2000:

• an average of 310 firms went public every year

ii) 2001-2018:

• an average of 104 firms went public every year

iii) 1980-2018:

• average first-day return is 17.9%

Step 1: Select lead underwriter

• Snap elected Morgan Stanely and Goldman Sachs as lead underwriters

Step 2: Decide IPO offering price & number of shares issued

• Snap: IPO offering price (17$)

Step 3: The entire number of shares from the IPO firm are sold to the market at the offering price

Average first-day return = (1st day closing price - IPO price) / IPO price

1) winner's curse = a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item.

—> gap in auctioned versus intrinsic value

2) Rock 1986

• Winners curse is built on information asymmetry between investors

  • informed vs. uninformed investors

  • good vs. bad issues

  • this causes uninformed investors to withdraw from the IPO market

  —> to encourage entire market to participate, IPOs must be underpriced on average

• signaling also build on information asymmetry (between IPO firms & investors)

• impressive first-day returns signal that the firm is better than what investors think —> investors will value these companies higher in the future

• high quality vs. low-quality firms

—> IPOs are underpriced to signal the quality to investors

Agency explanations between the IPO firm & their underwriters

1) Uncertainty about the market demand (firms) —> higher value of service (underwriters) —> lower offering price (lower risk)

2) Conflicting interests

• Firms: maximize the issuing value (raise more money)

• Underwriters: reputation/ success

• Firms don’t know whether underwriters work hard enough —> incentives

  —> lower offering price

Agency explanations between the managers & shareholders of the issuing firm

• managers conduct IPO to build their empire & publicity rather than raise money

• most dot.com companies have CEOs who own very little share of the company (—> no incentive at all to act in shareholders best interest)

—> these turn out to be the most heavily underpriced companies when going public

• price stabilization

  • actions to prevent the IPO market price from falling below its offer price

• Underwriters need to ensure that they have carefully priced the IPO firms

  • If glossy overvalued —> underwriters may hold legal responsibiltiy (incompetency, lack of efforts and honesty)

1) Expensive!

2) Information revealed to the public

3) undergo stricter regulation (e.g. the Sarbanes-Oxley Act targeting public US firms; SEC)

4) Public pressure

1) More & faster money!

2) Publicity

3) Ehances the firm credibility with customers, employees and suppliers

4) Monitoring is provided by external capital markets

1) Irrelevance theories: Capital Strucuture is irrelevant to firm’s value

• Modigliani & Miller (MM): Under perfect market assumptions, capital sturcture does not affect firm value

2) Relevance theories:

• Trade-off theroy: Tax-savings vs expected costs of financial distress

• Pecking order theory: Due to information asymmetry, costly to raise external capital

• Market timing theory: Companies opportunistically issue shares when they are overvalued and issue debt wehn they think debt is cheap

3) Puzzling theories:

• zero-leverage firms

MM propositions:

1) capital strucutre does not affect firm’s value, i.e., a firm’s financing decisions are entirely irrelevant for its value

2) firm value soley determined by cash flows generated by its operating assets

Example: think of firm as gigantic pizza, divided into quaters —> if now you cut each quater in half into eights, the MM proposition says that you will have more pieces but not more pizza

1) no corporate taxes

2) no transaction or issuance cost

3) individuals and firms can undertake financial transactions at the same prices (e.g., borrow at the same rate)

4) no asymmetric information & agency problems

5) no bankruptcy costs

• leaves out tax benefits

• neglects financial distress costs

• does not take into account how inefficiency of financial markets affects the way firms choose their capital structure

  —> MM leaves out important things

Conclusion

• once we relax MM’s perfect market assumptions, capital structure does matter to firm’s value

1) tax savings versus expected costs of financial distress

2) Value of firm = value of all-equity financed + PV (tax shield) - PV (cost of financial distress)

1) since there is a trade-off, there exists an optimal capital structure

2) firms that prefer debt over equity are does that face a lower likelihood of financial distress:

• low business risk/ large/ profitable … basically a cash cow

  —> becuase they can enjoy more tax shiled

1) Internal Funds/ Retained Earnings

• profitable

• company signals to market that it’s strong (e.g. can rely on own funding) —> also brings value to the shares of the company

2) Debt Financing

• confidence, undervalued

• may signal to market that company is confident in meeting its borrowing obligaton

• interest is tax deductable

• shareholding structure of the company remains the same

3) Equity Financing

• knowing that issuing equity makes investors think that a firm is overvalued, it deters firms from issuing equity

• more expensive due to risk being taken by equity holders (which is why they demand higher return)

• may signal market that company cannot fund itself and may have cash flow issues

• may also mean the share is overvalued

—> internal finance is the cheapest form of financing, followed by debt. Issuing equity is a last resort

1) there is no optimal point of capital structure

2) Equity issue is rare & only occurs when a firm is really desperate

3) Due to the information asymmetry between the firm & investors, firms that suffer the most from information problems (i.e. young, small, risky & opaque firms) are least likely to issue equity

• companies are more likely to issue share when they are overvalued & issue debt when the debt is cheap

  • also based on information asymmetry between companies and investors

Implications

1) Financing decision depends on the market performance (Lucas and McDonald, 1990)

2) Managers wait until the market conditions get better

3) no optimal targets / Borrowing & issuing share are purely opportunistic

1) Strong support of trade-off theory

• tax advantage is very important in determining capital structure

• 81% of firms have a target gearing

2) Some support for pecking order theory

• firms also list financial flexibility as one of the top priorities (pocket money is preferred over other financing options)

• smaller firms were more likely than large companies to raise debt when faced with insufficient internal funds

Findings:

Firm would use more debt (and less equity) when:

• its industry peers also use more debt -> there is an optimal point to “copy”

• it has lots of tangible assets -> lower likelihood of bankruptcy?

• it is larger —> lower likelihood of bankruptcy?

• it has slower growth (cash cow) ?

• it is less profitable ?

• inflation is high ?

Overall: Frank & Goyals (2009) findings provide much more supports for trade-off than pecking order theory

• Brav (2009) studies differences in capital structure between private and publicly-listed comapanies

Findings:

• Private companies are controlled by one or a few shareholders and are also more informationally opaque (=informationell undurchsichtig)

• as a result, private companies:

  • are much less able to seek external financing

  • prefer debt over equity

The paper:

1) works out the possible savings a firm can earn from debt

2) works out how much a firm could borrow more before the interest expenses become so large that firm loses tax savings on extra interest

3) from 1 & 2, works out the value of tax savings a firm forgoes for not having a higher level of leverage

Findings:

• many firms underexploit their tax saving benefits

• the PV of the “foregone” benefits is up to 15% of the firm’s value

• large, liquid, profitable firms with low expected distress costs use debt conservatively

• Puzzle: Why don’t many firms borrow more than they currently do?

• Product market factors, growth options, low asset collateral and planning for future expenditures lead to conservative debt usage

Implications:

• this contradicts trade-off theories

Paper poses puzzle similar to Graham (2000):

• in 2000, 14% of large public US firms had zero outstanding debt

• these zero-leverage firms are large, profitable & consistently pay dividends

• Why they “forfeit (=verlieren) “ their tax savings from issuing more debt?

They explain this showing that zero-leverage firms are:

• family firms because they have incentives to maintain the legacy of famility members and thus, choose not to borrow

• firms with higher CEO ownership —> as they are less diversified and personal costs of distress is substantially high

1) no theory is absolutely convincing, however trade-off seems to be the most plausible

• firms do have a targeted optimal capital structure

2) there remains a unsolved puzzle: many firms appear to be “undergeared”, i.e., they did not fully exploit the benefit of debt