Financial Institutions

and markets
Session 3

MARKETS

Equity and Equity Markets

Types of Equity securities

Common Equity
Preferred Equity
No Par Equity

Common Equity as security

Salient properties of common stock
that makes them different from the other
kinds of securities
Discretionary Dividend Payments
Residual Claim
Limited Liability
Voting rights

Price of Equity a recap

Price of equity or stock:
The value or price of any financial asset( or any
asset) is the PV of the cash flows from the asset.
Price or value of an equity is also the PV of the
cash flows expected from it-- Dividends and
final sale price
which basically boils down to the PV of all future
expected dividends.
5

Risk of equity.. A recap

Risk from investing in a stock is the uncertainty in the
expected cash flows.
Risk of a stock or equity has two principal components :
Systematic risk
Unsystematic risk.

and

Systematic risk: Risk or uncertainty that is going to

affect all the stocks or securities in general. This kind of
risk cannot be diversified away. Also called market risk.
Example : Political/social/economic events affecting the entire
economy, change in interest rate, inflation or purchasing power
adversely affected etc.
6

Risk of equity a recap ..contd..

Unsystematic risk component:
risk that is specific to the company
can be diversified away by adding more and
more stocks in a portfolio with little correlation
with each other.
an event that might adversely affect one
might suitably affect the other thereby
canceling out the company specific risk or
unsystematic risk.
7

Risk of equity a recap ..contd..

Unsystematic or firm specific risk can be again :
business risk or
finance risk.

Business risk of the firm is the total risk or uncertainty

inherent in the business of the firm.
Finance risk is the additional amount of risk placed on the
common stockholders as a result of the decision to finance
with debt and or preferred stock.( fixed obligation)
Use of debt and preferred stock ( financial leverage)
concentrates the business risk on the common
stockholders and makes the common stock riskier.
8

Preferred Equity

Preferred stock is a hybrid security :

It has characteristics of both a bond and a common stock.
The bond like characteristic is that the income from a preferred
stock is a fixed rate of dividend per year although sometimes a
preference shareholder may be guaranteed a minimum fixed
dividend on the share with an additional variable component
depending on the extent of profit made during the year.

The stock like characteristic emanates from a bit of residualness in

its claim on the assets of the company. In the payment of dividends
during the life of the business, as well as during reimbursement
during termination of the company, a preference shareholder gets
preference over the ordinary shareholder but they are second in line
after the debt holders, no payments can be made to the preference
shareholders till the debt holders payments are cleared.

Preference Stock Types

Participating and non participating : Participating a minimum fixed

dividend component plus a variable component depending on the
profit made. Non Participating fixed dividend irrespective of the
profits made.
Cumulative vs Non cumulative : In case of the cumulative pref.
shares ,if the dividend is not paid in a particular year due to say
insufficient profit ,it is cumulatively made good in the following year
or years. Thus the preference shareholders are provided additional
assurance. For the non cumulative ones there is no such
assurance and are thus riskier.
Redeemable vs irredeemable : The former may be repurchased by
the company at a future date while the latter may be permanent
like the ordinary shares.
Convertible preference shares: The preference share may be
convertible to ordinary shares in the future on terms and conditions
specified in advance.
10

No Par shares

In case of No Par Stocks the aggregate ownership is divided

into shares and shares are issued without par or nominal value.
First time used in US. Prevalent in US, Canada and in other
countries that have adopted variants of American corporate law.
The principal reasons for issuing no par shares was the desire to
remove restrictions on the selling price of newly issued shares.
Prices can be fixed depending on market quotations and number
of shares fixed thereby depending on the amount of capital to be
raised.
The dividend on these shares are paid at the rate of dollars or
cents per share rather than a percentage of the par value.

11

How Stocks are bought and sold..

Stock markets
Primary market
Secondary market

Raising equity money in the primary market

Why needed ?
Most businesses start as sole proprietorship or small
partnership, and initial capital that is required to start a
business is usually provided by the entrepreneur himself
and his immediate family or friends.
But one limitation for this set up is that the capital is often
small and so when the business needs to grow it is
almost always that external equity is needed.
Advantage of external equity is that the business risk is
shared which is not the case with other forms of external
financing like debt or preferred equity.
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Stages/Sources of funding ..initially

When a private company decides to raise equity capital, it can seek
funding from several potential sources :
angel investors :
First round of private equity for most start ups is often obtained from
them . They are rich friends or acquaintances of the entrepreneur. Their
capital contribution is often large compared to the capital already
employed in the business . As such they obtain substantial equity share
of the business .

Venture capital firms :

Typically institutional investors which specialize in identifying prospective
business ventures and raising money to invest in those ventures.

Strategic Investors :
Many established corporations purchase equity in younger, private
companies. A corporation that invests in private companies is called
many different names like corporate investor/corporate partner/strategic
partner/strategic investor etc. Example in 2001 Microsoft invested $51
million in Groove networks as a part of their strategic partnership.

IPO :
The process of selling stock to the public for the first time to raise money
is called the initial public offering ( IPO).

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Why do companies go public?

Question arises particularly as IPOs are extremely
expensive and involve commitment of huge amount of
resources ( money and management time and effort) on
the part of the company.
The main reasons could be as follows :
1)Prestige :
An IPO is a major accomplishment. The share market , analysts
and the press will suddenly begin taking notice.
Hiring new employees will become easier as publicly traded
companies are generally perceived to be more stable than
private companies.
Stock options become much more attractive now and can be
offered to cement an employees stake in the company.

15

Why do companies go public?...contd

2) cash Infusion : an IPO typically will raise a lot of
money for the company that nee not be returned but can
be used to build new facilities, fund research and
development and acquisition of new business.
3) getting rich : an IPO typically provides the
promoters( as well as employees) an opportunity to sell
a part of their holdings in the secondary market and reap
huge financial benefits. Apple computers went public in
1980. On the first day of trading 40 employees became
millionaires.
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Why do companies go public?...contd

4)Enhanced access to liquidity :An IPO gives the
company increased ability to raise even more
money. Banks are willing to lend more money and
extend credit to publicly traded company.
5)Stock as currency : a company can use its
stock as a currency to purchase other businesses
. Because of the lack of liquidity and because
they are hard to value private companies often
have difficulty acquiring new businesses.
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Some disadvantages of going public

1) Expense :
Huge expenses involved in an IPO. Biggest of the
expense items is Underwriters fees typically ranging
between 5-10% of the money raised.
Plus there are billable hours of attorneys and
accountants fees.
Plus printing costs( mind boggling paperwork is involved)
and
Filing fees with the regulator, listing fees with the
exchange etc.
Time and effort of management of the company in going
through the process
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Some disadvantages of going public contd

2) Doing business as a public company is more
complicated :
Publicly traded companies are required to make certain quarterly
and annual filings
They need a separate department to deal with shareholders
enquiries
Need to retain separate attorneys and accountants to handle
regulatory compliance.
Disclosure requirements are much more stringent for a public
company

3) Dilution of control :
a substantial part of the holding rests with the public after an IPO
leading to a dilution in the control on the part of the original
owners.
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Types of Public offerings

Primary cash offer :
New shares are issued to the general public at large ( common
IPO) Also called unseasoned new issue

Seasoned Equity offer:

A firms need for external capital rarely ends at the IPO. Usually
profitable growth opportunities occur throughout the life of the
firm, and in some cases it is not feasible to finance these
opportunities out of retained earnings. Thus, often firms return to
the equity markets and offer new shares for sale, a type of
offering called the seasoned equity offering.
These may be
General Cash offer : Firm offers the new shares to general public at
large
Rights offer : the firm offers new shares only to the existing
shareholders
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Investment Bank and underwriting in an IPO

If the public issue of securities is a large offer, an
Investment bank is usually involved.
Investment banks act as the intermediary
between the issuing firm and the general public.
Principal responsibilities of an investment bank
in an IPO are as follows :
issue management services like

Pricing the securities

Designing the method to be used to issue the securities
Selling the securities
Ensuring the required compliance with the regulator

Underwriting services
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Underwriting
Underwriting is an important service provided
by the Investment bank.
process whereby the investment banker gives an
assurance to the issuing company that they will be
able to raise the desired amount from the public and
the short fall if any, will be taken by them.

Choosing an underwriter :
A firm can offer its securities to the highest bidding
underwriter on a competitive basis, or
it can negotiate directly with an underwriter.
Except for a few cases, firms usually do new issues of
equity ( or debt also) on a negotiated offer basis.
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Underwritingcontd..
Two types of underwriting are involved in cash offer:
Firm commitment underwriting : the issuer issues the entire
issue to the underwriter and the underwriter then re sales the
issue to the public at a slightly higher price and the difference or
spread accounts for the fee of the underwriter for the service
provided and the risks taken.
Best efforts underwriting : the underwriter commits only best
efforts to sell the securities at the agreed upon offer price.
Beyond this the underwriter does not guarantee any particular
amount of money to be raised. These issues often incorporate
an all or none clause : either all the shares are sold or the deal
is called off.

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Other Principal agents in an IPO

1)Auditor :
The purpose of an auditor is to vouch for the
accuracy of a companys financial statements.
The auditor will also assist the company to draft
the financial reports in compliance with the
regulatory requirements and will issue a comfort
letter that the underwriter uses for due diligence.
If the audit is mismanaged, the IPO may get
delayed by the regulators questions about the
financial data.
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Other Principal agents in an IPO contd..

2)Attorneys :
Conducting an IPO requires a team of attorneys to deal with the many
complex regulations for compliance
They help amend the articles of incorporation and bylaws and advise on
what the company can and cannot say to the public.

3)Transfer Agents/registrars:
Their role is to maintain shareholder information. For example they will
hold the name, address, number of shares purchased and other details
for each shareholder.
They will also handle the delivery of the stock to each shareholder
during the IPO and even afterwards in the secondary market
transactions.
The registrar on the other hand ensures that a correct number of
shares are exchanged when there is a buy sell transaction. They will
also keep records of all shares destroyed/cancelled or lost.
In most cases the firms hire a single agent ,typically a bank to act both
as a registrar and a transfer agent.
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Mechanics of an IPO
1)Underwriters and syndicate:
Many IPOs usually large IPOs involve commitment of so much effort
and fund that the underwriters usually form groups or syndicates.
The primary I bank that is responsible for managing the deal is
called the lead manager and the other banks are members of the
syndicate each responsible for certain amount to be raised
2) Registration statement and Red Herring Prospectus :
Once the syndicate composition is finalised, the syndicate helps the
formulation of a registration statement with help from the issuing
firm. It is a legal document that is supposed to provide financial and
other relevant information for the prospective investors.
The firm needs to file or submit the statement with the regulator
( SEBI)
Part of the registration statement is called the preliminary or red
herring prospectus which circulates to the investors before the
stock is offered.
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Mechanics of an IPOcontd..
3)The regulator evaluates the registration statement to
make sure that the company has disclosed all of the
information necessary for investors to decide whether to
purchase the stock and approves the issue( May give
some recommendations).
4)Final Prospectus : The issuing firm and the syndicate
prepares the final prospectus incorporating
recommendations of the regulator, containing all the
details of the issue, including the number of shares
offered and the offer price.
Issue Opens
27

Mechanics of an IPOcontd..
5)Road shows :
Once an initial price range is established the
syndicate tries to evaluate what the market thinks of
the valuation.
They conduct road shows or presentations in which
senior management and lead underwriters travel
around the country promoting the issue and
explaining the rationale of the offer price to the large
customers particularly like institutional
investors( mutual funds, banks etc.)

6) Selling the issue----( book running or fixed

price mechanism) issue closes.
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Mechanics of an IPOcontd..

Green shoe option

many underwriting contracts contain a greenshoe option
sometimes also called the over allotment option, which gives the
members of the underwriting group the option to purchase additional
shares from the issuer at the agreed price and allocate ( in case of
oversubscription).

Name greenshoe is derived from the name of the Green Shoe

Manufacturing Company, which in 1963, was the first issuer that
granted such an option.

Particularly useful if the market sentiments are not very high and the
issuer and the syndicate are skeptical about raising the entire
desired amount at one go. ( If less than 90% is subscribed then
issue fails and money needs to be refunded --- which is extremely
costly for the company).
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Mechanics of an IPOcontd..
Lock up Period :
When a firm goes for an IPO there is usually a
lock up period, which specify how long insiders
must wait after an IPO before they can sell some
or all of their stock.
This is to prevent a single large inside
shareholder trying to unload all of his holdings in
the first few weeks of trading which
could send the stock downward, to the detriment
of all shareholders.
Typically between 90 to 180 days.
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Pricing of an IPO
The underwriters work closely with the company
to come up with a price range that they believe
provides a reasonable valuation for the firm.
Two ways to estimate the value of the company:
Estimate the future cash flows and compute the
present value
Estimate the value by examining comparable
companies
Most underwriters use both techniques , however
when the estimates are substantially different, the
comparables method is often relied upon.
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Pricing of an IPOcontd..

Valuation of an IPO using comparables :

Example : Wagner Inc. is a private company that designs,
manufactures, and distributes branded consumer products. During
the most recent fiscal year, Wagner had revenues of $325 million
and earnings of $15 million. Before the stock is offered Wagners Ibanks would like to estimate the value of the company using
comparable companies. They have assembled the following
information about some of the comparables in the same industry
that have recently gone public:
CompanyPrice/Earnings Price/revenues
1. Ray Products
18.8 X 1.2 X
2. Byce Frasier
19.5 X 0.9 X
3. Fashion industries 24.1 X 0.8 X
4. Recreation Inc.
22.4 X 0.7 X
Mean
21.2 X 0.9 X
After the IPO Wagner will have 20 million shares outstanding. Estimate the
IPO price for Wagner using the Price/earnings ratio and the
price/revenues ratio of the comparables
32

Pricing of an IPOcontd..
Example. Contd..
If the IPO is based on Price earnings ratio of the
recent IPOs of the comparables then its ratio should
equal the mean or 21.2
Given its earnings is $15 million, market value of its
IPO should be 21.2 x 15 = $318 million i.e price per
share should be 318/20 = $15.9
Similarly for the price/revenue ratio, the market value
of IPO should be 0.9 x 325 = $292.5 million i.e price
per share = 292.5/20= $14.63
Based on these estimates the underwriters may
probably establish an initial price range of the stock
from $14 to $16 to take on the road show.
33

Pricing of an IPOcontd..

After the initial price range is fixed by valuation exercises the I-banks and
the issuing firm may then agree to allocate the IPO in two ways :
fixed price mechanism or
the book building method.

A) Fixed Price IPO: In a fixed price IPO, the issue price and the total capital
to be raised is fixed and intimated to the investor prior to the subscription.
In a fixed price IPO there is generally a tendency to under price the shares
to ensure full subscription. ( except when the company and the investment
bank are extremely confident)
If the issue is not fully subscribed , and if there is an underwriting
agreement in place ( which is almost always the case), then the
underwriting syndicate make good the deficit. The fear of such occurrence
also adds to the tendency of under pricing.
Fixed price IPO would give a notice like this :
Public issue of 10,000,000 equity shares of Rs 10 par value at a price of
Rs.24( premium of Rs.14) each, aggregating Rs. 2400 million
34

Pricing of an IPOcontd..

B) Book Building Mechanism:

The problem of under pricing in a fixed price IPO is addressed in the
book building process which helps in a better price and demand
discovery for the shares.
In this process the issuer indicates the number of shares that they
are willing to issue ,but the price is not mentioned. Only a band of
price or a floor price is mentioned. The firm gives a notice like this :
Public issue of say 72,000,000 equity shares of Rs 10 par value at a
price of [ *] each, aggregating Rs [ *] million.

As the issue opens bids are collected by the investment bankers

running the book from the investors at various prices , which may
be above or equal to the floor price or within the price band
indicated by the company.
Example :

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Pricing of an IPOcontd..

Book building .. Contd..

Order Book
Bid Price( per share)

No of shares bid

Cumulative no of shares

501

200

200

400

2,000

2,200

250

7,900

10,100

200

46,500

56,600

150

607,400

664,000

140

856,100

1,502,300

135

2,548,700

4,051,000

130

31,929,600

35,980,600

125

45,486,400

81,467,000

120

184,976,400

92,425,700

115

78,101,500

98,527,200

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Pricing of an IPOcontd..

Book building .. Contd..

As the bid price falls to Rs. 125,the cumulative number of shares bid
exceed the 72,000,000.

Thus Rs.125 becomes the cut off price for the IPO, so that finally all
the bidders actually pay the price bid by the last bidder i.e Rs. 125
per share.

However at Rs. 125 the total demand is for 81,467,000 shares . If

the company intends to issue exactly 72,000,000 shares then it will
allocate the shares proportionally, and bidders will roughly get 88
shares for every 100 shares they bid for.

Or the company may be having a green shoe option ( the option

to take the over subscribed portion of the capital) to allocate
additional shares to the interested investors.
37

Cost of Issuing Equity

Direct expenses like
Spread or fees of the underwriter
filing fees, legal fees etc.

Indirect expenses like

cost of management time spent working on the new issue
Underpricing : deliberate underpricing by the underwriter or the
firm itself to ensure full subscription

Together they are known as floatation costs and

expressed as a percentage of the issue size. If the
targeted fund to be raised is 100 crore and floatation
costs account upto 2% , then the actual money to be
raised = (100/98)*100 crores.
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Seasoned equity Offerings

A firms need for outside capital rarely ends at an IPO.

Profitable growth opportunities occur throughout the life of the firm,
not always feasible to finance these opportunities out of retained
earnings.
Thus more often than not, firms return to the equity markets and
offer new shares for sale, a type of offering known as Seasoned
equity Offering or SEO.
Could be :
General cash offer to all public
Rights offer to existing shareholders

Law in India requires that the new ordinary shares must first be
issued to the existing shareholders on a rights basis.
Shareholders through a special resolution can forfeit this preemptive
rights. Obviously, this will dilute their ownership.

39

Chronology in a rights issue

Example : Say a company announces on 2nd January 2004 that all

shareholders whose names are there in the register of the members will be
issued rights shares, the right to opt for which will expire on 10th March
2004, the holder of rights record date being 12th of March, 2004 and the
company will mail the letter of rights on 5th April 2004.

Here 2nd January is the Announcement date :

Date when the issue is announced.

10th March is called the Ex Rights Date :

It is the date, after which the option to exercise the rights expires i.e all
purchasers of shares after this date will NOT be entitled to get the rights shares.

12th of March is called Holder of Record date or Record date

The date on which the existing shareholders on company records are designated
as the recipients of stock rights. 2 business days after the ex rights date.

5th April, 2004 is the offer of rights date.

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Issues involved in a rights offer

When the rights shares are offered to
existing sharehoders three principal issues
are involved :
The number of rights required to buy a share
The theoretical value of a right
The effect of a rights offering on the value of
the ordinary shares outstanding
We take an example to discuss these issues
41

Example Rights issue

The Sunshine industries limited has 900,000 shares
outstanding at current market price of Rs. 130 per
share. The company need Rs. 22.5 million to finance its
proposed modernisation-cum-expansion project. The
board of the company has decided to issue rights for
raising the required money. The subscription (issue)
price (Ps) has been fixed at Rs. 75 per share. The
subscription price has been set below the market price
to ensure that the rights issue is fully subscribed. How
many rights are required to purchase one new share ?
What is the value of a right ?

42

Example Rights issue..

Step I : determine the number of new shares @75/- each
to be issued to raise the required capital of Rs. 22.5
million = 22.5 million / 75 = 300,000 shares .
Step II : Each ordinary share will have one right to
purchase new shares, therefore there are 900,000 rights
floating around. Now the company wants to sell 300,000
new shares. The number of rights required to buy one
new rights share = 900,000/300,000 = 3
No of rights required to buy one new share = (no of old
shares/no of new shares)

43

Example Rights issue..

Step III : Price of the share after the rights offering : is equal to the sum of
the value of existing shares (900,000 nos )at the current market price of
130/- and the value of the new shares (300,000) at the subscription price
(Rs. 75/-) divided by the total number of shares after the rights
issue( 900,000 + 300,000)
The price after the issue =

Px

S 0 * P0 s * Ps
S0 s

Where Px = after rights price, P 0= before rights market price, s = number

of rights share issued, S 0 = Number of existing shares

In this example after rights price = (900,000 x 130 + 300,000 x

75)/1200,000 = Rs. 116.25
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Example Rights issue..

Step IV: Value of one right : To purchase a new
share ( whose value will be Rs 116.25 after the
issue) an existing shareholder will have to have

3 rights
75 Rs.
75 + 3 x R = 116.25 ( R being the value of one right)
R = Rs. 13.75
Which is exactly equal to the drop in price of the
share between cum rights and ex rights date. ( 130
-116.25)
Therefore P0 = Px + R
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Effect on Shareholders wealth

When a rights issue is offered an existing
shareholder is given three options:
He exercises his rights and gets the new
shares
He sells his rights to someone else
He does nothing that is he does not exercise
or sell the rights
He will lose under the third option. Let us
illustrate.
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Effect on Shareholders wealth contd..

Option I : exercises his rights and gets the new
shares
Suppose a shareholder in Sunshine owns three
shares. At the current market price of 130/- , his total
wealth is 390/ After exercising the rights he gets one additional
share ( 3 rights required for one additional share)
each priced at 116.25 . Total value of shares hold = 4
x 116.25 = Rs.465/ But he has paid 75/- for the rights share , so net value
= 465-75 = Rs. 390/- ( unchanged as before)
47

Effect on Shareholders wealth contd..

Option II : sells his rights to someone else
without exercising the rights himself :
so for three shares he gets three rights which
he sells at 3 x 13.75/- = Rs.41.25/ After the rights he has three shares worth 3 x
116.25 = Rs. 348.75/ Total value = 348.75 + 41.25 = Rs. 390/same as before.
48

Effect on Shareholders wealth contd..

Option III : He does not sell the rights nor
does he exercise :
He still owns 3 shares but at 116.25
Value = 3 x 116.25 = Rs. 348.75
Less than Rs. 390/-

49

Practice Problem 1
A firm is thinking of raising Rs. 5 crore . It has 5
lakh shares outstanding and the current market
price of a share is Rs. 170.The subscription
price of the new share will be Rs. 125 per share.
How many shares would be sold?
How many rights are needed to purchase one new
share ?
What is the value of one right?
Show the impact on a shareholders wealth who holds
required rights to buy one new share if a) he
exercises rights b) sells his rights and c) does not
exercise rights
50

Practice problem 2
Atlas corporation wants to raise $4.1 million via
a rights offering. The company currently has
490,000 shares of common stock outstanding
that sell for $40 per share. Its underwriter has
set a subscription price of $36 per share and will
charge the company a 4% spread. Over and
above that the other components of floatation
costs amount to another 2% of the subscription
price. If you currently own 5000 shares of stock
in the company and decide not to participate in
the rights offering, how much money can you get
by selling your rights ?
51

Practice Problem 3
XYZ co has announced a rights offer. The
company has announced that it will take four
rights to buy a new share in the offering at a
subscription price of $40.At the close of
business the day before the ex rights day, the
companys stock sells for $80 per share. The
next morning it is noticed that the stock sells for
$72 per share and the rights sell for $6 each. Are
the stocks and the rights correctly priced on the
ex rights day? If not, then describe a transaction
in which you could use these prices to create an
immediate profit.
52