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Created 7/1/1996
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Business Administration 130:

Issuing Securities/Dividend Policy

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty16.html

Basics:

• Present value of a perpetuity: C/r
• Present value of a growing (or shrinking) perpetuity: C/(r-g)
• Present value of C dollars t years from now: C/[(1+r)^t]
• Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)^t])
• "Rule of 72": (1+r)^t = 2 (approximately) whenever rt=.72
• beta = [E((r₁-r*₁)(r_m-r*_m)]/[(r_m-r*_m)²]
• r*_i = r*_f + beta_i(r*_m-r_f)
• Expected return of a portfolio with N securities, a share 1/N invested in each security:
  
• Standard deviation of a portfolio with N securities, a share 1/N invested in each security:
  

Issuing Securities

First Meriam venture partners invests one million in round one venture capital... Marvin Enterprises:

Started with $100,000; which was spent; then went looking for VC and sold a 50% stake for $1,000,000

	Assets	Liabilities + Net Worth
Cash	$1	$1	1m shares Venture Capital Equity
"Intangible"	$1	$1	1 m shares Founders' Equity
	$2	$2

Round 2 of venture capital; sell a 4/14 = 28.5% stake in the company for $4,000,000

	Assets	Liabilities + Net Worth
Cash from new equity	$4	$4	0.8 m shares 2nd Stage Equity @ $5/share
Fixed assets	$1	$5	1 m shares 1st Stage Equity
"Intangible"	$9	$5	1 m shares Founders' Equity
	$14	$14

Venture capital--a low probability of success, but the prospect of a big win...

Initial Public Offering

Register with the SEC; SEC approval; prospectus "Red herring"; registrar; transfer agent; underwriters; substantial administrative costs; underpricing IPO's.

Marvin sells 500,000 primary shares (for the company) and 400,000 secondary shares (from VCs and from founders) at $80 a share

	Assets	Liabilities + Net Worth
		$72	0.9 m shares IPO
Cashfrom new equity	$37.5	$48	0.6 2nd Stage Equity
Fixed assets	$5	$80	1.0 1st Stage Equity
"Intangible"	$221.5	$64	0.8 Founders' Equity
	$264	$264

IPO is costly. Roughly $1 million in legal fees; roughly $5 million (7% of issue) in investment banking fees; in addition there is underpricing--underpricing to the tune of 15% or so.

Does this mean that you should by IPOs exclusively and become rich? You probably can't--you'd probably have to give the investment banks extra business to get onto the IPO list, and then you would have to make sure that you didn't get stuck with the turkeys--after all, if an issue is cheap, it is likely to be oversubscribed.

Read quote on page 389: absolutely incredible...

"Contentment at selling an article for one-third of its subsequent value is a rarity"

General Cash Offers by existing companies; SEC registration; "shelf" registration; market reaction to new stock issues-- 1/3 of value soaked up in stock price decline. Why? Because people think that the fact that you are issuing stock means that the thing is probably overpriced.//distinction between voluntary and involuntary equity issues. Why people in IPOs are so eager to convince potential investors that this is an "information-free" corporate life-cycle transaction.

Role of the Underwriter:

• Make a good living: warrant that the company is a reasonable bet; stand by to purchase (and stabilize) if demand is not there.
• Underwriting not always fun. BP shares sold at 3.30 pounds per share; arrangements finalized on October 15, 1987; stock market crash; ultimately market price was 2.96 pounds per share--the underwriters lost more than a billion dollars...

Private Placement

Much lower transaction costs; have to find someone willing to take the issue; good for small and medium sized firms.

Should you worry about dilution?

Quangle's profitability:

Book net worth	$100,000
Number of shares	1000
Book value per share	$100
Net earnings	$8000
EPS	$8
PE	10
Price	$80 per share
Total market value	$80,000

By selling shares at less than market value, does the firm "dilute" its shareholders equity? You should see by now that this is the wrong question to ask. Suppose that Quangle has a 10% earnings-per-dollar invested opportunity open to it. Sells 100 shares at a price of $80 a share and puts the money to work at 10%--and is fine. Suppose that Quangle has a 20%-plus-one-dollar investment opportunity--and sells 200 shares at a price of $100 -less-half-a-penny a share

Book net worth	$100,000	$108,000	$119,999
Number of shares	1000	1100	1200
Book value per share	$100	$98.18	$99.999
Net earnings	$8000	$8,800	$12,000
EPS	$8	$8	$10
PE	10	10	10
Price	$80 per share	$80 per share	$100 per share
Total market value	$80,000	$88,000	$120,000

It's silly to tie what you do to book value.

Summary:

Larger is cheaper--bunch security issues, for transaction costs are considerable

There are no issue costs for retained earnings

Private placements are well suited for the small, risky, unusual, and complex

Watch out for underpricing--the lion's share of costs come from underpricing

New issues may depress price (and so should be coreographed to be information-free)

shelf registration for large firms that don't need to be warranteed by IBs

Rights Issues:

American Electric Power--in June 1977 issued $198 million of common stock by a "rights issue". SEC process the same as for any other issue. Shareholders sent 1/11 of a "right" to buy a share of stock for $22 a share. Underwriters paid $1 million; agreed to buy untaken-up shares for $21.70.

AEP's price at exercise date was $24 1/8--hence warrant were worth something, hence exercised by shareholders (or sold to people who then used them to buy the stock).

	1-for-11 @ $22	1-for-5 1/2 @ $11
Before Issue
# of shares:	11	11
Share price (rights on)	$24	$24
Value of holding	$264	$264
After Issue
Number of new shares	1	2
New investment	$22	$22
Total value of holding	$286	$286
# of shares	12	13
Share price (ex-rights)	$23.83	$22
Value of a right:	$.17	$2

Rights issues seem a very cheap way to issue stock and get cash... A puzzle that they are not used more often

Dividend Policy:

Defined as the tradeoff between retaining earnings on the one hand and paying out cash on the other hand.

You can't pay out your "par" capital as a dividend...

Share repurchases as an alternative to dividends...

• IRS has tried to define "proportional" repurchases of shares as cash dividends for tax purposes (successfully); wants to define "regular" repurchases.

Lintner on dividends; firm managers are:

• Changes much more important than levels
• Transitory earnings don't lead to dividend changes
• Terrified of reversing a recent change in dividends

Partial adjustment model...

Dividend increases are good news--signal managerial optimism.

Dividend Controversy

• Right wing: increasing payouts raise value
• Middle of the road: who cares about dividend policy?
• Left wing: increasing payouts lowers value

Franco Modigliani and Merton Miller; //Homemade leverage proof:

	Assets	Liabilities + NW
Cash	$1,000	0	Debt
Fixed Assets	$9,000	$10,000 + NPV	Equity
Inv. Oppor.	NPV
Total	$10,000 + NPV	$10,000 + NPV

Suppose you issue $1,000 dividend...

Suppose you finance it by issuing stock...

You haven't changed the assets of the company--it still has the same cash, fixed assets, and investment opportunities; hence it still has the same total value.

If the new stockholders did their math, they have stock worth the $1,000 they paid for it after the issue...

Hence old stockholders must have stock worth $9,000 + NPV...

Hence old stockholders have gone from having stock worth $10,000+NPV to $1,000 in cash plus stock worth $9,000+NPV.

Dividends are irrelevant once one buys the proposition that the value of a firm is the value of its current assets plus future investment opportunities.

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