finance

Advanced Managerial Finance

In Ji Jang

Raising Capital 2

Ch.20

Stages in the Financing Life Cycle • 1. Idea Stage

• 2. Private Equity Stage

• 3. Initial Public Offering (IPO) Stage

• 4. Seasoned Issuer Stage

• Let’s look at book value(BV), discounted cash flow (DCF) and market value (MV) balance sheets

Idea Stage • Entrepreneur has idea to spend $3 mil. on a project that will

earn $400K per year (discount rate 10%)

BV

0 0

DCF

0.4M/0.1 – 3M

= 1M 1M

MV

0 0

Private Equity Stage • VC puts on $3M for 80% of shares (800K shares)

• Post-money (after-the-money) valuation = 3/0.8 = 3.75M

• VC’s DCF value = 0.8 * 4M = 3.2 M

• Entrepreneur retains 20% of shares (200K shares) valued at (0.2*3.75)=0.75M and with DCF value of 0.8M (= 0.2*4M).

BV

3M 3M

DCF

0.4M/0.1

= 4M

Ent. 0.80M

VC 3.2M

MV

3.75M

VC 3M

Ent. 0.75M

IPO Stage • Need 100M for a project that generates $12.1mil. per year

• Sell 4M new shares to public at $25 per share

• VC has 800K shares worth 20M (=$25 * 800K) (16%)

• Entrepreneur has 200K share worth 5M (=$25*200K) (4%)

BV

103M 103M

DCF

125M (12.1+0.4)/0.1

= 125M

MV

125M Ent. 5M

VC. 20M

Public S/h

100M

Practice Problems • Question 3

Initial Public Offerings (IPO) • Why go public?

 Need for new capital

 Less reliance on individual banks or venture capital (VC)

 Increase visibility (not many investors know about a private company)

 Costs: Reporting requirement, legal liabilities, dispersed ownership etc.

• Basic Procedure

 Pre-underwriting conferences

 Registration statements filed/approval

 Pricing the issue

 Public offering & Sales

 Market stabilization

IPO Underpricing • Average IPO during 1960 to 2014 rose 16.9% in the first day

• Money left on the table: Issuing firm receives less money than it should have

 First day return: (Close price-Offer price)/Offer price

 Money on the table: # of shares sold × (𝐶𝑙𝑜𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑂𝑓𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒)

• Possible explanations  Underwriting risk: risk of being sued by investors

 Asymmetric information (winner’s curse)

IPO Underpricing: Why? • Rational explanation:

 Information asymmetry among investors (unequally informed investors )

Investor types Offer types

Informed good (oversubscribed)

Uninformed bad (winner’s curse)

Numerical Example • Good Offerings

• Good cash flow =$3/share

• R=10%

• Good price = $3/0.1 =$30

• 50% good offerings

• Bad Offerings

• Bad cash flow = $2/share

• R=10%

• Bad price = $2/0.1 =$20

• 50% bad offerings

If no one can distinguish between good from bad,

fair price = 0.5 *30 + 0.5*20 = $25

Underpricing • But, if there are informed and uninformed traders…

• Uninformed traders will end up with more shares in bad offerings (Winner’s Curse)

• Suppose, uninformed investors wind up with ¾ of bad offerings and ¼ of good offerings

• If they pay $25 their expected return is only 9%.

• Need to sell shares at $22.50 in order to give uninformed investors a 10% expected return.

3 1 (2) (3)

2.254 4 ( ) 9%

25 25 U

E R

    +   

    = = =

Other explanations? • Many researchers attempt to understand why issuers are willing

to leave money on the table at IPO  Rational explanations (information asymmetry) (e.g., Rock (1986))

 To attract more investors (informed and uninformed), shares are underpriced

 Behavioral explanations (Prospect theory) (e.g., Loughran and Ritter (2002))

 People hate losses more than the gain

 Loss after a gain is different from loss after a loss