Project Management

CORPORATE FINANCE II - LECTURE 1

Financing decisions:

• More complicated due to the wide variety of securities
• Face more intense competition in financial markets
• Sometimes easier as they don’t have the finality that investment decisions have

Sources of financing for companies:

• Retained earnings (internal)
• Equity (external)
• Debt (external)

Gap between money needed and cash generated internally = financial deficit

Basic financing:

• How much profit should be retained rather than paid out as dividends? (Dividend policy)
• What proportion of deficit should be financed by borrowing rather than equity issue? (Debt policy)
• What types of financial instruments are available? (Debt and equity instruments)

Debt VS. Equity: (between the two = hybrid)

Debt:

• Fixed claim
• High priority on cash flows
• Tax deductible
• Fixed maturity
• No management control

Equity:

• Residual claim
• Lowest priority on cash flows
• No tax deductible
• Infinite life
• Management control

Equity:

• In very small businesses: owners investing their savings
• Slightly larger businesses: venture capital or private equity
• Publicly traded firms: common stock

Debt:

• Private businesses: bank loans
• Publicly traded firms: bonds

Par value: stated value on a stock certificate.

• An accounting value, not a market value
• Total par value (dedicated capital of the corporation) = nb of shares x par value of share

Authorized VS. Issued common stock:

• Authorized capital: all the capital we have within a company (nb of shares of common stock)
• Issued shares: authorized shares sold to and held by the shareholders of the company. Treasury stock is considered part of issued shares.

Capital surplus: (= paid-in capital) amounts of directly contributed equity capital in excess of the par value

• Cap. surplus = (IPO – PAR) x nb of shares

Retained earnings: (= reinvested earnings) the earnings that are not paid out as dividends, reflect all the earnings retained since incorporation of the company

Market and book value:

• Market value (= market capitalization) = price of stock x nb of shares outstanding
• Book value (= net common equity) = PAR value + Capital surplus + Retained earnings

Voting procedure:

• Stockholders elect directors by a majority voting system
• Stockholders can vote in person or appoint a proxy to vote

Classes of stock: in case company want/needs fresh capital but shareholders don’t want -> existing shares are labeled class A and the class B shares is issued to outside investors (with limited voting right and sell for less). Then classes A and B differ in their right to vote or receive dividends.

Preferred stock: equity of a corporation

• Different of common stock because:

• PS have a stated liquidating value (usually $100 per share)
• P dividends are paid after bond/bank interest but before ordinary dividends
• During bankruptcy, P shareholders are paid first before ordinary shareholders but after debt holders
• P dividends are not guaranteed and can either cumulative or noncumulative

• Advantages to the issuer:

• Dividend is optional
• Usually no voting rights

• Disadvantages to the issuer:

• Higher cost of preferred stock relative to debt financing
• Preferred dividends are not tax deductible

• PS could be:

• Participating (dividends increased when high profits)
• Redeemable (finite life, initial capital repaid)
• Convertible (into ordinary share at specified date and terms)

Corporate debt:

• If company in financial distress: right to default on debt and hand over on assets to the lenders
• Lenders have normally no voting power
• Interests are tax deductible (interests are paid before tax income: government provides tax subsidy on debt -> not provide on equity: dividends on common stock and PS are paid after tax income)

Patterns on corporate financing:

• 2 sources of cash for companies:

• Raise money from external source (issue of shares or debt)
• Retain part of profits (generally companies rely on internal funds with about 80% of capital covered by internal funds)

• Companies prefer internally generated funds:

• More convenient than external financing
• Cost of issuing securities is avoided
• Not held up to close scrutiny by potential investors and bankers
• Avoiding information asymmetry and signaling effect

Formulas:

• Common shares (par value) = Par value of each share x nb of shares
• Additional paid-up capital (= Capital surplus) = (IPO – PAR) x nb of shares
  IPO = Cost of each share sold to public = Money raised by selling shares / nb of shares sold
• Net common equity = Common shares + Additional paid-up capital + Retained earnings
• Market value (= market capitalization) = price of stock x nb of shares outstanding
• Book value = PAR value + Capital surplus + Retained earnings

CORPORATE FINANCE II – LECTURE 2

Venture capital: money invested to finance a new firm provided by specialist venture capital firms, wealthy individuals, investment institutions (e.g. pension funds).

• To convince VC to invest in your firm:

• Prepare a business plan which describes your product, potential market, production method, resources
• Place your savings in the business to signal you faith and commitment for success

• VC will:

• Structure the deal for strong incentive to work hard
• Provide funds in stages when deliverables are met

• 3 early stages of financing:

• Seed financing: capital provided at “idea” stage (generally < $100,000 and used for product dev. and market research provided by individuals or business angels)
• Start-up financing: capital used in product dev. and initial marketing (generally for company in operation for < 1 year with no sold products/services)
• First stage financing: capital provided to initiate manufacturing and sales (generally betw. $500,000 and $2m, case by case basis)

• 3 stages of expansion financing:

• Second stage financing (series A funding): capital used for initial expansion of company that already produced and sold product but with unprofitable revenue. Series A optimizes product, user base, develops business mode to generate long-term profit (raises betw. $2m and $15m).
• Third stage financing (series B & C funding): beyond dev. phase and into growing the business. Provided to fund major expansion (talent acquisition, plant expansion, product improvement, marketing) in profitable companies (betw. $7m and $10m)
• Mezzanine or bridge financing: capital provided for company expecting to go public in < 1 year

• Unique features of VC:

• VC firms are not passive investors (they provide on-going advice, recruit senior management team…)
• VC investments are highly illiquid (holding period betw. 3 to 7 years). VC capitalists may exit in 2 ways:

• Once new business established track record: sold out to larger firm
• Company may decide to go public and provide VC opportunity to cash out and original entrepreneurs in control

• VC markets can thrive only if an active stock market trades in young and rapidly growing firms
• V capitalists accept low probability of success (average rate of success 20-30%) and identify losers early and cut losses

Initial Public Offering of stocks (IPO): primary offerings where new shares are sold to raise add. capital for company

• Arranging a IPO:

• Select the underwriter (usually major investment and commercial banks): they act as financial intermediary: provide company with procedural and financial advice, buy the issue and resell to the public (earn spread)
• Prepare a registration statement for the approval of Securities and Exchange Commission (SEC) (presents info about proposed financing, firm’s history, existing business, plans for future).
• Prepare the prospectus for investors (with info of company, current shareholders, price, volume of IPO, how proceeds will be used, risks involved)
• Underwriter and company determine price and volume of issue

• Pricing the IPO: before settling price, underwriters may arrange “roadshow”: potential investors give their reactions and suggestions.

• Based on comparison of P/E ratios of competitors in same industry
• Discounted cashflow calculations

• Cost of IPO:

• Direct costs:

• Administrative for preparation of registration statement and prospectus
• Underwriter’s spread

• Indirect costs:

• Underpricing of IPOs

• Underprincing IPO: Underwriters prefer underprice IPO to be sure to sell everything

Seasoned Equity Offering: Issue of add. stock by a company whose stock already publicly traded. Needs to be approved by company’s Board of Directors.

• Costs of an SEO:

• Administrative costs
• Underwriting spread

• Market reaction to stock issues: decline in stock price (information asymmetry): managers know their stock is overvalued -> they issue new stocks to gain high price -> investors understand the technic -> they mark down the price accordingly

Private placements: Issues sold to no more than a dozen knowledgeable investors.

• Disadvantages:

• Investor can’t easily resell security. However most institutions (e.g. life insurance company) invest large amounts in corporate debt for long run –> less concerned about marketability)

• Advantages:

• Lower issuance costs than public issue
• Can be custom tailored for firms. Simpler if firm wishes to change terms of debt.

Difference costs IPO/SEO:

• Direct costs:

• Admin costs: SEO < IPO (listing fees, lawyers & accountants, marketing, distribution)
• Spread: SEO < IPO

• Indirect costs:

• Underpricing: SEO (no underpricing) < IPO
• Negative signals: SEO (overvalued) > IPO

Financing:

1. Business angel
2. VC
3. Private equity
4. IPO
5. SEO

Formulas:

• Underpricing = ((Varrivée – Vdépart) / Vdépart) x100
• Cost of spread (= underwriter revenue) = price of share sold x nb of shares sold x percentage spread
• Total value of IPO = price of share sold x nb of shares sold
• Total cost of IPO = spread x total value of IPO
• Cost of IPO per share = spread x price of share sold
• Amount left (underpricing) = (closing price – initial price) x nb of shares sold
• Profit/Loss = price of share sold x nb of share sold – proceeds – out-of-pocket expenses
• Net funds raised = price of share sold x nb of share sold – cost of spread – administrative fees
• Break even percentage firm = Vinital / Vfinal
• Break even percentage VC = 100% - Break even percentage firm

CORPORATE FINANCE II - LECTURE 3

Fundamentals of debt finance:

• Corporate debt can short-term (< 1 year) or long-term
• Different from common stock:

• Creditor’s claim on corporation Is specified
• Promised cash flows
• Most are callable

• + Half of outstanding bonds are owned by life insurance companies & pension funds.
• Corpo. debt repayments take form of interest and capital payments of exotic compensations (commodities, shares)
• Debt finance is less expensive than equity finance because costs of raisings funds are lower and annual return required to attract investors is less than for equity
• Issuers of debt lowers the effective cost as interests are tax deductible
• Dangers:

• Creditors are often able to claim some/all of the assets of the firm if non-compliance with the terms of the loan (and company may be forced into liquidation)
• Security/collateral should be thought before a firm borrows capital. It can be inconvenient for company to grant bondholder on specific asset (firm will be limited in using the asset in future)

Types of debt:

• Plain vanilla/straight/bullet bonds: Regular, semi annual fixed coupons + specified redemption rate
• Zero coupons/deep discount bonds: No coupons + capital gain at maturity
• Variable-rate/floating-rate coupons/floaters: Coupons payments adjusted according interest rate index (e.g. T-bill rate, LIBOR, inflation)
• Maturity: Corporate bonds that can have every maturity possible. Debt < 1 year are short-term debt (unfunded debt) and carried on balance sheet as current liability. Debt > 1 year are long-term debt (or funded debt)
• Repayment provisions: Long-term bonds commonly repaid in steady regular payments. Publicly traded bonds repaid via a sinking fund (each year, firm puts aside a sum of cash into a sinking fund then used to buy back the bonds. Reduces risks and secures repayment for investor)
• Seniority: Some debt are subordinated and if default, subordinated lender has junior claim and is paid after all senior creditors are satisfied
• Secured bonds: Secured by fixed or floating charge against firm’s assets

• Fixed charge: specific assets are used as security: if default can be sold and proceeds used to repay bondholders
• Floating charge: loan is secured on assets of company and company can use its assets as it wishes until default which crystallizes floating charge

• Default risk: seniority & security do not guarantee payment
• Country & currency: capital markets have few national boundaries and companies may borrow from abroad. Eurobonds are international bonds marketed internationally
• Public VS. Private placements: Publicly issued bonds are sold to anyone who wants and freely traded on securities markets. Private placed bonds are sold directly to small nb of institutional investors
• Protective covenants: Bondholders can protect their investments by imposing protective covenants on companies that ensure companies will use money properly and not take on unreasonable risks
• Sovereign debt (and debt issued by government agencies): often regarded as default free instruments. Governments and government agencies issue debt to finance public expenditures

The public issue of bonds:

• Procedure is similar to issuance of stock
• Indenture (specific to bonds): written agreement between borrower and trust company. It lists: amount of issue, date of issue, maturity, denomination (par value), annual coupon, dates of coupon payments, security, sinking funds, call provisions, covenants

Bond covenants: terms used to protect interests of bondholder in the indenture: