Unit J
Unit J
Unit J
Agenda
1. What is equity?
2. Venture capital
3. Staged financing
Equity
• Seed Capital
• Prototype perhaps, business plan. Size: $1M - $5M
• Mezzanine Stage
• Last stage before VC exit (via eg, IPO). Multiple securities (debt,
convertibles) are often used.
Staged Financing
How do you calculate the ownership for each investor after a new funding round?
X
VC →
V
X
OI → 1− ×s
V
Staged Financing: Example
Given the following market value balance sheet, calculate the ownership structure:
• You: → 1
2 = 50%
• VC1: → 1
2 = 50%
Staged Financing: Example
• Suppose market value of assets increases to $10m.
• A new VC2 contributes $4m.
• VC2: 4
14 = 29%
• You: → 1
2 × (1 − 29%) ≈ 35% → 5M
VC Exit
1. IPOs
2. Underwriters
3. IPO Underpricing
4. Seasoned Offerings
5. Rights Issues
Initial Public Offerings (IPOs)
Corporations ‘go public’ when they raise equity finance by selling shares to
the public for the first time through a process called an Initial Public
Offering (IPO).
• Primary offering: new shares are issued to raise additional capital
• Secondary offering: existing large shareholder(s) cash in by selling
part of their stake in the company (ie, unrelated to the company).
IPO Benefits
• Monetary costs
• Administrative costs
• Underwriting costs (7–11%): This is the fee that Investment Banks charge
for their services.
• Underpricing: IPO (ie, issue) price << day 1 closing price.
• Disclosure requirements
1
Source: Prof. Jay Ritter’s website (cited in Berk & DeMarzo)
Money Left on Table in IPOs
2
Source: Prof. Jay Ritter’s website
Seasoned Offerings (SEOs)
• Private Placement
• Sale of securities to a limited number of investors without a public offering.
• Rights Issue
• Issue of securities offered only to current stockholders.
• An “X for Y” rights offer means for every Y shares you own, you have the
option to buy X more shares from the company.
Rights Issue: Example
17 + 4 = 21
1. What is debt?
• A loan, basically. Many different types, eg, bank loans, bonds, notes.
• Bonds are long-term securitised loans, ie, can be re-sold.
• Creditors/Debtholders typically receive legally obligated interest
payments (fixed or floating rates), and repayment of principal at
maturity.
• Interest payments are generally paid out of pre-tax profits.
Issuing a bond
1
Source: Brealey, Myers, and Allen
Repayment Provisions
• Sinking fund
• A sinking fund is a established to retire debt gradually before maturity
• The firm is obligated to make regular payments into the sinking fund.
• Call Provision
• The issuer has the right to repurchase the bond at a specific price (‘call
price’) on or after a specific date (‘call date’).
• Why do firms call and pay back debt early?
• Take advantage of lower interest rates.
• Lower leverage.
• The Yield to Call (YTC) of a callable bond is its yield calculated under the
assumption that the bond will be called on the earliest call date.
• Convertible Provision
• Gives the bondholder the right to convert each bond into a prespecified
number of shares (conversion ratio).
Debt Covenants
Debt covenants contained in a bond contract are restrictions imposed by
bondholders on the activities of the borrower.
• Negative covenants limit or forbid actions that the firm may take.
• Debt ratios:
• Senior debt limits senior borrowing
• Junior debt limits senior & junior borrowing
• Dividend restrictions
• Poison put: event-risk protections
• Certain events (eg, a merger) may oblige the borrower to repay the
loan.
The End
Cost of Equity
The Cost of Equity
Consider firm ABC, which is fully financed with equity. There are
N = 10 million shares outstanding, all of them owned by you. Today
you have forecasted expected cash flows (in £million) as follows:
If equity markets are competitive, re is the internal rate of return (ie, the
value that solves)
15 20 29
−50 + + 2
+ =0
(1 + re ) (1 + re ) (1 + re )3
• Not many! Note that we did not invoke “market efficiency” or “market
rationality” here.
• No price impact or transaction costs; for simplicity only.
• Because the debt is risk-free and it is issued at par (that is, the
market price of debt is equal to its face value, £5m), the cost of debt
is equal to the (risk-free) interest rate on the debt:
• Notice that 6% × 5m = 0.3m, which is the annual interest or coupon.
Risky Debt: An Example
• For reasons that will become apparent later, this is sometimes also
known as the Pre-tax Weighted Average Cost of Capital (Pre-tax
WACC).
The Asset Cost of Capital