Question 1

The Jumbo Group restaurant chain launched its initial public offering (IPO) in October 2015. As a financial analyst of Tiger Investment Fund, your boss has requested for you to brief her on this investment opportunity.

Required:

Draft a memorandum on covering the following matters:

(a) Describe the listing requirements and process of issuing equity securities on SGX Catalist and the indicative timetable of Jumbo's IPO.

(15 marks)

(b) Discuss the role of UOB Limited in this IPO.

(8 marks)

(c) Analyse the costs (direct and indirect) associated with Jumbo's IPO.

(10 marks)

(d) Calculate the total amount of cash raised in this offering and describe the use of the proceeds.

(10 marks)

(e) Analyse the effect of dilution on existing shareholders in respect of new shares being issued.

(7 marks)

Question 2

On 1 January 2016, Fu Yu Ltd leased an equipment with a market value of $40 million and useful life of five years. The terms of the lease are as follow:

Lease term of 60 months.

Effective interest rate of 8%.

Instalments of $800,000 to be paid at the end of each month.

During the lease period, Fu Yu is responsible for maintain the insuring the equipment. It ownership of the equipment will be transferred to Fu Yu at the end of the lease term. The firm's financial year end is 31 December.

Required:

(a) Explain why this lease is classified as a finance lease.

(12 marks)

(b) Prepare the accounting entries for FY 2016 associated with this finance lease.

(9 marks)

(c) Discuss the financial implications if Fu Yu treated this transaction as an operating

lease.

(9 marks)

Question 3

Sometime in November 2015, Singapore Airlines ("SIA") launched its takeover offer for Tiger Airways with the intention of delisting and privatising the budget carrier. By February 2016, SIA's stake in Tiger Airways rose to more than 90%.

Required:

(a) Identify the type of general offer made by SIA for Tiger Airways and describe the key events in connection with the takeover process.

(10 marks)

(b) Identify, with reason(s), the type of acquisition made by SIA and analyse the rational of acquiring Tiger Airways.

(10 marks)

FIN351 CORPORATE FINANCE STUDY GUIDE (5CU) Course Development Team Head of Programme : Dr Ding Ding Course Developer(s) : Dr Ding Ding and Prof Sundaram Janakiramanan Production : Educational Technology & Production Team 2017 Singapore University of Social Sciences. All rights reserved. No part of this material may be reproduced in any form or by any means without permission in writing from the Educational Technology & Production, Singapore University of Social Sciences. Educational Technology & Production Singapore University of Social Sciences 461 Clementi Road Singapore 599491 Release V2.2 CONTENTS COURSE GUIDE 1. Welcome ............................................................................................................ 1 2. Course Description and Aims ........................................................................ 1 3. Learning Outcomes.......................................................................................... 3 4. Learning Material ............................................................................................. 3 5. Assessment Overview ..................................................................................... 4 6. Course Schedule ............................................................................................... 5 7. Learning Mode ................................................................................................. 5 STUDY UNIT 1 RAISING CAPITAL Learning Outcomes.......................................................................................... SU1-1 Overview ........................................................................................................... SU1-1 1. Sources of Funding for Private Corporations .......................................... SU1-2 2. Initial Public Offering .................................................................................. SU1-5 3. Mechanics of an IPO .................................................................................... SU1-9 4. Mechanics of Rights Offering ................................................................... SU1-18 5. Preference Shares ....................................................................................... SU1-20 6. Debt Financing ........................................................................................... SU1-22 STUDY UNIT 2 ANALYSIS OF LEASES Learning Outcomes.......................................................................................... SU2-1 Overview ........................................................................................................... SU2-1 1. Basic Terminologies in Leasing .................................................................. SU2-3 2. Types of Leases ............................................................................................. SU2-4 3. Operating Lease and Financial Lease ........................................................ SU2-5 4. End-of-Term Lease Options ....................................................................... SU2-7 5. Reasons to Lease........................................................................................... SU2-8 6. Accounting for Leases ............................................................................... SU2-11 7. Leases and Taxes ........................................................................................ SU2-13 8. Leases and Bankruptcy ............................................................................. SU2-14 9. Synthetic Leases ......................................................................................... SU2-15 10. Leasing Decision ...................................................................................... SU2-16 STUDY UNIT 3 REAL OPTIONS AND CAPITAL BUDGETING Learning Outcomes.......................................................................................... SU3-1 Overview ........................................................................................................... SU3-1 1. Adjusted Present Value Approach ............................................................ SU3-3 2. Real Options.................................................................................................. SU3-8 3. Use of Decision Trees ................................................................................ SU3-13 STUDY UNIT 4 MERGERS, ACQUISITIONS AND DIVESTITURES Learning Outcomes.......................................................................................... SU4-1 Overview ........................................................................................................... SU4-1 1. Introduction to Mergers and Acquisitions .............................................. SU4-2 2. Forms of Merger and Acquisition ............................................................. SU4-3 3. Motivation for Mergers and Acquisitions ................................................ SU4-6 4. Process of Takeover ................................................................................... SU4-11 5. Accounting for Mergers and Acquisitions ............................................. SU4-19 6. Tax Effects of Mergers and Acquisitions ................................................ SU4-20 7. Cost of Acquisition .................................................................................... SU4-21 8. Market Reactions to Takeover .................................................................. SU4-23 9. Defensive Tactics ........................................................................................ SU4-24 10. Divestitures and Restructuring .............................................................. SU4-27 STUDY UNIT 5 MERGERS, ACQUISITIONS AND DIVESTITURES Learning Outcomes.......................................................................................... SU5-1 Overview ........................................................................................................... SU5-1 1. Cash and Float Management ...................................................................... SU5-2 2. Investing Idle Cash ...................................................................................... SU5-5 3. Financial Distress ......................................................................................... SU5-6 4. Predicting Corporate Bankruptcy............................................................ SU5-14 STUDY UNIT 6 INTERNATIONAL CORPORATE FINANCE, COOPERATE GOVERNANCE, AND BUSINESS ETHICS Learning Outcomes.......................................................................................... SU6-1 Overview ........................................................................................................... SU6-1 1. Capital Budgeting in Multinational Corporations .................................. SU6-2 2. Corporate Governance ................................................................................ SU6-6 3. Business Ethics ........................................................................................... SU6-11 COURSE GUIDE FIN351 COURSE GUIDE 1. Welcome (Access video via iStudyGuide) Welcome to the course FIN351 Corporate Finance, a 5 credit unit (CU) course. This Study Guide will be your personal learning resource to take you through the course learning journey. The guide is divided into two main sections - the Course Guide and Study Units. The Course Guide describes the structure for the entire course and provides you with an overview of the Study Units. It serves as a roadmap of the different learning components within the course. This Course Guide contains important information regarding the course learning outcomes, learning materials and resources, assessment breakdown and additional course information. 2. Course Description and Aims FIN351 Corporate Finance introduces advanced topics in financial management and applies the tools and techniques learned in previous finance courses to real business situations. This case-study based course covers cash management, financing methods for both short-term and long-term, real options embedded investments, mergers and acquisitions, and corporate governance. It goes beyond deploying traditional tools of financial analysis to incorporate recent developments in the application of finance theories to provide a better understanding of decision making in the world of corporate finance. 1 FIN351 COURSE GUIDE Course Structure This course is a 5-credit unit course presented over 6 weeks. There are six Study Units in this course. The following provides an overview of each Study Unit. Study Unit 1 - Raising Capital This study unit aims to give students an understanding of how firms raise capital in the real world. Study Unit 2 - Analysis of Leases This study unit focuses on leasing, and different types of leases. It also covers how leases are included in accounting and taxes and how decision to lease as against outright purchase is made. Study Unit 3 - Real options and Capital Budgeting This study unit introduces advanced concepts in capital budgeting such as adjusted present value, and real options in capital budgeting Study Unit 4 - Mergers, Acquisitions and Divestitures This study unit aims to give students an understanding of mergers and acquisitions. In particular, emphasis will be on motivation for mergers and acquisitions, the process of takeover, and the analysis of costs and benefits Study Unit 5 - Cash Management and Financial Distress This study unit describes the management of cash in a corporate and the issues relate to financial distress Study Unit 6 - International Corporate Finance, Cooperate Governance, and Business Ethics This unit covers of the issues in international capital budgeting, the agency problems and the effective corporate governance practice 2 FIN351 COURSE GUIDE 3. Learning Outcomes Knowledge & Understanding (Theory Component) By the end of this course, you should be able to: Compute the external financing needed to fund a firm's growth Examine various short-term and long-term financing strategies and their role in financial planning Compare different types of leases and analyse the reasons for leasing Evaluate investment proposals with embedded real options Assess proposed mergers and acquisitions Appraise capital budgeting decisions for multinational corporations Analyse the cause and consequence of financial distress and evaluate financial restructuring decision Evaluate issues in corporate governance and financial ethics Key Skills (Practical Component) By the end of this course, you should be able to: Apply corporate finance theory to practical situations through case studies Demonstrate the essential knowledge and interpersonal skills to work effectively in a team Demonstrate proficiency in writing 4. Learning Material The following is a list of the required learning materials to complete this course. Required Textbook(s) Ross, Westerfield, Corporate Finance, 2015 Jaffe, Lim, Tan, and customized edition for Wong FIN351e 3 McGraw Hill/Irwin FIN351 COURSE GUIDE 5. Assessment Overview The overall assessment weighting for this course for the Evening Cohort is as follows: Assessment Assignment 1 Assignment 2 Examination Description Weight Allocation Pre-Class Quiz 1 6% Pre-Class Quiz 2 7% Pre-Class Quiz 3 7% Group-based Assignment Written Examination 30% 50% TOTAL 100% The overall assessment weighting for this course for the Day-time Cohort is as follows: Assessment Assignment 1 Assignment 2 Description Weight Allocation Pre-Course Quiz 1 1% Pre-Course Quiz 2 1% Pre-Course Quiz 3 1% Pre-Course Quiz 4 1% Pre-Course Quiz 5 1% Pre-Course Quiz 6 1% Tutor-Marked Assignment 15% Assignment 3 Group-based Assignment 19% Class Participation Class Participation 10% Examination Written Examination 50% TOTAL 100% 4 FIN351 COURSE GUIDE SUSS's assessment strategy consists of two components, Overall Continuous Assessment (OCAS) and Overall Examinable Component (OES) that make up the overall course assessment score. For SBiz courses, both components will be equally weighted: 50% OCAS and 50% OES. (a) OCAS: The sub-components are reflected in the tables above and are different for the day-time and evening cohort. The continuous assignments are compulsory and are non-substitutable. (b) OES: The Examination is 100% of this component. To be sure of a pass result you need to achieve scores of 40% in each component. Your overall rank score is the weighted average of both components. 6. Course Schedule To help monitor your study progress, you should pay special attention to your Course Schedule. It contains study unit related activities including Assignments, Selfassessments, and Examinations. Please refer to the Course Timetable in the Student Portal for the updated Course Schedule. Note: You should always make it a point to check the Student Portal for any announcements and latest updates. 7. Learning Mode The learning process for this course is structured along the following lines of learning: (a) Self-study guided by the study guide units. Independent study will require at least 3 hours per week. (b) Working on assignments, either individually or in groups. (c) Classroom Seminar sessions (3 hours each session, 3 sessions in total). 5 FIN351 COURSE GUIDE iStudyGuide You may be viewing the iStudyGuide version, which is the mobile version of the Study Guide. The iStudyGuide is developed to enhance your learning experience with interactive learning activities and engaging multimedia. Depending on the reader you are using to view the iStudyGuide, you will be able to personalise your learning with digital bookmarks, note-taking and highlight sections of the guide. Interaction with Instructor and Fellow Students Although flexible learning - learning at your own pace, space and time - is a hallmark at SUSS, you are encouraged to engage your instructor and fellow students in online discussion forums. Sharing of ideas through meaningful debates will help broaden your learning and crystallise your thinking. Academic Integrity As a student of SUSS, it is expected that you adhere to the academic standards stipulated in The Student Handbook, which contains important information regarding academic policies, academic integrity and course administration. It is necessary that you read and understand the information stipulated in the Student Handbook, prior to embarking on the course. 6 STUDY UNIT 1 RAISING CAPITAL FIN351 STUDY UNIT 1 Learning Outcomes At the end of this unit, you are expected to: Discuss venture capital investments and stages in venture capital financing Discuss the process of issuing securities to the public Compare alternative issuing methods Assess the advantage and disadvantage of cash offer and issues related to cash offer Analyse the cost of issuing new securities Analyse the effect of rights offering on price of stock and on shareholders Analyse the effect of dilution on stock price Describe the process of issuing long-term debt and compare the public issues of debt with private long-term financing Overview Most businesses start as either sole proprietorship or partnership. Limitation of sole proprietorship and partnership is that it does not allow access to raising funds in the capital market and hence have relatively little capacity to grow. In addition, the owners of the sole proprietorship and partnership hold a large fraction of their wealth in a single asset which is the business itself and hence tend to be undiversified. By incorporating as a corporation, business can gain access to capital and the founders can reduce the risk of their portfolios by selling some of their equity and diversifying. The initial capital that is required to start a business usually is provided by the entrepreneur himself and his immediate family. However, as the business grows, the business needs additional funds to support the growth. At this time, the entrepreneur incorporates the business as a private company by inviting others to take equity shares in the business. The advantage of incorporating as a private company is that the company has limited liability and the profits are taxed at corporate tax rate. SU1-1 FIN351 STUDY UNIT 1 1. Sources of funding for Private Corporations Companies need funding for financing working capital and capital investments. The working capital financing is usually done from bank loans while financing for capital investment can come from selling equity or through borrowings. When a private company starts up, it can raise funds through angel investors or venture capital firms. Angel investors are individual investors who buy equity in small private firms. For many start-up firms, the first round of outside private equity financing is obtained from angels. Because their capital investment is often relatively large relative to the amount of capital already in place in the firm, they typically receive a sizeable equity share in the business in return for their funds. As a result, these investors may have substantial influence in the business decisions of the firm. Angels may also bring expertise to the firm that the entrepreneur lacks. Though the capital available from angel investors may be sufficient for some companies, in most cases firms need more capital than what angels can provide. These firms that require equity capital for growth will turn to venture capital industry. A venture capital firm is a limited partnership that specialises in raining money to invest in the private equity of young firms. Typically, institutional investors such as pension funds are limited partners. The general partners run the venture capital firms and are called the venture capitalists. Venture capital firms invest in many start-ups and so the limited partners benefit from this diversification. The limited partners also benefit from the expertise of general partners. However, the general partners charge 1.5 to 2.5% of the fund's committed capital as management fees and the general partners also take a share of any positive return generated by the fund in a fee referred to as carried interest. The carried interest could range from 20 to 30% of any profits. Venture capitalists can provide firms with substantial capital for young companies. In return, venture capitalists typically control about one-third of the seats on the start-up company's board of directors and often represent the largest voting block on the board. The entrepreneurs generally view this control as a necessary cost of obtaining venture capital. The venture capitalists use their control to protect their investments and they may perform a key nurturing and monitoring role for the firm. In addition to angel investors and venture capital firms, sometimes funding for private companies is provided by established corporations. A corporation that invests in private companies is called many different names including corporate investor, corporate partner, strategic partner and strategic investor. Corporate SU1-2 FIN351 STUDY UNIT 1 investors usually invest in start-up companies more for strategic objectives than for financial returns. When a company founder decides to sell equity to outside investors for the first time, it is common practice for private companies to issue preferred stock rather than common stock to raise capital. Preferred stock issued by mature companies such as banks usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights. However, the preferred stock issued by young companies typically does not pay regular cash dividends. However, this preferred stock usually gives the owner an option to convert it into common stock on some future date, so it is often called convertible preferred stock. It will have all of the future rights and benefits of common stock if things go well. On the other hand, if the company runs into financial difficulties, the preferred stockholders have senior claims on the assets of the firm relative to any common stockholders. Example: RealNetworks was founded by Robert Glaser in 1993 and was initially funded with an investment of approximately $1 million by Glaser. As of April 1995, the initial investment by Glaser represented 13,713,439 shares of Series A preferred stock implying an initial purchase price of about $0.07 per share. When RealNetworks needed more capital, management decided to raise this money by selling convertible preferred stock. The company's first round of equity funding was Series B preferred stock. RealNetworks sold 2,686,567 shares of Series B preferred stock at $0.67 per share in April 1995. After this funding, the shares held by Glaser were worth $9.2 million representing 83.45 ownership. The new shares are valued at $1.8 million bringing the total valuation to $11 million. Of this, $9.2 million is known as pre-money valuation and $11 million is known as post-money valuation. Over the next few years, RealNetworks raised three more rounds of outside equity in addition to Series B as shown below: Series C with number of shares 2,904,305 at a price of $1.96 for $5.7 million in October 1995; Series D with 2,381,010 shares at a price of $7.53 for $17.9 million in November 1996; Series E with 3,338,374 shares at a price of $8.99 for $30 million in July 1977. In each case, investors bought preferred stock in the private company. Angel investors purchased the Series B stock; Investors in Series D and E were mainly venture capital funds. Microsoft also purchased stocks of Series E as a corporate investor. SU1-3 FIN351 STUDY UNIT 1 Over time, the value of a share of RealNetworks stock and the size of its funding increased. Because investors in Series E were willing to pay $8.99 per share of preferred stock with equivalent rights in July 1977, the post money valuation of existing preferred stock was 8.99 per share, representing a substantial capital gain for the early investors. Since RealNetworks was still a private company, investors could not liquidate their holdings and take the gains. An important consideration for investors in private companies is their exit strategy. Exit strategy describes how the early investors will eventually realise the return from their investment. Investors can exit in two ways: Through acquisition Through public offering Often large corporations purchase start-up companies, which is known as acquisition. The acquisition price is considerably more than the post money valuation and the initial investors make substantial returns on their investment. The other way to provide liquidity to initial investors is through public offering. SU1-4 FIN351 STUDY UNIT 1 2. Initial Public Offering The process of selling stock to the public for the first time is called initial public offering or IPO. There are two advantages of going public: a) It provides more liquidity to the shareholders by providing for trading in public stock exchanges b) It provides for better access to capital. Listing in an exchange provides for better information flow to the investor so that the investors can assess the investment in terms of its value. Listing also provides for recognition of the company and enables the company to raise funds through borrowings as well as issue of more equity. For example, RealNetworks raised $43 million when it went public in November 1997 and less than 2 years later, it raised additional $267 million by selling more stock. As a public company, RealNetworks was able to raise substantial funds. The major disadvantage of undertaking an IPO is that the equity holders of the corporation become more widely dispersed. This lack of ownership concentration undermines investors' ability to monitor the company's management and investors may discount the price they are willing to pay to reflect the lack of control. 2.1. Considerations in Initial Public Offering While a company is planning to go for initial public offering, it needs to consider the following: Where to issue shares and list the stock How to choose the investment banker How to decide the issue price Where to issue shares and list the stock When a company goes public with shares issued to the public, it will have to be listed in a stock exchange where it can be traded so that it provides liquidity to the investors. Different stock exchanges have different rules for listing a company's stock. The conditions usually provide for minimum turnover over the past few years, profits over the past few years as well as the amount of capital that is raised through public issue. In addition, exchanges also may have different rules regarding SU1-5 FIN351 STUDY UNIT 1 information disclosure. Thus, a company which is planning a public offering will have to see how well it satisfies the conditions of the exchange in which it is planning to issue the shares. Usually, shares are listed in the domestic exchange or the exchange of the country in which the company is incorporated. However, there are companies which decide to issue the shares for the first time in a foreign country exchange. For example, when Alibaba wanted to go for IPO, it decided to list in New York rather than China. In fact, many Chinese companies list their stock for the first time in foreign country exchanges such as Singapore exchange, European exchanges, or New York. The advantage of listing in a foreign exchange is that it provides visibility of that company and its products and services in that country. In addition, it also provides for opportunity to raise capital in that exchange. The foreign investors may prefer to invest in shares of another country listed in their own country because of diversification benefits and hence provide for higher valuation. How to choose underwriters While a company plans to issue shares for the first time to the public, it should be noted that the public will not be aware of the company and hence they need to promote the issue in order to get the interest of the possible investors. In addition, issue of shares for the first time and listing the stocks requires that the issuer know the procedure well and also the relevant regulations. It is also necessary that the company is able to sell all the shares it is planning to sell which would raise the required funds. It is likely that there may not be sufficient demand from investors for these shares in which case the company will not be able to raise the funds needed. In order to avoid these issues, the company that plans its initial public offering usually employs an investment banker to help in this issue. Investment banking company usually provides the following services to the issuer. i) Provide advice - If the investment banker is employed only to provide advice, the investment banker would provide advice to the issuer regarding the time to issue the shares, the terms of the issue indicating the number of shares to be offered and the price at which the issue should be sold. For providing advisory services, the investment banker will charge a fee which can be about 1 to 2% of the value of issue. ii) Underwriting - The issuer faces the risk of not being able to sell all the shares that are being issued because of lack of demand for the shares. By employing underwriting services of the investment banker, the issuer can transfer the risk of not being able to sell all the shares to the public to the underwriters. SU1-6 FIN351 STUDY UNIT 1 Depending upon the type of underwriting, this risk can be either completely or partially transferred to the underwriters. Underwriters would demand a commission as a percentage of the total value of shares that are being issued. iii) Selling - The investment bank can also provide the service of selling the shares to the public instead of the issuer trying to sell the shares. This will be helpful to the issuer because the investment bankers are experienced in selling the issue and they would be able to do it at a lower cost compared to the cost to the company if it decides to sell the shares. In general, most issuers employ investment bankers to do all the three services. There are a number of investment bankers who offer the services and the issuer will have to select the investment banker carefully. Typically, the issuer will consider the following in deciding the investment banker: a) The experience of the investment banker in IPO market b) The experience of the investment banker in the industry in which the issuer operates c) The fees and commission charged by the investment banker d) The results of the earlier IPOs undertaken by the investment banker Deciding issue price Deciding issue price is the most important element in IPO. Since the company has been a private company for so long, details of its past performance are not known to the general public. The public also have no yardstick to identify the future prospects for the company in order to value the company. Thus, the issuer needs to provide all relevant and necessary information to the public so that the public can make estimate of the intrinsic value of the company shares. If the issuers settle on a very high issue price, there may not be sufficient demand and the company may not be able to sell all the shares planned. On the other hand, if the issue price is set too low, the amount of funds raised will be low. Thus, it is important that the issue price is set properly. 2.2. Types of IPO The underwriting can be either best efforts underwriting or firm commitment underwriting. In case of best efforts underwriting, the underwriter does not guarantee that the whole issue will be sold but instead tries to sell the stock for the best possible price. This type of underwriting is used when the issue size is small. Often, the best efforts SU1-7 FIN351 STUDY UNIT 1 underwriting deals have all or none clause. This means that either all the shares are sold or the deal is called off. In most cases, the underwriter and issuer agree to a firm commitment underwriting in which the underwriter guarantees that it will sell all of the stock at the offer price. Typically, the underwriter purchases the entire issue from the issuer at a slightly lower price than the offer price and then resells the issue to the public at the offer price. The difference between the offer price and the price at which the underwriter buys the issue is the profit made by the underwriter. If the entire issue is not sold, the underwriter will keep the unsold shares in their books. In general, these shares will have to be sold at a lower price and the underwriter will take the loss. Firm commitment underwriting can lead to losses for the investment banker. As an example, consider the case of British government privatising British petroleum. It sold its final shares in October 1987 through firm underwriting. The offer price was set during the week of October 15, 1987 and the offering was set for early November 1987. During the intervening period, the stock market crash happened and the investment bankers could not sell the stocks at the offer price. The investment bankers had loss of about $1.3 billion. The price fell further until Kuwait Investment office purchased all the shares. Auction IPO Investment banking firm WR Hambrecht and Company started the auction IPO process. Under the auction IPO process, the new shares are issued directly to the public using online auction IPO called OpenIPO. In this process, the issue price is not decided by the issuer; instead, the market determines the price through the auction mechanism. In this, the investors place bids over a set period of time. It sets the highest price such that the number of bids above or below that price equals the number of offered shares. All winning bidders pay the same price even if their bids were higher. The first OpenIPO was the $11.55 million IPO for Ravenswood Winery completed in 1999. In 2004, Google went public using the auction mechanism raising $1.76 billion followed by Morningstar in 2005 to raise $140 million. In spite of the attractiveness of auction IPO, it has not been used widely and traditional IPO process using investment banks still remain popular. Raising Capital - Part 1 (Access video via iStudyGuide) SU1-8 FIN351 STUDY UNIT 1 3. Mechanics of an IPO Many IPOs especially the larger offerings are managed by a group of underwriters. The lead underwriter is the primary investment banking firm responsible for managing the deal. The lead underwriter provides most of the advice and arrange for a group of other underwriters called the syndicate, to help market and sell the issue. Underwriters market the issue and they help the company with all necessary filings. Most importantly, they actively participate in determining the offer price. In the US, it is common for the underwriter to also commit to making a market in the stock after the issue, thereby guaranteeing that the stock will be liquid. 3.1. Valuation Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm. In valuing the firm, the underwriters can use anyone or all of the following methods: i) Discounted cash flow analysis - The value of the firm is calculated as the present value of the estimated future cash flows that can be generated by the company. ii) Comparable company analysis - In this procedure, the companies that are comparable to the issuing company are chosen. These companies are generally listed and traded in the exchange so that the market price is available. By choosing appropriate market multiples such as price to earnings ratio or price to book value ratio or price to sales ratio, the value of the issuing company is calculated from the multiples of the comparable companies. iii) Comparable companies based on recent IPOs - In this procedure, the market multiples such as price to earnings or price to revenues are calculated for companies that went IPO in the recent past and these multiples are then applied to the issuing company to arrive at the value. Once an initial price range is established, the underwriters try to determine what he market thinks of the valuation. They begin by arranging a road show in which the senior management and the lead underwriters travel around the country promoting the company and explaining the rationale for the offer price to the underwriters' largest customers, who are mainly institutional investors such as mutual funds and pension funds. SU1-9 FIN351 STUDY UNIT 1 At the end of the road show, customers inform the underwriters of their interest by telling the underwriters how many shares they may want to purchase. Although these commitments are non-binding, the underwriters' customers value their longterm relationships with the underwriters, so they rarely go back on their word. The underwriters then add up the total demand and adjust the price until it is unlikely that the issue would fail. This process of coming up with the offer price based on the customers' expression of interest is called book building. Because no offer price is set in an auction IPO, book building is not as important in auction IPO as it is in conventional IPOs. 3.2. Pricing the Deal and Managing Risks While an underwriter goes for firm commitment underwriting, it faces the risk of not able to sell all the stock at a price higher than the price at which the shares were bought by the underwriter. Underwriters appear to use the information they acquire during the book-building stage to intentionally underprice the IPO, thereby reducing their exposure to losses. Furthermore, once the issue price is set, underwriters may invoke another mechanism to protect themselves against a loss - the over-allotment allocation or greenshoe provision. This option allows the underwriter to issue more stock amounting to 15% of the original offer size at the IPO offer price. How does the greenshoe provision protect the underwriter? Assume that the issuer issues 3 million shares at $12.50 per share. The greenshoe provision provides for additional 450,000 shares to be issued at $12.50 per share. Underwriters will initially market both the initial and the greenshoe allotment or 3.45 million shares at $12.50 per share. They will shortsell the greenshoe allotment of 450,000 shares. If the issue is a success, the underwriter will exercise the greenshoe option and cover the short position. If the issue is not a success and its price falls, the underwriter covers the short position by repurchasing the greenshoe allotment in the aftermarket, thereby supporting the price. Once the IPO process is complete, the company's shares trade publicly on an exchange. The lead underwriter usually makes a market in the stock and assigns an analyst to cover it. By doing so, the underwriter increases the liquidity of the stock in the secondary market. This service is of value to both the issuing company and the underwriters' customers. A liquid market ensures that investors who purchased shares via the IPO are able to easily trade those shares. If the stock is actively traded, the issuer will have continued access to equity markets in the event the company decides to issue more shares in anew offering. In most cases, the pre-existing SU1-10 FIN351 STUDY UNIT 1 shareholders are subject to a 180-day lockup; they cannot sell their shares for 180 days after the IPO. Once the lockup period expires, they are free to sell their shares. 3.3. Issue Procedure in USA Once the issuing company and the investment bankers agree to the details of the security issue, the investment banker must first get the approval from the SEC in accordance with the Securities and Exchange Act of 1934. A registration statement, which includes details of the nature of the business, key provisions of the security being issued, risks involved in the security and details of the management must be submitted to the SEC. The purpose of the registration statement is to provide a complete and comprehensive disclosure about the company and security to be issued. A preliminary prospectus known as a \"red herring\" is prepared alongside the registration statement by the issuer and investment banker, which is provided to prospective buyers of the security. The SEC has 20 days from time of receipt of the registration statement to ask for additional information to be provided by the issuer. In general, it takes 20 days from the time the registration statement is lodged with SEC for it to become effective. In cases where it is an IPO or issue by an infrequent issuer, it may take months for SEC registration as they may require additional information. Once the SEC is satisfied and registers the issue, the issuer and investment banker will set details such as the final issue price of the security and then send the \"red herring\" prospectus to potential buyers. The time interval between lodging of registration statement with SEC and the actual registering of issue is known as the waiting period. The time period between the lodging of registration statement with SEC and actual sale of shares is known as the quiet period. During this period, the company cannot send any written communication to the public apart from information about the normal course of business. After the issue is registered, oral communication is allowed whereby executive of the company can arrange for road shows to reach out to investors. However, in 2004, the SEC modified rules so that companies with market capitalisation in excess of $700 million or debt exceeding $1 billion could communicate with the public even during the quiet period. In 1992, the SEC allowed use of shelf registration in order to reduce waiting time. This allows an issuer who is planning multiple issues of shares over a two-year period to submit only one registration statement that covers all issues. SU1-11 FIN351 STUDY UNIT 1 3.4. Issue of Securities in Singapore There are two different platforms of listing in the Singapore exchange, namely, Mainboard and Catalist. The listing requirement are detailed as follows: Mainboard listing requirements: Quantitative Criteria An issuer must also satisfy one of the following requirements: a) Minimum consolidated pre-tax profit (based on full year consolidated audited accounts) of at least S$30 million for the latest financial year and has an operating track record of at least three years. b) Profitable in the latest financial year (pre-tax profit based on the latest full year consolidated audited accounts), has an operating track record of at least three years and has a market capitalisation of not less than S$150 million based on the issue price and post-invitation issued share capital. c) Operating revenue (actual or pro forma) in the latest completed financial year and a market capitalisation of not less than S$300 million based on the issue price and post-invitation issued share capital. Real Estate Investment Trusts and Business Trusts who have met the S$300 million market capitalisation test but do not have historical financial information may apply under this rule if they are able to demonstrate that they will generate operating revenue immediately upon listing. SU1-12 FIN351 STUDY UNIT 1 Shareholding Spread and Distribution Directors and Management a) Directors and executive officers should have appropriate experience and expertise to manage the group's business. b) The character and integrity of the directors, management and controlling shareholders of the issuer will be a relevant factor for consideration. c) At least 2 non-executive directors who are independent and free of any material business or nancial connection with the issuer. Catalist listing requirements: Quantitative Criteria a) A listing applicant seeking admission to Catalist need not meet any market capitalisation requirements. b) The Exchange may publish specific additional or other criteria for different types of listing applicants. SU1-13 FIN351 STUDY UNIT 1 Shareholding Spread and Distribution a) The proportion of post invitation share capital in public hands must be at least 15% at the time of listing. The shareholding spread must not be obtained by artificial means, such as giving shares away and offering loans to prospective shareholders to buy the shares. b) In the computation of the percentage of shares to be held in public hands, existing public shareholders may be included, subject to an aggregate limit of 5% of the issuer's post-invitation issued share capital and provided such shares are not under moratorium. For the purpose of this Rule, "existing public shareholders" refer to shareholders of the issuer immediately before the invitation and who are deemed "public" as defined in the Manual. c) The number of public shareholders of the securities must be at least 200. Directors and Management a) Directors and executive officers should have appropriate experience and expertise to manage the group's business. b) The character and integrity of the directors, management and controlling shareholders of the issuer will be a relevant factor for consideration. c) At least 2 non-executive directors who are independent and free of any material business or nancial connection with the issuer. When the company wants to list in the main board, Singapore Exchange will review all IPO documents and decide on the listing. Once the company's shares are listed, SGX will monitor and supervise the company with powers of discipline. The issue managers have no supervisory roles and are not subject to the SGX rules. The catalist platform is based on sponsor supervision. Sponsors are qualified professional companies experienced in corporate finance who are authorised and regulated by the SGX. There are no quantitative requirements and sponsors decide whether the applicant is suitable to list its shares. It is taken up by small but fast growing companies. The procedure for IPO is as follows: The company will conduct a due diligence, which is the analysis and valuation of the company by a professional accounting firm. The purpose of due diligence is to SU1-14 FIN351 STUDY UNIT 1 provide all material information to the public. Once value is established, appropriate number of shares to be issued is decided. The next step is to appoint an underwriter, who underwrites the issue based on firm commitment or best efforts (as discussed previously). For listing on Catalist, the company will then find a sponsor who is a Singapore-based financial institution and a lead manager. This lead manager will submit the listing application to SGX and maintain all contacts in relation to the application for listing. The company may also appoint a lawyer, certified public accountant as well a public relations firm. The listing process consists of pre-submission preparations, post-submission approval and listing. The pre-submission preparation will take an average of 4 to 9 months and post-submission approval takes an average of 5 to 7 weeks. The listing process time may vary between 4 months and 2 years. 3.5. IPO Puzzles Research has shown that there are some puzzles with IPO that are relevant for the financial managers. They are: a) On average, IPOs appear to be under-priced: The price at the end of trading on the first day is often substantially higher than the IPO offer price. b) The number of issues is highly cyclical; when times are good, the market is flooded with new issues; when times are bad, the number of issues dries up. c) The costs of an IPO are very high and it is unclear why firms are willing to incur them. d) The long-run performance of a newly public company, three to five years from the date of issue, is poor. On an average, a three to five year holding strategy appears to be bad investment. Under pricing Generally, underwriters set the issue price so that the average first-day return is positive. On average, between 1960 and 2007, the price in the US after market was 17% higher at the end of the first day of trading. In India and China, the average first day return between 1990 and 2005 was more than 90%. Who benefits from under-pricing? The underwriters benefit by controlling their risk. The investors who are able to buy the stock from the underwriters at the IPO price also gain from the first-day under-pricing. However, the pre-IPO shareholders of the SU1-15 FIN351 STUDY UNIT 1 issuing firm bear the cost of this under-pricing. In effect, the owners of the firm are selling stock for far less than they could get in the after-market. Cyclicality There are some years in which there are a large number of IPOs and some years in which the number of IPOs is very small. Typically, when the early IPOs are successful, other companies jump in and want to take advantage of this favourable sentiment causing the number of IPOs to increase. On the other hand, if the IPO turns out to be unsuccessful, other companies do not want to take the risk of an unsuccessful IPO and hence wait until market recovers and promotes successful IPOs. Cost of IPO A typical spread, that is, the discount below the issue price at which the underwriter purchases the shares from the issuing firm is 7% of the issue price. If the issue size is $100 million, the discount amounts to $7 million. This cost coupled with the first-day under-pricing seems to be very large. Compared to other security issues, total cost of issuing stock for the first time is substantially larger than the costs for other securities. Long-run Performance Studies have shown that a strategy of holding the shares bought at IPO offer price provides a return much lower than the market return over a period of 3 to 5 years. 3.6. Seasoned Equity Offering As profitable growth opportunities exist throughout the life of the firm, the firm requires additional capital. When retained earnings are not sufficient to cover this investment, companies may have to go for additional issue of stock. This type of equity offering is known as seasoned equity offering. When a firm issues stock as a seasoned equity offering, it follows the same steps as for an IPO. The main difference is that a market price for the stock already exists and hence the price setting process is not necessary. Historically, intermediaries would advertise the sale of stock by taking out advertisements in newspapers called tombstones. Through these advertisements, investors would know who to call to buy the stock. The investors also could be informed through other media, road show or through book building process. SU1-16 FIN351 STUDY UNIT 1 Two kinds of seasoned equity offerings are possible, namely, cash offer and rights offer. In a cash offer, the firm offers the new shares to investors at large at the offer price and the new investors can purchase these shares from the firm at the offer price. In a rights offer, the firm offers the new shares only to the existing shareholders. Rights offer protect existing shareholders from under-pricing. Suppose a company holds $100 in cash and has 50 shares outstanding. Each share is worth $2. The company announces a cash offer for 50 shares at $1 per share. Once this offer is complete, the company will have $150 in cash and 100 shares outstanding. The price per share now is $1.50 to reflect the fact that new shares were sold at a discount. The new shareholders will receive $0.50 windfall at the expense of the old shareholders. The old shareholder will be protected if, instead of a cash offer, the company did a rights offer. In this case, every shareholder would have the right to purchase an additional share for $1 per share. If all shareholders choose to exercise their rights, then after the sale, the value of the company would be the same as with the cash offer: It would be worth $150 with 100 shares outstanding. However, $0.50 windfall accrues to the existing shareholders which exactly offsets the drop in the stock price. Thus, if a firm's management is concerned that its equity may be under-priced in the market, by using a rights offering the firm can continue to issue equity without imposing a loss on its current shareholders. Raising Capital - Part 2 (Access video via iStudyGuide) SU1-17 FIN351 STUDY UNIT 1 4. Mechanics of Rights Offering In a rights offering, each existing shareholder is issued an option to buy a specified number of new shares from the firm at a specified price within a specified time after which the rights expire. The terms of the option are provided by certificates known as share warrants or rights. Such rights are traded on securities exchanges or over the counter. In rights issue, the financial manager must answer the following questions: 1. What price should the existing shareholders be allowed to pay for a share of new stock? 2. How many rights will be required to purchase one share of stock? 3. What effects will rights offering have on the existing price of the stock? In a rights offering, the subscription price is the price that existing shareholders are allowed to pay for a share of new stock. A shareholder will subscribe to the rights only if the subscription price is below the market price of the stock on the offer's expiration date. The number of new shares to be issued depends on the amount of funds to be raised and the subscription price and is calculated as: Number of new shares = Funds to be raised / subscription price If the amount to be raised is $5,000,000 and the subscription price is $10, the number of new shares to be issued is 500,000. The number of rights needed to buy one share of stock is calculated by the number of existing shares divided by the number of new shares to be issued. For example, if the company already has 1,000,000 shares outstanding, then the number of rights needed to buy one new share is given by: Number of rights needed to buy one new share = 1,000,000 / 500,000 = 2 Thus, a shareholder needs to pay $10 and 2 rights to buy one new stock. If all stockholders exercise this option, the company will raise $5,000,000. On the other hand, if the subscription price were $20, the number of rights needed for buying one new share will be 4. SU1-18 FIN351 STUDY UNIT 1 Value of a right Suppose that a shareholder owns two shares of the stock which has a current price of $20. His value in the firm equals 2 * 20 = $40. Since he owns two shares, he will receive 2 rights and can exercise the right and purchase one new share for $10. If this shareholder exercises the right, he will own 3 shares worth $50. Then, the price per share will drop to 50/3 = $16.67. The difference between the old price and the new price after exercising the rights is called the value of the right which equals 20-16.67 = $3.33. The rights are traded in the market and those shareholders who do not want to exercise their rights can sell these rights in the right market. Those who want to buy stock can buy these rights and exercise the rights to buy the stock. Procedure for Issue of additional shares in Singapore In order to issue additional shares, the company must get approval from the shareholders in a general meeting. The new shares must not be priced at more than 10% discount to weighted average price of trades done on the Exchange for the full market day on which the placement agreement is signed. An issuer who is planning a rights issue must provide: i. ii. iii. The price, terms and purpose of issue Whether the issue will be underwritten Whether it has obtained or will obtain approval from the Exchange for listing of new shares arising from the rights issue The issuer must get approval from the Exchange before announcing the rights issue. The issuer must inform the existing shareholders within 2 market days or such a longer period as the Exchange may approve about the entitlement. The listing process for a non-rights issue is: i. ii. iii. iv. Issuer will make the appropriate announcement. Submit one copy of additional listing application with supporting documents. The exchange will review the application and approve additional issue of shares. The exchange will normally decide on the application within 3 weeks from date of submission. Once the application is approved, the issuer will use an underwriter to sell the shares. SU1-19 FIN351 STUDY UNIT 1 5. Preference Shares Preference shares are also called preferred stock. These shares have the characteristics of both bond and common shares and can be considered as a hybrid security. They are like common shares because these shares are ownership shares and they are like bonds because they pay a constant amount periodically to the owners. However, preference shares are junior to bonds because preferred dividends can be paid only after payment of coupon interest to the bondholders is made. The other difference between bonds and preference share is that interest will have to be paid to bondholders irrespective of whether the corporation makes a profit or not whereas the corporation can pay preferred dividend only if there is profit after paying interest and taxes. Also preference shareholders can claim only after all the claims of bondholders are met in case of liquidation. Thus, preference shares can be considered junior to bonds. On the other hand, they are senior to common shares. This is because dividends to common shareholders can be paid only after the preference shareholders are paid their dividends and in case of liquidation, claim of preference shareholders must be met before common shareholders can claim from the liquidation. Firms issue preference shares instead of bonds as the dividend can be missed without worrying about default of interest payment. It is also helpful for bonds because funds raised through preferred stock can be used to finance assets that would produce a cash flow to pay the interest on bonds. However, issue of preference stock also poses some risks. In case a corporation misses payment of preferred dividend, it can send a negative signal to the market and the corporation will find it difficult to raise funds at a future time. As preferred stocks have a higher risk than bonds, the cost of funds from preferred stock will be higher than the cost of raising funds through bond issue. The interest payment on debt is deductible as expense for tax purposes and hence there is a tax benefit from the issue of bonds. This tax benefit is foregone if the corporation issues preferred stock, as preferred dividends are not considered as an expense and hence is not tax-deductible. The preferred dividend is paid periodically, usually every quarter. It is usually expressed as a dollar amount or as a percentage of the face value of preferred stock. If the corporation issues 8% preferred stock, it means that preferred dividend per year is 8% of the face value. If the face value is $1000, annual preferred dividend will be $80, which will be paid as $20 every quarter. SU1-20 FIN351 STUDY UNIT 1 In general, preferred stockholders do not have voting rights. However, there could be exceptions to this and the preferred stockholders may receive voting rights in case the corporation misses payment of dividends for a certain period, say two years. Preferred stocks can be either non-participatory or participatory in nature. If the preferred stock is non-participatory, the preference shareholders will receive only the stated dividends irrespective of the performance of the company. If the preferred stock is designated as participatory, the corporation can pay a higher dividend if the profits are exceptionally high. Preferred stock can be either cumulative or non-cumulative. As was discussed earlier, the preferred dividend can be paid only when the corporation makes sufficient profit. In case the corporation makes a loss, preferred dividend cannot be paid. What will happen to this missed dividend if in the following year, the company makes exceptionally high profits? Are the preference shareholders eligible to receive the missed dividends? This will depend on whether preferred shares are cumulative or non-cumulative. Cumulative shares will receive missed dividend when there is sufficient profit made by the corporation at a future time. For noncumulative shares, on the other hand, missed dividends will be foregone and the preference shareholders are not entitled to receive these missed dividends in the future. SU1-21 FIN351 STUDY UNIT 1 6. Debt Financing Debt financing is very common for corporations. Debt is something that is to be repaid. Corporate debt repayments generally have taken the form of interest and capital payments. The capital repayments could be either spread over a period or given as a lump sum at the end of borrowing. Debt financing is less expensive than equity financing due to lower rate of return required by finance providers, lower transaction costs of raising debt financing, and the tax deductibility of interest. The lower required return arises because investors recognise that investing in bond is less risky compared to investing in stock. It is less risky because interest is paid out before dividends are paid and hence there is greater certainty of receiving payments from debt as compared to equity. In case the firm goes into liquidation, the bondholders would receive their share before the stockholders and thus reducing the risk for bondholders. However, the bondholders do not, generally, share in the value created by successful business and there is absence of voting power. There are also dangers associated with raising funds through debt. Creditors are often able to claim some or all of the assets of the firm in the event of noncompliance with the terms of the loan. This may result in liquidation. Debt financing can be obtained through bank loans, term loans and issue of bonds. Bank loans are usually short-term are used mainly for financing working capital needs. Term loans generally have a maturity of 5 to 7 years and are arranged with financial institutions. Bonds are issued to the general public. 6.1. Corporate Bonds Corporate bonds are long-term bonds issued by corporations. The minimum denomination of publicly traded corporate bonds is $1000 and coupon is paid semiannually on coupon bearing bonds. Corporate bonds are issued in two ways, namely: i. ii. Private placement Public offering Private Placement When a corporation is planning a private placement, it will try to find large institutional buyers or group of buyers to purchase the whole issue. Usually, the number of buyers would not exceed ten. The private placement is unregistered and SU1-22 FIN351 STUDY UNIT 1 it is assumed that the buyers would be able to analyse the risks of the issue and issuer. Privately placed bonds have a very inactive secondary market. They can be resold only to large financial institutions that are willing to buy and hold them. However, in the United States, regulations have been changed in relation to privately placed bonds. Regulation 144A was introduced in 1990, under which large investors could trade these bonds amongst themselves even though these issues do not require stringent disclosure requirements that bonds face when issued to the public. In general, the issuers of privately placed bonds are not well known and interest rate paid on these bonds tends to be higher than the rate on publicly placed bonds. Public Offering When a corporation is planning to issue bonds to the public, it needs to register the issue with the Securities and Exchange Commission (SEC). Registration will require stringent disclosure requirements. Once registration is completed, the company will appoint an investment banker to manage the issue. The investment banker will be asked to underwrite the issue. The underwriting could be either firm commitment underwriting or best efforts underwriting. In the firm commitment underwriting, the investment banker guarantees the corporation a price for the newly issued bonds by purchasing the whole issue at a fixed price, known as the bid price. By purchasing the whole issue, the corporation is guaranteed that it will sell the whole issue and receive the funds it required. The investment banker will then sell the bonds in the secondary market to investors at a price known as asked price. The asked price will generally be higher than the bid price and the difference between asked price and bid price, known as the bid-asked spread, is the profit made by the investment banker. Even though the underwriter would like to sell the bonds at a higher asked price than the bid price paid to the issuer, sometimes, the asked price could be lower than the bid price. This is likely if the interest rate in the market increases considerably so that prices of all the bonds decrease. In such a case, the underwriter can make a loss. The underwriting can be arranged through competitive bids or non-competitive negotiation. In non-competitive negotiation, t