Financing decisions (1) Class 15 Financial Management, 15.414MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Today Financing decisions • Financing patterns and stock market reaction • Payout policy Reading • Brealey and Myers, Chapter 17MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Financing decisions What is the goal? How can financing decisions create value? Ensure that funds are available, both today and in the future, for positive NPV investments Equity = flexibility; debt = constraints (in extreme, bankruptcy) Can constraints be good? Minimize taxes Signalling:Sell debt or equity for more than it’s worth What message isAnd avoid selling for less! sent? Corporate control 3MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 ‘Only the Paranoid Survive’ by Andrew Grove In other words, it is best when management recognizes and accepts the inevitability of change early on and acts before the vitality of the business has been sapped … The reality, unfortunately, is that we tend to do the opposite. Most management will do too little too late and therefore fritter away the protection that the bubble of their existing business provides. Recall Intel’s memory episode. We had been losing money in memories for quite some time. Yet we only reacted when the rest of our business went into a recession also. Next only acted when their cash needs forced them to. The previously successful Compaq was slow to react as the PC business turned into a lower margin commodity-like business. It took a six-month decline in revenue, profits and market share, including a $70 million loss and its first-ever layoffs before Compaq’s board of directors took draconian steps. From: Grove, Andrew S. “Only the Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company.” Doubleday, 1999. 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Direct costs of public offerings, 1990 – 1994 IPOs SEOs Proceeds Spread Other Total Spread Other Total 2 – 10 9.05% 7.91% 16.96% 7.72% 5.56% 13.28% 10 – 20 7.24 4.39 11.63 6.23 2.49 8.72 20 – 40 7.01 2.69 9.70 5.60 1.33 6.93 40 – 60 6.96 1.76 8.72 5.05 0.82 5.87 60 – 80 6.74 1.46 8.20 4.57 0.61 5.18 80 – 99 6.47 1.44 7.91 4.25 0.48 4.73 100 – 200 6.03 1.03 7.06 3.85 0.37 4.22 200 – 500 5.69 0.86 6.53 3.26 0.21 3.47 500 + 5.21 0.51 5.72 3.03 0.12 3.15 Average 7.31 3.69 11.00 5.44 1.67 7.11 Straight debt = 2.2%; convertible debt = 3.8% 5MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Underpricing of IPOs, 1960 – 1997 100% 80% 60% 40% 20% 0% -20% 6001 6307 6701 7007 7401 7707 8101 8407 8801 9107 9501 9807 Date (YearMonth) 6MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 International comparison of underpricing )Data Source(s) Sample Size Average Initial Return (%Years Country Australia Lee et al. 11.9 266 1976-89 Belgium Rogiers et al. 10.1 28 1984-90 Brazil Aggarwal et al. 78.5 62 1979-90 Canada Jog & Riding; Jog & Srivastava 5.4 258 1971-92 Chile Aggarwal et al. 16.3 19 1982-90 Finland Keloharju 9.6 85 1984-92 France Husson & Jacquillat; Leleux & Muzyka; Palliard & Belletante 4.2 187 1983-92 Germany Ljungqvist 10.9 170 1978-92 Hong Kong McGuinness 17.6 80 1980-90 Italy Cherubini & Ratti 27.1 75 1985-91 Japan Fukuda; Dawson & Hiraki; Hebner & Hiraki 32.5 472 1970-91 Korea Dhatt et al. 78.1 347 1980-90 Malaysia Isa 80.3 132 1980-91 Mexico Aggarwal et al. 33.0 37 1987-90 Netherlands Wessels; Eijgenhuijsen & Buijs 7.2 72 1982-91 New Zealand Vos & Cheung 28.8 149 1979-91 Portugal Alpalhao 54.4 62 1986-87 Singapore Koh & Walter 27.0 66 1973-87 Spain Rahnema et al. 35.0 71 1985-90 Sweden Ridder; Rydqvist 39.0 213 1970-91 Switzerland Kunz & Aggarwal 35.8 42 1983-89 Taiwan Chen 45.0 168 1971-90 Thailand Wethyavivorn & Koo-smith 58.1 32 1988-89 U.K. Dimson; Levis 12.0 2133 1959-90 7-- -- -- MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Stock market reaction How do stock prices react to security offerings? Type of security Industrials Utilities Common stock* -3.14% -0.75% Preferred stock -0.19 0.08 Convertible preferred -1.44 -1.38 Straight debt -0.26 -0.13 Convertible bonds -2.07 Private placements of debt -0.91 Bank loan agreements 1.93 *Approximately 30% of issue size (sometimes > 100%) 8-- MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Stock market reaction Debt issues Stated purpose Loan agreement Private placement Public straight bonds Repay debt 1.14% 0.51% -0.35% Cap expenditure 1.20 -0.23 0.55 General purpose 4.67 0.26 0.07 Repay bank loans 3.10 -2.07 -1.63 No purpose given 1.74 0.69 9MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Stock market reaction Recapitalizations Transaction Security issued Security retired Announce return Leverage increasing Stock repurchase Debt Common 21.9% Exchange offer Debt Common 14.0 Exchange offer Preferred Common 8.3 Leverage decreasing Call exercise Common Debt –2.1 Exchange offer Common Preferred –2.6 Exchange offer Preferred Debt –7.7 Exchange offer Common Debt –9.9 10MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Stock market reaction Stock issues are bad news, but debt issues are either neutral or good news Interpretation Dilution? Signaling: what types of firms issue equity vs. debt? Firms that are overvalued Firms with relatively poor prospects Exception: growth stocks Convertibles as ‘backdoor equity’ 11MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Financing decisions Empirical summary Pecking order Firms prefer internal to external financing, and external debt to external equity Target capital structure Firms seem to have target debt ratios. Different industries view the trade-off between debt and equity differently. Investor reaction Stock offerings are bad news, debt offerings are neutral, and bank loans are good news. Prices react positively to leverage-increasing transactions. 12MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Capital structure, 1997 Industry Debt / (Debt + Equity) High leverage Building construction Hotels and lodging Air transport Primary metals Paper Low leverage Drugs and chemicals Electronics Management services Computers Health services 60.2% 55.4 38.8 29.1 28.2 4.8 9.1 12.3 9.6 15.2 13MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 15 Payout policy Questions How do firms payout cash? What are the advantages and disadvantages of each method? How much cash should a firm hold? 14MIT SLOAN SCHOOL OF MANAGEMENT