Wa0025.

Chapter --
• Raising Capital
SMS August 2021 Slide:#

Sources of Financing
1- Venture Capital
2- Debt: Loans and Bonds
3- Stocks: preferred and common
4- leasing
SMS August 2021 Slide:1

1- Venture Capital
• Private financing for relatively new businesses in
exchange for stock
• The company should have an “exit” strategy

• Sell the company – VC benefits from proceeds from
sale
• Take the company public – VC benefits from IPO
• Many VC firms are formed from a group of

investors that pool capital

Choosing a Venture Capitalist
• Look for financial strength: to obtain
additional financing
• Choose a VC that has a management
style compatible with your own
• Obtain and check references: past
experience
• What is the exit strategy?

2- Types of Long-term Debt
• Bonds – public issue of long-term debt
• Private issues
• Term loans
• Direct business loans from commercial banks,
insurance companies, etc.
• Maturities 1 – 5 years
• Repayable during life of the loan
• Private placements
• Similar to term loans with longer maturity
• Easier to renegotiate than public issues
• Lower costs than public issues

3- Stocks
• Two types of Stocks
• Preferred Stock
• Common Stock

Preferred Stock
A hybrid security:
• It’s like common stock - no fixed maturity.
• Technically, it’s part of equity capital.
• It’s like debt - preferred dividends are fixed.

• Missing a preferred dividend does not
constitute default, but preferred
dividends are cumulative.

Common Stock
• Is a variable-income security.
• Dividends may be increased or decreased,
depending on earnings.
• Represents equity or ownership.
• Includes voting rights.
• Limited liability: liability is limited to amount of

owners’ investment.
• Priority: lower than debt and preferred.

Selling Securities to the Public
• Management must obtain permission from the
Board of Directors
• Firm must file a registration statement with the

Security Exchange Commission (e.g. KSE)
• A preliminary prospectus, called a red herring, is
distributed during the waiting period
• Securities may not be sold during the waiting period
• The price is determined on the effective date of the

registration
Alternate issue methods
• The offer can either be:
• A- public issue: company is required to register with SEC
• B- private issue: if the issue is sold to fewer than 35 investors.
Registration is not required.
• For equity sales there are 2 kinds of public issues:

• A- general cash offer: general public: on cash basis
• B- rights offer: existing shareholders
• First public equity issue is called an initial public offering (IPO) or

unseasoned new issue IPO
• Seasoned equity offering (SEO): new equity issue of securities by

a company that has previously issued securities to the public

Underwriters
• Services provided by underwriters
• Formulate method used to issue securities
• Price the securities
• Sell the securities
• Price stabilization by lead underwriter
• Syndicate – group of investment bankers that
market the securities and share the risk
associated with selling the issue
• Spread – difference between what the syndicate
pays the company and what the security sells for
initially in the market

Basic Types of Underwriting in
cash offer
A. Firm Commitment underwriting
B. Best efforts underwriting
C. Dutch Auction underwriting

A-Firm Commitment
Underwriting
• Issuer sells entire issue to underwriting syndicate
• The syndicate then resells the issue to the public
• The underwriter makes money on the spread

between the price paid to the issuer and the
price received from investors when the stock is
sold
• The syndicate bears the risk of not being able to

sell the entire issue for more than the cost
B- Best Efforts Underwriting
• Underwriter must make their “best effort” to sell
the securities at an agreed-upon offering price
• The company bears the risk of the issue not
being sold
• The offer may be pulled if there is not enough

interest at the offer price and the company does
not get the capital and they have still incurred
substantial flotation costs

C- Dutch Auction Underwriting
• Underwriter accepts a series of bids that include
number of shares and price per share
• The price that everyone pays is the highest price

that will result in all shares being sold
• There is an incentive to bid high to make sure

you get in on the auction but knowing that you
will probably pay a lower price than you bid

Example
Bidder Quantity (shares) Price ($)
A 100 16
B 100 14
C 200 12
D 100 12
E 200 10
If we want to sell 400 shares the offer price will be 12 so
A through D get the shares but not E. all winners pay the
same price (uniform) despite the fact that some bid
higher. At 12 we have bids for 500 shares which is more
than 400 shares. So allocation should be done. 400/500
= 0.80 and then multiply the ratio by the bid
IPO Underpricing
• Initial Public Offering – IPO
• May be difficult to price an IPO because
there isn’t a current market price available
• Private companies tend to have more
asymmetric information than companies that
are already publicly traded
• Underwriters want to ensure that, on average,
their clients earn a good return on IPOs
• Under pricing causes the issuer to “leave
money on the table”

Rights Offerings: Basic Concepts
• Issue of common stock offered to existing
shareholders
• Allows current shareholders to avoid the dilution
that can occur with a new stock issue
• “Rights” are given to the shareholders
• Specify number of shares that can be
purchased
• Specify purchase price
• Specify time frame
• Rights may be traded OTC or on an exchange

The Value of a Right
• The price specified in a rights offering is
generally less than the current market
price
• The share price will adjust based on the

number of new shares issued
• The value of the right is the difference

between the old share price and the “new”
share price SMS August 2021 Slide:18
Rights Offering Example
• Suppose a company wants to raise $10
million. The subscription price is $20 and
the current stock price is $25. The firm
currently has 5,000,000 shares
outstanding.
• How many shares have to be issued?
• How many rights will it take to purchase one
share?
• What is the value of a right?

Solution
• Shares issued = 10,000,000/20 = 500,000
• Rights to buy one share =
5,000,000/500,000 = 10
• Total investment = 10*25 + 20 = 270
• Price per share = 270 / 11 = 24.55
• Value of a right = 25 – 24.55 = .45
• Buy 10 rights = .45*10 = 4.50 + 20 =
24.50 difference due to rounding

EXAMPLE
• National Power wants to raise $5 million in new equity.
The subscription price is $10 and the market price is
$20. The company has 1000000 shares outstanding.
• How many shares National Power must issue?
• How many rights are needed to buy the new share?
• What is the value of the rights for a shareholder who
owns 2 shares before the rights offering is about to
expire?
• What is impact of the issue on the value of the
company?
• If you do not own shares in this company can you still
buy the new shares at the offer price?
Ex-rights price
• Ex-rights date:
The beginning of the period when stock is
sold without a recently declared right,
normally two trading days before the
holder of record date
• Holder of record date:
The date on which existing shareholders on
company records are designated as
recipients of stock rights
Example
• AAA proposed a rights offering. Current
price $40 per share, stockholders are
allowed to buy one new share for every
five shares they own at $25. what is the
value of a right? What is the ex-right price?

Solution
• Buy 5 rights on shares = 5X40 = 200
• Exercise the right for 25 so your total

investment = 225 and you end up with 6
ex-rights shares
• The ex-rights per share = 225/6= 37.5
• The rights worth 40-37.5= 2.5

Dilution
• Dilution is a loss in value for existing
shareholders
• Types of dilution
• Percentage ownership – shares sold to the
general public without a rights offering
• Market value – firm accepts negative NPV
projects
• Book value and EPS – occurs when market-
to-book value is less than one

Ownership dilution
• Occurs when the firm sells shares to the public
• AWA has 100000 shares outstanding and you
own 20000 shares (20%) of the votes and the
dividends
• If AWA issued another 100000 shares and you
did not buy, your ownership will be diluted
because it will drop to 10%
• The value of your shares is unaffected but you
own less percentage of the firm
• Dilution of ownership can be avoided by using rights
offering
Shelf Registration
• Permits a corporation to register a large issue with
the SEC and sell it in small portions
• Reduces the flotation costs of registration
• Allows the company more flexibility to raise money

quickly

4- Leasing
• Leasing is the process by which a firm can obtain the
use of certain fixed assets for which it must make a
series of contractual, periodic, tax-deductible payments.
• The lessee is the receiver of the services of the assets

under a lease contract.
• The lessor is the owner of the assets that are being

leased.

Leasing: Operating Leases
• An operating lease is a cancelable

contractual arrangement whereby the lessee
agrees to make periodic payments to the lessor,
often for 5 or fewer years, to obtain an assets
services.
• Generally, the total payments over the term of

the lease are less than the lessor’s initial cost of
the leased asset.
• If the operating lease is held to maturity, the

lessee returns the leased asset over to the
lessor, who may lease it again orSMS
sell the2021
August asset.
Slide:29
Leasing: Financial (or Capital) Leases
• A financial lease is a longer-term lease than an

operating lease.
• Financial leases are non-cancelable and obligate the

lessee to make payments for the use of an asset over a
predefined period of time.
• The total payments over the term of the lease are

greater than the lessor’s initial cost of the leased asset.
• Financial leases are commonly used for leasing land,

buildings, and large pieces of equipment.

Leasing: Leasing Arrangements
• A direct lease is a lease under which a lessor
owns or acquires the assets that are leased to a
given lessee.
• A sale-leaseback arrangement is a lease under
which the lessee sells an asset for cash to a
prospective lessor and then leases back the
same asset.
• A leveraged lease is a lease under which the
lessor acts as an equity participant, supplying
about 20 percent of the cost of the asset with a
lender supplying the balance.

Leasing: Leasing Arrangements (cont.)
• Operating leases normally require maintenance

clauses requiring the lessor to maintain the assets and
to make insurance and tax payments.
• Renewal options are provisions that grant the lessee

the option to re-lease assets at the expiration of the
lease.
• Finally, purchase options are provisions frequently

included in both operating and financial leases that allow
the lessee to purchase the asset at maturity—usually at
a pre-specified price.

Leasing: The Lease-Versus-
Purchase Decision
• The lease-versus-purchase decision is a common
decision faced by firms considering the acquisition of a
new asset.
• This decision involves the application of capital

budgeting techniques as does any other asset
investment acquisition decision.
• The preferred method is the calculation of NPV based on

the incremental cash flows (lease versus purchase)
using the following steps:

Purchase Decision (cont.)
Step 1: Find the after-tax cash outflows for each
year under the lease alternative.
Step 2: Find the after-tax cash outflows for each
year under the purchase alternative
Step 3: Calculate the present value of the cash
outflows from Step 1 and Step 2 using the after-tax
cost of debt as the discount rate.
Step 4: Choose the alternative with the lower
present value of cash outflows.

• Roberts Company, a small machine shop, is
contemplating acquiring a new machine tool
costing $24,000. Arrangements can be made to
lease or purchase. The firm is in the 40 percent
tax bracket.
• Lease. The firm would obtain a 5-year lease
requiring annual end-of-year payments of $6,000.
All maintenance costs will be borne by the lessor,
and the lessee would exercise the option to
purchase the machine for $4,000 at termination
of the lease. SMS August 2021 Slide:35
• Purchase.
The firm would finance the purchase of the machine with a
9%, 5-year loan requiring end -of-year installment
payments of $6,170. It would be depreciated under
MACRS using a 5-year recovery period. The firm would
pay $1,500 per year for a service contract that covers all
maintenance costs; insurance and other costs would be
borne by the firm. The firm plans to keep the machine
and use it beyond its 5-year recovery period.

Step 1: Find the after-tax cash outflows for each year under the
lease alternative.
The after-tax cash outflow from the lease payments can be found
as follows:
A-T Outflow from Lease = $6,000 x (1 - t)
= $6,000 x (1 - .40)
= $3,600
In the final year, the $4,000 cost of the purchase option would be
added to the $3,600 lease outflow to get a year 5 outflow of $7,600
($3,600 + $4,000).

Step 2: Find the after-tax cash outflows for each year

under the purchase alternative.
First, the annual interest component of each loan
payment must be determined since only interest can be
deducted for tax purposes as shown in the Table on the
following slide.
Second, the A-T outflows must be computed as shown
in Table below



Step 3: Calculate the present value of the cash

outflows from Step 1 and Step 2 using the after-tax
cost as the discount rate. This is shown in Table 16.3
on the following slide.


STEP 4: Choose the alternate with the smaller present value of cash
outflows.
Because the present value of cash outflows for leasing ($18,151) is lower
than that for purchasing ($19,539), the leasing alternative is
preferred—resulting in an incremental savings of $1,388.

Leasing: Advantages of Leasing
• The firm may avoid the cost of obsolescence if the
lessor fails to accurately anticipate the obsolescence of
assets and sets the lease payment too low.
• A lessee avoids many of the restrictive covenants
that are normally included as part of a long-term loan.
• Leasing—especially operating leases—may provide the
firm with needed financial flexibility.
• Sale-leaseback arrangements may permit the firm to
increase its liquidity by converting an existing asset into
cash, which may then be used as working capital.

Leasing: Advantages of Leasing (cont.)
• Leasing allows the lessee, in effect, to depreciate land,

which is prohibited if the land were purchased.
• Because it results in the receipt of service from an asset
possibly without increasing the assets or liabilities on the
firm’s balance sheet, leasing may result in misleading
financial ratios.
• Leasing provides 100 percent financing.
• When the firm becomes bankrupt or is reorganized, the
maximum claim of lessors against the corporation is 3
years of lease payments, and the lessor gets the
asset back.

Leasing: Disadvantages of
Leasing
• A lease does not have a stated interest cost.
• At the end of the term of the lease agreement,
the salvage value of an asset, if any, is realized
by the lessor.
• Under a lease, the lessee is generally prohibited
from making improvements on the leased
property or asset without approval of the lessor.
• If a lessee leases an asset that subsequently
becomes obsolete, it must still make lease
payments over the remaining term of the lease.

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Chapter --

SMS August 2021 Slide:#

2- Debt: Loans and Bonds

3- Stocks: preferred and common

SMS August 2021 Slide:1

• The company should have an “exit” strategy

• Many VC firms are formed from a group of

SMS August 2021 Slide:2

SMS August 2021 Slide:3

SMS August 2021 Slide:4

SMS August 2021 Slide:5

• It’s like debt - preferred dividends are fixed.

SMS August 2021 Slide:6

• Represents equity or ownership.

• Includes voting rights.

• Limited liability: liability is limited to amount of

• Priority: lower than debt and preferred.

SMS August 2021 Slide:7

• Firm must file a registration statement with the

• Securities may not be sold during the waiting period

• The price is determined on the effective date of the

• For equity sales there are 2 kinds of public issues:

• First public equity issue is called an initial public offering (IPO) or

• Seasoned equity offering (SEO): new equity issue of securities by

SMS August 2021 Slide:9

SMS August 2021 Slide:10

B. Best efforts underwriting

C. Dutch Auction underwriting

SMS August 2021 Slide:11

• The underwriter makes money on the spread

• The syndicate bears the risk of not being able to

• The offer may be pulled if there is not enough

SMS August 2021 Slide:13

• The price that everyone pays is the highest price

• There is an incentive to bid high to make sure

SMS August 2021 Slide:14

SMS August 2021 Slide:16

SMS August 2021 Slide:17

• The share price will adjust based on the

• The value of the right is the difference

SMS August 2021 Slide:19

SMS August 2021 Slide:20

SMS August 2021 Slide:23

• Exercise the right for 25 so your total

• The ex-rights per share = 225/6= 37.5

• The rights worth 40-37.5= 2.5

SMS August 2021 Slide:25

• Reduces the flotation costs of registration

• Allows the company more flexibility to raise money

SMS August 2021 Slide:27

• The lessee is the receiver of the services of the assets

• The lessor is the owner of the assets that are being

SMS August 2021 Slide:28

• An operating lease is a cancelable

• Generally, the total payments over the term of

• If the operating lease is held to maturity, the

• A financial lease is a longer-term lease than an

• Financial leases are non-cancelable and obligate the

• The total payments over the term of the lease are

• Financial leases are commonly used for leasing land,

SMS August 2021 Slide:30

SMS August 2021 Slide:31

• Operating leases normally require maintenance