Chapter 20

Overview
In the first five lessons in FIN 581, we learned about the analytical and conceptual foundation of the
capital structure (i.e., financing) decision. In addition, we reviewed empirical findings and survey
results on the key factors that CFOs and their finance teams consider in determining the target debt
ratio and the dividend policy for their firms. Though public companies rely heavily on their internally
generated equity capital (via dividend policy) to finance their investments, they raise external debt and
equity capital by issuing new securities in the financial markets periodically to supplement their
internal financing sources.

In this unit, we learn about capital raising activities in practice for both public and private firms. This
unit begins with the most crucial decision that converts a private firm into a public firm, i.e., the going
public process via its initial public offering (IPO). Further, we discuss the costs of going public, with
an emphasis on the IPO underpricing. For public firms, they seek external capital through rights
offering, public offering (traditional versus shelf registration), and private placement. This unit
discusses the fundamentals and issues concerning each of these issuance methods to sell new securities
by public firms. Lastly, this unit offers a brief overview of venture capital and equity crowdfunding in
meeting the financing needs of private firms.

Learning Objectives
Upon completion of this unit, students are expected to be able to:

• Explain the benefits and costs of going public.

• Explain the processes and methods of security issuance, and the roles of investment bankers in
each issuance method.
• Explain the going public process and describe various reasons offered to explain the IPO
underpricing.
• Explain the various components of IPO issuance costs and perform related calculations.
• Explain the rights offering method of seasoned equity issuance and perform related
calculations.
• Explain the shelf registration method of seasoned equity issuance, and discuss the strengths and
weaknesses of its recent developments.
• Discuss the empirical and survey findings on the practice of security issuance.
• Explain the roles of venture capital and equity crowdfunding in financing private firms.

Benefits of Going Public

• Lower the firm’s cost of capital
-- Before going public, owner-managers typically under diversify their investments as most (if
not all) of their wealth is tied up in the private firm. The proceeds from reducing their fractional
ownership in the firm when it goes public help them diversify their investment portfolio. The
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 risk diversification for owner-managers lowers their required return on the now public firm and
hence its cost of capital.
• Broaden capital base
-- With the sale of equity ownership of the firm to the public investors, the going public process
removes wealth constraints of current owners with a huge influx of new capital from a much
larger group of investors.
• Provide liquidity/marketability
-- With the support of an active stock market, the trading of common stocks of public firms is
much easier among investors. The improvement in liquidity lowers transaction costs and hence
the cost of capital.
• Lowering/Shifting monitoring costs
-- Public firms are required to comply with the disclosure regulations of the SEC and the stock
exchange where they are listed. In addition, there are professional institutions such as rating
agencies, research analysts, and institutional investors, etc. following public firms. These help
the efficient monitoring of public firms that also lowers monitoring cost and cost of capital.
• Provide information and market feedback to management on business decisions
-- The valuation of the public firms in the capital market continuously assesses the firm's
decision and performance for the reference of the management and the Board. The market price
of common stock also offers timely reference that facilitates future capital raising activities of
the firm.
• Increase exposure, prestige, and public image
-- The financial market activities of a public firm tend to get the attention of the media that may
enhance its visibility in the product market (and talented labor market) as well.
• Provide opportunities of stock acquisitions
-- The public trading of a firm's common stock facilitates mergers and acquisitions.
• Equity-based executive compensation
-- Stock options are commonly used as part of the equity based compensation that helps the
firm to attract and retain talented management team and employees.

Costs of Going Public

• Disclosure of proprietary information
-- In compliance with the requirements of various regulatory agencies, and in responses to the
inquiries of media and capital market participants, a public firm may disclosure information
that has an adverse impact on its competition and/or contract negotiation.
• Agency costs of equity financing
-- Recall from previous chapters on the agency costs resulted from the separation of
management and ownership that is a common concern for public firms.
• Administrative costs of registering SEC
-- It is costly for public firms to meet the regular reporting requirements, especially for smaller
companies. For instance, an unintended side effect of the SOX Act of 2002 was that the
increase in compliance costs pushed many companies to “go dark”, and to delist from the U.S.
stock exchanges and list overseas in order to avoid the hefty compliance costs. As a result, the
number of companies listed in the U.S. decreased by almost half from 1996 (n=8090) to 2019
(n=4266) before rising to almost 6000 in 2021. The number of IPOs was more than halved

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 from the peak of 677 in 1996 to the bottom of 63 in 2003 before bouncing back to a recent peak
of 311 in 2021.
• Dilution of ownership and control
-- In exchange for the proceeds from the IPOs, the owner-managers of the formerly private
firms greatly reduce their fractional ownership and hence lose their control and influence on
outside stockholders. Though the growing trend of recent IPO issuers adopting the multi-class
stock structure helps their owner-managers retain control of their firms after going public.
• Issuance costs
-- There are substantial direct and (especially) indirect costs associated with security issuance.
We will learn about the hefty indirect costs that take the form of underpricing in the following
sections.
• Compliance and litigation costs
-- It takes much time and efforts of senior executives and their teams to comply with the
regulations of the SEC and various regulatory bodies. In addition, they are liable for errors and
misinformation in prospectus and SEC reporting. These costs take the form of executive
compensation and the premium paid for the liabilities insurance for officers and directors.

Process for Issuing Securities

The Procedure

1. Management gets the approval of the Board on their preliminary proposal regarding security
type and dollar amounts.
2. The issuing firm (most likely working with the investment banking firm) prepares and files a
registration statement with the SEC. This document (known as "preliminary prospectus" or "red
herring") includes information on the proposed offer and on the issuing firm such as the
professional background of the management team, the firm's businesses, finances, and legal
issues, etc.
3. The SEC studies the registration statement during the waiting period. The SEC may ask the
issuing firm to provide additional information and/or answer their comments on the proposed
offer. During the waiting period, the issuing firm and its investment banking team conduct
“road show” (i.e., book-building) to promote their IPO and seek feedback from potential
investors that help to gauge the demand for the issue and determine the final offer price. Oral
offers (but not committed final sale) are allowed during the road show.
4. The firm prepares and files an amended registration statement (i.e. the "prospectus") with the
SEC.
5. With SEC approval, the final offer price is set and a full-fledged selling effort gets underway.

Please reference Lecture Slide 6 for the typical timeline of the IPO process.

Overview

Before we turn our focus to the common type of security offer in the U.S., i.e., the Cash Offer, let us
learn the basics of the two approaches of security offerings:
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 General cash offer – securities offered for sale to the general public on a cash basis.
This approach applies to most security types, i.e., both equity and debt, and to both initial
public offerings (IPOs) and seasoned offerings (SOs). Recall from FIN 531 or its equivalent
that an IPO refers to a company’s first equity issue made available to the public, and Seasoned
equity offering refers to a new issue of common equity securities by a public firm.

Rights offer – public issue in which securities are first offered to existing shareholders on a pro
rata basis. This approach only applies to a public firm raising additional common equity capital
with the intent to offer its existing shareholders the opportunities to retain their fractional
ownership such that they avoid the dilution effect of the offer on their control of the firm.

Please reference Lecture Slides 8&9 (Table 20.1 in the assigned text) for the summary of
security issuance methods.

Cash Offers
There are three methods for issuing securities for cash:

1. Firm Commitment Underwriting

The issuing firm sells the entire issue (at a discount off the offer price) to the
underwriting syndicate, and hence transfer the risk to the investment banking team that
underwrites the issue, i.e., underwriting. The syndicate then resells the issue to the
public at the offer price. 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. But the
syndicate bears the risk that the actual spread earned will not be as high as anticipated
(or may not even cover costs) in case that they cannot sell the entire issue to the public.
This is the most common issuance approaches for cash offers in the United States.

Given the risk of being stuck with unsold shares, the underwriting syndicate typically
conducts a “road show” to market the offering prior to the actual offer date. This is part
of the process of “bookbuilding.”

There are two approaches to select an underwriter under the Firm Commitment
Underwriting method:
-- The Competitive approach selects the investment bank that submits the highest bid
price for the securities.
-- The Negotiated approach, the more common (though expensive) approach, interviews
and screens investment banking firms for their previous experiences and performance,
client network, research capacity and reputation, etc., and select the best fit.

2. Best Efforts

The investment banking team must make their “best efforts” to sell the securities at an
agreed-upon offer price. Note that the investment banking team does NOT take position
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 in the offer. Hence, the issuing firm bears the risk of the market being unwilling to buy
at the offer price. The offer may be pulled if there is not enough interest at the offer
price, according to the agreement between the issuing firm and the investment banking
team. When this happens, the company does not get the capital, but they have still
incurred substantial flotation costs.

The Best Efforts method, which is more likely to be associated with smaller, riskier and
less liquid issues, is not as common as it used to be.

3. Dutch Auction Underwriting

Unlike under the firm commitment underwriting method, the underwriter does not set
the offer price. Instead, it accepts a series of bids (from the potential investors) that
include both the number of shares the investor is committed to purchase and the (bid)
price per share. At the close of the bidding window, the underwriter ranks all the bids in
the descending order of the bid prices. Under the Uniform Price Auction, the (same)
price that is paid by everyone is the highest price that will result in all shares being sold.
When the issue is over-subscribed, proportional allocation will apply.

There is an incentive for investors to bid high to make sure they get in the auction but
knowing that they will probably pay a lower price than their bid price. However, there
is a slight risk of being overly aggressive in the bid price that they are stucked with the
entire issue at their overly aggressive bid price.

The U.S. Treasury has sold bills, bonds, and notes using the Dutch auction process for
many years. Google is the highest profile Dutch auction IPO to date. Please read
Lecture Slide 14 for further details on Google's IPO!

Please read the "Dutch Auction - An Example" handout for further information
(including numerical illustrations) on this topic.

Role of Investment Bankers

Underwriters are investment banking firms that function as intermediaries between the issuer and the
public. Some of the services provided by underwriters include:

• Advise the type of security, i.e., debt, equity, or convertibles, to be offered

• Advise the issuance method and the offer terms that include the determination of the final offer
price
• Provide administrative services such as the SEC registration forms, etc.
• Promote and Sell the securities
-- Book building via “road show" to generate interests and visibility for the offer
-- Forming an underwriting syndicate with other investment banking firms that each has
their own network of clients for building a broad base of potential investors for the offer. The
syndicate also helps spread the risk bore by the managing banker.
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 • Provide after-market services and support for stabilizing the valuation of the newly issued
common stock in the weeks following the offer. Green Shoe provision, under which the issuing
firm agrees to sell additional shares to the underwriter syndicate at the offer price, facilitates the
price stabilization effort during a hot issue market that is characterized with excessive demand
for the issue.
• Quiet period – Restriction on material information released by the issuing firm and its
underwriters. During this period, only ordinary announcements and other purely factual matters
are allowed to be communicated to the public. The quiet period begins prior to the IPO (i.e.,
filing with the SEC) and extends until 40 days after the IPO. Under the JOBS Act of 2012, the
quiet period is shortened to 25 days post IPO for qualified issuers.
• Lockup period – Restriction on sale of IPO stock by insiders after the IPO. It is typically 180
days.

New Alternative Approaches for Going Public

In recent years, there are new ways that private firms adopt in their going public process. For instance,
the Direct Listing (or Direct Placement or Direct Public Offering, DPO). Issuing firms that meet
the listing requirements can work directly with the stock exchange (e.g., NYSE) to list their shares
without the involvement of investment banking firms. While this approach is less costly (i.e., no
underwriting fees and underpricing), the issuing firm takes on much administrative and sale tasks and
misses the benefits of the selling network with institutional investors. Besides, the issuing firm bears
the risk of being unable to raise sufficient capital as there is no underwriting in direct listing.
Please study the "IPO Alternative Direct Listing" article for further information on this topic!

Though it has been around for a while, the Special Purpose Acquisition Company, SPAC (or Blank
Check Company) is a unique approach that investors use to take their target private firms public. In
brief, a SPAC, a blank check company created by a sponsor, goes public to raise capital and then find a
non-listed operating company to merge with, in the process taking the target company public.
For more introductory information on SPAC, please reference
https://www.investopedia.com/terms/s/spac.asp

Please study the "IPOs vs SPACs vs Direct Listings" article for a comparison of the various
forms of IPO methods!

The Costs of New Issues

The costs of issuing securities can be broken down into the following main categories:

o Spread or underwriting discount – The difference between the underwriter’s buying

price and the offer price; it is the underwriter’s main source of compensation. For IPO’s
in the range of $20 to $80 million, the spread is typically 7%.
o Other direct expenses – SEC (Form S-1) filing fees; lawyer fees; auditor fees, etc.
o Indirect expenses such as the effort and time of the management team spent on the
issuance process. But the major components of indirect issuance costs take the forms of
abnormal returns for seasoned offerings and underpricing for IPOs.
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 1. Abnormal returns (Seasoned Offerings) – the impact of the negative stock price
reaction to the announcement on existing shares of common stock. This
represents a major component of indirect costs of seasoned offerings.
2. Underpricing or Initial Return (IPOs) – Differential between first day’s closing
price and the offer price.
3. Green Shoe Option – Underwriters can buy additional shares at the offer price
to cover over-allotments. Typically, it is capped at 15% of the issue.

Some observations:

• There are substantial economies of scale in the issuance costs, i.e., the larger the offer, the
smaller the issuance costs as a percentage of the total proceeds.
• An IPO is more expensive than a seasoned offering
• Selling debt is less costly. And straight bonds are cheaper to float than convertible bonds

An Example
The Green Hills Co. has just gone public. Under a firm commitment agreement, Green Hills received
$29.96 for each of the 7.5 million shares sold. The initial offering price was $32 per share, and the
stock rose to $34.56 per share in the first few minutes of trading. Green Hills paid $1,950,000 in direct
legal and other costs and $425,000 in indirect costs. What was the flotation cost as a percentage of
funds raised?

Answer:

Net Amount Raised = 7,500,000 * $29.96 - $1,950,000 - $425,000 = $222,325,000

Direct Costs = [$(32.0 - 29.96)*7,500,000] + $1,950,000 = $17,250,000

Indirect Costs = [$(34.56 - 32.0)*7,500,000] + $425,000 = $19,625,000

Total Issuance Costs = $17,250,000 + $19,625,000 = $36,875,000

Hence, Flotation Costs (%) = $36,875,000 / $222,325,000 = 16.59%

IPO Underpricing
IPO Underpricing (initial return) is computed as:

(first day closing price – offer price) / offer price

There is an average of about 20% underpricing in the US IPO market. If we believe that the stock
market is efficient, i.e., market price (closing price) reflects the true value of the stock, then the offer
price is relatively too low. Hence, we refer a positive initial return as the IPO being underpriced. When
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we multiply the initial return with the number of shares issued in the IPO, we get the amount of
"money left on the table."

The underpricing of IPOs is a common and global phenomenon. The record year is still 1999, with an
average first day return of almost 70%. For interested students, you will find insightful data and
statistics on IPOs compiled by Prof. Jay Ritter - https://site.warrington.ufl.edu/ritter/ipo-data/

The following table shows examples of IPOs with underpricing info:

IPO Offer Closing Shares $ on the Table

Firm name Underpricing
date price price (Mil) (Mil)
OfficeMax 11/2/94 $19.00 $24.50 28.95% 26.5 145.8
Polo Ralph
6/11/97 $26.00 $31.50 21.15% 23.5 129.3
Lauren*
Ticketmaster
12/2/98 $14.00 $40.25 187.50% 7.0 183.8
Online
Priceline.com 3/30/99 $16.00 $69.00 331.25% 10.0 530.0
Goldman Sachs* 5/4/99 $53.00 $70.38 32.78% 55.2 959.1
eToys 5/20/99 $20.00 $76.56 282.81% 8.3 470.6
Drugstore.com 7/28/99 $18.00 $50.25 179.17% 5.0 161.3
UPS* 11/10/99 $50.00 $68.25 36.50% 87.5 1597.2
Buy.com 2/8/00 $13.00 $25.12 93.23% 14.0 169.7
Palm 3/2/00 $38.00 $95.06 150.16% 23.0 1312.4
Google 8/19/04 $85.00 $100.33 18.04% 19.6 300.5
Tim Horton’s 3/23/06 $23.16 $28.17 21.63% 29.0 145.2
Visa 3/19/08 $44.00 $56.50 28.41% 406.0 5075.0

For an updated list, you can download ““Money Left on the Table in IPOs – by Firm”” at
https://site.warrington.ufl.edu/ritter/ipo-data/

Here are some explanations for IPO underpricing summarized by Prof. Ritter in Section 3.2 of his
"Initial Public Offerings" article. The IPO underpricing :

• compensates underwriters for bearing the underwriting risk under the firm commitment
underwriting method. By setting the offer price below the "fair" price, it increases the
likelihood of the issue to be oversubscribed and hence the entire issue to be sold by the
underwriting syndicate.
• compensates investors for the greater degree of information asymmetry in the valuation of
young opaque private firms that have no prior price history.
• compensates potential investors (mostly institutional investors) for truthfully revealing their
interests (i.e., demand) for the issue during the road show (i.e., the book-building process). The
revelation of demand also helps attract other investors to pursue the issue (i.e., the bandwagon

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 effect). The underpricing "leaves a good taste in IPO investors' mouths" that also helps the
underwriters to attract their clients to invest in future IPOs underwritten by them.
• serves as a positive signal about the issuer's future prospects such that they can sell additional
shares at a higher price and face less negative market reaction in their follow-on seasoned
equity offerings.
• ensures that, on average, less-informed investors earn a good return on IPOs. This is the
"winner's curse" argument that uninformed investors get more shares in low quality IPOs that
are under-subscribed, but fewer shares in high quality IPOs that are over-subscribed.
• mitigates the likelihood of lawsuit being filed by IPO investors. The underpricing serves as an
insurance policy against securities litigation.
• increases awareness and publicity of the issuing firm that generates positive spillover in the
product market.

The IPO underpricing could be a negative outcome of agency conflict between the underwriter and the
issuer that results in wealth transfer from the issuer to investors via their rent-seeking behavior.
(Institutional) investors may offer side payments to the underwriter in excessive trade commissions.
And underwriters may allocate better quality IPOs to their clients for gaining future businesses (i.e.,
spinning).

A behavioral explanation for IPO underpricing is that investors could be irrational during the internet
bubble period by overpaying for the issuing firm when shares of its common stock hit the market. In
other words, the positive initial return might be an indication of overpricing instead.

• Please closely study the REQUIRED reading - "Explanations for IPO Underpricing Review
JABFR2019" posted on the Module, and the summary highlight of the various explanations for IPO
underpricing presented in Lecture Slides 19 ~ 22, for your learning reference. Among various
explanations, the Information Asymmetry explanation (and its various versions) is most developed for
explaining IPO underpricing. Note from Lecture Slides 20 and 21 that the various versions are
associated with diverse sources of information asymmetry among IPO stakeholders, i.e., issuing firm,
underwriter, better-informed institutional investors, and less-informed retail investors, etc.

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What CFOs Say (CFOs View of IPOs; JACE 2006)
Firms go public for two primary reasons (Fig. 1):

• Raise capital to fund growth opportunities

• Create a publicly traded asset to facilitate M&A for growth

Additional benefits of public market access:

• Allow owners to diversify their holdings and to realize their wealth tied up in the firm
• Enhance reputation and visibility in the public

On IPO timing (Windows of Opportunity; Fig. 2):

• Focus primarily on overall stock market conditions , especially by VC backed IPOs, and
secondarily on industry conditions. This is evidenced by the IPO cycles, i.e., hot versus cold
issue, with the internet bubble period in late 1990s as an extreme example of hot issue market.

On (lead/managing) underwriter selection (Fig. 3):

• The key factors are the overall reputation (+ analysts) and industry expertise/connection of the
investment banks.
• Their institutional investor client base and deal-making support to facilitate the sale of the issue

On IPO underpricing (Fig. 4):

• CFOs are well aware of the IPO underpricing reality – 10% (expected) vs. 13.5% (actual)
• Tougher negotiation with non-integer offer prices may help!
• Primarily to compensate (less informed) investors for risk taking
• Secondarily to attract/ensure a market for the issue, especially the institutional investors

On signaling issuer’s quality (Fig. 5):

• Positive perception about the issuers that haves strong earnings records and reputable
underwriter. Reputable auditor and long lock-up period are also associated with favorable
perception of the issuer’s quality.
• Negative perception about the issuers if the issues are accompanied with secondary offerings,
i.e., insider selling. Given information asymmetry between the issuer and the public, insider
selling is interpreted as insider taking advantage of their information to be benefitted by selling
overvalued shares. Recall the Pecking Order and Signaling explanations from Chapter 17!

On staying private (Fig. 6):

• Remain in control in terms of managing the firm and/or fractional ownership (Chapter 15)

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Seasoned Equity Offerings
Stock prices tend to decline when a company announces a seasoned equity offering. Why?

o Managerial Information
▪ In Chapter 17, we learned that in an information asymmetric world where management
possesses privileged information about the quality of the firm that outside investors do not.
Following the "buy low sell high" principle, the market perceives the management's decision to
issue new equity as negative information about the firm because the sale of new equity by
management suggests the firm's common stock is being overvalued in the market.

o Debt Capacity
▪ If the market infers that managers issue new equity to reduce their debt-equity ratio due to the
specter of financial distress, the stock price will fall. In Chapter 17, we learned that a firm
issues debt as long as its earnings prospects can sustain the higher interest obligation.
Consequently, a stock issue indicates that management believes that their firm is too highly
leveraged relative to its earnings capacity.

o Falling Earnings
▪ If the market infers that the managers issue new equity to cover unanticipated increase in cash
needs resulted from shortfalls in earnings, the stock price will fall.

Other Motives for Seasoned Equity Offerings

Financing Growth Opportunities
• The issuing firms may have many positive NPV projects that exhaust the amount of internally
generated capital and their debt capacity. Hence, they issue new shares of common stock to
finance the value creating projects. Empirical findings show that while the growth opportunities
have a positive impact on the stock price reaction to the announcement of seasoned equity
offering, the overall valuation impact continues to be negative even for growth firms.

Regulatory Constraints
• Financial institutions are required to meet the capital and equity ratios under Basel III. Hence,
they may need to raise new equity capital to pass the stress test.

Corporate Control
• Management may issue new shares of common stock to a target group of "friendly" investors to
fence off a hostile takeover attempt. The increase in outside stockholders could weaken the
fractional ownership and hence control of the hostile takeover investors.

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Shelf Registration (Rule 415)
Overview

Shelf registration was initially introduced and put into effect under SEC Rule 415 in 1982 as an
alternate approach that simplifies the traditional approach of public offerings. It allows a public firm to
register all securities that it reasonably expects to issue within the next two years in one registration
statement. The firm can then issue the securities in smaller increments, i.e., “takedown off the shelf,”
on short notice without the need to file with SEC for further approval when funds are needed during
the two-year period. This allows issuing firms to time their offerings to take advantage of favorable
market conditions that mitigate the downward pressure of the offering announcements on stock
valuation. In addition, the flotation costs associated with “taking down off the shelf” are minimal when
compared to the traditional approach of public offerings.

A public firm can shelf-register both debt and equity securities using Rule 415 if it satisfies the
following qualifications:

• -- Debt securities must be rated investment grade

• -- No debt defaults in the last three years
• -- Market value of outstanding stock must be greater than $150 million
• -- No violations of the Securities Act of 1934 within the last three years

Recent Developments under SOR 2005

The Securities Offering Reform (SOR) that became effective December 1, 2005, represents major
amendments and modifications to the registration, communications, and offering processes of capital
raising of public firms since the Securities Act of 1933. The SOR has major impacts on the shelf
registration method and helps its growth to become the dominant approach in seasoned equity
offerings (SEOs).

In summary, the SOR relaxes disclosure restrictions for the large "Well-Known Seasoned Issuers"
(WKSIs) in several ways that benefit the use of shelf registration by the qualified issuing firms:

1. SOR removes the waiting period and changes the pre-filing and post-effective periods by
dropping communication restrictions throughout the entire SEO process. WKSIs may report, in
any period, factual and forward-looking information that the firm regularly releases.
2. SOR allows WKSIs to freely communicate (i.e., free write) during any period using a "Free
Writing Prospectus" (FWP). FWPs include written communications and electronic
communications that include roadshow presentations.
3. For WKSIs, shelf registrations are automatically effective without SEC review, and the
window during which registered securities can be "taken down off the shelf" is extended from
two to three years. WKSIs can also update or renew the shelf registration without SEC review.

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 4. WKSIs are NO longer responsible for ensuring that investors receive the final prospectus
because filing with the SEC is now viewed as "Access Equals Delivery.” These changes
increase a WKSI's ability to quickly takedown off the shelf when necessary.
5. SOR allows WKSIs to omit information (e.g., proposed offering amounts for each type of
security) from the shelf registration, which effectively shifts the SEO information event from
the filing date to the pre-issue date. The shelf registration Form S-3ASR allows WKSIs to
register to offer securities at any time without stating detailed information about the SEO.

In addition, the SOR 2005 facilitated newer forms of issuance methods such as At-the-Market
offerings (ATMs) that are also known as Dribble-out or Continuous offerings; Bought Deals (or Block
Trade); Registered Direct Offerings (RDOs); Over the Wall offerings; Confidentially Marketed Public
Offerings (CMPOs); etc. While each of these recently developed methods has its unique features, they
do share the following common characteristics that are valued by the issuing firms:

◼ The offering process tends to be “quiet” with limited advance disclosure and hence minimal
public awareness.
◼ The offering tends to be completed within a short window that helps reduce the adverse
valuation impact of common stock issuance on the issuing firm’s stock price.
◼ The offering process is highly adaptable to changing market conditions and hence offers great
flexibility to issuing firms to exercise marketing timing.
◼ The issuance costs tend to be low.

Please read Lecture Slides 40 - 42 and posted readings for further information on the Value of
Shelf Registration (Rule 415), the Securities Offering Reform (SOR 2005), and various recently
developed issuance methods!

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Rights Offerings

Basics
If a preemptive right is contained in the firm’s articles of incorporation, the firm must offer any new
issue of common stock first to existing shareholders. This allows shareholders to maintain their
percentage ownership (and hence their share of control via voting rights), i.e., avoid dilution, if they so
desire.

It is a privileged subscription – issue of common stock offered to existing stockholders. Offer terms are
evidenced by warrants or rights. Typically, the rights offer opens for a period of 2~4 weeks starting
from the day the registration statement becomes effective for interested shareholders to participate in
the subscription. Non-participating shareholders can trade their rights on exchanges or over the
counter.

Standby Rights Offerings - The issuing firm makes a rights offering and the underwriter makes a
commitment to “take up” (purchase) any unsubscribed shares on a standby basis. In return, the
underwriter receives a standby fee. In addition, shareholders are usually given oversubscription
privileges (the right to purchase unsubscribed shares at the subscription price).

Mechanics
Initial stages are the same as for a general cash offer, i.e., obtain approval from directors, file a
registration statement, etc. The difference is in the sale of the securities. Current shareholders get the
rights to buy new shares. They can subscribe (buy) the entitled shares, sell the rights or do nothing.

The management of the firm must decide:

• The subscription (or exercise) price, i.e., the price existing shareholders must pay for new
shares, Psub. The subscription price is typically set at a discount to recent market price of the
common stock.
• Given the amount of capital raised and the subscription price, the management can determine
o # of new shares = $ raised / subscription price, Psub
• Then, the number of rights required to purchase one new share of stock is
o # of rights required, N = # of shares outstanding / # of new shares
• These rights have value, VRight:
o Shareholders can either exercise their rights or sell their rights.
o VRight = (rights-on price – subscription price) / (# of rights required + 1)
o VRight = (PRO - Psub) / (N + 1)

Please reference Lecture Slide 30 copied below for notations and formulas used in rights
offerings calculations.

14
Rights Offerings – Examples
Example I:

Popular Delusions, Inc. is proposing a rights offering. There are 200,000 shares outstanding trading at
$25 each (i.e., PR0). There will be 10,000 new shares issued at a $20 subscription price (P sub).

(a) What is the new market value of the firm?

The new market value = $25*200,000 + $20*10,000 = $5,200,000.

(b) What is the ex-rights price, PX?

We first calculate # of rights required for each new share, N = 200,000 / 10,000 = 20
Thus, the value of an ex-rights share PX = (20*$25 + $20) / (20+1) = $24.7619

(c) What is the value of a right, VRight?

The value of a right, VRight = $25.0 – $24.7619 = $0.2381

Note that when a privileged subscription is used, the firm sets a holder-of-record date. The
stock sells rights-on, or cum rights, until two business days before the holder-of-record date.
After that, the stock sells without the rights or ex rights. Absent taxes and transaction costs,
shareholder wealth is not differentially affected whether they exercise or sell their rights, nor
does it matter what subscription price the firm sets as long as it is below the market price.

15
Example II:

Valley Corp.’s stock is currently selling at $37 per share. There are 1 million shares
outstanding. The firm is planning to raise $2.5 million to finance a new project. What are the
ex-rights stock price, the value of a right, and the appropriate subscription price under each of
the following scenarios?

(a) Two shares of outstanding stock are entitled to purchase one share of the new issue.
# new shares = 1,000,000 / 2 = 500,000 given N = 2.
Hence, the subscription price, Psub = $2,500,000 / 500,000 = $5.0; and
the ex-rights stock price, PX = (2*$37 + $5) / (2+1) = $26.3333; and
the value of a right, VRight = $37.0 - $26.3333 = $10.6667.

(b) Four shares of outstanding stock are entitled to purchase one share of the new issue.
o Here are the answers for your learning reference -
# new shares = 250,000; Psub = $10.0; PX = $31.60; and VRight = $5.40

(c) How does the stockholders’ wealth change from part (a) to part (b)?
o Let us assume that the existing shareholder owns 4 shares of the issuing firm's common
stock. Hence, the initial wealth level is 4*$37 = $148.
Under the first scenario in part a, the wealth level is (4+2)*$26.3333 - 2*$5 = $148.
Under the second scenario in part b, the wealth level is also $148!

Please reference Lecture Slides 35 - 36 for additional numerical example

The Puzzle
A pure rights offering is typically cheaper than underwriting or a rights offer with standby
underwriting. However, the vast majority of offerings in the U.S. are underwritten. Why?
Please study Section 20.8 in the assigned text and Lecture Slide 37 for this topic!

16
Overview – Other Financing Mechanisms
Previous sections of this unit focus on large established public firms that can handily access the capital
market when they need to raise funds from the public by issuing seasoned equity and debt.
Unfortunately for start-up and private firms, and firms in financial trouble, they have limited access to
the public equity market. Hence, these firms need to seek alternate financing mechanisms when they
need to raise capital.

In this section, we are introduced to the basics of venture capital and crowdfunding, as well as private
placements, that provide needed capital to private companies before they go public. Please study
Section 20.1 in the assigned text and posted readings for further information on the topics of
venture capital and equity crowdfunding.

Venture Capital
Though angel investors such as family and friends of the business owner provide early stage funding
for the start-up, a more well-known group of financiers is venture capitalists (VCs). Unlike angel
investors, VCs are financial intermediaries that raise funds from outside investors, and are typically
formed as limited partnerships. One distinguishing characteristic is that venture capitalists invest not
just their money, but also their business acumen and industry expertise. As such, venture capitalists
play an active role in overseeing, advising, and monitoring the business operation of the private
company, i.e., their investments, for the goal of a successful IPO (or more likely that it will be acquired
for a decent price). VCs generally do not want to own the investment forever and understandably like
to earn a great (and reasonably quick) return on their investment.

There are four types of suppliers of venture capital:

1. Old-line wealthy families

2. Private partnerships and corporations
3. Large industrial or financial corporations have established venture-capital subsidiaries.
4. Individuals, typically with incomes in excess of $100,000 and net worth over $1,000,000. Often
these “angels” have substantial business experience and are able to tolerate high risks.

Pros and Cons for Venture Capital

• Benefits
o Funding sources when lower cost capital is exhausted
o Expertise and network that will aid business development

• Costs
o Inflated cost of capital; typically 20%~40%
o Loss of control
▪ VC demands control over major decisions with their strong equity positions (via
convertibles), i.e., over 50% ownership, and their board membership.

17
 ▪ Given that VCs see the company as a part of their investment portfolio, their
interests are in conflict with those of the company founder. These conflicts in
interests many times lead to the displacement of the company founder.
From the VC’s perspective, financial performance dominates ideals via staged
financing.

Crowdfunding
With the wide availability of the internet and the credit crunch following the recent meltdown of the
financial system, many small companies have turned to crowdsourcing for raising capital. These
crowdfunding activities involve raising insignificant amounts of capital from a large number of people
by presale of products and services.

Most recently, there has been rapid growth in equity crowdfunding that raises capital from the crowd
through the sale of securities in a private company. Equity crowdfunding allows small private
companies to access a large base of retail investors with no restrictions on the qualification of
investors. It also opens up many investment opportunities for small retail investors to invest in start-
ups. In addition, the shares of the private companies can be traded on public markets after one year that
offer liquidity to the securities. The equity crowdfunding opens up a valuable financing alternative to
venture capital for small private companies. Please read the "Venture Capital vs. Equity
Crowdfunding" article posted on the Module for a comparison!

In June 2016, the SEC introduced the Regulation Crowdfunding that allows companies to raise up to
$5 million annually by selling securities such as equity or convertible note to the public online. And
this Regulation allows any investor over 18 years old to buy securities in private companies. In return,
issuing companies are required to publicly disclose its financial conditions and ongoing annual reports.

Private Placements
Private placements are used by both private and public firms in raising debt or equity capital to finance
their businesses and investments. Unlike public offerings, private placements allow the issuing firm to
avoid the costly SEC registration procedures and disclosure requirements. Typically, private placement
firms tend to be small, risky (growth) firms facing severe information asymmetry with inferior
performance.

The SEC typically restricts private placement issues to a limited number of “qualified” investors,
composing of mostly high net worth investors and institutions such as insurance companies, hedge
funds, and pension funds. In addition, there are restrictions on the resale of the unregistered securities
to the public, though there is no restriction on trading among "qualified" investors. Hence, the liquidity
of securities issued via private placements is limited compared to those issued via public offerings.

Please reference Lecture Slides 43 - 44 and the text chapter for further information on this topic.

18
 Chapter 22 – Options and Corp Finance
Overview and Learning Objectives

Overview
Options are important and versatile contracts. Investors can buy and sell stock options. Managers
can use options on foreign currency and interest rate instruments in risk management. Bonds may
have option-like features built into them. Convertible bonds are an example. We can even view a
corporation and the relationships between stockholders and bondholders in an option framework.
Thus, it is important to learn the basic features of options, regardless of whether you are working in
corporate management, investments, banking, or another field in finance. This lesson focuses on the
basic structure and valuation of options, and how we can use the option structure to understand
capital structure and financial decisions.

Learning Objectives
Upon completion of this unit, students are expected to be able to:

• Explain the basic structure, features and terminology of options.

• Construct the payoff and profit diagrams for call and put options from the perspectives of
both the buyer (holder) and the seller (writer).
• Identify in-the-money and out-of-the-money options using option quotes.
• Draw payoff and profit diagrams of selected combinations of options.
• Explain the concept of put-call parity, and perform related calculations.
• Calculate the value of a stock option using the Black-Scholes option pricing model
(B-S OPM).
• Explain how stock price, stock price variability, time to maturity, interest rate, and exercise
price affect the value of a call or put option on common stock.
• Explain how common stocks can be analyzed as put and call options, respectively, on the
firm's assets, and perform related calculations.
• Apply the five option value determinants to analyze the valuation impacts of financial
decisions on common stocks, and perform related calculations.
• Apply the option valuation framework to explain the impact of financial decisions on the
wealth transfer between stockholders and bondholders, and perform related calculations.

1
Stock Options – What are They?
There are two forms of stock options:
• Call Options
• Put Options

Call options are contracts that give the holder the RIGHT, but not an obligation, to buy a given
quantity of an asset (say, a share of stock) at a specified price (i.e., the exercise or strike price),
which is agreed upon today, on or before a specified date (i.e., maturity or expiration date) in the
future.

Put options are contracts that give the holder the RIGHT to sell the underlying asset (say, a
share of stock) at the exercise or strike price on or before the maturity or expiration date of the
option.

Note that exercise or strike price refers to the fixed price in the option contract at which the holder
can buy or sell the underlying asset when they exercise the option for such transaction.

In order for the option holder to enjoy the right offered by the contract, the writer is obligated to
fulfill the conditions specified in the option contract. For instance, the writer of a call option is
obligated to sell the asset at the strike price when the call option holder exercises the option to buy
the underlying asset, i.e., "call in" the asset.

Option Terminology
"In-the-money" Options versus "Out-of-the-money" Options

An option is "in-the-money" if it has a positive payoff. For example, if a call option has an
exercise price of $30 per share and the current stock price is $32 per share, then the option is "in-
the-money." An investor can exercise the call option, buying a $32 stock for $30 and enjoy a
positive payoff of $2 per share. If the current stock price is $29 per share, then the call option is
"out-of-the-money." In this case, the option holder will walk away from the call option because it
is less costly to buy the share directly from the market for $29 than through exercising the call
option.

For a put option, if the exercise price is $30 per share and the current stock price is $27 per share,
then it is "in-the-money." By exercising the put option, the option holder can sell the share at $30,
which is higher than the market price of $27, for a positive payoff of $3 per share. A put option with
an exercise price of $30 per share and a current stock price of $35 per share is "out-of-the-money."
Since the option holder can sell the share at a higher price in the market than through the put option,
they will walk away from the put option.

Both options are "at-the-money" when the current stock price matches the exercise price, i.e.,
both are $30 in the above example. Exercising an "at-the-money" option would result in a zero
payoff.
2
European versus American Option

A European option can only be exercised at its maturity date. An American option can be exercised
at any time up to and including its maturity date. Most of the options traded in U.S. markets are
American options. Theoretical models typically assume European options because the mathematics
is more tractable.

Option Quotes

The prices of stock options are quoted in the Wall Street Journal. For example, information on IBM
options is reported in Table 22.5 of the text and Slide 20.

--Call-- --Put--
Option/Strike Exp. Vol. Last Vol. Last
IBM 130 Oct 364 15¼ 107 5¼
138¼ 130 Jan 112 19½ 420 9¼
138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½
138¼ 140 Jul 1826 1¾ 427 2¾
138¼ 140 Aug 2193 6½ 58 7½
The first column on the left is the current stock price. Here, the stock price for IBM is $138.25 per
share. The second column from the left is the exercise or strike price for the options. The third
column gives the month in which the option expires. Options expire on the Saturday after the third
Friday of the month of expiration. The fourth and fifth columns from the left provide the trading
volumes and closing market prices for the call options. The sixth and seventh columns from the left
provide the trading volumes and closing market prices for the put options. The trading volume
numbers provide the number of contracts traded. Options trade in one hundred share contracts. In
other words, one option contract is for options on 100 shares of stock.

For example, a July call option with $135 exercise price is in-the-money by $3.25 = $138¼ – $135,
while a July put option with the same exercise price is out-of-the-money. The price of this July call
option is $4.75 while the July put option is $0.8125.

Please reference Slides 20 - 25 for additional illustrations and information on

interpreting option quotes.

3
Call Options
The payoff on a call option at expiry can be expressed as:

CT = Max[ST – E, 0]

where ST is the value of the stock at expiry (time T); E is the exercise or strike price; and C T is the
value of the call option at expiry

Assume Gail is an active investor. She believes Axon Inc.'s stock will rise to $63 per share in the
next couple of months. Gail purchases a call option on Axon stock for $10. The call option has an
exercise price of $50 per share. If Gail is right, and Axon stock's price climbs to $63 per share
before the option expires, Gail can exercise her option to buy at $50 per share. The payoff for Gail
from exercising the call option is $(63–50) = $13, and her profit is $(13-10) = $3 per share. In this
scenario, the call option is in-the-money.

For every stock option buyer, there has to be a seller or writer of the option contract. The option
writer contracts to sell the stock at the option exercise price on or before a specified date. Suppose
Mark writes an option on Axon with an exercise price of $50 per share. Mark sells the option for
$10. If Axon's stock price rises to $63 per share, Mark has an obligation to sell Axon at $50 per
share. Obviously, Mark will not be happy that Axon's stock price is above $50. The option holder,
Gail, will exercise the call option to buy Axon stock at $50 a share from Mark, who incurs a loss of
$3.

If Axon stock does not rise to above $50 per share, then Gail will not exercise the option. Suppose
Axon stock stays at $48 per share through the expiration date of the option. Why would Gail want
to pay $50 per share for a stock that is worth $48 per share? In this case, the payoff on the
unexercised call option is zero, and Gail has a loss of $10, the amount she paid for purchasing the
option. In this scenario, the call option expires out-of-the-money and will not be exercised. Mark
will pocket the money he received for selling the option (i.e., $10 per share) and do nothing. Mark's
willingness to write the option on Axon's stock suggests that he does not believe Axon's price will
rise above $50 over the coming months.

Take a look at the payoffs the investor can expect from the call option. The payoff to the investor
rises, as the stock price climbs, once the price is above $50 per share. Hence, holders/investors
taking a long position in the call option have a bullish view on the underlying asset, i.e., expecting
that the value of the underlying asset will go up. Since options are zero-sum games, a long position
in the call option gains at the cost of the short position in the same call option. Hence, writers
taking a short position in the call option have a bearish view on the underlying asset, i.e., expecting
that the value of the underlying asset to go down. The zero-sum game nature of options are
demonstrated in the following two payoff profiles that are mirror images to each other.

4
 xercise price

Now take a look at the payoffs to the writer or seller of the call option. One dollar is lost for every
$1 the stock price is above $50, the exercise price. This is a zero sum game. For every dollar the
option buyer gains, the option writer loses one dollar.

xercise price

Note that the above option payoff diagrams do not include the price of the option contract, i.e.,
option premium. To determine the profit on a position in options, we need to incorporate the option
premium in the diagram. The diagram below shows the profit profile for a long position (i.e., the
buyer’s perspective) in this call option in the example. When compared to the call option payoff
diagram, there is a vertical displacement that reflects the $10 call premium in the profit profile.

5
 Buy a call

xercise price option premium

Similarly, we can construct the profit profile for a short position in the call option (i.e., the writer’s
perspective). For this call option, at stock prices less than $50 per share, the writer gains $10 and the
buyer gives up $10. Visualize on this diagram that if we combined the option profits for the buyer
and writer, the net amount of profit is zero. This demonstrates the zero-sum game nature of option
trading.

Put Options
The payoff on a put option at expiry can be expressed as:

PT = Max[E - ST, 0]

where ST is the value of the stock at expiry (time T); E is the exercise or strike price; and P T is the
value of the put option at expiry

Assume that Bill is an active investor. He owns Eagle Inc. stock and is worried about a decrease in
the price of this stock. Bill can purchase an "insurance policy" against wealth changes due to a
decrease in stock price by buying a put option. Assume the exercise price on the put option is $50.
If agle’s stock price falls to 4 , Bill can exercise his “in-the-money” put option and sell Eagle at
$50 per share to the writer of the put option. Thus, Bill is sure of being able to get at least $50 per
share for his stock. In this scenario, the payoff to the put option holder, Bill, is $(50-40) = $10. If
Eagle’s stock is at the expiration date of the option, Bill will let his “out-of-the-money” option
expire unexercised because he can sell his share of Eagle Inc. directly in the market at $55, which is
higher than the strike price of $50 via exercising his put option.

6
The diagram below shows the payoffs to the buyer of a put option with an exercise price of $50.

Buy a put

xercise price

Jane is the writer of the put option on Eagle Inc. stock. Assume Jane received $10 per share for each
option sold. agle’s stock price falls to 4 per share, Jane has an obligation to buy agle at per
share. If agle’s stock price is when the option expires, Jane pockets the $10 per share and does
nothing else. This is what Jane is hoping for. If the stock price falls below $50 per share, Jane loses
$1 per share for every dollar the stock price falls.

See the diagram below for Jane’s payoffs.

Sell a put

xercise price

7
Similar to the case of call options, we can construct the corresponding profit profiles for put option
buyers and writers by adding the put premium as a vertical displacement to the corresponding
payoff diagrams. And by combining the option profits for the buyer and writer of this put option,
the net amount of profit is also zero. This demonstrates the zero-sum game nature of option trading
that the writer and buyer profits exactly cancel each other out.

Buy a call

Sell a call Sell a put

Buy a call
Buy a put

xercise price
Sell a call
option premium

8
Combinations of Options
Call and put options are the basic building blocks for more complex options. For example, suppose
an investor buys a stock and the underlying put option on that stock. When the price of the stock
goes up, the investor will benefit. When the price of the stock goes down, the investor will have the
payoffs on the put option to compensate for the losses on the stock. The exercise price of the put
option is a floor value for the investor’s position.

The figures below show the payoffs and profits of this strategy. Note that the resulting payoff
pattern is identical to a call option payoff.

alue at rotective ut payoffs

expiry

Buy the
stock Buy a put with an exercise
price of

alue of
stock at
expiry

alue at Buy the stock at 4

expiry
4 rotective ut
strategy has
downside protection
and upside potential

4
Buy a put with exercise price of
for
alue of
4 stock at
expiry

9
Now suppose the investor above writes a call option on the same stock at the same exercise price.
Take note that at stock prices above the exercise price, the negative payoffs associated with the
short position in the call option cancel out the gains on the stock. When the stock price falls below
the exercise price, the positive payoffs on the put option cancel out the losses on the stock. Putting
together the payoff profiles for the positions on the call, the put, and the stock, we get a straight
horizontal line representing the payoff profile for the entire portfolio. The horizontal payoff profile
represents a riskless position, i.e., whatever happens with stock price, the option payoffs and stock
gains and losses cancel each other out.

In summary, by taking a long position in both the put option and its underlying
asset, and a short position in the call option on the same underlying asset, with
the same strike price and expiration date on both options, one can get a risk-free
payoff from the combination, i.e., a perfectly hedged (riskless) portfolio. This is the
foundation of the Put-Call Parity Theorem!

ortfolio value today ortfolio value today

ption payoffs ( )

ption payoffs ( )

( )

Stock price ( ) Stock price ( )

Since these portfolios have identical payoffs, they must have

the same value today hence
ut all arity ( )

Please also reference Slide 30 for the risk-free profit profile of the above
combination of a long position in the protective put and a short position in the
call option!

10
Put-Call Parity
We can use the riskless combination of owning the stock (S), buying a put option (P) and selling a
call option (C) to discuss put-call parity. Put-call parity refers to the pricing relationship between a
call and put option on the same stock with the same strike price (E) and expiring on the same date
(T).

A discussion of put-call parity will lead us into a discussion of option valuation.

Value of stock + Value of put - Value of call = Present value of strike price discounted at rF.

Using notation, we can express the Put-Call Parity Theorem as:

S0 + P0 - C0 = E / (1 + rF)^T
Alternatively, the Put-Call Parity Theorem says that

Value of Put = Value of Call + PV of Exercise price (or value of riskless bond) – Value of Stock

i.e., by re-arranging the Put-Call Parity, we can calculate the price of the put option, i.e., put
premium, P0, using the observed prices for the other three securities namely the call option, C 0, the
underlying stock, S0, and the risk-free bond, B0 = E / (1 + rF)^T .

i.e., P0 = C0 + B0 - S0 ; Put Premium P = “CBS”!

The put-call parity holds precisely for European options, which can only be exercised at the
expiration, and approximately for American options. For our learning interest, we assume European
options in our discussions.

Numerical Illustration on the Put-Call Parity Theorem:

Consider the following investment strategy. You purchase the Microsoft stock at $90 3/8 and the
July $85 put option at 3 1/2. You sell the July $85 call option at 9 3/4. Assume that the price of
Microsoft stock is $100 on the expiration date. Your payoffs from these securities are:

Stock $100
Put $0 (because the market price, $100, is greater than the exercise price, $85)
- ($100 - $85)= - $15 (Exercised by the holder; you are the writer of the option and are
Call
obligated to sell the $100 stock at $85)

Net Total Payoffs = $100 + $0 - $15 = $85

11
What will your payoffs be if the price of Microsoft stock is $80 instead of $100 on the expiration
date?
Stock $80
Put $85 - $80 = $5
Call $0 (because the market price, $80, is lower than the exercise price, $85)

Net Total Payoffs = $80 + $5 - $0 = $85

Notice that your payoffs from this investment strategy (buy stock, buy put, sell call) are the same
regardless of the stock price on the expiration date. Since your payoff ($85) is certain, this
investment strategy is risk-free. What is the cost of this investment?
Stock $90 3/8
Put $3 1/2
Call - $9 3/4

Net investment = $90 3/8 + $3 1/2 -$ 9 3/4 = $84 1/8

➔ (Risk-free) return on investment: $(85 - 84.125)/$85 = 1.04% for 3 months (4.16% per year).

Since this investment portfolio has a risk-free payoff, its return should be equal to the risk-free rate
such as the yield on a Treasury security that matures on the expiration date of the call and put
options. If the return on this investment portfolio differs from the risk-free rate, there will be a risk-
free arbitrage opportunity. Therefore, the put-call parity always holds with the help of arbitragers
looking out for opportunities to reap arbitrage profits existed in the market.

Example on Using the Put-Call Parity Theorem to Calculate P0:

Suppose risk free rate of return = 2.04%; Time to expiration is one year;
Stock price = $45; Exercise price = $50; and Call premium = $4
According to the Put-Call Parity Theorem,
Put Premium, P = $4 + $50/1.0204^1 - $45 = $8

12
Option Pricing
Key information needed for option valuation is readily available. Remember the option quote
shown earlier? Three items can be found in the quote:

• Stock Price, S0
• Strike or Exercise Price, E
• Expiration Date (and hence time to expiration, t)

These three parameters, plus the risk-free interest rate, rF, and a measure of the volatility of the
stock price, σ2, are needed to value an option. The table below lists these five parameters (i.e.,
determinants) along with their relation to call and put option prices.

Determinants of Option Pricing Relation to Call Option Relation to Put Option

Stock price Positive Negative
Strike price Negative Positive
Risk-free rate Positive Negative
Volatility of the stock Positive Positive
Time to expiration date Positive Usually positive

The relationship between the value of an option and the stock price and exercise price is intuitive.
We discuss the relationship between the value of an option and the remaining three factors.

Risk-free Rate of Interest

The call option provides investors with the opportunity to delay purchase of the stock. When
interest rates are high, this option to defer purchase is more valuable. This is because the present
value of the exercise price can earn interest until the option is exercised. Consider that you prepare
yourself for exercising the call option by investing in a risk-free Treasury security that matures on
the option's expiration date. The higher the interest rates, the lower the current price of the Treasury
security. This works to the favor of the call option holders. Thus, the call option value is positively
related to the risk-free interest rate. The argument for the negative relationship between the risk-free
rate and the value of a put option follows similar logic. The higher the interest rates, the more
interest income is foregone for the case of put options.

Volatility of the Underlying Stock

The volatility of the underlying stock is an important option pricing variable. The greater the
dispersion of possible returns on a stock, the greater the probability that the option will expire "in-
the-money." See figure 22.9 in your textbook for an illustration of this concept. The value of both
put and call options increases with the volatility of the underlying stock. There is no equal concern
about potential adverse impacts of unfavorable stock price movements on option values because
option holders can walk away from the options that are "out of the money".

13
Time to Expiration Date

Consider two stock options that are identical, except for time remaining until expiration. One of the
options has six months until it expires and the other has nine months until it expires. The nine-
month option is more valuable because it has three additional months during which it can be
exercised. For both puts and calls, the longer the time remaining until maturity, the more valuable
the option. (Note: This discussion ignores the effects of dividends.)

In general, we can decompose the value (or premium) of an option into two parts –
Intrinsic Value and Speculative Value (or Time Premium.

ption Intrinsic Speculative

remium alue alue
4

Some observations:
◼ Note from the definition of the Intrinsic Value of an option that an option is “in-the-money”
when its intrinsic value is positive, implying a positive payoff to the holder upon exercise.
◼ Speculative alue of an option captures the value of the “hope” that the underlying asset
price will move in a favorable direction that leads to a larger payoff for the option holder.
Hence, the Speculative Value is positively impacted by both the time to expiration and the
volatility of the underlying asset price. Since Speculative Value will be zero upon exercise
and at expiry, American options are not early exercised, i.e., before expiry, in general.

14
The Black Scholes Option Pricing Model (B-S OPM)
The value of a call option (C) is:

here
the value of a uropean option at time
the risk free interest rate.
( ) robability that a
standardi ed, normally
distributed, random
variable will be less than
or e ual to .
he Black Scholes odel allows us to value options in
practice. 4

And d2 = d1 – (σ2*t)^1/2
where:

• S is the current stock price.

• E is the strike (exercise) price.
• t is the fraction of one year until expiration.
• σ2 is the variance of the stock.

N(x) is the cumulative standard normal probability for the variable x.

The variance of the stock is the most difficult parameter to estimate. Historic variance is not always
a perfect predictor of future variance.

Note: The value of a put option can be computed based on the value of the call option and the put-
call parity.

15
Assumptions of the Black-Scholes Option Pricing Model

• No restriction on short selling

• No transaction costs
• No taxes
• The option is European
• No dividend
• Stock price is continuous
• Market operates continuously
• rF is known and constant
• Stock price is lognormally distributed

The assumptions of the Black-Scholes Option Pricing Model may appear unrealistic. Many
refinements have been made to the Black-Scholes Model and these models appear to perform well
in valuing options.

Example of the Black Scholes Option Pricing Model

Below is a numerical example that illustrates the Black-Scholes Option Pricing Model.

Given: S = $27; E = $25; t = 120 days / 365; rF = 7%; σ2 = 0.0576

d1 = [ln(27/25) + (.07 + .5 x .0576) x(120/365)] / (.0576 x 120/365)(1/2) = .7953
d2 = .7953 - (.0576 x 120/365)(1/2) = .6577
➔ N(d1) = .7868 and N(d2) = .7446
➔ C = $27*.7868 - $25*e-(.07)(120/365)*.7466 = $3.05

By applying the Put-Call Parity Theorem, we can calculate the put premium as:

➔ P = C + B – S = $3.05 + $25*e-(.07)(120/365) - $27 = $0.48

You can calculate N(d1) using the standard normal distribution function (NORMSDIST) in Excel.
Alternatively, you can use Table 22.3 in your text. If you use the table in the text, notice that you
must make an adjustment to get cumulative probability.

Please reference Slides 41 - 46 for additional numerical examples on the Black-

Scholes Option Pricing Model.

16
Learning Exercise Problem:
a. What is the value of a European call and put options (no dividends) with an exercise price of
$100 and a maturity date 6 months from today if the stock price is $80 and the risk free rate is 5%?
You have estimated the instantaneous variance as 5% based on the variability of past price
movements.

b. Suppose the stock market is undergoing a period of unusually large stock price movements. If the
true variance of the stock is 8%, by how much have you under- or over-estimated the value of the
option?

Brief Notes on Options and Dividends

CBOE options do not receive dividends. This means that an increase in a dividend (and a
corresponding decrease in stock price; recall the ex-Dividend date from Chapter 19) causes call
options to fall and put options to rise in value.

An American call option on a non-dividend paying stock should never be exercised early.
Consequently, such options may be valued in the same way as European call options.

17
Stocks and Bonds as Options
We can think of the relationship between stockholders and bondholders of a corporation as having
option-like characteristics. The example below shows how we can look at the stockholder's position
as being similar to owning a call option on the value of the firm.

Levered Equity as a CALL Option Analogy

The underlying asset comprises the assets of the firm, and the strike price is the par value of the
bond. The shareholders do not own the firm, but hold the call option (on the firm's assets) written by
the bondholders. If at the maturity of their debt, i.e., the expiration date of the call option, the assets
of the firm are greater in value than the debt, the shareholders have an "in-the-money" call. They
will exercise the call option by repaying the bondholders the par value of the bonds, and “call in”
the assets of the firm i.e., take over the ownership the firm.

If at the maturity of their debt, the value of the firm's asset is less than the par value of the debt, the
shareholders have an "out-of-the-money" call and will choose to do nothing. This means that the
shareholders will not pay the bondholders, i.e., the shareholders will declare bankruptcy, and let the
call option expire. As call option holders, the shareholders enjoy the benefits of limited liability.

An Illustration
Suppose fixed financing payments (interest and principal due to lenders) are $1,000 (E) for a firm.
The firm's cash flows for the year are $1,500 (ST). The shareholders make the fixed financing
payments of $1,000 and keep the $500 that remains. For the shareholders, this is like exercising the
"in-the-money" call option to buy the firm from the bondholders.

Alternatively, suppose the firm’s cash flows are (ST) for the year. Now, the shareholders
cannot afford to make the entire fixed financing payment. Since the shareholders have limited
liability, they can default on the debt. The lenders keep the $700 of cash flow instead of the $1,000
that is owed to them. We can think of the shareholders as letting their call option on the firm expire.
If the firm's cash flows are only $700, this is analogous to a call option being out of the money. The
shareholders do not have to exercise the out-of-the-money option.

18
Levered Equity as a (Protective) PUT Option Analogy
The underlying asset comprises the assets of the firm, and the strike price is the par value of the
bond. If at the maturity of the debt, i.e., the expiration date of the put option, the assets of the firm
are less in value than the debt, the shareholders have an in-the-money put. They will put the firm to
the bondholders, i.e., bondholders will get the firm value, an amount that is less than the promised
debt payment. In this analogy, the shareholders own both the firm and the put option on the firm.

If at the maturity of the debt the shareholders have an out-of-the-money put, i.e., the value of the
firm is greater than what they owe to the bondholders, they will not exercise their put option i.e.,
NOT declare bankruptcy, and let the put option expire. By doing so, they keep the firm that they
own.

Corporate Debt and Put-Call Parity

In general, we can express the value of a levered firm, VF, as the sum of the value of its equity, VE,
and the value of its debt, VD. By rearranging the expression, we have VE = VF - VD. From the above
discussion, we learn that the equity of a levered firm can be considered as a call option on the firm's
assets with a strike price equals to the par value of debt, with its expiration date matching the
maturity date of the debt. From the put-call parity, we can express VE (i.e., C) = VF (i.e., S) + P - E
/ (1 + rF)^T.

Hence, the value of the risky corporate debt is equivalent to the value of a comparable riskless bond
(with the same par value and maturity date) minus a put option on the firm's assets held by
stockholders. In other words, VD = E / (1 + rF)^T - P

Other factors being equal, the riskier the underlying asset, the higher the value of the put option and
hence the lower the value of risky corporate debt. Similarly, the higher the debt ratio, the higher the
value of the put option, and hence the lower value of the risky corporate debt.

The view that risky corporate debt can be considered as a comparable riskless bond minus a put
option helps our understanding of the agency costs of debt financing learned in Chapter 17. In the
Asset Substitution scenario, the acceptance of the riskier project increases the volatility of the
underlying asset that increases the value of the put option. Hence, the value of risky debt decreases.
For the case of underinvestment, the rejection of NPV>0 projects also hurt holders of risky
corporate debt because they miss out the opportunities to increase the firm value. And an increase in
firm value will lower the value of the put option and hence increases the value of risky corporate
debt.

Please read Slides 49 - 50 and Section 22.9 of the assigned text for further
information on this topic.

19
Numerical Illustrations – Valuation of Equity and Debt with B-S OPM
This set of numerical examples is based on the information provided in Slides #52&#53!

We express the given information in the B-S OPM notation (ref: Slides #41&42):
For Company A – S = $40,000,000; E = $18,000,000; t = 4 years; σ = 0.40;
and the risk-free rate of interest, R = 0.04

Recognizing that a firm’s equity can be considered as a call option on the firm, we apply
the B-S OPM to compute the value of Company A’s equity as C 0 –
d1 = {ln(40M/18M) + [0.04+(0.5*0.40^2)]*4} / (0.40*√4)
= (0.7985 + 0.48) / 0.8 = 1.5981 ➔ N(1.5981) = 0.9450
d2 = 1.5981 – (0.40*√4) = 0.7981 ➔ N(0.7981) = 0.7876
Hence, the market value of equity is
C0 = $40,000,000*0.9450 - $18,000,000*e-0.04*4 *0.7876
= $37,800,000 - $12,080,672 = $25,719,328
And the market value of debt = $40,000,000 - $25,719,328 = $14,280,672

An extension – Compute the cost of debt capital, Rdebt :

Given the maturity of Company A’s (zero-coupon) debt is 4 years in Slide #52, we apply
the basic TVM analysis that we learned in FIN prerequisite to solve for the bond yield, i.e.,
the cost of debt capital.
$14,280,672 = $18,000,000 * e-Rdebt*4
➔ Cost of debt capital, Rdebt = ln($18,000,000/$14,280,672) / 4
Rdebt = 0.231465 / 4 = 0.057866
As expected, the yield on the risky corporate debt is higher than the risk-free rate!

Now, it is your turn to practice the above analysis with

(i) Company B’s data in Slides #52&53;
(ii) The combined firm in Slide #54
Note that the answers are provided in the slides for your checking!!!

Applications of Option Valuation in Corporate Decisions

Please study Sections 22.10 and 22.11 in the assigned text, and Slides 56 - 62 for
applications with numerical illustrations of the option valuation framework to
explain the impact of corporate financial decisions on the wealth transfer between
stockholders and bondholders.

20
 Chapter 24 – Warrants and Convertibles
Overview and Learning Objectives

Overview

The previous lesson focused on the option fundamentals and how they help explain corporate
finance topics. This lesson examines corporate securities that have options embedded in them or
packaged along with them. We examine the key features of these securities and compare them to
basic stock options. It is important to think about why these securities are issued.

Learning Objectives

Upon completion of this unit, students are expected to be able to:

• Compare and contrast warrants and stock (call) options.

• Describe the characteristics of warrants and convertible bonds.
• Explain how warrants and convertibles can be valued.
• Calculate the balance sheet changes associated with the issuance of bonds with warrants and
the subsequent exercise of the warrants.
• Use a diagram to explain the "floor value" for a convertible bond.
• Explain why firms may issue warrants and convertible bonds.

Option-like Securities

We will be reviewing the following topics in this lecture:

• Warrants
• Effect of Warrants on the Balance Sheet
• Effect of Warrants on Firm Shareholders and Warrant Holders
• Convertible Bonds
• Reasons for Issuing Convertible Securities

1
Warrants
Definition
A warrant is a call option issued by a company. It gives the holder the right to buy a stated number
of shares of the company’s common stock directly from the company at a specified price on or
before a specified date. Warrants are often issued with (privately placed) corporate bonds as a
"sweetener" or an “equity kicker.” Issuing firms could also issue warrants to underwriters under the
“Green Shoe” option for them to fulfill their price stabilization service immediately follows equity
security issuance (Chapter 20). In this case, the strike price on the warrant is typically set at the
offer price of the equity issuance.

Facts About Warrants

• Investors get a fixed return on the bond and the option to purchase common stock.
• The corporation is able to issue debt at a lower interest rate than would otherwise be
possible.
• Warrants are usually detachable. This means they can be sold separately from the bond.
• Warrants may be callable. When a warrant is called, the investor must either exercise the
warrant or accept the call price.

Differences Between Warrants and Stock (Call) Options

• Warrants are issued by the firm. Stock options are issued by an investor.
• Exercise of warrants brings new equity capital into the firm with the issuance
of new shares of stock. This leads to a dilution effect that adversely impacts the
ownership (control) of existing shareholders and the valuation of the stock.
Exercise of stock options does not bring new capital into the firm and has no
impact on stock valuation.
• Warrants have a longer time to maturity than stock options. While a warrant might mature in
six years, a stock option typically matures within a year.

Please reference Slides 5 - 8 for a numerical illustration that contrasts warrants

and call options on the firm's balance sheet and the value of existing
shareholders' claims.
◼ Note in Slide 8 that the adverse impact of the exercise of warrant on the ownership of
existing shareholders, i.e., reducing from ½ to 1/3, and the stock valuation, i.e., decrease to
$1,666.67 from $1,750. In comparison, the exercise of call option, which represents the
transfer of ownership between the two parties and has no impact on stock valuation.

2
Valuing Warrants
Warrants may be valued in a manner similar to call options on the firm's common stock. The Black-
Scholes model may be used, with a simple adjustment to account for the changed number of shares
outstanding for the firm. The adjustment factor is # / (# + #W)
where # is the number of shares outstanding before the warrants are exercised, and # W
is the number of new shares issued with warrant exercise.

And the value of a warrant is affected by the set of parameters in the same manner that these
parameters impact the value of a call option.

. Stock price
. ercise price
. nterest rate
. olatility in the stock price
. piration date
. ividends

The negative impact of dividends on the value of warrant, which is a call option on the company’s
common stock, is due to the ex-Dividend date effect learned in Chapter 19.

3
Effect of Warrants on the Balance Sheet
Example:

Eastern Widgets Inc., which currently has one million shares of common stock outstanding, has just
raised $25 million in debt funds with warrants attached. The debentures carry a 10% coupon rate
and with each debenture ($1000 face value) investors receive one warrant entitling each to purchase
four shares of common stock at $30 a share. The firm's capitalization is as follows (in millions of
dollars):

How about the dilution effect of the exercise of warrants on the value of common
stock?
Without Warrant: Share Price = $50M / 1 million = $50.0
With the Exercise of Warrant: Share Price = ($50M + 25,000*4*$30) / 1.1 million = $48.18
◼ There are 25,000 (=$25M/$1,000) warrants issued and each warrant can buy 4 shares (see
Slide 11 for further details)
➔ Adverse dilution effect on share price is $50.0 - $48.18 = $1.82 (or 3.64%)!

4
Effect of Warrants on Firm Shareholders and Warrant Holders
Example

Base Case
Suppose Sharon and Jack start their own corporation. Each puts up $75 and each receives 5 shares
of stock ($15 per share). The firm purchases 10 barrels of oil at $15/barrel. At this point, one share
represents one barrel of oil. In one year, the firm will sell its oil inventory and liquidate. The
estimated oil prices in one year are:

Warrants

Suppose Sharon and Jack finance $10 of their initial investment by selling Sam five warrants at $2
each. Each warrant allows the holder to purchase one share of the firm with an exercise price of $30
per share and an expiration date in one year. The remaining $140 needed to purchase the oil comes
from Sharon and Jack ($70 each).

If stock price is at or below the exercise price, E=$30, at the expiration date, Sam will not exercise
the warrants. If stock price is greater than the exercise price of $30, Sam will pay $150 to the firm
and receives 5 new shares of stock.

5
Effects of Issuing and Exercising Warrants on the Firm:

Why is the Value of the firm now $600 in the case that oil price is $45 per barrel? Because Sam, the
warrant holder, exercises his 5 warrants to buy 5 new shares of stock and contributes $30*5 = $150
of new equity capital to the firm. This amount of new capital is added to the $450 value of the firm
when oil is $45 per barrel.

Effects of Issuing Warrants on an Existing Shareholder (Sharon or Jack):

6
How do we get $200 for the claim on the firm of Sharon or Jack when oil price (and stock price) is
$45 per barrel (share)? The claim of the warrant holder, Sam, is 5*$40 = $200, and the value of the
firm is $600. Thus, the value to Sharon and Jack together is $400, i.e., $600 - $200. Each equity
investor has a stake worth $200. The original investment of each investor is $70. Thus, Sharon and
Jack each have a profit of $130, i.e., $200 - $70 = $130

Effects of Exercising Warrants on the Warrant-holder (Sam):

Sam originally invested $10. If the price of the stock does not grow above the exercise price of $30
per share, then Sam loses his entire investment of $10. However, if the price of the stock goes up to
$45 per share, Sam exercises his warrants, getting five shares of stock for $30 per share, rather than
for the market price of $40 per share. He invested $10 plus the exercise price of $150, i.e.,
5*$30=$150. He would have stock worth 5 * $40 = $200. This is a $40 profit, i.e., $200 – $(150 +
10) = $40.

An Alternate Computational Approach

The payoff on each warrant held by warrant holders can also be calculated as :

(Firm value net of debt + E x #W ) / (# + #W) – E

where E is the exercise price, # is the number of shares outstanding before the warrants are
exercised, and #W is the number of shares issued when the warrants are exercised.

In the above example, the payoff on each warrant held by Sam is

[($450 + $30*5) / (10 +5)] - $30 = $40 - $30 = $10
Since Sam paid $2 for each warrant, his net profit is $10 - $2 = $8 per warrant, totaling $40 for the
five warrants that he purchased from Sharon and Jack.

7
Warrant Pricing and Black-Scholes Model
Since warrants can be considered as long-term call options on common stock, we can apply the
Black-Scholes option pricing model that we learned in Chapter 22 to calculate the value of an
otherwise identical call option, i.e., treating the warrant as if it is a call option. Then, we adjust the
value of the calculated value of this call option for the dilution effect of warrant exercise on equity
value.

The adjustment factor is # / (# + #W)

where # is the number of shares outstanding before the warrants are exercised, and #W is the number
of new shares issued with warrant exercise.

An Example:

Consider a firm that has 7 million shares of common stock outstanding is valued at $165 million. It
issues 900,000 warrants that each gives the holder the right to buy a share of its common stock at
$25.0. The warrants will expire in one year. The annual continuously compounded risk-free rate is
7%. The annual volatility of its stock return is 0.20. Calculate the value of each warrant.

First, we calculate the stock price, S = $165 million / 7 million = $23.57. # = 7 million and #W =
900,000 as given.

From here, we apply the Black-Scholes option pricing model to calculate the value of an otherwise
identical call option:

d1 = (ln(23.57/25.0) + (0.07+0.5*0.20)) / (0.20*1)^0.5 = 0.2486 ==> N(d1) = 0.5981; and

d2 = 0.2486 - (0.20*1)^0.5 = -0.1987 ==> N(d2) = 0.4213

Then, the value of the "call option", C = $23.57*0.5981 - $25.0*e-0.07*1*0.4213 = $4.28; and hence
the value of the warrant = $4.28 * (7,000,000 / 7,900,000) = $3.79!

Please reference Slides 23&24 for another numerical illustration on this topic,
and if interested, Slides 20~22 for the proof of the adjustment factor.

8
Convertible Bonds
Definition

Convertible securities are bonds and preferred stock that can be exchanged for common stock at the
option of the holder.

A convertible bond is similar to a bond with warrants. But a bond with warrants can be separated
into different securities and sold individually. But a convertible bond cannot.

The biggest difference between warrants and convertibles is that when warrants are exercised
investors inject new (equity) capital into the firm. But convertibles simply change the capital
structure by exchanging the convertibles into common stock without any additional capital.

Terminology

• Conversion ratio (CR) is the number of shares of common stock an investor will
receive in exchange for a bond or preferred stock.
• Conversion price = Pc = Par value of bond / CR
• Conversion premium is the ratio of conversion price to the stock price at issuance,
i.e., (Pc – S0) / S0
o Typically, conversion price is set 10-30% above current stock price at issue, i.e.,
conversion premium is 10%-30% when the convertible security is issued.
Conversion premium indicates the extent the embedded call option in a convertible
security is out-of-the-money.

Convertible Bond Value

Convertible bonds have different components of value:

• Straight bond value, SBV: what the bond would sell for if it did not have a conversion
feature; SBV = present value of the bond's coupons over its life and its face
value at maturity
• Conversion value, CV: what a convertible bond would be worth if converted now; CV
= stock price multiplied by conversion ratio.
• Floor value: the greater of straight bond value and conversion value; Floor value =
MAX(SBV, CV).
• Market value: the selling price of the bond determined in financial markets.
• Option value, OV: the market value of the bond over and above the floor value; OV =
Market value - Floor value

Reference Slide 28 for a summary of key terms regarding convertible bonds.

9
 onvertible
ond alue
onvertible bond
values onversion
alue
floor value

floor Straight bond

value value
conversion ratio ption
value
Stock
rice

The diagram shows convertible bond value versus stock price. Note the similarities to the diagram
of the value of a call option on common stock. Straight bond value is shown by a straight horizontal
line. It does not change as stock price changes.

Conversion value starts at zero and increases as stock price increases.

The floor value of a convertible bond is equal to the straight bond value until stock price is high
enough so that conversion value equals straight bond value. At higher stock prices, the floor value is
the conversion value.

The convertible bond value is higher than the floor value because it includes value due to the
opportunity for stock price to increase further before the bond matures or is called.

10
Examples
Litespeed, Inc., just issued a zero coupon convertible bond due in 10 years. The conversion ratio is
25 shares. The appropriate interest rate is 10%. The current stock price is $12 per share. Each
convertible is trading at $400 in the market.
• What is the straight bond value?
• What is the conversion value?
• What is the conversion value?
• What is the option value of the bond?
Answer:
The straight bond value is: SBV=$1,000/(1.10)^10 =$385.54
The conversion value is: 25 shares × $12/share = $300.0
The floor value is: MAX($385.54, $300.0) = $385.54
The option value of the bond is: $400.0 – 385.54 = $14.46

2. You are a financial analyst hired to value a new 30-year callable convertible bond. The bond
has a 6% coupon payable annually. The conversion price is $125. The stock currently sells
for $35. The stock price is expected to rise 15% per year. The bond is callable at $1,100.
The required return on the bond is 10%.

What is the straight bond value?

$60 = payment
$1,000 = future value
30 = number of years
10% = yield on bond
Compute present value $622.92

What is the conversion value?

Conversion ratio, CR = $1,000 / $125 = 8
Conversion value, CV = 8 * $35 = $280

What is the floor value?

Floor value = MAX($622.92, $280) = $622.92

How long would it take for the conversion value to exceed a call price?
annual rate of return = 15% for I/Y
current stock price = $280 for PV
call price = $1,100 for FV
Compute N (number of years until conversion value > call price)
N = 9.79. It would take 9.79 years for the stock price to match the call price!
Alternatively, you may use the following equation:
(8 * $35) * (1.15)^N = $1,100 and solve algebraically for N = 9.79

11
Reasons for Issuing Warrants and Convertible Securities
This section is taken from Instructor’s Manual to Accompany Corporate Finance.
Please study Sections 24.6 - 24.8 of the assigned textbook and Slides 33 - 37 for
the selected topics!
This brings us to the real world view of convertibles. Firms issuing warrants or convertibles are
typically smaller, more highly levered, higher growth, and higher risk.

The following reasons for issuing warrants and convertibles help explain why convertibles are
usually subordinated and unsecured. Valid reasons for issuing warrants and convertibles include:

1. Matching of Cash Flows

Young, risky firms cannot afford high interest payments. If equity rises in value and
warrants or convertibles are exercised, the firm will probably be in a better position to afford
the dilution in equity.
2. Risk Synergy
When it is costly to assess the risk of the issuing firm, the straight bond value forms a floor
price.
3. Reduction in Agency Costs
Warrants and convertibles are debt equity hybrids and may reduce the conflict between debt
and equity securities.

Curiously, firms generally do not force conversion with the call provision until the conversion value
is significantly above the call price.

12
Overview

This lesson introduces the topic of mergers and acquisitions. The most important objective of
mergers and acquisitions is to create shareholder value. As you might imagine, in competitive
capital markets, this is a difficult challenge. Working with or studying mergers and acquisitions
requires understanding of concepts from many previous lessons. For example, merger valuation
is like a large complex capital budgeting problem. Future cash flows are forecasted and
discounted to obtain an estimate of value. Concepts related to cost of capital estimation and
capital structure are important in merger evaluation and deal negotiation. And as you might
expect, there are ample opportunities for agency conflicts related to mergers and acquisitions.

Learning Objectives

Upon completion of this unit, students are expected to be able to:

 Understand and explain various M&A terms

 Explain various sources of synergy
 Explain several reasons for mergers and determine whether they are in the best interest of
shareholders
 Understand various target firm valuation approaches and perform related analysis and
calculations
 Analyze cash versus stock financing of an acquisition and perform related calculations
 Understand and explain various defensive tactics
 Explain empirical findings on the value of mergers to both acquirer and target
 Understand accounting and tax treatments of M&A
 Understand and explain various forms of divestitures

Types of Acquisitions

Mergers and Consolidations

Mergers & Consolidations are legally simple and generally friendly. The transactions are mostly
non-taxable via exchange of bidder’s equity securities. Shareholders of each firm must approve
of the merger/consolidation. Target management cooperation is needed for this type of
acquisition.

Merger

One firm (A) completely absorbs another firm (B)’s assets and liabilities in a merger. The
acquired firm ceases to exist. The acquiring firm retains its name and identity.

• Statutory merger: A+B = A, B is absorbed by A; versus

• Subsidiary merger: A+B = A+B, B is owned and controlled by A

1
PepsiCo and Quaker Oats were involved in a merger during the 2000-2001 period.

In Fall 2000, PepsiCo bid $14.8 billion for Quaker Oats. Quaker Oats rejected the bid and
entered into talks with Coca Cola and Danone SA for a higher amount. Quaker Oats was
attractive to beverage/food companies because of its sports drink, Gatorade. Quaker Oats came
close to striking a deal with Coca Cola but at the last minute, the Coca Cola Board of Directors
refused to approve the terms of the deal. PepsiCo came back and purchased Quaker Oats for
$13.4 billion. (WSJ, December 2000)

Other examples for subsidiary mergers:

• Pfizer acquired Wyeth for $68 billion in 2009. Wyeth is now a wholly-owned subsidiary
of Pfizer.
• Microsoft’s $26B cash acquisition of LinkedIn in December 2016.
• Abbot Lab’s $30B cash and stock acquisition of St. Jude Medical LLC in January 2017.

An example for statutory merger - Hewlett-Packard’s acquisition of Digital Equipment

Corporation (DEC), DEC has ceased to exist (2006).

Consolidation

Two firms combine to form a new firm. The old firms cease to exist.

An example of a consolidation is DaimlerChrysler AG.

In Spring of 1998, Daimler Benz and Chrysler Corporation announced they would merge,
forming DaimlerChrysler AG. The Detroit News noted that the $38.3 billion deal was the largest
industrial merger in history. (Detroit News, May 7, 1998)

Another example - United (UAL Holdings) and Continental Airlines announced a "merger of
equals" in 2010. The new name of the firm is United Continental Holdings, Inc. and the name of
the airline is United Airlines. The logos painted on the planes are based on the Continental logo.

Acquisition of Stock

The bidding firm intends to take control of the target firm by purchasing its voting stock with a
combination of cash and the bidder's shares. Such deals (tender offers) are often contingent on
the bidder obtaining a minimum percentage of target's voting shares; otherwise, no go.

In a tender offer, the bidder deals directly with stockholders of the target firm that allows them
to circumvent target’s resisting management and board, especially in unfriendly bids. Proxy
contest to gain representation on (or control of) the board by the bidder may take place. Since
this is a public offer to buy shares of the target firm at a price above the current market price, no
formal vote of approval from target's stockholders is required. A downside in a tender offer is
that minority shareholders may hold out for more money. A tender offer is often followed by a

2
formal merger for absorption of the target firm. In a tender offer, if the bidder ends up with less
than 80% of the target firm’s stock, it must pay taxes on a portion of the dividends paid by the
target.

Example: Weyerhaeuser

Below are highlights from a November 29th, 2000, Wall Street Journal article on Weyerhaeuser's
bid for Willamette Industries.

"Weyerhauser plans to make hostile bid of $5.4 billion for Willamette Industries"

• Weyerhauser will launch a hostile cash tender offer for Willamette Industries.
• Tender offer comes in wake of a rejected unsolicited bid by Weyerhauser.
• The Weyerhauser bid represents a 38% premium to where Willamette had been trading.
• Willamette managers seem to be angling for a higher price. (WSJ 11/29/00)

At the Willamette Annual Meeting in July 2001, Weyerhaeuser won three seats on the
Willamette Board. It was a close director election. In October of 2001, Willamette announced
that it would negotiate seriously if Weyerhauser made an offer in the high 50s. Weyerhaeuser bid
$55.50 per share for Willamette. A $6.11 billion agreement was reached in January 2002. After
gaining control of Willamette, Weyerhaeuser operated the firm as a wholly-owned subsidiary.
On May 7th, 2002, Weyerhaeuser announced that it intended to complete the acquisition of
Willamette Industries on June 30th with a merger. After the merger, Willamette ceased to be a
separate legal entity.

Acquisition of Assets
The least common form of acquisitions. The transaction buys most or all of the seller’s assets,
but liabilities are not involved as with a merger. Transferring of asset titles can make the process
costly. The selling firm may remain in business. Unlike the other two forms, transaction
payments are made to selling firms, not (directly) to their shareholders. The transactions require
formal approval of shareholders of the selling firm.

Firms with private (as opposed to publicly-held) equity tend to use this approach.

Motives for Mergers and Acquisitions

Synergy

Synergy is defined as the whole being greater than the sum of the parts, i.e.,

VAB > VA + VB ==> ΔV > 0.

3
 Synergy, 1
1

Please reference Lecture Slides 12 - 13 for numerical illustration.

Synergy is an important motivation for corporate restructuring activity, such as mergers and
acquisitions. Synergies helped motivate the DaimlerChrysler merger, the PepsiCo/Quaker Oat
merger, and the Weyerhaeuser acquisition. For example, DaimlerChrysler expected to obtain
synergies in research and development, parts sourcing, and international expansion. PepsiCo
expected to obtain distribution synergies, distributing Gatorade with its soft drinks.
Weyerhaeuser expected to obtain operating synergies, with Willamette mills being located near
Weyerhaeuser timber holdings and vice versa. (WSJ, January 24, 2002)

RIGHT motives of synergy:

Operating Synergies

• Revenue enhancement synergy

o Marketing gains – changes in advertising efforts, distribution network, product
mix, etc.
o Strategic benefits – external growth into new products/markets/segments;
acquisition of unique capability and resources, etc.
o Market power – reduction in competition or increase in market share
• Cost reduction synergy
o Replacement of ineffective and/or inefficient management that helps mitigate
agency problems
o Economies of scale in production and operation (remove overcapacity), and in
administration (remove management layer)

4
 o Economies of vertical integration – coordinating closely related activities or
technology transfers
o Economies of scope through efficient usage of complementary resources
• Tax savings synergy
o Utilization of net operating losses – a firm with losses and not paying taxes may
be attractive to a firm with substantial amounts of taxable income and hence face
significant tax liabilities. The target's losses may be used to offset the acquirer's
taxable income and hence reduce its corporate taxes.
o Utilization of unused debt tax shield and debt capacity of the target firm that
increases tax benefits for the acquirer
• Reduction in working capital and fixed assets requirements, especially in mature
industries

Financial synergy

• Economies of scale in raising a larger amount of capital

o lower flotation and transactions costs
• Reduced risk due to less positively correlated cash flows between the target and the
acquirer
o reduced risk of financial distress and hence lower cost of capital

Cross-Border Sources of Synergies

• Exploiting market imperfections

• Overcoming adverse government policy
• Reaching potential clients
• Product differentiation

While the promise of synergy offers incentive for mergers and acquisitions, the reality is that
most acquisitions fail to create value for the acquirer. The main reasons for unsuccessful
acquisitions are (i) the acquirer's failure to integrate two entities after a merger; and (ii) the
management of the acquirer is over confidence and optimistic in their valuation of the target firm
and the potential synergy.

In general, the following factors improve the likelihood of a successful acquisition to the
acquirer:
• lower premium, i.e., lower offer price, paid for the acquisition
• fewer bidders, i.e., less competition
• stronger buyer in term of earnings and price momentum that favors the valuation of the
acquirer's stock and hence lowers the cost of stock acquisition

WRONG motives of synergy:

Bootstrapping Earnings

5
Bootstrapping earnings is an accounting illusion that "fools" the market or investors if they
mistakenly use pre-M&A P/E multiple to value post-M&A earnings per share, EPS. It refers to
the increase in EPS (i.e. earnings growth) as a result of a merger between a larger acquirer with
higher P/E and a target firm with lower P/E. An acquisition may give the appearance of growth
in EPS without actually changing cash flows. This happens when the bidder’s stock price is
higher than the target’s, so that fewer shares are outstanding after the acquisition than before.

If there are no synergies or other benefits to the merger, i.e., NPV=0, then the growth in EPS is
just an artifact of a larger firm and is not true growth (i.e., an accounting illusion). Rational
investors will see through this accounting illustration and applies the lower post-M&A P/E to the
valuation of the combined firm as illustrated in the example here. Note that the post-M&A P/E of
8.33, which is lower than the larger acquirer's pre-M&A P/E of 10.0!

An Example:

Pizza Shack wants to merge with Checkers Pizza with a stock offer that one share of Pizza Shack
is exchanged for two shares of Checkers Pizza. The merger will not create any additional value,
i.e., no synergy, so assuming the market is not fooled, the new firm, Stop ‘n Go Pizza, will be
valued at the sum of the separate market values of the firms, i.e., $1,500,000+$375,000 =
$1,875,000. Note that the post-M&A P/E of 8.33, which is lower than the larger acquirer's pre-
M&A P/E of 10.0!

Before and after merger financial positions:

Before After
Pizza Shack Checkers Pizza Stop ‘n Go Pizza
Total Earnings $150,000 $75,000 $225,000
Number of Shares 100,000 50,000 125,000
Earnings per Share $1.50 $1.50 $225,000/125,000 =
$1.80
Price per Share $15.00 $7.50 $1,875,000/125,000 =
$15.00
Price-to-Earnings Ratio 10 5 $15.00/$1.80 = 8.33
Total Value $1,500,000 $375,000 $1,875,000

Diversification

Diversification reduces unsystematic (or company-specific) risk. However, stockholders can

diversify on their own more economically than a corporation. Thus, diversification is a lousy
6
motive for a merger or acquisition. There were many conglomerate mergers during the 1960s.
These were largely dismantled in the 70's and 80's as managers decided that they could better
create value by focusing the firm on what it does best.

In fact, mergers and acquisitions that result in risk diversification could benefit bondholders at
the expense of stockholders. The co-insurance effect in a merger or acquisition occurs because
even if one of the pre-merger firm fails, the surviving firm will still pay bondholders. The co-
insurance effect can reduce the costs of financial distress if the cash flows between two firms are
not perfectly positively correlated. While this can increase total stakeholders' value, there may
also be a transfer of value from the stockholders to the bondholders through the co-insurance
effect.

Recall from Chapter 22 that stocks can be valued as a call option on the firm. In this view,
bondholders own the firm but sell shareholders an option to buy the firm at an exercise price
equals to the face value of debt. Recall also that one of the inputs to the OPM is the variability of
the underlying asset. When the variability of the underlying asset decreases, so does the value of
the call option (i.e. stock value). With no synergy, the merger and acquisition results in a
reduction in the value of the stock and a corresponding increase in the value of the bond. You
are strongly recommended to study (and work through) the numerical illustration
presented in Chapter 22 Lecture Slides 51 - 55!

To offset the wealth transfer from stockholders to bondholders due to the co-insurance effect, the
combined firm may want to increase its debt capacity and usage that results in greater interest tax
shields and lower taxes.

Misuses of Free Cash Flows

As we learned in Chapter 17 about agency costs of equity financing, management may misuse
free cash flows at their discretion in value-destroying M&A transactions that satisfy their desire
of control at the cost of stockholders. Common mistakes include over bidding for the target, and
participating in acquisitions that have limited synergy while having no plan to realize the
potential synergy afterwards.

Valuing Target Firms

An acquiring firm must estimate the value of the target firm. A well-accepted approach is to
estimate the future cash flows of the target, as well as the future cash flows due to synergy
between the acquiring firm and target. These cash flows are discounted at the target firm's cost of
capital to estimate the value of the acquisition. The value available to acquiring firm
shareholders depends on the price the acquiring firm must pay for the target.

NPV for acquirer = Target Firm Value + [Synergy Value - Cost of Target to Acquirer]

Where Target Firm Value = PV of target's expected future cash flows

7
 2 1

Due diligence is the process by which analysts for the acquiring firm research the target firm.
Financial documents are examined, factories are visited, employees are interviewed. The
acquiring firm managers need to know everything possible about the target in order to assess its
value.

A non-constant growth model (a discounted cash flow model) is often used to value target firm
cash flows. A simplified example of this approach is presented here.

Suppose a target firm is expected to have cash flow growth of 7% per year over the next five
years. After that, as the market becomes more competitive, growth is expected to slow down to
3%. This 3% annual growth rate is expected to continue indefinitely. The weighted average cost
of capital for the target firm is estimated at 20%.

The firm's cash flow available to shareholders for the most recent year was $1.2 million.

The cash flows for the first five years can be forecasted using the $1.2 million cash flow already
received and the 7% growth rate.

Cash flow 1 = 1.2 * 1.07 = 1.28

Cash flow 2 = 1.28 * 1.07 = 1.37
Cash flow 5 = 1.57 * 1.07 = 1.68

Assume that today is time period 0. Cash flow one occurs at time period one, which is the end of
the first year. Time period 5 is the end of the fifth year.

8
In order to estimate the value of all the cash flows that occur after year five (the terminal value),
a constant growth model must be used. This is the same as a growing perpetuity model.

The value at year five (of the cash flows coming after year five) = Cash flow 6 / (WACC - g)

Cash flow 6 is calculated by multiplying cash flow 5 by (1 + .03).

1.68 * 1.03 = 1.73 cash flow 6

1.73 / (.20 - .03) = 10.2 terminal value

The terminal value is the present value, at year five, of all the cash flows expected to come after
year five.

To calculate the value of the target firm today, discount the initial cash flows (that grew at 7%)
as well as the terminal value back to today.

The value of the target firm is $8.41 million. See the following spreadsheet calculation of the
target firm value.

Target Value Spreadsheet (.xls)

In addition to the valuation exercise discussed in this page, the acquiring firm should also
practice due diligence in their research when conducting qualitative analysis of the target firm.
Financial documents are examined, factories are visited, employees are interviewed. The
acquiring firm managers need to know everything possible about the target in order to assess its
value.

Please study the posted PRIMARY REQUIRED reading – “CFAI M&A Reading” for an
additional numerical example for the above discounted cash flow (DCF) valuation
approach, and more importantly, the other two M&A valuation approaches, i.e.,
Comparable Company Analysis and Comparable Transaction Analysis, which are widely
adopted by investment banking practitioners in M&A analysis! In addition to carefully
study of the detailed comprehensive numerical illustrations, I advise you to also pay close
attention to the lists of advantages and disadvantages of each valuation approach.

9
Financing the Deal
In addition to determining the valuation of the target firm (B), i.e., VB, and the synergy derived
from the acquisition, i.e., ΔV, the acquiring firm (A) needs to understand how their financing of
the deal impacts its NPV to them. There are two basic forms of financing, namely, cash
acquisition and stock acquisition. In practice, many acquisitions are financed with a
combination of both forms.

Recall from earlier discussions on the synergy topic that there is positive synergy when the value
of combined firm is greater than the sum of the values of the two firms, i.e., Δ > 0 when AB >
(VA + VB). By rearranging the terms, we derive NPV of an M&A to Firm A = VB* - Cost to
Firm A; where VB* = VB + ΔV is the value of the target firm to the acquirer

Since it is not uncommon that the acquirer needs to pay a merger premium over the stand alone
value of the target firm, we can express NPV of an M&A to Firm A = Synergy - Premium;
where Premium = Cost - VB

Cash Acquisition/Offer

2 2

An Example for Cash Acquisition

Reconsider the example of Pizza Shack’s merger with Checkers Pizza in page 6. Suppose Pizza
Shack (A) acquires Checkers (B) in a buyout. Pizza Shack has estimated the incremental value of
the acquisition, Δ , to be $75,000. The value of Checkers to Pizza Shack is VB* = VB Δ
$375,000 + $75,000 = $450,000. Checkers shareholders are willing to sell for $400,000. Thus,
the merger premium is $25,000, i.e., acquisition cost of $400,000 less VB of $375,000.
10
Take note that for cash acquisition, the acquisition cost is the cash cost paid by the
acquirer, i.e., $400,000 in this example!

Hence, NPV of the deal to Pizza Shack is VB* - Cash Cost = $450,000 - $400,000 = $50,000.
Alternatively, NPV = Synergy - Premium = $75,000 - $25,000 = $50,000.

To complete the analysis, the value of the combined firm, VAB = $1,500,000 + $50,000 =
$1,550,000, and hence with 100,000 shares outstanding, Pizza Shack's price per share becomes
$15.50!

Stock Acquisition

In the case that the acquirer pays for the acquisition with shares of their common stock, i.e.,
stock acquisition, the analysis is a bit more complicated. The acquisition cost, i.e., equity cost, to
the acquirer depends on the number of shares given to the target firm’s shareholders, i.e., the
exchange ratio, and hence the target firm’s shareholders’ ownership fraction, i.e., α, of the
combined firm.
Where Exchange ratio # of acquirer’s share for each share of target
Ownership fraction, α New shares issued/ Old shares New shares
and the value of the combined firm, VAB = VA + VB + ΔV.

An Example for Stock Acquisition

Suppose instead of cash, Pizza Shack (A) gives Checkers (B) stockholders Pizza Shack stock
valued at $15 per share. Checkers stockholders will get $400,000/$15 = 26,667 shares (rounded)
of Pizza Shack. The new firm will have 126,667 shares outstanding, i.e., 100,000 shares (from
Slide 15) + 26,667 shares, and a value of $1,500,000 + $375,000 + $75,000 = $1,950,000 for a
per share price of $15.39, i.e., $1,950,000/126,667 = $15.39.

In comparison to the cash acquisition, the stock acquisition costs more to the acquirer due to the
higher merger premium. In this example, the stated offer amount of $400,000 implies a merger
premium of $25,000 under the cash acquisition. However, using the stated offer amount to
determine the number of shares issued to the target's shareholders, the equity cost to Pizza Shack
in this example is 26,667 * $15.39 = $410,405.13, implying a higher merger premium of
$410,405.13 - $375,000 = $35,405.13! (This is compared to $25,000 under the cash acquisition
above)

The higher merger premium paid under the stock acquisition is due to the unintended further
allocation of the synergy to the target's shareholders through their ownership of the combined
firm. In this example, the target's shareholders actually are allocated a larger portion of the
synergy at an amount of $35,405.13, which is $10,405.13 higher than the intended amount of
$25,000! The extra $10,405.13 comes from allowing Checkers stockholders proportional
participation in the $50,000 NPV through their ownership in the combined firm.

In order to avoid "overpaying" the target under the stock acquisition, the acquirer should
calculate the number of shares to be issued to the target's shareholders (and hence their fractional

11
ownership of the combined firm) with the stated offer amount as the value of their ownership in
the combined firm instead. Note that this will result in the same stock price for the combined
firm under both financing methods, i.e., $15.50 per share in this example!

2 2

Considerations when choosing between cash and stock

 Sharing gains – target firm’s stockholders do not participate in stock price appreciation
with a cash acquisition
 Taxes – cash acquisitions are generally taxable to target firm’s stockholders
 Control – cash acquisitions do not dilute control of acquirer’s stockholders of the
combined firm
 Relative overpriced stock – wealth transfer from target firm’s stockholders to acquirer
stockholders

12
Acquisition NPV Example
Company A is analyzing the possible acquisition of Company B. Both firms have no debt.
Company A believes the acquisition will increase its total after-tax annual cash flows by $2.4
million indefinitely. The current market value of Company B is $58 million, and that of
Company A is $107 million. The appropriate discount rate for the incremental cash flows is
10%. Company A will offer either 0% of its stock or $73 million in cash to Company B’s
shareholders.

For either financing approach, i.e., cash versus stock acquisition, we first need to calculate the
value of the target to the acquirer, V*. The value of the target firm (Company B) to the acquiring
firm (Company A) will be the market value of the target plus the PV of the incremental cash
flows generated by the target firm. The incremental cash flows are a perpetuity, so

V* = $58,000,000 + $2,400,000/.10 = $82,000,000

A. Compute the NPV of the cash acquisition.

The cash cost is the amount of cash offered, so the cash cost is $73 million.
Answer:

NPV cash acquisition = $82,000,000 – $73,000,000 = $9,000,000

B. Compute the NPV of the stock acquisition.

The cost of the stock offer is the percentage of the acquiring firm given up times the sum of the
market value of the acquiring firm and the value of the target firm to the acquiring firm. So, the
equity cost of stock acquisition will be:

Equity cost = .40($107,000,000 + $82,000,000) = $75,600,000

Answer:

NPV stock acquisition = $82,000,000 – $75,600,000 = $6,400,000

Practice Questions
1. Firm B has agreed to be acquired by Firm A in exchange for 7,000 shares of Firm A stock.
Firm B has 15,000 shares of stock outstanding at a price of $11 per share. Firm A has 60,000
shares of stock outstanding at a price of $25 per share. The acquisition is expected to create
$30,000 worth of synergy.

13
A. What is the value of the merged firm?
Answer:

60,000x$25 + 15,000x$11 + $30,000 = $1,695,000

B. How many shares of stock will be outstanding in the merged firm?
Answer:

60,000 + 7,000 = 67,000 shares

C. What is the actual cost of acquiring Firm B to Firm A?
Answer:

$1,695,000 * (7,000/67,000) = $177,089.55

D. How many shares should Firm B receive if Firm A wants the acquisition cost to be
$168,000?
Answer:

Assume that X shares should firm B receive, we have:

$168,000/$1,695,000 = X/(60,000+X)
Solve for X = 6,601.18 shares

2. ALK, Inc., is acquiring Cactus for $1,800,000 in cash. Neither firm has any debt. ALK has
250,000 shares of stock outstanding at a price per share of $57. Cactus has 70,000 shares of stock
outstanding at a price per share of $24. The synergy value of the acquisition is estimated at
$310,000.

A. What is the merger premium per share?

Answer:

($1,800,000/70,000) - $24 = $1.71

B. What is the NPV of the acquisition?
Answer:

The NPV of a cash acquisition is:

NPV = (VB Δ – cash cost = VB* – cash cost

VB* = 70,000*$24 + $310,000 = $1,990,000

NPV = $1,990,000 - $1,800,000 = $190,000

14
Empirical Findings on M&A

Robert Bruner examines the empirical evidence on mergers and acquisitions in his paper titled
"Does M&A Pay? A Survey of Evidence for the Decision-Maker", Journal of Applied Finance,
Spring/Summer 2002. Overall, he finds that target firm shareholders earn large positive adjusted
returns while acquiring firm shareholders earn, on average, zero adjusted returns. Adjusted
returns are rates of return adjusted for the overall market performance.

Bruner also examines the net economic gain for acquirers and targets together. This is important
because target firms are often smaller than acquiring firms. A sizable percentage gain for the
target might be smaller in dollar amount than a small percentage loss for the acquirer. He
examines 20 previous studies that measure combined cumulative adjusted returns and finds that
almost all reported positive combined returns, with 11 reporting significantly positive combined
returns.

Surveys of executives were examined and Bruner replicated a survey study of executives. Bruner
notes that the qualitative results of these studies are surprisingly similar to the scientific studies
that look at abnormal returns to shareholders. Results of Bruner's own survey study show that
executives believe only 37% of M&A deals create value for the buyers and that only 21% of the
deals achieve their strategic goals. Interestingly, 58% of the surveyed executives believed that
their own M&As created value for buyers and 51% believed their own deals achieved strategic
goals. Bruner notes that "facts and opinions differ." (Bruner, 2002, p.62)

In general, empirical findings on mergers and acquisitions indicate that target firm shareholders
earn large positive risk-adjusted returns (especially for tender offers and unfriendly takeovers)
while acquiring firm shareholders earn, on average, zero risk-adjusted returns. Risk-adjusted
returns are rates of return adjusted for the overall market performance and the risk characteristics
of sample firms and stocks.

Empirical studies also examine the net economic gain for acquirers and targets together. This is
important because target firms are often smaller than acquiring firms. A sizable percentage gain
for the target might be smaller in dollar amount than a small percentage loss for the acquirer.
Empirical findings show that the value-weighted sum of the gains (i.e. cumulative risk-adjusted
returns) by acquirers and targets is positive on average.

Researchers also note that the qualitative results of surveys completed by finance executives are
similar to empirical studies that examine risk-adjusted returns to shareholders conducted by
academic researchers. For instance, finance executives believe only 37% of M&A deals create
value for acquirers and that only 21% of the deals achieve their strategic goals and realize
synergy. Interestingly, however, 58% of the surveyed executives believed that their own M&As
created value for acquirers and 51% believed their own deals achieved strategic goals. The
observed discrepancy in their opinions and facts suggest managerial hubris or overconfidence
among executives that may distort their decisions.

15
Please study Section 29.9 of the assigned text, Lecture Slides 37 - 39 and the supplemental
reading (Hazelkorn et al. JACF 2004) for further information on related empirical
findings, for your learning of this topic!

Accounting for Acquisitions – The Purchase Method

Effective 2001 (SFAS 141&142), acquisitions are accounted for with the purchase method.

The assets of the target firm are reported at fair market value on books of bidder. An asset called
goodwill is created. Goodwill is the part of the target firm's purchase price associated with brand
name, intellectual property, and workforce.

Instead, if asset values drop, goodwill must be adjusted immediately to reflect this decrease in
value. Annual asset impairment tests are required.

For acquisition of control, i.e., > 50%

 Adjust acquired firm’s balance sheet to reflect fair market value (FMV) of their assets and
liabilities
 Calculate Adjusted Net Asset Value (ANAV) = FMV Assets – FMV Liabilities, i.e., the
adjusted book value of equity
 Compute Goodwill = Purchase Price - ANAV
 Record Goodwill, along with acquired firm’s FM s and ANA , on the combined
post-M&A balance sheet
 Goodwill is evaluated and adjusted annually for impairment (i.e., decrease in value)
on the balance sheet. The impairment is amortized through the income statement.
 Intangibles, e.g., brand name, intellectual property, etc.

For acquisition of less than control (< 50%)

 Use Equity Accounting for 20%~50% of Target’s voting stock
 Percentage ownership of acquired firm is reflected on the acquirer’s income statement
and balance sheet
 Use Cost Accounting for < 20% of Target’s voting stock
◼ Acquirer records the investment in Target on its balance sheet at cost, and recognizes
taxable portion of dividend income received from Target on its income statement

Taxation for Acquisitions

If it is a taxable acquisition that takes the form of cash or non-equity transaction, selling (target)
firm’s shareholders need to figure their cost basis and pay taxes on any capital gains.

If it is not a taxable event, shareholders are deemed to have exchanged their old shares for new
ones of equivalent value. Shareholders are required to keep a continuity of equity interest.

16
Please reference Sections 29.10 and 29.11 for an overview highlight on these topics. Note that
the information provided in the assigned text could be outdated due to changing tax laws and
regulations

Defensive Tactics for Hostile Takeovers

Please reference Sections 29.7 and 29.8 of the assigned text, and Lecture Slides 31 - 36, for
information on

• Key differences between friendly versus hostile takeovers, and how the acquirer
approaches the target in a hostile takeover
• Defensive tactics that the target firm can pursue before (i.e. PRE-Offer) and/or after (i.e.
POST-Offer) the attempt of hostile takeovers

Other Forms of Corporate Restructuring

Please reference Sections 29.12 and 29.13 of the assigned text, and Lecture Slides 43 - 45, for a
brief introduction to the various alternative forms of corporate restructuring such as buyout,
divestiture, equity carve-out, spinoff, tracking stock, etc.

17
 Chapter 26 – Short-Term Finance and Planning

Cash and Net Working Capital (NWC)

In your finance prerequisite course (say FIN 531), you have probably been told that "Cash is
King", and liquidity is important for a firm to support its daily operating activities. Cash flow
management and liquidity is the key focus of short-term financial management or the
management of net working capital. Feedback from discussions with CFOs indicate that the day-
to-day complexities involving the management of net working capital (especially cash and
inventory) consume tremendous amounts of their team's time. Besides, poor short-term financial
decisions will impair the firm’s ability to remain operating, while good working capital decisions
could have a major impact on firm value.

I strongly suggest you all to review the basics about net working capital that you
learned in FIN 531 or its equivalent, and how cash is related to different balance
sheet items by studying Section 26.1 of the assigned text and Slides 3 - 6.

ong
et orking i ed
erm ity
apital ssets
ebt

ther
et orking rrent
ash rrent
apital iabilities
ssets

ong et orking
i ed
ash erm ity apital
ssets
ebt e cl ding cash

Recall from FIN 531 that an increase in long-term debt and/or equity, i.e.,
liabilities and/or equity items, leads to an increase in cash (i.e., source of cash), as
does a decrease in fixed assets or a decrease in the non-cash components of net
working capital, i.e., asset items. The opposite directions imply uses of cash!
Operating and Cash Cycles
The operating cycle measures the time interval between when the firm receives
raw materials from suppliers to when the firm collects cash from its customers.
The cash cycle measures the time interval between when the firm pays its
supplier to when the firm collects cash from its customers. The operating activities
of the firm create a pattern of cash outflows and inflows. The operating and cash
cycles reflect this pattern.

aw material
ash
p rchased inished goods sold
recei ed
rder tock
laced rri es

n entory period cco nts recei able period

ime
cco nts payable period

irm recei es in oice ash paid for materials

perating cycle

ash cycle
Calculate the operating and cash cycles as follows:
Operating Cycle = Days in Inventory + Days in Receivables
(or Operating Cycle = Inventory Period + Average Collection Period)

Cash Cycle = Operating Cycle - Days in Payables (or Payables Period)

where

"Days in Inventory (or Inventory Period)" is calculated as follows:

Average the inventory from the beginning and end of the current fiscal year. Divide cost of
goods sold, from the income statement, by average inventory. This gives inventory turnover
ratio. Divide the inventory turnover ratio into the number of days in the year. This provides the
average "days in inventory" to be used in the operating cycle calculation.
Days in Inventory = 365 / (Costs of Goods Sold / Average Inventory)

"Days in Receivables (or Receivables Period or Average Collection Period, ACP)":

Average the accounts receivable from the beginning and end of the fiscal year. Divide credit
sales, from the income statement, by average accounts receivables. This gives the receivables
turnover ratio. Divide the receivables turnover ratio into the number of days in the year. This
provides the average "days in receivables."
Days in Receivables = 365 / (Credit Sales / Average Accounts Receivables)

"Days in Payables (or Payables Period)":

Divide the cost of goods sold by average accounts payable. Then divide the result into the
number of days in the year.
Days in Payables = 365 / (Costs of Goods Sold / Average Accounts Payables)

The length of the operating cycle and cash cycle influences the amount of working capital
needed by the firm. If a firm reduces the amount of inventory on hand by selling finished goods
faster or reducing manufacturing time, it will reduce its operating cycle. Likewise, by collecting
cash from customers faster, the operating cycle will be reduced.
Example

Please use the following info to compute the:

• Inventory period
• Receivables period (or Average Collection Period, ACP)
• Operating cycle
• Payables period
• Cash cycle

Inventory: Beginning = $5,000; Ending = $6,000

Accounts Receivable: Beginning = $4,000; Ending = $5,000
Accounts Payable: Beginning = $2,200; Ending = $3,500
Net sales = $30,000
Cost of Goods sold = $12,000

Average inventory = $(5,000 + 6,000) / 2 = $5,500

➔ Inventory period = 365 / $(12,000/5,500) = 167.29 days

Average receivables = $(4,000 + 5,000)/2 = $4,500

➔ Receivables period = 365 / $(30,000/4,500) = 54.75 days

Operating cycle = 167.29 + 54.75 = 222.04 days, i.e., it takes the firm an average
of 222 days to collect cash from its customers since the day the firm receives raw
materials from its suppliers.
Average payables = (2200 + 3500)/2 = 2850
Payables period = 365 / 4.21 = 87 day

Cash Cycle = 222 – 87 = 135 days, i.e., it takes the firm an average of 135 days to
collect cash from its customers since the day it pays to its suppliers.
In other words, cash is tied up for 135 days in each operating cycle!

Please reference Slides 11 - 13 for another numerical example.

Current Asset Investment Policies
Financial managers must decide on the level of current assets the firm will carry relative to
operating revenues. Managers may decide on a flexible current assets policy. This involves
carrying high levels of current assets such as cash and inventory relative to the level of
operating activities, i.e., a high ratio of current assets to sales. Typically, firms choosing
this policy tend to be characterized as having relatively high shortage costs and relatively
low carrying costs. High levels of current assets help lower the likelihood of disruptions in
production and/or being unable to capture sales opportunities.

Lost sales due to stocking out on an item in demand by customers is an example of a shortage
cost. Disruptions in production due to shortage of raw materials is another example of shortage
cost. On the other hand, warehousing costs for inventory is an example of a carrying cost. For
cash, foregone interest due to holding cash balances is an example of a carrying cost. Transaction
fees are an example of a shortage cost related to cash.

A restrictive current asset policy is the extreme opposite of a flexible current asset policy that
is manifested with a low current assets to sales ratio. Firms choosing this policy typically
have low shortage costs and high carrying costs.

The policies described here are extremes. Most firms choose policies in between these extremes
that are compatible with the needs of their business. For example, if shortage costs are extremely
high for a particular firm, it makes sense to choose a flexible policy. In general, the optimal level
of current assets is the level that balances carrying costs and shortage costs so that total costs of
holding current assets are minimized.

otal costs of holding c rrent

inim m
point assets
arrying costs

hortage costs
Current Assets Financing Policies
Managers can finance current assets with short or long-term liabilities and equity. Financing
current assets with short-term debt is usually cheaper than with long-term debt or equity since
the normal yield curve is upward sloping. (If the yield curve is upward sloping, long-term rates
are higher than short-term rates on a specific type of debt instrument.) However, financing
current assets with short-term debt is riskier. This is because short-term loans have to be rolled
over frequently. If interest rates go up or the firm becomes riskier, it will face soaring financing
costs and/or have difficulty getting financing. With long-term funds, the firm has more time to
address problems or wait for adverse market conditions to change.

A current asset financing policy that relies heavily on long-term funds (short-
term funds) is referred to as a flexible (restrictive) financing policy. Excess cash is
available for investment in marketable securities at low points in the firm's business cycle with
the flexible financing policy. A current asset financing policy that finances current
assets with short-term funds and long-term assets with long-term funds is referred
to as a maturity matching policy.
Caveat
Be careful to note the difference between the current section and the previous section. This
section is referring to financing policies for current assets. The previous section focused on
investment policies related to the level of current assets maintained by managers. Both sections
discuss flexible and restrictive policies. However, as you will see in the comparison highlight in
Slide 15 (see below), the flexible policy related to current asset level is a totally different topic
than the flexible policy related to current asset financing. Students often get these mixed up,
resulting in missed exam points.
Cash Budgeting (Slides 23 ~ 29)
A cash budget, which is the primary tool for short-term financial planning,
forecasts both (i) the amount (how much) and (ii) the timing (when) of short-term
borrowing the firm will need in the near future. Cash receipts and disbursements
are estimated for the upcoming (typically) months (or maybe quarters). Cash
receipts are based on the sales forecast and historical payment patterns by
customers that help us estimate how much and when cash will be collected from
credit sales. Disbursements are based on historical experience and knowledge of
existing contracts with suppliers (i.e., payments of account payables), employees
(i.e., wages), the internal revenue service (i.e., taxes), and others (i.e., other cash
expenses such as utilities). In the disbursement section, planned capital
expenditures are included. And in cash receipts, planned asset sales are included.

The net cash flow for the month is added to the cumulative cash balance of the
firm. This amount is compared to the minimum required cash balance set by
the firm (or the compensating balance set by the bank serving the firm). If the
minimum required cash balance is above the new cumulative cash balance, the
firm borrows to bring cash levels up to the minimum cash balance. If the minimum
cash balance is below the new cumulative cash balance, then some borrowing can
be paid back or excess funds can be invested in safe short-term money market
securities.
Numerical Illustration
Slides 26~29 present a (quarterly) cash budget example. I advise you to closely
study Slides 27 ~29 including the calculations and explanations/interpretations
presented in the footnotes for your learning reference. A key requirement for
constructing a cash budget is to pay attention to and follow the details provided in
the information and data for this example. Hence, I ask you to get yourself familiar
with the information provided in Slide 26 below before going to the next slide!!!

Slide 27 (including the footnotes) focus on cash receipts while Slide 28 (including
the footnotes) is on cash reimbursements. Slide 29 is the key output of the cash
budget that presents periodic (i.e., quarterly) cash flow activities, and most
importantly how much and when short-term financing is needed to cover shortfall
in cash using the minimum (compensating) balance as the benchmark.
A Monthly Cash Budgeting Example and Learning Exercise
The “CashBudget Exercise” spreadsheet, which you can download from Chapter 26 Module,
shows the construction of a monthly cash budget with a comprehensive set of the information for
your learning reference and practice. I strongly recommend you to closely follow the construct
of the template, and complete the cash budget as a learning exercise.

I look forward to seeing your collaborative learning on this topic and reading the image of your
work on Canvas!

Further Comment on Cash Budgeting

In addition to the (commonly used) monthly cash budget, a firm may wish to develop a daily
cash budget if necessary. Within a given month, the inflows and outflows may not occur at the
same time, increasing borrowing needs within the month. For example if the firm has large
outflows of cash at the beginning of the month and cash inflows in the middle of the month, then
financing is needed to cover the gap. Again, the contribution of a cash budget is to help the
finance team to determine when (timing) and how much (quantity) is any cash shortfall that
needs to be covered with short-term loans for supporting the operations of the firm.