Corporate Finance

Lecture 5:
THE FINANCING PROCESS

Sana Tauseef
Associate Professor, Department of Finance
Institute of Business Administration, Karachi
Email: [email protected]
An Overview of Financing Choices
Debt:
◦ Fixed claim
◦ High priority on cash flows and assets
◦ Tax deductible
◦ Fixed maturity
◦ No management control

Equity:
◦ Residual claim
◦ Lowest priority on cash flows and assets
◦ Not tax deductible
◦ Infinite life
◦ Management control

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The Tradeoff: Debt versus Equity
Advantages of Debt Disadvantages of Debt
Tax Benefit: Bankruptcy Cost:
Higher tax rates=higher tax Higher business risk=higher cost
benefits
Added Discipline: Agency Cost:
Greater separation between Greater separation between
managers and stockholders and lenders=higher
stockholders=greater benefit cost
Loss of Future Financing Flexibility:
Greater uncertainty about future
financing needs=higher cost

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Equity Financing Options
Equity Choices for Private Firms:
◦ Funds brought in by the owners of the company or plowing
back of the company’s earnings-owner’s equity
◦ Funds from private investors against a share of ownership in
business- venture capital

Equity Choices for Publicly Traded Firms

◦ Issue common shares at a price market is willing to pay-
common stock
◦ Issuing options to investors to buy company’s shares in
future at a fixed price-warrants
◦ Issuing options to investors to sell company’s shares in
future at a fixed price-contingent value rights

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Debt Financing Options
 Private and public firms can borrow money
for short or long term from bank-bank debt
 Private and public firms can meet their
unanticipated or seasonal financing needs
through having a line of credit from bank
 Public firms can issue bonds which carry
more favorable financing terms and allow
issuer to add special features

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Choices While Issuing Bonds
 Choices on Maturity: short-term, long-term,
callable, puttable, extendible
 Choices on Interest Payments: fixed-rate, floating
rate, deep discount, floating rate with caps and
floors, floating rate with step-up or step down
 Choices on Security: senior, subordinates,
unsecure, asset-backed (mortgage and collateral)
 Choices on Currencies: Eurobonds, dual currency,
principal exchange linked
 Choices on Repayment: serial or balloon repayment

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Hybrid Securities
 Preferred Stocks
 Convertible Bonds: straight bond plus a call

option on firm’s equity

◦ Conversion ratio: number of shares for which each
bond may be exchanged
◦ Conversion price: face value of convertible bond
divided by conversion ratio
◦ Market conversion value: current value of shares for
which each bond may be exchanged
◦ Conversion option value/premium: excess of bond
value over its conversion value

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Example 1
Company Z has a convertible bond outstanding
with a face value of $1,000 which is convertible
into 50 shares of stock. The company’s stock
is trading at a price of $25 each and the
convertible bond is trading at $1,300 each.
Compute the following:
a. Conversion price
b. Conversion value
c. Conversion option value

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Example 2
Home Depot has a convertible bond issue with a
coupon of 3.25 percent and a face value of $1.1
billion that it issued in October 2016. In October
2018, following facts applied:
• Bonds were to mature in October 2021
• Each bond had a face value of $1,000 and was convertible
into 21.70 shares per bond until October 2021
• Company was rated A-. Straight bonds of similar rating and
similar maturity were yielding 5.80 percent
• Convertible bonds were trading at $1,255 per bond in
October 2018.
Separate the two (bond and equity) components of
convertible bonds.

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Firm’s Life Cycle and Financing
Choices
1. Start-up: private business funded by owner’s equity
and bank debt
2. Expansion: rapidly expanding business with financing
from venture capital or sometimes issuing stock
3. High Growth: high reinvestment needs financed
through issuing equities in the form of common
stock or warrant, convertible debt is also likely to be
used
4. Mature Growth: financing needs mainly covered
through internal sources, corporate bonds or bank
debt can be used
5. Decline: internal funds exceed financing need and are
used for debt retirement or stock buyback

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Financing Transitions
 Private firm approaching a private equity
investor or venture capitalist
 Private firm offering its equity to financial

market and going public

 A public company raises more equity
 Public company raising debt from financial

markets by issuing bonds

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Private Firm Expansion: Raising
Funds from Venture Capital
 Venture capital provides financing to small and
risky businesses in return for a share in
ownership.
 It provides financing in different stages:
◦ Seed–money/ first-stage capital: provides financing to
test a concept or develop a new model
◦ Second-stage capital: provides financing to begin
manufacturing, marketing and distribution of
established concepts/products
◦ Additional rounds: allow private firms that have more
established products and markets to expand

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Example 3
Office Helpers is a private firm that manufactures
and sells office supplies. The firm has limited capital
and is estimated to have a value of $100 million
with the capital constraints. A venture capitalist is
willing to contribute $25 million to the firm in
exchange for 30% of the value of the firm. With this
additional capital, the firm will be worth $140
million.
a. Should the firm accept the venture capital?
b. At what percentage of firm value would you (as
the owner of the private firm) break even on the
venture capital financing?
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From Private to Publicly Traded Firm: Initial
Public Offering

Benefits Costs
Access to new and big capital Loss of control as owner’s share
declines
Cash on the success by Have to meet the minimum
attaching a market value to the listing requirements
holdings
Have to follow the information
disclosure requirements
Have to spend time on investor
relations

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Selling Securities to Public: Choosing
an Investment Banker
 Help the firms meet legal requirements in preparing
and filing the necessary registration statements
needed for public offering
 Provide credibility which a small and unknown private
firm may need to induce investors to buy its stocks
 Provide advice on valuation of company and pricing of
new issue
 Absorb some of the risk in the issue by guaranteeing
an offer price on the issue-underwriting guarantee
 Help in selling the issue by assembling a group of
bankers called an underwriting syndicate

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Selling Securities to Public: Types of
Underwriting
 Underwriter can buy the entire issue,
assuming all financial responsibility for any
unsold shares-firm commitment
 Underwriter can sold as many shares as
possible but return any unsold shares without
any financial responsibility-best efforts
 Underwriter conducts an auction in which
investors bid for shares and the offer price is
based on the submitted bids-Dutch auction

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Example of Dutch Auction

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Underpricing of IPOs
First Trading Day Ten Trading Days
Floor Strike after IPO after IPO
IPO Price Price Closing Return Closing Return
Price (%) Price (%)

Ittefaq Iron 12 30.2 28.76 -4.77 30.64 1.46

(July 2017)

Matco Foods 26 26 27.3 5 27.95 7.50

(February 2018)

AGP 80 80 84 5 89.55 11.94

(March 2018)

Al-Tahur 20 21 22.05 5 27.65 31.67

(July 2018)
Interloop (March 45 46.1 46.15 0.11 45.19 -1.97
2019)

The Organic Meat 18 20 21.5 7.5 21.69 8.45

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(August 2020)
Mechanics of Rights Offering
 Existing shareholders are issued rights to buy
a specified number of new shares from the
firm at a specified price within a specified
time period.
 Shareholders receiving the rights can:

◦ Exercise their rights and subscribe for some or all

of entitled shares
◦ Sell their rights
◦ Do nothing and let the rights expire

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Example 4
In March 2018, Krypton Industries needed to
raise Rs.109.66 crores of new equity. It decided
to do so by offering its existing shareholders
the right to buy 17 shares for every 10 shares
that they currently held. The subscription price
was Rs.15 compared to the pre-announcement
price of Rs.20.
a. Compute the value of the right to buy each
new share.
b. What if the company makes a 34-for-10
issue?
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Equity Dilution
 Dilution is a result of a reduction in the ownership
percentage of a company, or shares of stock, due to
the issuance of new equity shares by the company

 While it primarily affects company ownership,

dilution also reduces the value of existing shares by
reducing the stock's earnings per share

 The potential upside of share dilution is that the

capital the company receives from selling additional
shares can improve the company's profitability and
the value of its stock

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Why would equity be subject to
dilution?
 Raising capital
 Stock options
 Warrants
 Convertible debt
 Convertible preferred stock

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Example 5
Teardrop Inc., wishes to expand its facilities. The
company currently has 10 million shares outstanding
and no debt. The stock sells for $50 per share, but the
book value per share is $40. Net income for Teardrop
is currently $15 million. The new facility will cost $35
million, and it will increase net income by $500,000.
a. Assuming a constant price-earnings ratio, what will
the effect be of issuing new equity to finance the
investment?
b. What would the new net income for Teardrop have
to be for the stock price to remain unchanged?

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References
 Brealey, R. A, Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles
of Corporate Finance. India: McGraw Hill
 Damodaran, A. (2001). Corporate Finance: Theory and Practice.
Hoboken, NJ: John Wiley & Sons
 Ethical and Professional Standards, Quantitative Methods, and
Economics. CFA-II Program Curriculum (2018).
 Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2012). Fundamentals
of Corporate Finance. India: McGraw Hill

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