The McGraw-Hill Companies, Inc.

, 2000 Irwin/McGraw Hill

14- 1
Topics Covered
The Initial Public Offering
The Underwriters
Underpricing and The Winners Curse
General Cash Offers
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 2
Initial Public Offering
Initial Public Offering (IPO) - First offering of stock
to the general public.

Two kinds of public offerings:
Primary offering new shares are sold to raise cash for the
company
Secondary offering existing shares (owned by VCs or firm
founders) are sold, no new cash goes to company

A single offering may include both of these
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 3
Initial Public Offering
Some benefits/motivations:

- Additional source of capital
- Increase debt capacity (give breathing room for debt)
- Stock prices give measure of performance
- Allows managers to be compensated with options, or have
incentives otherwise directly tied to shareholder value
- Potentially more information about firm (analyst following),
makes borrowing cheaper
- ?
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 4
Initial Public Offering
Arranging an IPO: First steps

Select Underwriter
- provides procedural, financial advice
- ultimately buys issue from company (at issue price)
- ultimately sells it to public (at offer price)

Prepare Registration Statement for approval of SEC (in
accord with Securities Act of 1933). Formal summary that
provides information on an issue of securities.

Prepare Prospectus Streamlined version of registration
statement, for consideration by potential investors

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 5
Initial Public Offering
Arranging an IPO: Trying to set price

Road show Talks organized to introduce company to
potential investors, before the IPO.

Bookbuilding Underwriter builds book full of
indications of interest (quantity, price at which
investors may be willing to buy). List of likely
orders. Useful to set offer price.

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 6
Initial Public Offering
Arranging an IPO: Selling the shares

Best efforts offering: IPO method in which underwriter
promises to sell as much as possible, give best effort,
not commit to selling all of issue. Or

Firm commitment offering: Method in which
underwriter buys the whole issue, bears all risk.

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 7
Initial Public Offering
Arranging an IPO: Selling the shares

Syndicate: Group of underwriters formed to sell a
particular issue

Spread - Difference between public offer price and
price paid by underwriter (issue price). Biggest part
of underwriter compensation.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 8
Top Underwriters
1,293 ers Underwrit All
33 Chase
46 Jenrette Lufkin Donaldson
58 Stearns Bear
68 ton First Bos Suisse Credit
104 Morgan JP
121 Brothers Lehman
137 Sachs Goldman
140 Stanley Morgan
167 Barney Smith Saloman
$208 Lynch Merrill
issues) total of ($bil
1997 in rs Underwrite U.S. Top
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 9
Top Underwriters
496 ers Underwrit All
18 Paribas
18 Brothers Lehman
22 Hoare AMRO ABN
23 Stanley Morgan
24 Morgan JP
27 ton First Bos Suisse Credit
29 Morgan Deutsche
29 Warburg SBC
32 Sachs Goldman
$37 Lynch Merrill
issues) total of ($bil
1997 in rs Underwrite Intl. Top
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 10
Tombstone
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 11
IPO Costs

Three basic IPO costs:

1. Administrative costs: for preparing registration, legal
counsel, preparing and printing prospectus, etc.

2. Spread

3. Underpricing: Difference between what stock is offered
at and what its really worth
Can be measured, roughly, as end-of-first-trading-day
price minus offer price
A hidden cost, but usually the biggest cost!
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 12
IPO Costs
Average costs on U.S. IPOs between 1990-1994
05 . 23 12.05 11.00 Issues All
25 . 13 7.53 5.72 up and 500
23 . 12 5.70 6.53 499.99 - 200
22 . 14 7.16 7.06 199.99 - 100
82 . 16 8.91 7.91 99.99 - 80
51 . 19 11.31 8.2 79.99 - 60
37 . 22 13.65 8.72 59.99 - 40
18 . 22 12.48 9.7 39.99 - 20
28 . 21 9.65 11.63 19.99 - 10
32 . 33 16.36 16.96 9.99 - 2
(%) Costs
Total
(%) Return
First Day Avg
(%) Costs
Direct
($mil)
Issues of Value
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 13
IPO Costs
Why is there underpricing? Several arguments.

- Best one: Winners curse
Suppose you apply for every IPO. You will have no
problem getting lots of shares in the bad firms (the ones no
one wants), but when the issue is attractive, there will not
be enough to go around, and you will receive less than you
wanted of the good firms. (This is the winners curse if
you win an auction, you are likely to have paid too much!)
So you would lose on average. You therefore need IPOs to
be underpriced on average, or else you will not play the
game.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 14
Public issues after the IPO
Seasoned Offering (SEO) An equity issue by a firm after its IPO

General Cash Offer
Sale of securities open to all investors by an already public company.
Used for virtually all U.S. equity and debt issues
Same procedure as IPO: register with SEC, sell issue to underwriter, who
sells issue to public

Shelf Registration - A procedure (created by SEC Rule 415 that
allows firms to file one registration statement for several issues of
the same security.
Covers financing plans up to 2 years ahead
Speeds up issue process; dont have to issue all at once
Usually used for relatively garden variety issues, not complex issues
where underwriters stamp of approval may have value
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 15
Public issues after the IPO: Costs
Direct costs (spread + administrative costs) of issues after the IPO:

$2M < Issue size < $9.9M
IPOs: 17%, SEOs: 13%, Convertible debt: 8%, Bonds: 5%

$40M < Issue size < $59.9M
IPOs: 8%, SEOs: 6%, Convertible debt: 4%, Bonds: 2%

$500M < Issue size < $+++
IPOs: 6%, SEOs: 3%, Convertible debt: 2%, Bonds: 1%

(Notice economies of scale)

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 16
Public issues after the IPO: Costs
Gross underwriter spreads of selected issues, 1998
Issue amount, Underwriter's
Type Company millions of dollars spread, percent
IPO Hypertension Diagnostics, Inc. 9.3 8.49
IPO Actuate Software Corp. 33.0 7.00
IPO Enterprise Product Partners 264.0 6.36
IPO EquantNY 282.2 5.25
IPO Conoco 4403.5 3.99
SEO Coulter Pharmaceuticals 60.0 5.48
SEO Stillwater Mining 61.5 5.00
SEO Metronet Commuications Corp. 232.6 5.00
SEO Staples, Inc. 446.6 3.25
SEO Safeway, Inc. 1125.0 2.75
SEO Media One Group 1511.3 2.74
Debt:
2-year notes General Motors Acceptance Corp. 100 0.18
30-year debentures Bausch & Lornb, Inc. 200 0.88
6-year notes Ararnark Corp. 300 0.63
15-year subordinated notes B anque Paribas 400 0.75
Convertible zero-coupon Aspect Telecommunications 490 3.00
bonds
10-year notes Federal Home Loan Mortgage Corp. 1500 0.15
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 17
Private Placements
Dont require registration with SEC
Therefore less costly
Usually restricted to dozen or less knowledgeable
investors
Investors cannot easily resell security
Rule 144A: SEC rule relaxing restrictions on who
can buy and trade unregistered securities. Allows
qualified institutional buyers to trade among
themselves.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 18
Rights Issue

Rights Issue - Issue of securities offered only to
current stockholders, as opposed to general public
offer.

Rights issues are not common in U.S., but are
common in Europe, usually used for seasoned
equity issues (SEOs)
The Dividend Controversy
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter
16.1-16.4
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 20
Topics Covered
What Do We Mean by Dividend Policy?
How Dividends Are Paid
How Do Companies Decide on Dividend
Payments?
Dividend Policy is Irrelevant in MM world
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 21
What is Dividend Policy?
Want to view dividend policy in isolation

Accounting fact: Flow of funds constraint
Inflow of cash into company
= Outflow of cash from company

Earnings + Stock sales + bond sales
= Investment + dividends + interest

If hold fixed investment and borrowing decisions, change dividends stock
sales have got to change

So DP is trade-off between changing # of shares (repurchasing, or selling new
shares) and changing dividends (increasing/decreasing)

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 22
Types of Dividends
Cash Dividend
Regular Cash Dividend
Special Cash Dividend




Cash Dividend - Payment of cash by the firm
to its shareholders.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 23
Types of Dividends
Stock split/Stock dividend
Just increases # of shares, but assets, profits, and
total value are unaffected
So just reduces value per share in proportion


Stock Dividend - Payment of shares by the
firm to its shareholders.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 24
Dividend payment process





Cum Dividend with dividend share
whose buyer is eligible to receive declared
dividend
Ex Dividend share whose buyer is not
eligible to receive declared dividend
Record Date - Person who owns stock on this
date will receive the dividend.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 25
Types of Dividends
Stock Repurchase 3 ways
Buy shares on the market
Tender offer
Private negotiation (Greenmail)


Tax on repurchase: only capital gain
Tax on cash dividend: as ordinary income

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 26
Stock Repurchase Volume
0
20
40
60
80
100
120
140
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
$

B
i
l
l
i
o
n
s

U.S. Stock Repurchases 1985-1997
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 27
The Dividend Decision: Lintner
1. Firms have long-run target dividend payout ratios.
2. Managers focus more on dividend changes than on
absolute levels.
3. Dividends changes follow shifts in long-run,
sustainable earnings.
4. Managers are particularly reluctant to make dividend
changes that might have to be reversed.
Lintners Stylized Facts
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 28
The Dividend Decision: Lintner
Dividend targets vary from firm to firm:



Dividend change equals:
1
1
EPS ratio target
dividend target DIV
=
=
0 1
0 1
DIV - EPS ratio target
change target DIV - DIV
=
=
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 29
The Dividend Decision: Lintner
Managers (say Lintner) smooth dividends
Even if earnings are high now, may be low later, so if
want to avoid having to reverse dividend later, only want
to move partway to target payment.
Final Lintner model:





0 < Adjustment rate < 1
Model seems to work pretty well in the data
( )
0 1
0 1
DIV - EPS ratio target rate adjustment
change target rate adjustment DIV - DIV
=
=
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 30
M&M Dividend irrelevance

Modigliani & Miller dividend proposition

Dividend policy is irrelevant in perfect capital
markets

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 31
M&M Dividend irrelevance
Interpretations
If companys investment policy is fixed, its NPV is fixed.
The pattern of dividend payments doesnt affect NPV
In perfect capital market, investors dont care how they get
their money, so long as they get it. They can get it through
stock price changes or dividends
Since investors do not need dividends to convert shares to
cash, they will not pay higher prices for firms with higher
dividend payouts.
You cannot help or hurt your stockholders by changing
dividends
Repurchases have exactly same effect as dividends. Flow of
funds identity says if you cancel dividend, you have to buy
shares. If you increase dividend, have to sell shares.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 32
M&M Dividend irrelevance
Some key assumptions:

Investment policy held constant
No transaction costs (e.g. repurchasing premium for
company, cost of mailing dividend checks)
Dividends and capital gains taxed at same rate



If you claim dividends do matter, one or more of
these assumptions must be violated. That is the
power of the theorem: it clarifies how dividends
could matter.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 33
M&M Dividend irrelevance
Example - Assume Rational Demiconductor has $1,000 cash, and requires
$1,000 for investment, but decides to declare a $1,000 dividend. Given the
following information (left side), show that the dividend doesnt affect the
value of the firm assuming that the investment policy is held constant (and
therefore new shares are issued to pay for the required investment).

Original Pmt Date Post Pmt, Post Issue
Cash 1,000 0 1,000 (91 shs @ $11)
Asset Value 9,000 9,000 9,000
New Proj NPV 2,000 2,000 2,000
Total Value 12,000 11,000 12,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11


The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 34
M&M Dividend irrelevance
Example - Assume Rational Demiconductor has $1,000 cash, and had
earmarked $1,000 for investment, but learns project is a loser (NPV<0), so
plans to distribute cash by repurchase. Given the following information (left
side), show that the repurchase itself doesnt affect the value of the firm.

(New) Original Post-repurchase
Cash 1,000 0 (repurchase 100 shares at $10)
Asset Value 9,000 9,000
New Proj NPV 0 0
Total Value 10,000 9,000
# of Shares 1,000 900
price/share $10 $10

Does Debt Policy Matter?
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 17
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 36
Topics Covered
Leverage is Irrelevant in MM World
How Leverage Affects Returns and Risk in
MM World
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14- 37
M&M Debt Policy Proposition I

Modigliani & Miller debt policy proposition:

The market value of a company is independent of its
capital structure.
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 38
M&M Debt Policy Irrelevance
Interpretations:
Firm value is determined by real assets and growth
opportunities, not by security choice
The total amount of pizza is unaffected by how it is
sliced
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 39
M&M Debt Policy Irrelevance
Some key assumptions:
No taxes
Investment policy fixed
Bankruptcy is not costly
Efficient capital markets, no transaction costs
Symmetric information


The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 40
M&M Debt Policy Irrelevance
The proof:

Imagine two firms, firm U is unlevered (all
equity) and firm L is levered. Have same profits.

So V
U
= E
U
and V
L
= E
L
+ D
L


Which do you prefer to invest in?
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 41
M&M Debt Policy Irrelevance
Suppose buy 1% of U:
Dollar investment Dollar return
.01*V
U
.01*Profits

Or could buy 1% of Ls debt and equity:
Dollar investment Dollar return
Debt .01*D
L
.01*Interest
Equity .01*E
L
.01*(Profits Interest)
Total .01*(D
L
+E
L
) .01*Profits
= .01*V
L

Same dollar payoffs, must have same dollar cost: V
U
= V
L
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 42
M&M Debt Policy Irrelevance
Another way to see it
Suppose buy 1% of Ls equity:
Dollar investment Dollar return
.01*E
L
.01*(Profits-Interest)
= .01*(V
L
- D
L
)

Or could borrow 1% of D
L
on own account, buy 1% of
Us equity:
Dollar investment Dollar return
Borrowing -.01*D
L
-.01*Interest
Equity .01*V
U
.01*Profits
Total .01*(V
U
- D
L
) .01*(Profits-Interest)


Same dollar payoffs, must have same dollar cost: V
U
= V
L
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 43
M&M Debt Policy Irrelevance
Some implications

Argument can be extended to full range of capital
structure choices, not just D/E ratio
Debt maturity structure (long-term vs. short-term) irrelevant
Secured/unsecured debt choice irrelevant
Convertible/nonconvertible debt irrelevant
Preferred/common stock irrelevant

Financial managers irrelevant? This course irrelevant?
Dont be discouraged, few of the assumptions hold in practice

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 44
Example Macbeth Spot Removers 100% Equity
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A
Outcomes
10,000 $ Equity of Value Market
$10 share per Price
1,000 shares of Number
Data
M&M Debt Policy Irrelevance
Expected
outcome
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 45
Example
Now
suppose
50% debt
50% equity

M&M Debt Policy Irrelevance
30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ Debt of ue Market val
5,000 $ Equity of Value Market
$10 share per Price
500 shares of Number
Data
D
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 46
Example - Macbeths - 100% Equity
- Debt replicated by investors
(say they borrow $10 and invest $20
in two unlevered Macbeth shares
same payoff as levered equity!)
30 20 10 0% (%) investment net $10 on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A

M&M Debt Policy Irrelevance
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 47
M&M Debt Policy Irrelevance
20 15 (%) share per return Expected
10 10 ($) share per Price
2.00 1.50 ($) share per earnings Expected
Equity 50% Debt, 50%
: Structure Proposed
Equity 100%
: Structure Current
Macbeth continued
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 48
M&M Debt Policy Irrelevance
securities all of ue market val
income operating expected
r assets on return Expected
A
= =
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
r
E D
E
r
E D
D
r
We know that
and also that
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 49
M&M Debt Policy Proposition II
( )
D A A E
r r
E
D
r r + =



Rearranging
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 50
M&M Debt Policy Irrelevance
15 .
000 , 10
500 , 1
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
D A A E
r r
E
D
r r + =
( )
20% or 20 .
10 . 15 .
5000
5000
15 .
=
+ =
E
r
Macbeth continued
Check Prop. II for Macbeth. For 100% equity firm
For 50% equity,
50% debt firm
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 51
r
D
E
r
D
r
E
M&M Debt Policy Irrelevance
r
A
Risk free debt Risky debt
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 52
M&M Debt Policy Irrelevance
20 0 (%) shares on Return
2 0 ($) share per Earnings
: equity 50%
debt, % 50
15 5 (%) shares on Return
1.50 .50 ($) share per Earnings : equity 100%
$1,500
Income
$500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
14- 53
M&M Debt Policy Irrelevance
|
.
|

\
|

+
+
|
.
|

\
|

+
=
E D A
B
E D
E
B
E D
D
B
( )
D A A E
B B
E
D
B B + =