Introduction & Learning Objectives
This guide is your interactive companion to understanding the core concepts of **Raising Capital**, based on **Chapter 15 of Ross's textbook**. This chapter covers the various methods firms use to obtain financing, from early-stage venture capital to seasoned public offerings.
Learning Objectives (Ross, page 502)
- Describe the venture capital market and its role in financing new, high-risk ventures.
- Explain how securities are sold to the public and the role of investment banks.
- Define initial public offerings and some of the costs of going public.
- Demonstrate how rights are issued to existing shareholders and how to value those rights.
1. Early-Stage & Alternative Financing
Venture Capital (VC)
Venture capital refers to financing for new, high-risk ventures. It is typically provided in stages, with funding contingent on the firm reaching specific milestones. This staged financing helps limit the risk for venture capitalists.
Textbook Link: Ross, Chapter 15, Section 15.1 (Page 503)
Alternative Issue Methods
Firms can raise capital through a variety of methods, which are generally categorized as public or private issues. Public issues can be further broken down into cash offers and rights offers.
Textbook Link: Ross, Chapter 15, Section 15.3 (Page 511)
| Method | Type | Definition |
|---|---|---|
| Public Issue | Traditional Negotiated Cash Offer | Underwriters buy the issue and resell it. |
| Dutch Auction Cash Offer | Underwriters auction shares to find the highest price. | |
| Rights Offer | New shares are offered to existing shareholders first. | |
| Private Issue | Direct Placement | Securities are sold directly to a limited number of investors. |
2. IPOs & Underwriting
The Basic Procedure
The process of selling securities to the public is regulated by the SEC. It involves several key steps, including obtaining board approval, filing a registration statement, and a waiting period before the issue can be sold.
Textbook Link: Ross, Chapter 15, Section 15.2 (Page 509)
Exam Hint: Be familiar with the purpose of a **registration statement** and the **preliminary prospectus (red herring)**.
Underwriters & Costs
**Underwriters** are investment banks that help firms sell securities. They perform services like pricing, distribution, and risk-sharing. Their primary compensation is the **gross spread**.
Textbook Link: Ross, Chapter 15, Section 15.4 & 15.7 (Page 512 & 524)
Key Costs of Issuing Securities:
- **Gross Spread:** The fee paid to underwriters.
- **Other Direct Expenses:** Legal, accounting, and printing fees.
- **Underpricing:** The opportunity loss from selling shares below their true value.
- **Abnormal Returns:** The drop in a stock's price upon announcement of a new equity issue.
Exam Hint:
Expect questions on calculating flotation costs and their impact on NPV, as seen in **Problem 14.3** and **Problem 15.1** from the review problems.
3. Rights Offerings
Mechanics of a Rights Offering
A rights offering gives existing shareholders the right to buy new shares at a specified subscription price. The number of rights needed to buy a new share is determined by the firm.
Textbook Link: Ross, Chapter 15, Section 15.8 (Page 526)
Value of a Right
A right has value because it allows the holder to purchase a share at a discount to the market price. This value is determined by the difference between the stock's market price before and after the rights issue.
Where $P_{ex}$ is the ex-rights price, $P_{cum}$ is the rights-on price, $P_s$ is the subscription price, and $N$ is the number of rights needed to buy one new share. The value of a right is $P_{cum} - P_{ex}$.
Exam Hint:
Be able to calculate the value of a right and the ex-rights price, as tested in **Problem 1** and **Problem 2** from the review problems.
Dilution
Dilution refers to a loss in existing shareholders' value. This can be dilution of proportionate ownership, book value, or market value. **True dilution only occurs if the NPV of the new project is negative**.
Textbook Link: Ross, Chapter 15, Section 15.9 (Page 531)
Exam Hint: Understand that a rights offering can prevent dilution of proportionate ownership. Also, be able to explain the difference between accounting and market value dilution, a key concept tested in **Problem 9** and **Problem 10**.
4. Problems & Solutions
Problem Statement: Hassinah, Inc., is proposing a rights offering. Presently there are 435,000 shares outstanding at $71 each. There will be 50,000 new shares offered at $64 each.
a. What is the new market value of the company?
b. How many rights are associated with one of the new shares?
c. What is the ex-rights price?
d. What is the value of a right?
e. Why might a company have a rights offering rather than a general cash offer?
Solution:
a. New Market Value:
Old Value = 435,000 * $71 = $30,885,000
Funds Raised = 50,000 * $64 = $3,200,000
New Market Value = $30,885,000 + $3,200,000 = $34,085,000
b. Rights per New Share:
Rights needed = Old Shares / New Shares = 435,000 / 50,000 = 8.7 rights per new share.
c. Ex-Rights Price:
Ex-Rights Price = New Market Value / New Shares Outstanding = $34,085,000 / (435,000 + 50,000) = $69.26
d. Value of a Right:
Value of a Right = Rights-on price - Ex-rights price = $71 - $69.26 = $1.74
e. Reason for Rights Offering:
Rights offerings are generally **cheaper** than general cash offers because they can be done without an underwriter. They also allow existing shareholders to maintain their proportional ownership.
Problem Statement: Bell Buckle Mfg. is considering a rights offer. The company has determined that the ex-rights price would be $71. The current price is $76 per share, and there are 29 million shares outstanding. The rights offer would raise a total of $95 million. What is the subscription price?
Solution:
We can use the formula for the theoretical ex-rights price to solve for the subscription price ($P_s$).
$P_X = \frac{P_{RO} \times N + P_S}{N+1}$
We first need to find N, the number of rights needed to buy one new share. We know that the value of a right is the difference between the rights-on and ex-rights price.
Value of a right = $P_{RO} - P_X = \$76 - \$71 = \$5$
We also know the value of a right can be expressed as: $V = \frac{P_{RO} - P_S}{N+1}$
Since we don't know $P_S$ or $N$, we need to find N first. The funds to be raised ($95M$) equals the new shares ($S_{new}$) multiplied by the subscription price ($P_s$). $S_{new} = 95M / P_S$. And $N = S_{old} / S_{new} = 29M / (95M/P_S) = (29/95)P_S$.
We can use another method from the book: $P_X = \frac{S_{old} \times P_{RO} + S_{new} \times P_S}{S_{old} + S_{new}}$
$71 = \frac{29M \times \$76 + S_{new} \times P_S}{29M + S_{new}}$
Since $S_{new} \times P_S = \$95M$, we can substitute that directly.
$71 = \frac{29M \times \$76 + \$95M}{29M + S_{new}} \implies 71 \times (29M + S_{new}) = 2204M + 95M$
$2059M + 71S_{new} = 2299M \implies 71S_{new} = 240M \implies S_{new} = 3.38M$
Now we can find the subscription price: $P_S = \$95M / 3.38M = \$28.11
To check: $N = 29M / 3.38M = 8.58$. $V = (76-28.11)/(8.58+1) = 47.89/9.58 = \$5.00$. This matches.
Problem Statement: Nougat Corp. wants to raise $5.1 million via a rights offering. The company currently has 530,000 shares of common stock outstanding that sell for $55 per share. Its underwriter has set a subscription price of $30 per share. If you currently own 5,000 shares of stock in the company and decide not to participate in the rights offering, how much money can you get by selling your rights?
Solution:
First, find the number of new shares to be sold and the number of rights needed for one new share.
New Shares = Funds Raised / Subscription Price = $5.1M / $30 = 170,000 shares
Rights needed (N) = Old Shares / New Shares = 530,000 / 170,000 = 3.1176
Now, find the ex-rights price ($P_X$) and the value of a right ($V$).
Old Market Value = 530,000 * $55 = $29,150,000
New Market Value = $29,150,000 + $5.1M = $34,250,000
Total Shares = 530,000 + 170,000 = 700,000
$P_X = $34,250,000 / 700,000 = $48.93
$V = P_{RO} - P_X = $55 - $48.93 = $6.07
You own 5,000 shares, so you have 5,000 rights. The amount of money you get from selling your rights is:
Money from Rights = 5,000 rights * $6.07/right = $30,350