The

 capital  Market:  
Intermediate  and  Long-­‐
Term  Financing
Prof.  Mohamed  Amine  ISSAMI
Lecture  2
September  27th,  2018
‘’Going public is a stressful situation and is not always a
successful undertaking. It involves a lot of costs and requires
the complete attention of a company’s management. The
costs do not end after the company has gone public. Every
year, the company has to pay for additional regulatory costs,
preparation of financial statements, and legal costs. From
ownership perspective, IPOs results in loss of control and
bureaucracy, which might affect operations. Prior to
undertaking an IPO, the company must consider other
financing options and their possible benefits. IPO is certainly
not recommended for small capital needs since the issuance
costs are much higher in percentage terms. If the managers
are issuing securities for company expansion or special
projects, they must consider the costs of the issue when
evaluating the benefit from the expansion’’.
From  Chen,  H  &  Ritter,  J  (2000)  'The  Seven  Percent  Solution',  Journal  of  Finance,  55,  pp.  1105-­‐1132.
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 Keywords
• Public  Issue
• Privileged  Subscription
• Regulation  of  Security  Offerings
• Private  Placement
• Initial  Financing
• Signaling  Effects

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 Déjà  Vu  All  Over  Again
Capital Market -­‐-­‐ The market for relatively long-­‐
term (greater than one year original maturity)
financial instruments.
Primary Market -­‐-­‐ A market where new securities
are bought and sold for the first time (a “new
issues” market).
Secondary Market -­‐-­‐ A market for existing (used)
securities rather than new issues.
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 Déjà  Vu  All  Over  Again

INVESTMENT  SECTOR Public  issue

Privileged
subscription

INTERMEDIARIES
FINANCIAL  BROKERS Private

FINANCIAL
placement
Indicates  the  possible
presence  of  a  
SECONDARY  MARKET “standby  arrangement”
Indicates  the  financial
intermediaries’ own
SAVINGS  SECTOR securities  flow  to  the
savings  sector
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 Initial  Financing  -­‐-­‐ Initial  
Public  Offerings
Initial  Public  Offering  (IPO)  -­‐-­‐ A  company’s  first  offering  
of  common  stock  to  the  general  public.  
• Often  prompted  by  venture  capitalists  who  wish  to  
realize  a  cash  return  on  their  investment.
• Founders  of  the  firm  may  wish  to  go  through  an  IPO  
to  establish  a  value  for  their  company.
• There  exists  greater  price  uncertainty  with  an  IPO  
than  with  other  new  public  stock  issues.

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Signaling  Effects

3 Relative  Abnormal
Stock  Returns  for  a
2 New  Equity  Issue
Abnormal   Return  (%)
Cumulative  Average  

0
-­‐1
-­‐2
-­‐3
-­‐4

-­‐10          -­‐8          -­‐6          -­‐4          -­‐2          0          2          4          6          8

Time  Around   Announcement   (in  days)
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 Possible  Explanations  for  
Price  Reactions
Expectations  of  Future  Cash  Flows
◆ The unexpected sale of securities may be associated with
lower than expected operating cash flows and interpreted as
bad news. Hence, the stock price might suffer accordingly.

Asymmetric  (Unequal)  Information

– Potential investors have less information than management
(particularly for common stock).

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 The  Secondary  Market
• Purchases and sales of existing stocks and bonds
occur in the secondary market.
• Transactions in the secondary market do not provide
additional funds to the firm.
• The secondary market increases the liquidity of
securities outstanding and lowers the required returns
of investors.
• Composed of organized exchanges like the New York
Stock Exchange and American Stock Exchange plus the
over-­‐the-­‐counter (OTC) market. 9
 Public  Issue
Public  Issue  -­‐-­‐ Sale  of  bonds  or  stock  to  the  
general  public.
• Securities are sold to hundreds, and often thousands,
of investors under a formal contract overseen by
federal and state regulatory authorities.
• When a company issues securities to the general
public, it is usually uses the services of an investment
banker.

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 Investment  Banker
Investment  Banker  -­‐-­‐ A  financial  institution  that  
underwrites  (purchases  at  a  fixed  price  on  a  fixed  date)  
new  securities  for  resale.

• Investment banker receives an underwriting spread

when acting as a middleman in bringing together
providers and consumers of investment capital.
• Underwriting spread -­‐-­‐ the difference between the
price the investment bankers pay for the security and
the price at which the security is resold to the public.
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 Investment  Banker
• Investment bankers have expertise, contacts, and the
sales organization to efficiently market securities to
investors.
• Thus, the services can be provided at a lower cost to the
firm than the firm can perform the same services
internally.
Three primary means companies use to offer securities to
the general public:
– Traditional (firm commitment) underwriting
– Best efforts offering
– Shelf registration 12
 Traditional  Underwriting
Underwriting  -­‐-­‐ Bearing  the  risk  of  not  being  able  to  
sell  a  security  at  the  established  price  by  virtue  of  
purchasing  the  security  for  resale  to  the  public;  also  
known  as  firm  commitment  underwriting.

• If the security issue does not sell well, either because

of an adverse turn in the market or because it is
overpriced, the underwriter, not the company, takes
the loss.
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 Traditional  Underwriting
Underwriting  Syndicate  -­‐-­‐ A  temporary  combination  
of  investment  banking  firms  formed  to  sell  a  new  
security  issue.
A.  Competitive-­‐bid  
– The issuing company specifies the date that
sealed bids will be received.
– Competing syndicates submit bids.
– The syndicate with the highest bid wins the
security issue.
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 Traditional  Underwriting
B.  Negotiated  Offering
• The issuing company selects an investment banking firm
and works directly with the firm to determine the
essential features of the issue.
• Together they discuss and negotiate a price for the
security and the timing of the issue.
• Depending on the size of the issue, the investment banker
may invite other firms to join in sharing the risk and
selling the issue.
• Generally used in corporate stock and most corporate
bond issues. 15
 Traditional  Underwriting
Best  Efforts  Offering  -­‐-­‐ A  security  offering  in  which  the  
investment  bankers  agree  to  use  only  their  best  efforts  
to  sell  the  issuer’s  securities.  The  investment  bankers  do  
not  commit  to  purchase  any  unsold  securities.

Shelf  Registration  -­‐-­‐ A  procedure  whereby  a  company  is  

permitted  to  register  securities  it  plans  to  sell  over  the  
next  two  years;  also  called  SEC  Rule  415.  These  securities  
can  then  be  sold  piecemeal  whenever  the  company  
chooses.
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 Shelf  Registration:    Flotation  
Costs  and  Other  Advantages
• A firm with securities sitting “on the shelf” can require that
investment banking firms competitively bid for its
underwriting business.
• This competition reduces underwriting spreads.
• The total fixed costs (legal and administrative) of successive
public debt issues are lower with a single shelf registration
than with a series of traditional registrations.
• The amount of “free” advice available from underwriters is
less than before shelf registration was an alternative to
firms.
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 Privileged  Subscription
Privileged  Subscription  -­‐-­‐ The  sale  of  new  securities  in  
which  existing  shareholders  are  given  a  preference  in  
purchasing  these  securities  up  to  the  proportion  of  
common  shares  that  they  already  own;  also  known  as  a  
rights  offering.

Preemptive  Right  -­‐-­‐ The  privilege  of  shareholders  to  

maintain  their  proportional  company  ownership  by  
purchasing  a  proportionate  share  of  any  new  issue  of  
common  stock,  or  securities  convertible  into  common  
stock.
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 Terms  of  Offering
Right -­‐-­‐ A  short-­‐term  option  to  buy  a  certain  number  (or  
fraction)  of  securities  from  the  issuing  corporation;  also  
called  a  subscription  right.
Terms  specify:
– the number of rights required to subscribe for an
additional share of stock
– the subscription price per share
– the expiration date of the offering

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 Subscription  Rights
Options  available  to  the  holder  of  rights:
◆ Exercise  the  rights  and  subscribe  for  additional  
shares
◆ Sell  the  rights  (they  are  transferable)
◆ Do  nothing  and  let  the  rights  expire

Generally,  the  subscription  period  is  

three  weeks  or  less.
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 Subscription  Rights
A  shareholder  who  owns  77  shares  and  just  
received  77  rights  would  like  to  purchase  8  new  
shares.    It  takes  10  rights  for  each  new  share.
What  action  should  the  shareholder  take?

The  shareholder  can  then  purchase  7  shares  (use  70  

rights)  and  still  retain  the  7  remaining  rights.    Thus,  the  
shareholder  needs  to  purchase  an  additional  3  rights.

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 Value  of  Rights
What  gives  a  right  its  value?
A  right  allows  you  to  buy  new  stock  at  a  discount  that  
typically  ranges  between  10  to  20  percent  from  the  
current  market  price.
The  market  value  of  a  right  is  a  function  of:
– the  market  price  of  the  stock
– the  subscription  price
– the  number  of  rights  required  to  purchase  an  additional  
share  of  stock
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 How  is  the  Value  of  a  
Right  Determined?

R0 =  P0 -­‐ [  (R0)(N)  +  S ]

R0 = the market price of one right when the stock is

selling “rights-­‐on”
P0 = the market price of a share of stock selling
“rights-­‐on”
S = the subscription price per share
N = the number of rights required to purchase one
share of stock

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 How  is  the  Value  of  a  
Right  Determined?
P0 -­‐ S
Solving  for  R0. R0      =
N +  1

PX =  P0 -­‐ R0 =  [  (R0)(N)  +  S ]

By  substitution  for  R0,  we  can  solve  the  
“ex-­‐rights” value  of  one  share  of  stock,  PX.  

(P0  )(N)  +  S
PX   =
N +  1
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 Example  of  the  Valuation  of  
a  Right
What  is  the  value  of  a  right  when  the  stock  is  selling  
“rights-­‐on”?    What  is  the  value  of  one  share  of  stock  
when  it  goes  “ex-­‐rights”?
• Assume  the  following  information:
– The  current  market  price  of  a  stock  “rights-­‐
on” is  $50.
– The  subscription  price  is  $40.
– It  takes  nine  rights  to  buy  an  additional  share  
of  stock.
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 How  is  the  Value  of  a  
Right  Determined?
$50 -­‐ $40
Solving  for  R0. R0      =
9 +  1

R0 =      $1

Solving  for  PX. ($50 )(9)  +  $40

PX   =
9 +  1

PX   =    $49
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Problem  A

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Solution  A

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 Problem  B
The VPN Computer Corporation will issue 200,000 shares of
common stock at $40 per share through a privileged
subscription. The 800,000 shares of stock currently
outstanding have a “rights-­‐on” market price of $50 per share.
1. Compute the number of rights required to buy a share of stock
at $40.
2. Compute the value of a right.
3. Compute the value of the stock “ex-­‐rights”.
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 Theoretical  versus  Actual  
Value  of  Rights
Why  might  the  actual  value  of  a  right  differ  from  
its  theoretical  value?
– Transaction  costs
– Speculation
– Irregular  exercise  and  sale  of  rights  over  
the  subscription  period
Arbitrage  acts  to  limit  the  deviation  of  the  
actual  right  value  from  the  theoretical  value.
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 Standby  Arrangement
Standby  Arrangement -­‐-­‐ A  measure  taken  to  ensure  
the  complete  success  of  a  rights  offering  in  which  an  
investment  banker  or  group  of  investment  bankers  
agrees  to  “stand  by” to  underwrite  any  unsubscribed  
(unsold)  portion  of  the  issue.

• Fee  often  composed  of  a  flat  fee  and  an  additional  fee  for  
each  unsold  share  of  stock.
• The  greater  the  risk  of  an  unsuccessful  rights  offering,  the  
more  desirable  a  standby  arrangement.
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 Privileged  Subscription  versus  
Underwritten  Issue
• Investors are familiar with the firm’s operations when
using a rights offering.
• The principal sales tool is a discounted price (rights
offering) and the investment banking organization
(underwriting).
• A disadvantage of a rights offering is that the shares will
be sold at a lower price.
• There is greater dilution with a rights offering which
many firms attempt to avoid.
• There is a wider distribution of shares with a public
offering.
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 Private  Placement
Private  (or  Direct)  Placement  -­‐-­‐ The  sale  of  an  entire  
issue  of  unregistered  securities  (usually  bonds)  directly  
to  one  purchaser  or  a  group  of  purchasers  (usually  
financial  intermediaries).
• Eliminates  the  underwriting  function  of  the  investment  
banker.
• The  dominant  private  placement  lender  in  this  group  is  
the  life-­‐insurance  category  (pension  funds  and  bank  
trust  departments  are  very  active  as   well).

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 Private  
Placement  Features
• Allows  the  firm  to  raise  funds  more  quickly.
• Eliminates  risks  with  respect  to  timing.
• Eliminates  SEC  regulation  of  the  security.
• Terms  can  be  tailored  to  meet  the  needs  of  the  
borrower.
• Flexibility  in  borrowing  smaller  amounts  more  
frequently  rather  than  a  single  large  amount.

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World  Bank  Group
FLAGSHIP  REPORT

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2016  Africa  Capital  Markets  Watch

FEBRUARY  2017

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IPOs  by  African  exchange,  2012-­‐2016

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42
43
44
FOs  by  African  exchange,  2012  -­‐ 2016

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