Issuing securities and

Hybrid Financing
12th meeting (Ch.20 and 19)

Issuing securities
Efficient Market Concept
Bonds and Stock
Hybrid Financing

Issuing securities and Working Capital

1 Management
 Efficient market
We assume that securities are issued in
an efficient market.
An efficient market is a market where
securities pricing reflect all relevant
information instantaneously.
The concept of efficient market is not a
black and white concept, but rather a
continuum. The faster market reacts to
new information, the more efficient is
the market
In an efficient market financial
transaction is a zero NPV transaction
since prices are fair.
Issuing securities and Working Capital
2 Management
 Three forms of market
efficiency
Conventionally the efficiency is classified into
three types of efficiency.
Weak form efficiency (also called return
predictability), when investors cannot obtain
abnormal returns by using past price changes.
Semi-strong form efficiency (also called event study),
when investors cannot obtain abnormal returns by
using public information.
Strong form efficiency (also called private information
test), when investors cannot obtain abnormal returns
by using public and private information.
More would be discussed in an investment
management course.

Issuing securities and Working Capital

3 Management
 Issuing securities
Issuing securities (bonds or additional
common stocks) means that company
needs external financing.
Questions need to be addressed are;
Why need external financing?
How much should be raised?
Should company issue additional bonds or
additional common stock?

Issuing securities and Working Capital

4 Management
 Issuing bonds
After the amount has been determined,
company must set price (or coupon rate)
of the bonds. The higher the rating the
lower the coupon rate (ask rating
agency service).
Get approval from the capital market
supervisory agency (now is Financial
Service Authority, OJK).
Organize public expos to inform and
test investors potential demand.
Ask a securities company to underwrite
and sell the bonds.
Issuing securities and Working Capital
5 Management
 Issuing common stocks at initial
public offering (IPO)
Basically the firm should be a good, big,
and in the form of limited liability
(Perseroan Terbatas)
Obtain authority (that is Financial
Service Authority, OJK) approval.
Ask securities company to be
underwriter and organize the offering (at
what price?) to public investors.
Listed at least in the Indonesia Stock
Exchange (IDX).
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6 Management
 Why would a company consider
going public?
Advantages of going public
Current stockholders can diversify.
Liquidity is increased.
Easier to raise capital in the future.
Going public establishes firm value.
Makes it more feasible to use stock as
employee incentives.
Increases customer recognition.

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 Disadvantages of Going Public
Must file numerous reports.
Operating data must be disclosed.
Officers must disclose holdings.
Special deals to insiders will be more
difficult to undertake.
A small new issue may not be actively
traded, so market-determined price
may not reflect true value.
Managing investor relations is time-
consuming.
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 Determining IPO price
The most crucial step is determining IPO price
since there is no reference price.
Issuing company must offer discount (under-
pricing) to potential investors due to asymmetric
information.
Theoretically the underpricing must be
determined in such a way that there is no
transfer of wealth from old shareholders to new
shareholders.
In practice it is determined jointly by issuing
company and underwriter. It is often that the
underwriter would like to set price in such a way
to place the firms P/E and M/B ratios in line with
publicly traded firms in the same industry having
similar risk and growth prospects.
Issuing securities and Working Capital
9 Management
 What is a roadshow?
Senior management team, underwriter
(perusahaan sekuritas), and lawyer visit
potential institutional investors
Usually travel to ten to twenty cities in a
two-week period, making three to five
presentations each day.
Management cant say anything that is not
in prospectus, because company is in
quiet period.

10
 What is book building?
Underwriter (perusahaan sekuritas) asks
investors to indicate how many shares they
plan to buy, and records this in a book.
Investment banker hopes for
oversubscribed issue.
Based on demand, underwriter
(perusahaan sekuritas) sets final offer price
on evening before IPO.

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 Determining IPO price
(an illustration) ...1

PT. ISKA is winning a contract at the beginning 20X2

that needs investment of Rp500 billion (for fixed
assets and net operating working capital). It is
expected that the project will generate positive NPV of
Rp200 billion. At the end of 20X1 the balance sheet
B/S end
(B/S) is of
as20X1 In bio
follows (in billion rupiah): In bio
Book value Rupiah Rupiah
Assets 1,000 Debt 400
Equities
Paid in capital 300
Retained 300
Earnings
Total 1,000 Total 1,000
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12 Management
 Issuing additional debt or additional
equity?
Because internal financing is not sufficient
(simply does not available), the company
need external financing.
After long discussion, the owners finally
decided to issue additional equity from
capital market.
(Discussion: What arguments are in support for issuing additional equity?)

Issuing securities and Working Capital

13 Management
 Determining IPO price:
an illustration . . . (2)
How to determine ownership sharing
with new (public) shareholders?
Should ownership sharing is based on book
value? If this is the case, new shareholders
receive [500/(500+600)] x 100% = 45%
ownership?
The answer is NO. It should be based on
market value.

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14 Management
 Determining IPO price:
an illustration . . . (3)

If it is based on market value, then we

have to estimate the market value of
the equity.
Suppose the existing business is expected
to generate Earnings After Tax of Rp120 b
(ROE = 20%). Forty percent of the earnings
is expected to be distributed as dividend
(i.e next year dividend is Rp48 b). In other
words, 60 percent of earnings is retained.
The company is in steady state, therefore
the g = 0.6 (0.2) = 0.12.
Cost of equity is estimated of 16 percent.

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15 Management
 Determining IPO price:
an illustration . . . (4)

Value of equity of the current business:

V of equity = 48 / (0.16 0.12) = Rp1,200 billion
Components Value Proportion
(billion Rupiah) (%)
Old Equity 1,200 63.16
New Equity 500 26.31
NPV 200 10.53
Total 1,900 100,00

The public ownership will be in between 26.31

up to 36.84 (that is 26.31 + 10.53) percent

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 Suppose public shareholders agree
to receive 26.31%
It means that public shareholders would
provide Rp500 billion to the company and
after the shares are traded in the stock
exchange, its value remains at Rp500
billion.
Suppose at the IPO market the shares are
offered at Rp2,500 per share (200 million
new shares are offered). After the shares
are traded at the stock exchange the price
would remain Rp2,500. Public shareholders
receive no capital gains.
Allsecurities
Issuing capital gains
and Working Capitalare enjoyed by old
17
shareholders.
Management
 Public stockholders receive 26.31%:
Comparison of capital gains
Old New
sharehold (public)
ers shareholde
rs
Ownerhip (%) 73.69 26.31
Number of shares (in 560 200
million) 2,500 2,500
Price (Rupiah) 1,400 500
Value (billion Rupiah)

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 The B/S after the IPO:
When the new investors receive only 26.31% of ownership
B/S end of 20X1 In bio In bio
Book value Rupiah Rupiah
Cash 500 Debt 400
Other Assets 1,000 Equities
Paid in Capital 560
(old) 200
Paid in Capital 300
(new) 40
Additional paid
in cap
Retained
Nominal value of stock is Rp1,000 per share, 200 million new shares are
issued at a price of Rp2,500 per share.Earnings
Since the Paid In Capital is
recorded at the nominal value, Additional Paid In Capital of Rp300 b is
Total 1,500 Total 1,500
recorded. The old shareholders own 560 million shares, therefore Rp260
billion of retained earnings is converted into paid in capital and Rp40 b is
left as Retained Earnings.
Issuing securities and Working Capital
19 Management
 Suppose the old shareholders agree
to receive 63.16 %
It means that public shareholders would
provide Rp500 billion to the company and
after the shares are traded in the stock
exchange, their value increases to
Rp700 billion.
Suppose at the IPO market the shares are
offered at Rp2,500 per share (200 million
new shares are offered). After the shares
are traded at the stock exchange the price
would increase to Rp3,500.
The old shareholders receive no capital
gains.
Issuing securitiesAll capital
and Working Capital gains are enjoyed by the
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new (public) shareholders.
Management
 The old stockholders agree to receive 63.16 %:
Comparison of capital gains
Old New
sharehold (public)
ers shareholde
rs
Ownerhip (%) 63.16 36.84
Number of shares (in 342,888 200
million) 3,500 3,500
Price (Rupiah) 1,200 700
Value (billion Rupiah)

Issuing securities and Working Capital

21 Management
 The B/S after the IPO:
When the new investors receive only 36.84% of ownership
B/S end of 20X1 In bio In bio
Book value Rupiah Rupiah
Cash 500 Debt 400.0
Other Assets 1,000 Equities
Paid in Capital 342.9
(old) 200.0
Paid in Capital 300.0
(new) 257.1
Additional paid
in cap
Retained
Nominal value of stock is Rp1,000 per share, 200 million new shares are
issued at a price of Rp2,500 per share.Earnings
Since the Paid In Capital is
recorded at the nominal value, Additional Paid In Capital of Rp300 b is
Total 1,500 Total 1,500.0
recorded. The old shareholders own 342.9 million shares, therefore Rp42.9
b of retained earnings is converted into paid in capital and Rp257.1 b is left
as Retained Earnings.
Issuing securities and Working Capital
22 Management
 Hybrid financings
They are termed hybrid because they
have both debt and equity
characteristics. Examples are preferred
stocks, warrant and convertible bonds.
Since preferred stock has been
discussed at 3rd meeting, it is not
discussed now. Only warrants and
convertible bonds are going to discuss.
They have option characteristics.
Therefore, first, we are going to discuss
Option Pricing Theory.
Warrants and convertible bonds are
Lease financing, Hybrid financing, and Risk
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issued to reduce debt agency costs.
Management
 What is an option?
A contract that gives its holder the
right, but not the obligation, to buy (or
sell) an asset at some predetermined
price within a specified period of time.
This is called as American type option.
If the right can be exercised only at
specified date, it is called as European
option.
Most important characteristic of an
option:
It does not obligate its owner to take action.
It merely gives the owner the right to buy
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or sell an asset.
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Management
 Types of option
Call option a right to buy an asset at
some predetermined price at specified date
(European type option) or within some
future period (American type option).
Put option a right to sell an asset at some
predetermined price at specified date
(European type option) or within some
future period (American type option).

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25 Management
 Call option contract
(example)
The holder of this call is entitled to buy
1 (one) shares* of BBRI common stocks
from PT. Bulaksumur at price of
Rp12,300 per share at August 5, 2015.

Yogyakarta, May 18, 2015

PT. Bulaksumur
Director
________________________________________________________
Note: BBRI current price is, for example,
Rp12,000/share.
*In practice the contract is for 100 shares not only for 1 share.
The option is being offered at price Rp.200 per
share.
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26 Management
 Call value per share if it were exercised
Exercise price is Rp12,300 per share
Stock Call value per
price share
Call value per share
(Rupiah) (Rupiah)
12,700 400
12,600 300
12,500 200
12,400 100
12,300 0
12,200 0
12,100 0
0 12,300
12,000 0 Stock price
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27 Management
 Profit (loss) of buying the call if it were exercised, per share
Exercise price Rp12,300 / share, call price Rp200 / share

Stock Call Profit

price value (Loss)
Profit (loss)
(Rupiah per
) share
(Rupiah
)
12,700 400 200
12,600 300 100
12,500 200 0
12,400 100 (100)
12,300 0 (200) 0 12,500
12,200 0 (200) -200
stock price
12,100 0 (200)
12,000 0 financing,
Lease financing, Hybrid (200)
and Risk
28 Management
 How to estimate call option price
before expiration?
Two models, both are based on the
concept of risk less hedge, are available;
A model based on two estimates of the
underlying asset price (with the same
probability) at the exercise date. Its also
called binomial option pricing model.
Black-Scholes option pricing model. This
model is more realistic than the first one. It is
easier to apply by using a software in
investment or Excel (will be discussed in
Portfolio Management course).

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29 Management
 Binomial option pricing model
Information needed to estimate the call
option value;
Exercise date is three months from now.
Risk free rate is 7 percent annually or
approximately 1.75 percent for three month.
Exercise price is Rp12,300 per share.
Current share price is Rp12,000.
At the exercise date it is estimated that
BBRIs stock will be selling at one of two
prices, either Rp11,500 or Rp13,500 per
share.

Lease financing, Hybrid financing, and Risk

30 Management
 A model based on two estimates of
underlying asset price
The idea:
Find two investment opportunities that
produces identical payoffs for the two
estimates of share price. The two
opportunities must have identical value.
The two investment opportunities are:
1. Buy the call option for one share.
2. Buy one share and borrow a certain
amount.

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31 Management
 A model based on two estimates . . :
(illustration)
1. Buy call for one If price 3 If price 3
share months later is months later is
Rp11,500 Rp13,500
Value of the call 0 Rp1,200

2. Buy one share If price 3 If price 3

and borrow months later is months later is
Rp11,300 Rp11,500 Rp13,500
Value of one Rp11,500 Rp13,500
share
Repayment of Rp11,500 Rp11,500
principal plus 0 Rp 2,000
interest
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32 Management
 A model based on two estimates . . :
(illustration) ... contd
Value of 1 calls = Value of 1 share +
borrow Rp11,300
Value of 1 calls = Rp12,000 Rp11,300
= Rp700
Value of 1 call = Rp420

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33 Management
 Factors affecting a call options
value
As the factor increases Option value
Current stock price Increases
Exercise price Decreases
Time to expiration Increases
Risk-free rate Increases
Stock return volatility Increases

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34 Management
 How can a knowledge of call options
help one understand warrants and
convertibles?

A warrant is a long-term call option.

Except that when the option is exercised
new (additional) common stocks are
issued and creates dilution. And dilution
reduces call value.
A convertible bond consists of a fixed rate
bond plus a call option.

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35 Management
 Issuing bonds with warrants
ABCD Corp is planning to issue bonds with
warrants:
The bonds with warrants has nominal value
of Rp1,000,000 per share.
Coupon rate is 9% annually fixed.
The maturity is 5 year.
The bonds with warrants package is offered
at face value of Rp1,000,000.
Rp100 billion worth package will be issued.
Threfore 100,000 shares of bonds will be
issued.

Lease financing, Hybrid financing, and Risk

36 Management
 Issuing bonds with warrants
. . (2)
Additional information;
rd of equivalent 5-year annual payment
bonds without warrants = 12%.
Current ABCD stock price (P0) = Rp.2,000.
Risk free rate = 8%.
Number of ABCD stocks outstanding is 300
million shares

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37 Management
 If the coupon of the bonds is only 9%, can PT. ABCD
offer the bonds at nominal value, that is Rp1 million
per share?
NO. Investors would value the bonds at
Rp892 thousands per share. Here is the
calculation.
Using rd = 12%, value of bond without
warrant
5
is,
90,000 1,000,000
V Bond (1 0.12)

t 1
892,000
t
(1 0.12)5

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38 Management
 The warrant
Suppose the warrant says that each
warrant is entitled to buy one share of
ABCD Corp common stock at price of
Rp.3,000 at the bonds maturity date and
each bond is entitled to have 200 shares of
ABCD Corp common stock.
In other words each bond has 200
warrants.

Lease financing, Hybrid financing, and Risk

39 Management
 Value of the warrant
For investors whod like to buy the investment
package consisting of bonds + warrant at the
price of Rp1 million, they value that the
warrant value is more than Rp108 thousands.

Bond with the Being offered

value of + Warrant = at a price of
Rp892 thousand Rp1 million

Lease financing, Hybrid financing, and

40 Risk Management
 What is the return of the investors
who buy the investment package?
The investors do not know what is the
price of ABCD stock at 5 year later.
If the share price at year 5 is Rp3,000 per
share, the investors return is only 9%
annually.
If the share price at year 5 = Rp5,000 per
share, the investors return is almost 15%.
In other words, the minimum return is
9% might be more.

Lease financing, Hybrid financing, and Risk

41 Management
 How to estimate value of the
warrant?
We need to estimate the ABCD stock
price in the next 5 year but the
estimate must be expressed in two
prices with the same probability.
Suppose the management estimates that by
end of next 5 years the stock price can be
either Rp5,500 or Rp1,500. In other words
the expected price in the next 5 year is
Rp5,500 (0.5) + Rp1,500 (0.5) = Rp3,500

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42 Management
 Value of the right to buy stock at a
certain price
The right of warrant holder is to buy the
stock at the price of Rp3000 in the year 5;
If the stock price is Rp1,500 no investor
would like to buy the stock at a price of
Rp3,000. The value = 0.
If the stock price is Rp5,500, the value of the
right = Rp5,500 Rp3,000 = Rp2,500

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43 Management
 The value of each warrant if there is no
dilution
1. Buy one If price six If price six
warrant month later is month later is
Rp.1,500 Rp.5,500
Value of the 0 Rp.2,500
warrant

2. Buy one share If price six If price six

and month later is month later is
borrow Rp.1,500 Rp.5,500
Rp.1,020
Value of one Rp.1,500 Rp.5,500
share
Repayment of Rp.1,500 Rp.1,500
44 principal plus
Lease financing, Hybrid financing, and Risk
Management 0 Rp.4,000
interest
 The value of each warrant . . . (contd)
Value of 1.6 warrants = Value of one
share + borrow Rp1,020
Value of 1.6 warrants = Rp2,000
Rp.1,020
= Rp980
Value of one warrant = Rp612.50
If dilution factor has not been taken into
account the number of warrant should
be attached is Rp108 thousand /
Rp.612.50 = 176. If each bond is
45
entitled
Lease to
financing, Hybrid
Management
buy
financing, and200
Risk shares, then it is
cheap.
 The dilution factor
The execution of the rights will increase the
number of shares.
As a result of the dilution the value of
warrant declines.
The following is the formula to calculate
the value after dilution. VW after = the
value after dilution,Number VW before =shares
of old the value
VW, after VW, before x
before the dilution. Number of old shares Number of new shares

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46 Management
 Take into account the dilution
The bonds issued is 100,000 shares.
New stocks issued = 200 x 100,000 =
20 million shares.
Value of each warrant before the dilution
300 million
VW, after 612.50 x
= Rp612.50.300 million 20 milllion
VW, after 574.2

If each bond is entitled to buy 200 new

shares, then its value = 200 x Rp574.2
= Rp114,840. Because it is still higher
47 than Rp108,000, it is still cheap.
Lease financing, Hybrid financing, and Risk
Management
 The problem
If number of warrants are too few, potential
investors are not interested in buying the
package.
If number of warrants are too many,
potential investors will be very much
interested to buy the package but it will
cause loss to existing shareholders.
Remember that the transaction is a zero
sum game.
In this example the difference is relatively
small, and notice it depends on the
management estimate of the stock price in
year 5.
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48 Management
 Convertible bonds (CB)
The fair valuation is very much similar to
warrants, except that by end of bond
maturity the holders have option to ask for
redemption (and receive nominal value) or
convert it to number of stocks.
Therefore;
Value of straight bonds + Value of rights =
Offering price

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49 Management
 Suppose ABCD Corp issues CB rather
than a package of bonds and warrants
The offering price is Rp.1,000,000.
How many stocks each bond can be
converted to stock at the end of year 5?
PV of straight bonds = Rp.892
thousands.
Therefore;
Value of rights to convert = 1,000 892
= Rp108 thousands
The next procedures are very similar to
warrants valuation.
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50 Management