Financial Management

Long Term Financing

Long Term Financing
• Debt
• Equity
• Preference Shares
• Domestic/Overseas

2
Equity Shares
• Share capital other than pref. share capital is known
as equity share capital. Equity shareholders have the
following rights:
– Voting rights at general meetings of the company
– Rights to have share in the profits of the company in the
form of distribution of dividend and bonus shares

• However, in the event of closing of the company,

equity share capital is repayable only after repayment
of claims of all the creditors and preference
shareholders.

3
Preference Shares
• Preference shareholders get preferential rights to
payment of dividend over common stockholders and
are to be repaid on liquidation.

• Preference shares may be either cumulative Or non-

cumulative.

• Preference shares can also be convertible or

redeemable.

4
Debentures
• A debenture is a certificate issued by a company
acknowledging indebtedness. It provides for payment
of interest at a fixed rate and repayment of principal
at fixed dates.

• A debenture is a debt security issued by a corporation

that is not secured by specific assets
•
• In India ‘bonds’ and ‘debentures’ are used
interchangeably.

5
Debentures: Convertibility
• According to convertibility, debentures can be
classified into three categories:
– Fully Convertible Debentures (FCD)
• A type of debt security where the whole value of the debenture is
convertible into equity shares

– Partly Convertible Debentures (PCD)

• A type of convertible debenture, part of which will be redeemed by
the issuing company after a specified period of time and part of
which is convertible into equity or preference shares at the end of
the specified period.

– Non-Convertible Debentures (NCD)

6
Equity Warrants
• A warrant in which the underlying security is a stock.
– That is, an equity warrant is a certificate issued with a
security giving the holder the option of buying a stock at a
certain strike price for a certain period of time.

• Warrants are issued by companies during a round of

financing as an added incentive to buy a security to
enhance the marketability.

• The warrant is a tradable negotiable instrument and is

listed on the stock exchanges for trade.

7
Equity Warrants: Issuer
• Warrants generally are used by small, rapidly
growing firms as “sweeteners”.
– Such firms are regarded by investors as highly risky, so
their bonds can be sold at extremely high coupon rates.
– Giving warrants with the bond enables an investors to share
in the company’s growth, assuming it does in fact grow and
prosper.

• When the warrants are exercised, there is a wealth

transfer from existing stockholders to exercising
warrant holders.

8
Venture Capital
• Financial intermediaries that are typically set up as
limited partnerships
• Corporations are also getting into VC game :
Strategic Investment

• Play an active role in overseeing, advising, and

monitoring companies in which they invest

• Generally do not want to own the investment

forever

9
Venture Capital
• Promoters without any track record of performance
but with good project ideas can approach venture
capital funds to raise capital for launching and
developing a business.

• The underlying sources of funds for them are from

high net worth individuals, pension funds, insurance
companies, banks, large corporations and others.

10
Venture Capital…Cont’d
• VC funds usually provide financing in stages. At each
stage, they invest enough money to reach the next stage.

• For example, they may provide seed capital or first stage

financing to build a prototype. If that is successful, then
they may provide second stage financing to buy plant and
machinery for commercial manufacturing and marketing
and so on.

• Some VC funds specialize in certain stages of funding.

Some even actively participate in running the business.

11
 IPO Exits for VC-backed Firms Have Been Limited

Source: NVCA 2015 Yearbook Figures 9 and 10

12
Issuance of common stocks: equity
• If a company intends to raise new share capital, it can
do so in many ways:
– 1) Offer new shares to existing shareholders on a pro
rata basis through a rights issue.

– 2) Offer new shares to the general public through

initial public offering of new shares. (IPO)

– 3) Offer new shares to employees/directors through

Employee Stock Ownership Schemes (ESOP).

13
Issuance of common stocks: equity
• A company can raise long-term resources from the
public by issuing equity shares, preference shares,
debentures or convertible bonds.

• The guidelines for issuing securities in India have

been issued by SEBI and are called the Securities and
Exchange Board of India (Disclosure and Investor
Protection) Guidelines, 2009.

14
Issuance of common stocks: Steps
• The major steps involved in issuing securities are as
follows:
• a) An approval of the board of directors with the approval of
the shareholders is required for making an issue of securities.

• b) The company has to appoint a lead merchant banker.

• c) The lead merchant banker will have to submit a draft offer

document and other documents to SEBI for seeking
permission to issue securities.
– The offer document or Prospectus shall contain all material
information, which shall be true and adequate so as to enable the
investors to make informed decision on the investments in the issue.

15
Issuance of common stocks: Steps
• d) After the prospectus is ready and duly approved by
SEBI and permission from ROC and Stock exchanges
obtained, the issue can be opened for subscription.

• e) Later, an allotment of securities has to be made to

the subscribers to the issue. If excess money has been
received, the same has to be refunded to the
subscribers.

16
Issuance of common stocks: Other Features
• a) The issue of securities should be in dematerialized
form.

• b) Differential pricing
– A public issue of equity shares or securities convertible at a
later date into equity shares can be made to applicants in
the firm allotment category at a price higher than the price
at which securities are offered to the public.

17
Issuance of common stocks: Other Features…Cont’d
• c) Price Band
– Issuer company can mention a price band of 20% (cap in
the price band should not be more than 20% of the floor
price) in the offer document filed with SEBI and actual
price can be determined at a later date before filing the
offer document with the Registrar of Companies (ROC).

• d) The issuer company has the freedom to determine

the denomination of shares for public/rights issues
and to change the denomination of existing shares but
at any given time, there shall be only one
denomination for the shares of a company.
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Issuance of common stocks: Other Features…Cont’d
• e) A composite issue means an issue of securities by a
listed company on a public cum rights basis through a
single offer document.

• f) Promoters’ Contribution
– The promoters shall contribute not less than 20% of the
post issue capital. Promoters shall bring in the full amount
of the promoters’ contribution including premium at least
one day prior to the issue opening date.

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Issuance of common stocks: Other Features…Cont’d
• g) Lock-in Requirements
– The promoters’ contribution shall be locked in for a period
of 3 years.

• (h) Due Diligence

– The lead merchant banker shall exercise due diligence to
satisfy himself about all the aspects of offering, veracity
and adequacy of disclosure in the offer documents. The
lead merchant banker will have to furnish a Due Diligence
Certificate.

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Issuance of common stocks: Other Features…Cont’d
• i) Firm Allotment
– An issuer company can make allotment on a firm basis in
public issues to Underwriters.

• j) Green-shoe Option
– Option to allot excess subscribed shares to the extent of
15% to stabilize post-listing price.

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Is going public too costly?
Fees paid to investment bankers

Regulatory costs including auditing costs

Money left on the table due to underpricing

 Number of Offerings and Average First-day Returns on Chinese IPOs, 1990-2014
(There were no IPOs in 2013, due to a CSRC moratorium starting in October 2012)

Source: Jia, Xie, and Zhang (2014)

Number of Offerings (bars) and Average First-Day Returns on Indian IPOs, 1990-2015
900 600%

750 500%

Average First-day Returns

600 400%
Number of IPOs

450 300%

300 200%

150 100%

0 0%

Sources: Marisetty and Subrahmanyam, Dealogic. Note that 1990-1996 includes small offerings, unlike later years. 2015 numbers
are though November
IPOs are underpriced in every country
In the U.S. from 1980-2014, the average
first-day return is 18%
 Average first-day returns on (mostly) European IPOs
60%

50%
Average first-day returns

40%

30%

20%

10%

0%

-10%
 150%
Average first-day returns on non-European IPOs
140%
130%
120%
110%
Average first-day returns

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Firm Commitment Underwriting
• The issuing firm sells the entire issue to the
underwriting syndicate.
• The syndicate then resells the issue to the public.
• The underwriter makes money on the spread between
the price paid to the issuer and the price received
from investors when the stock is sold.
• The syndicate bears the risk of not being able to sell
the entire issue for more than the cost.

28
Best Efforts Underwriting
• Underwriter must make their “best effort” to sell the
securities at an agreed-upon offering price.
• The company bears the risk of the issue not being
sold.
• The offer may be pulled if there is not enough interest
at the offer price. The company does not get the
capital, and they have still incurred substantial
flotation costs.

29
Dutch Auction Underwriting
• Underwriter accepts a series of bids that include
number of shares and price per share.
• The price that everyone pays is the highest price that
will result in all shares being sold.
• There is an incentive to bid high to make sure you get
in on the auction but knowing that you will probably
pay a lower price than you bid.
• The Treasury has used Dutch auctions for years.

30
Dutch Auction : Allotment of Shares
Price based auction of an existing security 8.24% GS 2018
Maturity Date: April 22, 2018 Coupon: 8.24%
Auction date: September 5, 2008 Auction settlement date: September 8, 2008*
Notified Amount: Rs.1000 crore

Details of bids received in the decreasing order of bid price

Amount of bid Implicit Cumulative
Bid no. Price of bid
(Rs. Cr) yield amount
1 100.31 300 8.1912% 300
2 100.26 200 8.1987% 500
3 100.25 250 8.2002% 750
4 100.21 150 8.2062% 900
5 100.20 100 8.2077% 1000
6 100.20 100 8.2077% 1100
7 100.16 150 8.2136% 1250
8 100.15 100 8.2151% 1350

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also
is at the same price, bid numbers 5 and 6 would get allotment in proportion so that the notified
amount is not exceeded. In the above case each bidder would get Rs. 50 crore. Bid numbers 7
and 8 are rejected as the price quoted is less than the cut-off price.
Source: RBI, * September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.
IPO Underpricing
• May be difficult to price an IPO because there is not a
current market price available.
• Private companies tend to have more asymmetric
information than companies that are already publicly
traded.
• Underwriters want to ensure that, on average, their
clients earn a good return on IPOs.
• Underpricing causes the issuer to “leave money on
the table.”

32
The Announcement of New Equity and the Value
of the Firm
• The market value of existing equity drops on the
announcement of a new issue of common stock.
• Reasons include:
– Managerial Information
Since the managers are the insiders, perhaps they
are selling new stock because they think it is
overpriced.
– Debt Capacity
If the market infers that the managers are issuing new
equity to reduce their debt-equity ratio due to the specter
of financial distress, the stock price will fall.
– Issue Costs

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The Cost of New Issues
1. Gross spread, or underwriting discount

2. Other direct expenses

3. Indirect expenses

4. Underpricing

34
The Costs of Equity Public Offerings

Proceeds Direct Costs Underpricing

(in millions) SEOs IPOs IPOs
2 - 9.99 35.11% 25.22% 20.42%
10 - 19.99 13.86% 14.69% 10.33%
20 - 39.99 9.54% 14.03% 17.03%
40 - 59.99 13.96% 9.77% 28.26%
60 - 79.99 6.85% 8.94% 28.36%
80 - 99.99 6.72% 8.55% 32.92%
100 - 199.99 5.23% 7.96% 21.55%
200 - 499.99 4.94% 6.84% 6.19%
500 and up 3.37% 5.50% 6.64%`

35
Rights
• If a preemptive right is contained in the firm’s articles
of incorporation, the firm must offer any new issue of
common stock first to existing shareholders.

• This allows shareholders to maintain their percentage

ownership if they so desire.

36
Rights Offering Example
• Popular Delusions, Inc. is proposing a rights offering.
There are 200,000 shares outstanding trading at Rs.25
each. There will be 10,000 new shares issued at a
Rs.20 subscription price.

• What is the new market value of the firm?

• What is the ex-rights price?

• What is the value of a right?

37
 What is the new market value of the firm?

Rs.25 Rs.20
Rs,5,200,000  200,000 shares   10,000 shares 
share shares

There are 200,000 There will be 10,000 new

outstanding shares at shares issued at a Rs.20
Rs.25 each. subscription price.

38
What Is the Ex-Rights Price?
• There are 210,000 outstanding shares of a firm with a
market value of Rs.5,200,000.
• Thus the value of an ex-rights share is:

Rs.5,200,000
= Rs.24.7619
210,000 shares

 Thus, the value of a right is:

 Rs.0.2381 = (Rs.24.7619 – Rs.20)/20

39
The Rights Puzzle
 The vast majority of new issues are underwritten, even
though rights offerings are much cheaper.
 A few explanations:
 Underwriters increase the stock price. There is not
much evidence for this, but it sounds good.
 The underwriter provides a form of insurance to the
issuing firm in a firm-commitment underwriting.
 Underwriters “certify” the price to the market.
 The proceeds from underwriting may be available
sooner than the proceeds from a rights offering.

40
Dilution
• Dilution is a loss in value for existing shareholders:
– Percentage ownership – shares sold to the general
public
– Market value (stock price) – firm accepts negative
NPV projects
– Earnings per share – may decline even with
positive NPV projects (at least in short run)
– Book value– occurs when market-to-book value is
less than one

41
Long-run Performance of IPOs
 20

18

Annual Percentage Returns

16

14

12

10

0 Style Matched

First Year
Second Year IPOs
Third Year
Fourth Year
Fifth Year

Annual returns in the five years after going public for U.S. 8,278 IPOs from 1970-2011. Style-matched firms match
on market cap and book-to-market.
 3-year Buy-and-hold Style-adjusted Returns
7,700 U.S. IPOs from 1980-2012. Style-adjusted returns exclude the opening day return
Style controls for market capitalization and book-to-market

Annual Sales, $millions (2005 purchasing power)

Euro - Issues
• Since 1992, Indian companies are permitted to issue
Global Depository Receipts (GDR) or American
Depository Receipts (ADR) abroad to raise equity
share capital.

• They can also raise debt capital abroad by issuing

Foreign Currency Convertible Bonds (FCCB).

45
Global Depository Receipt (GDR)
• A GDR is a foreign currency denominated instrument
in the form of a Depository receipt or certificate
created by the Overseas Depository Bank outside
India and issued to non-resident investors against the
issue of ordinary shares or Foreign Currency
Convertible Bonds of issuing company in India.

46
Global Depository Receipt (GDR)…Features
• GDR holders have rights to dividend, rights issues
and bonus issues pertaining to the underlying equity
shares of the issuer company.

• GDR holders have no voting rights in the meetings of

the issuer company’s shareholders.

• Issuer company does not bear any foreign currency

exchange risk. The same is borne by the GDR
holders.

47
Global Depository Receipt (GDR)…Features...
• GDRs are fungible both ways. A GDR holder has the
option to surrender the GDRs and hold equity shares
of the issuer company instead. Also, the underlying
equity shares received on redemption of GDRs can be
reconverted into GDRs again.

• There is no lock-in period for GDRs. An investor who

wants to cancel a GDR may do so immediately after
allotment of GDR and receive equity shares.

48
American Depository Receipt (ADR)
• American Depository Receipts (ADR) is listed in an
American stock exchange and primarily aims at
investors in America. ADRs and corresponding
dividends are denominated in dollars.

• The accounting statements of the issuer company

have to comply with the stringent requirements of
Securities and Exchange Commission of USA and US
GAAP (Generally Accepted Accounting Principles).

49
American Depository Receipt (ADR)

S.No. Company Ticker Exchange Industry

1 Dr. Reddy's Laboratories RDY NYSE Pharma. & Biotech.

2 HDFC Bank HDB NYSE Banks

3 ICICI Bank IBN NYSE Banks
4 Infosys INFY NYSE Software&ComputerSvc

5 MakeMyTrip Limited MMYT NASDAQ Travel & Leisure

6 Sify Technologies Limited SIFY NASDAQ Software&ComputerSvc

7 Tata Motors TTM NYSE Industrial Engineer.

8 Vedanta VEDL NYSE Indust.Metals&Mining

9 Videocon d2h VDTH NASDAQ TV Services

10 Wipro WIT NYSE Software&ComputerSvc

11 WNS Holdings WNS NYSE Support Services

50
American Depository Receipt (ADR)
S.No. Company Ticker Exchang Ratio Industry Deposi Price
e/Market of tory USD/
DR:OR Bank INR
D

Dr. Reddy's RDY NYSE 1:1 Pharma. & Biotech. JPMC 43.46/
Laboratories 2975
1
HDFC Bank HDB NYSE 1:3 Banks JPMC 64.34/
1267
2
ICICI Bank IBN NYSE 1:2 Banks DB 7.57/
257
3
Infosys INFY NYSE 1:1 Software&Compute DB 945/
rSvc 14.09
4
Tata Motors TTM NYSE 1:5 Industrial Engineer. CIT 39.05/
540
5
Vedanta VEDL NYSE 1:4 Construct.&Material CIT 14.40/
s 252
6

51
Foreign Currency Convertible Bonds (FCCB)
• A type of convertible bond issued in a currency
different than the issuer's domestic currency
• The features are:
– These are quasi-debt securities denominated in a foreign
currency.
– These are convertible into equity shares of the issuer
company or into depository receipts on the expiry of a
minimum lock-in period. The exchange rate for the
conversion and the conversion price are fixed.
– These bonds are with put and call options.

52
Term Loan
• Companies can raise Term loans from financial
institutions and banks.
• Term loans are direct business loans.
• The maturity period of loan is usually long term
(more than one to around ten years).
• The loans carry market interest rate and the principal
is repaid in installments after a period of moratorium.

53
 Multiple Choice Question - 1
True or False?
a) A company pays preference shareholders after payment
of dividend to equity shareholders.

b) In case of cumulative preference shares, dividends if not

paid in a particular year are paid in a subsequent year
before payment of equity dividends.

c) Equity shareholders lose all their money in case of

winding up of a company.

d) A debenture is a debt instrument.

e) Partly convertible debentures are converted into equity

shares in full at a pre-specified time. 54
 Multiple Choice Question - 1
f) Equity warrants are equity shares.
g) A company can raise equity capital by issuing
employee stock options.
h) SEBI is the regulator for all capital market issues in
India.
i) Equity shares issued to the public need not be listed in
a stock exchange for trading.
j) Credit rating of a debt instrument issued to public is a
must.

55
 Multiple Choice Question - 1
k) Book building of shares is done to issue shares at a
fair value to both investors and issuer.

l) Offer for sale of shares to public is undertaken to

increase share capital.

m) GDRs are listed in an Indian stock exchange to

provide liquidity to investors.

n) ADRs can be issued if the accounting statements are

prepared conforming to US GAAP.

o) A start-up software company can approach VC funds

for initial capital. 56
 Multiple Choice Question - 1
Ans.
(a) False (f) False (k) True
(b) True (g) False (l) False
(c) False (h) True (m) False
(d) True (i) False (n) True
(e) False (j) True (o) True

57
 Multiple Choice Question - 2
Issue costs for debt issues are generally
less than those for equity issues because:
a) Debt issues are generally privately placed.
b) Debt issues are fixed period instruments.
c) Debt capital is raised after raising equity
capital.
d) Debt issues carry regular interest payments.

58
 Multiple Choice Question - 2
Ans. (a)

59
 Multiple Choice Question - 3
Cost of ADR/GDR issue is less than the same for
equity issues in India because:
a) Size of ADR/GDR issue is usually large.
b) The issues are privately placed by road shows.
c) ADR/GDR issues are listed in overseas stock
exchanges.
d) Large companies undertake these issues.

60
 Multiple Choice Question - 3
Ans. (a) and (b)

61
 Multiple Choice Question - 4
ESOPs are issued primarily:
a) To raise equity capital.
b) To provide incentives to employees.
c) To reduce taxes on perquisites given to
employees.
d) To increase the market value of equity shares
of a company.

62
 Multiple Choice Question - 4
Ans. (b)

63
 Multiple Choice Question - 5
Book-building of equity shares is undertaken:
a) To create demand for the equity shares of the
company.
b) To raise capital speedily.
c) To determine the fair market price of the equity
shares of the company.
d) To prepare a list of prospective subscribers who may
be approached later to raise capital.

64
 Multiple Choice Question - 5
Ans. (c)

65
Thank You!

66