# Investment Banking

Investment Banks are intermediaries in transactions, positioned between companies and investor money. Their role and services may include:

• Capital Raising via issuance, underwriting and initial public offerings (IPO’s)
• Mergers & Acquisitions (M&A)
• Market making and brokerage of financial securities

## Capital Structure and Valuation

'The Capital Structure of a company will be the same value, irregardless of Debt and Equity proportions' (Franco Modigliani and Merton Miller)

Modigliani & Miller Propostion I (MM I): 'In a world without taxes, the enterprise, or market, value is independent of capital structure':

• For example: A company with an enterprise value of \$100 million and a capital structure of \$30 million debt and \$70 million equity. It may borrow \$20 million to buy back shares (retiring \$20 million of equity) leaving it with \$50 million debt and \$50 million equity. By issuing shares and buying back bonds in a total of \$20 million the capital structure is back to the starting point.
• From the corporate perspective, as the company can restructure if it chooses there is no intrinsic value in a corporate structure. The investor perspective is the same, with no intrinsic value created through any capital structure. The enterprise or market value is just the sum of all securities issued at market value. This is the sum of the market capitalisation of equity and net debt, or sometimes the market price of debt. Therefore because market capitalisation is being included care is needed in justifying any market valuation.

Modigliani & Miller Proposition II (MM II): 'The cost of equity is proportional to gearing':

• Weighted Average Cost of Capital (WACC) refers to the ‘theoretical’ cost of a company’s capital, or the weighted average of Debt and Equity [D = Market Value of Debt, E = Market Value of Equity, KD = Cost of Debt, KE = Cost of Equity];
• thus: C = [D/(D+E)] * KD + [E/(D+E)] * KE

MM Proposition I: Means that WACC is constant, and cannot be changed by values of debt and equity:

• MM Proposition II: With a constant WACC, the cost of equity rises linearly with gearing (equation of a straight line). D/E (Debt/Equity) refers to the Gearing Ratio.

KE

• [E/(D+E)] = C – [D/(D+E)] * KD
`  	    `

KE

• E = C * (D+E) – D * KD

KE = C * [(D/E)+1] – D/E * KD

KE = C + (D/E) * (C – KD)

For example, and as an academic exercise because of the realities of taxes: Cost of capital (C) = 10%, Debt = \$30 million @ 5%, Equity = \$70 million (i.e. if there was no debt and 100% equity, KE would be 10%).

C = [D/(D+E)] * KD + [E/(D+E)] * KE –> 10% = [30/(30+70)] * 5% + [70/(30+70)] * KE = 1.50% + 0.7 KE

Therefore, KE = (10 – 1.5)/0.7 = 12.1%

However, creation of additional value for investors unable to get tax deductions or relief may follow from the reality that interest expenses are tax-deductible for companies:

• This leads to a change of the WACC formula to account for marginal corporation tax rate (t): C = D/(D+E) * KD * (1 - t) + E/(D+E) * KE

For example, Debt = \$100 million, Coupon = 5%; amounts to \$5 million. At a corporation tax rate of 25% there's a \$1.25 million saving. The net cost = \$5 million x (1 – 25%) = KD (1 – t) = \$3.75 million

Thus to provide the tax deductible maximum, want to gain from leverage by maximising debt (borrowing more): With taxes: Extra value is created as a result of deducting interest and reducing corporation taxes. However, increased borrowing leads to greater risk and investors expect commensurate higher returns. The cost of debt rises due to compensation for risk-taking, with higher gearing implying more risk and an increased likelihood of prospective financial distress.

In reality the market factors this in; higher gearing, greater costs. Companies owing to a firm in this position understand any weak position and may hold-up payments, accentuating difficulties. So it is not only cash costs, but many other factors also affect costs. This is because the market appreciates the possible considerable costs of breaking up a business, and in that pragmatic reality of taking on equity risk in such a distressed event.

An agency problem also tends to exist in appreciation of financing choices. Individuals are concerned about themselves and their own jobs, despite any potential more objective advantages or disadvantages of increasing gearing, due to the extra risk. This leads to conflicts of trust parties, including shareholders, managers and creditors.

As an example, the largest listed companies will generally have less than 30% gearing. Long established companies with stable cash flows, such as utilities, have higher gearing.

Risks from gearing, and availability (inhibitors on company setting its policy):

• (i) Agency costs
• (ii) Security, a charge over assets; and Covenants, a promise to typically maintain interest cover greater than 2x. For example, Earnings Before Interest and Taxes (EBIT)/Interest maintained at 2x, no acquisitions (leaving the company at a strategic disadvantage to competitors, no dividends.
• (iii) Competition, pressure on prices may lead to a price war
• (iv) Rising cost of debt
• (v) Financial distress

Using WACC as a valuation method:

The cost of debt must be inferred appropriately from the debt and borrowings, using yield to maturity or calculating the market value of bonds or short term money market instruments. The tax from the marginal corporation tax rate. To ascertain the cost of equity inference is needed from similar or comparable companies using the Capital Asset Pricing Model (CAPM): KE = rf + ß(Rm -rf) proportional to Gearing (risk-free rate + Beta * market risk premium).

Finding a comparable company provides an alternative beta (measure of systematic risk) and therefore represents a different level of gearing, so it's necessary to convert the comparable company’s geared beta to an ungeared beta, then re-gear at the ratio of the company under analysis = Ungeared beta * [1 + (1 – tax) * New D/E ratio]

Deriving the equity is an iterative process via computation and discounting cash flows using WACC: (a) Estimate E0 (eg. book value), (b) Calculate WACC, © Discount the cash flows to get debt and equity (the enterprise value), (d) Calculate E1 by deducting the debt and assess if it's significantly different from E0, (e) Use E1 to calculate WACC. In preparing cash flows, even small errors in the assumptions of the risk free rate and beta may therefore lead to significant differences, a weakness in the model.

Summary: Applying corporate finance theory the choice between debt and equity depends on three main factors: (1) relative tax rates; (2) bankruptcy costs, should it occur; (3) agency costs.

## Price/Earnings Ratio (PER) & Earnings Per Share (EPS)

• Company profits are limited to those funds generated, beyond the level of stability needed to maintain the size and health of a company, available to the shareholders.
• There are notable flaws of conventional accounting methods, but such methods remain generally accepted indicators of shareholder's interest in the corporate cash flow.
• Using historical, rather than current cost of assets as base for depreciation.
• Arbitrary division between current and capital expense.
• Goodwill amortisation
• Complexities of capital structure (options, warrants, discount share issues, mergers) – contentious
• Earnings Per Share (EPS) valuation is subject to fundamental problems of current dividend calculation; cash flow, model based on dividends. The true cost of equity is the dividend yield plus the expected capital appreciation, not just the current earnings yield. Historic earnings are more economically accurate indicator of a company’s current situation than dividends, but still not a perfect measure of future dividends. So where, P = Price, E = Earnings per share, r = discount rate (expected rate of return), g = growth rate of earnings
• P = E/(r-g), P/E = 1/(r-g). Earnings are representative or prospective, so cannot be distorted. But gearing/PER are inversely related (more gearing implies a higher EPS and lower PER). As gearing may distort, other ratios may be used such as EV/EBIT.
• Considerations in using PER tool in ratio analysis:
• Changing Margins; changes in earnings per share (EPS), therefore differences between companies (valuations): P/E = 1/(r-g)
• EPS: consideration of rationale; growth, overpriced, extraordinary earnings
• Comparison of PERs: Valuing current or potential earnings.
• Assessment also subject to growth inflation.
• High gearing for companies with very little debt? Although margin lower, more gearing; return on equity higher
• Low book (sales) value (looking cheap due to relationship between Market Capitalization and Sales)

WACC v. PER:

WACC strengths:

• Incorporates the tax benefits of gearing.
• Can be applied to uneven cash flows, including restructuring (PER requires a representative earnings figure).

WACC weaknesses:

• Difficult to measure the cost of equity (beta, equity risk premium).
• Cash flows not known in the market place, so only valuing what the market would be valuing if it's disclosed.
• Assuming that gearing ratio is the same is another potential source of error, although not necessarily significant.

PER Strengths:

• Needs no estimation of the cost of equity, other firms' data can be used.
• Does not need five to ten year cash flow forecasts, although it does need a representative earnings forecast.
• Easy to use.

PER Weaknesses:

• Gearing is not explicitly taken into account, although EV/EBIT can be used. This is not always of great significance because levels may be the same across some industries.
• No allowance for tax.
• Differences in growth rate are not taken into account explicitly.
• Small errors in r and g make massive differences

When PER does not work:

When PER:EPS = 0, negative or poorly performing. Thus, there's an issue of distortion and in all three of these scenarios a proxy for EPS may be used to better estimate the earnings potential of a business:

• (i) Price/Sales: Market Capitalisation/Sales. Because sales is a proxy for earnings, and by applying margin gives x% Profits; [Earnings = Sales * Margin]. This is exactly the same idea as that behind PER, but in the case where EPS = 0, negative or underperforming.
• (ii) Price/Book: Market Capitalisation/Net (or book) Assets. Net Assets are the reported or recalculated shareholders’ equity value. Because net book value (NBV) is a proxy for earnings, multiplying by return on equity (ROE) gives Profits/Earnings. This measure is not appropriate for insurance and service companies where their balance sheet does not represent earnings potential.

Although market capitalisation is a theoretical calculation of value (multiplying the latest share price on a marginal transaction by the number of shares) it remains one of the better and available measures to shareholders on interest in a company.

## Securitization

Lending is constrained by liquidity and a capital base, or share capital. When the regulatory maximum level has been reached no more lending is possible, with regulators requiring for example total loans < 8x capital.

The options may then include:

• a. Issuing more shares to increase share capital, or
• b. Altering the portfolio (lowering risk), or
• c. Securitize

Where constrained by capital, a Special Purpose Vehicle (SPV) entity may obtain loans and/or issue bonds. For example:

• Trustees (separate off-balance sheet entity) — SPV ←– Portfolio of Loans, funded by loan from trustees
• The SPV issues bonds, secured on loan portfolio, repays loan from trustees: Assets—SPV—Bonds

Considerations:

• History of credit behaviour (risk of default):
• (i) Income
• (ii) Historical Default Rates
• (iii) Pre-Payment (maturity)
• (iv) Credit History
• (v) Geographic Data
• (vi) LTV Ratio (loan/asset value)
• 'Assignment' (legal Instrument) establishing responsibilities and legality for the SPV
• Administration (and counterparty default risk) managed via a third-party manager
• Or support from Insurance Companies:
• Writing 'credit enhancement' to give a little extra credit structure to ensure bonds achieve their target ratings. The general idea is to combine credit quality, history and credit enhancement, with bonds in tranches or layers giving theoretically predictable cash flows.
• Other Securitization Examples:
• (i) Collaterised Debt Obligation (CDO): A means of exploiting anomalies in credit ratings. Gathering loans or debt securities payable by various companies into a pool, and securitising loans on them. Alternatively issuing other new securities which pay out according to the pool’s collective performance. CDO's may be divided into several risk levels, with the lowest equity tranche taking the first loss if any loans in the pool default. If losses go further the next, mezzanine, level suffers. The senior or most protected level takes losses only if the collective pool has severe losses.
• (ii) Collaterised Bond Obligation (CBO): Grouped together predictable cash flows and credit quality, generally achieving an investment grade from a pool of diversified non-investment grade, or junk, bonds.
• (iii) Collaterised Mortgage Obligation (CMO): Mortgage (home-loan) backed in risk tranches.
• Other examples of securitization include car loans, credit card receivables (outstanding credit card debt), TV rentals, other property.

## Private Equity and Management Buy Outs

Private Equity (PE):

• Provision of risk, (equity) capital (no-listing) for corporate acquisition. High risk funding for companies that aren’t listed, or whose shares are not yet traded on a recognised exchange. Start ups are high risk endeavour that comes down to (i) implementation (often not the idea) and (ii) focusing on the growth.

• A Management Buy-In (MBI) refers to the case where a third party management buy into a business;
• An Institutional Buy-In where a funder recruits management, and may not be very different from the MBI except the equity is given to management;

MBO's are more appealing than Private Equity because: (i) transactions are larger; (ii) bettter economy in monitoring costs; (iii) management quality; (iv) lower risk (size and lower growth).

Capital Provision:

Investment trusts bring investors together in a closed end investment vehicle. They receive a capital-gains exemption, with tax free gains on the portfolio, making the ventures primarily about tax avoidance. Third party private equity funds manage other people's money. Their structure tends towards medium sized institutions subcontracting the management function.

Corporate Structure for these deals:

A limited partnership with no corporate vehicle between to generate another level of taxation. Investors with limited liability, and a private equity investment manager, or unlimited partner.

Financial Structure:

• (a.) Maximise use of debt, in order to
• (b.) Minimise use of equity.
• (c.) Use intermediate forms of capital (for example junior, mezzanine or junk debt)

Strategy; to make money by buying cheaply:

• Increase costs (not Capital Expenditure?)
• Review accounting policies
• Assess potential acquisitions if straightforward
• Marketing and product development

Aspects to encourage of group management:

• Future capital expenditure
• Revise budgets lower
• Pricing
• Working capital; use up more cash
• Debtors
• Paying surplus earlier; more stock
• Strip off cash; get products into market following the buy-out

For example,

 Profits x2 i.e. x6 therefore: Bought \$10 million \$5 million Equity PER x3 Sold \$60 million \$5 million Debt \$55 million

Time scale/planning objectives:

• 0 - 2 years: Invest
• 5 - 10 years: Realise investment and return \$ to investors. i.e. A fund life of 5-10 years

Managers remuneration:

(i) Fixed fee: ‘housekeeping’ with lower annual management fee and (ii) ‘Carry’ of, for example, 20% of excess returns over a benchmark and sharing in the up-side. The intention is to align the interests of directors to those enjoyed and benefited from by management, as with hedge funds.

Investment Objectives:

Via the prospectus; (i) Industry preferences, and particularly what is not preferred; (ii) Deal types (for example MBO’s) and Size (for example no start-ups); (iii) Geographic Preferences. All objectives centre on raising money for the fund.

Transaction Economics:

• 1) Using projections, estimate exit value (for example in year 5)
• 2) Use a conservative valuation multiple (i.e. a low P/E ratio or EV/EBIT as not distorted byt debt)
• 3) Compare the exit value with the initial investment and compute the internal rate of return (IRR), for example:
 t = 0 t = 5 Plan EBIT \$20 million EV/EBIT Multiple 5x \$100 million (estimated exit value 5 years out
• Purchase price \$20 million – Equity \$12 million, Debt \$8 million.
• Equity at exit:
 100 Exit value -8 Debt = 92 60 (Reinvested \$12 million x 5 = \$60 million) 32 million ‘surplus’
• Of the \$92 million, \$32 million (34%) to management and \$30 million (66%) to the Private Equity Investor. The Rate of return using basic discounting, an exit value (t=5) of \$100m and an initial investment (t=0) of \$20 million; IRR = 37.8% pa

Transaction Process:

• 1) Identify transaction
• 3) 3-5 year time horizon
• 4) Critically evaluate plan:
• (i) Test assumption integrity, that it's robust and makes sense.
• (ii) Test sensitivities, for example Sales assumptions, efficiency (margins), interest rates, foreign exchange (hedged or market risk), delays, competition (including any barriers to entry, patents or regulation.
• (iii) Identify risk areas.
• (iv) Assess management team.
• 5) Due diligence: Involves expensive professional fees, solicitors and accountants.
• (i) A detailed verification and investigation process, relative to an assessment of the deal economics.
• (ii) Persuade vendor to underwrite abort costs (the risks of aborting include vendor deciding not to sell, a sales war, a trade buyer. Ideally ensuring the vendor provides warranties and indemnities.
• 6) Management participation: Depends on
• (i) Economics of the deal
• (ii) The financial input of managers. Monetary investment by the management ensures a greater committment and mutual interest in success
• (iii) The envy ratio:
• (iv) Ratchets and other incentives:

Envy Ratio: a means of assessing and dividing a surplus.

Management % / Management \$ investment : Private Equity investor % / Private Equity \$ investment

For example, management invest \$600,000. The envy ratio is [34% / \$0.6 million : 66% / \$12 million] = 57:5.5 = 10:1

Ratchets and other incentives:

With a base case where management receive 10% and EBIT of \$16 million. With a sliding-scale of exit values from \$100 to \$130 million, management receive a rising percentage with deal and exit performance. For example,

 \$100 million 10% \$110 million 11% \$120 million 12.5% \$130 million 15%

This is intended to cope with the problems arising from management belief that they can do better than the target, however it works both ways with the sliding scale working to the private equity firm's benefit in the case of underperformance; lowering their risk.

• 7) Exit Strategies:
• (i) Trade sale is generally preferred, as it will likely generate more and sell 100% getting cash back
• (ii) Flotation

## Underwriting

Focusing on Initital Public Offerings (IPO's), although this perspective applies to underwriting in general.

Why go Public:

• The company’s shares will become marketable, enabling existing shareholders to realise part of their investment both at the time of flotation and afterwards, while retaining control if they want to.
• New capital may be raised by the company by issuing shares at the time of flotation, as well as subsequently by further shares, ensuring a robust financial structure on flotation.
• Allows greater flexibility in future fund raising and, usually, reduced costs of capital.
• Better able to expand by acquisition, due to the ability to offer own marketable shares as consideration, and flexibility of access to the public equity markets in raising cash. In some cases vendors may also be able to defer capital gains tax liabilities which can be of value in purchase negotiations.
• Commercial advantages may flow from higher company profile and status after publicity of flotation.
• May help improve management and employee motivation, perticularly with tax efficient share options, profit-sharing and share purchase schemes, introduced at the time of flotation or afterwards.

Why be private:

• Following a period of falling share prices and with fund managers and analysts focusing on larger, more fail-proof firms, many well run and profitable firms trade cheaply, often below the book value of their assets. At such prices, any motivation deriving from the ability to raise capital scarcely apllies.
• The heads of private firms have greater control and face less tiresome scrutiny and corporate governance. Being private may give managers the freedom to make hard strategic decisions, such as selling a failing division at a loss, that would be punished on the public markets
• Freedom from shareholder lawsuits.

Removing firms from public scrutiny could increase their ability to engage in reckless or even fraudulent business practice. But at least that would hurt only professional financiers, not small shareholders. In both of the two main types of IPO, the financial success of the issue is basically guaranteed, in so far as vendor shareholders and the company are concerned.

• An offer of new and/or existing shares in a company to the public, including institutional investors, usually made on behalf of the company by an issuing house, and is usually made at a fixed price.
• In some instances, a price established by tender may be appropriate – involving the offer of shares at a minimum price, where applicants can offer to purchase the shares at a price at or above this level. The eventual “striking” price at which shares are sold is up to the highest price at which sufficient applications received to cover the number of shares offered.

B. Placing:

• Involves book building, an arrangement made by investment bank to clients only, or a selected sub-group, and is normally less expensive due to lower rates of underwriting commission and less onerous advertising requirements and less publicity as the public cannot access the issue.
• Purchasers of the shares are pre-selected from institutional and other investors by the issuing house and the stockbroker to the issue. This may be accompanied by either an offer or an intermediaries offer, under which other stockbroking firms may apply for shares for distribution to their own clients at the issue price.

Thus, an IPO; raising money; Capital:

 Expansion or Growth New Reduce gearing New Sale of existing shares Old Liquidity – Introduction - 'rare'

Generally organised at the optimum time for Company, so not necessarily the best investment choice.

Timetable:

 Marketing -6m Preparation of LFR -3m Prepare Prospectus D-day Listing particulars

When and Why:

• Market conditions ok.
• Close to publication of financial information; historic but recent, or forecast. In principle, as close to the end of the financial year as possible; far enough in to be able to speak with confidence. Forecast; ability to ‘manipulate’ but will do when they can; not necessarily when they most want.
• Seasonality of business (not holidays).

Investment Bank; Marketing - Prospectus + Legal/Accounting issues:

• Reorganisation: Wealth generated by Company; entrepreneurs’ income comes form this company, therefore concentrate on this core business.
• Due-diligence: Ensuring that what’s in prospectus is a reasonable description of the company. Contacts with local auditing firm, but need name recognised by the market. A ‘Long-Form Report’ and a ‘Short-Form Report’ is prepared to go into the prospectus.

Long Form Report: ‘Instruction’ and ‘perceived risk’ ideas:

• Suitability; skeletons (bad history), bankruptcies (lesser so now, but still significant).
• Directors: history (trade record and anything that would/should affect it).
• Liabilities
• Accounting Policies: May overstate (impress), may understate (avoid tax).
• Environmental or’Green’ issues: difficult to market any bad publicity
• Profitability
• Competition
• Supplier or Customer dependence: will affect future of the company. Exploit any power of presence. Pressure on suppliers, ensuring no overdependence.

Legal Issues:

• Land and Buildings
• Intellectual Property: relating back to the prospectus and what the company needs to run business.
• Product Liability
• Contracts
• Employment and Unions
• Litigation outstanding: any actions, disclosure.
• Service contracts for key personnel: ensuring these are put in place if don’t already exist, tie-ins.
• Share Option scheme
• Reorganise Share Capital: to ensure not cheap or expensive
• Solicitors: to Company, to Issue and to Investment Bank
• Accountants
• Public Relations/Investor Relations
• Property and other
• Investment Bank
• Company
• (Show to Stock Exchange much later; just short draft of listing particulars for now)

Marketing:

• Possibly simultaneous international offerings and marketing efforts
• Domestic only: marketing events, Press at approx -2 months. OUtlining the company story

Mutuality and De-mutualisation

A Mutual Society is one owned by its members. A Building society is owned by its depositors. In the case of a Mutual society, de-mutualise existing members (depositors) and become owner of shares of the company.

Spinning:

• A US practice, notable during the TMT boom, whereby IPO’s are priced and allocated at a discount to trusted market price. A discount [(close on first day - issue price) / issue price] of 5-10%. Banks prefer big discounts as they are obviously more likely to succeed. Greater pricing difficulties and complexities, greater discounts. ~2% of X shares to CEO, offering instant profits on the first days of trading. Investment banks give stocks because they might receive valuable investment banking business in return.

• Profit allocation of 1/3 to the Investment Bank and 2/3 to investors. Effectively about recapturing profit through commission that may have been lost in allocations. Both spinning and laddering are therefore driven by big discount.

Rights Issues:

• These are secondary offerings, where shares are already listed, and underwritten. 'Right' refers to 'Pre-emption Rights'; if you want to issue new shares for cash, shares must be offered to existing shareholders pro rata. Thus, this is a system for avoiding dilution; but if you don’t have the money, do get diluted. A ‘typical’ right is one for four old shares = weight of the issue (and is usually not more than 1 for 4). The price has a typical range of 15-20% discount. For example:

|5 old shares at \$1 |\$5.00 |

 1 new share at \$0.8 (20% discount) \$0.80 6 shares at \$0.967 \$5.80
• Letter of offer to purchase new shares sent on impact day, open for 21 days. After the letter is posted old shares become 'Ex-Rights', and only those who received the letter have an option. For example:
 5 old shares at \$1 \$5.00 1 new share at \$0.8 (20% discount) \$0.80 6 shares at \$0.90 \$5.40

Cum-rights price = \$1.00, Ex-rights price = \$0.97. The value of a right to buy a new share = \$0.17. because the value of the share is \$0.97 and paying \$0.80

• Nil-paid rights - value \$0.17 = option –> X = 0.80, S = 0.97, t = 21 days. For example, before:
 5 old shares at \$1.00 \$5.00 5 post-rights at \$0.967 \$4.83 1 nil-paid right at \$0.17 \$0.17

(Thus, a fail if the price post-IPO falls below \$0.80)

• So, look at the policy and underwriting service. Fees perhaps of 2% up to 30 days, and 1/8% for each whole/part:
 Rights = if Annual General Meeting (AGM) is needed 23 days offer period 21 days Total 44 days

Underwriter 2% offer \$ in takeover. System for avoiding underwriting (and therefore the fees) in deep discount issues:

• Much bigger discount (than conventional means):
 5 old shares at \$1.00 1 new share at \$0.80

Conventionally, raising \$0.16 for new share per old share; 80/5

• Deep discount, structures with no underwriting, risk is if issue fails:
 1 old share at \$1.00 1 new share at \$0.16 \$1.16

Because there's a desire to raise the same amount of cash

2 post-rights (\$0.58) = \$1.16, so each obviously \$0.58; Nil-paid rights price is X = \$0.16, S = \$0.58 –> X = \$0.42

(Thus, a fail if the price post-impact day falls below \$0.16 because if less than \$0.16 can be bought at a lower price on the market)

Comparison between underwriting IPO's and Rights Issues:

 Rights Issues IPO’S Offering Secondary Primary Discounts 15-20% 5-10% More valuable Term > 21 days 10 days Less valuable Volatility (Risk) Existing Price (no risk because know Theoretical More valuable it’s between 15-20% less than price 'Evaluated': you know, unless failure) source of risk

Therefore not really appropriate to compare on a like-for-like basis, because different process and concepts. In summary, the underwriting price is equal to the discount to ‘theoretical’ market price. In the US market, there may be a separate spread (in addition to this) rather than fee. Thus, much the same package.

Incorporation of Options in longer term financing

• A Right Issue is a call option: The right, but not the obligation, to buy shares at given (exercise) price. When shares are issued are marked ex-rights, the rights (call options) trade independently. They frequently trade at intrinsic value only, which raises the question of arbitrage opportunities; as why not including the time value? The discounting of the strike price is rarely very significant, due to the fairly short time period over which they may trade independently. However, the volatility issue can be very important. Important to note than buying/selling an option is effectively buying/selling volatility
• Underwriting - Company buying put option from the underwiter: Some argue that because underwriting commissions are fixed, this indicates that there is a cartel. However, this is rather debatable. An underwriting agreement is a put option. Conventional put options haves a fixed exercise price and a negotiable premium. The put option in an underwriting agreement generally has a fixed underwriting fee (the option premium) and the company has the ‘right but not the obligation to sell’ shares to the underwriters at a negotiable exercise price.

But, this inversion of the negotiable element of the option does not imply a restrictive practice. If anything it intensifies the competition, since the underwriting institutions feel more comfortable with this structure and therefore feel able to bid more competitively. Marketing the sub-underwriting involves trawling round institutions, until a price (the exercise price of the option) is agreed at which the underwriting market will clear. Thus competitive forces do work in the underwriting market.

There still remains the curious issue of why companies pay the premium, rather than merely deep discounting the rights price. Signalling is usually the reason given, and it is here that there is a strong argument supporting those who claim the practice needs to be reviewed. Investment banks clearly like this work, as it strengthens relationships with other institutions, and could be said to be feathering their own nest.

• The danger of the combined, synthetic forward position: By undertaking a rights issue, the company has granted shareholders a call option (have the right but not the obligation to buy shares at agreed exercise price). By having the rights issue underwritten, the company has gone long of a put option. Therefore, that short call/long put is actually a synthetic forward position]. So if the rights issue bombs, with fewer acceptances for shares than necessary, the underwriters could be wearing the remainder. Thus, writing put options is the risk of underwriting, as they may be exercised against you.

## Effects of Changing Capital Structure on Earnings Per Share

The relationships between Gearing (G) & Earnings Per Share (EPS) under different Price Earning Ratios (PER)

Capital structure changes can impact on EPS, but depends on PER:

• With a low PER; G up = EPS up and G down EPS down
• With a high PER; G up = EPS down and G down EPS up

Breakeven PER of cash: 100/(i(1-t))

Examples:

 \$100.0 Interest Cost (7%) 7.0 Tax (30%) 2.1 Net Cost 4.9%
• Therefore, breakeven PER = \$100/4.9 = 20.4x. A PER greater than 20.4; increase gearing reduces EPS, and vice-versa.
 \$100.0 Breakeven PER, i = 6%? 6.0 1.8 4.2%
• Therefore, breakeven PER = \$100/4.2 = 23.8x
 \$100.0 Breakeven PER, i = 8% 8.0 2.4 5.6%
• Therefore, breakeven PER = \$100/5.6 = 18x. (the same as doing \$100/(8 x 70%) = 18x)

Is it the Capital Structure or Acquisition which is doing this?

The question matters, for example: Issuing one share; EPS to be unchanged EPS/Price, therefore interest rate earned for each \$100 = i(1–t)/\$100 ←→ \$100/i(1-t). Considering the break even point in the case of an acquisition; this will be reliant on equal/equal gearing. The calculation, therefore, also only makes sense if there’s an element of ‘synergy’.

## Mergers and Acquisitions

Acquisitions and Disposals:

Buyer and Seller: 'Consideration' [‘right, interest, profit or benefit accruing to one party or some forbearance, detriment, loss or responsibility, given suffered or undertaken by other’]

Legal Mechanism to effect transaction:

• Contract to purchase/sell either:
• (i) Shares in a limited Company
• (ii) Assets comprising a business, for example if business acquired was only a division or a part of the Company's activities.
• Contract between purchaser and seller.
 Takeover Acquisition Merger Distinction between them? Self – Explanatory Tend to be hostile (Public) (Private) ←– Same thing —>

For example, A buys B: Takeover = Public, Acquisition = Private. Maybe B ‘chooses’ A to be taken-over by (increase value), but this may be called a Merger, which lessens any element of superiority or inferiority (could form vehicle C, which bids for both of them).

Involves reorganising existing contractual relationships: Customers/debtors and suppliers/creditors, paying/dealing with Plc. Changes necessary are a nuisance due to arrangements/re-constructing employment contracts, land, property, IP transfer. There are no such requirements with a share purchase.

Liabilities of the business are acquired with the purchase of shares.

 a) Environmental: Check back in history, any pollution or contamination, all past misdemeanours b) Product Liability: Recalls etc. Due diligence; forewarned if information exists on particular problem c) Tax: Arrange in a 'beneficial’ way d) Financial: Easier to identify, but contract always requires checking; warranty/indemnity possibilities

An asset purchase avoids the assumption of such liabilities (e.g. land). But, purchaser can mitigate the risks (of liabilities) by means of:

• (i) Due Diligence: Protect yourself. Ensure stock is what's expected (quality/quantity). In the case of agricultural trade, for example, go and take a look.
• (ii) Escrow Arrangement:Retention held; not giving all the monies at once (for example, 10% protecting purchaser against claims made under warranty/indemnity) to allow for problems to emerge. Insurance is also a possibility but risks telegraphing concerns.
• (iii) Warrants & Indemnities: Given by the vendor to the purchaser in the contract. i.e Sensitivity to all the tricks that could kill the acquisition.

Purchase of shares in a Listed Company:

Private companies, or subsidiaries of other companies; warranties and indemnities should be available. Listed (Public) Companies: the contract for the purchase of shares is extremely simple and there are no warranties and indemnities. Many shareholders; no knowledge to give any warranties or indemnities; no appetite to give any comfort (they bought shares without any such support). Consequentially:

• (i) Situation of greater risk.
• (ii) Need for Due Diligence: maybe able to utilise a little but other means may not be available, so exacerbates risk. It is possible to become stuck because who can you sue if over-paid for the company; very difficult to sue the auditors.

Why takeover a Public Company?

Auditors may help to mitigate risk. A Company with High PER buys Low PER = earnings enhancement. But, the inverse scenario goes too = EPS dilution (reduced). Thus, it is clearly good for valuations if can be earnings enhancing.

Hostile vs. Agreed (or recommended) acquisitions:

• The UK and US for example have similar business ethics and language, with markets much more open for acquisitions.
• Directors of target company must recommend or give direction: Accept (agreed) or Reject (hostile) to shareholders. Generally, directors don’t enjoy being taken over (as they lose their jobs) so; instinctively reject.
• In Continental Europe shares with 'voting rights' are prevalent. Due to the nature of publicly quoted companies in Europe, it's necessary to overcome the opposition of public companies and semi-governmental bodies with differing agendas such as job security. Lower chance now of Take-Over; lower dividends. ‘UK Takeover Code’: If Buyer acquires 30%, has to offer for 100% [All Share Price]; so all shareholders treated equally. This is regardless of the means of getting there – the key is getting past the 30% cut-off point.

The ‘International Accounting Standards Board’ (IABB) is slowly trying to harmonise standards and practices across the board. For example, in Germany there is predominantly a “minimise tax” philosophy – not about informing investors. This is big disincentive to potentials. Considering P/E: profits published will be low, therefore the effect is to push PER up (although profits probably up too).

• General Principles behind UK Takeover Code:

1. Treat all shareholders of the same class (preference shares) similarly.

2. Information must be furnished to all shareholders, if any, by offeror.

3. Only announce offer after careful & responsible consideration - no false market (manipulation).

4. Give shareholders enough information to make informed decisions (good/bad – why?).

5. All info for shareholders must be prepared with highest standards of care and accuracy).

6. Manage distribution carefully - avoid creation of false market in securities (reflecting true value).

7. Once offer made in good faith, offeree must get shareholders approval before frustrating it. (Otherwise: Anti-takeover making acquisition more difficult/expensive - Golden Parachutes: ‘large termination payments to existing management if control of the firm is changed and management is terminated’ (extending notice periods / stock options…)

8. Rights of control must be exercised in good faith, with no minority oppression.

9. Directors of offeror/ee must act in this capacity, considering shareholders’ interests as a whole. (In capacity of individual shareholder (personal capacity) may not accept) 10. Where ‘control’ acquired (30%+ limit), offer must be generally ‘unconditional’ to all shareholders.

## References

Brealey and Myers (2002), Principles of Corporate Finance

Copeland and Weston (1992), Financial Theroy and Corporate Policy