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seasoned issue starts with the current market price, simplifying the process. Often, the
price of a seasoned issue will be set just below the current market price.
The overall evidence on the cost of public offerings indicates that it is still clearly
much more expensive to issue stock rather than bonds, and the cost of the issue is a
decreasing function of the size of the issue.

Private Placements

An alternative to a general subscription is a private placement, in which
securities are sold directly to one or a few investors. The terms for the securities are
negotiated between the two parties. The primary advantage of private placements over
general subscriptions is the lower cost, since there are fewer intermediaries and no need
for underwriting guarantees or marketing. There are also substantial savings in time and
administrative costs because the SEC registration requirements are bypassed. The other
advantages are that the terms of the bond can be tailored to meet the specific needs of the
buyer, and the firm can convey proprietary information (presumably positive) to the
potential investors.
The primary disadvantage of private placements is that there are relatively few
potential investors, since large private placements may expose the investor to firm-
specific risks. This is why private placements of corporate bonds are much more common
than private placement of equity. In a typical private placement, the buyer tends to be a
long-term institutional investor, such as a life insurance company or a pension fund.
These investors tend to invest in these bonds and hold them until maturity. Private
placements generally range from $ 25 million to $ 250 million in size and have more
restrictions associated with them than typical corporate bond issues.

Rights Offerings

The third option available to seasoned issuers is a rights offering. In this case,
instead of trying to sell new stock at the current market price to all investors, the existing
investors in the firm are given the right to buy additional shares, in proportion to their
current holdings, at a price much lower than the current market price.


A company that uses a rights offering generally issues one right for each
outstanding common share, allowing each stockholder to use those rights to buy
additional shares in the company at a subscription price, generally much lower than the
market price. Rational stockholders will either exercise the right or sell it. Those
investors who let a right expire without doing either will find that the market value of
their remaining holding shrinks ““ the market price will almost certainly drop when the
rights are exercised since the subscription price is set much lower than the market price.
In general, the value of a right should be equal to the difference between the stock price
with the rights attached ““ the rights-on price ““ and the stock price without the rights
attached ““ the ex-rights price. The reasoning is simple. If this were not true, there
would be opportunities for easy profits on the part of investors and the resulting price
would not be stable. To illustrate, if the price of the right were greater than the difference
between the rights-on price and the ex-rights price, every stockholder would be better off
selling the right rather than exercising it. This, in turn, would push the price down toward
the equilibrium price. If the price of the right were lower than the difference between the
rights-on and the ex-right price, there would be an equally frenzied rush to buy the right
and exercise it, which, in turn, would push the price up towards the equilibrium price.
The value of a right can be estimated using the following equation “
Price of a right = (Rights-on Price - Subscription Price)/(n + 1)
where n is the number of rights required for each new share.
Rights offerings are a much less expensive way of raising capital than public issues, for
two reasons. First, the underwriting commissions are much lower, since a rights offering
has little risk of not receiving subscriptions if the subscription price is set well below the
market price. Second, the other transactions and administrative costs should also be lower
because there is a far smaller need for marketing and distribution.
What is the drawback of making a rights issue? The primary reservation seems to
be that it increases the number of shares outstanding far more than a general subscription
at the existing stock price. To illustrate, a firm that makes a rights issue at $ 5 per share
when the stock price is $ 10 will have to issue 10 million shares to raise $ 50 million. In
contrast, the same firm would have had to issue only 5 million shares, if the issue had
been at the existing stock price of $ 10. Some financial managers argue that this dilutes


the share holding and lowers the market price. While this is true in a technical sense, the
existing stockholders should not object since they are the only ones who receive the
rights. In other words, the stock price will drop, but everyone will own proportionately
more shares in the firm. In general, firms in the United States have been much more
reluctant to use rights issues than European firms, in spite of the significant cost savings
that could accrue from them. Part of this reluctance can be attributed to the fear of

Illustration 7.3: Valuing a Rights Offering ““ Tech Temp Inc.
Tech Temp Inc. has 10 million shares outstanding, trading at $ 25 per share. It
needs to raise $ 25 million in new equity and decides to make a rights offering. Each
stockholder is provided with one right for every share owned, and 5 rights can be used to
buy an additional share in the company at $12.50 per share. The value of a right can be
calculated as follows:
Before Rights Exercised After Rights Exercised

Number of Shares 10 million 12 million
Value of Equity $ 250 million $ 275 million
Price per share $ 25.00 $ 22.92
The rights-on price is $ 25.00 per share, and the ex-rights price is $ 22.92, leading to a
per right value of $ 2.08. This can be confirmed by using the equation:
Value per Right = (Rights-on Price - Subscription Price)/(n + 1)
= ($25 - $ 12.50)/ (5 + 1)
= $ 12.50 /6 = $ 2.08
If the rights price were greater than this value, investors would want to sell their rights.
Alternatively, if the rights could be acquired for less than $ 2.08, there would be an
opportunity to gain by acquiring the rights at the lower price and exercising them.

rights.xls: This spreadsheet allows you to estimate the ex-rights price and the value
per right, in a rights issue.


7.10. ˜: Rights Issues and existing stockholders
Assume that you own 1000 shares in Tech Temp, trading at $25 a share, and that
you receive the rights described in the last illustration. Assume also that, due to an
oversight, you neither exercise the right nor sell it. How much would you expect to lose
as a result of the oversight?
a. Nothing. You still own the shares.
b. $ 416
c. $ 2,080
d. $12,500

Shelf Registrations

Firms that want to raise external financing have to disclose information and file
the required statements with the SEC before they can issue securities. This registration
process is costly and time consuming and is one reason why some firms rely on internal
financing. In response to this criticism, the SEC simplified its rules and allowed firms
more flexibility in external financing. Rule 415, which was issued in 1982, allows firms
to make a shelf registration, in which they can file a single prospectus for a series of
issues the firm expects to make over the next two years.
Besides making the process less cumbersome, shelf registration also gives firms
more flexibility in terms of timing, since stock and bond issues can be made when
windows of opportunity open up. Thus, a firm might make a shelf registration for $200
million in bonds and make the bond issue when interest rates are at a low point. This
flexibility in timing also allows firms to open up the process to aggressive bidding from
investment banks, reducing transactions costs substantially. Some firms make the issues
themselves rather than use investment bankers, since the process is simpler and faster.
Overall, the spreads on new issues, especially for bonds, have been under pressure
since the passage of shelf registration. In spite of its benefits, however, shelf registration


is more likely to be used by large firms making bond issues and less likely to be used by
small firms making equity issues.

The Trade off of Debt
Now that we have defined debt and considered how financing choices change as a
function of where a firm is in it™s life cycle, we can tackle a fundamental question. Why
use debt instead of equity? In this section, we will first examine the benefits of using debt
instead of equity and then follow up by looking at the costs.

The Benefits of Debt
In the broadest terms, debt provides two differential benefits over equity. The first
is the tax benefit : interest payments on debt are tax deductible, while cash flows on
equity are not. The second is the added discipline imposed
Double Taxation: There is
on management , by having to make payments on debt.
double taxation when the same income
Both benefits can and should be quantified if firms want to
gets taxed twice, once at the entity
make reasonable judgments on debt capacity. level and once at the individual level.
Thus, dividends, which are paid out of
after-tax corporate profits, are double
1. Debt Has A Tax Advantage
taxed when individuals have to pay
The primary benefit of debt relative to equity, is the
taxes on them, as well.
tax advantage it confers on the borrower. In the United
States, interest paid on debt is tax deductible, whereas cash flows on equity (such as
dividends) have to be paid out of after-tax cash flows. For the most part, this is true in
other countries as well, though some countries try to provide partial protection against the
double taxation of dividends by providing a tax credit to investors who receive the
dividends for the corporate taxes paid (Britain) or by taxing retained earnings at a rate
higher than dividends (Germany).
The tax benefits from debt can be presented in three ways. The first two measure the
benefit in absolute terms whereas the third measures it as a percentage cost.
In the first approach, the dollar tax savings in any financial year created by interest

expenses can be computed by multiplying the interest expenses by the marginal tax
rate of the firm. Consider a firm that borrows $B to finance it operations, on which it


faces an interest rate of r%, and assume that it faces a marginal tax rate of t on
income. The annual tax savings from the interest tax deduction can be calculated as
Annual Interest Expense arising from the Debt = r B
Annual Tax Savings arising from the Interest Payment = t r B
In the second approach, we can compute the present value of tax savings arising from

interest payments over time. The present value of the annual tax savings can be
computed by making three other assumptions. The first is that the debt is perpetual,
which also means that the dollar savings are a perpetuity. The second is that the
appropriate discount rate for this cash flow is the interest rate on the debt, since it
reflects the riskiness of the debt. The third is that the expected tax rate for the firm
will remain unchanged over time, and that the firm is in a tax paying position. With
these three assumptions, the present value of the savings can be computed as follows:
Present Value of Tax Savings from Debt = t r B / r = t B
= Marginal tax rate * Debt
While the conventional view is to look at the tax savings as a perpetuity, the approach
is general enough to be used to compute the tax savings over a shorter period (say, ten
years.) Thus, a firm that borrows $ 100 million at 8% for ten years and has a tax rate
of 40%, can compute the present value of its tax savings as follows “
Present Value of Interest Tax Savings = Annual Tax Savings (PV of Annuity)
= (.08* 0.4 * $ 100 million) (PV of Annuity, 8%,10 years) = $ 21.47 million
When asked to analyze the effect of adding debt on value, some analysts use a short
cut and simply add the tax benefit from debt to the value of the firm with no debt:
Value of Levered Firm with debt B = Value of Unlevered Firm + t B
The limitation of this approach is that it considers only the tax benefit from borrowing
and none of the additional costs. It also yields the unrealistic conclusion that firm
value increases monotonically with more debt.
In the third approach, the tax benefit from debt is expressed in terms of the difference

between the pre-tax and after-tax cost of debt. To illustrate, if r is the interest rate on
debt, and t is the marginal tax rate, the after-tax cost of borrowing (kd) can be written
as follows:


After-tax Cost of Debt (kd) = r (1 - t)
This is the familiar formula used for calculating the cost of debt in the cost of
capital calculation. In this formula, the after-tax cost of debt is a decreasing
function of the tax rate. A firm with a tax rate of 40%, which borrows at 8%, has
an after-tax cost of debt of 4.8%. Another firm with a tax rate of 70%, which
borrows at 8%, has an after-tax cost of debt of 2.4%.
Other things remaining equal, the benefits of debt are much greater when tax rates are
higher. Consequently, there are three predictions that can be made about debt ratios
across companies and across time.
The debt ratios of entities facing higher tax rates should be higher than the debt ratios

of comparable entities facing lower tax rates. Other things remaining equal, you
would expect German companies that face a 38.5% marginal corporate tax rate to
borrow more money than Irish companies that face a 12.5% marginal corporate tax
If tax rates increase over time, we would expect debt ratios to go up over time as well,

reflecting the higher tax benefits of debt.
Companies with large net operating losses carried forward should get far less in tax

benefits from debt than firms without these net operating losses.

There is a data set on the web that summarizes, by sector, the effective tax rates
of firms in the sector.

7.11. ˜: Net Operating Loss Carryforward and Tax Benefits


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