. 79
( 100 .)


case, that the enthusiasm for Broadcast.com has been
$18 and reached as high as $74 before closing at
overdone. He says: “ There are no entrenched players in
$62.75” a gain of nearly 250% on the day after a feed-
this space. The ˜old™ media are aware that the intelli-
ing frenzy in which 6.5m shares changed hands. After
gence to exploit the Internet lies outside their organiza-
the dust had settled, Broadcast.com was established
tions and are standing back waiting to see what hap-
as a $1 billion company, and its two 30-something
pens. Broadcast.com is well-positioned to be a service
founders, Mark Cuban and Todd Wagner, were worth
intermediary for those companies and for other content
nearly $500m between them.
owners.” Persuaded?
In its three years of existence, Broadcast.com, for-
merly known as AudioNet, has lost nearly $13m, and its
offer document frankly told potential investors that it Source: © 1998 The Economist Newspaper Group, Inc. Reprinted
had absolutely no idea when it might start to make with permission. Further reproduction prohibited. www.economist.
money. So has Wall Street finally taken leave of its com.

half the shares you bid for when the issue is underpriced. Suppose you bid for $1,000 of
shares in two issues, one overpriced and the other underpriced. You are awarded the full
$1,000 of the overpriced issue, but only $500 worth of shares in the underpriced issue.
The net gain on your two investments is (.10 — $500) “ (.05 — $1,000) = 0. Your net profit
is zero, despite the fact that on average, IPOs are underpriced. You have suffered the
winner™s curse: you “win” a larger allotment of shares when they are overpriced.

What is the percentage profit earned by an investor who can identify the underpriced
Self-Test 2
issues in Example 2? Who are such investors likely to be?

The costs of a new issue are termed flotation costs. Underpricing is not the only
The costs incurred when a flotation cost. In fact, when people talk about the cost of a new issue, they often think
firm issues new securities to only of the direct costs of the issue. For example, preparation of the registration state-
the public. ment and prospectus involves management, legal counsel, and accountants, as well as
underwriters and their advisers. There is also the underwriting spread. (Remember, un-
derwriters make their profit by selling the issue at a higher price than they paid for it.)
Table 5.10 summarizes the costs of going public. The table includes the underwrit-
ing spread and administrative costs as well as the cost of underpricing, as measured by
the initial return on the stock. For a small IPO of no more than $10 million, the under-

How Corporations Issue Securities 525

TABLE 5.10
Value of Issue Direct Average First-Day Total
Average expenses of 1,767
Costs, %b Return, %b Costs, %c
(millions of dollars)
initial public offerings,
2“9.99 16.96 16.36 25.16
10“19.99 11.63 9.65 18.15
20“39.99 9.70 12.48 18.18
40“59.99 8.72 13.65 17.95
60“79.99 8.20 11.31 16.35
80“99.99 7.91 8.91 14.14
100“199.99 7.06 7.16 12.78
200“499.99 6.53 5.70 11.10
500 and up 5.72 7.53 10.36
All issues 11.00 12.05 18.69

a The table includes only issues where there was a firm underwriting commitment.
b Direct costs (i.e., underwriting spread plus administrative costs) and average initial return are expressed as
a percentage of the issue price.
c Total costs (i.e., direct costs plus underpricing) are expressed as a percentage of the market price of the

Source: J. R. Ritter et al., “The Costs of Raising Capital,” Journal of Financial Research 19, No. 1, Spring
1996. Reprinted by permission.

writing spread and administrative costs are likely to absorb 15 to 20 percent of the pro-
ceeds from the issue. For the very largest IPOs, these direct costs may amount to only
5 percent of the proceeds.

Costs of an IPO
When the investment bank Goldman Sachs went public in 1999, the sale was partly a
primary issue (the company sold new shares to raise cash) and partly a secondary one
(two large existing shareholders cashed in some of their shares). The underwriters ac-
quired a total of 69 million Goldman Sachs shares for $50.75 each and sold them to the
public at an offering price of $53.6 The underwriters™ spread was therefore $53 “ $50.75
= $2.25. The firm and its shareholders also paid a total of $9.2 million in legal fees and
other costs. By the end of the first day™s trading Goldman™s stock price had risen to $70.
Here are the direct costs of the Goldman Sachs issue:
Direct Expenses
69 million — $2.25 = $155.25 million
Underwriting spread
Other expenses 9.2
Total direct expenses $164.45 million

The total amount of money raised by the issue was 69 million — $53 = $3,657 million.
Of this sum 4.5 percent was absorbed by direct expenses (that is, 164.45/3,657 = .045).
In addition to these direct costs, there was underpricing. The market valued each
share of Goldman Sachs at $70, so the cost of underpricing was 69 million — ($70 “

6 No prizes for guessing which investment bank acted as lead underwriter.

$53) = $1,173 million, resulting in total costs of $164.45 + $1,173 = $1,337.45 million.
Therefore, while the total market value of the issued shares was 69 million — $70 =
$4,830 million, direct costs and the costs of underpricing absorbed nearly 28 percent of
the market value of the shares.

Suppose that the underwriters acquired Goldman Sachs shares for $60 and sold them to
Self-Test 3
the public at an offering price of $64. If all other features of the offer were unchanged
(and investors still valued the stock at $70 a share), what would have been the direct
costs of the issue and the costs of underpricing? What would have been the total costs
as a proportion of the market value of the shares?

The Underwriters
We have described underwriters as playing a triple role”providing advice, buying a
new issue from the company, and reselling it to investors. Underwriters don™t just help
the company to make its initial public offering; they are called in whenever a company
wishes to raise cash by selling securities to the public.

Most companies raise capital only occasionally, but underwriters are in the
business all the time. Established underwriters are careful of their reputation
and will not handle a new issue unless they believe the facts have been
presented fairly to investors. Thus, in addition to handling the sale of an
issue, the underwriters in effect give it their seal of approval. This implied
endorsement may be worth quite a bit to a company that is coming to the
market for the first time.

Underwriting is not always fun. On October 15, 1987, the British government final-
ized arrangements to sell its holding of British Petroleum (BP) shares at £3.30 a share.
This huge issue involving more than $12 billion was underwritten by an international
group of underwriters and simultaneously marketed in a number of countries. Four days
after the underwriting arrangement was finalized, the October stock market crash oc-
curred and stock prices nose-dived. The underwriters appealed to the British govern-
ment to cancel the issue but the government hardened its heart and pointed out that the
underwriters knew the risks when they agreed to handle the sale.7 By the closing date
of the offer, the price of BP stock had fallen to £2.96 and the underwriters had lost more
than $1 billion.

Since underwriters play such a crucial role in new issues, we should look at who they
are. Several thousand investment banks, security dealers, and brokers are at least spo-
7 The government™s only concession was to put a floor on the underwriters™ losses by giving them the option
to resell their stock to the government at £2.80 a share. The BP offering is described and analyzed in C. Mus-
carella and M. Vetsuypens, “The British Petroleum Stock Offering: An Application of Option Pricing,” Jour-
nal of Applied Corporate Finance 1 (1989), pp. 74“80.
How Corporations Issue Securities 527

TABLE 5.11
Underwriter Value of Issues
Top underwriters of U.S. debt
and equity, 1998 (figures in Merrill Lynch $ 304
billions) Salomon Smith Barney 225
Morgan Stanley Dean Witter 203
Goldman Sachs 192
Lehman Brothers 147
Credit Suisse First Boston 127
J. P. Morgan 89
Bear Stearns 83
Chase Manhattan 71
Donaldson Lufkin & Jenrette 61
All underwriters $1,820

Source: Securities Data Co.

radically involved in underwriting. However, the market for the larger issues is domi-
nated by the major investment banking firms, which specialize in underwriting new is-
sues, dealing in securities, and arranging mergers. These firms enjoy great prestige, ex-
perience, and financial muscle. Table 5.11 lists some of the largest firms, ranked by
total volume of issues in 1998. Merrill Lynch, the winner, raised a total of $304 billion.
Of course, only a small proportion of these issues was for companies that were coming
to the market for the first time.
Earlier we pointed out that instead of issuing bonds in the United States, many cor-
porations issue international bonds in London, which are then sold to investors outside
the United States. In addition, new equity issues by large multinational companies are
increasingly marketed to investors throughout the world. Since these securities are sold
in a number of countries, many of the major international banks are involved in under-
writing the issues. For example, look at Table 5.12 which shows the names of the prin-
cipal underwriters of international issues in 1998.

TABLE 5.12
Underwriter Value of Issues
Top underwriters of
international issues of Warburg Dillon Read $ 63.6
securities, 1998 (figures in Merrill Lynch 52.3
billions) Morgan Stanley Dean Witter 43.6
Goldman Sachs 42.5
Deutsche Bank 39.0
Paribas 38.7
J. P. Morgan 36.0
Barclays Capital 31.1
Credit Suisse First Boston 25.7
All underwriters $665.5

Source: Securities Data Co.

General Cash Offers
by Public Companies
After the initial public offering a successful firm will continue to grow and from time
to time it will need to raise more money by issuing stock or bonds. An issue of addi-
tional stock by a company whose stock already is publicly traded is called a seasoned
offering. Any issue of securities needs to be formally approved by the firm™s board of
directors. If a stock issue requires an increase in the company™s authorized capital, it
Sale of securities by a firm
also needs the consent of the stockholders.
that is already publicly
Public companies can issue securities either by making a general cash offer to in-
vestors at large or by making a rights issue, which is limited to existing shareholders.
In the latter case, the company offers the shareholders the opportunity, or right, to buy
Issue of
more shares at an “attractive” price. For example, if the current stock price is $100, the
securities offered only to
company might offer investors an additional share at $50 for each share they hold. Sup-
current stockholders.
pose that before the issue an investor has one share worth $100 and $50 in the bank. If
the investor takes up the offer of a new share, that $50 of cash is transferred from the
investor™s bank account to the company™s. The investor now has two shares that are a
claim on the original assets worth $100 and on the $50 cash that the company has
raised. So the two shares are worth a total of $150, or $75 each.

Rights Issues
Easy Writer Word Processing Company has 1 million shares outstanding, selling at $20
a share. To finance the development of a new software package, it plans a rights issue,
allowing one new share to be purchased for each 10 shares currently held. The purchase
price will be $10 a share. How many shares will be issued? How much money will be
raised? What will be the stock price after the rights issue?
The firm will issue one new share for every 10 old ones, or 100,000 shares. So
shares outstanding will rise to 1.1 million. The firm will raise $10 — 100,000 = $1 mil-
lion. Therefore, the total value of the firm will increase from $20 million to $21 mil-
lion, and the stock price will fall to $21 million/1.1 million shares = $19.09 per share.

In some countries the rights issue is the most common or only method for issuing
stock, but in the United States rights issues are now very rare. We therefore will con-
centrate on the mechanics of the general cash offer.

When a public company makes a general cash offer of debt or equity, it essentially fol-


. 79
( 100 .)