Raising Capital from Bond and Equity Markets - Case Study Example

I. Introduction This paper aims to explore how companies raise capital from the debt and equity markets. These include initial public offering, seasoned equity offering, and straight debt issues. Various finance literatures which explore the topics in-depth are looked into. Also, the importance of the capital asset pricing model for firms which want to evaluate their cost of capital, is explored in the next part. The link between CAPM, the required return on equity and the weighted average cost of capital is explored, with the help of various academic journals. II. Body A. Raising capital from bond and equity markets i. The initial public offering When a company is in need of capital, there are two options which will comprise the mix of its capital structure: one is debt, and the other is equity. If the company chooses to raise capital from equity financing, there are also various options. One of these options include raising capital from financial markets such as the stocks market either through seasoned offering or a new issue, most commonly known as the initial public offering (Inmoo et al. 1996). The initial public offering takes place when a company decides to issue stocks that are available for the publics purchase (Sherman 2003). A company employs underwriters—investment banks that first buy the securities from the issuing corporation and re-selling it to investors-at-large (Szewczyk & Varma 1991). Underwriters help the issuing company prepare a prospectus, which is a document that describes the company as well as its prospects. Many practitioners as well as academicians regard IPOs as one of the most expensive ways to raise equity capital. IPOs are required, by law to be registered in the Securities and Exchange Commissions (Gay 1999). The issuing company pays for legal and administrative fees, which are part of the IPO registration (Lee & Kocher 2001). Aside from this, another cost to the company is the underwriting spread, which is the difference in the price of the shares of the firm when it has been bought by the underwriter, and the price that the public pays the underwriter. The firm which raises capital through IPO usually needs access to a really huge amount of cash, where the benefits of undertaking the IPO is bigger than the costs. ii. Seasoned equity offerings If initial public offerings are for issuing companies that does not have an existing issued stocks in the stocks market, seasoned equity offerings or SEOs are stock issues for companies that are already publicly listed in the stocks market (Sherman 2003). If a company that has already undergone an IPO needs to raise substantial capital again and it chooses to issue new equity in order to finance it, this is called seasoned equity offering (Butler, Grullon & Wetson 2005). Seasoned equity offerings come in different variations as regards the terms of the offer such as offering the stocks at investors-at-large or through a rights offerings. Under the rights offering, the company can issue rights to the purchasing the new shares to recipient investors on a proportionate basis (Weller 1962). These rights can either be sold or utilised depending on the recipient investors (Weller 1962). If the initial public offering is already considered costly, seasoned equity offerings also have some shortcomings. For one, after an SEO, it is very usual that the stock price of the company gets lower because of the increase in price. There is a period of time before the price of the stocks will incorporate the information about the company, and this information will be reflected in the stock price (Lang 2008). When a company announces an SEO, findings of some studies say that the public perceives the action as negative, which drives down the price of the companys stock (Lee & Kocher 2001). This is because of the information asymmetry between the investors and the management (Lang 2008). Therefore, SEOs are usually the last resort that academicians recommend when raising equity capital. iii. Straight debt issues Aside from raising capital by equity financing, a company can choose to employ debt financing through bond issues when bank overdrafts and long-term loans are no longer the companys options. The company can raise capital through debt issues. The difference between this and the equity issue is the financial instrument that is being sold (Bharath 2005). When bonds are bought by bondholders, they do not become part owner of the company; instead they become creditors to the company. Debt issues also undergo the same process as the equity issues (Szewczyk & Varma 1991). However, debt issues do not usually provide the economies of scale that come with equity issues. This is because, debt issues are associated with the companys credit rating (Szewczyk & Varma 1991). The higher the debt issue is and its effect on the total capitalisation of the company, the higher the perceive risk is to the debt investors (Szewczyk & Varma 1991). Therefore, the price of debt becomes higher as the credit rating of the company goes down, due to the increase in the amount of the debt issue. B. Relevance of the capital asset pricing model (CAPM) to a company seeking to evaluate its ‘cost of capital’ i. The capital asset pricing model: evaluation of risk and return CAPM or the capital asset pricing model has been a tool in modern finance that has been extensively used for capital budgeting (Jagannathan & Meier 2002). The capital asset pricing model is useful in estimating the required return on an equity stock of a company (Perold 2004). Under the principle of finance that rational investors will require higher returns to compensate them when they undertake projects with higher risks, CAPM captures this concept which has made it popular in corporate finance literatures as well as widely accepted in practice (Mullins 1982). As an equation, CAPM is stated as follows: the required rate of return on equity is equal to a risk-free rate plus the product of the companys beta to the market premium (the difference between the return on the stock market and the risk-free rate) (Mullins 1982). The most common instrument that is used to determine the risk-free rate is the 90-day treasury bill (Jagannathan & Meier 2002), under the assumption that these bills issued by the government are almost risk-less because a government cannot default. The beta of the company is the volatility of the companys stock which is based on the historical correlation of the companys returns measured against the returns of the stock market over a long period (Homaifar & Graddy 1990). In short, beta in CAPM is the measure of the systematic risk, or the risk that cannot be diversified because it is not inherent to the company (Mullins 1982). According to this model, if the companys stock has a beta higher than 1, the companys stock is riskier than the stock market. When this risk is incorporated by multiplying it to the risk premium, the required rate of return is adjusted in order to compensate the investors depending on the level of risk that they undertake (Perold 2004). ii. Required return on equity, cost of capital and the CAPM valuation CAPM is important to companies that seek to evaluate their cost of capital because of the link between the required return on equity and the companys weighted average cost of capital. The companys weighted average cost of capital is comprised of the cost of utilising debt and the cost of utilising equity for a companys capital structure (Litzenberger, Ramaswamy & Sosin 1980). Because CAPM is one of the methods most commonly used in estimating a companys required return on equity, it is valuable for computing for the companys weighted average cost of capital (Treynor 1993). The weighted average cost of capital is computed by getting the cost of utilising debt (the proportion of debt in the companys capital structure multiplied by the after-tax rate of debt), plus the cost of utilising equity (the proportion of equity in the companys capital structure multiplied by the companys required rate of return on equity) (Litzenberger, Ramaswamy & Sosin 1980). As stated above, among the different models that are used to estimate the companys required rate of return on equity, CAPM includes the relevance of risk in the analysis. Therefore, if the required rate of return on equity that is used is based on the CAPM analysis, the resulting weighted average cost of capital as the hurdle rate reflects the expectations of the investors, and the true cost of the firms overall financing (Treynor 1993). iii. Underlying assumptions of CAPM 12manage.com in its explanation of William Sharpe’s model, lists down the assumptions under which the CAPM can only be valid, because its simplicity requires that there are certain things that should be left constant. These assumptions include “investors are risk-averse individuals who maximize the expected utility of their end period of wealth; investors have homogeneous expectations (beliefs) about asset returns; asset returns are distributed by the normal distribution; there exists a risk-free asset that investors may borrow or lend unlimited amounts of this asset at a constant rate; there is a definite number of assets and their quantities are fixated within one period world; all assets are perfectly divisible and priced in a perfectly competitive market; asset markets are frictionless and information is costless and simultaneously available to all investors; there are no market imperfections such as taxes, regulations, or restrictions on short selling (2008).” Capital asset pricing model is too simple that it requires some assumptions in order for its analysis to be valid. As mentioned earlier, when the market is assumed to be in a perfectly competitive state where information is available to everyone and people are rational investors who maximize their economic utility, CAPM is valid (McNulty et al. 2002). Also, this assumption of a perfect competition includes the assumption that buyers are small enough to influence the price of the securities in the market; therefore there are less imperfections and distortions in the market as regards the rates that are used for the model (Mullins 1982). The assumption of the investors being able to borrow and lend unlimited amounts at a risk-free rate is determined, as the borrowing and lending activities do not distort the market rates. Also, the presence of taxes is eliminated in the model, as well as other costs that are related to the transactions that would affect the rates of the market (Mullins 1982). This simple model incorporates all these assumptions, and requires that the analysis fulfil the assumptions in order for the model’s results be considered valid. iv. Limitations of CAPM CAPM also has its fair share of criticisms as much as its accolades. One of these criticisms include the conflict between the volatility and the correlation when the beta is estimated for the companys beta. According to McNulty et al., distortions happen when the correlation of a companys stock to the market movement is being incorporated in the analysis (2002). The rationale behind this is that, for diversifying investors, the correlation will serve as some hedge in terms of the stock value when a stock is being incorporated in the investors portfolio of investments. However, a major criticism is formed behind the profile of investors. According to McNulty et al., the diversifying investor does not incorporate all the types of investors (2002). For corporate investors for example who minimise their risks by controlling management decisions instead of diversifying portfolio, this type of investors should require higher risks in theory in order to compensate also for their efforts (2002). Another criticism for the CAPM, especially in estimating the beta of the companys stocks is its reliance on historical data (McNulty et al. 2002). Since the stock market as well as the company cannot be predicted mainly on the basis of the historical performance, the risks that the beta represents does not include the risks that the future decisions of the companys management will incur in relation to undertaking some projects. III. Conclusion There are two types of financing the company can choose from when it decides to raise additional capital. These are equity and debt financing. While there are private issues of both of these types of financing, this paper explores the ways companies raise capital in the public market, or the stocks and bond markets. These public issues are usually very costly. These costs include direct costs such as the cost of registration, administrative and legal costs for the issuing company. Aside from these, underwriting spreads, or the difference between the price the underwriter pays for purchasing the companys stocks, and the price the investors-at-large buy from the underwriters are significantly huge enough costs for a company to consider. As for CAPM, this model is important in determining a companys cost of capital as this reflects the true expectations of its investors; this hurdle rate is what the company uses in order to decide on projects that will increase the companys value. Because the model incorporates the measure of risks in terms of the volatility and correlation of the companys historical stock returns versus those of the stock markets, this is widely accepted both by practitioners and academicians. Although certain limitations weaken the usefulness of the model, CAPM is still a relevant model when a company assesses its cost of capital. References 12Manage.com. 2008 November 8. Valuing stocks, securities, derivatives, and/or assets by relating risk and expected return: Explanation of Capital Asset Pricing Model of William Sharpe. Available from http://www.12manage.com/methods_capm.html. (Accessed November 4, 2009) Bharath, Kaveer. 2005. "Going the debt route." Finance Week 62-65. Business Source Premier, EBSCOhost (accessed November 4, 2009). Butler, Alexander W., Gustavo Grullon, and James P. Weston. 2005. "Stock Market Liquidity and the Cost of Issuing Equity." Journal of Financial & Quantitative Analysis 40, no. 2: 331-348. Business Source Premier, EBSCOhost (accessed November 4, 2009). Gay, Keith. 1999. "Status Quo to IPO: Ways to Raise Equity Capital for Your Company." Training & Development 53, no. 2: 43. Business Source Premier, EBSCOhost (accessed November 4, 2009). Homaifar, Ghassem, and Duane B. Graddy. 1990. "VARIANCE AND LOWER PARTIAL MOMENT BETAS AS ALTERNATIVE RISK MEASURES IN COST OF CAPITAL ESTIMATION: A DEFENSE OF THE CAPM BETA." Journal of Business Finance & Accounting 17, no. 5: 677-688. Business Source Premier, EBSCOhost (accessed November 4, 2009). LANG, MARK H. 2008. "Discussion of "Analyst Coverage and the Cost of Raising Equity Capital: Evidence from Underpricing of Seasoned Equity Offerings." Contemporary Accounting Research 25, no. 3: 701-706. Business Source Premier, EBSCOhost (accessed November 4, 2009). Lee, Hei Wai, and Claudia Kocher. 2001. "Firm Characteristics And Seasoned Equity Issuance Method: Private Placement Versus Public Offering." Journal of Applied Business Research 17, no. 3: 23. Business Source Premier, EBSCOhost (accessed November 4, 2009). Lee, Inmoo, Scott Lochhead, Jay Ritter, and Zhao Quanshui. 1996. "THE COSTS OF RAISING CAPITAL." Journal of Financial Research 19, no. 1: 59. Business Source Premier, EBSCOhost (accessed November 4, 2009). LITZENBERGER, ROBERT, KRISHNA RAMASWAMY, and HOWARD SOSIN. 1980. "On the CAPM Approach to the Estimation of A Public Utilitys Cost of Equity Capital." Journal of Finance 35, no. 2: 369-383. Business Source Premier, EBSCOhost (accessed November 4, 2009). Jagannathan, Ravi, and Iwan Meier. 2002. "Do We Need CAPM for Capital Budgeting?." Financial Management (Blackwell Publishing Limited) 31, no. 4: 55. Business Source Premier, EBSCOhost (accessed November 4, 2009). McNulty, James J., Tony D. Yeh, William S. Schulze, and Michael H. Lubatkin. 2002. "Whats Your Real Cost of Capital?." Harvard Business Review 80, no. 10: 114-121. Business Source Premier, EBSCOhost (accessed November 4, 2009). Mullins Jr., David W. 1982. "Does the capital asset pricing model work?." Harvard Business Review 60, no. 1: 105. Business Source Premier, EBSCOhost (accessed November 4, 2009). Sherman, Andrew J. 2003. "Strategies for Raising Equity Capital." Fast-Track Business Growth 193. Business Source Premier, EBSCOhost (accessed November 4, 2009) Szewczyk, Samuel H., and Raj Varma. 1991. "RAISING CAPITAL WITH PRIVATE PLACEMENTS OF DEBT." Journal of Financial Research 14, no. 1: 1-13. Business Source Premier, EBSCOhost (accessed November 4, 2009). Perold, André F. 2004. "The Capital Asset Pricing Model." Journal of Economic Perspectives 18, no. 3: 3-24. Business Source Premier, EBSCOhost (accessed November 4, 2009). Treynor, Jack L. 1993. "In Defense of the CAPM." Financial Analysts Journal 49, no. 3: 11. Business Source Premier, EBSCOhost (accessed November 4, 2009). WELLER, KENNETH J. 1962. "AN ANALYSIS AND APPRAISAL OF RIGHTS OFFERINGS AS A METHOD OF RAISING EQUITY CAPITAL." Journal of Finance 17, no. 3: 529-530. Business Source Premier, EBSCOhost (accessed November 4, 2009). Read More