The Cost of Issuing Securities
Issuing securities to the public isn’t free, and the costs of different methods are important determinants of
which is used. These costs associated with floating a new issue are generically called flotation costs.
The cost of issuing securities can be broken down into the following main categories:
• Spread • Other direct expenses – legal fees, filing fees, etc. • Indirect expenses – opportunity costs, i.e., management time spent working on issue • Abnormal returns – price drop on existing stock • Underpricing – below market issue price on IPOs • Green Shoe option – cost of additional shares that the syndicate can purchase after the issue has gone
to market
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IPO Cost – Example
• The Faulk Co. has just gone public under a firm commitment agreement. Faulk received $32 for each of the 4.1 million shares sold. The initial offering price was $34.40 per share, and the stock rose to $41 per share in the first few minutes of trading. Faulk paid $905,000 in legal and other direct costs and $250,000 in indirect costs. What was the flotation cost as a percentage of funds raised?
• The net amount raised is the number of shares offered times the price received by the company, minus the costs associated with the offer, so:
• Net amount raised = (4,100,000 shares)($32) – 905,000 – 250,000 = $130,045,000
The company received $130,045,000 from the stock offering
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IPO Cost – Example
• Next, we can calculate the direct costs. Part of the direct costs are given in the problem, but the company also had to pay the underwriters. The stock was offered at $34.40 per share, and the company received $32 per share. The difference, which is the underwriters’ spread, is also a direct cost.
• Total direct costs = $905,000
+ ($34.40 – 32)(4,100,000 shares) = $10,745,000
• We are given part of the indirect costs, but the underpricing is another indirect cost.
• Total indirect costs = $250,000
+ ($41 – 34.40)(4,100,000 shares) = $27,310,000
Now we can calculate the direct costs. Part of the direct costs are given in the problem, but the company
also had to pay the underwriters. The stock was offered at $25 per share, and the company received
$23.25 per share. The difference, which is the underwriters spread, is also a direct cost.
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IPO Cost – Example
• Total costs = $10,745,000 + 27,310,000 = $38,055,000
• The flotation costs as a percentage of the amount raised is the total cost divided by the amount raised, or:
• Flotation cost percentage = $38,055,000 / $130,045,000
• Flotation cost percentage = .2926, or 29.26%
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Rights Offerings: Basic Concepts
• Issue of common stock offered to existing shareholders
• Allows current shareholders to avoid the dilution that can occur with a new stock issue
• “Rights” are given to the shareholders ▪ Specify number of shares that can be purchased
▪ Specify purchase price
▪ Specify time frame
• Rights may be traded OTC or on an exchange 15-23
Privileged subscription – issue of common stock offered to existing stockholders.
Offer terms are evidenced by warrants or rights.
Rights are often traded on exchanges or over the counter.
If a preemptive right is contained in the firm’s articles of incorporation, the firm must first offer any new
issue of common stock to existing shareholders.
In a rights offering, each shareholder is issued rights to buy a specified number of new shares from the
firm at a specified price within a specified time
Rights offerings have some interesting advantages relative to cash offers. For example, they appear to be
cheaper for the issuing firm than cash offers. In fact, a firm can do a rights offering without using an
underwriter.
Rights offerings are fairly rare in the United States.
The Mechanics of a Rights Offering
Early stages are the same as for a general cash offer, i.e., obtain approval from directors, file a registration
statement, etc. The difference is in the sale of the securities. Current shareholders get rights to buy new
shares. They can subscribe (buy) the entitled shares, sell the rights, or do nothing.
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• Dilution is a loss in value for existing shareholders.
▪ Percentage ownership – shares sold to the general public without a rights offering
▪ Market value – firm accepts negative NPV projects
▪ Book value and EPS – occurs when market-to-book value is less than one