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Chapter 39 CAPITAL INCREASES

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Chapter 39 CAPITAL INCREASES Chapter 39 CAPITAL INCREASES There are no victories at bargain prices The previous chapters have already begun our study of equity financing. This chapter analyses the consequences for the shareholder of a capital increase via an issue of new shares for cash. Capital increases resulting from mergers and acquisitions will be dealt with in Chapter 43. Section 39.1 A DEFINITION OF CAPITAL INCREASE 1/ A CAPITAL INCREASE IS A SALE OF SHARES... A capital increase is first of all a sale of shares. But who is the seller? The current shareholder. The paradox is that the seller receives no money. As we shall see in this chapter, to avoid diluting his stake in the company at the time of a capital increase, the shareholder must subscribe to the same proportion of the new issue that he holds of the pre-existing shares. Only if he subscribes to more than that is he (from the standpoint of his own portfolio) buying additional control; if less, he is selling control. Up to now, we have presented market value as a sanction on the company’s man- agement, an external judgement that the company can ignore so long as its shareholders are not selling out and it is not asking them to stump up more money. A capital increase, which conceptually is a sale of shares at market value, has the effect of reintroducing this value-sanction via the company’s treasury, i.e. its cash balance. For the first time, market value, previously an external datum, interferes in the management of the company. 2/ ...THE PROCEEDS OF WHICH GO TO THE COMPANY, AND THUS INDIRECTLY TO ALL OF ITS INVESTORS, ... This may seem paradoxical, but it is not. The proceeds of the capital increase indeed go to the company. Shareholders will benefit to the extent that the additional funds enable the 816 EQUITY CAPITAL AND DIVIDENDS company to develop its business and thereby increase its earnings. Creditors will see their claims on the company made less risky and therefore more valuable. 3/ ...WHICH IMPLIES SHARING BETWEEN OLD AND NEW SHAREHOLDERS When a company issues bonds or takes out a loan from a bank, it is selling a “financial product”. It is contracting to pay interest at a fixed or indexed rate and repay what it has borrowed on a specified schedule. As long as it meets its contractual obligations, the company does not lose its autonomy. In contrast, when a company issues new shares, the old shareholders are agreeing to share their rights to the company’s equity capital (which is increased by the proceeds of the issue), their rights to its future earnings and their control over the company itself with the new shareholders. A capital increase is simply a sale of shares. It implies sharing the parameters of the company. The magnitude of this sharing depends on the market value of the equity capital, but it applies to a cake made larger by the proceeds of the capital increase. To illustrate, consider company E with equity capital worth BC1000m split between two shareholders, F (80%) and G (20%). If G sells his entire shareholding (BC200m) to H, neither the value nor the proportion of F’s equity in the company is changed. If, on the other hand, H is a new shareholder brought in by means of a capital increase, he will have to put in BC250m to obtain a 20% interest, rather than BC200m as previously, since the value of equity after a capital increase of BC250m is BC1250m (1000 + 250). The new shareholder’s interest is indeed 20% of the larger amount. Percentage interests should always be reckoned on the value including the newly issued shares. After this capital increase has been made to the BC1000m base, the value of F’s share- holding in the company is the same as it was (BC800m) but his ownership percentage has decreased from 80% to 64% (800/1250), while G’s has decreased from 20% to 16%. We see that if a shareholder does not participate in a capital increase, his percentage interest declines. This effect is called dilution. In contrast, if the capital increase is reserved entirely for F, his percentage interest in the company rises from 80% to 84% (1050/1250), and the equity interest of all other shareholder(s) is necessarily diluted. Lastly, if F and G each take part in the capital increase in exact proportion to their 1 The figures in parentheses current shareholding, the market value of equity no longer matters in this one particular indicate cash case. Their ownership percentages remain the same, and each puts up the same amount of flows: positive funds for new shares regardless of the market value. This is illustrated in the table below1 means an inflow, B B B negative an for equity values of C500m, C1000m and C2000m. In effect, F and G are selling new outflow. shares to themselves. Chapter 39 CAPITAL INCREASES 817 (BC million) Value of Value of Value of Value of equity shares held shares held shares held in E by F by G by H Before capital increase 1000 800 or 80% 200 or 20% G sells 20% of the shares to H 1000 800 or 80% 0 or 0% 200 or 20% for 200 (+200) (−200) H subscribes to a cash capital 1250 800 or 64% 200 or 16% 250 or 20% increase of 250 (−250) G sells 20% of the shares to F 1000 1000 or 100% 0or0% for 200 (−200) (+200) F subscribes to a cash capital 1250 1050 or 84% 200 or 16% increase of 250 (−250) F and G subscribe to a cash 1250 1000 or 80% 250 or 20% capital increase of 250 in (−200) (−50) proportion to their ownership percentage at different initial 2250 1800 or 80% 450 or 20% values of equity (1000, 2000 (−200) (−50) and 500, respectively) 750 600 or 80% 150 or 20% (−200) (−50) Section 39.2 CAPITAL INCREASES AND FINANCE THEORY 1/ CAPITAL INCREASES AND MARKETS IN EQUILIBRIUM A capital increase is analysed first and foremost as a sale of new shares at a certain price. If that price is equal to the true value of the share, there is no creation of value, nor is any current shareholder made worse off. This is an obvious point that is easily lost sight of in the analysis of financial criteria that we will get to later on. If the new shares are sold at a high price (more than their value), the company will have benefited from a low-cost source of financing to the detriment of its most recent shareholders. The Internet companies that were able to raise money on very advantageous terms until early 2000 can be cited as an example. Recall that the cost entailed by a capital increase is neither the immediate return on the stock nor the accounting rate of return on equity. It is the rate of return required by shareholders given the market valuation of the stock (see Chapter 22 for the determination of cost of equity). As we have seen, however, this cost is eminently variable. The sanction for not meeting it is that, other things being equal, the value of the share will decline. The company will be worth less, but in the short term there will be no impact on its treasury. 818 EQUITY CAPITAL AND DIVIDENDS 2/ TAXATION A cash capital increase generally results in immediate de-leveraging, making the capi- tal structure less advantageous from a tax standpoint. But the equity injection is usually part of a plan to achieve a new capital structure. For this reason, the tax factor is not a fundamental parameter of a capital increase. 3/ SHAREHOLDERS AND CREDITORS For a company in financial difficulty, a capital increase results in a transfer of value from shareholders to creditors, since the new money put in by the former enhances the value of the claims held by the latter. According to the contingent claims model, the creditors of a “risky” business are able to appropriate most of the increase in the company’s value due to an injection of additional funds by shareholders. The value of the put option sold by creditors to shareholders has a lower value. This is the reason why recovery plans for troubled companies always link any new equity financing to prior or concomitant concessions on the part of lenders. Recapitalisation increases the intrinsic value of the equity and thereby reduces the riskiness of the company, thus increasing the value of its debt as well. Creditors run less risk by holding that debt. This effect is perceptible, though, only if the value of debt is close to the value of operating assets – that is, only if the debt is fairly high risk. 4/ SHAREHOLDERS AND MANAGERS A capital increase is generally a highly salutary thing to do because it helps to reduce the asymmetry of information between shareholders and managers. A call on the market for fresh capital is accompanied by a series of disclosures on the financial health of the com- pany and the profitability of the investments that will be financed by the capital increase. This practice effectively clears management of suspicion and reduces the agency costs of divergence between their interest and the interest of outside shareholders. A capital increase thus encourages managers to manage in a way that maximises the shareholders’ interest. The reader will already have applied the line of reasoning above, so familiar has it become by now. What is new here is the conflict between old and new shareholders, under the cover of the oft-repeated hypocrisy that “we are all partners” in the same company.
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