1. A share issue is a sale of shares …

A share issue 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 share issue, 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 management, 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 share issue, 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 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 current 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.

To illustrate, consider Company E with equity capital worth $1000m split between two shareholders, F (80%) and G (20%).

If G sells his entire shareholding ($200m) 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 an issue of new shares, he will have to put in $250m to obtain a 20% interest, rather than $200m as previously, since the value of equity after a capital increase of $250m is $1250m (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 share issue has been added to the $1000m base, the value of F’s shareholding in the company is the same as it was ($800m), 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 share issue 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 share issue in exact proportion to their current shareholding, the market value of equity no longer matters in this one particular case. Their ownership percentages remain the same, and each puts up the same amount of funds for new shares regardless of the market value. This is illustrated in the table below¹ for equity values of $500m, $1000m and $2000m. In effect, F and G are selling new shares to themselves.

1. Share issues and markets in equilibrium

A share issue 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 start-ups that were able to raise money on very advantageous terms in the first semester of 2014 can be cited as an example.

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.

2. Shareholders and creditors

For a company in financial distress, a share issue 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 a large share 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.

3. 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 company and the profitability of the investments that will be financed by the issue of new shares. This practice effectively clears management of suspicion and reduces the agency costs of divergence between their interest and the interest of outside shareholders. A share issue thus encourages managers to manage in a way that maximises the shareholders’ interest.

4. Share issue as a signal

If one assumes that managers look out for the interests of current shareholders, it is hard to see how they could propose an issue of new shares when the share price is undervalued.

If one believes in asymmetry of information, a share issue ought to be a signal that the share price is overvalued. A share issue may be a sign that managers believe the company’s future cash flows will be less than what is reflected in the current share price. The management team takes advantage of the overvaluation by issuing new shares. The funds provided by this issue will then serve not to finance new investments but to make up for the cash shortfall due to lower-than-expected operating cash flows.

Furthermore, as we have already noted, a share issue implies a change in capital structure. Following the injection of new funds, financial leverage is appreciably decreased. The company’s risk diminishes, and there is a transfer of value from shareholders to creditors; the value of the company’s shares does not increase by the full value of the funds that are raised.

In practice, the announcement of a capital increase produces a downward adjustment of 3–5% in the share price. Only the current shareholders suffer this diminution of value. Some claim that this effect is due to the negative consequences of the share issue on the company’s accounting ratios (see Section 38.4). We do not think so. Others explain it by invoking a market mechanism: a product sells for a bit less when there is a larger quantity of it; “you catch more flies with honey than with vinegar”. Lastly, still others explain it as being due to the negative signal that a share issue sends. The reader who wants to raise fresh capital for his company should take this effect into account and be able to respond in advance to the criticisms.

The strong increase in share issues in 2008 and 2009 is mainly explained by the strengthening of financial institutions’ balance sheets, which had suffered from the crisis (UBS, Citi, RBS, etc.), by the financing of external growth (Carlsberg, Inbev, etc.) or refinancing of external growth initially implemented with debt (Lafarge, Pernod-Ricard, etc.), or finally by capital-raising in anticipation of future transactions (CRH).

1. Dilution of control

Returning to the examples given above, we see that there is dilution of control – that is, reduction in the percentage equity interest of certain shareholders – whenever those shareholders do not subscribe to an issue of new shares in proportion to their current shareholding.

The dilution is greatest for any shareholder who does not participate at all in the capital increase. It is nil for any shareholder who subscribes in proportion to his holding. By convention, we will say that:

Recall that if new shares are issued at a price significantly below their value, current shareholders will usually have pre-emptive subscription rights that enable them to buy the new shares at that price. This right of first refusal is itself tradeable and can be acquired by investors who would like to become shareholders on the occasion of the capital increase.

In the absence of subscription rights, the calculation of dilution of control by a share issue is straightforward:

When the issue of shares is made with an issue of pre-emptive subscription rights, this calculation no longer holds. Rights allow the shareholder to partially participate in the issue of shares without spending any money, as he can sell part of his rights and participate with these funds and the remaining rights to the rights issue. This transaction does not imply any cash-in or cash-out. Hence, the dilution that he suffers is overestimated by the previous calculation. It is therefore necessary to compute the dilution due only to the share issue regardless of the method used (rights issue).

The simplest way to calculate real dilution is to reckon on an aggregate basis rather than per share. Real dilution is then calculated as follows:

This dilution reflects the dilution of the power of the shareholder in the company and has nothing to do with the dilution of EPS, which we will analyse in Section 38.4.

2. Anticipation mechanism

Take the example of a highly profitable company, entirely equity-financed, that now has investments of 100. With these investments, the company is on track to be worth 400 in four years, which corresponds to an annual rate of return on equity of 41.4%. Suppose that this company can invest an additional 100 at a rate of return similar to that on its current investments. To finance this additional capital requirement, it must sell new shares. Suppose also that the shareholders’ required rate of return is 10%.

Before the company announces the share issue and before the market anticipates it, the value of its equity capital four years hence is going to be 400, which, discounted at 10%, is 273 today.

If, upon the announcement of the capital increase, management succeeds in convincing the market that the company will indeed be worth 800 in four years, which is 546 today, the value accruing to current shareholders is 546 − 100 = 446. There is thus instantaneous value creation of 173 (446 – 273) for the current shareholders.

The anticipation mechanism operates in such a way that new shareholders will not receive an excess rate of return. They will get only the return they require, which is 10%. If the intended use of funds is clearly indicated when the capital increase is announced, the share price before the capital increase will reflect the investment opportunities, and only the current shareholders will benefit from the value creation arising from them.

Some share prices that show very high P/E ratios are merely reflecting anticipation of exceptional investment opportunities. The 400 of added value in this example is already priced in. The reader will himself be able to observe companies whose share prices are at times so high that they cannot correspond to growth opportunities financed in the traditional way by operating cash flow and borrowing. The shareholders of these companies have placed a bet on the internal and external growth opportunities the company may be able to seize, as it may have done in the past, financed in part by issuing new shares.

1. Share issue and earnings per share

A capital increase will change earnings per share instantaneously. If EPS decreases, there is said to be dilution of earnings; if it increases, there is said to be accretion (or the operation is said to be “earnings-enhancing”, which may sound better). This dilution has nothing in common with the dilution of Section 38.1 but the name, and is calculated differently. The one has to do with a shareholder’s percentage of ownership, the other with earnings per share.

Consider Company B, the shares of which carry a low P/E (5) justified by the company’s high risk and low growth prospects and Company A, where high prospects for EPS growth justify a high P/E (20). For both companies, shareholders require an after-tax rate of return on equity of 10%, and we will assume that both Company B and Company A invest the funds raised by a capital increase at 10%; there is neither creation nor destruction of value on this occasion. For both, the value of equity capital therefore increases by the amount of the capital increase.

Company A and Company B each increase the number of shares by 50%, which, invested at 10%, will increase their net earnings. The impact of the capital increase will be as shown in the table below.

Company B’s EPS decreases by 17%, whereas the transaction does not destroy value. Similarly, Company A’s EPS increases by 33% but the transaction does not create value.

This demonstrates once again that earnings per share are not a reliable indicator of value creation or destruction. These changes are merely mechanical and depend fundamentally on:

• the company’s P/E ratio; and
• the rate of return on the investments made with the proceeds of the share issue.

More generally, the rule the reader will want to retain is that any capital increase will:

• dilute EPS whenever the reciprocal of P/E is greater than the rate of return on the investments financed by the share issue;
• be neutral whenever the reciprocal of P/E is equal to this incremental return; and
• increase or “enhance” EPS whenever the reciprocal of P/E is less than incremental return.

It can easily be demonstrated that the earnings dilution occasioned by a capital increase at the market price is equal to:

For Company A, any investment that generates a return per year greater than 5% (the reciprocal of P/E of 20) will increase earnings per share, whereas for Company B the bar is set higher at 20% (reciprocal of 5). Hence the appeal of issuing new shares when P/Es are high, even though no value is created.

In the short term, it is rare for funds raised by a capital increase to earn the required rate of return immediately, either because they are sitting in the bank waiting for the investments to be made or because some period of time must elapse before the achieved rate of return reaches the required level. Consequently, it is not rare for EPS to decrease following a capital increase – but this does not necessarily mean that value is being destroyed.

Three measures of EPS dilution might be distinguished here: instantaneous dilution, with no reinvestment of the funds raised, which is seldom calculated because it holds no interest; dilution, assuming investment of the funds at the risk-free rate of interest, which is the measure that financial analysts generally calculate; and dilution with reinvestment of the funds, which is obviously the measure of most interest, but is difficult to get hold of because it requires forecasting the rate of return on future investments.

In the long term, EPS dilution should normally be offset by the earnings generated by the investment financed by the capital increase. It is therefore necessary to study the expected rate of return on that investment, for it will determine the future course of the company’s value.

2. Share issue and value of equity capital

To say that the book value of a company’s equity increases after a capital increase is to state the obvious, since the proceeds of the share issue are included in that book value.

It is of more interest to compare the percentage increase in book value with the ratio of the proceeds of the capital increase to the market value of equity and to calculate the growth in value per share.

Let us go back to the example of ArcelorMittal and make several different assumptions about market value (only the last of which is true). In all cases, we set the proceeds of the capital increase at the actual percentage level, which is 33% of the group’s market capitalisation before the transaction.

In the real case, because the market value ($9145m) is below the book value of equity ($25 272m), the increase in capital requires a major effort from shareholders (25%) and leads only to a limited increase in ArcelorMittal’s book equity: +12%.

On the contrary, when the market value of equity is way above its book value (case 3), the same effort by shareholders in dilution terms (25%) leads to a much higher increase of book equity (+39%).

We can illustrate this with the example of Alibaba, that was valued at the time of its IPO at $160bn and that had only $4.9bn book equity. The IPO was implemented partly through an issue of new shares for $8.4bn. The new shareholders, who brought 63% of the book equity of Alibaba post-transaction, only have 5% of capital. The existing shareholders have had their equity per share rise from $2.09 to $5.40 (+158%). The new shareholders, who contributed $68 per Alibaba share, are left with a mere $5.4 book equity per share (hence an immediate dilution of 92%)! This is the entrance fee for getting access to a highly profitable firm (but also very risky!).

At a constant capital structure, the increase in equity allows a parallel increase in debt and thus in the company’s overall financial resources. This phenomenon is all the more important when the company is profitable and its market value is greater than its book value. Here we link up again to the PBR (price-to-book ratio) notion that we examined in Chapter 22.

A capital increase may increase a company’s financial power considerably, with relatively little dilution of control.

• If market value of equity coincides with book value, the dilution of control will be accompanied by a similar increase in the company’s overall financial resources.
• If market value is greater than book value, the dilution of control will be countered by a greater increase in financial resources.
• If market value is less than book value, the dilution of control will be accompanied by a lesser increase in financial resources.

For shareholders of a highly profitable company, i.e. of which the market value of equity is much higher than the book value, the share issue will have a very positive impact in the short term.

In the mid-term all depends on the use of the proceeds of the share issue and obviously on the return of the investment undertaken compared to its cost of capital.

Bibliography