The Costs of Selling Stock to the Public

The costs of selling stock are classified in the following table and fall into six categories: (1) the gross spread, (2) other direct expenses, (3) indirect expenses, (4) abnormal returns (discussed previously), (5) underpricing, and (6) the Green Shoe option.

The Costs of Issuing Securities

1. Gross spread The gross spread consists of direct fees paid by the issuer to the underwriting syndicate—the difference between the price the issuer receives and the offer price.

2. Other direct expenses These are direct costs, incurred by the issuer, that are not part of the compensation to underwriters. These costs include filing fees, legal fees, and taxes—all reported on the prospectus.

3. Indirect expenses These costs are not reported on the prospectus and include the costs of management time spent working on the new issue.

4. Abnormal returns In a seasoned issue of stock, the price of the existing stock drops on average by 3 percent upon the announcement of the issue. This drop is called the abnormal return.

Ross et al.: Fundamentals VI. Cost of Capital and 16. Raising Capital of Corporate Finance, Sixth Long-Term Financial Edition, Alternate Edition Policy

CHAPTER 16 Raising Capital 543

For initial public offerings, losses arise from selling the stock below the true value.

The Green Shoe option gives the underwriters the right to buy additional shares at the offer price to cover overallotments.

Table 16.4 reports direct costs as a percentage of the gross amount raised for IPOs, SEOs, straight (ordinary) bonds, and convertible bonds sold by U.S. companies over the five-year period from 1990 through 1994. These are direct costs only. Not included are indirect expenses, the cost of the Green Shoe provision, underpricing (for IPOs), and abnormal returns (for SEOs).

As Table 16.4 shows, the direct costs alone can be very large, particularly for smaller issues (less than $10 million). On a smaller IPO, for example, the total direct costs amount to 16.96 percent of the amount raised. This means that if a company sells $10 million in stock, it will only net about $8.3 million; the other $1.7 million goes to cover the underwriter spread and other direct expenses. Typical underwriter spreads on an IPO range from about 5 percent up to 10 percent or so, but, for about half of the IPOs in Table 16.4, the spread is exactly 7 percent, so this is, by far, the most common spread.

Overall, four clear patterns emerge from Table 16.4. First of all, with the possible exception of straight debt offerings (about which we will have more to say later), there are substantial economies of scale. The underwriter spreads are smaller on larger issues, and the other direct costs fall sharply as a percentage of the amount raised, a reflection of the mostly fixed nature of such costs. Second, the costs associated with selling debt are substantially less than the costs of selling equity. Third, IPOs have higher expenses than SEOs, but the difference is not as great as might originally be guessed. Finally, straight bonds are cheaper to float than convertible bonds.

As we have discussed, the underpricing of IPOs is an additional cost to the issuer. To give a better idea of the total cost of going public, Table 16.5 combines the information in Table 16.4 for IPOs with data on the underpricing experienced by these firms. Comparing the total direct costs (in the fifth column) to the underpricing (in the sixth column), we see that they are roughly the same size, so the direct costs are only about half of the total. Overall, across all size groups, the total direct costs amount to 11 percent of the amount raised, and the underpricing amounts to 12 percent.

Finally, with regard to debt offerings, there is a general pattern in issue costs that is somewhat obscured in Table 16.4. Recall from Chapter 7 that bonds carry different credit ratings. Higher-rated bonds are said to be investment grade, whereas lower-rated bonds are noninvestment grade. Table 16.6 contains a breakdown of direct costs for bond issues after the investment and noninvestment grades have been separated.

Table 16.6 clarifies three things regarding debt issues. First, there are substantial economies of scale here as well. Second, investment-grade issues have much lower direct costs, particularly for straight bonds. Finally, there are relatively few noninvestment-grade issues in the smaller size categories, reflecting the fact that such issues are more commonly handled as private placements, which we discuss in a later section.

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