V Pattabhi Ram and A V Vedpuriswar
It was another tough day for Wafers. All this late sitting, which was now becoming a part of her life, was beginning to take its toll. It wasn’t easy auditing till 3 am and then turning up for classes at 6 am. The week’s class on public issue had stumped her. You can’t sleep three hours and still be awake in the class to understand public issue pricing. This business of old and new shareholders foxed her. It was taking her too much time to understand.
Sipping into his third peg of coffee, China said, “you could either be an existing shareholder or you could be a new one investing in the public issue.” Wafers realized that this was what the professor had meant when in Rule 1 he talked about “old” shareholders and “new” shareholders. It suddenly dawned on her that anyone investing in the public issue, including an existing shareholder would be a “new shareholder” for this purpose. “Yup, he would be “new” to the extent of the fresh investments that he makes,” said China, reading Wafers’ mind and, in the process, shocking her again.
Wafers recalled what she had learnt in capital budgeting. “Money must be used in projects that have a positive NPV”. To her it meant that one must compute the NPV of any project in which the public issue money is used. Her professor had called it Step 1. China volunteered a point. “The NPV should be split between the “old” and “new” shareholders. How much should be each one’s share is what the “issue price” is all about. As a “new” shareholder, given the issue price, you can figure out the share of gain”. Wow! Wasn’t this what the professor had called Case 1?
Sitting here at the Chennai Coffee Pub (which was rapidly becoming her second alma mater) Wafers had learnt that if a project has a positive NPV the market capitalization of the company goes up by the amount of NPV. Wisdom, Buddha style, dawned on her. Once the public issue was over, the market price of the share would undergo a change since the numerator would go up by the amount of NPV and the denominator by the number of additional shares issued. Rinku, the journalist, decided to showcase his knowledge. “This is what is called the theoretical post public issue price.” Step 2 told Wafers to no one in particular.
China supplied some numbers to clear the air. If a company has issued 10 lakhs shares and the market price of each share is Rs 60 the current market capitalization would be Rs 600 lakhs. Now if the company is raising Rs 500 lakhs through the public issue and issuing the shares at Rs 50 apiece, it would mean floating 10 lakhs shares. And finally if the NPV of the project in which this money is put is Rs 200 lakhs, the total capitalization would be Rs 600 + 500 +200 = Rs 1300 lakhs. As the number of shares outstanding is 10 +10 =20 lakhs, the theoretical post public issue price will be Rs 1300/20 viz. Rs 65 per share.
Wafers saw light in the darkness. So, the share will quote at Rs 65 in the market. This would mean that the new shareholders will gain Rs 5 per share (increased from Rs 60 to Rs 65). Wasn’t this what Step 3 was all about? That, “the difference between the theoretical market price and current market price represents the gain to the old shareholders”.
The price of Rs 65 would also mean that the “new” shareholders would gain Rs 15 per share (price Rs 65; paid Rs 50). Wasn’t this what Step 4 was about? That “the difference between the theoretical market price and issue price represents the gain to the new shareholders”.
Rinku summed it all up. “Since there are 10 lakhs old shares and there is a gain of Rs 5 per share, the old shareholders gain Rs 50 lakhs. And since there are 10 lakhs new shares and there is a gain of Rs 15 per share, the new shareholders gain Rs 150 lakhs. The gain aggregating to Rs 200 lakhs, is the value of the NPV.” Phew. 75% of the total gain (150/200) had gone to the new shareholders. Wafers had understood it all. Step 1, compute NPV. Step 2, compute theoretical post issue price. Step 3 and Step 4, compute gain to “old” shareholders and “new” shareholders. Wow, it had all fallen in place.
Recognizing that Wafers was quick on the uptake China decided to take the discussion to the next level. How is the price to be fixed? “In fixing the issue price, the ‘old’ shareholders will have to decide how much share of the NPV they would like to take and how much would they like to hand over to the ‘new’ shareholders.” The process would then simply have to be inverted. Wafers asked herself, “Wasn’t this what the professor had called Case 2?”
Rinku suggested that they revert to China’s numerical example to get a hang of the process. Wafers agreed. Nothing appealed to her more than numbers. Suppose the old shareholders wanted a 50% share of the NPV. This would mean that they would take Rs 100 lakhs (50% of 200 lakhs). “Hah, that was the professor’s Step 1. Compute the value of gain for old shareholders.”
China narrated, “Since there are 10 lakhs old shares, the value of NPV per share would be Rs 10. Hence the theoretical post public issue price should be current market price per gain per share viz Rs 60 plus 10 = Rs 70”. Wafers recalled Step 2. “Theoretical post public issue price equals current market price plus the old shareholder’s share of gain.”
It then struck Wafers that it was now possible to find the number of shares to be issued. Mark it, total market capitalization post public issue was known viz Rs 1300 lakhs. So was the theoretical post public issue price viz Rs 70. The number of shares would then be one divided by the other. In this case 18,57,143. Since the old shareholders held 10 lakhs shares, the number of shares to be issued was 857,143. Since Rs 500 lakhs was being raised, the price per share would be Rs 500 lakhs/857143 namely Rs 58.33 per share.
The night was closing out and it was the wee hours of the morning. Wafers told herself that it was a night well spent. She now knew a few things about public issues. “Would it not be a good idea to run classes in the night”, she asked aloud!