Beginning in the 1980s and continuing to date, governments around the world have privatized companies previously owned by the state. The word “privatization” can be confusing, because in the United States we refer to many companies as “publicly owned” when they are actually owned by private investors. So-called “public” companies like General Electric, Intel, and Boeing are not owned by the government. They are owned by private individuals, mutual funds, pension funds, and other investors. This has been a common practice in the United States for over 100 years. However, in many countries—especially socialist and communist countries—the auto industry, steel industry, aerospace industry, and virtually all other major industries have been owned by the state. The process of privatization involves investment bankers taking companies public, but instead of selling companies formerly owned by individuals, the companies sold had been previously owned by governments.
Although Britain privatized its state-owned steel industry in the 1950s, in many respects, the privatization of British Telecom in 1984 was the first significant effort to turn state-owned businesses into private companies. Subsequently, a wave of privatizations swept Western Europe, Latin America, and the more capitalist countries of Asia. With the collapse of the USSR, many of the former communist countries such as Poland, Hungary, and the Czech Republic began to privatize their industries with public offerings of common stock. In recent years, China and Russia have joined the push toward reducing government ownership of assets. In 2007, three of the world’s four largest public stock offerings involved the privatization of petroleum and coal companies in China and a government-owned bank in Russia.
Around the world, governments continue to own a wealth of assets. Consider the United States, a country with a tradition of private ownership. The federal and state governments still own 88 percent of Alaska’s land, over 320 million acres. Almost all of the roads in the United States are owned by state, local, and federal governments. There may be good reasons for state ownership of these assets, but as the public demands more services from the government, a huge source of potential cash could be tapped by the privatization of some of these assets. In 2006 Indiana effectively privatized the Indiana East-West Toll Road by leasing the road to a Spanish-Australian partnership, which now operates it. The road needed to be upgraded, and the Indiana government balked at spending taxpayer money on a toll road when other needs were deemed to be more pressing. In many other countries, the fraction of wealth owned by the state is much higher than in the United States. It can be expected that governments around the world will continue to privatize government businesses and assets.
The investment banker acts as an intermediary between corporations in need of funds and investors having funds, such as the investing public, pension funds, and mutual funds, to name a few. Of course the investment banker charges a fee to the corporation selling securities, and the fee is based on the size of the offering, the risk associated with the company, and whether the security is equity or debt.
The role of the investment banker is critical to the distribution of securities in the U.S. economy. The investment banker serves as an underwriter or the risk taker by purchasing securities from the issuing corporation and redistributing them to the public; he or she may continue to maintain a market in the distributed securities after they have been sold to the public. The investment banking firm can also help a company sell a new issue on a “best-efforts” basis. As corporations become larger and more global, they need larger investment banks, and this has caused consolidation in the investment banking industry. A few large investment banks that are able to take down large blocks of securities and compete in international markets now dominate the industry.
Investment bankers also serve as important advisors to corporations by providing advice on mergers, acquisitions, foreign capital markets, and leveraged buyouts, and also on resisting hostile takeover attempts. The fees earned for this advice can be substantial.
The advantages of selling securities in the public markets must be weighed against the disadvantages. While going public may give the corporation and major stockholders greater access to funds, as well as additional prestige, these advantages quickly disappear in a down market. Furthermore the corporation must open its books to the public and orient itself to the short-term emphasis of investors.
Companies may decide to go from public to private. This trend was evident in the late 1980s, 1990s, and mid-2000s with many large companies going private through leveraged buyouts. However, a number of these companies again publicly distributed their shares a year or two later, generating large profits for their owners in the process.
LIST OF TERMS
investment banker 474
“best-efforts” basis 476
managing investment banker 477
underwriting syndicate 477
underwriting spread 478
dilution of earnings 481
market stabilization 482
shelf registration 484
public placement 485
private placement 489
going private 489
leveraged buyout 489
1. In what way is an investment banker a risk taker? (LO15-2)
2. What is the purpose of market stabilization activities during the distribution process? (LO15-1)
3. Discuss how an underwriting syndicate decreases risk for each underwriter and at the same time facilitates the distribution process. (LO15-2)
4. Discuss the reason for the differences between underwriting spreads for stocks and bonds. (LO15-2)
5. What is shelf registration? How does it differ from the traditional requirements for security offerings? (LO15-1)
6. Discuss the benefits accruing to a company that is traded in the public securities markets. (LO15-4)
7. What are the disadvantages to being public? (LO15-4)
8. If a company were looking for capital by way of a private placement, where would it look for funds? (LO15-1)
9. How does a leveraged buyout work? What does the debt structure of the firm normally look like after a leveraged buyout? What might be done to reduce the debt? (LO15-5)
10. How might a leveraged buyout eventually lead to high returns for a company? (LO15-5)
11. What is privatization? (LO15-5)
PRACTICE PROBLEMS AND SOLUTIONS
Dilution effect of new issue
1. Dawson Motor Company has 6 million shares outstanding with total earnings of $12 million. The company is considering issuing 1.5 million new shares.
a. What will be the immediate dilution in earnings per share?
b. If the new shares can be sold at $25 per share and the proceeds will earn 12 percent, will there still be dilution? Based on the new EPS, should the new shares be issued?
2. Gallagher Corp. will issue 300,000 shares at a retail (public) price of $40. The company will receive $37.90 per share and incur $160,000 in out-of-pocket expenses.
a. What is the percentage spread?
b. What percentage of the total value of the issue (based on the retail price) are the out-of-pocket costs?
1. a. Earnings per share before the stock issue:
Earnings per share after the stock issue:
b. New income = 12% × (1.5 million shares × $25) = 12% × 37,500,000
Total income = $12,000,000 + $4,500,000 = $16,500,000
Earnings per share based on the additional income included in total income:
There is no longer dilution. Earnings per share will grow from the initial amount of $2.00 to $2.20. The new shares should be issued.
Selected problems are available with Connect. Please see the preface for more information.