Why should a company try to price it’s public issue of shares as high as possible?

In fact, any company trying to price its public issue higher than its market price is being silly.  For that matter any company trying to price any of its products higher than the market price is being silly.  It should be obvious, that in such a case the investor (or the customer) will eject the offered share (or the product) outright, unless the higher price is qualitatively justified or he is ill informed.  True, there have been many instances following the free pricing policy where companies have priced their issues higher than the market price.  But these are errors of judgment, which a company soon comes to learn and learns to correct.  However, one important reason for the propensity of companies to price their shares unduly high may be attributed to their mistaken notion that the higher the price at which a company issues its shares, the lower its cost of capital.

Men who should know better, for example, our chief executives of companies and development banks, have frequently gone on record saying that under free pricing it is cheaper to raise equity than debt.  Such statements are made on the argument that while a debenture issue involves a cost of around 18% to 19%, the cost of raising equity can be as low as 3% (for example, when a company paying 30% dividend on a share with a par value of Rs.10 is issued at Rs.100, that is at or near the market price of the share).  According to this notion, the abolition Controller of Capital Issues (CCI – an official of the Ministry of Finance, a position now abolished) has reduced the cost of raising capital significantly.  Hence the abolition of CCI is considered welcome.  This is one reason why some companies have issued shares at prices higher than their prevailing market prices.  Let us see if this view is tenable.

Let us consider a situation where a share of par value of Rs.10 has been issued at Rs.100 (the market value of the share being close to Rs.100).  if the company has been paying a dividend of Rs.3 per share, implying a 30% dividend, the dividend yield translates to a mere 3% (being dividend / market price).  Is the cost of equity 30%?  The answer is NO.  The concept of cost of equity has to be understood properly.

If the cost of equity is interpreted as 3%, this implies that the equity holders investing in the company’s shares are prepared to accept a return of 3% on their investment.  This is clearly absurd.  If the debenture holders receive a return of 17% or 18% on their investment, clearly the shareholders must be expecting a higher return, to compensate for their higher level of risk on their investment.  Let us say that the shareholders expect a return of 24% on their investment.  However, they receive a dividend yield of mere 3%.  So how do they receive their remaining 21% return?  Obviously this must come in the form of capital appreciation on their share.  In other words, if a Rs.100 share were worth Rs.121 at the end of a year after paying Rs.3 as dividend, then together with the dividend, they earn a return of 24%.  But then under what circumstances would a share worth Rs.100 in the market appreciate to Rs.121 a year later, after paying a dividend of appreciate to Rs.121 a year later, after paying a dividend of Rs.3.  Alternatively put, when will the value of a share appreciate from Rs.100 to Rs.124 (including the dividend worth Rs.3).  This would be the case only if the company has been able to earn a return of 24% on the original investment of Rs.100.  Thus, in an on-going system, if the shareholder continues to receive a 3% yield as dividend, he must continue to receive a capital appreciation of 21% annually to earn an overall expected return of 24%.  This would be feasible only if the company continued to earn a minimum return of 24&% on shareholder’s funds (though paying out only 3% as dividend and pumping back the rest into the business).  Thus the cost of equity in this case is said to be 24%, which is the expected return of the shareholder.  And the expected return of the shareholders is quite independent of the price at which a company may make its public issue.

Let us consider another company identical to the one above, but paying 50% dividend, i.e., Rs.5 per share.  In this case, since the shareholder still expects a return of 24%, but only 5% (Rs, 5 dividend on a share with a market value of Rs.100) is being received as dividend, the remaining 19% return will have to come in the form of capital appreciation of the share, so that once again, the overall return the company will have to earn on its investments will be 24%, which constitutes the cost of capital.  In case you are wondering how two companies paying 30% and 50% dividends will have the same cost of capital, just remember that the two firms are assumed to be otherwise identical.  Thus, the second firm in order to remain identical to the first will have to resort to external funds to compensate for the higher dividend payout for its investment schemes, so that their earning streams are identical.

What happens, if, a company raises capital from the public at Rs.100 per share and deploys the capital in operations earning a return of, say, only 15%, while the shareholders expect a return of 24%.  The situation implies that the company earns a stream of only Rs.15 per share.  This stream of earnings per share capitalized at 24% implies a market value per share of only Ra.62.50 (being 15/0.24).  in other words, an investor who wants 24% return form his investment in this company’s share will be prepared to pay only Rs.62.50 for the share, since the company earns a stream of only Rs.15 per share.  Thus, if shareholder who desires a return of 24% on his investment subscribes to a share at Rs.100 in a company, which earns a return of mere 15% on the investment, he will find the value of the share dropping to about Rs.62.50, so that he would have suffered a major loss on his investment.

Clearly then, in the above situation, no matter at what price the public issue is made, the cost of capital, that is the return the company is obliged to earn on its investments remains 24%.  It is just that when an issue is made below the market price of a share, there is transfer of wealth from the existing shareholders to new shareholders.  But there is no change in the cost of capital.

It is in the interest of the companies not to price their issues too high and thereby risk erosion of investors confidence should the price of the share fall steeply later.  After all a company is a going concern which needs to come back to the capital market again and again.  Irrespective of how a company prices its issue, an investor must develop the ability to assess the reasonableness of the price for himself.

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