General motors 1991 Equity financing

Name: Group 9, General Motors Case ! General Motors (GM) is an American multinational car and truck manufacturer considered to be one of the ‘Big 3’s’ in the automobile industry. GM faced a financial crisis in 1990 due to overcapacities, rising oil prices and increasing competition. During the period of 1990-1992 GM suffered losses of over $4. 5 Billion. Initial measures such as a cut in dividends, selling of assets and the closing of plants GM could reduce the re-financing amount to about $500-$750 Million. GM was now looking towards a viable method to raise the remaining amount. Solutions GM had a choice between different long-­?

term financing measures listed below. Debt: Debt is usually less expensive than equity funding, because the debt issuing bank has the right to seize the assets of the company in a case of bankruptcy. However, for GM this was not a viable option as rating agencies would downgrade their credit rating for the following reasons. • A new debt issue would not be received well by the market because it would increase the debt/equity ratio, which was already high: 1990 1989 1988 Total liabilities 71,209M 59,823M 55,261M Equity 31,331M 36,633M 35,261M 2,3 1,6 1,5 Debt/equity ratio

• Due to a previous downgrade the interest on the debt would be higher, making it expensive. • Adding leverage to the balance sheet in a time where the company was losing money would decrease confidence in the company and the attractiveness of the share. ! Convertible debt GM could have issued a bond with a coupon two percent lower than a straight debt issue. The lower coupon was made possible due to the conversion option, giving investors the opportunity to also benefit from a capital gain. However rating agencies would have regarded it as full debt, increasing the D/E ratio, which would lead to the same problems as with full debt. Equity:

Equity financing is usually more expensive than debt financing for two reasons: • Generally the market asks a higher return for the risk of investing into a company rather than in a risk free investment such as government bonds. • Investors do not have a guarantee to receive their investment back i. e. they will be the last people to be paid if money will be left in the bankruptcy process. Common shares General Motors had three types of shares in 1991: Price Dividend Yield Outstanding shares $10 $41 $1. 60 3. 9% 615millions E $46,5 $0. 64 1. 4% 98millions H 17 0,72 4,2% 70millions The first option was to issue $10 common shares because it was the most convenient and the

simplest way to raise $500-­? $750 millions needed: ! • The shares were well known in the market • The yield was only 3. 9%, allowing GM to raise the money with a reasonable cost but made it unattractive for investors. • Since only 12 million shares would be needed to raise the capital, it would be unattractive for private investors who wanted to have power position within the company, as 12 million shares only correspond to 2% of 615 million outstanding shares. Moreover the share repurchasing policy of GM in the last few years would have been contradictory to issuing shares in the current situation.

This would have given the market a negative signal because it would have meant that GM: • Was desperate and had no other way to finance. • The price of its stock was overvalued, making the share less attractive. The other two shares were not a viable option because they were not well known in the market. Raising money through this option would have taken too long to be an effective financing method. Preferred Stock The advantages of this option was that investors had a higher yield and enjoyed tax advantages since only 30% of the yield were subjected to tax.

The yield of 8. 75% was higher than a 30 years government bond of 8,47%. It would have been valid only if GM had not already issued two other kinds of preferred stocks in the past with yield of 8,13% and 8. 26%. GM would have to raise the yield to 8. 75% to make the option interesting for the market, making the issue too expensive for the company because it would have to pay that interest forever. ! Convertible Preferred The company could not afford this option because the market would have seen it as a call option.

Generally speaking a company sells a call if it thinks that the price of the share would Profit making not the increase, market suspicious about the future Strike price • Loss of the company without Underlying

Price • Max risk allowing the company to raise 500-­? 750$ millions. Preferred Equity Redemption Cumulative Stock (PERCS) They are a form of convertible preferred stock that pays a higher dividend than common shares, but they only have a potential for limited capital gain. GM had the opportunity to raise between $500-­? 750 million issuing PERCS at $41 and with a strike price of $53. 79 (30%) with a time frame of three years and a dividend of $3. 31 (8%). A

fter three years there are two different scenarios: • The underlying price is below the cap: in this case at maturity each PERCS will be swapped into common shares with a ratio

of 1:1. ! • The underlying price is above the cap: in this case the conversion will be subject to the following formula: !”#  ! “#$% !”##”$  !?! “#  ! “#$% GM furthermore had the option to call the conversion early if the appreciation of the stock would rise too much. The investor is covered from this scenario by the fact that the cap price at the day of the issuing is put higher than at end of three years by factoring in the gain through dividends1. The cap price at the start of the year is being depreciated every day, lowering it to the final strike price at the end of the period.

This scenario would be accepted by an investor due to the higher and secured dividend of PERCS share. This option has the following advantages: • It has a lower yield of 8% in comparison to 8. 75% of the preferred stock option. • After three years the PERCS shares will be swapped into common shares, meaning lower dividends.

Conclusion We recommend PERCS as the proposed $3. 31 annual dividend on PERCS is not too high. It equals an 8% yield, which was higher than the three-­? year government bond yield (7. 35%) and the actual yield of the common stock (3. 9%). Risk-­? neutral investors and those not looking for voting rights would be interested in PERCS because of the balance

of payout and risk because PERCS have a fixed income and the price is more stable. Issuing a straight equity would have meant that the price of the shares were overvalued and the company was desperate for money, taking into account the company? s repurchasing policies of the previous year. Issuing convertible preferred would have meant that the company was 1 E. g. : Strike price at the end of three year period: $53. 79; Strike price at the issuing day is 53. 79*(3. 31*3)= 63. 72; Depreciated by 0,9 cents a day ! betting against an increase in its share price. Consequently, the shares would have not been attractive to the market.