Text book Problems wk 4

10 Stock Offerings and Investor Monitoring

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the private equity market,

· ▪ describe investor participation in the stock markets,

· ▪ describe the process of initial public offerings,

· ▪ describe the process of secondary offerings,

· ▪ explain how the stock market is used to monitor and control firms, and

· ▪ describe the globalization of stock markets.

Stock markets facilitate equity investment into firms and the transfer of equity investments between investors.

10-1 PRIVATE EQUITY

When a firm is created, its founders typically invest their own money in the business. The founders may also invite some family or friends to invest equity in the business. This is referred to as private equity because the business is privately held and the owners cannot sell their shares to the public. Young businesses use debt financing from financial institutions and are better able to obtain loans if they have substantial equity invested. Over time, businesses commonly retain a large portion of their earnings and reinvest it to support expansion. This serves as another means of building equity in the firm.

   The founders of many firms dream of going public someday so that they can obtain a large amount of financing to support the firm's growth. They may also hope to “cash out” by selling their original equity investment to others. Normally, however, a firm's owners do not consider going public until they want to sell at least $50 million in stock. A public offering of stock may be feasible only if the firm will have a large enough shareholder base to support an active secondary market. With an inactive secondary market, the shares would be illiquid. Investors who own shares and want to sell them would be forced to sell at a discount from the fundamental value, almost as if the firm were not publicly traded. This defeats the purpose of being public. In addition, there are many fixed costs associated with going public, and these costs would be prohibitive for a firm that seeks to raise only a small amount of funds.

10-1a Financing by Venture Capital Funds

Even if a firm wants to sell at least $50 million of stock to the public, it may not have a long enough history of stable business performance that it can raise money from a large number of investors. Private firms that need a large equity investment but are not yet in a position to go public may attempt to obtain funding from a venture capital (VC) fund. Such funds receive money from wealthy investors and from pension funds that are willing to maintain the investment for a long-term period, such as 5 or 10 years. These investors are not allowed to withdraw their money before a specified deadline. Venture capital funds have participated in a number of businesses that ultimately went public and became very successful, including Apple, Microsoft, and Oracle Corporation.

Venture Capital Market  The venture capital market brings together the private businesses that need equity funding and the VC funds that can provide funding. One way of doing this is through venture capital conferences, where each business briefly makes its pitch as to why it will be successful (and generate high returns to the VC fund) if it receives equity funding. Alternatively, businesses may submit proposals directly to VC funds. If a VC fund identifies a proposal that it believes has much potential, it may arrange a meeting with the business's owners and request more detailed information. Most proposals are rejected, however, since VC funds recognize that the majority of new businesses ultimately fail.

Terms of a Venture Capital Deal  When a VC fund decides to invest in a business, it will negotiate the terms of its investment, including the amount of funds it is willing to invest. It will also set out clear requirements that the firm must meet, such as providing detailed periodic progress reports. When a VC fund invests in a firm, the fund's managers have an incentive to ensure that the business performs well. Thus, the VC fund managers may serve as advisers to the business. They may also insist on having a seat on the board of directors so that they can influence the firm's future progress. The VC fund often provides its funding in stages based on various conditions that the firm must satisfy. In this way, the VC fund's total investment is aligned with the firm's ability to meet specified financial goals.

Exit Strategy of VC Funds  A VC fund typically plans to exit from its original investment within about four to seven years. One common exit strategy is to sell its equity stake to the public after the business engages in a public stock offering. Many VC funds sell their shares of the businesses in which they invest during the first 6 to 24 months after the business goes public. Alternatively, the VC fund may cash out if the company is acquired by another firm, since the acquirer will purchase the shares owned by the VC fund. Thus, the VC fund commonly serves as a bridge for financing the business until it either goes public or is acquired.

Performance of VC Funds  The performance of VC funds tends to vary over time. In periods when stock prices are low, VC funds can invest their money more wisely in companies, and therefore have a better chance of earning decent returns. However, when stock prices are high, VC funds may pay too much when investing in companies.

   The performance of VC funds is also influenced by the amount of investment received from investors. In some periods, they might receive more funds from investors than they can feasibly invest, especially if prevailing valuations of companies are high. Under these conditions, they are more likely to compete with each other to buy companies, and the bidding will cause them to pay a higher premium for the company. Conversely, when VC funds receive more limited funds, they can focus only on the most desirable investments, and are less likely to pay too much when investing in companies.

10-1b Financing by Private Equity Funds

Private equity funds pool equity funding provided by institutional investors (such as pension funds and insurance companies) and invest in businesses. They also rely heavily on borrowing to finance their investments. Unlike VC funds, private equity funds commonly take over businesses and manage them. Their managers typically take a percentage of the profits they earn from their investments in return for managing the fund. They pursue companies that are overvalued and mismanaged (in their opinion), because they can more easily achieve a high return on their investment when buying weak firms that they can improve. They also charge an annual fee for managing the fund. Because they commonly purchase a majority stake or all of a business, they have control to restructure the business as they wish. They sell their stake in the business after several years.

   If they were able to improve the business substantially while they managed it, they should be able to sell their stake to another firm for a much higher price than what they paid for it. Alternatively, they may be able to take the business public through an initial public offering (IPO) and cash out at that time.

   Some critics (including some unions) suggest that private equity firms destroy firms by laying off employees. Yet private equity firms might counter that the firms they target are overstaffed and inefficient, and that they need to restructure these firms to help them survive.

Performance of Private Equity Funds  The performance of private equity firms tends to vary over time. Like VC funds, private equity funds invest their funds more wisely in companies when stock prices are generally low. However, if they invest in companies while stock prices are very high, private equity funds may be subject to large losses (if stock market conditions deteriorate) even if they can improve operations.

   Private equity funds may be especially prone to making bad investments when they receive large amounts of funds from investors, and pursue more investments than are feasible. Conversely, when they receive more limited funds, they can more carefully screen their potential targets, and are more likely to make feasible investments.

10-2 PUBLIC EQUITY

When a firm goes public, it issues stock in the primary market in exchange for cash. This changes the firm's ownership structure by increasing the number of owners. It changes the firm's capital structure by increasing the equity investment in the firm, which allows the firm to pay off some of its debt. It also enables corporations to finance their growth.

A stock is a certificate representing partial ownership in the firm. Like debt securities, common stock is issued by firms in the primary market to obtain long-term funds. Yet the purchaser of stock becomes a part owner of the firm, rather than a creditor. This ownership feature attracts many investors who want to have an equity interest in a firm but do not necessarily want to manage their own firm. Owners of stock can benefit from the growth in the value of the firm and therefore have more to gain than creditors. However, they are also susceptible to large losses, as the values of even the most respected corporations have declined substantially in some periods.

   The means by which stock markets facilitate the flow of funds are illustrated in  Exhibit 10.1 . The stock markets are like other financial markets in that they link the surplus units (that have excess funds) with deficit units (that need funds). Stock issued by corporations may be purchased directly by households. Alternatively, households may invest in shares of stock mutual funds; the managers of these funds use the proceeds to invest in stocks. Other institutional investors such as pension funds and insurance companies also purchase stocks. The massive growth in the stock market has enabled many corporations to expand to a much greater degree and has allowed investors to share in the profitability of corporations.

   In addition to the primary market, which facilitates new financing for corporations, there is also a secondary market that allows investors to sell the stock they previously purchased to other investors who want to buy it. Thus the secondary market creates liquidity for investors who invest in stocks. In addition to realizing potential gains when they sell their stock, investors may also receive dividends on a quarterly basis from the corporations in which they invest. Some corporations distribute a portion of their earnings to shareholders in the form of dividends, but others reinvest all of their earnings so that they can achieve greater growth.

Exhibit 10.1 How Stock Markets Facilitate the Flow of Funds

10-2a Ownership and Voting Rights

The owners of small companies also tend to be the managers. In publicly traded firms, however, most of the shareholders are not managers. Thus they must rely on the firm's managers to serve as agents and to make decisions in the shareholders' best interests.

   The ownership of  common stock  entitles shareholders to a number of rights not available to other individuals. Normally only the owners of common stock are permitted to vote on certain key matters concerning the firm, such as the election of the board of directors, authorization to issue new shares of common stock, approval of amendments to the corporate charter, and adoption of bylaws. Many investors assign their vote to management through the use of a proxy, and many other shareholders do not bother to vote. As a result, management normally receives the majority of the votes and can elect its own candidates as directors.

10-2b Preferred Stock

Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights. Preferred shareholders technically share the ownership of the firm with common shareholders and are therefore compensated only when earnings have been generated. Thus, if the firm does not have sufficient earnings from which to pay the preferred stock dividends, it may omit the dividend without fear of being forced into bankruptcy. A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred stock dividends (both current and those previously omitted) have been paid. The owners of preferred stock normally do not participate in the profits of the firm beyond the stated fixed annual dividend. All profits above those needed to pay dividends on preferred stock belong to the owners of common stock.

   Because the dividends on preferred stock can be omitted, a firm assumes less risk when issuing it than when issuing bonds. However, a firm that omits preferred stock dividends may be unable to raise new capital until the omitted dividends have been paid, because investors will be reluctant to make new investments in a firm that is unable to compensate its existing sources of capital.

   From a cost perspective, preferred stock is a less desirable source of capital for a firm than bonds. Because a firm is not legally required to pay preferred stock dividends, it must entice investors to assume the risk involved by offering higher dividends. In addition, preferred stock dividends are technically compensation to owners of the firm. Therefore, the dividends paid are not a tax-deductible expense to the firm, whereas interest paid on bonds is tax deductible. Because preferred stock normally has no maturity, it represents a permanent source of financing.

10-2c Participation in Stock Markets

Investors can be classified as individual or institutional. The investment by individuals in a large corporation commonly exceeds 50 percent of the total equity. Each individual's investment is typically small, however, which means that ownership is scattered among numerous individual shareholders.

   The various types of institutional investors that participate in the stock markets are summarized in  Exhibit 10.2 . Because some financial institutions hold large amounts of stock, their collective sales or purchases of stocks can significantly affect stock market prices.

   In addition to participating in stock markets by investing funds, financial institutions sometimes issue their own stock as a means of raising funds. Many stock market transactions involve two financial institutions. For example, an insurance company may purchase the newly issued stock of a commercial bank. If the insurance company someday sells this stock in the secondary market, the purchaser may be a mutual fund or pension fund.

Exhibit 10.2 Institutional Use of Stock Markets

TYPE OF FINANCIAL INSTITUTION	PARTICIPATION IN STOCK MARKETS
Commercial banks	· • Issue stock to boost their capital base. · • Manage trust funds that usually contain stocks.
Stock-owned savings institutions	· • Issue stock to boost their capital base.
Savings banks	· • Invest in stocks for their investment portfolios.
Finance companies	· • Issue stock to boost their capital base.
Stock mutual funds	· • Use the proceeds from selling shares to individual investors to invest in stocks.
Securities firms	· • Issue stock to boost their capital base. · • Place new issues of stock. · • Offer advice to corporations that consider acquiring the stock of other companies. · • Execute buy and sell stock transactions of investors.
Insurance companies	· • Issue stock to boost their capital base. · • Invest a large proportion of their premiums in the stock market.
Pension funds	· • Invest a large proportion of pension fund contributions in the stock market.

10-2d How Investor Decisions Affect Stock Prices

Investors make decisions to buy a stock when its market price is below their valuation, which means they believe the stock is undervalued. They may sell their holdings of a stock when the market price is above their valuation, which means they believe the stock is overvalued. Thus, stock valuation drives their investment decisions. Investors commonly disagree on how to value a stock (as explained in  Chapter 11 ). Thus some investors may believe a stock is undervalued while others believe it is overvalued. This difference in opinions allows for market trading, because it means that there will be buyers and sellers of the same stock at a given moment in time.

   When there is a shift in the demand for shares or the supply of shares for sale, the equilibrium price changes. When investors revise their expectations of a firm's performance upward, they revise their valuations upward. If the consensus among investors is a favorable revision of expected performance, there are more buy orders for the stock. Then the demand for shares exceeds the supply of shares for sale, placing upward pressure on the market price. Conversely, if the consensus among investors is lowered expectations of the firm's future performance, there are more sell orders for the stock. In this case, the supply of shares for sale exceeds the demand for shares, placing downward pressure on the market price. Overall, the prevailing market price is determined by the participation of investors in aggregate. Stock transactions between investors in the secondary market do not affect the capital structure of the issuer; they merely transfer shares from one investor to another.

10-2e Investor Reliance on Information

Investors respond to the release of new information, which affects their opinions about a firm's future performance. In general, favorable news about a firm's performance will make investors believe that the firm's stock is undervalued at its prevailing price. The demand for shares of that stock will increase, placing upward pressure on the stock's price. Unfavorable news about a firm's performance will make investors believe that the firm's stock is overvalued at its prevailing price. Some investors will sell their holdings of that stock, placing downward pressure on the stock's price. Thus, information is incorporated into stock prices through its impact on investors' demand for shares and the supply of shares for sale by investors.

   Each stock has its own demand and supply conditions and therefore has a unique market price. Nevertheless, new information about macroeconomic conditions commonly causes expectations for many firms to be revised in the same direction and therefore causes stock prices to move in the same direction.

   Investors continually respond to new information in their attempt to purchase stocks that are undervalued or sell their stock holdings that are overvalued. When investors properly determine which stocks are undervalued, they can achieve abnormally high returns from investing in those stocks. Thus, the valuation process used by an investor can have a strong influence on the investor's investment performance.

10-3 INITIAL PUBLIC OFFERINGS

A corporation first decides to issue stock to the public in order to raise funds. It engages in an initial public offering (IPO), which is a first-time offering of shares by a specific firm to the public. An IPO is commonly used not only to obtain new funding but also to offer some founders and VC funds a way to cash out their investment. A typical IPO is for at least $50 million, since this would be the minimum size needed to ensure adequate liquidity in the secondary market if investors wish to sell their shares.

10-3a Process of Going Public

Because firms that engage in an IPO are not well known to investors, they must provide detailed information about their operations and their financial condition. A firm planning on going public normally hires a securities firm that serves as the lead underwriter for the IPO. The lead underwriter is involved in the development of the prospectus and the pricing and placement of the shares.

Developing a Prospectus  A few months before the IPO, the issuing firm (with the help of the lead underwriter) develops a prospectus and files it with the Securities and Exchange Commission (SEC). The prospectus contains detailed information about the firm and includes financial statements and a discussion of the risks involved. It is intended to provide potential investors with the information they need to decide whether to invest in the firm. Within about 30 days, the SEC will assess the prospectus and determine whether it contains all the necessary information. In many cases the SEC, before approving the prospectus, recommends some changes in order to provide more information about the firm's financial condition.

   Once the SEC approves the prospectus, it is sent to institutional investors who may want to invest in the IPO. In addition, the firm's management and the underwriters of the IPO meet with institutional investors. Often these meetings occur in the form of a road show: the firm's managers travel to various cities and put on a presentation for large institutional investors in each city. The institutional investors are informed of the road show in advance so that they can attend if they have any interest in purchasing shares of the IPO. Some institutional investors may even receive separate individual presentations. Institutional investors are targeted because they may be willing to buy large blocks of shares at the time of the IPO. For this reason, they typically have priority over individual investors in purchasing shares during an IPO.

   A law in 2012 loosened the reporting restrictions for smaller firms about to go public. However, most of the firms that could have qualified did not capitalize on the looser requirements, because they wanted to provide investors with as much financial information as possible. They may have attracted more interest from institutional investors by providing more complete information.

Pricing  Before a firm goes public, it attempts to gauge the price that will be paid for its shares. It may rely on the lead underwriter to determine the so-called offer price. The valuation of a firm should equal the present value of the firm's future cash flows. Although the future cash flows are uncertain, the lead underwriter may forecast future cash flows based on the firm's recent earnings.

   The offer price also may be influenced by prevailing market and industry conditions. If other publicly traded firms in the same industry are priced high relative to their earnings or sales, then the offer price assigned to shares in the IPO will be relatively high.

   During the road show, the lead underwriter solicits indications of interest in the IPO by institutional investors as to the number of shares that they may demand at various possible offer prices. This process is referred to as bookbuilding.

EXAMPLE

Saint Louis Company has hired Bucknell Investment Company as lead underwriter for its IPO. Bucknell organizes a road show for a large set of institutional investors that commonly invest in IPO shares. During the road show, managers from St. Louis Company explain the firm's business and how it will use the IPO proceeds. Then Bucknell contacts the investors to request indications of interest. A summary of its findings is provided in Exhibit 10.3. Based on the feedback received, Bucknell decides that an initial offer price of $11 would be appropriate. This price is low enough that it will almost surely result in sufficient demand for 4 million shares, which would provide $44 million to St. Louis Company. Bucknell is concerned that if it sets the price higher, it might not be able to place all of the shares in the IPO.

Exhibit 10.3 Summary of Bookbuilding Process Just before the IPO

POSSIBLE OFFER PRICE	TOTAL SHARES DEMANDED	TOTAL PROCEEDS TO ISSUER
$13	3,000,000	$39,000,000
$12	3,500,000	$42,000,000
$11	4,000,000	$44,000,000
$10	4,300,000	$43,000,000

   As a result of the bookbuilding process for setting an offer price, many institutional investors pay a lower price than they would have been willing to pay for the shares. In the preceding example, some institutional investors would have paid $13, but the underwriter used an offer price of $11 for all investors to ensure that at least 4 million shares would be sold. Should the issuing firm be satisfied as long as all the shares are placed? What if St. Louis Company firmly believes that all 4 million shares could have been sold at an offer price of $13 per share? In this case the firm would have received $52 million (4 million shares × $13 per share), but instead received only $44 million. It gave up $8 million because the underwriter sold the shares for a lower price. In finance terminology, this is known as “leaving money on the table.” Some issuing firms may be especially concerned that they left money on the table when the market price rises substantially on the day of the IPO, because the price increase may suggest that the demand for shares exceeded the supply of shares for sale on that day. The underwriter might counter that the lower offer price was appropriate because it ensured that all the shares would be sold at the offering. If the stock price rises over time (which means that the IPO investors benefit from their investment), the issuing firm may more easily engage in another stock offering in the future because it has gained investors' trust.

   Some critics suggest that setting a lower offer price provides institutional investors with special favors and may be a way for the securities firm that is underwriting the IPO to attract other business from institutional investors. To the extent that the shares were essentially discounted from their appropriate price, the proceeds that the issuing firm receives from the IPO are less than it deserves.

   In some other countries, an auction process is used for IPOs and investors pay whatever they bid for the shares. The top bidder's order is accommodated first, followed by the next highest bidder, and so on, until all shares are issued. The issuer can set a minimum price at which the bidding must occur for shares to be issued. This process prevents the underwriter from setting the offer price at a level that is intended to please specific institutional investors.

Allocation of IPO Shares  The lead underwriter may rely on a group (called a syndicate) of other securities firms to participate in the underwriting process and share the fees to be received for the underwriting. Each underwriter in the syndicate contacts institutional investors and informs them of the offering. Most of the shares are sold to institutional investors, as it is more convenient for the underwriting syndicate to sell shares in large chunks. Brokerage firms may receive a very small portion (such as 2 percent) of the IPO shares, which they can sell to their individual investors. They normally give priority to their biggest customers.

Transaction Costs  The transaction cost to the issuing firm is usually 7 percent of the funds raised. For example, an IPO of $50 million would result in a transaction cost of $3.5 million (0.07 × $50 million). In addition, the issuer incurs other costs, such as the cost of assessing whether to go public, compiling data for the prospectus, and ensuring that the prospectus is properly written. It also incurs fees from hiring legal or financial advisers during this process. Thus the total cost of engaging in an IPO may be close to 10 percent of the total offering.

10-3b Underwriter Efforts to Ensure Price Stability

The lead underwriter's performance can be partially measured by the movement in the IPO firm's share price following the IPO. If investors quickly sell the stock that they purchased during the IPO in the secondary market, there will be downward pressure on the stock's price. Underwriters may attempt to stabilize the stock's price by purchasing shares that are for sale in the secondary market shortly after the IPO. If most stocks placed by a particular underwriter perform poorly after the IPO, institutional investors may no longer want to purchase shares sold by that underwriter.

Lockup  The lead underwriter attempts to ensure stability in the stock's price after the offering by requiring a lockup provision, which prevents the original owners of the firm and the VC firms from selling their shares for a specified period (usually six months from the date of the IPO). The purpose of the lockup provision is to prevent downward pressure that could occur if the original owners or VC firms immediately sold their shares in the secondary market.

   In reality, the provision simply defers the possible excess supply of shares sold in the secondary market. When the lockup period expires, the number of shares for sale in the secondary market may increase abruptly, in which case the share price typically declines significantly. In fact, some investors who are allowed to sell their shares before the lockup expiration date now recognize this effect and sell their IPO shares just before that date. Consequently, the stock price begins to decline shortly before the expiration date.

10-3c Timing of IPOs

Initial public offerings tend to occur more frequently during bullish stock markets, when potential investors are more interested in purchasing new stocks. Prices of stocks tend to be higher in these periods, and issuing firms attempt to capitalize on such prices.

EXAMPLE

WEB

www.nasdaq.com/markets/ipos/

Information about IPOs, including a schedule of planned IPOs.

In the 2004-2007 period, stocks of most firms were priced high relative to their respective earnings or revenues. Investor demand for new stocks was strong. Firms were more willing to engage in IPOs because they were confident that they could sell all of their shares at relatively high prices.

   After the credit crisis began in 2008, the stock market weakened and thus reduced the valuation of stocks relative to earnings or revenues. For this reason, some firms that had planned to go public withdrew their plans. They recognized that their shares would have to be sold for a Lower price than they desired. In addition, as economic conditions weakened, some firms cut back on their expansion plans and therefore had Less need for additional funds. These firms recognized that they should defer their offering until economic conditions were more favorable and stock prices were higher.

10-3d Initial Returns of IPOs

The initial (first-day) return of IPOs in the United States has averaged about 20 percent over the last 30 years. Such a return is unusual for a single day and exceeds the typical return earned on stocks over an entire year. The initial return on IPOs was especially high for Internet firms during the 1996–1999 period. During 1998, for example, the mean increase in price on the first trading day following the IPO was 84 percent for Internet stocks. Thus a $1 million investment in each of the Internet IPOs in 1998 would have resulted in a one-day gain of $840,000.

   The successful IPOs of some Internet firms turned small investors into millionaires, and the resulting media attention attracted many other investors who had never invested in the stock market before. Some investors were investing money that they could not afford to lose, not recognizing the risk associated with investing in Internet stocks. Many of the Internet firms wasted the proceeds of their IPOs, and their stock prices fell below their initial IPO prices within a year. Many Internet firms ultimately went bankrupt, and the investors who invested in those IPOs and held on to the shares lost their entire investments.

10-3e Flipping Shares

Some investors who know about the unusually high initial returns on IPOs attempt to purchase the stock at its offer price and sell the stock shortly afterward. This strategy is referred to as flipping. Investors who engage in flipping have no intention of investing in the firm over the long run and are simply interested in capitalizing on the initial return that occurs for many IPOs. If many institutional investors flip their shares, the market price of the stock may decline shortly after the IPO. Thus underwriters are concerned that flipping might place excessive downward pressure on the stock's price. To discourage flipping, some securities firms make more shares of future IPOs available to institutional investors that retain shares for a relatively long period of time. The securities firms may also prevent institutional investors that engage in flipping from participating in any subsequent IPOs that they underwrite.

10-3f Google's IPO

On August 18, 2004, Google engaged in an IPO that attracted massive media attention because of the firm's name recognition. Google generated $1.6 billion from the offering, more than four times the combined value of the IPOs by  Amazon.com , America Online, Microsoft, Netscape, and  Priceline.com . Google's two co-founders, Larry Page and Sergey Brin, sold a portion of their shares within the IPO for about $40 million each but retained shares valued at $3 billion each. The Google IPO offers interesting insight into the process by which firms obtain equity funding from investors.

Estimating the Stock's Value  Investors attempt to determine the value of the stock that is to be issued so that they can decide whether to invest in the IPO. In the case of Google, some investors used Yahoo! as a benchmark because Yahoo! stock had been publicly traded since 1996. To determine the appropriate price of Google's stock, investors multiplied Google's earnings per share by Yahoo!'s price-earnings ratio. This method had some major limitations, however. First, Google and Yahoo! are not exactly the same type of business. Some investors might argue that Microsoft would have been a better benchmark than Yahoo! for Google. If Google has more growth potential than Yahoo!, it might deserve a higher multiple. In addition, Yahoo! and Google use different accounting methods, so estimating a value by comparing the earnings of the two firms was subject to further error. These limitations of valuation are discussed in more detail in Chapter 11, but the main point here is that stock valuations are error prone, especially for IPOs, where the firms have no stock market history.

The Auction Process  Google's IPO was unique in that it used a Dutch auction process instead of relying almost exclusively on institutional investors. Specifically, it allowed all investors to submit a bid for its stock by a specific deadline. It then ranked the bid prices and determined the minimum price at which it would be able to sell all of the shares that it wished to issue. All bids that were equal to or above that minimum price were accepted, and all bids below the minimum price were rejected.

   From Google's perspective, the benefit of the auction process was lower costs (as a percentage of proceeds) than with a traditional IPO. The auction may have saved Google about $20 million in fees. In addition, the auction allowed Google to attract a diversified investor base, including many individual investors. However, such an auction process is unlikely to be as successful for firms that are less well known to individual investors as Google.

    Results of Google's Dutch Auction  Google's auction resulted in a price of $85 per share, meaning that all investors whose bids were accepted paid $85 per share. Google was able to sell all of its 19.6 million shares at this price, which generated proceeds of $1.67 billion. Some investors who obtained shares at the time of the IPO sold (flipped) their shares in the secondary market shortly after the auction was completed. The share price increased by 18 percent to $100.34 by the end of the first day, so investors who obtained shares through the auction and sold them at the end of the first day earned an 18 percent return.

   In retrospect, Google was undervalued at the time of the IPO, since its price increased more than 700 percent by 2013.

10-3g Facebook's IPO

On May 18, 2012, Facebook engaged in an IPO, and raised about $16 billion with its offering. Because of its popularity, Facebook's IPO attracted much attention. There were 33 securities that served as underwriters by selling the shares to investors. These underwriters earned fees of about $176 million for their services. This fee is actually lower than the norm for underwriters engaged in an IPO, but many securities firms were willing to accept a lower fee in order to participate in this major event. The opening stock price of Facebook was $38 on the IPO date. The stock price initially increased but then declined later in the day. Based on the open price, the market value of Facebook was about $104 billion at that time, larger than almost all other firms in the United States.

   On the day of Facebook's IPO, about 571 million shares were traded, and the stock price of Facebook ended at $38.23, just 23 cents above the open price. Yet some traders experienced substantial profits or losses because of wild gyrations in the stock price on the first day. Some institutional traders reportedly lost more than $100 million on this single day of trading.

   As the price declined from its high of about $43 and approached the opening price of $38, some of the securities firms that served as underwriters for the offering purchased shares in order to provide price support. They essentially offset the excess supply of shares for sale at that time in order to prevent the market price from declining below the open price on that day.

   One month after the IPO, Facebook's stock price was $31.40. Three months after the IPO, Facebook's stock price was about $20 per share, or about 48 percent below the IPO open price. In other words, its market valuation declined by about $50 billion in three months. A $10,000 investment in the IPO at the opening price would have been worth about $5,200 three months later.

   One obvious lesson of the Facebook IPO is that a company can be very valuable, yet overpriced. Many investors were willing to invest in Facebook at any price at the time of the IPO, without considering whether the stock price was justified based on fundamental characteristics that influence Facebook's expected cash flows and true valuation. The financial media documented how some investors recognized that the price might be too high at the time of the IPO, but just hoped for a quick “pop” in price, so that they could sell their shares at a quick profit. In other words, some investors did not mind paying an excessive price for an overvalued stock as long as they could quickly sell their shares to other investors who were willing to pay even more than they did.

   The opening price of $38 per share reflected a multiple of about 100 times Facebook's annual earnings per share at the time. As a basis of comparison, Apple's price-earnings ratio at that time was about 14. In August 2013, Facebook's stock price surged to about $37 per share. The only way that Facebook's extremely high stock price could be justified was if its growth in earnings would be much higher than that of Apple and other companies. For Facebook's earnings to grow at this rate, its customer base would have to grow substantially across the world. However, some countries already had local firms that provided a similar service. Some of the more conservative valuations based on less aggressive growth assumptions estimated the value of Facebook to be about $20 per share, consistent with the price three months after the IPO.

10-3h Abuses in the IPO Market

Initial public offerings have received negative publicity because of several abuses. In 2003, regulators issued new guidelines in an effort to prevent such abuses in the future. Some of the more common abuses are described here.

Spinning  Spinning occurs when the underwriter allocates shares from an IPO to corporate executives who may be considering an IPO or to another business requiring the help of a securities firm. The underwriter hopes that the executives will remember the favor and hire the securities firm in the future.

Laddering  When there is substantial demand for an IPO, some brokers engage in laddering. In other words, these brokers encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum. Some investors may be willing to participate to ensure that the broker will reserve some shares of the next hot IPO for them.

Excessive Commission  Some brokers have charged excessive commissions when demand was high for an IPO. Investors were willing to pay the price because they could normally recover the cost from the return on the first day. Because the underwriter set an offer price significantly below the market price that would occur by the end of the first day of trading, investors were willing to accommodate the brokers. The gain to the brokers was a loss to the issuing firm, however, because its proceeds were less than they would have been if the offer price had been set higher.

Distorted Financial Statements  Prior to an IPO, a firm must disclose financial statements to summarize its revenue, expenses, and financial condition. Many investors use this information to derive a valuation of the firm, which can be used to determine a value per share based on the firm's number of shares. With this information, investors can decide whether the offer price of shares at the time of the IPO is below or above their own valuation, which will dictate whether they purchase shares. To the extent that financial statements are distorted, so may be the valuations.

EXAMPLE

On November 4, 2011, Groupon went public. Its stock price quickly jumped from $20 to about $31 (a 55 percent return) on the first day of the IPO, before declining. Critics voiced their concerns that Groupon was understating its expenses, and therefore exaggerating its earnings. In its first year as a public company, Groupon frequently made amendments to its financial statements to correct them. It then acknowledged that its internal controls were weak. By November 2012, its stock price had declined to about $3 per share, which represented an 85 percent loss from its offer price at the time of the IPO. Thus, an employee who owned shares before the IPO was able to sell 1,000 shares for $20,000 at the time of the I PO. But an investor who purchased those 1,000 shares for $20,000 at the time of the IPO would have received about $3,000 from selling those shares one year later. In retrospect, it appears that owners of Groupon before the IPO benefitted from the exaggerated earnings, because the investors who trusted the financial statements paid too much for shares during the IPO.

   The lesson of this example is that even with all the existing regulations for reporting financial statements, accountants still have much flexibility in their reporting process, and therefore can still exaggerate earnings. Consequently, those investors who rely on earnings to value IPO shares might pay too much if the earnings are later determined to be exaggerated.

10-3i Long-Term Performance Following IPOs

WEB

www.hoovers.com/ipo-centrallipoperformance/100004163-1.html

Information on the performance of stocks following the IPO.

There is strong evidence that, on average, IPOs of firms perform poorly over a period of a year or longer. Thus, from a long-term perspective, many IPOs are overpriced at the time of the issue. Investors may be overly optimistic about firms that go public. To the extent that investors base their expectations on the firm's performance before the IPO, they should be aware that firms do not perform as well after going public as they did before. There are several reasons for this. First, this weak performance may be partially attributed to irrational valuations at the time of the IPO, which are corrected over time. Second, the poor performance following an IPO may be caused by the firm's managers, who may spend excessively and waste some of the funds received from the IPO by making bad investments. Third, some firms might have exaggerated their earnings at the time of the IPO in order to maximize the price at which the shares can be sold. The price is corrected downward over time once it becomes obvious that the firm cannot sustain such a high earnings level.

10-4 STOCK OFFERINGS AND REPURCHASES

Even after a firm has gone public, it may issue more stock or repurchase some of the stock that it previously issued. These actions are explained next.

10-4a Secondary Stock Offerings

A firm may need to raise additional equity to support its growth or to expand its operations. A  secondary stock offering  is a new stock offering by a specific firm whose stock is already publicly traded. Some firms have engaged in several secondary offerings to support their expansion. A firm that wants to engage in a secondary stock offering must file the offering with the SEC. It will likely hire a securities firm to advise on the number of shares it can sell, to help develop the prospectus submitted to the SEC, and to place the new shares with investors.

   Because there is already a market price for the stock of a firm that engages in a secondary offering, the firm hopes that it can issue shares at the existing market price. But given that a secondary offering may involve millions of shares, there may not be sufficient demand by investors at the prevailing market price. In this case, the underwriter will have to reduce the price so that it can sell all the new shares. Many secondary offerings cause the market price to decline by 1 to 4 percent on the day of the offering, which reflects the new price at which the increased supply of shares in the market is equal to the demand for those shares. Because of the potential for a decline in the equilibrium price of all of its shares, a firm considering a secondary stock offering commonly monitors stock market movements. It prefers to issue new stock when the market price of its outstanding shares is relatively high and when the general outlook for the firm is favorable. Under these conditions, it can issue new shares at a relatively high price, which will generate more funds for a given amount of shares issued.

   Corporations sometimes direct their sales of stock toward a particular group, such as their existing shareholders, by giving them preemptive rights (first priority) to purchase the new stock. By placing newly issued stock with existing shareholders, the firm avoids diluting ownership. Preemptive rights are exercised by purchasing new shares during the subscription period (which normally lasts a month or less) at the price specified by the rights. Alternatively, the rights can be sold to someone else.

Shelf Registration  Corporations can publicly place securities without the time lag often caused by registering with the SEC. With this so-called shelf registration, a corporation can fulfill SEC requirements as many as two years before issuing new securities. The registration statement contains financing plans over the upcoming two years. The securities are, in a sense, shelved until the firm needs to issue them. Shelf registrations allow firms quick access to funds without repeatedly being slowed by the registration process. Thus, corporations anticipating unfavorable conditions can quickly lock in their financing costs. Although this is beneficial to the issuing corporation, potential purchasers must realize that the information disclosed in the registration is not continually updated and therefore may not accurately reflect the firm's status over the shelf-registration period.

10-4b Stock Repurchases

Corporate managers have information about the firm's future prospects that is not known by the firm's investors, knowledge that is often referred to as asymmetric information. When corporate managers believe that their firm's stock is undervalued, they can use the firm's excess cash to purchase a portion of its shares in the market at a relatively low price based on their valuation of what the shares are really worth. Firms tend to repurchase some of their shares when share prices are at very low levels.

   In general, studies have found that stock prices respond favorably to stock repurchase announcements, which implies that investors interpret the announcement as signaling management's perception that the shares are undervalued. Investors respond favorably to this signal.

   Although many stock repurchase plans are viewed as a favorable signal, some investors may ask why the firm does not use its funds to expand its business instead of buying back its stock. Thus, investors' response to a stock repurchase plan varies with the firm's characteristics.

10-5 STOCK EXCHANGES

Any shares of stock that have been issued as a result of an IPO or a secondary offering can be traded by investors in the secondary market. In the United States, stock trading between investors occurs on the organized stock exchanges and the over-the-counter (OTC) market.

10-5a Organized Exchanges

Each  organized exchange  has a trading floor where floor traders execute transactions in the secondary market for their clients. Although there are several organized stock exchanges in the United States, the New York Stock Exchange (NYSE) is by far the largest. The NYSE was merged with stock exchanges in Paris, Brussels, and Amsterdam in 2007, resulting in NYSE Euronext. In December 2012, NYSE Euronext was purchased by Intercontinental Exchange (ICE) Inc., (subject to regulatory approval) although it would still use the NYSE Euronext name. The ICE, based in Atlanta, emerged in 2000 to facilitate electronic trades of futures contracts on commodities such as cotton and oil. It is known for its efficiency in electronic trading of derivative contracts and went public in 2005. The combination of the ICE and NYSE Euronext exchanges creates a massive network that can trade stocks, bonds, commodities, and derivative securities across the world. The firms listed on the NYSE are typically much larger than those listed on the other exchanges. For some firms, more than 100 million shares are traded on a daily basis.

   The NYSE has a trading floor where trades can be executed. It has two broad types of members: floor brokers and specialists.  Floor brokers  are either commission brokers or independent brokers.  Commission brokers  are employed by brokerage firms and execute orders for clients on the floor of the NYSE.  Independent brokers  trade for their own account and are not employed by any particular brokerage firm. However, they sometimes handle the overflow for brokerage firms and handle orders for brokerage firms that do not employ full-time brokers. The fee that independent brokers receive depends on the size and liquidity of the order they trade.

    Specialists  can match orders of buyers and sellers. In addition, they can buy or sell stock for their own account and thereby create more liquidity for the stock.

WEB

www.nyse.com

New York Stock Exchange market summary, quotes, financial statistics, and so forth.

   While the NYSE was always known for its trading floor, much of the trading has been executed by the NYSE Super Display Book System (SDBK), which is an electronic system for matching trades. At the time NYSE Euronext was purchased by Intercontinental Exchange, only about 20 percent of the NYSE trades were executed on the trading floor, versus about 40 percent in 2007. The other trades are executed electronically. The proportion of trades executed electronically will likely increase to the point in which the trading floor is no longer needed.

Listing Requirements  The NYSE charges an initial fee to firms that wish to have their stock listed. The fee depends on the size of the firm. Corporations must meet specific requirements to have their stock listed on the NYSE, such as a minimum number of shares outstanding and a minimum level of earnings, cash flow, and revenue over a recent period. Once a stock is listed, the exchange also requires that the share price of the stock be at least $1 per share. As time passes, new listings are added and some firms are delisted when they no longer meet the requirements.

   The requirement of a minimum number of shares outstanding is intended to ensure adequate liquidity. For a stock to be liquid, there should be many willing buyers and sellers at any time so that an investor can easily buy or sell the stock at the prevailing market price. In a liquid market, the bid price that brokers are willing to pay for a stock should be just slightly less than the ask price at which they would sell the stock.

10-5b Over-the-Counter Market

Stocks not listed on the organized exchanges are traded in the over-the-counter (OTC) market. Like the organized exchanges, the OTC market also facilitates secondary market transactions. Unlike the organized exchanges, the OTC market does not have a trading floor. Instead, the buy and sell orders are completed through a telecommunications network. Because there is no trading floor, it is not necessary to buy a seat to trade on this exchange; however, it is necessary to register with the SEC.

Nasdaq  Many stocks in the OTC market are served by the  National Association of Securities Dealers Automatic Quotations (Nasdaq) , which is an electronic quotation system that provides immediate price quotations. Firms that wish to have their prices quoted by the Nasdaq must meet specific requirements on minimum assets, capital, and number of shareholders. More than 3,000 stocks trade on the Nasdaq. Although most stocks listed in this market are issued by relatively small firms, stocks of some very large firms (e.g., Apple and Intel) are also traded there.

WEB

www.nasdaq.com

Trends and other statistical information on various Nasdaq indexes.

OTC Bulletin Board  The OTC Bulletin Board lists stocks that have a price below $1 per share, which are sometimes referred to as penny stocks. More than 3,500 stocks are listed here. Many of these stocks were once traded in the Nasdaq market but no longer meet that exchange's requirements. Penny stocks are less liquid than those traded on exchanges because there is an extremely limited amount of trading. They are typically traded only by individual investors. Institutional investors tend to focus on more liquid stocks that can be easily sold in the secondary market at any time.

Pink Sheets  The OTC market has another segment, known as the “pink sheets,” where even smaller stocks are traded. Like those on the OTC Bulletin Board, these stocks typically do not satisfy the Nasdaq's listing requirements. Financial data on them are very limited, if available at all. Companies whose stocks are traded on the pink sheets market do not have to register with the SEC. Some of the stocks have very little trading volume and may not be traded at all for several weeks.

10-5c Extended Trading Sessions

The NYSE and Nasdaq market offer extended trading sessions beyond normal trading hours. A late trading session enables investors to buy or sell stocks after the market closes, and an early morning session (sometimes referred to as a pre-market session) enables them to buy or sell stocks just before the market opens on the following day. Beyond the sessions offered by the exchanges, some electronic communication networks (ECNs) allow for trading at any time. Since many announcements about firms are made after normal trading hours, investors can attempt to take advantage of this information before the market opens the next day.

   However, market liquidity during the extended trading sessions is limited. For example, the total trading volume of a widely traded stock at night may be only 5 percent (or less) of its trading volume during the day. Some stocks are rarely traded at all during the night. Thus, a large trade is more likely to jolt the stock price during an extended trading session because a large price adjustment may be necessary to entice other investors to take the opposite position. Some investors attempt to take advantage of unusual stock price movements during extended trading sessions, but they are exposed to the risk that the market price will not adjust in the anticipated manner.

10-5d Stock Quotations Provided by Exchanges

WEB

www.nasdaq.com

U.S. stock quotes and charts.

The trading of stocks between investors in the secondary market can cause any stock's price to change. Investors can monitor stock price quotations at financial websites and in newspapers. Although the format varies among sources, most quotations provide similar information. Stock prices are always quoted on a per share basis, as in the example of Zikard Company in Exhibit 10.4. Use the exhibit to supplement the following discussion of other information in stock quotations.

52-Week Price Range  The stock's highest price and lowest price over the previous 52 weeks are commonly listed just to the left of the stock's name. The high and low prices indicate the range for the stock's price over the last year. Some investors use this range as an indicator of how much the stock price fluctuates.

Exhibit 10.4 Example of Stock Price Quotations

YTD % CHANGE	HI	LO	STOCK	SYM	DIV	YLD%	PE	VOL 100S	LAST	NET CHG
+10.3	121.88	80.06	ZIKARD CO.	ZIK	.56	.6	20	71979	93.77	+1.06
Year todate percentage change in stock price	Highest price of the stock in this year	Lowest price of the stock in this year	Name of stock	Stock symbol	Annual dividend paid per year	Dividend yield, which represents the annual dividend as a percentage of the prevailing stock price	Price– earnings ratio based on the prevailing stock price	Trading volume during the previous trading day	Closing stock price	Change in the stock price from the close on the day before

   Notice that Zikard's 52-week high price was $121.88 and its low price was $80.06 per share. The low price is about 34 percent below the high price, which indicates a wide range of values over the last year.

Symbol  Each stock has a specific symbol that is used to identify the firm. This symbol may be used to communicate trade orders to brokers. Ticker tapes at brokerage firms or on financial news television shows use the symbol to identify each firm. If included in the stock quotations, the symbol normally appears just to the right of the firm's name. Each symbol is usually composed of two to four letters. Zikard's ticker symbol is ZIK. Nike's symbol is NKE, the symbol for Home Depot is HD, and the symbol for Motorola is MOT.

Dividend  The annual dividend (Div) is commonly listed to the right of the firm's name and symbol. It shows the dividends distributed to stockholders over the last year on a per share basis. Zikard's dividend is $0.56 per share, which indicates an average of $0.14 per share for each quarter. The annual dollar amount of dividends paid can be determined by multiplying the dividends per share by the number of shares outstanding.

Dividend Yield  Next to the annual dividend, some stock quotation tables also show the dividend yield (Yld), which is the annual dividend per share as a percentage of the stock's prevailing price. Since Zikard's annual dividend is $0.56 per share and its prevailing stock price is $93.77, its stock's dividend yield is

Dividend yield =	Dividends paid per share Prevailing stock price
=	$0.56 $93.77
=	0.60%

   Some firms attempt to provide a fairly stable dividend yield over time, but other firms do not.

Price-Earnings Ratio  Most stock quotations include the stock's price–earnings (PE) ratio, which represents its prevailing stock price per share divided by the firm's earnings per share (earnings divided by number of existing shares of stock) generated over the last year. Zikard's PE ratio of 20 in Exhibit 10.4 is derived by dividing its stock price of $93.77 by the previous year's earnings. Price–earnings ratios are closely monitored by some investors who believe that a low PE ratio (relative to other firms in the same industry) signals that the stock is undervalued in terms of the company's earnings.

 USING THE WALL STREET JOUNAL: Late Trading

The Wall Street Journal provides information on stocks that were heavily traded after normal trading hours, as shown here. It describes the trading volume and the percentage change in the stock price for specific stocks that were heavily traded.

Source: Reprinted with permission of the Wall Street Journal, Copyright © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Volume  Stock quotations also usually include the volume (referred to as “Vol” or “Sales”) of shares traded on the previous day. The volume is normally quoted in hundreds of shares. It is not unusual for several million shares of a large firm's stock to be traded on a single day. Exhibit 10.4 shows that more than 7 million shares of ZIK stock were traded. Some financial media also show the percentage change in the volume of trading from the previous day.

Closing Price Quotations  Stock quotations show the closing price (“Last”) on the day (on the previous day if the quotations are in a newspaper). In addition, the change in the price (“Net Chg”) is typically provided and indicates the increase or decrease in the stock price from the closing price on the day before.

10-5e Stock Index Quotations

WEB

finance.yahoo.com/indices

Quotations on various U.S. stock market indexes.

Stock indexes serve as performance indicators of specific stock exchanges or of particular subsets of the market. The indexes allow investors to compare the performance of individual stocks with more general market indicators. Some of the more closely monitored indexes are identified next.

Dow Jones Industrial Average  The Dow Jones Industrial Average (DJIA) is a value-weighted average of stock prices of 30 large U.S. firms. ExxonMobil, IBM, and the Coca-Cola Company are among the stocks included in the index. Since the DJIA is based on only 30 large stocks, it is not always an accurate indicator of the overall market or (especially) of smaller stocks.

Standard & Poor's 500  The Standard & Poor's (S&P) 500 index is a value-weighted index of stock prices of 500 large U.S. firms. Because this index contains such a large number of stocks, it is more representative of the U.S. stock market than the DJIA. However, because the S&P 500 index focuses on large stocks, it does not serve as a useful indicator for stock prices of smaller firms.

Wilshire 5000 Total Market Index  The Wilshire 5000 Total Market Index was created in 1974 to reflect the values of 5,000 U.S. stocks. Because stocks have been added over time, the index now contains more than 5,000 stocks. The Wilshire 5000 is the broadest index of the U.S. stock market. It is widely quoted in financial media and closely monitored by the Federal Reserve and many financial institutions.

New York Stock Exchange Indexes  The NYSE provides quotations on indexes that it has created. The Composite Index is the average of all stocks traded on the NYSE. This is an excellent indicator of the general performance of stocks traded on the NYSE. However, because these stocks represent mostly large firms, the Composite Index is not an appropriate measure of small stock performance. In addition to the Composite Index, the NYSE also provides indexes for four sectors:

· 1. Industrial

· 2. Transportation

· 3. Utility

· 4. Financial

   These indexes are commonly used as benchmarks for comparison to an individual firm or portfolio in that respective sector. Although the indexes are positively correlated, there are substantial differences in their movements during some periods.

Nasdaq Stock Indexes  The National Association of Securities Dealers (NASD) provides quotations on indexes of stocks traded on the Nasdaq. These indexes are useful indicators of small stock performance because many small stocks are traded on that exchange.

10-5f Private Stock Exchanges

Prior to an IPO, some private firms list their private shares on a private stock exchange. Thus, employees or owners who own shares of these firms can sell their shares to other investors. Second Market and Shares Post are examples of private stock exchanges that facilitate the sale of private firm shares. The main advantage of a private stock exchange is that it allows owners of a private firm to obtain cash. The owners can sell some of their shares to investors in exchange for cash. In addition, the private stock exchange allows investors to become part owners of privately held firms. Many of these firms may ultimately engage in IPOs, which would allow investors to purchase shares. However, if investors can invest in private firms, they may be able to obtain shares at a lower price. In addition, they may not have access to purchasing shares at the time of the IPO, because most IPOs give priority to the large institutional investors. When investors purchase shares of a private firm, they might be able to pay a lower price than if they wait until the private firm goes public.

   There are some possible disadvantages of a private stock market that should also be considered. First, investors need to register with the private stock exchange, and prove that they have sufficient income (such as about $200,000 per year) and sufficient net worth (such as at least $1 million). Therefore, the private stock exchanges are not for all investors. Second, the required disclosure of information by private firms listed on private stock exchanges may be less than what is required when firms go public. Firms are required to have their financial statements audited when their shares are publicly traded. The limited information could cause some investors to make bad investment decisions. Third, investors should consider why the existing owners of a private firm are willing to sell their shares for a specific price. Is it because the owners need cash, or because they know that the firm is worth less than the price at which they can sell the shares? Investors are at a disadvantage because they do not have all the information that the owners have in order to estimate the proper value of shares. Fourth, the trading volume in a private stock market is very limited. With such limited participation by investors, it is difficult to determine the appropriate market price. The price at which the shares are trading could possibly be much higher than what they would sell at if the shares were publicly traded, which suggests that the investors are paying too much for private shares. Alternatively, the shares might be trading at lower prices than if the shares were publicly traded, which suggests that the existing owners are not receiving a sufficient price for their shares. Even the existing owners can make mistakes when attempting to determine the proper valuation of shares, because the true market valuation (when the firm goes public in the future) is partially influenced by market sentiment, which is difficult to forecast.

10-6 MONITORING PUBLICLY TRADED COMPANIES

Since a firm's stock price is normally related to its performance, the return to investors depends on how well the firm is managed. A publicly traded firm's managers serve as agents for shareholders by making decisions that are supposed to maximize the stock's price. The separation of ownership (by shareholders) and control (by managers) can result in agency problems because of conflicting interests. Managers may be tempted to serve their own interests rather than those of the investors who own the firm's stock.

   Many institutional investors own millions of shares of a single firm and therefore have an incentive to ensure that managers serve the shareholders' interests. The easiest way for shareholders to monitor the firm is to monitor changes in its value (as measured by its share price) over time. Since the share price is continuously available, shareholders can quickly detect any abrupt changes in the value of the firm. If the stock price is lower than expected, shareholders may attempt to take action to improve the management of the firm. In addition, publicly traded firms are required to provide financial statements that disclose their financial condition to the public, so investors can monitor these statements as well.

   Investors also rely on the board of directors of each firm to ensure that its managers make decisions that enhance the firm's performance and maximize the stock price. A firm's board of directors is responsible for supervising its business and affairs. The board attempts to ensure that the business is managed in a way that serves the shareholders. Directors are also responsible for monitoring operations and making sure that the firm complies with the laws. They cannot oversee every workplace decision, but they can ensure that the firm has a process that can guide some decisions about moral and ethical conduct. They can also ensure that the firm has a system for internal control and reporting.

10-6a Role of Analysts

WEB

finance.yahoo.com/marketupdate/upgrades?

List of stocks that were upgraded or downgraded by analysts.

Analysts are often employed by securities firms and assigned to monitor a small set of publicly traded firms. They communicate with the high-level managers of the firms that they cover. Because they have expertise in analyzing the financial condition of these firms and in valuing stocks, analysts may detect financial problems within a firm that would not be recognized by most investors. Analysts publicize their opinion of the companies that they monitor for investors by assigning a rating (or recommendation) to the firm's stock such as Strong Buy, Buy, Hold, or Sell.

   Although analysts can provide useful information for investors, they have historically been very generous when rating stocks. Thus, their effectiveness in monitoring publicly traded companies has been limited. In fact, the bonuses paid to analysts were sometimes based on how much business they generated for their employer and not on the accuracy of their stock ratings.

Stock Exchange Rules  In the 2002–2004 period, U.S. stock exchanges imposed new rules to prevent some obvious conflicts of interest faced by analysts. First, analysts cannot be supervised by the division that provides advisory services, and their compensation cannot be based on the amount of advisory business they generate. This rule is intended to encourage analysts to provide more unbiased ratings of stocks. Second, securities firms must disclose summaries of their analysts' ratings for all the firms that they rate so that investors can determine whether the ratings are excessively optimistic.

10-6b Accounting Irregularities

To the extent that managers can manipulate the financial statements, they may be able to hide information from investors. In recent years, many firms (including Enron, Tyco, and WorldCom) used unusual accounting methods to create their financial statements. As a result, it was difficult for investors to ascertain the true financial condition of these firms and therefore to monitor them. The problem was compounded because the auditors hired to audit the financial statements of some firms allowed them to use these irregular accounting methods. A subset of a firm's board members serve on an audit committee, which is supposed to ensure that the audit is performed properly. In some firms, however, the committee failed to monitor the auditors. Overall, investors' monitoring of some firms was limited because the accountants distorted the financial statements, the auditors did not properly audit, and the audit committees of those firms did not properly oversee the audit.

10-6c Sarbanes-Oxley Act

The Sarbanes-Oxley Act was enacted in 2002 to ensure more accurate disclosure of financial information to investors, and therefore allows investors to more effectively monitor the financial condition of firms. It requires firms to establish an internal control process to improve their reporting. It also attempts to prevent potential conflicts of interest that could occur when firms have their financial statements audited by a public accounting firm. For example, it prevents a public accounting firm from auditing a client firm whose chief executive officer (CEO) or other executives were employed by the accounting firm within one year prior to the audit. The act also prevents the members of a firm's audit committee from receiving consulting or advising fees or other compensation from the firm beyond that earned from serving on the board. This provision prevents a firm from providing excessive compensation to the members of an audit committee as a means of paying them off so that they do not closely oversee the audit. In addition, the act requires that the CEO and CFO of firms certify that the audited financial statements are accurate, which forces the CFO and CEO to be accountable. The act specifies major fines or imprisonment for employees who mislead investors or hide evidence.

   Although the Sarbanes-Oxley Act has improved transparency, investors still have limited financial information about publicly traded firms, which can cause errors in valuations.

EXAMPLE

Lehman Brothers was ranked the highest in the Barron's annual survey of corporate performance for large companies. In 2007, Fortune magazine put Lehman Brothers at the top of its list of “Most Admired Securities Firms.” In March 2007, the value of Lehman's stock was about $40 billion. Yet in September 2008, Lehman filed for bankruptcy and its stock was worthless. How does a company lose $40 billion in value in 18 months? Some critics would argue that its value should never have been as high as $40 billion because the reported market value of its assets was exaggerated.

Cost of Being Public  Establishing a process that satisfies the Sarbanes-Oxley provisions can be very costly. For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per year. Hence many small, publicly traded firms decided to revert back to private ownership as a result of the act. These firms perceived that they would have a higher value if they were private, rather than publicly held, because they could eliminate the substantial reporting costs required of publicly traded firms.

10-6d Shareholder Activism

If shareholders are displeased with the way managers are managing a firm, they have three general choices. The first is to do nothing and retain their shares in the hope that management's actions will ultimately lead to strong stock price performance. A second choice is to sell the stock. This choice is common among shareholders who do not believe that they can change the firm's management or do not wish to spend the time and money needed to bring about change. A third choice is to engage in shareholder activism. Some of the more common types of shareholder activism are examined here.

Communication with the Firm  Shareholders can communicate their concerns to other investors in an effort to place more pressure on the firm's managers or its board members. Institutional investors commonly communicate with high-level corporate managers and have opportunities to offer their concerns about the firm's operations. The managers may be willing to consider changes suggested by a large institutional investor because they do not want such investors to sell their holdings of the firm's stock.

EXAMPLE

The California Public Employees' Retirement System (CALPERS) manages the pensions for employees of the state of California. It manages more than $80 billion of securities and commonly maintains large stock positions in some firms. When CALPERS believes that these firms are not being managed properly, it communicates its concerns and often proposes solutions. It might even request a seat on the board of directors, or that the corporation replace one of the board members with an outside investor. In response, some of the firms adjust their management to accommodate CALPERS.

   CALPERS periodically announces a list of firms that it believes have serious agency problems. These firms may have been unwilling to respond to CALPERS's concerns about their management style.

   Firms are especially responsive when institutional investors communicate as a team. Institutional Shareholder Services (ISS), which is part of Risk Metrics Group, organizes institutional shareholders to push for a common cause. After receiving feedback from institutional investors about a particular firm, ISS organizes a conference call with high-ranking executives so that it can obtain information from the firm. It then announces the time of the conference call to investors and allows them to listen in on the call. The questions focus on institutional shareholders' concerns about the firm's management. Unlike earnings conference calls, which are controlled by firms, ISS runs the conference call. Common questions asked by ISS include:

· ▪ Why is your CEO also the chair of the board?

· ▪ Why is your executive compensation much higher than the industry norm?

· ▪ What is your process for nominating new board members?

   Transcripts of the conference calls are available shortly after they conclude.

Proxy Contest  Shareholders may also engage in proxy contests in an attempt to change the composition of the board. This is a more formal effort than communicating with the firm and is normally considered only if an informal request for a change in the board (through communication with the board) is ignored. If the dissident shareholders gain enough votes, they can elect one or more directors who share their views. In this case, shareholders are truly exercising their control.

   Institutional Shareholder Services may recommend that shareholders vote a certain way on specific proxy issues. As a result of these more organized efforts, institutional shareholders are having more influence on management decisions. At some firms, they have succeeded in implementing changes that can enhance shareholder value, such as:

· ▪ Limiting severance pay for executives who are fired.

· ▪ Revising the voting guidelines on the firm's executive compensation policy.

· ▪ Requiring more transparent reporting of financial information.

· ▪ Imposing ceilings on the CEO's salary and bonus.

· ▪ Removing bylaws that prevent takeovers by other firms.

· ▪ Allowing for an annual election of all directors so that ineffective directors can be quickly removed from the board.

Shareholder Lawsuits  Investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders. This action is intended to force the board to make decisions that are aligned with the shareholders' interests. Lawsuits are often filed when corporations prevent takeovers, pursue acquisitions, or make other restructuring decisions that some shareholders believe will reduce the stock's value.

   At some firms, the boards have been negligent in representing the shareholders. Nevertheless, since business performance is subject to uncertainty, directors cannot be held responsible every time a key business decision has an unsatisfactory outcome. When directors are sued, the court typically focuses on whether the directors' decisions were reasonable, not on whether they increased the firm's profitability. Thus, from the court's perspective, the directors' decision-making process is more relevant than the actual outcome.

10-6e Limited Power of Governance

Although much attention has been given in financial markets to how managers are subject to increased governance, there is some evidence that the governance is not very effective. There are numerous examples of executives who continue to receive extremely high compensation even when the performance of their firm is quite weak. In spite of the Sarbanes-Oxley Act, shareholder activism, proxy contests, and shareholder lawsuits, the agency problems of some firms remain severe.

10-7 MARKET FOR CORPORATE CONTROL

When corporate managers notice that another firm in the same industry has a low stock price as a result of poor management, they may attempt to acquire that firm. They hope to purchase the business at a low price and improve its management so that they can increase the value of the business. In addition, the combination of the two firms may reduce redundancy in some operations and allow for synergistic benefits. In this way, the managers of the acquiring firm may earn a higher return than if they used their funds for some other type of expansion. In essence, weak businesses are subject to a takeover by more efficient corporations and are thus subject to the “market for corporate control.” Therefore, if a firm's stock price is relatively low because of poor performance, it may become an attractive target for other corporations.

   A firm may especially benefit from acquisitions when its own stock price has risen. It can use its stock as currency to acquire the shares of a target by exchanging some of its own shares for the target's shares. Some critics claim that acquisitions of inefficient firms typically lead to layoffs and are unfair to employees. The counter to this argument is that, without the market for corporate control, firms would be allowed to be inefficient, and this is unfair to the shareholders who invested in them. Managers recognize that if their poorly performing business is taken over, they may lose their jobs. Thus, the market for corporate control can encourage managers to make decisions that maximize the stock's value so that they can better avoid takeovers.

   In general, studies have found that the share prices of target firms react positively but that the share prices of acquiring firms are not favorably affected. Investors may not expect the acquiring firm to achieve its objectives. There is some evidence that firms engaging in acquisitions do not eliminate inefficient operations after the acquisitions, perhaps because of the low morale that would result from layoffs. In addition, an acquiring firm commonly has to pay a very large premium, such as 20 to 40 percent above the publicly traded target firm's prevailing stock price, in order to gain control of the target firm. It is difficult to achieve sufficient benefits from the acquisition to offset the very large cost of the acquisition.

10-7a Use of LBOs to Achieve Corporate Control

The market for corporate control is enhanced by the use of leveraged buyouts (LBOs), which are acquisitions that require substantial amounts of borrowed funds. That is, the acquisition requires a substantial amount of financial leverage. Some so-called buyout firms identify poorly managed firms, acquire them (mostly with the use of borrowed funds), improve their management, and then sell them at a higher price than they paid. Alternatively, a group of managers who work for the firm may believe that they can restructure the firm's operations to improve cash flows. These managers may attempt an LBO in the hope that they can improve the firm's performance.

   The use of debt to retire a company's stock creates a highly leveraged capital structure. One favorable aspect of such a revised capital structure is that the ownership of the firm is normally reduced to a small group of people, who may be managers of the firm. Agency costs should be reduced when managers' interests are thus aligned with those of the firm. A major concern about LBOs, however, is that the firm will experience cash flow problems over time because of the high periodic debt payments that result from the high degree of financial leverage. A firm financed in this way has a high potential return but is also risky.

   Some firms that engage in LBOs issue new stock after improving the firm's performance. This process is referred to as a reverse leveraged buyout (reverse LBO). Whereas an LBO may be used to purchase all the stock of a firm that has not achieved its potential performance (causing its stock to be priced low), a reverse LBO is normally desirable when the stock can be sold at a high price. In essence, the owners hope to issue new stock at a much higher price than they paid when enacting the LBO.

10-7b Barriers to the Market for Corporate Control

The power of corporate control to eliminate agency problems is limited by barriers that can make it more costly for a potential acquiring firm to acquire another firm whose managers are not serving the firm's shareholders. Some of the more common barriers to corporate control are identified next.

Antitakeover Amendments  Some firms have added antitakeover amendments to their corporate charter. For example, an amendment may require that at least two-thirds of the shareholder votes approve a takeover before the firm can be acquired. Antitakeover amendments are supposed to be enacted to protect shareholders against an acquisition that will ultimately reduce the value of their investment in the firm. However, it could be argued that shareholders are adversely affected by antitakeover amendments.

Poison Pills  Poison pills are special rights awarded to shareholders or specific managers on the occurrence of specified events. They can be enacted by a firm's board of directors without the approval of shareholders. Sometimes a target enacts a poison pill to defend against takeover attempts. For example, a poison pill might give all shareholders the right to be allocated an additional 30 percent of shares (based on their existing share holdings) without cost whenever a potential acquirer attempts to acquire the firm. The poison pill makes it more expensive and more difficult for a potential acquiring firm to acquire the target.

Golden Parachutes  A golden parachute specifies compensation to managers in the event that they lose their jobs or there is a change in control of the firm. For example, all managers might have the right to receive 100,000 shares of the firm's stock whenever the firm is acquired. It can be argued that a golden parachute protects managers so that they may be more willing to make decisions that enhance shareholder wealth over the long run, even though the decisions adversely affect the stock price in the short run.

   Golden parachutes can discourage takeover attempts by increasing the cost of the acquisition. To the extent that this (or any) defense against takeovers is effective, it disrupts the market for corporate control by allowing managers of some firms to be protected while serving their own interests rather than shareholder interests.

10-8 GLOBALIZATION OF STOCK MARKETS

Stock markets are becoming globalized in the sense that barriers between countries have been removed or reduced. Thus, firms in need of funds can tap foreign markets, and investors can purchase foreign stocks. In recent years, many firms have obtained funds from foreign markets through international stock offerings. This strategy may represent an effort by a firm to enhance its global image. Another motive is that, because the issuing firm is tapping a larger pool of potential investors, it can more easily place the entire issue of new stock.

10-8a Privatization

WEB

www.bloomberg.com

World market coverage, various financial instruments, financial analysis, charts, quotes, and news.

In recent years, the governments of many countries have allowed privatization, or the sale of government-owned firms to individuals. Some of these businesses are so large that the local stock markets cannot digest the stock offerings. Consequently, investors from various countries have invested in the privatized businesses.

10-8b Emerging Stock Markets

Emerging markets enable foreign firms to raise large amounts of capital by issuing stock. These markets also provide a means for investors from the United States and other countries to invest their funds. Some emerging stock markets are relatively new and small, and they may not be as efficient as the U.S. stock market. Hence some stocks could be undervalued, which may attract investors to these markets.

   However, stock markets in some developing countries are still subject to certain limitations. First, non-U.S. regulatory agencies provide little enforcement to ensure that the financial information offered by issuers is correct. Second, businesses that do not repay investors are rarely prosecuted. Third, courts in many countries do not provide an efficient system that investors can use to obtain the funds they believe they are owed.

   Fourth, the smaller markets might be especially susceptible to manipulation by large traders. Furthermore, insider trading is more prevalent in many foreign markets because rules against it are not enforced. In general, large institutional investors and insiders based in the foreign markets may have some advantages.

   Although international stocks can generate high returns, they may also exhibit high risk. Some of the emerging stock markets are often referred to as “casinos” because of the wide variation in prices that sometimes occur. Large price swings are common because of two characteristics of emerging markets. For stocks with very limited trading activity, large trades can jolt the equilibrium price. In addition, valid financial information about firms is sometimes lacking, causing investors to trade according to rumors. Trading patterns based on continual rumors are more volatile than trading patterns based on factual data.

10-8c Variation in Characteristics across Stock Markets

The volume of trading activity in each stock market is influenced by legal and other characteristics of the country. Shareholder rights vary among countries, and shareholders in some countries have more voting power and can have a stronger influence on corporate management.

   The legal protection of shareholders also varies substantially among countries. Shareholders in some countries can more effectively sue publicly traded firms if their executives or directors commit financial fraud. In general, common law countries such as the United States, Canada, and the United Kingdom allow for more legal protection than civil law countries such as France and Italy.

   The government's enforcement of securities laws also varies among countries. If a country has laws to protect shareholders but does not enforce the laws, shareholders are not protected. Some countries tend to have less corporate corruption than others; in these countries, shareholders are less exposed to major losses due to corruption.

   In addition, the degree of financial information that must be provided by public companies varies among countries. The variation may be due to the accounting laws set by the government for public companies or to reporting rules enforced by local stock exchanges. Shareholders are less susceptible to losses due to a lack of information if public companies are required to be more transparent in their financial reporting.

   In general, more investors are attracted to stock markets in countries that provide voting rights and legal protection for shareholders, strictly enforce the laws, do not tolerate corruption, and impose stringent accounting requirements. These conditions enable investors to have more confidence in the stock market and allow for greater pricing efficiency. In addition, companies are attracted to the stock market when there are many investors because then the companies can easily raise funds in the market. Conversely, if a stock market does not attract investors then it will not attract companies needing to raise funds. Those companies will have to rely on stock markets in other countries or on credit markets to raise funds.

10-8d Methods Used to Invest in Foreign Stocks

Investors can obtain foreign stocks by purchasing shares directly, purchasing American depository receipts (ADRs), investing in international mutual funds, and purchasing exchange-traded funds (ETFs). Each of these methods is explained in turn.

Direct Purchases  Investors can easily invest in stocks of foreign companies that are listed on the local stock exchanges. Foreign stocks not listed on local stock exchanges can be purchased through some brokerage firms.

American Depository Receipts  An alternative means of investing in foreign stocks is by purchasing American depository receipts (ADRs), which are certificates representing shares of non-U.S. stock. Many non-U.S. companies establish ADRs in order to develop name recognition in the United States. In addition, some companies wish to raise funds in the United States.

   American depository receipts are attractive to U.S. investors for several reasons. First, they are closely followed by U.S. investment analysts. Second, companies represented by ADRs are required by the SEC to file financial statements that are consistent with generally accepted accounting principles in the United States. These statements may not be available for other non-U.S. companies. Third, reliable quotes on ADR prices are consistently available, with existing currency values factored in to translate the price into dollars. A disadvantage, however, is that the selection of ADRs is limited. Also, the ADR market is less active than other stock markets, so ADRs are less liquid than most listed U.S. stocks.

International Mutual Funds  Another way to invest in foreign stocks is to purchase shares of international mutual funds (IMFs), which are portfolios of international stocks created and managed by various financial institutions. In this way, individuals can diversify across international stocks by investing in a single IMF. Some IMFs focus on a specific foreign country, whereas others contain stocks across several countries or even several continents.

WEB

finance.yahoo.com/indices

Click on “World” for quotations on various stock market indexes around the world.

International Exchange-Traded Funds  Exchange-traded funds are passive funds that track a specific index. International ETFs represent international stock indexes, and they have become popular in the last few years. By investing in an international ETF, investors can invest in a specific index representing a foreign country's stock market. An ETF trades like a stock: it is listed on an exchange, and its value changes in response to trading activity. Although ETFs are denominated in dollars, the net asset value of an international ETF is determined by translating the foreign currency value of the foreign securities into dollars.

   A major difference between ETFs and IMFs is that IMFs are managed whereas ETFs simply represent an index. If investors prefer that the portfolio be rebalanced by portfolio managers over time, they may prefer an IMF. However, ETFs have lower expenses because they avoid the cost of active portfolio management. The difference in expense ratios between an IMF and an ETF may be 2 percent annually or more.

   The price of a share of each international ETF is denominated in dollars, but the underlying securities that make up the index are denominated in non-U.S. currencies. For this reason, the return on the ETF will be influenced by any movement of the foreign country's currency against the dollar. This is true also for IMFs. If the foreign currency appreciates (increases in value), that will boost the value of the index as measured in dollars. Conversely, if the foreign currency depreciates (decreases in value), that will reduce the value of the index as measured in dollars.

SUMMARY

· ▪ When businesses are created, they normally rely on private equity along with borrowed funds. Some private businesses that expand attempt to obtain additional private equity funding from venture capital firms. When venture capital firms provide financing, they commonly attempt to pull their cash out in four to seven years. Going public changes the firm's ownership structure by increasing the number of owners, and it changes the firm's capital structure by increasing the equity investment in the firm. Stock market participants include individual investors as well as institutional investors such as stock mutual funds, pension funds, and insurance companies. Upon the release of new information about a firm, some investors respond by either selling their stock holdings or buying more stock. Their actions affect the supply and demand conditions for the stock and thus influence the equilibrium stock price.

· ▪ An initial public offering (IPO) is a first-time offering of shares by a specific firm to the public. Many firms engage in an IPO to obtain funding for additional expansion and to give the founders and venture capital funds a way to cash out their investments. A firm that engages in an IPO must develop a prospectus that is filed with the SEC, and it typically uses a road show to promote its offering. The firm hires an underwriter to help with the prospectus and road show and to place the shares with investors.

· ▪ A secondary stock offering is an offering of shares by a firm that already has publicly traded stock. Firms engage in secondary offerings when they need more equity funding to support additional expansion.

· ▪ There are various ways in which publicly traded firms are monitored. Analysts monitor firms so that they can assign a rating to their stock. Investors that purchase stock of firms monitor performance and may use shareholder activism to ensure that managers make decisions that are beneficial to the firm's shareholders. The market for corporate control allows firms to acquire the control of businesses that they can improve by replacing managers or revising operations.

· ▪ Many U.S. firms issue shares in foreign countries, as well as in the United States, so that they can spread their shares among a larger set of investors and possibly enhance the firm's global name recognition. Global stock exchanges exist to facilitate the trading of stocks around the world. U.S. investors can invest in foreign stocks by making direct purchases on foreign stock exchanges, purchasing ADRs, investing in international mutual funds, and investing in international exchange-traded funds.

POINT COUNTER-POINT

Should a Stock Exchange Enforce Some Governance Standards on the Firms Listed on the Exchange?

Point  No. Governance is the responsibility of the firms, not the stock exchange. The stock exchange should simply ensure that the trading rules of the exchange are enforced and should not intervene in the firms' governance issues.

Counter-Point  Yes. By enforcing governance standards such as requiring a listed firm to have a majority of outside members on its board of directors, a stock exchange can enhance its own credibility.

Who Is Correct?  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Shareholder Rights Explain the rights of common stockholders that are not available to other individuals.

· 2. Stock Offerings What is the danger of issuing too much stock? What is the role of the securities firm that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?

· 3. IPOs Why do firms engage in IPOs? What is the amount of the fees that the lead underwriter and its syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs in other periods?

· 4. Venture Capital Explain the difference between obtaining funds from a venture capital firm and engaging in an IPO. Explain how the IPO may serve as a means by which the venture capital firm can cash out.

· 5. Prospectus and Road Show Explain the use of a prospectus developed before an IPO. Why does a firm do a road show before its IPO? What factors influence the offer price of stock at the time of the IPO?

· 6. Bookbuilding Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a means of setting the offer price?

· 7. Lockups Describe a lockup provision and explain why it might be required by the lead underwriter.

· 8. Initial Return What is the meaning of an initial return for an IPO? Were initial returns of Internet IPOs in the late 1990s higher or lower than normal? Why?

· 9. Flipping What does it mean to “flip” shares? Why would investors want to flip shares?

· 10. Performance of IPOs How do IPOs perform over the long run?

· 11. Asymmetric Information Discuss the concept of asymmetric information. Explain why it may motivate firms to repurchase some of their stock.

· 12. Stock Repurchases Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares.

· 13. Corporate Control Describe how the interaction between buyers and sellers affects the market value of a firm, and explain how that value can subject a firm to the market for corporate control.

· 14. ADRs Explain how ADRs enable U.S. investors to become part owners of foreign companies.

· 15. NYSE Explain why stocks traded on the New York Stock Exchange generally exhibit less risk than stocks that are traded on other exchanges.

· 16. Role of Organized Exchanges Are organized stock exchanges used to place newly issued stock? Explain.

Advanced Questions

· 17. Role of IMFs How have international mutual funds (IMFs) increased the international integration of capital markets among countries?

· 18. Spinning and Laddering Describe spinning and laddering in the IPO market. How do you think these actions influence the price of a newly issued stock? Who is adversely affected as a result of these actions?

· 19. Impact of Accounting Irregularities How do you think accounting irregularities affect the pricing of corporate stock in general? From an investor's viewpoint, how do you think the information used to price stocks changes in response to accounting irregularities?

· 20. Impact of Sarbanes-Oxley Act Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss how this act affects the monitoring by shareholders.

· 21. IPO Dilemma Denton Company plans to engage in an IPO and will issue 4 million shares of stock. It is hoping to sell the shares for an offer price of $14. It hires a securities firm, which suggests that the offer price for the stock should be $12 per share to ensure that all the shares can easily be sold. Explain the dilemma for Denton Company. What is the advantage of following the advice of the securities firm? What is the disadvantage? Is the securities firm's incentive to place the shares aligned with that of Denton Company?

· 22. Variation in Investor Protection among Countries Explain how shareholder protection varies among countries. Explain how enforcement of securities laws varies among countries. Why do these characteristics affect the valuations of stocks?

· 23. International EFTs Describe international ETFs, and explain how ETFs are exposed to exchange rate risk. How do you think an investor decides whether to purchase an ETF representing Japan, Spain, or some other country?

· 24. VC Fund Participation and Exit Strategy Explain how venture capital (VC) funds finance private businesses as well as how they exit from the participation.

· 25. Dilemma of Stock Analysts Explain the dilemma of stock analysts that work for securities firms and assign ratings to large corporations. Why might they prefer not to assign low ratings to weak but large corporations?

· 26. Limitations of an IPO Businesses valued at less than $50 million or so rarely go public. Explain the limitations to such businesses if they did go public.

· 27. Private Equity Funds Explain the incentive for private equity funds to invest in a firm and improve its operations.

· 28. VCs and Lockup Expiration Following IPOs Venture capital firms commonly attempt to cash out as soon as is possible following IPOs. Describe the likely effect that would have on the stock price at the time of lockup expiration. Would the effect be different for a firm that relied more heavily on VC firms than other investors for its funds? 29. Impact of SOX on Going Private Explain why some public firms decided to go private in response to the passage of the Sarbanes-Oxley (SOX) Act.

· 30. Pricing Facebook's IPO Stock Price Describe the dilemma of securities firms that serve as underwriters for Facebook's IPOs, when attempting to satisfy Facebook and the institutional investors that invest in Facebook's stock. Do you think that the securities firms that served as underwriters for Facebook's IPO satisfied Facebook or its investors in the IPO? Explain.

· 31. Private Stock Market What are some possible disadvantages to investors who invest in stocks listed on a private stock market?

Interpreting Financial News

Interpret the following statements made by Wall Street analysts and portfolio managers.

· a. “The recent wave of IPOs is an attempt by many small firms to capitalize on the recent runup in stock prices.”

· b. “IPOs transfer wealth from unsophisticated investors to large institutional investors who get in at the offer price and get out quickly.”

· c. “Firms must be more accountable to the market when making decisions because they are subject to indirect control by institutional investors.”

Managing in Financial Markets

Investing in an IPO As a portfolio manager of a financial institution, you are invited to numerous road shows at which firms that are going public promote themselves and the lead underwriter invites you to invest in the IPO. Beyond any specific information about the firm, what other information would you need to decide whether to invest in the upcoming IPO?

PROBLEM

Dividend Yield Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend yield for Calzone stock?

FLOW OF FUNDS EXERCISE

Contemplating an Initial Public Offering

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year.

· a. If Carson issued stock now, it would have the flexibility to obtain more debt and would also be able to reduce its cost of financing with debt. Why?

· b. Why would an IPO result in heightened concerns in financial markets about Carson Company's potential agency problems?

· c. Explain why institutional investors, such as mutual funds and pension funds, that invest in stock for longterm periods (at least a year or two) might prefer to invest in IPOs rather than to purchase other stocks that have been publicly traded for several years.

· d. Given that institutional investors such as insurance companies, pension funds, and mutual funds are the major investors in IPOs, explain the flow of funds that results from an IPO. That is, what is the original source of the money that is channeled through the institutional investors and provided to the firm going public?

INTERNET/EXCEL EXERCISES

Go to  http://ipoportal.edgar-online.com/ipo/home.asp  and review an IPO that is scheduled for the near future. Review the deal information about this IPO.

· 1. What is the offer amount? How much are total expenses? How much are total expenses as a percentage of the deal amount? How many shares are issued? How long is the lockup period?

· 2. Review some additional IPOs that are scheduled. What is the range for the offer amount? What is the range for the lockup period length?

WSJ EXERCISE

Assessing Stock Market Movements

Review a recent issue of the Wall Street Journal. Indicate whether the market prices increased or decreased, and explain what caused the market's movement.

ONLINE ARTICLES WITH REAL -WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. private equity AND investment

· 2. venture capital AND investment

· 3. initial public offering

· 4. plans to go public

· 5. stock repurchase

· 6. stock offering

· 7. stock listing AND exchange

· 8. extended trading session AND stock

· 9. stock AND analyst

· 10. stock AND shareholder activism