FNCE30002 Study Guide - Final Guide: Corporate Finance, Institutional Investor, Underwriting
22 May 2018
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Corporate Finance Notes:
Corporate finance: Lecture 1
Det holders do’t ote; does this ea the hae o ifluee o the opa?
Yes they do have control over the company ➔ they can enforce various lending restrictions because
they are having my money. Ex: restrictive covenants and in this case they can change how
management runs the business.
Why do firms float?
▪ To create public shares to use in future acquisitions
▪ To establish a market value for our firm
▪ To enhance reputation for their company
▪ To broaden the base of ownership
▪ To allow one or more principals to diversify personal holdings
IPO: the process
Step 1: Engage an investment Banker
Investment banker will help manage the process and a prepare a legal document that is used to
market the float (prospectus), as well as providing services such as underwriting.
How does a firm decide on its subscription price?
1. Fixed pricing
2. Book building: bidding by institutional investors
2 approaches:
• Open pricing, you take bids from institutional investors and then decide what bids
will clear their book.
o Clearing the book means: lets assume we have 4 shares for sale, and people
bid 66, 67, 68, 69, 70, 71, 72. Then they will start from the top, 72, 71, 70,
69. The lowest price is 69 so the shares will be sold for 69.
• Constrained open pricing – within a range
o Tell me your bid but its going to be at least $68.
Step 2: The roadshow
The banker hit the streets to market the float and attempt to gauge investor interest
This is important because it will assist them in determining the Subscription price:
• If it was too high – no one will buy the shares and the float will fail
• If it was too low – The original owner of the shares suffers an opportunity cost (leaving
money on the table)
Step 3: Set the price and list
The shares are issued in the primary market; the funds are received by issuing firm.
Then the shares begin trading on the stock exchange, in the secondary market the funds paid by
buyers of shares does not go to the firm, it goes to the share seller.
Underpricing: When a subscription price is set below the true market value of the firm as indicated,
by the share price upon listing.
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IPOs: Explanation of underpricing
1. Iforatio asetr ad the Wier’s Curse
Investors are of 2 categories:
• Informed Investors – able to judge whether the IPO is underpriced or not
• Uninformed investors- not able to judge
Because uninformed investors would take any IPO and because the informed investors would
recognize the underpriced IPO and take it, the uninformed investors would be crowded out when an
underpriced IPO is there, and they will end up stuck with the overpriced IPOs. So, to ensure that the
uninformed investors stay in the market, IPOs need to – on average – be significantly underpriced.
Issuers need the uninformed investors in the market because informed investors are capital
ostait, the dot hae eough ash to fud all the IPOs.
➔ IPOs are underpriced on average to compensate uninformed investors to participate in the
market.
Capital ostait eas the dot hae eough ash to u the udepied IPOs.
2. Market Feedback Hypothesis (
• The issue ill e uetai of the tue alue of the fi
• The initial book building process offers the issuer an opportunity to find out the tue alue
from the market.
• The underpricing would be compensation for the institutional investors to reveal this
information.
So, Underpricing: compensation for feedback from the market about the true value of the
shares.
3. Market Bandwagon (Cascades hypothesis, dominos)
• Investors are more likely to subscribe to a float that they perceive as popular with other
investors
• In order to induce the first wave of popularity, issuers underprice the issue
• This may result in positively-sloped demand curves
4. Investment banker monopsony power
• We rely on banker/underwriter on advising us on the subscription price.
• This creates a potential conflict for at least 2 reasons:
1. Underpricing can reduce their own cost (it is easier to sell shares at $9 than
shares are $10)
2. Underpricing can be used (unethically) to develop relationships with other
potential clients (this practice is known as IPO spinning and is illegal in many
jurisdictions)
5. Lawsuit avoidance and implicit insurance
• The prospectus is a marketing document which might contained stretched truth which
the managers can be sued for it
• Underpricing will ensure that investors that subscribes enjoy a gain from investment
• Management have essentially purchased implicit insurance, that the pre-existing
shareholders pay for and the CEO receives the benefit (Underpricing can act as a form of
implicit insurance, but it is an agency problem, because the CEO enjoyed the insurance
but it is the original SH of the firm who paid for the insurance)
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find more resources at oneclass.com
6. Signaling as part of a longer term strategy:
• The CEO would know that the IPO is only the next stage in a multi-stage strategy for
expansion, and in the future you have to go back to the market to raise more capital
• B udepiig the fist tie, ou a leae iestos ith good taste aout the opa.
7. Ownership Dispersion:
As the CEO of the company, after the company floats, he would be in danger of losing his job. So
it is in his interest to:
higher the underpricing → increased demand → More dispersed ownership
→ 1) Greater liquidity, easier to buy and sell the share.
2) Security of tenure, this would assist of managerial entrenchment, which is when the
management cannot be removed even if though it is destroying the value.
IPO: Long- run performance of IPOs
1. Divergence of opinion hypothesis:
• Market of IPO consist of optimistic and pessimistic investors
• Successful IPOs subscribers are naturally optimistic
• Over time, the optimism adjusts resulting in a fall in share price
2. Impresario hypothesis:
• Investment bankers ay attempt to create the appearance of excess demand by underpricing IPOs
• Investors are initially taken by this, but as soon as the investment bankers move on to their next
investment, the share price would fall as efforts are withdrawn
3. Windows of opportunity hypothesis:
Suggests that the decision to list is not independent of market conditions. The decision to list is linked to
expectations of future cash flows. And hence you see clustering in IPOs activities.
There are 3 typed of SEOs (Seasoned Equity offerings):
1. Rights issues to existing shareholders
2. General offers to the public
3. Placements to financial institution
Note: IPO is unseasoned equity offer, because shares have not been previously issued in the market.
How do companies choose between alternatives?
1. Cost
2. Time to implement
3. Transfer of wealth from old shareholders to new shareholders.
Equity issuance and dilution (remember the beer example): the whole point is that wealth are not being
generated, but it is becoming less for shareholders.
Placements:
Advantage:
• Timeliness: you can raise funds very quickly (within 2 hours)
• Transaction costs: low, you do not need a prospectus because you are working with informed
institutional investors.
Disadvantage:
• Potential dilution in voting power
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Yes they do have control over the company they can enforce various lending restrictions because they are having my money. Ex: restrictive covenants and in this case they can change how management runs the business. Investment banker will help manage the process and a prepare a legal document that is used to market the float (prospectus), as well as providing services such as underwriting. How does a firm decide on its subscription price: fixed pricing, book building: bidding by institutional investors. The banker hit the streets to market the float and attempt to gauge investor interest. This is important because it will assist them in determining the subscription price: If it was too high no one will buy the shares and the float will fail. If it was too low the original owner of the shares suffers an opportunity cost (leaving money on the table) The shares are issued in the primary market; the funds are received by issuing firm.
