RSM333H1 Study Guide - Capital Asset Pricing Model, John Lintner, Dividend Discount Model

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18 Apr 2012
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QUALITATIVE QUESTIONS
OPTIONS
Why aren't American-style call options normally exercised before maturity? Under what circumstances would you make
an exception to this? (4 marks)
In the case of a non-dividend paying stock, it is never optimal to exercise early. If anything, you should sell it back to the
exchange to collect the TV as well as IV.
When (if ever) should someone consider exercising an American-style put option on a non-dividend paying stock before
maturity? (4 marks)
If it is deep in the money and the price of the underlying is expect to rise then early exercise might be optimal
What empirical fact suggests that the Black-Scholes option pricing model may underestimate the price of both put and call
options when they are deep in- or out-the-money? ( 4marks)
Additional kurtosis over 3 in the empirical distribution of returns. The BS model assumes a normal distribution
MERGERS AND ACQUISITISIONS
Synergetic Benefits
- economies of scale
- better market knowledge to help with expansion
Why are straight cash offers often preferred over purchases made with common stock or even combined cash/stock
offers?
There is no risk associated with a straight cash purchase for the shareholders of the target firm and yet they capture some
of the synergy value during the transaction
Why would a hostile takeover offer be more likely to misprice a target acquisition than a friendly acquisition?
Asymmetrical information. A friendly acquirer is provided with internal information that is not publicly known to help in
making a valuation.
Why are the average prices of firms with shareholder rights plans (aka poison pills) generally lower than those without
such means to fend off hostile takeovers?
These measures generally end up protecting bad managers. Shareholders generally prefer to be bought out, especially if
someone else could manage the assets better.
INVESTMENT BANKING
Benefits and costs of taking a firm public
Benefits
Costs
- access to capital
- greater public visibility
- venture capitalists can cash out
- can reward employees with marketable stocks
- listing requirement costs
- underwriting and distribution costs
- listing fees
Explain briefly why the Ontario Securities Commission wields enormous influence over national policies governing the role
of investment houses in the primary and secondary markets for common stocks
Ontario has the only public stock exchanges (TSX/Venture Exchange) so the other provincial regulators follow OSC’s
lead.
Identify and explain briefly three major roles investment bankers play in the intermediation process between those with
investable capital and those looking to pay for the use of that capital.
1. advisors: help issuers to structure their securities in ways that will match up with the needs of those with
capital
2. marketing: help market new securities by maintaining a strong network of institutions who have the capital
available to support new issuers
3. Research and market makers: provide research on new and existing issues while often acting as market
makers for the securities of their clients
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Explain the difference between “best efforts” and “firm commitment” offering for an IPO. In each case, who carries the risk
that the issuance of stock will not generate sufficient interest among buyers?
“best efforts” – sell the more as much as we can issuer bears risk
“firm commitment” – buy it for agreed price and sell it off to investors (institutions and public)
investment bankers bear the risk
** other forms:
- bought deal: we will buy them from you even before you have the prospectus prepared it’s that good
- standby/rights offering: existing shareholders have first rights to the new stock but if they don't buy it, I-bankers
will
Why are “bought deal” style offerings more common for short-term debt securities (commercial paper) than for long-term
bonds?
Because bond issuances tend to be large and infrequent, their disclosures often need to be updated whereas CP
is issued on a regular basis
Why can’t securities sold in the exempt market be re-sold to the general public?
They do not have a prospectus that is required when offering to the general public
Should an IPO be accompanied by an offering memorandum or prospectus? Explain why and indicate the main difference
between the two kinds of filings
IPO implies a sale to the public at large and therefore must be accompanied by a prospectus. A prospectus
involves significantly more informational disclosure than an offering memorandum, which is for exempt markets only. This
is to reduce information symmetries between issuers and investing public.
Explain why reducing info asymmetries between the issuers and buyers of securities leads to faster rates of capital
information
It reduces barriers to entrance for investor capital by helping to distinguish between good and bad investments.
Broader general participation provides more investible capital, enabling faster rates of capital formation
Why does the Ontario Securities Commission require a quiet period following an IPO?
At time of IPO, all info should have been included in the prospectus. It prevents I-banking analysts from
aggressively supporting new issues to assist underwriters in creating “hype” for the new security, which can lead to
significant price distortions. The quiet period reduces the likelihood of this type of conflict of interest from occurring.
Possible explanations for IPO under-pricing and why is not as pronounced in Canada (~6%) as in other markets (15%)
Spinning: I-banks sell new securities to their favored clients at a discount
Liquidity Risks: institutions require compensation for upsetting their portfolios
Litigation: class action law suits against I-banks when prices fall after IPO
Competition: lack of competition among big I-banks can lead them to “charging” extra fees by selling securities
for less than they are worth to help create demand
Canada has a competitive I-Banking market with a concentrated nature therefore cannot afford to under-price for fear of
losing clients
Explain how requiring firms to incur the costs of preparing audited financial statements and maintaining continuous
disclosure (which is ultimately born by the shareholders themselves) produces value for shareholders
Imposing such costs reduces the likelihood that investors have put their money in a bad investment. Although
there is a cost to be paid for these disclosures, they help reduce information asymmetries
When issuing securities, there are several floatation costs which must be absorbed by the issuing firm
- underwriting costs to investment banks
- legal and accounting costs
- info gathering for public disclosure
- market underpricing to create liquidity
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