Financial Markets and Institutions

Abridged 10th Edition

by Jeff Madura

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1
 Part 4 Equity Markets

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 10 Stock Offerings and Investor Monitoring
Chapter Objectives

■ 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
■ describe the globalization of stock markets

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3
 Private Equity

Private equity is a business that is privately held and

the owners cannot sell their shares to the public.
Some business owners hope to go public so that:
■ They can obtain financing to support the firm’s growth
■ They can “cash out” by selling their original
equity investment to others.

A public offering is feasible if:

■ The owners want to sell at least $50 million in
stock.
■ The shareholder base will be large enough to
support an
4 active secondary market.
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 Private Equity

Financing by Venture Capital Funds

■ Venture capital funds (VC 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.
■ Investors are not allowed to withdraw their money before
a specified deadline.

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 Private Equity

Venture Capital Market

■ Brings together the private businesses that need
equity funding and the VC funds that can provide
funding.

Terms of a Venture Capital Deal

■ A VC fund will negotiate the terms of the deal when it
decides to invest in a business.
■ The VC fund will set out requirements for the business and
VC fund managers may serve as advisers to the business.

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 Private Equity

Exit Strategy of VC Funds

■ VC funds typically plan to exit in 4 to 7 years by selling
the equity stake to the public.

Financing by Private Equity Funds

■ Private equity funds pool money provided by institutional
investors (such as pension funds and insurance
companies) and invest in businesses.
■ They also rely heavily on debt to finance their
investments.

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 Public Equity

■ When a firm goes public, it issues stock in the primary

market in exchange for cash.
■ Going public has two effects on the firm.
 It 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.
■ Stock markets are like other financial markets in that they
link the surplus units (that have excess funds) with deficit
units (that need funds).
■ The secondary market allows investors to sell the stock
they previously purchased to other investors.
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 Exhibit 10.1 How Stock Markets Facilitate the Flow of
Funds

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 Ownership and Voting Rights

■ Owners of small companies also tend to be the

managers. In publicly traded firms, most shareholders are
not the managers.
■ Ownership of common stock entitles shareholders to a
number of rights.
 Normally, only the owners of common stock are permitted
to vote on certain key matters concerning the firm.
 Many investors assign their vote to management
through the use of a proxy.

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 Preferred Stock

■ Preferred stock represents an equity interest in a firm that

usually does not allow for significant voting rights.
■ Preferred shareholders share the ownership of the firm with
common shareholders and are therefore compensated
only when earnings have been generated.
■ A cumulative provision on most preferred stock prevents
dividends from being paid on common stock until all preferred
stock dividends have been paid.
■ Because the dividends on preferred stock can be omitted, a
firm assumes less risk when issuing it than when issuing
bonds.
■ Dividends are not tax-deductible for the firm, making preferred
stock less desirable than bonds.
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 Participation in Stock Markets

■ How Investor Decisions Affect Stock Prices

 When there is a shift in the demand for shares or the supply of
shares for sale, the equilibrium price changes.
 Overall, the prevailing market price is determined by the
participation of investors in aggregate.
■ Investor Reliance on Information
 In general, favorable news about a firm’s performance will make
investors believe that the firm’s stock is undervalued at its
prevailing price.
 Information is incorporated into stock prices through its impact
on investors’ demand for shares and the supply of shares for sale
by investors.

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 Exhibit 10.2 Institutional Use of Stock Markets

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 Initial Public Offerings

A first-time offering of shares by a specific firm to the public.

1. Process of Going Public
a. The issuer must develop a prospectus containing detailed
information about the firm, including financial statements and a
discussion of risks. The prospectus is filed with the Securities
and Exchange Commission (SEC).
b. The lead underwriter must determine the offer price at which the
shares will be offered at the time of the IPO.
c. 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.
d. Transaction Costs - Usually 7 percent of the funds raised.
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 Exhibit 10.3 Summary of Bookbuilding Process Just
before the IPO

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 Initial Public Offerings

2. Underwriter Efforts to Ensure Price Stability

a. Underwriters may attempt to stabilize the stock’s price by
purchasing shares that are for sale in the secondary
market shortly after the IPO.
b. Lockup
i. Prevents the original owners of the firm and the VC
firms from selling their shares for a specified period.
ii. Prevents downward pressure that could occur if the
original owners or VC firms immediately sold
their shares in the secondary market.
3. Timing of IPOs
Initial public offerings tend to occur more frequently
during bullish stock markets.
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 Initial Public Offerings

4. Initial Returns of IPOs

a. The initial (first-day) return of IPOs in the United States
has averaged about 20 percent over the last 30 years.
b. Flipping Shares
i. Investors flip shares by buying the stock at its offer
price and selling the stock shortly afterward.
ii. If many institutional investors flip their shares, the
market price of the stock may decline shortly after
the IPO.

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 Initial Public Offerings

5. Google’s IPO
a. On August 18, 2004, Google engaged in an IPO that generated
$1.6 billion.
b. Estimating the Stock’s Value - investors multiplied Google’s
earnings per share by Yahoo!’s price-earnings ratio.
c. Google’s Communication to Investors before the IPO - Google
provided substantial financial information about its operations and
recent performance.
d. The Auction Process – Google used a Dutch auction process
allowing all investors to submit a bid for its stock by a specific
deadline.
e. Results of Google’s Dutch Auction - resulted in a price of $85
per share.
f. Trading after the Auction - took place in the secondary
18 market.
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 Initial Public Offerings

6. Abuses in the IPO Market

a. Spinning - occurs when the underwriter allocates shares from an
IPO to corporate executives who may be considering an IPO or to
another business that will require the help of a securities firm.
b. Laddering - brokers encourage investors to place first-day bids
for the shares that are above the offer price. This helps to build
upward price momentum investors multiplied Google’s earnings
per share by Yahoo!’s price-earnings ratio.
c. Excessive Commissions - 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.

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 Initial Public Offerings

7. Long-Term Performance Following IPOs

a. There is strong evidence that, on average, IPOs of firms perform
poorly over a period of a year or longer.
b. From a long-term perspective, many IPOs are overpriced at the
time of the issue.
c. This weak performance may be partially attributed to irrational
valuations at the time of the IPO, which are corrected over time.
8. Impact of the Sarbanes-Oxley Act on IPOs
a. Requires that a firm have an internal control process in place one
year before going public.
b. Since it went into effect, investors have made their decisions
based on financial information rather than hype.
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 Stock Offerings and Repurchases

1. Secondary Stock Offerings

a. A secondary stock offering is a new stock offering by a specific
firm whose stock is already publicly traded.
b. Corporations sometimes direct their sales of stock toward their
existing shareholders by giving them preemptive rights.
c. Shelf Registration - Corporations can publicly place securities
without the time lag often caused by registering with the SEC.
2. Stock Repurchases
a. Firms tend to repurchase some of their shares when share prices
are at very low levels.
b. 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.
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 Stock Exchanges

1. Organized Exchanges
a. Each organized exchange has a trading floor where floor
traders execute transactions in the secondary market for
their clients.
b. New York Stock Exchange (NYSE) is by far the largest with
two broad types of members.
i. Floor brokers are either commission brokers or
independent brokers.
ii. Specialists can match orders of buyers and sellers.
c. Listing Requirements - minimum number of shares
outstanding and a minimum level of earnings, cash flow, and
revenue over a recent period.
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 Stock Exchanges

2. Over-the-Counter Market
a. Stocks not listed on the organized exchanges are traded in the
over-the-counter (OTC) market.
b. Nasdaq - National Association of Securities Dealers Automatic
Quotations (Nasdaq), which is an electronic quotation system that
provides immediate price quotations.
c. OTC Bulletin Board - lists stocks that have a price below $1 per
share, which are sometimes referred to as penny stocks.
d. Pink Sheets - The OTC market has where even smaller stocks are
traded. Some of the stocks have very little trading volume and
may not be traded at all for several weeks.

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 Stock Exchanges

3. Extended Trading Sessions

a. The NYSE and Nasdaq market offer extended trading
sessions beyond normal trading hours.
b. Market liquidity during the extended trading sessions
is
limited.

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 Stock Exchanges

4. Stock Quotations Provided by Exchanges

a. 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.
b. Symbol - Each stock has a specific symbol that is used to
identify
the firm.
c. Dividend - The annual dividend (DIV) is commonly listed to the
right of the firm’s name and symbol.
d. Dividend Yield - Annual dividend per share as a percentage of
the stock’s prevailing price. Shown next to the annual dividend.
e. Price-Earnings Ratio - 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.
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 Exhibit 10.4 Example of Stock Price Quotations

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 Stock Exchanges

4. Stock Quotations Provided by Exchanges (Cont.)

f. Volume - Stock quotations also usually include the volume of
shares traded on the previous day. The volume is normally
quoted in hundreds of shares.
g. 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.

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 Stock Exchanges

5. Stock Index Quotations

a. Dow Jones Industrial Average - value-weighted average of stock
prices of 30 large U.S. firms.
b. Standard & Poor’s 500 - a value-weighted index of stock prices
of 500 large U.S. firms.
c. Wilshire 5000 Total Market Index - index now contains more
than 5,000 stocks. The Wilshire 5000 is the broadest index of the
U.S. stock market.
d. New York Stock Exchange Indexes - The Composite Index is the
average of all stocks traded on the NYSE. NYSE also provides
indexes for four sectors: Industrial, Transportation, Utility,
Financial.
e. Nasdaq Stock Indexes - The National Association of Securities
Dealers (NASD) provides quotations on indexes of stocks traded
on the Nasdaq.
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 Monitoring Publicly Traded Companies

 The easiest way for shareholders to monitor the firm is to

monitor changes in its value (as measured by its share
price) over time.
 If the stock price is lower than expected, shareholders
may attempt to take action to improve the management
of the firm.
 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.

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 Monitoring Publicly Traded Companies

1. Role of Analysts
a.Analysts are often employed by securities firms and assigned
to monitor a small set of publicly traded firms.
b.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.
i. 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.
ii. 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.
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 Monitoring Publicly Traded Companies

2. Accounting Irregularities
a.In recent years, many firms used unusual accounting methods
to create their financial statements.
b.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.

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 Monitoring Publicly Traded Companies

3. Sarbanes-Oxley Act
a.Prevents a public accounting firm from auditing a client firm
whose chief executive officer (CEO), chief financial officer
(CFO), or other employees with similar job descriptions were
employed by the accounting firm within one year prior to
the audit.
b.Requires that only outside board members of a firm be on
the firm’s audit committee, which is responsible for making
sure that the audit is conducted in an unbiased manner.
c.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.
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 Monitoring Publicly Traded Companies

3. Sarbanes-Oxley Act (Cont.)

d.Requires that the CEO and CFO of firms of a specified size (or
larger) certify that the audited financial statements are accurate.
e. Specifies major fines or imprisonment for employees who mislead
investors or hide evidence.
f. Allows public accounting firms to offer nonaudit consulting
services to an audit client only if the client’s audit committee pre-
approves the nonaudit services to be rendered before the audit
begins.
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.

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 Monitoring Publicly Traded Companies

4. Shareholder Activism
a. If shareholders are displeased with the way managers are managing
a firm, they have three choices.
i. Do nothing and retain their shares.
ii. Sell the stock.
iii. Engage in shareholder activism
b.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.
c. Proxy Contest - Shareholders may also engage in proxy contests in
an attempt to change the composition of the board.
d.Shareholder Lawsuits - Investors may sue the board if they
believe that the directors are not fulfilling their responsibilities to
shareholders.
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 Monitoring Publicly Traded Companies

5. Limited Power of Governance

a.There is some evidence that the governance is not
very effective.
b.In spite of the Sarbanes-Oxley Act, shareholder activism,
proxy contests, and shareholder lawsuits, the agency
problems of some firms remain severe.

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 Market for Corporate Control

1. 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.
2. Barriers to the Market for Corporate Control
a.Antitakeover Amendments - an amendment may require that
at least two-thirds of the shareholder votes approve a
takeover.
b.Poison Pills - Special rights awarded to shareholders or
specific managers on the occurrence of specified
events.
c.Golden Parachutes - specifies compensation to managers in
the event that they lose their jobs or change in control of the
firm.
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 Globalization of Stock Markets

1. Privatization - In recent years, the governments of many

countries have allowed privatization, or the sale of
government-owned firms to individuals.
2. Emerging Stock Markets - Emerging markets enable
foreign firms to raise large amounts of capital by issuing
stock.
3. 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.
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 Globalization of Stock Markets

4. Methods Used to Invest in Foreign Stocks.

a.Direct Purchases - Investors can easily invest in stocks of foreign
companies that are listed on the local stock exchanges.
b.American Depository Receipts - 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.
c. International Mutual Funds - portfolios of international stocks
created and managed by various financial institutions.
d.International Exchange-Traded Funds - Passive funds that track
a specific index. International ETFs represent international stock
indexes, and they have become popular in the last few years.

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 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 4 to
7 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.
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 SUMMARY (Cont.)

 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.

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 SUMMARY (Cont.)

 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.
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