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Chapter 10

Stock Offerings and Investor Monitoring

Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline Background on stock Initial public offerings Secondary stock offerings Stock exchanges Investor participation in the secondary market Monitoring by investors The corporate monitoring role Globalization of stock markets

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Background on Stocks A stock is a certificate representing partial ownership in a

corporation Stock is issued by firms to obtain long-term funds Owners of stock:

Can benefit from the growth in the value of the firm Are susceptible to large losses

Individuals and financial institutions are common purchasers of stock

The primary market enables corporations to issue new stock The secondary market creates liquidity for investors who invest in

stock Some corporations distribute earnings to investors in the form of

dividends

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Background on Stocks (cont’d) Ownership and voting rights

The owners are permitted to vote on key matters concerning the firm:

Election of the board of directors Authorization to issue new shares Approval of amendments to the corporate charter Adoption of bylaws

Voting is often accomplished by proxy Management typically receives the majority of the

votes and can elect its own candidates as directors

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Background on Stocks (cont’d) Preferred stock

Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights

A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid

Preferred stock is less risky because dividends on preferred stock can be omitted

Preferred stock is a less desirable source of funds than bonds because:

Dividends are not tax deductible Investors must be enticed to purchase the preferred stock since

dividends do not legally have to be paid

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Background on Stocks (cont’d)

Issuer participation in stock markets The ownership feature attracts many investors who

want to have an equity interest but do not necessarily want to manage their own firm

A firm issuing stock for the first time engages in an IPO

If a firm issues additional stock after the IPO, it engages in a secondary offering

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Initial Public Offerings

An IPO is a first-time offering of shares by a specific firm to the public

Usually, a growing firm first obtains private equity funding from VC firms

An IPO is used to obtain new funding and to offer VC firms a way to cash in their investment Many VC firms sell their shares in the secondary

market between 6 and 24 months after the IPO

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Initial Public Offerings (cont’d) Process of going public

An investment banking firm normally serves as the lead underwriter for the IPO

Developing a prospectus The issuing firm develops a prospectus and files it with the SEC The prospectus contains detailed information about the firm and

includes financial statements and a discussion of risks The prospectus is intended to provide investors with the

information they need to decide whether to invest in the firm Once approved by the SEC, the prospectus is sent to institutional

investors Underwriters and managers meet with institutional investors in the

form of a “road show”

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Initial Public Offerings (cont’d) Process of going public (cont’d)

Pricing The offer price is determined by the lead underwriter During the road show, the number of shares demanded at

various prices is assessed Bookbuilding

In some countries, an auction process is used for IPOs Transaction costs

The issuing firm typically pays 7 percent of the funds raised The lead underwriter typically forms a syndicate with other

firms who receive a portion of the transaction costs

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Initial Public Offerings (cont’d)

Underwriter efforts to ensure price stability The lead underwriter’s performance can be measured by the

movement in the IPO shares following the IPO If stocks placed by a securities firm perform poorly, investors may

no longer purchase shares underwritten by that firm The underwriter may require a lockup provision

Prevents the original owners from selling shares for a specified period

Prevents downward pressure When the lockup period expires, the share price commonly

declines significantly

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Initial Public Offerings (cont’d) Timing of IPOs

IPOs tend to occur more frequently during bullish stock markets

Prices are typically higher In the 2000–2001 period, many firms withdrew their IPO plans

Initial returns of IPOs First-day return averaged about 20 percent over the last 30 years In 1998, the mean one-day return for Internet stocks was 84

percent Most IPO shares are offered to institutional investors About 2 percent of IPO shares are offered as allotments to

brokerage firms

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Initial Public Offerings (cont’d) Abuses in the IPO market

In 2003, regulators attempted to impose new guidelines that would prevent abuses

Spinning is the process in which an investment bank allocated IPO shares to executives requiring the help of an investment bank

Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand

Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO

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Initial Public Offerings (cont’d)

Long-term performance following IPOs IPOs perform poorly on average over a period of a

year or longer Many IPOs are overpriced at the time of issue Investors may be overly optimistic about the firm Managers may spend excessively and be less efficient with

the firm’s funds than they were before the IPO

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Secondary Stock Offerings A secondary stock offering is:

A new stock offering by a firm whose stock is already publicly traded

Undertaken to raise more equity to expand operations Usually facilitated by a securities firm

In the late 1990s, the volume of publicly placed stock increased substantially

From 2000 to 2002, the volume of publicly placed stock declined as a result of the weak economy

Existing shareholders often have the preemptive right to purchase newly-issued stock

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Secondary Stock Offerings (cont’d)

Shelf-registration A corporation can fulfill SEC requirements up to two

years before issuing new securities Allows firms quick access to funds Potential purchasers must realize that information

disclosed in the registration is not continually updated

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Stock Exchanges

Stock trading between investors occurs on an organized stock exchange or on the over-the-counter (OTC) market

Organized exchanges Includes the NYSE and AMEX The NYSE controls 80 percent of the value of all

organized exchange transactions There are 1,366 seats Floor brokers and specialists are members of the NYSE

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Stock Exchanges (cont’d) Organized exchanges (cont’d)

Trading floor Consists of trading posts and trading booths 20 trading posts are maintained by specialists and their clerks There are 1,500 trading booths along the perimeter of the floor

where brokers obtain orders Listing requirements

NYSE requirements include number of shares outstanding, minimum level of earnings, cash flow, and revenue

Minimum number of shares ensures adequate liquidity Exchanges charge a listing fee, which depends on the size of the

firm

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Stock Exchanges (cont’d)

Over-the-counter market Buy and sell orders are completed through a

telecommunications network Nasdaq

The Nasdaq is an electronic quotation system that provides immediate price quotations

Firms must meet requirements on minimum assets, capital, and number of shareholders

Transaction costs as a percentage of the investment tend to be higher on Nasdaq than on the NYSE

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Stock Exchanges (cont’d)

Over-the-counter market (cont’d) Nasdaq (cont’d)

Nasdaq components are: Nasdaq National Market Nasdaq Small Cap Market

More stocks are listed on Nasdaq than on NYSE The market value of stocks listed on Nasdaq is smaller

than stocks listed on the NYSE

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Stock Exchanges (cont’d)

Over-the-counter market (cont’d) OTC Bulletin Board

Lists stocks that have a price below $1 per share (penny stocks) More than 3,500 stocks are listed Stocks are mostly traded by individual investors

Pink sheets Lists stocks smaller than those listed on the OTC Bulletin Board Contains about 20,000 stocks Families and officers of the firms commonly control much of the

stock

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Stock Exchanges (cont’d)

Extended trading sessions The NYSE, AMEX, and Nasdaq markets all offer extended

trading sessions Late trading sessions enable investors to buy or sell stocks

after the market closes An early morning session enables investors to buy or sell

stock just before the market opens on the following day Total trading volume of widely traded stocks is typically about

5 percent or less of the trading volume during the day ECNs also allow for trading at any time

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Stock Exchanges (cont’d)

Stock quotations provided by exchanges The format varies among newspapers, but most

provide similar information: 52-week price range Symbol Dividend Dividend yield Price-earnings ratio Volume Previous day’s price quotations

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Computing A Dividend YieldXYZ Corporation annual dividend is $1.02 per share. XYZ’s prevailing stock price is $20. What is the annual dividend yield of XYZ stock?

%10.520$02.1$

price stock Prevailingshare per paid Dividends yieldDividend

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Stock Exchanges (cont’d)

Stock index quotations The Dow Jones Industrial Average (DJIA) is a price-weighted

average of stock prices of 30 large U.S. firms Assigns a higher weight over time to those stocks that experience

higher prices Does not necessarily serve as an adequate indicators of the

overall market The Standard and Poor’s (S&P) 500 is a value-weighted index

of stock prices of 500 large U.S. firms Does not serve as a useful indicator for stock prices of smaller

firms

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Stock Exchanges (cont’d) Stock index quotations (cont’d)

Wilshire 5000 Total Market Index Created in 1974 to reflect the values of 5,000 U.S. stocks Represents the broadest index of the U.S. stock market Closely monitored by the Federal Reserve

New York Stock Exchange Indexes The Composite Index represents the average of all stocks

traded on the NYSE Sector indexes:

Industrial Transportation Utility Financial

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Stock Exchanges (cont’d)

Stock index quotations (cont’d) Other stock indexes

AMEX indexes Nasdaq indexes

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Investor Participation in the Secondary Market The price of a firm’s stock represents the value of the

firm per share of stock:

The stock price by itself does not clearly indicate the firm’s value

The return on the investment is determined by dividends received and the price of the stock from the time when they purchased the shares until they sell them

shares of Numberfirm of Valueprice Stock

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Investor Participation in the Secondary Market (cont’d) How investor decisions affect the stock price

Investors buy or sell shares based on their valuation of the stock relative to the prevailing market price

Investors arrive at different valuations which means there will be buyers and sellers at a given point in time

As investors change their valuations of a stock, there is a shift in the demand for and supply of shares and the equilibrium price changes

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Investor Participation in the Secondary Market (cont’d) How investor decisions affect the stock price

(cont’d) Investor reliance on information

Favorable news increases the demand for and reduces the supply of the security

Unfavorable news reduces the demand for and increases the supply of the security

Investors continually respond to new information in their attempt to purchase or sell stocks

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Investor Participation in the Secondary Market (cont’d) Types of investors

Individual investors typically hold more then 50 percent of the total equity in a large corporation

Ownership is scattered Institutional investors have large equity positions in

corporations and have more voting power Can influence corporate policies through proxy contests Insurance companies, pension funds, and stock mutual funds are

common purchasers of newly issued stock in the primary market The collective sales and purchases of stocks by institutions can

significantly affect stock market prices

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Type of Financial Institution

Participation in Stock Markets

Commercial banks Issue stock Manage trust funds

Stock-owned savings institutions

Issue stock to boost their capital base

Savings banks Invest in stocks for their investment portfolios

Finance companies Issue stock

Stock mutual funds Use the proceeds from selling shares to invest in stocks

Securities firms Issue stock Place new issues of stockOffer advice to corporations that consider acquiring stock companiesExecute buy and sell orders

Insurance companies Issue stockInvest a large proportion of their premiums in the stock market

Pension funds Invest a large proportion of pension fund contributions in the stock market

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Monitoring by Investors

Managers serve as agents for shareholders to maximize the stock price

Managers may be tempted to serve their own interests rather than those of investors

Shareholders monitor their stock’s price movements to assess whether the managers are achieving their goal When the stock price declines or does not rise as high as

shareholders expected, shareholders may blame the weak performance on the firm’s managers

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Monitoring by Investors (cont’d)

Accounting irregularities To the extent that firms can manipulate financial

statements they may be able to hide information from investors

e.g., Enron, Tyco, and WorldCom The auditors hired to audit financial statements

allowed them to use unusual accounting methods Board members on the audit committee were not always

monitoring the audit

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Monitoring by Investors (cont’d)

The Sarbanes-Oxley Act: Was implemented in 2002 to ensure more accurate disclosure

of financial information to investors Attempts to force accountants of a firm to conform to regular

accounting standards Attempts to force auditors to take their auditing role seriously Prevents a public accounting firm from auditing a client whose

CEO, CFO, or other employees are employed by the client firm within one year prior to the audit

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Monitoring by Investors (cont’d) The Sarbanes-Oxley Act:

Requires that only outside board members of a firm be on the firm’s audit committee

Prevents the members of a firm’s audit committee from receiving consulting or advising fees from the firm

Requires that the CEO and CFO of firms that are of at least a specified size level to certify that the audited financial statements are accurate

Specifies major fines or imprisonment for employees who mislead investors or hide evidence

Allows public accounting firms to offer non-audit consulting services to an audit client only if the client pre-approves those services

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Monitoring by Investors (cont’d)

Shareholders activism Communication with the firm

Shareholders can communicate their concerns to other investors to place more pressure on managers or its board members

Institutional investors commonly communicate with high-level corporate managers and offer their concerns

Institutional Shareholder Serves (ISS) Inc. is a firm that organizes institutional shareholders to push for a common cause

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Monitoring by Investors (cont’d)

Shareholders activism (cont’d) Proxy contest

Normally considered only if an informal request for a change in the board is ignored

If dissident shareholders gain enough votes, they can elect one or more directors who share their views

As a result of a more organized effort, institutional shareholders are more influential on management decisions

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Monitoring by Investors (cont’d) Shareholders activism (cont’d)

Shareholder lawsuits Investors may sue the board if they believe that the

directors are not fulfilling their responsibilities to shareholders

Lawsuits are often filed when corporations prevent takeovers, pursue acquisitions, or make other restructuring decisions that shareholders believe will reduce the stock’s value

When directors are sued, courts typically focus on whether the director’s decision seems reasonable, rather than on whether the decision led to higher profitability

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The Corporate Monitoring Role

If managers believe their stock is undervalued in the market, they may take actions to capitalize on this discrepancy

Stock repurchases Use excess cash to purchase shares in the market

at a low price Stock prices respond favorably to stock repurchase

announcements

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The Corporate Monitoring Role (cont’d) Market for corporate control

A firm may engage in acquisitions to increase the value of a target firm

Can also create synergistic benefits A high stock price is useful to exchange acquirer shares for

target shares Share prices of target firms react very positively Leveraged buyouts

LBOs are acquisitions that require substantial amounts of borrowed funds

A reverse LBO is desirable when the stock can be sold at a high price

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The Corporate Monitoring Role (cont’d) Barriers to corporate control

Antitakeover amendments are designed to protect shareholders against an acquisition that will ultimately reduce the value of their investment in the firm

e.g., may require at least two-thirds of shareholder votes to approve a takeover

Poison pills are special rights awarded to shareholders or specific managers upon specified events

e.g., the right for all shareholders to be allocated an additional 30 percent of all shares without cost whenever a potential acquirer attempts to acquire the firm

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The Corporate Monitoring Role (cont’d) Barriers to corporate control (cont’d)

A golden parachute specifies compensation to managers in the event that they lose their jobs

e.g., all managers have the right to receive 100,000 shares of the firm’s stock whenever the firm is acquired

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Globalization of Stock Markets Barriers between countries have been removed or

reduced Firms in need of funds can tap foreign markets Investors can purchase foreign stocks

Foreign stock offerings in the U.S. Large privatization programs in Latin America and Europe can

not be digested in local markets By issuing stock in the U.S., foreign firms diversify their

shareholder base SEC regulations may prevent some firms from offering stock in

the U.S. Some foreign firms use American depository receipts (ADRs)

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Globalization of Stock Markets (cont’d) International placement process

Many U.S. investment banks and commercial banks provide underwriting services in foreign countries

Listing on a foreign stock exchange: Enhances the liquidity of the stock May increase the firm’s perceived financial standing Can protect the firm against hostile takeovers Entails some costs

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Globalization of Stock Markets (cont’d) Global stock exchanges

Recently, stocks outside the U.S. have been issuing stock more frequently

The percentage of individual versus institutional ownership varies across countries

Emerging stock markets: Enable foreign firms to raise large amounts of capital by issuing stock Provide a means for investors from other countries to invest their

funds May not be as efficient as the U.S. stock market May exhibit high returns and high risk May be volatile because of fewer shares and trading based on rumors

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Globalization of Stock Markets (cont’d) Methods used to invest in foreign stocks

Direct purchases involves directly buying stock of foreign companies listed on the local stock exchanges

American depository receipts are attractive because:

They are closely followed They are required to file financial statements with the SEC They are quoted reliably

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Globalization of Stock Markets (cont’d) Methods used to invest in foreign stocks

(cont’d) International mutual funds are portfolios of

international stocks created and managed by various financial institutions

World equity benchmark shares represent indexes that reflect composites of stocks for particular countries that can be purchased or sold