The Public Issues and Markets

The Public Issue The Basic Procedure

– Management gets the approval of the Board of Directors.

– The firm prepares and files a registration statement with the SEC.

– The SEC studies the registration statement during the waiting period.

– The firm prepares and files an amended registration statement with the SEC.

– If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway.

Alternative Issue Methods

There are two kinds of public issues:– The general cash offer– The rights offer

Almost all debt is sold in general cash offerings.

The Cash Offer

There are two methods for issuing securities for cash:– Firm Commitment– Best Efforts

There are two methods for selecting an underwriter– Competitive– Negotiated

Firm Commitment Under a firm commitment underwriting, the

investment bank buys the securities outright from the issuing firm.

Obviously, they need to make a profit, so they buy at “wholesale” and try to resell at “retail”.

To minimize their risk, the investment bankers combine to form an underwriting syndicate to share the risk and help sell the issue to the public.

Best Efforts Under a best efforts underwriting, the

underwriter does not buy the issue from the issuing firm.

Instead, the underwriter acts as an agent, receiving a commission for each share sold, and using its “best efforts” to sell the entire issue.

This is more common for initial public offerings than for seasoned new issues.

Mechanics of Rights Offerings The management of the firm must decide:

– The exercise price (the price existing shareholders must pay for new shares).

– How many rights will be required to purchase one new share of stock.

These rights have value:– Shareholders can either exercise their

rights or sell their rights.

Rights Offering Example Popular Delusions, Inc. is proposing a rights

offering. There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new shares issued at a $20 subscription price.

What is the new market value of the firm?

What is the ex-rights price?

What is the value of a right?

Rights Offering Example What is the new market value of the firm?

There are 200,000 outstanding shares at $25 each.There will be 10,000 new shares issued at a $20 subscription price.

shares

20$shares 000,10

share

25$shares 000,200000,200,5$

Rights Offering Example What is the ex-rights price?

There are 210,000 outstanding shares of a firm with a market value of $5,200,000.

Thus the value of an ex-rights share is:

7619.24$shares 000,210

000,200,5$

• Thus the value of a right is $0.2381 = $25 – $24.7619

Private Placements Avoid the costly procedures associated with

the registration requirements that are a part of public issues.

The SEC restricts private placement issues or no more than a couple of dozen knowledgeable investors including institutions such as insurance companies and pension funds.

The biggest problem is that the securities cannot be easily resold.

Public offering vs. Private Placements

Venture Capital The limited partnership is the dominant form

of intermediation in this market.

There are four types of suppliers of venture capital:1. Old-line wealthy families.2. Private partnerships and corporations.3. Large industrial or financial corporations have

established venture-capital subsidiaries.4. Individuals, typically with incomes in excess of

$100,000 and net worth over $1,000,000. Often these “angels” have substantial business experience and are able to tolerate high risks.

Stages of Financing

1. Seed-Money Stage: Small amount of money to prove a concept or develop a product.

2. Start-Up : Funds are likely to pay for marketing and product refinement.

3. First-Round Financing : Additional money to begin sales and manufacturing.

Stages of Financing4. Second-Round Financing : Funds

earmarked for working capital for a firm that is currently selling its product but still losing money.

5. Third-Round Financing : Financing for a firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing.

6. Fourth-Round Financing : Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing.

Summary and Conclusions Larger issues have proportionately much

lower costs of issuing equity than small ones.

Firm-commitment underwriting is far more prevalent for large issues than is best-effort underwriting. Smaller issues probably use best effort because of the greater uncertainty.

Rights offering are cheaper than general cash offers.

Venture capitalists are an increasingly important influence in start-up firms and subsequent financing.

Market is any mean through which buyers and seller are

brought together to transfer goods and services

Market structure characteristics;

Price-driven (Pure auction market) : when buyers and sellers submit their bid and ask prices to a central location and transactions are matched by brokers who do not have a position in the stock.

Order-driven (Dealer market) : when buyer and sellers submit their orders to dealers, who either buy the stock for their own inventory or sell the stock from their own inventory.

Market The characteristics of a well-functioning securities market

1.Provide timely and accurate information on the price

and volume of past transactions and on the supply of

and demand for current goods and services

2.Provide liquidity

2.1 marketability : being able to sell quickly

2.2 price continuity : prices not change much from a

transaction to the next in the absence of new news.

2.3 Depth : numerous buyers and seller willing to trade.

3. Internal efficiency : the lowest possible transaction costs.

4. External efficiency : prices rapidly adjust to new

information so that the prevailing market price reflects all

available information regarding the asset.

Markets are also categorized as primary or secondary.

Primary markets : relate to the sale of new issues of securities. They are markets for “ Initial Public Offering (IPO) ”

Secondary markets : are place where securities trade or exchange after their IPO. The secondary markets play an important role for liquidity.

Market

Broker : an entity that acts as the agent of an investor who wishes to execute orders.

Dealer : an entity that stands ready and willing to either buy stocks for its own account or sell from its account.

Bid : willingness to buy a security at a given price. Offer : willingness to sell a security at a given price.

Dealers always take advantages on “spread” between Bid and Offer. They buy cheap and sell expensive.

Market

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Over-the-counter (OTC) : a market where listed stocks and unlisted stocks are traded by multiple market makers.

US markets : 1. The National security exchanges : i.e. NYSE , AMEX

2. Regional security exchanges : i.e. Midwest, Pacific, Philadelphia, Boston, and Cincinnati.

3. OTC market : i.e. NASDAQ

Market

Efficient Capital Markets

An efficient capital market is one in which stock prices fully reflect available information.

The efficient capital market has implications for investors and firms.

– Since information is reflected in security prices quickly, knowing information when it is released does an investor no good.

– Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.

Reaction of stock price to new information in efficient and inefficient Markets

Stock Price

-30 -20 -10 0 +10 +20 +30Days before (-) and

after (+) announcement

Efficient market response to “good news”

Overreaction to “good news” with reversion

Delayed response to

“good news”

Reaction of stock price to new information in efficient and inefficient Markets

Stock Price

-30 -20 -10 0 +10 +20 +30

Days before (-) and after (+)

announcement

Efficient market response to “bad news”

Overreaction to “bad news” with reversion

Delayed response to “bad news”

The different types of efficiency Weak Form

– Security prices reflect all information found in past prices and volume.

Semi-Strong Form– Security prices reflect all publicly

available information.

Strong Form– Security prices reflect all information—

public and private.

Weak Form Market Efficiency Security prices reflect all information found in

past prices and volume.

If the weak form of market efficiency holds, then technical analysis is of no value.

Often weak-form efficiency is represented as

Pt = Pt-1 + Expected return + random error t

Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.

Semi-Strong Form Market Efficiency Security Prices reflect all publicly

available information.

Publicly available information includes:

– Historical price and volume information

– Published accounting statements.

– Information found in annual reports.

Strong Form Market Efficiency Security Prices reflect all information—public

and private.

Strong form efficiency reflected weak and semi-strong form efficiency.

Strong form efficiency says that anything related to the stock and known to at least one investor is already incorporated into the security’s price.

Relationship among three different information sets

All informationrelevant to a stock

Information setof publicly available

information

Informationset of

past prices

Market Orders : an order executed at the best price available in the market.

Limit Orders : an conditional order which be executed only if the limit price or a better price can be obtained.– Buy limit order : means that stock may be

purchased only at the designated price or lower.

– Sell limit order : means that stock may be sold only at the designated price or higher.

Types of Orders

Price-weighted : an arithmetic average of current prices ;therefore, index is influenced by the differential prices of its components. i.e. Dow Jones Industrial average 30(DJIA), Nikkei 225

Index and Benchmark

Pit

Dadj

DJIAt = i=1

30

DJIAt = the value of the DJIA on day t

Pit = the closing price of stock i on day t

Dadj = the adjusted divisor on day t

Value-weighted : compares market value (number of shares outstanding x current price) at time t with market value on the base day. i.e. SET Index.

Index and Benchmark

PtQt

PbQb

x Beginning Index ValueIndext =

Indext = Index value on day t

Pt = the ending prices of stocks on day t

Qt = the number of outstanding shares on day t

Pb = the ending prices of stocks on base day

Qb = the number of outstanding shares on base day

S&P indexes are committee driven whereas Russell’s indexes are completely formula driven.

S&P indexes are market-cap weighted, whereas Russell’s are market-float weighted. Cap weighted is more transparent than float weighted since determining the number of shares outstanding is easier than determining those available for purchase.

S&P rebalances its indexes continuously – when a company goes out of business or is acquired, S&P finds a replacement. In contrast to Russell which makes all index changes once a year (on June 30).

S&P indexes vs. Russell’s indexes