Lecture 7

Question 1

What is Public Placement?

Answer 1

• The public sale of shares are done via investment banks
• If it’s first time for a firm being listed in the stock market (IPO), it will be done by “Cash offers”
• The equity is offered to all investors in the market via cash

Question 2

What are the disadvantages of Public Placement?

Answer 2

• Equity holders become more widely dispersed; the firm must satisfy all the requirements of public companies
• Underpricing: The firm sets an offer price. Market opens and the firm’s shares trade at the offer price. When the market closes, the shares usually have a higher price. The difference is called “money left on the table”. Although the closing price is higher, it is still usually less than the true value of that firm.
• Overvaluation: “Adverse Selection Theory”
• Fear of financial distress: issuing shares may also signal that a firm might be in financial distress and thus, the firm prefers to issue equity than costly debt. Consequently, investors choose to pay less than the true value of the firm when buying shares.
• Overpricing: firm might fear that it will set the offering price too low and too much money will be left on the table on the first day of public offering. Hence, it decides on a higher offering price. But due to the reasons mentioned above, investors may not even trade on the offering price, pushing the closing price even lower.

Question 3

How do banks act as underwriters in Public Placement?

Answer 3

• They buy all the shares from the company directly
• The shares are purchased by investment banks at the day of public offering
• But at a lower price than the offering price because they take the risk of not being able to sell all shares
• Offering price - underwriter’s price = spread (discount) => way for underwriter to receive compensation for taking a risk
• Then, they either offer the shares:
  With a fixed price to the public → firm commitment
  Or via uniform price auction → dutch auction underwriting

Question 4

What is the underwriting spread?

Answer 4

Compensation underwriters typically receive for their services in helping a firm to issue new securities

Question 5

Who gets the “money left on the table” in the case of underpricing?

Answer 5

• Rights offers: it is still a public placement of firm’s shares. But this time, the firm’s shares are already traded in the stock market
• When the company decides to issue more new shares, it contacts investment banks. The announcement of these seasoned new shares are made in public; BUT, underwriters contact only the “current” shareholders of the firm
• The shares are offered at a price to the existing shareholders only for a limited period of time. If they decide to increase their ownership within the firm, they buy some of these seasoned new shares
• The unsold shares expire at the end of the offer period and stay within the firm

Question 6

What is Private Placement?

Answer 6

• Not all firms are big enough to be accepted in the public stock markets and also attract investors in those markets
• Some firms choose to issue their shares via private placement
• Contact some private equity firms which will act as underwriters
• Those underwriters sell the shares to institutional investors, insurance firms, mutual fund and pension fund companies