Module 2.3

Question 1

Private Equity

Answer 1

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 active secondary market.

Question 2

Financing by Venture Capital Funds

Answer 2

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.

Question 3

Financing by Venture Capital Funds (cont.)

Answer 3

Business Proposals Intended to Attract Venture Capital
Venture capital conferences bring 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.

Question 4

Exit and Performance Stategy of Venture Capital Funds

Answer 4

Exit Strategy of VC Funds
VC funds typically plan to exit in four to seven years by selling the equity stake to the public.
Performance of VC Funds
Tends to vary over time
Funds can be invested more wisely when stock prices are low
Also influenced by the amount of investment received by investors

Question 5

Financing by Private Equity Funds (cont.)

Answer 5

Private equity funds pool money provided by institutional investors (such as pension funds and insurance companies) and invest in businesses.
Use of Financial Leverage by Private Equity Funds
They also rely heavily on debt to finance their investments.
Performance of Private Equity Funds
Tends to vary over time
Funds can be invested more wisely when stock prices are low
May be especially prone to making bad investments when they receive large amounts of funds from investors

Question 6

Financing by Crowdfunding

Answer 6

Companies also have the option of trying to raise funds from a large number of investors through a process called “crowdfunding” over the Internet.
The founders of a company provide information about their business or project on an Internet platform.
Investors then can invest their funds in the projects of their choice.
Examples are Crowdfunder, Indiegogo, and Kickstarter.

Question 7

Public Equity

Answer 7

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). (Exhibit 10.1)
The secondary market allows investors to sell the stock they previously purchased to other investors.

Question 8

Ownership and Voting Rights

Answer 8

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.

Question 9

Preferred stock

Answer 9

— 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.

Question 10

Participation in Stock Markets

Answer 10

Investors can be classified as individual or institutional (Exhibit 10.2)
Individual investments commonly exceed 50% of the total equity.
Because of the size of investment, institutional investors can significantly affect stock market prices.

Question 11

How Investor Decisions Affect Stock Prices

Answer 11

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.

Question 12

Initial Public Offerings

Answer 12

A first-time offering of shares by a specific firm to the public.
Process of Going Public
Developing a Prospectus — 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).
Pricing and Bookbuilding — The lead underwriter must determine the offer price at which the shares will be offered at the time of the IPO.
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.
Transaction Costs — Usually 7% of the funds raised.

Question 13

Underwriter Efforts to Ensure Price Stability

Answer 13

Underwriters may attempt to stabilize the stock’s price by purchasing shares that are for sale in the secondary market shortly after the IPO.
Overallotment Option
Allows underwriter to allocate an additional 15% of the firm’s shares for a period of up to 30 days after the IPO.
Gives the lead underwriter the right to purchase those extra shares from the issuing firm at the IPO offer price.
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Question 14

Lockup

Answer 14

Prevents the original owners of the firm and the VC firms from selling their shares for a specified period.
Prevents downward pressure that could occur if the original owners or VC firms immediately sold their shares in the secondary market.
Timing of IPOs
Initial public offerings tend to occur more frequently during bullish stock markets.

Question 15

Initial Returns of IPOs

Answer 15

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

Question 16

Google’s IPO

Answer 16

On August 18, 2004, Google engaged in an IPO that generated $1.6 billion.
Estimating the Stock’s Value — Investors multiplied Google’s earnings per share by Yahoo!’s price-earnings ratio.
Google’s Communication to Investors before the IPO — Google provided substantial financial information about its operations and recent performance.
The Auction Process — Google used a Dutch auction process, allowing all investors to submit a bid for its stock by a specific deadline.
Results of Google’s Dutch Auction — Resulted in a price of $85 per share.

Question 17

Facebook’s IPO

Answer 17

On May 18, 2012, Facebook engaged in an IPO that generated $16 billion.
Facebook’s opening price was $38/share. The price fluctuated through the day with a high of about $43. Many traders lost experienced substantial profits are losses in the first day
Three months after the opening, the price fell to $20/share.
Lesson — A company can be very valuable yet overpriced.

Question 18

Abuses in the IPO Market

Answer 18

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.
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.

Question 19

Abuses in the IPO Market (cont.)

Answer 19

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.
Distorted Financial Statements — Even though financial statements summarize revenue, expenses, and financial condition, accountants still have much flexibility in their reporting process, and therefore still can exaggerate earnings.

Question 20

Long-Term Performance Following IPOs

Answer 20

There is strong evidence that, on average, IPOs of firms perform poorly over a period of a year or longer.
From a long-term perspective, many IPOs are overpriced at the time of the issue.
This weak performance may be partially attributed to irrational valuations at the time of the IPO, which are corrected over time.

Question 21

Stock Offerings and Repurchases

Answer 21

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

Question 22

Organized Exchanges

Answer 22

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

Question 23

Over-the-Counter Market

Answer 23

Stocks not listed on the organized exchanges are traded in the over-the-counter (OTC) market.
Nasdaq — National Association of Securities Dealers Automatic Quotations (Nasdaq), which is an electronic quotation system that provides immediate price quotations.
OTC Bulletin Board — Lists stocks that have a price below $1 per share, which are sometimes referred to as penny stocks.
Pink Sheets — The OTC market is 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.

Question 24

Extended Trading Sessions

Answer 24

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

Question 25

Stock Quotations Provided by Exchanges

Answer 25

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. Symbol — Each stock has a specific symbol that is used to identify the firm. Dividend — The annual dividend (DIV) is commonly listed to the right of the firm’s name and symbol. Dividend Yield — Annual dividend per share as a percentage of the stock’s prevailing price. Shown next to the annual dividend. 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.

Question 26

Stock Quotations Provided by Exchanges (Cont.)

Answer 26

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

Question 27

Stock Index Quotations

Answer 27

Dow Jones Industrial Average — Value-weighted average of stock prices of 30 large U.S. firms. Standard & Poor’s 500 — A value-weighted index of stock prices of 500 large U.S. firms. 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. 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. Nasdaq Stock Indexes — The National Association of Securities Dealers (NASD) provides quotations on indexes of stocks traded on the Nasdaq.

Question 28

Private Stock Exchanges

Answer 28

Prior to an IPO, some private firms list their private shares on a private stock exchange. Advantages Allows owners to obtain cash. Purchasers may be able to pay a lower price than when a firm goes with IPO. Disadvantages Investors need to register with the private exchange and prove that they have sufficient income Limited information available to investor. Little may be known on how firm was valued. Trading volume is limited.

Question 29

Monitoring Publicly Traded Companies

Answer 29

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.

Question 30

Role of Analysts

Answer 30

Analysts are often employed by securities firms and assigned to monitor a small set of publicly traded firms. 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. 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. 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.

Question 31

Accounting Irregularities

Answer 31

In recent years, many firms used unusual accounting methods to create their financial statements. 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.

Question 32

Sarbanes-Oxley Act

Answer 32

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. 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. 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

Question 33

Sarbanes-Oxley Act (Cont.)

Answer 33

Requires that the CEO and CFO of firms of a specified size (or larger) 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 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.

Question 34

Shareholder Activism

Answer 34

If shareholders are displeased with the way managers are managing a firm, they have three choices: Do nothing and retain their shares. Sell the stock. Engage in shareholder activism 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. Proxy Contest — Shareholders may also engage in proxy contests in an attempt to change the composition of the board. Shareholder Lawsuits — Investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders.

Question 35

Limited Power of Governance

Answer 35

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

Question 36

Market for Corporate Control

Answer 36

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

Question 37

Globalization of Stock Markets (

Answer 37

Privatization — In recent years, the governments of many countries have allowed privatization, or the sale of government-owned firms to individuals. Emerging Stock Markets — Emerging markets enable foreign firms to raise large amounts of capital by issuing stock. 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.

Question 38

Methods Used to Invest in Foreign Stocks.

Answer 38

Direct Purchases — Investors can easily invest in stocks of foreign companies that are listed on the local stock exchanges. 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. International Mutual Funds — Portfolios of international stocks created and managed by various financial institutions. 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.