The direct and indirect costs of conducting an IPO
Direct costs
The commissions and fees to the investment banks and stock brokers involved in the issue. In uk, the sponsor charges 2% of the money to be raised in the issue. In US, the underwriter spread is often 7% of IPO proceeds.
Fee payable to: lawyers, accountants, public relations companies, registrars.
Costs of printing and distributing the prospectus
The costs of advertising
The substantial part of these costs are independent of the size of the company and how much intends to raise through the issue.
Direct costs –fraction of proceeds are lower for larger scale
Indirect costs
The value of the IPO was intentionally set below the true value. Therefore, it is possible to make either at loss or gain from investing ipos.
The typical succession of finance resources over the lifestyle of a business
In early stage. External finance is likely come from entrepreneurs, family , friends, business angles.
2: funding from venture capitalist providers-from any form of equity finance to unquoted
3:later stage: equity finance to fund further company expansion: buyout/going private transaction
4:time to access the public debt to equity markets (company’s shares begin to be traded on stock exchange. To raise external equity, company can issue shares at the time of flotation through IPO. It can also issue shares after flotation through a seasoned equity offering.
Private equity can help to bridge the financing gap that exists for companies that have passed the earliest stage and require more funding that can be provided by friends and family (supplemented by st bank loans) but that are not yet mature enough to float on the stock market.
The long-term underperformace of IPO and SEO
According to the findings by Khurshed(), there is some relationship between IPO and post IPO performance of the firms:
1) The more profitable of a UK company before the ipo, the worse its post ipo long run performace
2) The larger the size of the firm, the better its long-run performance
3) The higher the stake sold by the insiders at the time of ipo, the worse is the post ipo performance.
Theoretical explanation for the long run underpeformance of ipos
1) Behavoural and expectations-based
2) Agency costs hyp
3) Mismeasurement
1)A hypothesis that companies priced at the upper end of the initial price range perform better than those priced at the lower end, but no support is found.
Underperformace is due to failure to include the value of legal damages in performance evaluation. But further study pointed out that the risk of litigation s not significant
Price support hypothesis is based on the assumption that underwriters keep the initial trading prices artificially high and once the price support has been withdrawn the prices will adjust downwards to true market velue. One study has been suggested that the prices are set by marginal, most optimistic investor. As information flow increases with time, the divergence of expectations decrease and thus the prices are adjusted downwards. Long rum performance is negatively related to the extent of the divergence of opinion.
Further studies argue that firms go pubic when investors are optimistic about the growth prospect of IPO companies. This means that investors overpay initially but mark price down as more infor is available.
2)The agency cost hypothesis
Studies has been found that (by mikkelson et al) the long run performance within one year of offering and during the first ten years of public trading is unrelated to ownership structure. However, jain and kini found a significant relation between post ipo operating performance and equity retention by original shareholders.
3)mis measurement
Mismeasurement either because risk is not property controlled for, or due to the problems related to measurement of returns over long horizons Underperformance can also be caused by wrong choice of benchmark. The hypothesis proposed that the long run underperformance may be due to failure to adjust returns for ime-varying systematic risk. No empirical evidence has been found for this hypothesis-a series of studies tried to adjst for risk but still found that newly listed firms underperform.
However, it has been argued that oer a period of time in various studies that several aspects of the long-run event study metholodology create serious statistical difficulities . On the other hand, it has been demonstrated that the measurement f the long run performance of the ipoS IS SENSITIVE TO BENCHMARK EMPLOYED.
The motives of companies go private
1) Poor operating performance of the company and poor performance of its stock
2) Calls for company to be restructured. Such restructuring may be easier to acheive once any conflicts of interests between relevant players within the companies are eliminated. Such conflicts of interest may arise between managements and shareholders, and between groups of shareholders. A further reason for going private may be initia owners seeking to avoid the loss of control through a hostile takeover or the unwelcome influence and attention from media, analysists and investors. Owners of companies who feel the company shares ae undervalued by the stock market may be particularly worried about the takeover bds. If the PTP transaction is driven ny insider’s private infor that the shares are undervalued. Then the buying shareholders benefit at the expense of selling shareholders. This possibility explains why some PTP transactions have caused controversy among investors.
3) Sometimes, there may be market condition that favors PTP transaction. The availability of relatively cheap debt finance (low interest rate) over the past few years seems to have spurred the lastest wave of PTP transaction. Private equity providers plan an active role in seeking out companies that might benefit from going private and propose PTP deals to the owners of those companies.
The below is reference
(a) Do companies follow a managed or a residual payout policy (in terms of their dividends and repurchases)?
(12.5 marks)
(12.5 marks)
Residual payout policy-in each period they simply distribute all the cash that cannot be invested in projects that increase firm value (positive net present value projects). In each year, the total payout of residual payout Residual payout paid out all the internally generated cash that could not be invested in value-increasing investments. Its payout policy was characterized by large-inter-temporal variability in payout levels.
Managed payout policy-not all the cash that remains after investing in positive npv PROJECTS IS NECESSAILY DISTRIBUTED. Undistributed cash can be kept and eventually used to finance future investments
The total payout of managed payout policy is less volatile over time than residual.
This is because managed payout aimed at reducing variations in payout levels over time.
Managed payout was able to distribute increasing quantities of cash during year 1 and 3. Due to its existing stock of accumulated cash, over the past 5 years, managed payout followed a managed payout policy with the objective of paying out steadily increasing amounts of cash.
On the whole, managers do not simply follow a residual payout policy but try to manage payout levels. According to the study by Lintner 1956, managers are more inclined to managed payout policy, and they are more particularly concerned wth changes in dividend payment rather than the level of payments. In other words, when deciding on the level of future dividend payment, managers carefully considered the difference between the level of the future payment and the levels of previous dividend payment
Based on the beliefs on shareholders’ preference, managers are very reluctant to increase dividend payment when this increase cannot be sustained in the long term and it was likely tht the increase would have to be reversed in the future. It is also true that managers are particularly averse to cuts in dividend payments due to managers’ expectation of adverse response from investors.
Lintner’s interview also highlighted that managers hold views about their target dividends and over time they try to move towards their targets. These targets are normally expressed in terms of fraction of earnings that were paid through dividend payments. Also, managers with valuable investment projects normally had lower dividend payout targets than the more mature counterparts. Findings support Lintner’s findings. 90% of managers agree that they smooth dividend payment overtime, 78% EXECUTIVES AGREE THAT THEY AVOID TAKING decisions on dividend level that may be reserve in the future.
Repurchase policy Jagannathan , stephens, and weisbach found that repurchases are more sensitive conditions than dividends. Repurchase payout increase significantly during boom times and fall substantially during recessions. Repurchases are more closely related than dividend to non-operating cash flows. The cash flow do not derive from main operating cash flows and therefore they are by nature transient and volatile. On the contrary, dividend payment are more related to operating cash flows which are generated by main business of the firm.
Jagannathan , stephens, and weisbach shows that managers use repurchase because they regard them as a flexible way of paying out cash to shareholders than dividends. Managers prefer to have volatile repurchase payout levels rather than volatile dividend payout levels. Which managers view as undesirable. Managers are more concerned with managing their dividend payout than managing their repurchase payout. Therefore repurchase payout is more resililar to residual payout than dividend payout policy. This is certainly true with respect to the payout stabilization practices that managers use far more smooth dividend payments than to smooth repurchase payout.
(b) What possible link is there between payout policy (dividends and repurchases) and the agency conflict between corporate managers and shareholders?
Distributions of cash, through repurchase or dividends, reduce the cash flow control of managers, hence, it might limit their ability to invest in value-adding projects. On the contrary, they are beneficial if they prevent managers from reducing firm value by investing destroying projects by using resources to satisfy personal needs. The objective of managers are maximization of value of their company. However, private objectives of may conflict with those of shareholders. The conflict of interest between managers and shareholders in normally not feasible, results in so called-agency conflict.
For instance, managers may pursue a policy of increasing the size of the company because working for a larger company is professionally more rewarding and executive pay in often higher. By investment, they may try to grow the company as much as possible, even in the projects may destroy the firm value. Also, managers may indulge in excessive consumption of work-related benefits, so called perks. For example, they may acquire company cars or jet and use them for private purpose.
This kind of self-serving managerial behavioral are more likely to happened in companies with large reserve of unused cash. Hence, paying out cash through dividends and repurchases can increase firm value if the money would otherwise have been misused by managers.
Kayak Plc is closing down its factory which will make all the workers redundant. Kayak’s CEO is enraged to learn that the firm must continue to pay for workers’ health insurance for 4 years. The cost per worker next year will be £2,400. The inflation rate is expected to be 4% per year and the health costs are expected to increase 3 percentage points faster than inflation. The nominal discount rate is 10%. What is the present value of this obligation?
(8 marks)
2400 /worker
Inflation:4%
Health cost 3% faster than inflation
Norminal discount rate:10%
Nominal discount rate at 10%:
2400/(1.1^4)=1639.23
Health care in Real terms
Year 1:2400/1.1=2181.81
Year2:2181.81/1.1^2=1803.16
Year3:1803.16/1.1^3=1355.07
Year4:1355.07/1.1^4=925.53
Real discount rates:
Year 1:1.1/1.04=1.058
Year 2:1.1/1.04^2=1.017
Year3:1.1/1.04^3=0.978
Year 4:1.1/1.04^4=0.85
NPV=
Year 1:2181.81/1.058=2062.2
Year2:1803.16/1.017=1773.02
Year 3:1355.07/0.978=1385.55
Year 4:925.53/0.85=1088.86
(b) You are to receive cash payments of £1,000 at the end of each of the next three years. Assuming a nominal discount rate of 7 percent, what is the present value of these cash flows? If the rate of inflation is 2 percent in years one and two and 3 percent in year 3, what are the values of these cash flows in real terms and what are the real discount rates for years one, two, and three? Show that discounting real cash flows using real discount rates gives the same present value as discounting nominal cash flows at a nominal discount rate.
Cash flows in real terms:
1000*(1+0.07)^3= XXXXXXXXXX
Year 0=1000
Year 1=1000/(1+0.02)=980.39
Year 2=980.39/(1+0.02)^2=942.32
Year3=942.32/(1+0.03)=914.87
Real discount rate:
Year 0=
Year 1=(1.07/1.02)
Year 2=1.07/1.02^2
Year3=1.07/1.03
Discounting real cash flow in real discount rate:
XXXXXXXXXX/(1.07/ XXXXXXXXXX/(1.07/1.02^ XXXXXXXXXX/1.03)= XXXXXXXXXX
How about the NPV in norminal discount rate?
XXXXXXXXXX/ XXXXXXXXXX/1.07^2+1000/1.07^3= XXXXXXXXXX
Supposing the real and nominal term should be the same, any wrong with my calculation?
Real cahs flow at date t=norminal cash flow at date t/(1+ inflation rate)t
(9 marks)
(c) A two-year and a five-year bond both have coupon rates of 7%. Both bonds are currently selling at par. How much does the price of each bond change if the interest rates fall to 5%? Explain the difference in the price change for these bonds?
(8 marks
Both of the bonds are annuities:
2-year bond
C(1/r-1/r(1+r)^n)
PV=C(1/0.07-1/ XXXXXXXXXX)^2
=C16.36
5-year bond
PV=c(1/0.07-1/ XXXXXXXXXX)^5
=C20.04
At 7%
2-year bond
PV=c(1/0.05-1/ XXXXXXXXXX)^2
=C22.05
5-year bond
PV=c(1/0.05-1/ XXXXXXXXXX)^5
=c22.53
At 5%
As comparison, we can tell that longer the year it takes, and the higher the interest rate, the higher the par value.
Rank the following alternatives in terms of present value assuming a discount rate of 8 percent.
(i) A growing perpetuity paying £25,000 each year, with the first payment in one year’s time. The growth rate of the perpetuity is 4 percent.
PV=C/r-g
25000/ XXXXXXXXXX=625000
(ii) A four-year annuity paying £200,000 each year, with the first payment in one year’s time.
C(1/r-1/r(1+r)^n)
XXXXXXXXXX/0.08-1/ XXXXXXXXXX)^4=666000
(iii) A payment of £750,000 in two years’ time.
750000*1.08^2=874800
(iv) A growing perpetuity paying £30,000 each year, with the first payment due immediately. The growth rate of the perpetuity is 3 percent.
PV=C/r-g
30000/ XXXXXXXXXX=600000
You are thinking of buying a fridge-freezer. Two competitive retailers, Dickson’s Plc and Flurry’s sell this machine with a price tag of £500. They have a buy now pay later scheme with Dickson’s Plc charging a flat interest rate of 9.4% with monthly compounding and Flurry’s Plc charging a rate of 9.2% with quarterly compounding. If you plan to repay in one year’s time, which retailer would you prefer to buy your machine from? What are the EARs charged by the two firms?
Dickson
500
9.4%
Monthly compounding
1+0.94/12-1=7.83%(effective annual rate)
PV=500/1.078=463.82
PV+C/1+r^n
Flurry
500
9.2%
Effective annual rate:
1+1.92/3-1=6.4%
PV=500/1.064=469.9
Quarterly compounding
F
(c) A stock’s end-of-year price over a four year period is: 150p, 152p, 145p, and 180p. The dividend in each of the last three years, paid immediately before the date of the end-of-year price, is 8p. What are the returns on the stock in each of the last three years? What is the total return over the three years to an investor who buys the stock at 150p and holds the stock for three years, reinvesting intermediate dividends back into the stock? What is the equivalent constant annual average return over the three year period?
I do not know how to calculate this one. Would you please give me some hints and show me the calculation?
150p, 152p, 145p, 180p
Dividend: 0p, 8p, 8p, 8p
Po=dividend/r-g
Po=div/1+r+P1/1+r+P2/1+R+P3/1+R+P4/1+R
0/1+
R=div/Po+g
ROE:earnings/book equity=EPS/book equity per share
(a) Modigliani Inc. is a company that operates in a world with perfect capital markets (including no taxation). Its annual net operating income (NOI) is $1,000,000, and it is financed entirely by equity with a market value of 5 million.
The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E =
I have not learnt this one. Would you please give me some hints and show me the calculation?
Required:
(i) Calculate the rate of return on equity given the present capital structure of the company (entirely equity-financed). Briefly explain your method and result.
(4 marks)
(ii) Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) the company faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.
(7 marks)
(iii) The company management approaches you for advice on its capital structure. Can you suggest an optimal capital structure that maximises the company value and minimises the cost of capital faced by the company?
(7 marks)
(b) Explain why companies tend to prefer internal to external funds when financing profitable investment projects. Draw on existing theories and relevant empirical findings.
(7 marks)