Decentralized Investment Banking The Case of Discount Dividend-Reinvestment and Stock-Purchase Plans

Objectives

Objectives Test the degree to which investors can profit from discount plans by investing $3 million in discount plans, to determine if the discount plan can be a substitute for conventional capital raising methods, and the possibility of the subsequent decentralization of investment banking

Process

Step 1 Identify 74 companies with discount plans concentrated in banking, real estate and public utility industries, and split the 3.6m investment in them. Most of the plans have mostly 5% discount. Source of information: S&P Cumulative Dividends. Telephoned or wrote to the administrators of each plan

Step 2 Purchased a single share in each plan, and then invested in each discount plan in batches Increased average actual discount to 5.26% by avoiding the averaging period in which share price declines Negotiated a favorable commission fee with a broker, and sell the shares immediately after buying them at discounts

Step 3 Purchased insurance against price decline on positions, and opened line of credit to finance Reasons for not using traditional hedging 1. Long in the money put options 2. Short sell 3. Macro hedge

Results

Results As a result, the income of this strategy is $74,600 above bench mark return (Salomon bro 35 bank stock index), and the excess return is 12% per year. Poor stock performance of sponsoring firm doesn’t wipe out the discount income

Findings

Findings from experiment Eight firms with 5% discount raised 98% of the common/ preferred share they paid, while seven firms with similar financials but no discount only raised 12% Firms with lower discounts, their stocks are traded less actively, making execution costs higher Discount plans doesn’t necessarily reduce company’s stock price

Conclusions

Conclusions Offering shareholders shares at a discount makes them better off than they would under conventional underwritings Discount stock slows down the rate at which the fund was raised, thus mitigating the adverse selection that might harm the company Offering shareholders shares at a discount also enables companies to raise capital at low cost

Drawbacks

Drawbacks Shareholders who purchase small ownership interest in secondary market and then buy disproportionate amount of discounted shares Hard to achieve economies of scale Hard to achieve the same level of discount Hard to negotiate as favorable a commission fee with brokers Regulations and taxations have changed