1. Stock Offerings and Investor Monitoring
Chapter 10
Stock Offerings and
Investor Monitoring
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. Chapter Outline Background on stock Initial public offerings
Secondary stock offerings
Stock exchanges
Investor participation in the secondary market
Monitoring by investors
The corporate monitoring role
Globalization of stock markets

3. Background on Stocks
A stock is a certificate representing partial ownership in a corporation
Stock is issued by firms to obtain long-term funds
Owners of stock:
Can benefit from the growth in the value of the firm
Are susceptible to large losses
Individuals and financial institutions are common purchasers of stock
The primary market enables corporations to issue new stock
The secondary market creates liquidity for investors who invest in stock
Some corporations distribute earnings to investors in the form of dividends

4. Background on Stocks (cont’d)
Ownership and voting rights
The owners are permitted to vote on key matters concerning the firm:
Election of the board of directors
Authorization to issue new shares
Approval of amendments to the corporate charter
Adoption of bylaws
Voting is often accomplished by proxy
Management typically receives the majority of the votes and can elect its own candidates as directors

5. Background on Stocks (cont’d)
Preferred stock
Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights
A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid
Preferred stock is less risky because dividends on preferred stock can be omitted
Preferred stock is a less desirable source of funds than bonds because:
Dividends are not tax deductible
Investors must be enticed to purchase the preferred stock since dividends do not legally have to be paid

6. Background on Stocks (cont’d)
Issuer participation in stock markets
The ownership feature attracts many investors who want to have an equity interest but do not necessarily want to manage their own firm
A firm issuing stock for the first time engages in an IPO
If a firm issues additional stock after the IPO, it engages in a secondary offering

7. Initial Public Offerings
An IPO is a first-time offering of shares by a specific firm to the public
Usually, a growing firm first obtains private equity funding from VC firms
An IPO is used to obtain new funding and to offer VC firms a way to cash in their investment
Many VC firms sell their shares in the secondary market between 6 and 24 months after the IPO

8. Initial Public Offerings (cont’d)
Process of going public
An investment banking firm normally serves as the lead underwriter for the IPO
Developing a prospectus
The issuing firm develops a prospectus and files it with the SEC
The prospectus contains detailed information about the firm and includes financial statements and a discussion of risks
The prospectus is intended to provide investors with the information they need to decide whether to invest in the firm
Once approved by the SEC, the prospectus is sent to institutional investors
Underwriters and managers meet with institutional investors in the form of a “road show”

9. Initial Public Offerings (cont’d)
Process of going public (cont’d)
Pricing
The offer price is determined by the lead underwriter
During the road show, the number of shares demanded at various prices is assessed
Bookbuilding
In some countries, an auction process is used for IPOs
Transaction costs
The issuing firm typically pays 7 percent of the funds raised
The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs

10. Initial Public Offerings (cont’d)
Underwriter efforts to ensure price stability
The lead underwriter’s performance can be measured by the movement in the IPO shares following the IPO
If stocks placed by a securities firm perform poorly, investors may no longer purchase shares underwritten by that firm
The underwriter may require a lockup provision
Prevents the original owners from selling shares for a specified period
Prevents downward pressure
When the lockup period expires, the share price commonly declines significantly

11. Initial Public Offerings (cont’d)
Timing of IPOs
IPOs tend to occur more frequently during bullish stock markets
Prices are typically higher
In the 2000–2001 period, many firms withdrew their IPO plans
Initial returns of IPOs
First-day return averaged about 20 percent over the last 30 years
In 1998, the mean one-day return for Internet stocks was 84 percent
Most IPO shares are offered to institutional investors
About 2 percent of IPO shares are offered as allotments to brokerage firms

12. Initial Public Offerings (cont’d)
Abuses in the IPO market
In 2003, regulators attempted to impose new guidelines that would prevent abuses
Spinning is the process in which an investment bank allocated IPO shares to executives requiring the help of an investment bank
Laddering involves increasing the price above the offer price on the first day of issue in response to substantial demand
Excessive commissions are sometimes charged by brokers when there is substantial demand for the IPO

13. Initial Public Offerings (cont’d)
Long-term performance following IPOs
IPOs perform poorly on average over a period of a year or longer
Many IPOs are overpriced at the time of issue
Investors may be overly optimistic about the firm
Managers may spend excessively and be less efficient with the firm’s funds than they were before the IPO

14. Secondary Stock Offerings
A secondary stock offering is:
A new stock offering by a firm whose stock is already publicly traded
Undertaken to raise more equity to expand operations
Usually facilitated by a securities firm
In the late 1990s, the volume of publicly placed stock increased substantially
From 2000 to 2002, the volume of publicly placed stock declined as a result of the weak economy
Existing shareholders often have the preemptive right to purchase newly-issued stock

15. Secondary Stock Offerings (cont’d)
Shelf-registration
A corporation can fulfill SEC requirements up to two years before issuing new securities
Allows firms quick access to funds
Potential purchasers must realize that information disclosed in the registration is not continually updated

16. Stock Exchanges
Stock trading between investors occurs on an organized stock exchange or on the over-the-counter (OTC) market
Organized exchanges
Includes the NYSE and AMEX
The NYSE controls 80 percent of the value of all organized exchange transactions
There are 1,366 seats
Floor brokers and specialists are members of the NYSE

17. Stock Exchanges (cont’d)
Organized exchanges (cont’d)
Trading floor
Consists of trading posts and trading booths
20 trading posts are maintained by specialists and their clerks
There are 1,500 trading booths along the perimeter of the floor where brokers obtain orders
Listing requirements
NYSE requirements include number of shares outstanding, minimum level of earnings, cash flow, and revenue
Minimum number of shares ensures adequate liquidity
Exchanges charge a listing fee, which depends on the size of the firm

18. Stock Exchanges (cont’d)
Over-the-counter market
Buy and sell orders are completed through a telecommunications network
Nasdaq
The Nasdaq is an electronic quotation system that provides immediate price quotations
Firms must meet requirements on minimum assets, capital, and number of shareholders
Transaction costs as a percentage of the investment tend to be higher on Nasdaq than on the NYSE

19. Stock Exchanges (cont’d)
Over-the-counter market (cont’d)
Nasdaq (cont’d)
Nasdaq components are:
Nasdaq National Market
Nasdaq Small Cap Market
More stocks are listed on Nasdaq than on NYSE
The market value of stocks listed on Nasdaq is smaller than stocks listed on the NYSE

20. Stock Exchanges (cont’d)
Over-the-counter market (cont’d)
OTC Bulletin Board
Lists stocks that have a price below $1 per share (penny stocks)
More than 3,500 stocks are listed
Stocks are mostly traded by individual investors
Pink sheets
Lists stocks smaller than those listed on the OTC Bulletin Board
Contains about 20,000 stocks
Families and officers of the firms commonly control much of the stock

21. Stock Exchanges (cont’d)
Extended trading sessions
The NYSE, AMEX, and Nasdaq markets all offer extended trading sessions
Late trading sessions enable investors to buy or sell stocks after the market closes
An early morning session enables investors to buy or sell stock just before the market opens on the following day
Total trading volume of widely traded stocks is typically about 5 percent or less of the trading volume during the day
ECNs also allow for trading at any time

22. Stock Exchanges (cont’d)
Stock quotations provided by exchanges
The format varies among newspapers, but most provide similar information:
52-week price range
Symbol
Dividend
Dividend yield
Price-earnings ratio
Volume
Previous day’s price quotations

23. Computing A Dividend Yield
XYZ Corporation annual dividend is $1.02 per share. XYZ’s prevailing stock price is $20. What is the annual dividend yield of XYZ stock?

24. Stock Exchanges (cont’d)
Stock index quotations
The Dow Jones Industrial Average (DJIA) is a price-weighted average of stock prices of 30 large U.S. firms
Assigns a higher weight over time to those stocks that experience higher prices
Does not necessarily serve as an adequate indicators of the overall market
The Standard and Poor’s (S&P) 500 is a value-weighted index of stock prices of 500 large U.S. firms
Does not serve as a useful indicator for stock prices of smaller firms

25. Stock Exchanges (cont’d)
Stock index quotations (cont’d)
Wilshire 5000 Total Market Index
Created in 1974 to reflect the values of 5,000 U.S. stocks
Represents the broadest index of the U.S. stock market
Closely monitored by the Federal Reserve
New York Stock Exchange Indexes
The Composite Index represents the average of all stocks traded on the NYSE
Sector indexes:
Industrial
Transportation
Utility
Financial

26. Stock Exchanges (cont’d)
Stock index quotations (cont’d)
Other stock indexes
AMEX indexes
Nasdaq indexes

27. Investor Participation in the Secondary Market
The price of a firm’s stock represents the value of the firm per share of stock:
The stock price by itself does not clearly indicate the firm’s value
The return on the investment is determined by dividends received and the price of the stock from the time when they purchased the shares until they sell them

28. Investor Participation in the Secondary Market (cont’d)
How investor decisions affect the stock price
Investors buy or sell shares based on their valuation of the stock relative to the prevailing market price
Investors arrive at different valuations which means there will be buyers and sellers at a given point in time
As investors change their valuations of a stock, there is a shift in the demand for and supply of shares and the equilibrium price changes

29. Investor Participation in the Secondary Market (cont’d)
How investor decisions affect the stock price (cont’d)
Investor reliance on information
Favorable news increases the demand for and reduces the supply of the security
Unfavorable news reduces the demand for and increases the supply of the security
Investors continually respond to new information in their attempt to purchase or sell stocks

30. Investor Participation in the Secondary Market (cont’d)
Types of investors
Individual investors typically hold more then 50 percent of the total equity in a large corporation
Ownership is scattered
Institutional investors have large equity positions in corporations and have more voting power
Can influence corporate policies through proxy contests
Insurance companies, pension funds, and stock mutual funds are common purchasers of newly issued stock in the primary market
The collective sales and purchases of stocks by institutions can significantly affect stock market prices

31. Type of Financial Institution
Participation in Stock Markets
Commercial banks
Issue stock
Manage trust funds
Stock-owned savings institutions
Issue stock to boost their capital base
Savings banks
Invest in stocks for their investment portfolios
Finance companies
Stock mutual funds
Use the proceeds from selling shares to invest in stocks
Securities firms
Place new issues of stock
Offer advice to corporations that consider acquiring stock companies
Execute buy and sell orders
Insurance companies
Invest a large proportion of their premiums in the stock market
Pension funds
Invest a large proportion of pension fund contributions in the stock market

32. Monitoring by Investors
Managers serve as agents for shareholders to maximize the stock price
Managers may be tempted to serve their own interests rather than those of investors
Shareholders monitor their stock’s price movements to assess whether the managers are achieving their goal
When the stock price declines or does not rise as high as shareholders expected, shareholders may blame the weak performance on the firm’s managers

33. Monitoring by Investors (cont’d)
Accounting irregularities
To the extent that firms can manipulate financial statements they may be able to hide information from investors
e.g., Enron, Tyco, and WorldCom
The auditors hired to audit financial statements allowed them to use unusual accounting methods
Board members on the audit committee were not always monitoring the audit

34. Monitoring by Investors (cont’d)
The Sarbanes-Oxley Act:
Was implemented in 2002 to ensure more accurate disclosure of financial information to investors
Attempts to force accountants of a firm to conform to regular accounting standards
Attempts to force auditors to take their auditing role seriously
Prevents a public accounting firm from auditing a client whose CEO, CFO, or other employees are employed by the client firm within one year prior to the audit

35. Monitoring by Investors (cont’d)
The Sarbanes-Oxley Act:
Requires that only outside board members of a firm be on the firm’s audit committee
Prevents the members of a firm’s audit committee from receiving consulting or advising fees from the firm
Requires that the CEO and CFO of firms that are of at least a specified size level to 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 non-audit consulting services to an audit client only if the client pre-approves those services

36. Monitoring by Investors (cont’d)
Shareholders activism
Communication with the firm
Shareholders can communicate their concerns to other investors to place more pressure on managers or its board members
Institutional investors commonly communicate with high-level corporate managers and offer their concerns
Institutional Shareholder Serves (ISS) Inc. is a firm that organizes institutional shareholders to push for a common cause

37. Monitoring by Investors (cont’d)
Shareholders activism (cont’d)
Proxy contest
Normally considered only if an informal request for a change in the board is ignored
If dissident shareholders gain enough votes, they can elect one or more directors who share their views
As a result of a more organized effort, institutional shareholders are more influential on management decisions

38. Monitoring by Investors (cont’d)
Shareholders activism (cont’d)
Shareholder lawsuits
Investors may sue the board if they believe that the directors are not fulfilling their responsibilities to shareholders
Lawsuits are often filed when corporations prevent takeovers, pursue acquisitions, or make other restructuring decisions that shareholders believe will reduce the stock’s value
When directors are sued, courts typically focus on whether the director’s decision seems reasonable, rather than on whether the decision led to higher profitability

39. The Corporate Monitoring Role
If managers believe their stock is undervalued in the market, they may take actions to capitalize on this discrepancy
Stock repurchases
Use excess cash to purchase shares in the market at a low price
Stock prices respond favorably to stock repurchase announcements

40. The Corporate Monitoring Role (cont’d)
Market for corporate control
A firm may engage in acquisitions to increase the value of a target firm
Can also create synergistic benefits
A high stock price is useful to exchange acquirer shares for target shares
Share prices of target firms react very positively
Leveraged buyouts
LBOs are acquisitions that require substantial amounts of borrowed funds
A reverse LBO is desirable when the stock can be sold at a high price

41. The Corporate Monitoring Role (cont’d)
Barriers to corporate control
Antitakeover amendments are designed to protect shareholders against an acquisition that will ultimately reduce the value of their investment in the firm
e.g., may require at least two-thirds of shareholder votes to approve a takeover
Poison pills are special rights awarded to shareholders or specific managers upon specified events
e.g., the right for all shareholders to be allocated an additional 30 percent of all shares without cost whenever a potential acquirer attempts to acquire the firm

42. The Corporate Monitoring Role (cont’d)
Barriers to corporate control (cont’d)
A golden parachute specifies compensation to managers in the event that they lose their jobs
e.g., all managers have the right to receive 100,000 shares of the firm’s stock whenever the firm is acquired

43. Globalization of Stock Markets
Barriers between countries have been removed or reduced
Firms in need of funds can tap foreign markets
Investors can purchase foreign stocks
Foreign stock offerings in the U.S.
Large privatization programs in Latin America and Europe can not be digested in local markets
By issuing stock in the U.S., foreign firms diversify their shareholder base
SEC regulations may prevent some firms from offering stock in the U.S.
Some foreign firms use American depository receipts (ADRs)

44. Globalization of Stock Markets (cont’d)
International placement process
Many U.S. investment banks and commercial banks provide underwriting services in foreign countries
Listing on a foreign stock exchange:
Enhances the liquidity of the stock
May increase the firm’s perceived financial standing
Can protect the firm against hostile takeovers
Entails some costs

45. Globalization of Stock Markets (cont’d)
Global stock exchanges
Recently, stocks outside the U.S. have been issuing stock more frequently
The percentage of individual versus institutional ownership varies across countries
Emerging stock markets:
Enable foreign firms to raise large amounts of capital by issuing stock
Provide a means for investors from other countries to invest their funds
May not be as efficient as the U.S. stock market
May exhibit high returns and high risk
May be volatile because of fewer shares and trading based on rumors

46. Globalization of Stock Markets (cont’d)
Methods used to invest in foreign stocks
Direct purchases involves directly buying stock of foreign companies listed on the local stock exchanges
American depository receipts are attractive because:
They are closely followed
They are required to file financial statements with the SEC
They are quoted reliably

47. Globalization of Stock Markets (cont’d)
Methods used to invest in foreign stocks (cont’d)
International mutual funds are portfolios of international stocks created and managed by various financial institutions
World equity benchmark shares represent indexes that reflect composites of stocks for particular countries that can be purchased or sold