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.

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CHAPTER OUTLINE
 Private Equity Market
 Investor Participation in the Stock Markets
 Initial public offerings
 Secondary stock offerings
 The corporate monitoring role
 Globalization of stock markets

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PRIVATE EQUITY
 Venture Capital Funds
 From wealthy investors and from pension funds that are willing to
maintain the investment for a long-term period
 Not allowed to withdraw money before specified deadline
 Venture capital market: venture capital conferences
 Terms of a venture capital deal
 Exit strategy of VC funds: (1)sell the equity to the public, or (2)cash out if
the company acquired by another firm.
 Therefore, commonly serves as a bridge.
 Private Equity Funds
 From institutional investors (pension funds and insurance companies) and
invest in business.
 Take over, manage, and have a control to restructure the businesses.
 Charge annual fee for managing the fund.
 Exit strategy of PE funds: (1)sell the stake to another firm, or (2)cash out
when the business become public.

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DIFFERENCES
Venture Capital Private Equity
 Invest in start-ups with  Buy established
high growth potential companies
 Mostly < 50% in equity  Mostly 100% ownership:
 In many different total control
companies: spread the  In single company
risk  Also use both cash and
 Deal with equity only debt in the investment

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VENTURE CAPITAL FIRMS (INA)

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PUBLIC EQUITY
 Firm goes public
 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
 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
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HOW STOCKS MARKETS FACILITATE THE FLOWS OF FUNDS

$ to buy stock
Households
of stock mutual
$ to buy shares

funds

$
Spending
Corporation to Expand
Stock Mutual $ to buy stock Operations
Funds

Other $ to buy stock

Institutional
Investor

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PUBLIC EQUITY (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

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PARTICIPATION IN STOCK MARKETS
 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

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Type of Financial Participation in Stock Markets
Institution
Commercial banks Issue
stock
Manage trust funds

Stock-owned savings Issue stock to boost their capital base

institutions
Savings banks Invest in stocks for their investment portfolios

Finance companies Issue stock

Stock mutual funds Use the proceeds from selling shares to invest in stocks

Securities firms Issue stock

Place new issues of stock
Offer advice to corporations that consider acquiring stock
companies
Execute buy and sell orders

Insurance companies Issue stock

Invest a large proportion of their premiums in the stock market

Pension funds Investa large proportion of pension fund contributions in the

stock market

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PARTICIPATION IN STOCK MARKETS (CONT’D)
 The price of a firm’s stock represents the value of the
firm per share of stock:
Value of firm
Stock price 
Number of shares
 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

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PARTICIPATION IN STOCK MARKETS (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

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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
 ManyVC firms sell their shares in the secondary
market between 6 and 24 months after the IPO

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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”

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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

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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

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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

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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

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INITIAL PUBLIC OFFERINGS
(CONT’D)
 Long-term performance following IPOs
 IPOsperform 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

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STOCK OFFERINGS AND
REPURCHASES
 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
 Existing shareholders often have the preemptive right to purchase newly-
issued stock
 Shelf registrations.
 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
 Stock Repurchases
 Asymmetric information. Firm purchase a portion of its shares in the market
-> signaling the undervalued shares
 Use excess cash to purchase shares in the market at a low price
 Stock prices respond favorably to stock repurchase announcements
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STOCK EXCHANGES
 Stock trading between investors occurs on an
organized stock exchange or on the over-the-
counter (OTC) market
 Organized exchanges
 NYSE (the largest)
 Two broad types of members:
 Floor brokers: commission or independent brokers
 Specialist

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STOCK EXCHANGES (CONT’D)
 Organized exchanges (cont’d)
 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

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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

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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

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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

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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

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STOCK EXCHANGES (CONT’D)
 Stock quotations provided by exchanges
 Theformat varies among newspapers, but most
provide similar information:
 52-week price range
 Symbol
 Dividend
 Dividend yield
 Price-earnings ratio
 Volume
 Closing price quotations

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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
Dividends paid per share
Dividend yield 
Prevailing stock price
$1.02
  5.10%
$20

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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

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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

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STOCK EXCHANGES (CONT’D)
 Stock index quotations (cont’d)
 Other stock indexes
 AMEX indexes
 Nasdaq indexes

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MONITORING PUBLICLY TRADED
COMPANY
 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

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MONITORING PUBLICLY TRADED
COMPANY (CONT’D)
 Accounting irregularities
 Tothe extent that firms can manipulate financial
statements they may be able to hide information
from investors
 e.g., Enron, Tyco, and WorldCom
 Theauditors hired to audit financial statements
allowed them to use unusual accounting methods
 Board members on the audit committee were not always
monitoring the audit

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MONITORING PUBLICLY TRADED
COMPANY (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

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MONITORING PUBLICLY TRADED
COMPANY (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

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MONITORING PUBLICLY TRADED
COMPANY (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

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MONITORING PUBLICLY TRADED
COMPANY (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

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MONITORING PUBLICLY TRADED
COMPANY (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

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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

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MARKET FOR CORPORATE
CONTROL (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

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MARKET FOR CORPORATE
CONTROL (CONT’D)
 Barriers to corporate control (cont’d)
Agolden 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

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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

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GLOBALIZATION OF STOCK
MARKETS (CONT’D)
 Privatization
 The sale of government-owned firms to individuals
 Too large to be digested by local stock markets only -> foreign
investor
 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
 Limitation:
 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

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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

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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

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