Financial Markets and Institutions

13th Edition
by Jeff Madura

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 10 Stock Offerings and Investor Monitoring

Chapter Objectives

• Describe the private equity market.

• Describe the public equity market.
• Describe the process of initial public offerings.
• Describe secondary offerings and stock
repurchases.
• Explain how the stock market is used to influence
the management of firms.
• Describe the market for corporate control.
• Describe the globalization of stock markets.
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2
 Private Equity (1 of 7)

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.

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 Private Equity (2 of 7)

Financing by Venture Capital Funds

• 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.

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 Private Equity (3 of 7)

Financing by Venture Capital Funds (continued)

• 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.

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 Private Equity (4 of 7)

Financing by Venture Capital Funds (continued)

• 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

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 Private Equity (5 of 7)

Financing by Private Equity Funds (continued)

• 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.
• Strategy of Private Equity Funds
• Private equity firms look for companies that are undervalued
and mismanaged because they can more easily achieve a
high return on their investment when buying weak firms that
they can improve.
• Private equity funds tend to sell their stake in the business
after several years, sometimes by taking the company public
once its performance has improved.

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 Private Equity (6 of 7)

• Financing by Private Equity Funds (continued)

• Exit Strategy of Private Equity Funds
• Private equity funds can sell their stake in a private business
in the same way that VC funds do. If the business conducts
an IPO, the private equity fund can cash out by selling its
ownership to new investors. Alternatively, it can sell the
business to another company.
• 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

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 Private Equity (7 of 7)

Financing by Crowdfunding
• 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.

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 Public Equity (1 of 6)

• 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.

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 Public Equity (2 of 6)

Ownership and Voting Rights

• Owners of small companies also tend to be the managers.
In publicly traded firms, most shareholders are not the
managers.
• Common Stock — 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.

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 Public Equity (3 of 6)

• Preferred stock — 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.
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 Public Equity (4 of 6)

• How Stock Markets Facilitate Corporate Financing

(Exhibit 10.1)
• The stock markets are like other financial markets in that
they link surplus units (that have excess funds) with deficit
units (that need funds).
• Individual investors participate in stock offerings by
corporations by purchasing stocks directly or by investing in
shares of stock mutual funds, which then use the proceeds
to invest in stocks.
• Individual investments commonly exceed 50% of the total
equity.
• Because of the size of investment, institutional investors can
significantly affect stock market prices.

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 Exhibit 10.1 How Stock Markets Facilitate
the Flow of Funds

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 Public Equity (5 of 6)

Participation of Financial Institutions in Stock

Markets(Exhibit 10.2)
• Some financial institutions hold large amounts of stock,
their collective sales or purchases of stocks can
significantly affect stock market prices.
• In addition to participating in stock markets by investing
funds, financial institutions sometimes issue their own
stock as a means of raising funds. Many stock market
transactions involve two financial institutions.

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 Exhibit 10.2 Institutional Use of Stock Markets

TYPE OF FINANCIAL
INSTITUTION PARTICIPATION IN STOCK MARKETS
Commercial banks • Issue stock to boost their capital base.
• Manage trust funds that usually contain stocks.
Stock-owned savings institutions • Issue stock to boost their capital base.
Savings banks • Invest in stocks for their investment portfolios.
Finance companies • Issue stock to boost their capital base.
Stock mutual funds • Use the proceeds from selling shares to individual investors to
invest in stocks.
Securities firms • Issue stock to boost their capital base.
• Place new issues of stock.
• Offer advice to corporations that consider acquiring the stock of
other companies.
• Execute buy and sell stock transactions of investors.
Insurance companies • Issue stock to boost their capital base.
• 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.

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 Public Equity (6 of 6)

Secondary Market for Stocks

• Secondary equity market allows investors to sell stocks
that they previously purchased to other investors. Thus,
the secondary market creates liquidity for investors who
invest in stocks.
• Stock Price Dynamics in the Secondary Market—
Investors may decide to buy a stock when its market price
is below their valuation of that stock, which means they
believe the stock is undervalued. They may sell their
holdings of a stock when its market price is above their
valuation, which means they believe the stock is
overvalued.

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 Initial Public Offerings (1 of 8)

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.

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 Initial Public Offerings (2 of 8)

Underwriter Efforts to Ensure Price Stability

• Underwriters may attempt to stabilize the stock’s price by
purchasing shares that are for sale in the secondary market shortly
after the IPO.
• Underwriter Efforts to Prevent
• Flipping is a strategy adopted by some investors who know about the
unusually high initial returns on many IPOs attempt to purchase the
stock at the offer price and sell the stock shortly afterward.
• To discourage flipping, some securities firms make more shares of
future IPOs available to institutional investors that retain shares for a
relatively long period of time.
• 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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 Initial Public Offerings (3 of 8)

Underwriter Efforts to Ensure Price Stability (continued)

• Lockup
• 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.

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 Initial Public Offerings (4 of 8)

Facebook’s IPO
• 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.

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 Initial Public Offerings (5 of 8)

Abuses in the IPO Market

• 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.

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 Initial Public Offerings (6 of 8)

Abuses in the IPO Market (continued)

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.

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 Initial Public Offerings (7 of 8)

Long-Term Performance Following IPOs

• 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.

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 Stock Offerings and Repurchases

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.

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 Initial Public Offerings (8 of 8)

Initial Returns of IPOs

• 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.

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 Stock Exchanges (1 of 7)

Organized Exchanges
• 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.

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 Stock Exchanges (2 of 7)

Over-the-Counter Market
• Stocks not listed on the organized exchanges are traded in
the over-the-counter (OTC) market.
• OTC Bulletin Board — Lists stocks that have a price below
$1 per share, which are sometimes referred to as penny
stocks.
• OTC Markets Group — The OTC Markets Group has three
segments where even smaller stocks are traded: OTCQX,
OTCQB, and Pink.

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 Stock Exchanges (3 of 7)

Extended Trading Sessions

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

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 Stock Exchanges (4 of 7)

Stock Quotations Provided by Exchanges (Exhibit 10.3)

• 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.
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 Exhibit 10.3 Example of Stock Price
Quotations

YTD % VOL NET

HI LO STOCK SYM DIV YLD % PE LAST
CHANGE 100S CHG
+10.3 121.88 80.06 ZIKARD ZIK .56 .6 20 71979 93.77 +1.06
CO.
Year Highest Lowest Name Stock Annual Dividend Price– Trading Closing Change
to-date price of price of stock symbol dividend yield, which earnings volume stock in the
percentage the stock of the paid per represents ratio during price stock
change in in this stock year the annual based the price
stock price year in this dividend on the previous from the
year as a prevailing trading close on
percentage stock Day the day
of the price before
prevailing
stock price

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 Stock Exchanges (5 of 7)

Stock Quotations Provided by Exchanges (Continued)

• 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.

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 Stock Exchanges (6 of 7)

Stock Index Quotations

• 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.
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 Stock Exchanges (7 of 7)

Private Stock Exchanges

• 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.
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 Monitoring Publicly Traded Companies (1 of 6)

• 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.

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 Monitoring Publicly Traded Companies (2 of 6)

Role of Analysts
• 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.

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 Monitoring Publicly Traded Companies (3 of 6)

Sarbanes-Oxley Act
• 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.

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 Monitoring Publicly Traded Companies (4 of 6)

Sarbanes-Oxley Act (Continued)

• 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.
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 Monitoring Publicly Traded Companies (5 of 6)

Shareholder Activism
• 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.

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 Monitoring Publicly Traded Companies (6 of 6)

Limited Power of Governance

• 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.

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 Market for Corporate Control

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.

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 Globalization of Stock Markets (1 of 2)

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.

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 Globalization of Stock Markets (2 of 2)

Methods Used to Invest in Foreign Stocks.

• 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.
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 SUMMARY (1 of 3)

• When businesses are created, they normally rely on private

equity along with borrowed funds. Some private businesses
that expand attempt to obtain additional private equity funding
from VC firms. When VC firms provide financing, they
commonly attempt to pull their cash out in four to seven years.
Going public changes the firm’s ownership structure by
increasing the number of owners, and it changes the firm’s
capital structure by increasing the equity investment in the
firm. Stock market participants include individual investors as
well as institutional investors such as stock mutual funds,
pension funds, and insurance companies. Upon the release of
new information about a firm, some investors respond by
either selling their stock holdings or buying more stock. Their
actions affect the supply and demand conditions for the stock
and thus influence the equilibrium stock price.

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 SUMMARY (2 of 3)

• An initial public offering (IPO) is a first-time offering of

shares by a specific firm to the public. Many firms
engage in an IPO to obtain funding for additional
expansion and to give the founders and VC funds a
way to cash out their investments. A firm that engages
in an IPO must develop a prospectus that is filed with
the SEC, and it typically uses a road show to promote
its offering. The firm hires an underwriter to help with
the prospectus and road show and to place the shares
with investors.
• A secondary stock offering is an offering of shares by a
firm that already has publicly traded stock. Firms
engage in secondary offerings when they need more
equity funding to support additional expansion.
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 SUMMARY (3 of 3)

• Publicly traded firms are monitored in various ways. Analysts monitor

firms so that they can assign a rating to their stock. Investors that
purchase stock of firms monitor performance and may use
shareholder activism to ensure that managers make decisions that
are beneficial to the firm’s shareholders. The market for corporate
control allows firms to acquire the control of businesses that they can
improve by replacing managers or revising operations.
• Many U.S. firms issue shares in foreign countries, as well as in the
United States, so that they can spread their shares among a larger
set of investors and possibly enhance the firm’s global name
recognition. Global stock exchanges exist to facilitate the trading of
stocks around the world. U.S. investors can invest in foreign stocks
by making direct purchases on foreign stock exchanges, purchasing
ADRs, investing in international mutual funds, and investing in
international exchange-traded funds.

46 © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.