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 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 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 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 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 not legally have to be paid Background on Stocks (cont’d)  Issuer participation in stock markets  The ownership feature attracts many investors who want to have an equity interest but 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 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 and 24 months after the IPO 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” 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 percent of the funds raised The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs 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 10 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 33 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 34 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 35 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 highlevel corporate managers and offer their concerns  Institutional Shareholder Serves (ISS) Inc is a firm that organizes institutional shareholders to push for a common cause 36 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 37 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 38 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 39 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 40 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 41 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 42 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) 43 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 44 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 45 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 46 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 47 .. .Chapter Outline         Background on stock Initial public offerings Secondary stock offerings... downward pressure When the lockup period expires, the share price commonly declines significantly 10 Initial Public Offerings (cont’d)  Timing of IPOs  IPOs tend to occur more frequently during... yield of XYZ ?stock Dividend yield = = Dividends paid per share Prevailing stock price $1.02 = 5 .10% $20 23 Stock Exchanges (cont’d)  Stock index quotations  The Dow Jones Industrial Average