Equity Market Flashcards
What are the advantages of raising public equity?
4
1) Ability to raise large amount of funds
2) Increase credibility due to more public accountability
3) Higher bargaining power with creditor and banks (they can negotiate for better terms)
4) Image enhancement
(Easier to attract & retain talents/businesses)
5) Not obliged to pay dividends & no interest payments unlike debt (Between bondholders and stockholders, stockholders have a higher cost to hold stocks as they may not receive payments)
What are the disadvantages of raising public equity?
5
1) Issuing cost (Average 10-11%)
2) Regulation compliance cost (Have to comply with more regulations, thus, need to set up a company system, usually a compliance department)
* Basically going public involves huge costs
3) Loss of privacy
4) Dilution control
(Constantly getting questioned by shareholders & stakeholders)
(Need to publicise company report)
5) Pressure to pay dividends
(Company must share profits with the stockholders)
How does the payoff structure look like for a debtholder?
> Resembles a short put option
y-axis: Payoff
x-axis: Value of Firm
1) Starts from 0 and increase 45 degrees upwards.
- This is the bankruptcy zone
- When value of firm is 0, there is nothing for debtholders
- In the bankruptcy zone, the value of company is lesser than the value of debt, therefore, every value earned is returned to the debtholder
2) Payoff stays constant no matter how much the value of firm increase
- Once value of firm > value of debt
- Debtholders do not gain anything beyond the value of debt
How does the payoff structure look like for an equity holder?
> Resembles a long call option
y-axis: Payoff
x-axis: Value of Firm
1) Starts from a certain value of firm and start increasing upwards at a constant rate /
- As equity holders have limited liability, they will lose at most what they have invested
- Thus, the payoff will not be negative
2) Only when value of firm > value of debt, equity holders will get their payoffs
(Note! Debt holders get paid first before equity holders)
What are the 2 types of public equity?
1) Public offering
- IPO (Initial public offering)
- Any retail investor can purchase
2) Private placement
- Company wants to raise funds but not from the general public
- Sale of new shares to private investors (high net worth individuals; institutional investors)
What are the 3 ways to price a public equity?
1) Fixed price
2) Single strike price auction
3) Discriminatory pricing auction
How does fixed price work?
Most common method.
- A single price for everyone
- Standard pricing
- Usually negotiatied between underwriter and company
How does single strike price auction work?
Basic floor price
- Clear the market at the price where all the shares can be cleared.
Example: If you bid $5 but the clearing price is $2, you pay $2
- All successful competitive and non-competitive bidders are awarded securities at the price equivalent to the highest rate or yield of accepted competitive tenders
How does discriminatory pricing auction work?
Pay whatever you bid for
What are the 4 interesting features of the IPO market?
1) Underpricing of IPOs
- Compare IPO price with the closing price on the 1st day of trading
- If closing price is greater, IPO is underpriced as it can be sold at a higher price on the first day
- On the second day, the basis will not be $1.00 anymore but the price that is calculated at the end of the first day
2) There are “hot periods” for IPOs:
- Normally during bull run
- Many IPOs
- Higher trading volume
- Higher first day returns
> Leads to more severe underpricing
3) IPOs underperform in the long run (more than 5 years)
- Returns of portfolio of IPOs will be lower than the market returns in the long-term
- In the short-term, the portfolio of IPOs may have a higher return than the market
4) Average underpricing is calculated per country
What happens when IPO underpricing become more severe?
The percentage increases.
IPO closing prices are higher than the IPO on the first day.
Vice versa
Example:
IPO - $1.00
Japan - 28.4% –> Closing price is $1.284
Why are some countries’ underpricing more severe?
When stock market is young, e.g. China, there tends to be a higher demand for IPOs that come from China.
More mature market, underpricing will be less severe.
Why do we think that the market is rational?
2
1) Any irrational behaviour and anomalies will be priced away
2) Underpricing is persistent across all markets
- Even if there are market disturbances that cause IPOs to be overpriced, they will not persist like underpricing of IPOs
