McGraw-Hill/Irwin
Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

3.1 HOW FIRMS ISSUE SECURITIES
3-2

Primary Versus Secondary Markets
Primary Market: Market for new issues
(stocks, bonds, and other securities) between investment banks and the public
Initial Public Offerings (IPOs) vs. Seasoned
Equity Offerings (SEOs)
Key feature: Issuer receives the proceeds from the sale
Secondary Market
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is not directly involved
3-3

How Securities Are Issued
Three common methods of the sale of shares in an IPO:
– Firm commitment : Investment banks purchase the securities from the issuer and then resell them to the public
– Best efforts : Investment banks only pledge to provide its “best efforts” to sell between prespecified minimum and maximum number of shares
– Competitive auction
3-4

Figure 3.1 Relationship Among a Firm
Issuing Securities, the Underwriters and the Public
3-5

Shelf Registration
Introduced in 1982 under SEC Rule 415
Allows the issuer to register securities and gradually sell them to the public for two years after the initial registration
Little additional paperwork
Sold in small quantities to save substantial flotation costs
3-6

Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Allowed under Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings
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Two Anomalies: The New
Issues Market
1.
Short-Term Underpricing of Initial
Public Offerings
Internet Bubble Period (1999-2000) a.
b.
Average first trading day returns
1999: 72% and 2000: 56%
182 out of 803 IPOs: First trading day return of
100% or higher
2.
Long-Term Underperformance a.
b.
US IPO firms overvalued by about 50% relative to its industry peers in 1980-1997.
Only 12 out of 323 internet IPOs in 1999-2000:
Trading above their offer price as of early 2001.
3-8

U.S. IPO Statistics
Unit: $ Billion
Number of Average First Number of IPOs Money Left Gross
Year IPOs Day Return with Return >100% on the Table Proceeds
1990 104 10.8%
1991 273
1992 385
12.1%
10.2%
1
0
2
$0.45
$1.79
$2.15
$5.61
$15.92
$26.37
1993 483
1994 387
1995 432
1996 621
12.8%
9.8%
21.5%
16.7%
2
1
13
7
$3.92
$1.65
$5.03
$7.38
$34.42
$19.32
$28.35
$45.94
1997 432
1998 267
1999 457
2000 346
13.8%
22.3%
71.7%
56.1%
2001 80 14.0%
Total 4,267 24.19%
2
12
$4.64
$5.35
$31.70
$34.63
111 $37.94 $66.77
71 $27.68 $62.59
0 $2.97 $34.34
222 $100.99 $405.97
3-9

IPOs with Negative Earnings
Prior to Going Public
-----------------------------------------------------------------------------------------------------------------
Number of IPOs with 1 st
Day Returns
Period IPOs Negative EPS EPS<0 EPS>0
1980-1989 1,982 19% 9.1% 6.8%
1990-1994 1,632
1995-1998 1,752
26%
37%
1999-2000 803 79%
2001 80 49%
10.8%
19.2%
72.0%
13.3%
11.4%
17.4%
43.5%
11.6%
1980-2001 6,249 34% 31.4% 12.5%
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Long-Term Stock Performance of New Issues (IPOs and SEOs)
------------------------------------------------------------------------------------------------------------
Period
Number of 3-Year Return
Type Sample
5-Year Return
Issuer Nonissuer Issuer Nonissuer
A. US Market
1970-1990 IPO 4,753 8.4% 35.3%
1970-1990 SEO 3,702 15.0% 48.0%
B. Japanese Market
15.7% 66.4%
33.4% 92.8%
1971-1992 IPO 180 34.2% 82.9%
1971-1992 SEO 1,389 33.7% 51.5%
C. UK Market
62.1% 101.4%
74.1% 112.9%
1980-1988 IPO 806 55.7% 97.8% n.a.
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Long-Term Operating
Performance of IPO and SEO
Firms
Industry-adjusted operating return on assets:
Usually peak prior to the offering
Industry-adjusted asset turnover and other longterm performance measures: Deteriorate over time after the offering
IPO and SEO firms expand their assets faster than their sales overtime…..
Investment in negative NPV projects?
3-12

Which Anomaly Deserves
More Attention?
Long-term underperformance is a more serious issue a.
Due to Welfare Implications for
Investors b.
Short-Term Underpricing is a oneday phenomenon and can be corrected to some degree
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IPO Performance:
Japan’s Experience
Period*
I
II
III
Notes:
Number of IPOs
93
17
37
1 st
Day
Return Return**
70%
19%
12%
3-Day
0.8%
-0.8%
0.2%
* Period I (1/1/1980 - 5/1/1988):
Price Limits and Formula-Based Pricing
Period II (5/2/1988 - 3/31/1989):
No Price Limits but Formula-Based Pricing
Retained
Period III (4/1/1989 – 3/31/1993):
No Price Limits and Auction-Based Pricing
** Not including 1 st
day return
3-14

Typical Formula
Offer Price = P x [(A'/A) + (B'/B) + (C'/C)]/3 where
P = Average stock price of three similar companies;
A' = Dividends per share of the issuer;
A = Average dividends per share;
B' = Net income per share of the issuer;
B = Average net income per share;
C' = Net assets per share of the issuer; and
C = Average net assets per share.
3-15

What Explains Long-Term
Underperformance?
IPO and SEO firms exhibit unusually large and significant gains in operating performance one year prior to the offer date
SEO firms exhibit superb stock performance in the year prior to the offering
>>>>>> Earnings Management which mislead investors to be over optimistic about the issuer’s prospects
3-16

600
Distribution of Scaled Earnings
(Whole Sample)
500
400
300
200
100
0
-0.30
-0.25
-0.2
-0.15
-0.1
-0.05
0 0.05
0.1
0.15
0.2
Level of Earnings Scaled by the Beginning Total Assets
0.25
3-17

180
160
140
120
100
80
60
40
20
0
-0.30
Distribution of Scaled Earnings
(Large Size Quintile)
-0.25
-0.2
-0.15
-0.1
-0.05
0 0.05
0.1
0.15
Level of Earings Scaled by Beginning Total Assets
0.2
0.25
3-18

Distribution of Scaled Earnings
(Small Size Quintile)
180
160
140
120
100
80
60
40
20
0
-0.30
-0.25
-0.2
-0.15
-0.1
-0.05
0 0.05
0.1
0.15
0.2
Level of Earnings Scaled by Beginning T otal Assets
0.25
3-19

Country Classification by
Earnings Opacity Measure
Rank 5 (Most Opaque):
India, Indonesia, Japan, Korea, Greece
Rank 4:
Malaysia, Pakistan, Singapore, Taiwan, Turkey, S. Africa
Rank 3:
Hong Kong, Thailand, Austria, Finland, Germany, Ireland,
Netherlands
Rank 2:
Australia, Denmark, France, Sweden, Switzerland, United
Kingdom
Rank 1 (Least Opaque):
Belgium, Canada, Norway, Portugal, United States
Source: Bhattacharya, Daouk, and Welker(2002)
3-20

How to Minimize Long-Term
Underperformance of IPO and
SEO Firms?
Better Financial Disclosure
Improved Accounting Reporting System
Monitoring over Underwriting Activities
Corporate Governance
Investor Education
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3.6 BUYING ON MARGIN
3-22

Buying on Margin
Buying on margin means: You borrow part of the purchase price of the stock from a broker. The source of financing is called “ broker’s call loans .”
The broker in turn borrows money from banks at the call money rate .
The “margin” in the account is the portion of the purchase price you have to contribute.
The initial margin requirement is 50% at present., which means you have to pay in cash or T-bills (or equivalent) at least 50% of the purchase price, with the rest borrowed.
All securities purchased on margin must be maintained with the brokerage firm in street name because the securities are collateral for the loan.
3-23

Buying on Margin
Initial margin is currently 50% which is set by the
Fed.
Maintenance margin : The minimum amount of equity that must be maintained in a margin account.
Percentage margin is defined as the ratio of equity value to the market value of the securities
Margin call : notification from your broker when the percentage margin falls below the maintenance margin
3-24

Margin Trading – An Example
X Corp $70
50%
40%
Initial Margin
Maintenance Margin
1000 Shares Purchased
Initial Balance Sheet Position:
Stock $70,000 Borrowed $35,000
Equity 35,000
3-25

Margin Trading - Maintenance
Margin
Stock price falls to $60 per share
New Balance Sheet Position:
Stock $60,000 Borrowed $35,000
Equity 25,000
%Margin = $25,000/$60,000 = 41.67%
3-26

Margin Trading - Margin Call
How far can the stock price fall before a margin call?
Since 1000P - Amt Borrowed = Equity then:
(1000P - $35,000) / 1000P = 40%
P = $58.33
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3.7 SHORT SALES
3-28

Short Sales
Purpose : to profit from a decline in the price of a stock or security
Mechanics
Borrow stock from your broker
Sell it and deposit proceeds and margin in an account
Closing out the position: buy the stock and return to the party from which is was borrowed
3-29

Short Sale - Initial Conditions
Z Corp
50%
30%
100 Shares
Initial Margin
Maintenance Margin
$100 Initial Price
Your Initial Balance Sheet Position
Sale Proceeds
Margin (in T-Bills)
$10,000 Stock Owed $10,000
5,000 Net Equity 5,000
3-30

Short Sale - Maintenance Margin
Stock Price Rises to $110
New Balance Sheet Position
Sale Proceeds
Margin
$10,000 Stock Owed $11,000
5,000 Net Equity 4,000
%Margin (=4000/11000) 36%
3-31

Short Sale - Margin Call
How much can the stock price rise before a margin call?
Since Initial margin plus sale proceeds =
$15,000, then:
($15,000 - 100P) / (100P) = 30%
P = $115.38
3-32

1 st HW Assignments
Chapter 3 Problems 7, 8, and 10
Due date: February 6, 2008
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