QUESTION 1:
INTRODUCTION:
Pet.com is an e-business, founded by two graduates and Ms. Solberg, with a total equity capital of $1.5 million. Despite greater losses the company has tolerated, investors are eager to invest in the shares. Seeing the excitement, company decided to go public with the sale of 500,000 shares in initial public offering by the three existing shareholders, along with the sale of additional 750,000 shares by the company so as to provide funds for expansion. Further, the underwriters suggested placing price at $18 a share instead of $24, but financial manager was worried about the fact that IPO cost would not be covered with the issued cost. However, underwriters dismissed the manager’s point by considering IPO cost as part of the issue cost. The concern that has emerged is about the role of manager. The report has presented some theoretical findings leading to spontaneous results and solutions that will help business owners to take a decision.
PRICING:
On average, initial public offerings (IPOs) are underpriced. The average prices of stocks that are traded in the secondary market are much higher than the IPO price. Numerous research papers claim that mostly the private companies with higher uncertain equity projections are difficult to value; thus companies imagine that the complexity of valuation problem can be effectively solved through underpricing. On the other hand, many researchers have doubted that this process of IPO price setting would result in extreme underpricing of IPO stocks.
The main issue of contradiction is about the price of IPO. Issuers want higher price as in this case as this leads to a higher amount of capital. However, from underwriters’ point of view, they tend to decline the prices of the IPO with the intention of reducing the risk of holding unsold shares in the open market. The lower prices of shares maximize the probability of selling all the shares that underwriters hold and ease the financial burdens of underwriters. However, underwriters are willing to lower the prices of shares from its ideal level as issuers do not have adequate information about market conditions (Tirole, 2010). Whereas, the issuer is reluctant to opt for the underpriced IPO as this will cause all the wealth to transfer from issuers to underwriters.
There are numerous theories and models that are discussed below to identify the key factors that cause the securities to be underpriced. According to researches of Megginson and Weiss in 1991, and Cater and Manaster in 1990, there is a negative relationship between underpricing of issues and reputation of underwriters (Razafindrambinina and Kwan, 2013).
THEORIES AND MODELS OF UNDER PRICING:
Therefore, a number of competing theoretical models have been developed to explain the initial underpricing of stocks. The major theories that describe the IPO literature are the winner’s curse hypothesis, the ownership and control hypothesis, book building theories, signaling theories and so on. Based on the winner’s curse hypothesis, the most important theory of underpricing was developed by Rock in 1986 (Bansal and Khanna, 2012). He differentiates the uninformed and informed investors. The underpriced issues result in oversubscription of IPOs by the informed investors and in this way uninformed investors would get the limited number of shares. Similarly, the overpriced issues result in exclusive selling of IPOs to uninformed investors that will generate negative initial returns. Therefore, the complete shares will be won by uninformed investors, but at an unfavorable price, that developed the situation of winner’s curse. So as to keep the uninformed investors in the IPO market, securities are presented at the discount rate from their expected prices aftermarket prices. Hence, the reduction in information asymmetry between informed and uninformed investors would result in a decline in IPO underpricing.
Dolvin and Jordon in 2008 addressed the consequences of underpricing by claiming that high underpricing has adverse impacts on pre-existing shareholders. He led to the results that high underpricing are connected with higher retention of shares, which effectively equalize the potential cost to the greater extent. Hence, the percentage shareholder wealth lost is stable by the time, contrasting underpricing itself. Moreover, many factors of underpricing are not crucial factors of going public cost to pre-existing owners (Bansal and Khanna, 2012).
Another researcher, Kumar (2008), observed the efficiency of issuing mechanism of IPO by studying the sample of Indian IPOs. According to the findings, the issuers are using either book building or fixed price offers do not affect in terms of the total cost. It has been identified that the expenses incurred in the issuance of shares are more. Hence the magnitude of underpricing in IPOs is different in both cases (Bansal and Khanna, 2012).
Besides the financial aspects, the standings of the underwriters have significant impact on initial return of shares. In general, the financial and non-financial factors of IPO affect the IPO underpricing. There are a number of financial as well as non-financial factors that influence IPO. Financial factors are current ratio, earning per share, return on asset, financial leverage and earnings growth and others. Some of the non-financial factors that influence IPO include; the type of industry, company’s age and size, and reputation affect the IPO underpricing (Razafindrambinina and Kwan, 2013).
UNDERPRICED IPOs:
Theories have explained that underpricing that is set due to ownership dispersion and information production will give the favor to issuing firms. The issuing firms who wish to have greater extent of dispersed ownership, underpricing their IPOs would be the best option which will encourage more investors to search for information about the issues and thus purchase the shares. The ownership dispersion will help to increase the liquidity and aftermarket trading while the existing owners retain their control throughout the company. Thus, it concludes that there is a positive relation between liquidity, aftermarket trading and underpricing. However, an explanation proposes an indirect relationship between liquidity, aftermarket trading and underpricing. When there is a risk of narrowing down the aftermarket trading for IPO, the trading cost associated with asymmetric information increases, which lead to increasing demand for maximum underpricing in order to compensate the liquidity risk investors are facing (Booth, n.d.).
Moreover, there is an argument that underpricing serves as an alternate for marketing expenditure. Highly underpriced IPOs receive media attention and publicity to some extent. According to research, the underpricing of IPOs minimizes the additional marketing expenditure by the same rate. Also, more analyst coverage is attained with the higher underpriced IPOs (Booth, n.d.).
Undoubtedly, underpricing is set at the expense of business owners and capitalists of the issuing company. However, these owners do not typically oppose the underpricing as they usually sell their shares after the six months of lockup expiration period. Underpricing is also the source of creating excitement among. This excitement would develop sustainable interest in the company’s issues. Hence, owners seek to make the demand strong until the lockup period runs out. Also, owners feel satisfy with additionally generated wealth and thus capable to give some money advantage to new investors. Simply, underpricing is seen as a foreseeable cost of going public (Booth, n.d.).
Part A: Whether Pet.com would prefer a low stock price?
A thorough view of the company’s equity position, its expenses and the number of shares it has to issue has been presented in the below calculations. This computation has provided the brief outlook of the situation to reach the best possible decision, by considering share prices, company’s expenses and the difference between net returns of both the proposed prices of the share.
According to the total equity and number of shares, Pet.com has issued 250,000 shares. The company has observed high level of investors’ interest in the issue of these shares, and hence suggested selling the issue at price $24 per share. However, underwriters proposed to sell the issue at price $18 per share. The matter is to identify whether this underpricing will be fruitful for the company or not.
It has been identified that the net inflow of the company is more when the shares are issued at $24 than $18. The difference between returns at both share prices is calculated to be 1.5million which is huge.
Despite this huge difference, Pet.com should prefer to sell the issue at $18 per share. Considering the current situation of the company, underpricing can fulfill the purpose of the company to flourish. With the limited ownership, Pet.com can gain benefits of dispersed ownership to a greater extent by underpricing their IPOs. Therefore, this option would be the best option as this will encourage more investors to search for information about their issues and thus purchase the shares. The ownership dispersion will help to increase the liquidity and aftermarket trading while the existing owners retain their control throughout the company.
Also, underpricing will protect the company from losing the value of issues after the six months of lockup expiration period. Underpricing is considered to be a foreseeable cost of going public that will help in creating excitement among investors to maintain their interests in the company’s issues. In this way, company can make the demand strong until the lockup period terminates. Also, company will be able to generate additional wealth and thus capable to give money advantage to its new investors.
Moreover, underpricing will help to build a strong relationship with reputable underwriters as the issues at lower prices are likely to sell successfully that underwriters hold and thus ease the financial burdens of underwriters.
Part B: Whether this would make the issue of shares less costly
Underpricing makes the issue less costly as it serves as an alternate for marketing expenses. There is a great advantage to the company because underpriced IPOs receive media attention and publicity to some extent. As the report has discussed the relevant research in the theory which concluded that underpricing of IPOs minimizes the additional marketing expenditure by the same rate. Also, more analyst coverage is attained with the higher underpriced IPOs. These advantages will reduce the cost of the company.
Part C: The issue of underpricing of the issue price of Pet.com if the existing shareholders had not planned to sell:
The major threat that the Pet.com is facing with underpricing of the issue price is the fear of transfer of wealth to underwriters. Issuers always want to issue at higher prices in order to generate greater capital. However, on the other hand, underwriters make efforts to lower the prices so that the risk of unsold holding shares reduces. Since issuers are not aware of the current market conditions; underwriters have enough control to lower the prices of shares from its ideal level. Therefore, this situation results in the fear of undue transfer of wealth from the issuer to the underwriter.
QUESTION 2:
This report analyses the financial condition and performance of a multinational company and then the future payout policy and strategy of the company have been discussed. The question rises whether the company issue dividends or prefer repurchase their shares. To consider this, CFO has discussed the case in favor as well as against both the policies with regards to the multinational company, including reference to MM dividend irrelevance theory.
ISSUING DIVIDENDS:
Primary disadvantage that a multinational company will face is that the stock dividends enhance the numbers of outstanding shares, in result; companies cut the share into numerous but smaller pieces. Suppose, if dividends occur at some different time regardless of events that change the future projections of company’s cash flows. For example, projections of higher earnings, in that case, shareholders would expect the alteration in the price of stocks so that it would not affect the investors’ wealth.
Another drawback of the dividend is that it is challenging to develop a persuasive justification for small stock dividends such as 5% or 10%. Stockholders have to tolerate the administration cost relate to the distribution. However, there is no economic value being generated or distributed. In addition, most multinational companies today evade small stock dividends as it is complicated to hold the odd number of shares that may come as a consequence of small stock dividend.
The major benefit of the stock dividend is that there is the best possible price range for stocks. For example, if a stock has a price range of about $20-$80, then investors will purchase stock in round figures at minimum commissions. The stock with the higher prices would place round lots that a small investor cannot afford, and lower prices of stocks would reflect the image of poor stocks. Therefore, companies mostly try to keep their stock within the range of $20 to $80. If this situation goes in favor of the company, it will decrease the prices by splitting its stocks occasionally.
Another influencing factor is that the management of a multinational company will pay a dividend if the earnings and dividends are projected to improve in the future, then dividend actions will give a positive signal and consequently increase the stock prices. Contrary, if future dividend and earnings are expected to fall, the stock price will also decline while managers will lose the credibility (Farre-Mensa, Michaely and Schmalz, 2014).
STOCK REPURCHASE:
It refers to distributing the cash to stockholders by repurchasing its own stocks instead of paying out as dividends. The major advantages that multinational company can gain are listed below:
- A repurchase announcement serves as a positive signal believing that the company’s shares are undervalued.
- Stock repurchase gives the choice or flexibility to the shareholders i.e. they can either collect cash and pay taxes or hold the shares and then avoid taxes.
- A repurchase does not force the management to carry any future repurchases.
- Repurchased stocks are treasury stocks that can be used in mergers. The company can resell these stocks easily in the open market whenever it requires cash.
- Repurchases change by the time without projecting any unfavorable signals, unlike dividends.
- Capital structure can be varied at large-scale through repurchases.
However, there are some threats that are detrimental for the multinational company, including:
- If a multinational company has very few favorable investment opportunities, then in such situations, the option of repurchasing the shares can decline the prices of stock. However, such a strategy reflects the management is making investment in low-return ventures.
- Huge penalties could be imposed if IRS of the multinational company found that repurchase was made to keep away from taxes on dividends.
- The multinational company may propose a stock price which results the company to pay a higher share prices. In this case, shareholders who are selling their shares would gain profits at the cost of the shareholders left behind. This scenario can happen if the tender offer were presented with the higher prices of shares, or else repurchases were done in an open market and the buying pressure increases prices higher than its equilibrium level (Farre-Mensa, Michaely and Schmalz, 2014).
In relation to Modigliani and Miller’s dividend irrelevance proposition, the theory refers that the dividend policy is irrelevant in terms of its effects on the value of the company as investors do not differ between capital gains and dividends. Modigliani and Miller proposed this dividend irrelevance theory. They made few restrictive assumptions which include:
- There will no transaction cost, when stocks are bought or sold.
- There is no tax payment on the dividends.
- Mangers and investors will have identical information about company’s future earnings.
MM also reported that growth rate of the company declines if the company pays a dollar per share of dividends since, new shares will be sold to substitute the capital remunerated as dividend. Considering this assumption, every dollar spent on dividends will decrease the stock price by one dollar. Hence, MM proves that shareholders are indifferent between capital gains and dividends (Villamil, n.d.).
Keeping in mind all the crucial effects that multinational company can meet, I, as a CFO would recommend the repurchase share policy as company’s future payout policy, to cope up with the slow economy of US. The reasons behind this decision are that repurchases can vary with the time without giving any unfavorable signal to future performances. Also, repurchased stocks can be resold easily in an open market whenever the cash is required. Repurchases provide the decision flexibility to shareholders about payment of taxes and collecting of cash. Therefore, repurchasing of stock will help the multinational company can control and change its capital structure.
References
Bansal, R., & Khanna, A. (2012). Determinants of IPOs Initial Return: Extreme Analysis of Indian Market. Journal of Financial Risk Management, vol. 1, no. 4, pp. 68-74.
Booth, L. (n.d.). The Cost of Going Public: Why IPOs Are Typically Underpriced. QFinance. [online] Available at: http://www.qfinance.com/contentFiles/QF02/gjbkw9a0/17/0/the-cost-of-going-public-why-ipos-are-typically-underpriced.pdf [Accessed 21 May 2014].
Farre-Mensa, J., Michaely, R., & Schmalz, M. C. (2014). Payout Policy. Available at SSRN 2400618.
Kumar, S. S. S. (2008). Is Bookbuilding an Efficient IPO Pricing Mechanism?-The Indian Evidence. In 21st Australasian Finance and Banking Conference.
Razafindrambinina, D., & Kwan, T. (2013). The Influence of Underwriter and Auditor Reputations on IPO Under-pricing. European Journal of Business and Management, vol. 5, no. 2, pp. 199-212.
Tirole, J. (2010). The theory of corporate finance. Princeton University Press.
Villamil, A., n.d.. The Modigliani-Miller Theorem. The New Palgrave Dictionary of Economics. [online] Available at: http://www.econ.uiuc.edu/~avillami/course-files/PalgraveRev_ModiglianiMiller_Villamil.pdf [Accessed 21 May 2014]
