Question 1
Stock flipping refers to buying stocks during an initial public offer with the intention of reselling them immediately at a profit. It is a short term investment strategy that takes advantage of existence of liquid markets. Institutional investors engage more in stock flipping than individual investors since they have more shares availed to them at the offer price .
Investment banks encourage stock flipping for various reasons. If an IPO is allocated only to long term investors, there will be no trade in the secondary market. The stocks will be in the public but they will be illiquid since nobody is selling. This is an undesirable outcome for investment banks since they will have no role in the secondary market. It will also deny them revenue since investment bank revenue is mainly from brokerage commission from facilitating selling and buying of stock by the public. Investment banks price IPO stocks below the market clearing price to encourage flipping. Under pricing IPO stock creates excess demand, the investment bank then rations the stock among investors. This in turn creates high demand in the aftermarket causing the stock price to appreciate. An appreciation in the stock price encourages flipping hence stimulating trading activities in the secondary market .
Investment banks are however cautious not to encourage over flipping. Both flippers and investment banks are looking for buyers. In case an investments bank places all the shares with flippers, the investment bank would have failed to find stock buyers which would disappoint the issuer firm. Investment firms therefore strike a balance between encouraging flipping and selling to long term investors.
Question 2
American Depositary Receipts (ADRs) are foreign stocks that are traded in the United States exchanges in United States dollars. Many foreign firms use ADRs to tap American individual and institutional investors. ADRs involve issuing of dollar dominated claims issued by United States investment banks on behalf of the issuing firm. ADRs can be classified into two categories; sponsored ADR and unsponsored ADR.A sponsored ADR is one which the issuing company absorbs all financial and legal costs associated with the creation and trade in the security. The issuing company pays an American depository firm to create and sell the security. On the other hand, an unsponsored ADR refers to one which the issuing company is not in any way involved with the issue of the security .
ADRs are popular with investors in the United States because it provides them with an opportunity to diversify their portfolio internationally. This acts as a hedge to mitigate losses that may arise in their American stocks in a bear market. Another reason why ADRs are popular with American investors is that ADRs eliminate foreign exchange risk associated with dealing in multiple currencies since dividends are paid in dollars and their prices are also quoted in dollars. Lastly ADRs are covered with the United States securities laws and are subjected to similar settlement and clearing procedures like any other Americans stocks and securities. American investors are therefore more conversant with them compared to other offshore investments that are subject to a different set of securities laws and regulations .
Question 3
Debentures are long term promissory notes that are used to raise debt finance. The firm promises to pay interest periodically and the principal amount on maturity. Generally, debentures are not secured on a specific firm’s property .
Debentures are the most common type of corporate bonds in the United States for the following reasons; it is a cheap source of finance, does not dilute ownership, interest obligation decline during periods of inflation and debenture holders do not participate in extra ordinary earnings of the company. Debentures are less costly because they are considered less risky by investors. Therefore, they have lower rates of return, interest paid on debentures is tax deductable and they have lower floatation cost when compared to common stock. Debenture holders do not participate in decision making of the firm. Therefore issuing debenture has no effect on the ownership of the firm. Interest obligation on debentures is fixed when they are issued hence, during inflation the company benefits as its obligation to pay interest and the principal amount is fixed yet there is a decline in real terms. Lastly, debenture holders do not participate in extra ordinary earning since their earnings is limited to interest .
Debentures are not as popular among European companies as they are with American firms. Debentures are classified as debt and therefore impacts on gearing level. Increased gearing level increases financial risk associated with fixed interest obligations. Failing to honour debt agreements could lead to liquidation of a company. European managers are risk averse and hence prefer equity financing to debt .
Question 4
A lease is a contractual agreement that involves the transfer of possession and enjoyment rights of an asset for a stipulated period of time. There are numerous advantages and disadvantages of leasing over buying an asset .
Preservation of capital is one the advantages of leasing over buying an asset. Leasing firms provides 100 percent finance. This allows the firm to invest the cash that would have been used in purchasing the asset in profitable projects. Secondly, leasing is an off balance sheet financing. If the firm were to purchase an asset it might be forced to borrow to finance the purchase. This will increase the firm’s gearing level. However, leasing does not affect gearing level of a firm. Lastly, leasing mitigates obsolescence risk. Leasing transfers the risk of an asset being obsolete due to changes in technology as lease agreements are cancellable. However, once an asset is purchased, a firm cannot transfer obsolescence risk .
The key disadvantages of leasing compared to purchasing an asset include; lack of salvage value, high interest cost and difficulty in making property changes. At the expiration of a lease agreement, the salvage value of the asset is realized by the lesser. For assets that appreciate over time such as land, it would be more prudent for a firm to acquire them than lease them. Lease agreements tend to have higher interest rates than loans. It would therefore be cheaper to borrow to finance acquisition of the asset. Lastly, lease agreements prohibit the lessee from making improvement on the property without the leaser’s approval. This restricts a firm operation and utilization of an asset.
Question 1
A rights issue is the selling of shares of a firm to existing shareholders of the firm on a pro rata basis. This increases the number of shares current shareholders have but the voting powers and proportion of ownership remain the same. Rights issues are more common in Europe than in the United States .
American companies’ main interest in stock markets is to raise equity capital to finance growth. Rights issue limit the potential market for newly issued shares increasing the likelihood that some shares will be unsubscribed for. American companies therefore prefer allowing the entire public to subscribe for its shares to ensure they are fully subscribed. Allowing the entire public enables them to sell their shares at higher prices than would be possible in the case of a rights issue. Hence they can raise more funds to finance growth. Another reason is that American managers are risk takers and therefore more willing to take additional debt to finance new projects compared to European managers.
Europeans firms have different objectives for listing in the stock market. European firms’ interest in the stock market is to achieve certain capital and control structure. By issuing a rights issue, assuming all shareholders take up their rights, the proportional ownerships remains unchanged. Therefore, rights issue help European firms to achieve their objectives. European managers generally tend to be risk averse. They therefore strive to maintain low gearing levels by financing new projects with equity finance. The easiest way to raise equity finance from the stock market is through a rights issue.
Question 2
An initial public offer (IPO) is the sale of a company’s shares for the first time to the public. The lack of a historical market share price makes it difficult to price an IPO .Pricing an IPO is important to avoid under pricing or over pricing. If I were an investment banker I would consider several factors in pricing an IPO.
First, I would determine the beta of the firm from data of similar listed firms in the same industry. Beta is affected by leverage, therefore I would remove the leverage component then compute the weighted average of the unlevered betas. I would then assume the value is the unleveraged beta for the firm. Using the levering formula will obtain the cost of equity for the firm issuing the IPO. This will enable me to compute the theoretical market value of the offering .
Secondly, I would consider other qualitative and quantitative factors that would affect the value of the firm. These factors include; economic cycles, industry performance, public image of the firm and performance of other IPO offer. I would meet potential investors and gather information on the perception of the public about the company. I would also consider whether the market is bullish or bearish to determine investors’ level of optimism about the stock market. This will help me determine by what degree I need to under price the offering just to generate enough interest in the IPO without causing over flipping. Based on the results of the analysis, I would then determine by how much I would price the IPO below the theoretical market price.
Question 3
Callable bonds are bonds that contain a provision that allows the issuer firm to repurchase the bond and retire it before expiry of its duration at a pre-determined call price. Most firms issue bonds with call provision to permit them to retire the bond before maturity when need arises. Call provision normally has a window period within which it can be exercised .
A call provision on bonds always benefits the issuing firm more than the investor. Without a call provision, the issuer will be forced to continue making periodic interest payments until the bond matures. Firms issue callable bonds to hedge against interest rate risk. The interest rate risk is transferred to investors. Call options on bonds are normally exercised by the issuing firm when interest rates have declined. This enables the issuer to make a new debt issue at the lower interest rate thereby reducing associated finance costs .
Investors also benefit from the call provision since callable bonds have a higher coupon rate than non-callable bonds to compensate investors for accepting higher risk. However, when bonds are called investors can only invest at the new interest rate which is lower.
Call price is normally higher than the par value. This difference is known as the call premium. Call premium is meant to compensate investors for the loss of future interest payments. Call premium normally decline as the bond approaches maturity since the investor’s loss from disrupted interest income reduces as the bond approaches maturity .
Question 4
A lease is a contractual agreement that involves the transfer of possession and enjoyment rights of an asset for a stipulated period of time. There are numerous advantages and disadvantages of leasing over buying an asset. There two types of leases; finance lease and operating lease. An operating lease is short term in nature and only confers to the lessee the right to use the asset but does not confer all benefits associated with the asset ownership. A finance lease refers to a long term lease. It is also referred to as capital lease. A lease has to meet certain criteria to be referred as a finance lease .
For a lease to be classified as a finance lease; the lease term must be equal to or greater than 75 percent of the estimated useful life of the leased asset or property. Secondly, the present value of all rental or any other minimum lease payments should be equal to or greater than 90 percent of the fair market value of the leased asset minus investment tax credits that were retained by the landlord. Thirdly, the contractual agreement of the lease expressly states that the ownership of the leased asset or property will be vested on the lessee on the expiry of the lease agreement. The lease agreement should also contain a clause that states that the lease is non cancellable. Lastly. the lease contains a purchase bargain option. The purchase bargain option should be relatively below the anticipated fair market value as an assurance that the lease agreement will be exercised.
References
DeMarzo, P. M., & Berk, J. B. (2007). Corporate finance (illustrated ed.). New York: Pearson Addison Wesley.
Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach (3, illustrated ed.). Chicago: Cengage Learning.
Megginson, W. L., Smart, S. B., & Gitman, L. (2007). Corporate Finance (2, illustrated ed.). Thompson South-Western: Cengage Learning.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
