Chapter 18 Equity Trading

1
The Public Issues and Markets
2
The Public Issue

• The Basic Procedure
• Management gets the approval of the Board of
  Directors.
• The firm prepares and files a registration
  statement with the SEC.
• The SEC studies the registration statement during
  the waiting period.
• The firm prepares and files an amended
  registration statement with the SEC.
• If everything is copasetic with the SEC, a price
  is set and a full-fledged selling effort gets
  underway.

3
Alternative Issue Methods

• There are two kinds of public issues
• The general cash offer
• The rights offer
• Almost all debt is sold in general cash offerings.

4
The Cash Offer

• There are two methods for issuing securities for
  cash
• Firm Commitment
• Best Efforts
• There are two methods for selecting an
  underwriter
• Competitive
• Negotiated

5
Firm Commitment

• Under a firm commitment underwriting, the
  investment bank buys the securities outright from
  the issuing firm.
• Obviously, they need to make a profit, so they
  buy at wholesale and try to resell at retail.
• To minimize their risk, the investment bankers
  combine to form an underwriting syndicate to
  share the risk and help sell the issue to the
  public.

6
Best Efforts

• Under a best efforts underwriting, the
  underwriter does not buy the issue from the
  issuing firm.
• Instead, the underwriter acts as an agent,
  receiving a commission for each share sold, and
  using its best efforts to sell the entire
  issue.
• This is more common for initial public offerings
  than for seasoned new issues.

7
Mechanics of Rights Offerings

• The management of the firm must decide
• The exercise price (the price existing
  shareholders must pay for new shares).
• How many rights will be required to purchase one
  new share of stock.
• These rights have value
• Shareholders can either exercise their rights or
  sell their rights.

8
Rights Offering Example

• Popular Delusions, Inc. is proposing a rights
  offering. There are 200,000 shares outstanding
  trading at 25 each. There will be 10,000 new
  shares issued at a 20 subscription price.
• What is the new market value of the firm?
• What is the ex-rights price?
• What is the value of a right?

9
Rights Offering Example

• What is the new market value of the firm?
• There are 200,000 outstanding shares at 25
  each.There will be 10,000 new shares issued at a
  20 subscription price.

10
Rights Offering Example

• What is the ex-rights price?
• There are 210,000 outstanding shares of a firm
  with a market value of 5,200,000.
• Thus the value of an ex-rights share is

• Thus the value of a right is
• 0.2381 25 24.7619

11
Private Placements

• Avoid the costly procedures associated with the
  registration requirements that are a part of
  public issues.
• The SEC restricts private placement issues
• or no more than a couple of dozen knowledgeable
  investors including institutions such as
  insurance companies and pension funds.
• The biggest problem is that the securities cannot
  be easily resold.

12
Public offering vs. Private Placements
13
Venture Capital

• The limited partnership is the dominant form of
  intermediation in this market.
• There are four types of suppliers of venture
  capital
• Old-line wealthy families.
• Private partnerships and corporations.
• Large industrial or financial corporations have
  established venture-capital subsidiaries.
• Individuals, typically with incomes in excess of
  100,000 and net worth over 1,000,000. Often
  these angels have substantial business
  experience and are able to tolerate high risks.

14
Stages of Financing

• 1. Seed-Money Stage Small amount of money to
  prove a concept or develop a product.
• 2. Start-Up Funds are likely to pay for
  marketing and product refinement.
• 3. First-Round Financing Additional money to
  begin sales and manufacturing.

15
Stages of Financing

• 4. Second-Round Financing Funds earmarked for
  working capital for a firm that is currently
  selling its product but still losing money.
• 5. Third-Round Financing Financing for a firm
  that is at least breaking even and contemplating
  expansion a.k.a. mezzanine financing.
• 6. Fourth-Round Financing Financing for a firm
  that is likely to go public within 6 months
  a.k.a. bridge financing.

16
Summary and Conclusions

• Larger issues have proportionately much lower
  costs of issuing equity than small ones.
• Firm-commitment underwriting is far more
  prevalent for large issues than is best-effort
  underwriting. Smaller issues probably use best
  effort because of the greater uncertainty.
• Rights offering are cheaper than general cash
  offers.
• Venture capitalists are an increasingly important
  influence in start-up firms and subsequent
  financing.

17
Market

• is any mean through which buyers and seller are
  brought together to transfer goods and services
• Market structure characteristics
• Price-driven (Pure auction market) when buyers
  and sellers submit their bid and ask prices to a
  central location and transactions are matched by
  brokers who do not have a position in the stock.
• Order-driven (Dealer market) when buyer and
  sellers submit their orders to dealers, who
  either buy the stock for their own inventory or
  sell the stock from their own inventory.

18
Market

• The characteristics of a well-functioning
  securities market
• 1.Provide timely and accurate information on the
  price
• and volume of past transactions and on the
  supply of
• and demand for current goods and services
• 2.Provide liquidity
• 2.1 marketability being able to sell
  quickly
• 2.2 price continuity prices not change much
  from a
• transaction to the next in the absence of new
  news.
• 2.3 Depth numerous buyers and seller
  willing to trade.
• 3. Internal efficiency the lowest possible
  transaction costs.
• 4. External efficiency prices rapidly adjust
  to new
• information so that the prevailing market
  price reflects all
• available information regarding the asset.

19
Market

• Markets are also categorized as primary or
  secondary.
• Primary markets relate to the sale of new
  issues of securities. They are markets for
  Initial Public Offering (IPO)
• Secondary markets are place where securities
  trade or exchange after their IPO. The secondary
  markets play an important role for liquidity.

20
Market

• Broker an entity that acts as the agent of an
  investor who wishes to execute orders.
• Dealer an entity that stands ready and willing
  to either buy stocks for its own account or sell
  from its account.
• Bid willingness to buy a security at a given
  price.
• Offer willingness to sell a security at a given
  price.
• Dealers always take advantages on spread
  between Bid and Offer. They buy cheap and sell
  expensive.

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24
Market

• Over-the-counter (OTC) a market where listed
  stocks and unlisted stocks are traded by multiple
  market makers.
• US markets
• 1. The National security exchanges i.e. NYSE ,
  AMEX
• 2. Regional security exchanges i.e. Midwest,
  Pacific, Philadelphia, Boston, and Cincinnati.
• 3. OTC market i.e. NASDAQ

25
Efficient Capital Markets

• An efficient capital market is one in which stock
  prices fully reflect available information.
• The efficient capital market has implications for
  investors and firms.
• Since information is reflected in security prices
  quickly, knowing information when it is released
  does an investor no good.
• Firms should expect to receive the fair value for
  securities that they sell. Firms cannot profit
  from fooling investors in an efficient market.

26
Reaction of stock price to new information in
efficient and inefficient Markets
Stock Price
Overreaction to good news with reversion
Delayed response to good news
Efficient market response to good news
-30 -20 -10 0 10 20 30
Days before (-) and after () announcement
27
Reaction of stock price to new information in
efficient and inefficient Markets
Efficient market response to bad news
Stock Price
Delayed response to bad news
-30 -20 -10 0 10 20 30
Overreaction to bad news with reversion
Days before (-) and after () announcement
28
The different types of efficiency

• Weak Form
• Security prices reflect all information found in
  past prices and volume.
• Semi-Strong Form
• Security prices reflect all publicly available
  information.
• Strong Form
• Security prices reflect all informationpublic
  and private.

29
Weak Form Market Efficiency

• Security prices reflect all information found in
  past prices and volume.
• If the weak form of market efficiency holds, then
  technical analysis is of no value.
• Often weak-form efficiency is represented as
• Pt Pt-1 Expected return random error t
• Since stock prices only respond to new
  information, which by definition arrives
  randomly, stock prices are said to follow a
  random walk.

30
Semi-Strong Form Market Efficiency

• Security Prices reflect all publicly available
  information.
• Publicly available information includes
• Historical price and volume information
• Published accounting statements.
• Information found in annual reports.

31
Strong Form Market Efficiency

• Security Prices reflect all informationpublic
  and private.
• Strong form efficiency reflected weak and
  semi-strong form efficiency.
• Strong form efficiency says that anything related
  to the stock and known to at least one investor
  is already incorporated into the securitys price.

32
Relationship among three different information
sets
33
Types of Orders

• Market Orders an order executed at the best
  price available in the market.
• Limit Orders an conditional order which be
  executed only if the limit price or a better
  price can be obtained.
• Buy limit order means that stock may be
  purchased only at the designated price or lower.
• Sell limit order means that stock may be sold
  only at the designated price or higher.

34
Index and Benchmark

• Price-weighted an arithmetic average of
  current prices therefore, index is influenced by
  the differential prices of its components. i.e.
  Dow Jones Industrial average 30(DJIA), Nikkei 225

DJIAt the value of the DJIA on day t Pit
the closing price of stock i on day t Dadj
the adjusted divisor on day t
35
Index and Benchmark

• Value-weighted compares market value (number of
  shares outstanding x current price) at time t
  with market value on the base day. i.e. SET
  Index.

Indext Index value on day t Pt the
ending prices of stocks on day t Qt the
number of outstanding shares on day t Pb the
ending prices of stocks on base day Qb the
number of outstanding shares on base day
36
SP indexes vs. Russells indexes

• SP indexes are committee driven whereas
  Russells indexes are completely formula driven.
• SP indexes are market-cap weighted, whereas
  Russells are market-float weighted. Cap weighted
  is more transparent than float weighted since
  determining the number of shares outstanding is
  easier than determining those available for
  purchase.
• SP rebalances its indexes continuously when a
  company goes out of business or is acquired, SP
  finds a replacement. In contrast to Russell which
  makes all index changes once a year (on June 30).