Questions
1. Shareholder Rights. Explain the rights of common stockholders that are not available to other
individuals.
ANSWER: Common stockholders are permitted to vote on key matters concerning the firm such as
2. Stock Offerings. What is the danger of issuing too much stock? What is the role of the securities firm
that serves as the underwriter, and how can it ensure that the firm does not issue too much stock?
ANSWER: The issuance of too much stock can cause dilution of ownership, and can depress stock
Securities firms distribute or place stock for corporations. They serve as intermediaries since
3. IPOs. Why do firms engage in IPOs? What is the amount of fees that the lead underwriter and its
syndicate charge a firm that is going public? Why are there many IPOs in some periods and few IPOs
in other periods?
ANSWER: Firms engage in IPOs when they have feasible expansion plans but are already near their
debt capacity.
Firms prefer to engage in IPOs when business conditions and market conditions are favorable. They
4. Venture Capital. Explain the difference between obtaining funds from a venture capital firm and
engaging in an IPO. Explain how the IPO may serve as a means by which the venture capital firm can
cash out.
ANSWER: Before a firm engages in an IPO, it may obtain equity funding from a venture capital firm
5. Prospectus and Road Show. Explain the use of a prospectus developed before an IPO. Why does a
firm do a road show before its IPO? What factors influence the offer price of stock at the time of the
IPO?
ANSWER: A prospectus specifies how the proceeds of the offering are to be used, the past
The firm does a road show to promote its offering. That is, it explains to various institutional
The offer price is influenced by market conditions, industry conditions, and the prevailing market
6. Bookbuilding. Describe the process of bookbuilding. Why is bookbuilding sometimes criticized as a
means of setting the offer price?
ANSWER: The lead underwriter engages in bookbuilding by soliciting indications of interest in the
7. Lockups. Describe a lockup provision and explain why it is required by the lead underwriter.
ANSWER: Describe the pressure of the share price at the lockup expiration date. The lockup
provision restricts insiders and venture capital firms from selling their shares until a specified period
8. Initial Return. What is the meaning of an initial return for an IPO? Were initial returns of Internet
IPOs in the late 1990s higher or lower than normal? Why?
ANSWER: The initial return is the return from the offer price until the end of the first day of trading.
9. Flipping. What does it mean to “flip” shares? Why would investors want to flip shares?
ANSWER: Flipping shares refers to selling shares shortly after (such as a day or two) obtaining them
at the IPO. Some institutional investors attempt to flip shares to take advantage of an initial return
10. Performance of IPOs. How do IPOs perform over the long run?
11. Asymmetric Information. Discuss the concept of asymmetric information. Explain why it may
motivate firms to repurchase some of their stock.
12. Stock Repurchases. Explain why the stock price of a firm may rise when the firm announces
that it is repurchasing its shares.
ANSWER: Stock repurchases may signal that the firm’s managers believe the stock is undervalued, so
13. Corporate Control. Describe how the interaction between buyers and sellers affects the market value
of a firm, and explain how that value can subject a firm to the market for corporate control.
ANSWER: If a firm’s business performance is weak, investor demand for shares will typically be
14. ADRs. Explain how ADRs enable U.S. investors to become part owners of foreign companies.
ANSWER: American depository receipts (ADRs) are certificates that represent ownership of a
15. NYSE. Explain why stocks traded on the NYSE generally exhibit less risk than stocks that are traded
on other exchanges.
16. Role of Organized Exchanges. Are organized stock exchanges used to place newly issued stock?
Explain.
Advanced Questions
17. Role of IMFs. How have international mutual funds (IMFs) increased the international integration of
capital markets among countries?
ANSWER: International mutual funds (IMFs) have allowed investors easy access to foreign
18. Spinning and Laddering. Describe spinning and laddering in the IPO market. How do you think
these actions influence the price of a newly issued stock? Who is adversely affected as a result of
these actions?
ANSWER: Spinning is the process in which an investment bank allocates shares from an IPO to
corporate executives who may be considering an IPO or other business that would require the help of
Laddering ultimately results in upward price momentum, which may or may not accurately reflect the
fair value of the underlying stock. If spinning occurs at favorable stock prices, this may keep the stock
19. Impact of Accounting Irregularities. How do you think accounting irregularities affect the pricing
of corporate stock in general? From an investor’s viewpoint, how do you think the information used
to price stocks changes in response to accounting irregularities?
ANSWER: Generally speaking, accounting irregularities introduce additional uncertainty and risk.
The existence of accounting irregularities probably results in closer scrutiny of financial statements
20. Impact of Sarbanes-Oxley Act. Briefly describe the provisions of the Sarbanes-Oxley Act. Discuss
how this act affects the monitoring by shareholders.
ANSWER: The Sarbanes-Oxley Act:
1) Prevents a public accounting firm from auditing a client firm whose employees were employed by
the client firm within one year prior to the audit.
21. IPO Dilemma. Denton Co. plans to engage in an IPO and will issue 4 million shares of stock. It is
hoping to sell the shares for an offer price of $14. It hires a securities firm, which suggests that the
offer price for the stock be $12 per share to ensure that all the shares can be easily sold. Explain the
dilemma here for Denton Co. What is the advantage of following the advice of the securities firm?
What is the disadvantage? Is the securities firm’s incentive to place the shares aligned with that of
Denton Co.?
ANSWER: The advantage is that Denton Co. wants to have a successful offering in which it can sell
The securities firm wants to place all the shares for Denton. However, it does not suffer the loss in
proceeds when it lowers the offer price, although its fees from performing the underwriting function
22. Variation in Investor Protection among Countries. Explain how shareholder protection varies
among countries. Explain how enforcement of securities laws varies among countries. Why do these
characteristics affect the valuations of stocks?
ANSWER: Shareholders in some countries have more voting power and can have a stronger
influence on management of corporations. The legal protection of shareholders also varies
substantially among countries. Shareholders in some countries can more effectively sue
Investors have more power to ensure that management serves their interests if they have more
23. International ETFs. Describe international ETFs, and explain how ETFs are exposed to exchange
rate risk. How do you think an investor decides whether to purchase an ETF representing Japan,
Spain, or some other country?
ANSWER: Exchange-traded funds are passive funds that track a specific index. By investing in an
international exchange-traded fund, investors can invest in a specific index representing a foreign
The decision to purchase a specific ETF for a specific country is based on expected return and risk,
24. VC Fund Participation and Exit Strategy. Explain how venture capital (VC) funds finance
private businesses, as well as how they exit from the participation.
ANSWER: VC funds review proposals by private businesses that need funding. If they provide the
business with an equity investment, they may attempt to exit about 4 or 7 years later by selling its
25. Dilemma of Stock Analysts. Explain the dilemma of stock analysts that work for securities firms and
assign ratings to large corporations. Why might they prefer not to assign low ratings to weak but large
corporations?
ANSWER: Although analysts can provide useful information for investors, they have historically
been very generous when rating stocks. In the past, the bonuses paid to analysts were sometimes
26. Limitations of an IPO. Businesses valued at less than $50 million or so rarely go public. Explain
the limitations to such businesses if they did go public.
ANSWER: A public offering of stock may be feasible only if the firm will have a large enough
shareholder base to support an active secondary market. With an inactive secondary market, the
27. Private Equity Funds. Explain the incentive for private equity funds to invest in a firm and improve
its operations.
ANSWER Managers of a private equity fund typically take a percentage of the profits they earn
from their investments in return for managing the fund. They also charge an annual fee for managing
28. VCs and Lockup Expiration Following IPOs. Venture capital firms commonly attempt to cash out
as soon as is possible following IPOs. Describe the likely effect that would have on the stock price at
the time of lockup expiration. Would the effect be different for a firm that relied more heavily on VC
firms than other investors for its funds?
ANSWER: If many VC firms are selling their shares at lockup expiration, there is downward pressure
29. Impact of SOX on Going Private. Explain why some public firms decided to go private in response
to the passage of the Sarbanes-Oxley (SOX) Act.
ANSWER: For many firms, the cost of adhering to the guidelines of the act exceeds $1 million per
year. Many small, publicly traded firms decided to revert back to private ownership as a result of the
30. Pricing Facebook’s IPO Stock Price. Describe the dilemma of securities firms that serve as
underwriters for Facebook’s IPOs, when attempting to satisfy Facebook and the institutional investors
that invest in Facebook’s stock. Do you think that the securities firms that served as underwriters for
Facebook’s IPO satisfied Facebook or its investors in the IPO? Explain.
ANSWER: Based on the stock price movements over the first few months after the IPO, one may
argue that Facebook benefitted to a greater degree than its institutional investors. The stock price
31. Private Stock Market. What are some possible disadvantages to investors who invest in stocks
listed on a private stock market?
ANSWER: Investors need to register with the private stock exchange, and prove that they have
sufficient income (such as about $200,000 per year) and sufficient net worth (such as at least $1
million). Second, there is limited transparency because the required disclosure of information by
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers:
a. “The recent wave of IPOs is an attempt by many small firms to capitalize on the recent run-up in
stock prices.”
Firms prefer to go public when stock market conditions are favorable so that they can benefit
b. “IPOs transfer wealth from unsophisticated investors to large institutional investors who get in at
the offer price and get out quickly.”
Some institutional investors invest in IPOs at the offer price, and then quickly sell (flip) their
shares to individual investors who were not able to buy shares at the offer price. The individual
c. “Firms must be more accountable to the market when making decisions because they are subject
to indirect control by institutional investors.”
Managing in Financial Markets
As a portfolio manager of a financial institution, you are invited to numerous road shows at which firms
that are going public promote themselves, and the lead underwriter invites you to invest in the IPO.
Beyond any specific information about the firm, what other information would you need to decide
whether to invest in the upcoming IPO?
Market conditions should be assessed. As stock market conditions change, valuations change. In
addition, industry conditions change over time, which affect valuations of firms within a particular
industry.
Problem
1. Dividend Yield. Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each of
the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend
yield for Calzone stock?
ANSWER:
When the firm is publicly owned, management is at least partially separated from ownership.
Managers are agents who are supposed to be serving shareholder interests. Yet, the managers
c. Explain why institutional investors such as mutual funds and pension funds that invest in stock
for long-term periods (at least a year or two) may prefer to invest in IPOs rather than to purchase
other stocks that have been publicly traded for several years?
d. Given that institutional investors such as insurance companies, pension funds, and mutual funds
are the major investors in IPOs, explain the flow of funds that results from an IPO. That is, what
is the original source of the money that is channeled through the institutional investors and
provided to the firm going public?
The money invested by insurance companies comes from insurance premiums paid by
policyholders. The money invested by pension funds comes from retirement accounts of