Spring 2022 Final Exam on Initial Public Offers- Corporate Finance, University of Arkansas
Taking corporate finance exams on initial public offers (IPOs) can prove difficult for some students. This is why we have created this blog with some of the questions asked in the Spring 2022 final exam at the university of Arkansas. You can use these questions to help you complete future exams. We are also a finance exam writing service and you can always hire our qualified corporate finance exam helpers to do you test for you.
Exam Question
During the launch of a new public company favourable conditions are needed for a successful outcome. State two of the most important elements to consider when launching public companies.
Exam Solution
Two of the most important elements are timing and pricing. A listing that is otherwise sound can fail if the timing of the launch is poor. Even if all other circumstances are auspicious, the market is not likely to accept an issue that is over-priced.
TIMING
The art of timing has been likened to astrology. The object is to divine when three factors which may only be approximately related to each other will swing into alignment. It is important for those planning a flotation to catch the market while it is in a receptive mood. In smaller markets, the duration of this atmosphere may be quite brief. If conditions change, it may be a question not simply of adjusting the terms of the issue but of re-evaluating whether the issue can be undertaken at all.
PRICING
The pricing of a new issue may be approached from a theoretical and a practical angle. It is necessary to build up from fundamentals an assessment of what the price ought to be within a reasonable range. However, it must be recognized that over-sophistication can be dangerous. Discrepancies are inevitable between the theoretical basis and the realities of the marketplace. In practice, investors have a choice between shares in the new company and existing shares. Pricing must be set with an eye to the alternative opportunities open to investors.
Exam Question
The art of timing is important when a launching a public company. What are three factors to consider with regards to timing of an IPO?
Exam Solution
- Market cycles
- Fashions in sectors
- Fortunes of the particular company
Stock markets tend to run in cycles of some years' duration. Periods of time when, on average, prices are increasing are called 'bull' markets, while periods, when they are in decline, are dubbed 'bear' markets. Flotations are likely to be concentrated in the later phases of a bull market, particularly when the level of market turnover is also high. It is fairly obvious that companies would seek to issue new shares, or existing shareholders seek to dispose of some part of their holdings when prices are high. It is less obvious why investors also tend to be more receptive to flotations during a bull market. They might be expected to consider prices expensive and to be suspicious that existing shareholders were trying to off-load their shares at or near the peak of the market.
While some such feelings do no doubt exist, they seem to be outweighed by a mood of buoyant optimism that a bull market tends to bring with it. Investors are feeling confident and confidence spawns a willingness to experiment with new companies. Profits on existing holdings may be viewed as a bonus, available for trying something new. There may also be a shortage of sellers of shares in the more familiar companies. In these conditions, a pool of funds seems to be attracted to a series of new issues. As one closes, the over-subscriptions tend to be rolled into the next one.
In addition to generally favorable market conditions, the success of flotation is dependent on investors' current view of the sector in which a company is located. The market can be fickle as regards which sectors it finds attractive. Previously favored sectors can go rapidly out of style. Sometimes changes in basic economic conditions lie behind the market movements. For example, a drop in inflation, which can assist the industrial sector, may not suit property or financial shares. At other times, trends may reflect media attention or other ephemeral factors.
In view of the butterfly existence of a sector's popularity, it may be necessary to accelerate launch plans. However, the first company in a new sector to go public often plays a pioneering role, awakening investor interest and smoothing the path for others to follow. The pricing of the first issue is likely to be conservative. It may be more advantageous for the company going public to be a close follower rather than a leader. Some sectors may be so depressed that it is unlikely that a flotation on any reasonable terms would be acceptable to investors. If an industry like shipping or steel is caught in the throes of a long-term crisis, even a good company in the sector may beat on the door to no avail.
The final element in the timing of flotation is to identify a period when an upswing in a company's own fortunes coincides with its sector being in fashion and the market being in a bullish phase. The ideal time in the development of the company is when it can show a solid history of past performance and when a strong current year's profit can be forecast so as to achieve an attractive price for existing shareholders.
From a market point of view, there should be still the prospect of growth after the current year is completed. Markets are alert to an owner selling out a company in the peak year of its performance. The multiple at which the issue is pitched may prove misleading if earnings are reduced in the following years.
A balance should be struck between obtaining the best price for existing shareholders and something for the market to go for. It may be argued that an enthusiastic response to the issue is, in any case, in the existing shareholders' if it results in a well-spread shareholder base with an appetite for further investment and a good level of trading. This should prove of greater benefit to the company and its shareholders than engineering one-time killing. Assuming the original shareholders retain the majority of their holdings, they should be more concerned with the market value of their remaining shares than with achieving the highest possible issue price.
Exam Question
When determining the pricing of a new public company, fundamental analysis should be considered a starting point. State and explain the fundamental factors that valuation should be based on.
Exam Solution:
The starting point is to determine the appropriate basis for analysis. Care must be taken that valuation is not based on an assumption of a willing buyer/willing seller for the whole company, which will incorporate a premium for control. The value must be considered from the point of view of the buyer of a small number of shares in the market. However, companies are principally valued for stock market purposes by reference to their future earnings and dividends and their net asset backing.
- Multiple of earnings and related methods
- Net asset basis
Earnings forecasts for inclusion in a prospectus rarely cover a period of more than one year, so short-term factors predominate. in considering the price, the merchant bank should ask for, and will normally have access to, earnings projections for some longer period depending on the company's own planning process and the nature of the industry. Such forecasts are used mainly to assess the quality of the company's earnings and are not published. The earnings used in the price-earnings valuation formula will normally be the forecast earnings for the year currently in progress.
The projections which form the basis of earnings forecasts can be adapted to produce forecasts of cash flow to the company or to the shareholders in the form of dividends. Valuations can therefore also be carried out on the basis of discounted cash flow or dividends. Specific projections are rarely available beyond say three years, after which the usual expedient is to assume a constant growth rate. It should be appreciated, however, that, ignoring any differences in tax effects, valuations by reference to earnings, cash flow, or dividends are all variations on the same theme. Any material differences in the results of valuations of the same company based on these three factors must be due to a difference in the assumptions underlying the calculations.
The main factors determining the multiple to be applied to the forecast earnings are expected future growth and financial and commercial risk. If cash flows are used then the discount rate will be set principally to reflect risk. The estimate of growth will be built into the cash flows themselves. As a matter of mathematics, if cash flows are not assumed to increase, then an identical valuation will be produced by using a discount rate which is the reciprocal of the
price-earnings ratio. For example, if cash flows are assumed not to grow and to continue indefinitely, a price-earnings ratio of 8 and a discount rate of 121% will produce the same valuation. If dividends are used, the discount rate will again be set by risk factors. However, it is very likely that cash flows to the company will be substantially higher than cash flows to the shareholders, i.e. dividends paid. Consequently, the discount rate will have to be significantly lower if a valuation based on dividends is to be in the same range as one based on the company's cash flow. One justification for a lower discount rate is that the retention of earnings should produce higher growth. For the purpose of flotation, it seems unhelpful to base a valuation on dividends. The dividend yield on a share is likely to form only part of the investors' returns, the remaining and sometimes more significant contribution coming from capital gains in the market value.
An asset-intensive company, such as those in the property or shipping sectors, maybe most usefully priced by reference to the valuation of those assets fewer liabilities. On a theoretical basis, it is possible to argue that the value should include a premium over asset value to reflect the skill involved in putting together a portfolio, arranging the finance, and presenting a convenient package for an investor.
In practice, the price in the market often reflects a discount from the underlying asset value. This is most easily observed in the case of investment trusts whose assets consist of other listed shares and where the market value of the portfolio is regularly calculated and published. Despite the liquidity of these investments and the fact that the prices of the shares owned by the trust may already reflect a discount from their own underlying net asset value, the price of the shares in the investment trust usually reflects a further discount from the total market price of its portfolio, say, in the range of 10 to 15%. The reason for this phenomenon is not entirely clear; it may reflect an investor preference for being as close to the actual asset as possible. While this effect is most easily calculable in the case of investment trusts, it seems likely that it applies generally to companies valued in the market on a net asset basis.
The level of gearing will also be relevant. The growth of companies that are capital intensive is likely to be significantly dependent on the skill with which loan finance is deployed. The ideal level of gearing is one which reflects management's ability to use borrowings to increase shareholders' returns while not approaching levels that could impose financial strain and cramp the company's commercial freedom.
It is of course possible to analyze a group into businesses that are best valued on an earnings basis and those which are best valued on an assets basis and then add the two.
Exam Question
The realities of the market also play a part when determining the pricing of a new public company. What are the most important realities to consider as valuation is being done?
Exam Solution
The price at which a company is floated is influenced at least as much by the multiples of existing listed companies which are considered to be comparable as by the theoretical valuation exercise. In addition, discreet soundings will be taken by the merchant bank and the stockbroker among their market contacts to establish what the market feels is a reasonable price range for the flotation.
- Comparable companies
- Market soundings
Considerable time and effort will be spent in selecting the companies which can be legitimately used as the basis of comparison for setting the appropriate multiple of earnings (or, less frequently, discount to net assets) to be applied to the company to be listed. A price-earnings multiple is essentially an artificial thing. created by dividing the market price, an observable fact, by the reported earnings per share which may be open to some interpretation but are nevertheless calculated on generally accepted principles. Dividing one by the other often produces a seductively plausible figure, such as 8.39 times. It only remains plausible, however, as long as nothing untoward happens to either of its parents. A loss-making company has a market price but no price-earnings multiple. Anything which changes the market price or the reported earnings per share will also change the price-earnings multiple. The question should be asked whether this is anything but a piece of mathematics.
If a new company fits neatly into a clearly defined market sector, the average multiple for that sector may be taken. However, a sector average is precisely that and may be biased by the rating of a few very large companies. A newly listed company is likely to be at the smaller end of the scale so an average rating too heavily affected by big companies may be misleading.
Special factors may affect the multiple of individual companies in the sector. A price may be depressed after a disappointing recent announcement or be 'frothy' owing to possible takeover prospects. A company that has very low profits may appear to have a very high multiple; however, this may be better interpreted as the market's expectation of a recovery in earnings to a more normal level. Companies that are not comparable for one of these reasons, although they may be in the same market sector, should be discarded to leave a more relevant list.
There are usually sufficient grounds for disagreement on what is or is not a comparable company that even pricing on the basis of comparables has a degree of subjectivity. The merchant bank and stockbroker will therefore take soundings from their own colleagues and from close associates in the market to see whether an approximate consensus can be identified on what the pricing should be. The identity of the company will be disguised which confuses the issue somewhat but worthwhile reactions can be obtained. These opinions are of course themselves formed partly by fundamentals and comparables but will also include an element of personal interpretation and market feel.
In different markets, investors place different degrees of reliance on the factors underlying a valuation. In some markets, for example, investors prefer shares to be fully backed by net assets despite the fact that they are most appropriately valued by reference to earnings. The regulatory authorities may impose, officially or unofficially, certain guidelines such as a maximum price-earnings ratio, a minimum discount of the share price to net assets, and a minimum dividend yield. Part of the significance of the sounding-out process is that the people contacted will later be approached as sub-underwriters and possible subscribers for the issue.
Exam Question
State and explain the procedures used when using the tender method of pricing a new public company.
Exam Solution
Rather than fixing the price in advance, it is possible to specify a minimum price and call for tenders. Under this procedure, the applicants themselves choose the price at which they wish to apply subject to a stated minimum. After applications have been received, a 'striking price' is fixed which generally is the price per share that realizes the desired amount of money for the issue or sale of the fewest number of shares. Since it is conceivable that one applicant could tender for the whole issue at the highest price, factors such as the spread of shareholders will also be taken into account. In this manner, the pricing decision is chiefly determined by the forces of supply and demand prevailing over a short period of time.
Exam Question
What are the advantages and disadvantages of the tender method of pricing a newly floated company
Exam Solution
Advantages
The tender method may appeal where the issue is not very large and there are no obviously comparable companies on which to base the price. A typical example might be a company with a new technology that is the first of its kind to be listed on the stock market. Existing shareholders may feel that pricing will be pitched too cautiously. The lack of similar listed companies means that underwriters are in uncharted waters. If the issue is small and a large over-subscription is expected after sounding out investor interest, vendors may feel they have little to risk and everything to gain by calling for tenders.
Disadvantages and effect on 'stagging'
The tender method of fixing prices is not always welcomed by potential investors who find a fixed price less complicated and more easily evaluated. It may also be considered that tenders reduce or eliminate stagging profits. Stagging is a term used for subscriptions by speculators often in excess of the holding they actually desire (in the expectation that applications will be scaled down) and with the object of selling at a profit as soon as trading begins.
The success of issues in some markets may be heavily dependent on the activities of the stags. A market view develops on whether an issue is conservatively priced, in which case it will be heavily over-subscribed, or slightly over-priced in which case the level of subscription may be very low indeed.
If the issue is priced at such a level that stags do not believe a profit is obtainable, arguments about the fundamental attractions of the company as an investment tend to fall on deaf ears. Even investors who believe such arguments may take the view that an under-subscription will result in a weak opening price. caused partly by selling from underwriters keen to limit losses on commitments they have been obliged to take up. If investors see a likelihood of obtaining shares in the market at a discount to the issue price, no amount of cajoling them to support the issue is likely to succeed. Some prospect of capital gain is in any case needed to compensate applicants for having funds locked into the issuing procedures rather than making purchases on market terms when trading begins.