173A Exam 1

True or False. In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price in the long run, or the stock's "intrinsic value."

True

(blank) allows the underwriter to issue more stock amounting to 15% of the original offer size, at the IPO offer price. It is used to cover both oversubscription and excess demand

overallotment allocation or greenshoe provision

The preliminary prospectus is also called a(n) (blank)

red herring

Describe the mechanics of an IPO: What is a road show?

senior management and lead underwriters travel and promote the company and boost publicity on the IPO

Mechanics of an IPO Valuation (What is a Road Show?)

senior management and lead underwriters travel and promote the company and boost publicity on the IPO

Which of the following organization forms accounts for the greatest number of firms?

sole proprietorship

Which is the best measure for an asset held in a diversified portfolio?

the best measure of risk for an asset held in a portfolio is beta

True or false: In most cases, the preexisting shareholders are subject to a 180-day lockup; they cannot sell their shares for 180 days after the IPO.

true, but they are free to sell after the 180 days

On average, IPOs appear to be

underpriced

Aaron Inc went public at $10 per share. Aaron's investment banker charged them $0.70 per share for the IPO. This fee is called a(n): (blank)

underwriters spread/fee

Geometric Average defintion

what was your average compound return over a particular period

When correlation is 0 this means

zero correlation between stocks

True or false: Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific" or "unsystematic" events, and their effects on investment risk can be diversified away.

- True - Investors' degree of risk aversion determines the market risk premium, which will ultimately determine the slope of the SML

Going Private

- Private group, usually existing management, purchases the stock of a publicly traded firm - The stocks is taken off the market and no longer traded - Shareholders are forced to accept cash for their shares - Frequently LBO (leveraged-buyout)

Explain securitization

- The process of creating a financial security - A debt instrument that formerly was rarely traded becomes actively traded, usually because the size of the market increases and the terms of the debt instrument become more standardized - A security can be created by the pledging of specific assets, resulting in the creation of asset-backed securities

Types of Offerings: Firm Commitment

- The underwriter agrees and guarantees that it will sell all the stock at the offer price and the underwriter themselves buy the entire issue (lower than offer) and then resells it to the public - Firm is able to offload all the IPOs and now underwriter bears the risk and might suffer loss if the shares are not sold - Most common type of underwriting in the US

What is the role of shareholders, the board of directors, and management in a corporation? (Board of Directors)

- Top governing body - can hire/fire CEOs

Stock A's beta is 1.9 and Stock B's beta is 0.9. According to the CAPM, the expected return on Stock A will be greater than that on B.

- True, Expected return on Stock = Risk free rate + Beta * Market risk premium - So as Stock A's Beta is greater, expected return on Stock A is greater.

Define auction IPO.

- Underwriter accepts a series of bids and the price that everyone pays is the highest price that will result in the shares being sold

Type of Offerings: Auction IPO

- Underwriter accepts a series of bids and the price that everyone pays is the highest price that will result in the shares being sold

The intercept point of the security market line is the rate of return which corresponds to: (blank)

Risk free rate of return

What is the role of shareholders, the board of directors, and management in a corporation? (Shareholders)

Shareholders: owners, vote for the board of directors

A group of investment bankers who pool their efforts to underwrite a security are known as a(n)

Syndicate

What is a financial market? List different types of financial markets and financial institutions?

- A financial market is a place where individuals/organizations wanting to borrow funds are brought together with those having a surplus. - Different types of financial markets are money, capital, primary and secondary.

What is the firm's fundamental or intrinsic value? How do we estimate the intrinsic value of a company

- A firm's intrinsic value is an estimate of the actual true value of a company. - This is estimated by calculating the sum of all the company's future expected free cash flows discounted to present value into today's dollars.

Mechanics of an IPO: Pricing the Deal and Managing Risk

- After the IPOs are successful, company needs to pay underwriting fees, usually 7% - Underwriters use information they acquire during book building to intentionally underprice IPO so the underwriters do not suffer loss but still sell the entire issue - Overallotment allocation/greenshoe provision: allows underwriter, in case of risk of loss, to issue more stock and then buy it at a low price (NOT SURE IF I UNDERSTAND IT RIGHT) - Once IPO process is complete, company shares trade publicly on the secondary market - 180 day lockup: shareholders cannot sell their shares for the first 180 days after an IPO launch

Mechanics of an IPO: Valuation

- Before offer price is set, underwriters work closely with company to come up with a price range - Two easy to value price range: estimate future cash flows and compute present value or estimate value by looking at comparable companies - Road shows and book building

What are the major advantages and disadvantages of going public?

- Benefits of going public - New capital for company, publicly traded stock for acquisition (being able to trade stock for that of a target firm) it being a compensation vehicles (luring managers to help the company and boost the stock), personal wealth and liquidity (entrepreneurs can now diversify their portfolios), media attention - Drawbacks of going public - Financial and managerial costs, once IPOs are released there is an emphasis on maximizing that price and if not done successfully could result in job losses for managers, life in a fishbowl (shareholders have the right to a great deal of information regarding internal affairs of the firm)

What is the role of shareholders, the board of directors, and management in a corporation? (Management)

- CEOs - help the firm run properly

Mechanics of an IPO: SEC Filings

- Companies need to prepare registration statement (legal document that provides financial and other information to investors prior to IPO launch) - SEC studies registration statement for 20 days - Preliminary prospectus and red herring (the same thing) is part of the registration statement which provides investors with vital information of the firm

What is market efficiency? Are financial markets efficient?

- Efficient market is the market in which prices are close to intrinsic values. In an efficient market prices quickly and accurately adjust to reflect new information - The market is not completely efficient - Not everyone has access to the same news, nor does everyone receive the news in a timely fashion

Leveraged Buyout (LBO)

- Financed with a large amounts of debt and a small group of investors, usually managers of the firm, supply little equity capital - Shareholders are paid premium above the market price - Reasons for value creation are extra debt provides a tax deduction which increases value and increased efficiency: managers become owners giving them incentive to work hard

What is financial management? What is the primary goal of financial management?

- Financial Management focuses on decisions related to how much and what type of assets to acquire, how to raise capital needed to purchase assets, and how to run a firm to maximize its value. - The primary goal of financial management is to maximize intrinsic value or maximize stock price in the long run.

Drawbacks of going public

- Financial and managerial costs - once IPOs are released there is an emphasis on maximizing that price and if not done successfully could result in job losses for managers - life in a fishbowl (shareholders have the right to a great deal of information regarding internal affairs of the firm)

Explain the decision to go private

- In a going private transaction, the entire equity of a publicly held firm is purchased by a small group of investors, with the firm's current senior management usually maintaining or increasing their ownership stakes. - The primary advantages of going private are 1. Administrative cost savings 2. Increased managerial incentives 3. Increased managerial flexibility 4. Increased shareholder oversight and participation 5.Increased financial leverage

Mechanics of an IPO: Underwriters and Syndicate

- Investment banks are the underwriters - Lead underwriter leads and provides advice for the deal, arranges for a group of other underwriters, the syndicate, to help and sell the issue - Underwriters help determine the type of security, method of sale, and offer price; help promote the IPO, file paperwork, stabilize IPO prices in the aftermarket making sure it is liquid in the market

What is a private placement?

- It's one way to sell common stock, in which the firm's stock is sold to select individuals- usually the firms employees, friends, members of the community, and more. Helps avoid many demanding requirements of securities laws. - For most start-ups, the first round of external financing comes through a private placement of equity to one or two individual investors, called angel investors.

Benefits of going public

- New capital for company - publicly traded stock for acquisition (being able to trade stock for that of a target firm) it being a compensation vehicle (luring managers to help the company and boost the stock) - personal wealth and liquidity (entrepreneurs can now diversify their portfolios) - media attention

IPO Puzzles

- On average, IPOs appear to be underpriced as the price at the end of trading on the first day is often substantially higher than the IPO price and the IPO underpricing is the typical first-day appreciation of about 10-15% - The number of issues is highly cyclical which means when times are good, the market is flooded with new issues; when times are bad, the number of issues dries up - The costs of an IPO are very high, and it is unclear why firms willingly incur them - The long-run performance of a newly public company (3-5 years from the issue date) is poor and on average, a 3 to 5 year buy and hold strategy appears to be a bad investment

Types of Offerings: Best Efforts

- Underwriter makes their best effort to sell the securities on the agreed upon price, does not guarantee all the stocks to be sold which means the company bears risk of the stocks not being sold - All-or-none clause: either all the shares or sold in the IPO or the deal is off

Basic Definition of IPO

- a firm selling stock/shares to the public for the first time - They are special because there is no existing market price, shares are in general risky, issuers face many regulations

Describe the mechanics of an IPO: What is greenshoe provision?

- allows underwriter to increase shares if needed - if the IPO prices rises, the underwriter could buy the extra shares and sell them for profit - if the IPO prices drops, the underwriter would buy back shares to stabilize the price

Describe investment banking activities

- banks are the underwriters when it comes to setting up investment deals and helping companies launch their IPOs - underwriters help perform critical functions before IPO launch - these functions include: determine type of security, method of sale, offer price, market the IPO, help with the proper filing, stabilize the IPO in the secondhand market

What is the difference between best efforts and firm commitment IPOs?

- best efforts is when underwriters agree to try their best to sell all the shares and the firm launching the IPO bears the risk - firm commitment is when the underwriters buy the entire issue and guarantees that it will sell the entire issue and now the underwriter bears the risk

Explain the correlation

- correlation is simply measurement of the relationship between the returns on 2 stocks

What are the two ways of selecting underwriters and what are the characteristics of each? The way she phrased this is weird but it's asking what are the two types of underwriters and what do they do

- lead underwriter who manages the deal - syndicate who is a group of other underwriters who help the sell the issue

What are the principal forms of business organization? What are the advantages and disadvantages of each form? (Corporations)

- legal entity created by a state, separate and distinct from its owners - Advantages: limited liability, easy transferability of ownership (stock represents ownership), unlimited life, easier for corporations than for proprietorships and partnerships to raise money in the financial markets (can issue stocks and bonds) - Disadvantages: setting up and filing state and federal reports is complex and time consuming, earnings are subject to double taxation → income taxed at the corporate rate and dividends taxed at the personal rate

Explain variance and standard deviation.

- measures of risk of an asset held in isolation NOT in a portfolio - to get standard deviation you square root the variance

When correlation is -1 this means

- perfect negative correlation - one stock goes down, the other goes down too

When correlation is 1 this means

- perfect positive correlation - one stock goes up, the other goes up too

What is the Security Market Line (SML)? How is beta related to a stock's required rate of return?

- represents what the CAPM formula is - rate of return is equal to risk free rate if beta is 0 - securities that are correctly price are exactly on the line itself - points that are above the line are undervalued - points that are below the line are overvalued

total risk is comprise of what two things?

- systematic risk (market risk) and is measured by beta - unsystematic risk (idiosyncratic risk)

Which is the best measure of risk for an asset held in isolation?

- the best measure of risk of an asset held in isolation is standard deviation and variance

Suppose an investor starts with a portfolio consisting of one randomly selected stock. As more and more randomly selected stocks are added to the portfolio, what happens to the portfolio's risk? Explain the formula that relates total risk, market risk, and diversifiable risk

- the portfolio risk decreases as more and more randomly selected stocks are added to the portfolio - adding more stocks decreases diversifiable risk which overall decreases total risk

Describe the mechanics of an IPO: What is underpricing?

- underwriters purposely underprice an IPO so they don't suffer losses - in general IPOs are underpriced

What are the principal forms of business organization? What are the advantages and disadvantages of each form? (Proprietorship)

- unincorporated business owned by one individual - Advantages: easy and inexpensive to form, subject to few government regulations, taxed like an individual (taxed only once) - Disadvantages: The owner (proprietor) has unlimited personal liability for business, life of proprietorship is limited to time the creator owns it, transferring ownership can be difficult, difficult for proprietorship to obtain large sums of capital (funds)

What are the principal forms of business organization? What are the advantages and disadvantages of each form? (Partnership)

- unincorporated business owned by two or more persons - Advantages: easy and inexpensive to form, subject to free government regulations. Taxed like an individual (taxed only once) Disadvantages: partners have unlimited personal liability for business debts, life of partnership is limited to time the same group of partners owns it, transferring ownership can be difficult, difficult for partnership to obtain large sums of capital (funds), but better than for a proprietorship

Empirical evidence suggests that new equity issues are generally underpriced by

10 - 15 % on average

What is a characteristic line? How is this line used to estimate a stock's beta coefficient?

?

What are seasoned equity offerings?

A firm that already has publicly traded stock issues additional shares to the public

Under the (blank) IPO, the underwriter does not purchase the shares but merely acts as an agent trying to sell the shares for the best possible price.

Best efforts

According to the Capital Asset Pricing Model, what measures the amount of risk that an individual stock contributes to a well-diversified portfolio? Define this measurement.

Beta

True or false: A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

False

True or false: In a firm commitment IPO, the underwriter purchases the entire issue at the offer price and then resells it at a slightly higher price to interested investors.

False, In a firm commitment, the underwriter will be purchasing the entire issue at small discount and he will be reselling it at the offering price to the public.

True or False. A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio.

False, beta in general is more relevant to stockholders who have portfolios

True or false: A stock with a beta equal to −1.0 has zero systematic (or market) risk.

False; I don't think beta can ever be negative

True or false: If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

True

True or false: Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

True

True or false: When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk

True

Which of the following statements concerning the variance are correct? a.) The variance is the best measure of risk for an asset held in isolation. b.) If a stock portfolio is well diversified, then the portfolio variance may be less than the variance of the least risky stock in the portfolio. c.) The larger the variance, the more the actual returns tend to differ from the average return. d.) The larger the variance, the greater the total risk of the investment. e.) the larger the variance, the smaller the standard deviation

a.) The variance is the best measure of risk for an asset held in isolation. b.) If a stock portfolio is well diversified, then the portfolio variance may be less than the variance of the least risky stock in the portfolio. c.) The larger the variance, the more the actual returns tend to differ from the average return. d.) The larger the variance, the greater the total risk of the investment.

Describe the mechanics of an IPO: What is book building?

at the end of road show in which underwriters add up the total demand and adjust the price so it is unlikely the issue will fail to sell at the shares

Mechanics of an IPO Valuation (What is a Book Building?)

at the end of road show in which underwriters add up the total demand and adjust the price so it is unlikely the issue will fail to sell at the shares

The distinguishing feature of a corporation is that:

it is a legally defined, artificial being, separate from its owners.

the slope of a characteristic line is called (blank)

beta

At the end of the road show, customers inform the underwriters of their interest by telling the underwriters how many shares they may want to purchase. Although these commitments are nonbinding, the underwriters' customers value their long-term relationships with the underwriters, so they rarely go back on their word. The underwriters then add up the total demand and adjust the price until it is unlikely that the issue will fail. This process for coming up with the offer price based on customers' expressions of interest is called (blank)

book building

Which of the following organization forms for a business does NOT avoid double taxation?

corporation

Which of the following statements concerning the variance are incorrect? a.) The variance is the best measure of risk for an asset held in isolation. b.) If a stock portfolio is well diversified, then the portfolio variance may be less than the variance of the least risky stock in the portfolio. c.) The larger the variance, the more the actual returns tend to differ from the average return. d.) The larger the variance, the greater the total risk of the investment. e.) the larger the variance, the smaller the standard deviation

e.) the larger the variance, the smaller the standard deviation; higher variance means higher standard deviation - example variance of 49 means standard deviation of 7 is greater than a variance of 36 which has a standard deviation of 6

True or false: Corporations generally face relatively few regulations.

false

True or false: Corporations generally find it relatively difficult to raise large amounts of capital.

false

True or false: A "road trip" is where senior management and the lead underwriters travel around the country (and sometimes around the world) promoting the company and explaining their rationale for the offer price to the underwriters' largest customers-mainly institutional investors such as mutual funds and pension funds

false; this is called a road show

A (blank) IPO occurs when the investment banker buys the securities for less than the offering price and accepts the risk of not being able to sell them.

firm commitment

A stock with an actual return that lies above the security market line:

has yielded a higher return than expected for the level of risk assumed and is deemed undervalued

A stock with an actual return that lies below the security market line:

has yielded a lower return than expected for the level of risk assumed and is deemed overvalued