One method utilized by companies to obtain the long-term capital necessary to run and grow their businesses is by providing the general public with the option to purchase stocks. The company's first sale of stock is known as the initial public offering (IPO). When a company first offers the IPO, stocks are, on average, underpriced.
1. Discuss the implications of such underpricing to established theories of market efficiency.
2. Explain the role market efficiency might play in the underpricing theories presented by Loughran and Ritter.
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Underpricing of IPOs
The existence of underpricing has been documented in literature pertaining to finance as it is a common feature of international markets. Although underpricing is a cost to the issuing company it is still undertaken largely (Gregoriou, n.d). Underpricing creates more demand for IPO which is an indicator of success of the IPO.
According to prospect theory (Loughran and Ritter), issuer is more concerned about the wealth rather than its level. When offer price is increased during book-building process as a result of increased public information, issuer of public offering leaves more money on the table for investors. As a result a bargaining model is developed in which if market returns are high the issuer bargains less aggressively with the investment bank for the IPO. Hence it leads to greater underpricing and a lower probability that the IPO would be withdrawn. Favorable public knowledge puts pressure on issuer to price the issue less aggressively. It in turn increases the probability of success of the ...
The solution discusses the underpricing and corresponding theories regarding IPOs.
Multiple Choice Questions: net float, financial policy, static theory of capital structure, security market line, optimal capital structure, net present value of the project, IPOs and underpricing, preemptive right, earnings per share, cost of equity, financial statement analysis, aftertax income, levered value of the firm, financial leverage, efficient financial markets, operating cash flow
A firm writes 300 checks a day for an average amount of $200 each. These checks generally clear the bank in 3 days. In addition, the firm generally receives an average of $70,000 a day in checks which it deposits immediately. Deposited funds are made available in 3 days. What is the firm s net float?
a. net disbursement float of $30,000
b. net disbursement float of $42,000
c. net collection float of $15,000
d. net disbursement float of $15,000
e. net collection float of $30,000
A flexible short-term financial policy:
a. tends to increase the cash inflows of a firm in the future more so than a restrictive policy does.
b. tends to cause more production interruptions than does a restrictive policy due o inventory shortages.
c. tends to lower the selling prices that can be charged versus the prices under a restrictive policy.
d. lowers the costs of maintaining current assets.
e. tends to indicate that the carrying costs of a firm are relatively high as compared to the shortage costs
Mr. Bean currently owns 650 shares of ABC, Inc. Each share is worth $59. If the company declares a 3-for-2 stock split, Mr. Bean will own _____ shares at a value of _____ per share, all else constant.
a. 867; $44.25
b. 488; $78.67
c. 867; $78.67
d. 975; $39.33
e. 975; $34.25
The maximum firm value, according to the static theory of capital structure, occurs at a point where the:
a. financial distress costs are equal to zero.
b. value of the firm, as defined by M&M Proposition I, with tax, is exactly equal to the value of the firm, as defined by M&M Proposition I, without tax.
c. value of the firm equalizes the costs of financial distress with the present value of the tax shield on debt.
d. value of a levered firm initially begins to exceed that of an unlevered firm.
e. value of the firm is equal to the value defined by M&M Proposition I, with tax.
Stock C has a beta 0.9 and an expected return 12%. Stock D has a beta 1.4. If the risk free rate 4.8%, what is Stock D's expected return so that Stock D can be plotted on the security market line?
A firm's optimal capital structure:
a. exists when the debt-equity ratio is 0.50.
b. is the debt-equity ratio that exists at the point where the firm's weighted aftertax cost of debt is minimized.
c. is the debt-equity ratio that results in the lowest possible weighted average cost of capital.
d. is found by locating the mix of debt and equity which causes the earnings per share to equal exactly $1.
e. is generally a mix of 40% debt and 60% equity.
A firm is considering a project with an initial cost $6,200,000. The project will produce cash inflows $1,800,000 a year for 5 years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +2%. The firm has a pre-tax cost of debt of 6.7% and a cost of equity of 9.4%. The debt-equity ratio is 0.6 and the tax rate is 35%. What is the net present value of the project?
Which one of the following statements concerning IPOs and underpricing is correct?
a. IPO underpricing generally increases the spread per share earned by underwriters.
b. IPO underpricing primarily benefits the issuing firm.
c. The more an issue is underpriced, the more it tends to be oversubscribed.
d. An investor tends to receive a higher percentage allocation of shares as the percentage of underpricing increases.
e. Underpricing tends to discourage investors from participating in the IPO market
If shareholders are granted a preemptive right they will be:
a. able to determine who the candidates should be for any open seats on the board.
b. given the first right to purchase any new shares of stock that are issued.
c. given the choice of receiving dividends in cash or in additional shares of stock.
d. granted shares that receive additional voting privileges.
e. paid dividends prior to the preferred shareholders during the preemptive period.
A firm is an all-equity firm with a total market value $230,000. The firm has 25,000 shares of stock outstanding. Management is considering issuing $100,000 of debt at an interest rate 7% and using the proceeds to repurchase shares. Management estimates that the economy will be fairly normal and thus the firm's earnings before interest and taxes (EBIT) will be $57,000. Ignore taxes. What is the anticipated earnings per share (EPS) if the debt is issued?
A company has paid increasing dividends of $0.54, $0.58, $0.62, $0.67, and $0.72 a share over the past five years, respectively. The firm estimates that future increases in their dividends will be comparable to the arithmetic average growth rate over these past five years. The stock is currently selling for $38.60 a share. The risk-free rate is 4 percent and the market risk premium is 8%. What is your best estimate of the company's cost of equity if their beta is 1.35?
Which one of the following statements concerning financial statement analysis is correct?
a. The purchase of inventory using long-term credit will decrease the current ratio.
b. The firm with the highest price-earnings ratio will produce the highest earnings per share for the following year.
c. The company within a particular industry that has the lowest debt-equity ratio is the most profitable.
d. An increase in the accounts receivable turnover rate is an indication that a firm is collecting its receivables faster.
e. The Du Pont identity provides a measure of a firm's operating efficiency, asset use efficiency, and cash flow efficiency.
A firm has just completed their review of proposed projects for the coming year and has determined that they would like to invest a total of $219,000 in new projects. The firm follows a residual dividend policy and has a target debt-equity ratio 0.6. The firm wants to pay dividends totaling $39,500 this year. To do so, how much must the firm earn in aftertax income this year?
A company is an all-equity firm that has projected earnings before interest and taxes, $497,000, forever. The current cost of equity is 16% and the tax rate is 34%. The company is in the process of issuing $1,100,000 of bonds at par that carry a 6% annual coupon. What is the levered value of the firm?
Which one of the following statements concerning financial leverage is correct?
a. Financial leverage is always beneficial to a firm when the interest rate on the debt is less than 10%.
b. The benefits of leverage are unaffected by changes in a firm's earnings before interest and taxes.
c. The earnings per share remain constant even when an all-equity firm switches to a debt-equity ratio of 0.4.
d. If a firm employs financial leverage, the shareholders will be exposed to greater risk.
e. A firm employing leverage will always have a higher earnings per share than a firm which does not employ leverage
If the financial markets are efficient, then an unexpected negative announcement about a firm s earnings will:
a. cause all prices in the market to decline over a week s period as the news spreads.
b. cause the price of that firm s stock to instantly adjust with minor corrections being made in the following week so that the news is accurately reflected in the price.
c. cause the price of that firm s stock to instantly adjust to the appropriate price given the new information without further tendency to move upward or downward.
d. cause the price of that firm s stock to decline over a week s period as the news spreads.
e. instantly cause all prices in the market to decline and then readjust over a couple of days as the information is absorbed.
Question 56. A company is a specialty company in a niche market. Based on their latest projections, the company expects to increase their annual dividend by 40% per year for the next two years and by 10% for the following year. After that, the company plans to pay a constant dividend of $0.98 a share. The last dividend they paid was $0.40 a share. What should you expect to pay per share if the market rate of return on this stock is 15%?
Question 57. A company is a specialty company in a niche market. Based on their latest projections, the company expects to increase their annual dividend by 40% per year for the next two years and by 10% for the following year. After that, the company plans to pay a constant dividend of $0.98 a share. The last dividend they paid was $0.40 a share. What should you expect to pay per share if the market rate of return on this stock is 15%?
A project has expected cash inflows, starting with year 1, of $6,200, $9,700, $10,200 and finally in year 4, $8,000. The profitability index is 1.3 and the discount rate is 8%. What is the initial cost of the project?
A company currently sells micro-fiber recliners for $199 each. The firm is considering selling leather recliners. The leather recliner would sell for $399 each and the company expects to sell 1,200 a year. If the firm carries the leather recliner, management feels that their sales of the micro-fiber recliner will decline by 300 units. Variable costs on the micro-fiber recliner are $99 each and $270 each on the leather recliner. The incremental annual fixed costs related to the leather recliner are $70,000 and the incremental annual depreciation related to the leather recliner is $15,000. The tax rate is 34%. What is the projected operating cash flow for this project?
Question 60. Which one of the following is a correct statement regarding a firm's weighted average cost of capital (WACC)?
a. A reduction in the risk level of a firm will tend to increase the firm's WACC.
b. The WACC will decrease when the tax rate decreases for all firms that utilize debt financing.
c. The WACC can be used as the required return for all new projects with similar risk to that of the existing firm.
d. A 5 percent increase in a firm s debt-equity ratio will tend to increase the firm's WACC.
e. An increase in the market risk premium will tend to decrease a firm's WACC.