FIN 3403 Chapter 2 Notes

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Feb 20, 2024

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Chapter 2 Notes Financial markets – forums in which suppliers and demanders of funds can transact business directly  Two key markets: o Money Market  Where short-term debt instruments, or marketable securities, are traded o Capital Market  Where long-term securities—bonds and stocks— are traded Firms use private placements or public offerings to raise money  Private placement – the sale of a new security directly to an investor or group of investors (ex. insurance company or a pension fund)  Public offerings – the sale of bonds or stocks o Used when firms need to raise a large sum of money o Primary market – market where securities are initially sold by the issuing entity

Chapter 2 Homework (with aids) Transaction costs – In late December you decide to sell a losing position that you hold in Twitter so you can capture the loss and use it to offset some capital gains, thus reducing your taxes for the current year. However, since you believe that Twitter is a good long-term investment, you wish to buy back your position in February next year. You call your Charles Schwab brokerage account manager and request that he sell your 1,300 shares of Twitter and buy them back in February. Charles Schwab charges a commission of $25 for broker-assisted trades. a. Suppose that your total transaction costs for selling the 1,300 shares of Twitter in December were $45.00. What was the bid/ask spread for Twitter at the time your trade was executed? a. Transaction cost = Number of shares x (0.5 x bid/ask spread) + Brokerage commission i. Bid/ask spread = [(transaction cost – brokerage commission / number of shares] / 0.5 ii. b/a spread = [(45.00 – 25) / 1300] / 0.5 = 0.0307 b. Given that Twitter is listed on the NYSE, do your total transaction costs for December seem reasonable? Explain why or why not. True - "Twitter is listed on the NYSE, a broker market. So, had Charles Schwab routed the order to the NYSE, it could have been executed against a buy order, and total transaction costs would have been only the $25 brokerage commission. But transaction costs included half the bid/ask spread per share traded, so either: (i) the order went to the NYSE, no public buy order was available, and the market maker bought the 1,300 shares for her inventory (at a cost of half the bid/ask spread per share) or (ii) Charles Schwab routed the order to a dealer market like NASDAQ, and a market maker added the shares to her inventory (at half the spread per share)." c. When your February statement arrives in the mail, you see that your total transaction costs for buying the 1,300 shares of Twitter were $40.20. What was the bid/ask spread for Twitter at the time your trade was executed? a. Transaction cost = number of shares x (0.5 x bid / ask spread) + brokerage commission b. Bid / ask spread = [(transaction cost – brokerage commission) / number of shares] / 0.5 c. [(40.20-25) / 1300] / 0.5 = 0.0234 d. What are your total round-trip transaction costs for both selling and buying the shares, and what could you have done differently to reduce the total costs? What could you have done differently to reduce the total costs? a. Total transaction costs = transaction cost from sale + transaction cost from purchase b. 45.00 + 40.20 = 85.20 Costs could have been reduced by placing both trades online with a request for routing to the NYSE where the chance of crossing with other public orders is greatest. Initial Public Offering. – A biotechnology company, Keros Therapeutics, completed its IPO on April 8, 2020, and listed on the Nasdaq. Keros sold 6,000,000 shares of stock to primary market investors at an IPO offer price of $15.72, with an underwriting discount of 6.9%. Secondary market investors, however, were paying $20.89 per share for Keros' 19,189,391 shares of stock outstanding (which includes the newly-issued shares). a. Calculate the total proceeds for Keros' IPO. a. Number of shares sold at the offer price x price per share b. (6,000,000 x 15.72) = 94,320,000 b. Calculate the dollar amount of the underwriting fee for Keros' IPO. a. Total proceeds x underwriting discount rate b. 94,320,000 x 6.9 = 6,508,080 c. Calculate the net proceeds for Keros' IPO. a. Underwriting fee – total proceeds b. 94,320,000 – 6,508,080 = 87,811,920 d. Calculate market capitalization for Keros' outstanding stock. a. Number of outstanding shares x secondary market price

b. 19,189,391 x 20.89 = 400,866,378 e. Calculate IPO underpricing for Keros' IPO. a. [(secondary market price – IPO offer price) / IPO offer price] x 100 b. [(20.89 – 15.72) / 15.72] x 100 = 32.89 f. Explain the IPO underpricing for Keros. a. "Positive underpricing indicates that secondary-market investors were willing to pay more for the company's shares than the IPO offer price that the shares were sold for in the primary market." True The Pros and Cons of Being Publicly Listed – William Bradley is the founder and chief executive officer of a private firm called Robo-Tech Inc., which specializes in developing robotic limbs. Robo-Tech's sales are on the rise, gross profit margins are strong, and market share is growing, so Bradley feels that the timing is right to retool the manufacturing operation, expand the distribution network, and add new products in order to remain competitive and grow the firm's value. Robo-Tech needs to acquire additional financing resources, and Bradley has decided to take his company public in order to meet its long-term goals. Bradley understands that going from private to public requires some major adjustments. In particular, instead of reporting to a few private investors, management will be responsible to hundreds, or even thousands, of new "owners" who expect a good return on their investment. This public pressure may at times push the company to focus on short-term gains rather than long-term goals. In addition to dealing with new outside shareholders, Robo-Tech will have to comply with the SEC's stricter reporting requirements on public companies. For example, quarterly and annual reports must be filed with the Securities and Exchange Commission and an annual report must be sent to all shareholders. Under Bradley's management, Robo-Tech has had a history of strong financial performance and solid growth potential, and well developed strategic vision and business plan. In order to help with the process of going public, Robo-Tech has hired a team of professional advisors, including lawyers, investment bankers, and accountants. These professionals will assist Robo-Tech with the registration, valuation, marketing, and placement processes. Robo-Tech will also have to decide on a listing exchange, where its shares will continuous trade after the public offering. Options include the New York Stock Exchange, the American Stock Exchange, a regional exchange, or the Nasdaq Market. If all goes according plan, Robo-Tech will soon have access to a new valuable external financing resource, that it can use to finance it future growth potential. To Do a. For Robo-Tech, what are the advantages of being a publicly listed company? a. Being a publicly-listed company provides access to the money they need to grow. b. Going public gives the owner the chance to get a return for his or her hard effort. c. For a publicly-listed company shareholders provide cash without having an ability to take the company to bankruptcy court if a payment is not made. d. By going public, the owner can diversify their portfolio. In fact, without going public, it is difficult to determine the value of their firm. b. For Robo-Tech, what are the disadvantages of being a publicly listed company? a. One disadvantage to going public is that going publicly leaves the owner open to the potential that an individual or firm might purchase all the publicly available shares, or at least enough to control the board of directors, and remove the founder from the management team. b. One disadvantage to going public is that there is no guarantee that shareholders will want to invest in one's firm. If they avoid its shares, it will be priced below expected value. c. One disadvantage to going public is that there may be low trading volume for the company's shares.

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c. If Robo-Tech prefers that its shares trade on a centralized exchange, what listing exchanges make the most sense for Robo-Tech and why? a. Not enough information is provided to determine whether Robo-Tech meets the listing requirements to be on the NYSE Euronext. That would be the goal because it is the largest and have the largest number of potential investors. d. Once Robo-Tech has sold its shares to the public does it care whether capital markets are efficient? In other words, how does market efficiency affect Robo-Tech? a. If the market is efficient, the firm will have an increased number of potential investors and this will help Robo-Tech sell shares now and in the future, as it continues to need funds to finance expansions. b. If the market is efficient, prices are an unbiased estimate of firm value. c. If the market is efficient, the more confidence investors will have in the firm's market price. Chapter 2 Homework (no aids) Transaction costs You would like to purchase one Class A share of Berkshire Hathaway through your TD Ameritrade brokerage account. TD Ameritrade advertises a $5 commission for trades using their phone-based interactive voice response system. You call and learn that the bid price is $262,825.00 and the ask price is $263,790.00, and you submit your order for one share. a. What is the current bid/ask spread for Berkshire Hathaway Class A shares? a. Bid/ask price is the ask price – bid price b. 263,790.00 – 262,825.00 = $965 b. If TD Ameritrade routes your buy order to the NYSE, where Berkshire Hathaway is listed, what's the potential minimum your total transaction costs will be? a. Minimum = 1 commission cost -> $5.00 c. If, instead, TD Ameritrade routes your buy order to NASDAQ, where Berkshire Hathaway is not listed, what's the potential maximum your total transaction costs will be? a. Total transaction costs = (0.5 x bid/ask spread) + commission b. (0.5 x 965) + 5 = 487.50 d. Regardless of how your trade is executed, based on the bid/ask spread, what is the market value of your trade? a. Implied market value = [(bid price + ask price) / 2] x number of shares b. [(262,825 + 263,790) / 2] x 1 = 263,307.50 Initial public offering On April 18, 2019, the video conferencing company, Zoom completed its IPO on the Nasdaq. Zoom sold 9,911,434 shares of Class A stock with 1 vote per share at an offer price of $36 and an underwriter discount of $1.87 per share. Zoom's closing stock price on the first day of trading on the secondary market was $62.78, and 24,070,086. Class A shares were outstanding. There were also 232,318,285 shares of Class B common stock with 10 votes each outstanding and held privately by Zoom insiders. a. Calculate the total proceeds for Zoom's IPO. a. Number of shares x offer price b. 9,911,434 x 36 = $ 356,811,624 b. Calculate the percentage underwriter discount. a. (Underwriter discount per share / offer price per share) x 100 b. (18/36) x 100 = 5.19% c. Calculate the dollar amount of the underwriting fee for Zoom's IPO. a. Number of shares x underwriter discounts b. 9,911,434 x 1.87 = 18,534,382 d. Calculate the net proceeds for Zoom's IPO. a. Total proceeds – underwriting fees

b. 356,811,624 – 18,534,382 = $338,277,242 e. Calculate Zoom's IPO underpricing assuming that market value per share is the same for both classes of stock. a. [(market price – offer price) / offer price] x 100 b. [(62.78 – 36) / 36] x 100 = 74.4 f. Calculate Zoom's market capitalization assuming that market value per share is the same for both classes of stock. a. Market price of stock x number of share b. 16,096,061,931 g. What percentage of Zoom's total common stock (Class A plus Class B) do Class A stockholders own after the IPO? What percentage of votes do they control? a. The common stockholders own 9.39% of all Zoom stock b. The Class A stockholders control only 1.04% Zoom.