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Corporate finance – IPO questions

Part 1

Giving examples where possible, explain any three of the following

(a) Perfect capital markets and Fisher’s separation theorem 250 words

Answer:
Fisher’s separation theorem
With perfect capital markets, the firm’s optimal investment decision depends only on
estimated cash flows from the investment and market interest rates/returns. Applying the
NPV rule to these data maximizes shareholder wealth regardless of shareholders’ various
preferences for current versus future consumption.

(b) The direct and indirect costs of conducting an IPO 300 words
answer :
direct cost :
• commission and fees to sponsoring investment bank and broker 2-7% proceeds (geddes ,2003)
• fees to lawyers ,accountant ,PR
• printing and advertising cost
Cost vary with ossue method and market segment
AIM was designed to allow for cheaper flotation
But is listing on AIM really cheap ?
Estimated typical cost for IPO on AIM in 2004 242,500-770,000 pound

Indirect cost :
• disruption to business and opportinuty cost of managerial time
• underpricing

(c) Advantages and disadvantages of going public 250 words

Answer :

Advantages:
1. Raise funds
for company
For existing shareholder

2. Reduce gearing
3. Access to further
Equity
And to private and public dept
4. Higher public profile for company and its owners
5. Motivation and compensation of management and employees
6. Information production and improved performance measurement
7. Exit for pre-IPO investors (including VCs)
8. Exploiting temporary mispricing
a. Timing of issue during ‘windows of opportunity “
9. Acquisition
Access to external equity to finance acquisitions
And quoted shares can be used to pay for acquisitions
10. Facilitate
Transfers control
• Go public with a view to being taken over and bought out
Succession (in family firms)

Disadvantages

1. High costs of
a. Going public (direct and indirect )
b. Maintaining a listing ;ongoing costs
2. Potential loss of control
3. Hostile take-over threat
4. Separation of ownership and control
5. More public scrutiny
6. Increased disclosure and loss of confidentiality
7. Short-termisr pressure
8. Excessive interference ,restrictions on management

(d) The long-term underperformance of IPOs and SEOs
ipo don’t seem to good long term investment ..even on average

theories of under performance
1. agency cost explanation
2. price support hypothesis
3. behavioual finance explanations
4. underperformance is due to mis measurement

part 2

(a) ‘An IPO is a costly undertaking and therefore firms should avoid conducting an
IPO.’ Do you agree with this statement? Why or why not? 400 words

Answer :
the direct costs of conducting the issue.
These include the commissions and fees to the investment banks and stock brokers
involved in the issue. In the UK, the sponsor (usually an investment bank) plays a role
similar to the managing underwriter in the US . In the UK, the
sponsoring bank charges 2% of the money to be raised in the issue .
By contrast, in the US the underwriter spread is often 7% of IPO proceeds . There are also fees payable to other professionals involved in the issue:
lawyers, accountants, public relations companies and registrars

In addition to the direct cost, there is an indirect cost resulting from the apparent
discounting of the offer price (the price at which shares are sold by the issuing company to investors). It has been shown that, for the average IPO, the stock price rises above
the offer price in the first (few) day(s) of trading. This has been interpreted as evidence
that the offer price was intentionally set below the true value of the shares, in other
words, that the IPO was underpriced. The precise magnitude of this “initial return”
varies from IPO to IPO, so it is possible to make either a short-term loss or a gain from
investing IPOs. However, on average, if you invest in a large number of IPOs you can expect
to make a substantial short-term, or initial, return

Advantages :
1. Raise funds
for company
For existing shareholder

2. Reduce gearing
3. Access to further
Equity
And to private and public dept
4. Higher public profile for company and its owners
5. Motivation and compensation of management and employees
6. Information production and improved performance measurement
7. Exit for pre-IPO investors (including VCs)
8. Exploiting temporary mispricing
a. Timing of issue during ‘windows of opportunity “
9. Acquisition
Access to external equity to finance acquisitions
And quoted shares can be used to pay for acquisitions
10. Facilitate
Transfers control
• Go public with a view to being taken over and bought out
Succession (in family firms)

Disadvantages

1. High costs of
a. Going public (direct and indirect )
b. Maintaining a listing ;ongoing costs
2. Potential loss of control
3. Hostile take-over threat
4. Separation of ownership and control
5. More public scrutiny
6. Increased disclosure and loss of confidentiality
7. Short-termisr pressure
8. Excessive interference ,restrictions on management

(b) How do firms go private? How are these public-to-private (PTP) transactions
funded? 400 words

Answer :

Economics predicts that companies ought to consider going private
when the (perceived) costs of remaining publicly traded to the shareholders of a
company exceed the (perceived) benefits of being publicly traded. Commonly cited reasons for going private include poor operating performance of the
company and/or poor performance of its stock. This is likely to result in calls for the
company to be restructured. Such restructuring may be easier to achieve once any
conflicts of interests between the relevant players within the company are eliminated.
Such conflicts of interests may arise between management and shareholders, and
between different groups of shareholders

Even if the transaction involves the founder or management, outside investors are
usually also involved to help finance the deal. Private-equity firms are specialist providers
of finance for PTP transactions. However, in large transactions, only a fraction of the
total funds required to finance the transaction is provided by private equity firms, the
founder, management and possibly other equity investors. A significant share of the
finance comes in the form of debt provided typically by groups (consortiums) of banks.
Some of this debt may be high-risk debt called mezzanine finance, e.g. in the form
of so-called junk bonds
Part 3

(a) Discuss the main theories that explain the underpricing of IPOs. 400 words:
Answer:
The short-run underpricing anomaly is not time and stock market specific ,two possible explanation can be offered for these abnormal returns
Ipo are delibratly underpriced by underwriter
Underwriter systematically fail to price IPOs correctly

Most commonly it is issumed that the first of these possibilities ,rather than the second is at play

Theories are :
Underwrire risk –aversion hypothesis
Signaling the quality of the firm
Information asymmetry abd the winner’s curse hypothesis
Insurance hypothesis
Marketing
Ownership ,control and agency costs hypotheses

(b) Discuss the theories of long-run underperformance of IPOs 400 words:
answer :
theories of under performance
1. agency cost explanation
2. price support hypothesis
3. behavioual finance explanations
4. underperformance is due to mis measurement

Part 4

(a) What are the main issues an entrepreneur ought to consider when deciding whether to take his/her company public and make an initial public offering (IPO)? 400 words

(b) What are the main issues the CEO of a quoted company ought to consider when deciding whether to take his/her company private? 400 words:

Answer:

Perceived cost of listing >benefits
Poor performance
Need restructuring
And need control of agency problems
Low valuation
Takeover threat ,high cost of capital
Unwelcome influence and attention from media analysts ,investors
Ready available of cheap buyout finance

Part 5

(a) What were the main findings of Lintner’s 1956 study on the dividend policy of
US corporations, and how have they been interpreted? 300 words:

Answer :

What Lintner found is that managers definitely followed a managed dividend policy.
More specifically, he found that managers, when thinking about how to manage their
dividend policy, were particularly concerned with changes in dividend payments,
rather than the levels of these payments. In other words, when deciding on the level
of a future dividend payment, managers carefully considered the difference between
the level of this future payment and the levels of previous dividend payments.
According to Lintner’s study, managers preferred stable dividend payments and were
reluctant to change the level of these payments. This was because managers believed
that shareholders preferred relatively stable and steadily growing dividend payments.

(c) Consider the typical time line of the cash dividend payment of a US company 250 words

from the decision to pay out a dividend to the actual payment date. Sort the
following four events into chronological order and explain what happens at each
of the four dates.
• Ex-dividend date
• Payment date
• Record date
• Declaration or announcement date

Payments of cash
dividends are decided by a meeting of the board of directors After taking its decisions,
the board releases information on the announcement date about the size of the cash
dividends through a public statement. Dividends will be paid only to shareholders
that are registered on the specific future record date that is stated in the dividend
announcement. Shares are traded cum dividend when they provide their owner with
the right to receive announced cash dividend payments. In other words, an investor
who purchases cum dividend stocks between the announcement date and the record
date is entitled to receive the announced cash dividend. On the ex dividend date,
which is between the announcement and the record date, stocks go ex dividend, i.e.
an investor who buys the stock ex dividend does not acquire the right to receive this
period’s cash dividend. Stocks normally go ex dividend a few days before the record
date. The time lag between ex dividend and record date allows companies at the
time of the record date to have an up to date list of all shareholders that are entitled
to receive cash dividends. Finally, dividend cheques are sent to shareholders on the
payment date, normally two weeks after the record date

(d) Briefly explain what is meant of the following four terms: 350 words

• Open-market repurchase

In an open market repurchase, own shares are bought back by companies directly in
the open market

• Fixed-price tender offer
fixed-price self-tender offer is very different from an open market repurchase. Tender
offers are normally used by bidders (acquiring companies) in takeovers (mergers and
acquisitions) to buy the stock of a target company (the company that is purchased).

• Dutch-auction self-tender offer
A Dutch-auction self-tender offer is very similar to a fixed-price self-tender offer.
The main distinctive characteristic of Dutch-auction self-tender offers is that when
companies announce them they disclose a range of prices at which they commit
themselves to buying back their own shares
• Targeted repurchase
While open market repurchases and self-tender offers target own shares from all the
shareholders, targeted repurchases are carried out by companies to buy back stocks from
some specific groups of shareholders

part 6

Explain and critically discuss the following TWO statements relating to the supposed
purposes of company payouts to shareholders in the form of dividends and share
repurchases:

(a) Payouts allow insiders to signal favorable private information to uninformed
outside investors. 400 words:

(b) Payouts reduce the agency conflict between managers and shareholders. 400 words

Part 7

(a) Do companies follow a residual or a managed payout policy? Discuss in the light
of empirical evidence on dividends and share repurchases. 400 words

(b) Discuss whether and how taxes might affect the payout policies of companies. 400 words

PArt 8

(a) What is the main difference between a residual and a managed payout policy? Provide a numerical example to highlight this difference. 400 words

(b) What do academics means when they say the companies cater to a particular “payout clientele “ when paying out cash to their shareholders? 400 words
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Part One
(a) Perfect capital markets and Fisher’s separation theorem
The perfect capital markets model exists along some assumptions. First, capital markets are assumed to be perfect. In this regards, agents are considered to be rational while pursuing maximum utility. The fact that all assets including any form of regulation or taxes are perfectly divisible implies that there are no direct transaction costs in this model. Furthermore, the competition is perfect in both security and product markets. In perfect capital markets, the agents identified earlier provided with information simultaneously. It is also paramount to understand that the number of agents bestowed and provided with initial resources is arbitrary. Another assumption made in this model is the fact that agents demonstrate a decreasing marginal utility and have diverse, but, monotonous preferences.
One theorem used to elucidate perfect capital markets is the Fisher’s Separation Theorem. According to this theorem, market rates/returns and the estimated cash flows are the major determinants of the optimal investment decision with perfect capital markets. In other words, with perfect capital markets as the initial conditions, the decision to produce denoted by (P0, P1) is solely dependent on the profit maximization objective. According to this theorem, the production decision is separated from the consumption decision denoted by (C0, C1) which is dependent on utility maximization (Gregoriou, 2005). Fisher’s theorem has a different definition known as the unanimity principle. The theorem elucidates more on the gains accrued from trade specialization and the differences in preferences. It is a means through which shareholders get to agree unanimously on the best profit maximization strategy.
(b) The direct and indirect costs of conducting an IPO
IPOs are the best means through which companies re-invent themselves. While the need to conduct an IPO as a transformational tool appears important, firms fail to determine the underlying costs. The scope and degree of these costs vary across different organizational contexts and other variables including the readiness of the company to conduct an IPO, complexity of the IPO and the size of the IPO. There are both direct and indirect costs. Directs costs can be incurred on many items. To begin with there are expenses incurred from road shows. Apart from this, a firm has to give underwriter discounts, which, on the other hand, are based on public registration statements. These fees have been estimated to be around 4%-7% of the gross returns of a firm. Another direct cost is the printing, accounting, and legal fees incurred. The three items are all related to the drafting of the comfort letter and the registration statement. Restructuring costs including all costs incurred in drafting new articles for the firm also make up direct costs. On average, it is estimated that firms incur over $1 million of direct costs when conducting an IPO.
On the other hand, indirect costs may come up as a result of long-term expenses. Under-pricing is the first indirect cost of conducting an IPO. Alongside this, the firm also has to incur the costs of identifying and recruiting a new BOD. In other words, managerial time is lost as a well as a significant disruption of the normal business operations and processes. The cost of coming up with a new financial reporting system including a new compensation plan is also an indirect cost. Implementing internal controls over time may also be costly because the firm has to maintain compliance with SOX (Gregoriou, 2005). HR functions are a significant part of conducting an IPO. Thus, most indirect costs are related to the staffing needs as well as stakeholder/investor needs. It is difficult to estimate the indirect costs of conducting an IPO as they may differ sharply regarding organizational context and their corresponding nature.
(c) Advantages and Disadvantages of Going Public
As a transformational event for a firm; going public has got its pros and cons. As much as it may be beneficial, firms are advised first to consider the costs of conducting an IPO before making a move to conduct one. There are significant merits of conducting an IPO. First, Gregoriou (2005) suggests that the firm can access funds that enhance its financial position. This could be in terms of reduced gearing or increased access to further equity and both public and private debt. Financial capabilities such as the acquisition of other firms by stock in part are also facilitated through an IPO. This allows access to external equity. The firm can also use the stock in different stock options to offer incentive compensation to workers and contractors. The firm also gains a high public profile through increased visibility and prestige. With an IPO, a firm is able to produce relevant information and also improve the process of performance evaluation. The departure of pre-IPO investors including VCs during the IPO is also advantageous as it allows the firm to come up with novel strategies based on significant interests. The firm is also able to exploit temporary mispricing. IPOs also facilitate transfers control as well as timing of issue during the ‘windows of opportunity’.
The disadvantages, on the other hand, are also significant to note. First the expenses and costs incurred in going public are substantial. Both indirect and direct costs constitute a high expense rate which calls for proper budgeting. As such, inappropriate budgeting due to ongoing costs that characterize IPOs could plunge a firm in serious financial issues. A company’s management may also lose out on the control of the firm due to the inability to act without the approval of the board. Going public also makes investors and other stakeholders judge the firm’s management based on its profitability. As a result, the management can easily resort to short-term strategies rather than long term strategies (short-term pressure). Going public also comes with the burden of revealing sensitive information about a firm. This also includes a regular auditing of fiscal reports which may sometimes make the firm to lose focus on the most critical elements. This increases public scrutiny at the same time increasing disclosures and loss of confidentiality. Hostile takeovers due an IPO could separate the owners of the firm from those in control due to excessive interference restrictions on management.
(d) The long-term underperformance of IPOs and SEOs
Nowadays, IPO and SEO are some of the hottest topic being debated across the world. The more they are debated is the more the issue of IPO and SEO underperformance comes in. Research and proprietary data indicate that indeed most firms which conduct IPOs and participate in SEOs tend to underperform especially following the IPO. Notably, it is important to comprehensively understand that most firms chose to go public during a period in which they think that they have a high-value reception in the market. Studies have concluded that such firms perform exceptionally poorer in the long-run when the market trends shift. There are several theories that have been developed to try and understand the nature of the underperformance and why it makes long term investment into IPO a ‘disaster’. Despite the varying scope and degree of underperformance in different firms across the globe, the evidence of long-run underperformance is overwhelming. Furthermore, it has come out clear that even on average; IPO does not seem to be a good long-term investment. Although reasons for underperformance may also vary, the impact of conducting an IPO is substantial and can potentially harm an organization. Underperformance in the long-run is likely to hurt the main aim of conducting an IPO which is to raise funds.

Part Two
(a) An IPO is a costly undertaking and, therefore; firms should avoid conducting an IPO.’ Do you agree with this statement? Why or why not?
There is no agreement to this statement. In fact, there are several reasons why a firm should conduct an IPO than there are reasons not to. First and foremost, going public is a transformational strategy rather than a ceremonial company process. It requires proper planning and execution of activities for guaranteed success. The benefits of going public outweigh the costs of going public. Notably, by going public, a firm enhances its ability to access funds that are not refundable (Gregoriou, 2005). This could be a source of working/operational capital for a firm. Furthermore, the firm can use stock in part to facilitate the acquisition of other firms to enhance profitability. Fiscal capabilities are hence, improved when firms go public.
Going public is also not only beneficial to the firm as a whole, but also to the key stakeholders including employees, investors, etc. For instance, employees and contractors can obtain incentives in the form of stock from the firm concerning compensation. More benefits to the firm after conducting an IPO come from the great visibility and prestige that a firm publicly holds. As a result, the firm is likely to gain a high public profile which means popularity and fame. The gained positive publicity may help to expand the market share by attracting new customers. To the shareholders, conducting an IPO is a gateway towards expanding investment portfolios as the marketability of share increases tremendously.
Because publicly traded shares command a comparatively greater price, the firm is likely to gain a lot from an IPO. Although one may argue that the costs of conducting an IPO are substantial, it is questionably significant not to ignore the possibility of complementing these costs. As noted, firms are expected to conduct extensive research before conducting an IPO. This research allows the firm to come up with the most appropriate budget that well fits the one-time and ongoing expenses. Proper planning also allows the management to prepare fully for the IPO so that time is not wasted and any possible disruptions on business are kept to the minimum. The disadvantages associated with increased public scrutiny could as well be considered to be significant advantages. Public auditing and revelation of sensitive information on the firm are all means towards increasing accountability and transparency, which, on the other hand, are keys to unlocking value. Conducting an IPO thus, is beneficial to a firm if appropriately conducted ceteris paribus (Gregoriou, 2005).
(b) How do firms go private? How are these public-to-private (PTP) transactions funded?
There are several reasons why a firm can choose to go private. Apart from the poor performance of its stock, a firm can also be faced with poor operating performance. The process of privatization equals to restructuring a firm. There are several ways for privatization. First there is a share-issue form of privatization where a firm sells its shares on the stock market to private investors. The firm is set to become private once its shares change ownership to private investors. The second form of privatization may include restructuring where a firm sells the entire organization to a private investor. In some cases, this process is conducted through an auction. The sale of an entire organization calls for an elimination of any possible conflicts of interest.
The process can also be defined by voucher privatization. This process involves the firm issuing or distributing ownership shares to citizens. At times, such shares are free of charge while, in some instances, they may attract a minimal fee. All these processes define how firms go private. Furthermore, privatization may sometimes call for an entire restructuring of a firm including major shuffles in the personnel, departments, management, etc. Nevertheless, the need to go private remains the sole discretion of a firm. In other words, the management and founder of the firm have the last word on the privatization of a firm. However, despite this provision, the deal is financed through different avenues. Specifically, external investors may be involved in financing the transactions. Privatization may not be as easy as it sounds. The PTP transaction may attract heavy investment that cannot be managed singlehandedly.
Particularly, the main financiers of PTP transactions are private equity firms. As specialist providers of the PTP funds, their main aim is to facilitate a successful transition from a publicly owned business to a privately owned business. Nevertheless, in some cases the PTP transaction may be too large prompting the private equity firm to provide only a fraction of the total amount needed to fund the transaction. In such a case, the founder/management needs to seek the financial assistance of other equity investors. Significantly, bank groups also finance PTP transactions in the form of debts. At a later period, the amount from such institutions is normally refunded. All the same, it is significant to note that the success of a privatization process is subject to significant financial input.
Part Three
(a) Discuss the main theories that explain the underpricing of IPOs.
The underwriter risk where the bank is the underwriter involved in floatation refers to how the underwriter markets shares to prospective investors. The investor, the price and prospective investor make up the major subjects of the marketing process. Marketing is a significant component of the IPO process. In fact, it is predicted that marketing has greater role in underpricing as the marketing strategy is likely to determine the response and receipt that the firm gets from the public. Underpricing could be the result of a poor marketing strategy as well as lack of adequate publicity. Furthermore, insurance policies have been found out to profoundly influence the pricing of shares. Firms are always expected to obtain insurance covers. Changes from a private to public company may be subject to strict insurance policies such as the payment of premiums. Although this theory is purely hypothetical, it holds water. Additionally, even though pricing may be subject to local regulations underwriters tend to shift the risk away from them by fixing a price that generates a high interest in the share. When the issue of shares becomes oversubscribed, allocation rules come into play. The fairness of these allocation rules definitely limits the ability of the issuer. Highly reputable underwriters are always in support of taking the best companies that are anticipated to show lower underpricing. In essence, it is hypothesized that the underwriter will always try to avert the risk through underpricing hence, the phrase ‘aversion-hypothesis’.
Another significant model explaining the underpricing of IPOs is the signaling theory of IPO underpricing. This model makes the assumption that there exist informational asymmetries between external prospective investors and the IPO companies. In this model, specific information is known to insiders only. This information may include management expertise, future cash flows and any possibility of new investment opportunities. This model was developed and expanded in 1989 by Faulhaber et al. (Gregoriou, 2005). The model views underpricing as a signal which means that a firm is the best. In other words, the more a firm is underpriced, the more it is considered to be the best. The signaling theory anticipates that firms should raise extra funds through SEOs. Agency costs are also a fundamental model to note. IPOs come with significant differences between owners, management and investors. Each party has their own interests. Agency costs which come about as a result of control by these forces have a crucial role in the underpricing of shares. This theory however lacks empirical evidence as it is purely theoretical.
(b) Discuss the theories of long-run underperformance of IPOs
Theories of long-run underperformance of IPOs are generally associated with behavioral explanations. The first behavioral model is known as the agency cost explanation. This model developed by Miller (1977) attempts to explain both underpricing and long-run underperformance of IPOs. This theoretical basis emphasizes on the fact that investors have the ability to make different viewpoints about the future of a firm. Initially, it is expected that there is high divergence in opinion. As new information comes in, the model assumes that divergence in opinion proportionally reduces.
In contrast to efficient market theoretical models, the price support hypothesis theory proposes that the marginal investor has the right to set the market clearing price. This price should optimistically be adequate to buy the share. As new information comes in, the marginal investor re-evaluates the expectations of investors and hence, a decline in the share price is experienced. Notably, the initial degree of opinion divergence compromises long-run performance. As such, if the uncertainty about the true value is initially large, the performance in the long-run is expected to be poor.
Another theoretical model is the behavioral finance explanations. Firms are generally able to determine specific periods when prospective investors are more optimistic and hence, will decide to conduct an IPO when there is more favorable valuation in the market. The aim is to optimize the compensation to the highest possible level. When the optimism fades away, a firm fails to meet expectations and hence underperforms in the long run. This model therefore states that investors and firms cannot generally have correct opinions about the future. Hence, rational investors update their knowledge of events and expectations as new information flows in. In other words, this theory emphasizes on learning from consequent events. Initial over-optimism and failure to learn are both reasons for long-run underperformance.
The inability of a firm to appropriately measure and project the firm’s future performance can also be the basis of underperformance. In case investors are unable to identify if firms engage in window dressing, they assume that a high price offering translates to high reported earnings. Based on this assumption, the prospective investors thus slot in the figures in their future expectations. The consequence in this case can be overrated valuations. The end result is the inability of the firms to manipulate earnings. Continued impossibility to do so increase post-floatation which, on the other hand, gives prospective investors access to more accurate information. The new information is also incorporated in future expectations. As the future projections are adjusted downwards, the consequence is long-run underperformance.
Part Four
(a) What are the main issues an entrepreneur ought to consider when deciding whether to take his/her company public and make an initial public offering (IPO)?
Conducting an IPO is not a ceremonial event but, rather, a transformative process that requires precision and prudence. Before deciding to make a company public and make an IPO, an entrepreneur is expected to take into consideration some issues. To begin with, they are expected to consider the corporation suitability of conducting an IPO. In other words, the entrepreneur should determine whether the firm is realistically in a position to make a successful public offering. Corporation suitability is the umbrella body of all factors required for a successful IPO. An entrepreneur is expected to take into consideration the potential that a firm has in conducting an IPO (Gregoriou, 2005). Potentiality, in this case, refers to a record of success, innovativeness, quality products and strong momentum to success that attract the interest of investors.
The size of the firm is also a factor to consider. However, size, in this case, does not necessarily mean the physical structure of a firm but, rather the market value that it holds. A large market value has the potential of attracting institutional investors. Major underwriters always take interests in firms with high market values. All the same, the assets of a firm are also a significant factor to take into consideration. A successful IPO depends on the solid net worth of a business, normally supported by concrete assets. The more solid the net worth of a business is, is the more its business prospects will be strong. In other words, an entrepreneur should determine the quality of their business’ patent portfolio including intellectual property before making the decision to go public.
Another significant factor to consider is the firm’s business plan. The entrepreneur should ponder about the long-term business objectives and determine if conducting an IPO is the most necessary means of financing growth. A plan on profit spending is one consideration that investors and underwriters make. The entrepreneur is also expected to consider the market grasp that a firm has as one of the major precedents. In simpler terms, the firm’s competitiveness in light of its strengths and weaknesses is vital to consider. Above all, the owner should consider the corporate structure and governance of the firm including the management and board of directors. Apart from this, other factors worth consideration include accounting processes, internal controls, share structure issues and the choice of underwriters.
(b) What are the main issues the CEO of a quoted company ought to consider when deciding whether to take his/her company private?
Before privatization, there are several issues that a CEO ought to consider. To begin with, the CEO should consider the valuation of the asset or property of the firm. This is a priority consideration as it is the basis of determining the estimation and corresponding evaluation of the firm price. Another consideration to make is the national interest that a firm commands. This allows the CEO to determine the attention, significance and concern that the firm commands. The amount of concern and interest is crucial in determining the bids that the firm is likely to get from auctioned privatization.
The CEO should also determine the technical capability of a bidder before making a move to privatize. Technical capability of the bidder refers to the practicality, realness and actuality of a bidder’s capacity to ‘buy’ the firm. Some bidders may, evidently, make a bid to buy a firm although they lack the ability to do so. Hence, it is crucial for the CEO to identify the most technically able bidder before privatizing. The transparency of decisions and processes qualifies as a major factor to put into consideration before privatizing a firm. CEOs are expected to determine the nature of decisions and processes and hence, establish whether they are apparent enough to guarantee a privatization process.
The financial status of the bidder is also a crucial consideration as it helps the CEO determine the most viable bidder. Debatably, if the financial status is promising enough; then it is advisable to go on with the privatization process. However, if the financial status of a bidder is doubtful, CEOs are advised to keep off the privatization process no matter how pressurized they are to go with the process. Another factor that is worth consideration is the welfare of employees. In other words, after privatization, what happens to them? The welfare of employee stands out as a pivotal factor as it has a major impact on the success and productivity of a firm. Notably, during privatization, there is a high probability that significant changes will be made not only to the leadership but also to operations and other procedural policies such as compensation. Hence, it is crucial for CEOs to consider the welfare of employees before making the decision to privatize. Both reducing the government’s liability and revenue generation by the firm have been identified as minor factors to consider when privatizing.
Part Five
(a) What were the main findings of Lintner’s 1956 study on the dividend policy of US corporations, and how have been the interpretations about the conclusions?
Lintner came up with some findings in his study of dividend policy. These findings have, notably, received diverse interpretations. First and foremost, Lintner found out that managers categorically pursued a managed dividend policy in the US. America has a good number of institutional structures that have a strong impact on the capability of firms. Lintner also identified the fact that managers prioritized and showed more interest in changes in dividend payments rather than the level of dividend payment. This concern majorly came about during the processing of managing the dividend policy and pondering on the best management practice. Analytically, this finding can be translated in many ways. First, managers should be more concerned with any significant changes and shifts in the payment of dividends. Secondly, the managing of dividend policy should be taken as a significant process and hence, conducted with precision.
Remarkably, during the process of determining the level of a future dividend payment, managers are expected to establish the differences between the level of future payment and the corresponding previous dividend payments prudently. This comparison allows the managers to come up with the best management strategy that guarantees maximum viability. Furthermore, it is the basis of making significant decisions about dividend policy. Another major finding in the study is the fact that managers had a strong preference for stable dividend payments and hence, showed reluctance to change the levels of payments (Lease, et al., 2000). This implies that managers are rational in their choice of best management strategy owing to how they prefer stable dividend payments and are unwilling to change. The unwillingness to change depends on the assumption that shareholders have a preference of comparatively stable and consistently growing dividend payments. Conclusively, Lintner’s findings have been interpreted in different ways despite being applauded for the study findings. Managing dividend policy is not an easy task for the management, as Lintner concludes.
(b) Consider the typical timeline for the cash dividend payment of a US company from the decision to pay out a dividend to the actual payment date. Sort the following four events into chronological order and explain what happens at each of the four dates.
The company in consideration here is Green Electric.
Declaration Date
This represents the very first date on the divided timeline where the firm legitimately declares a dividend. Whether it is a regular dividend of any other type of dividend, once the board approves and authorizes the dividend, it is announced. On this exact date on the timeline, the firm is also expected to make announcements on the actual payment date and the record date for the dividend.
Ex-dividend Date
This entails the ex-date marking the day when the firm’s stock begins trading without dividend. Investors who have stock before this date always receive the dividends. Often, in most markets globally, this date is set two days before the record date. This period allows for the adjustment of the settlement cycle.
Record Date
This date encompasses the holder-of-record date. On this date, the shareholders who have the possession of stock are expected to receive their dividend. This date, as noted earlier, comes two days after the ex-date. Notably, this date is established and set by the firm independently and in most cases it comes between one week and one month after the firm declares dividends. This date is the second last date on the chronological timeline of dividend policy.
Payment Date
On this date, the dividend is paid out to shareholders in actuality. This date is also determined independently by the firm and can be put on any day even if it is a holiday. The period between the record date and the payment date varies across different contexts, but it occurs between a few days to a month or even more. The payment date marks the last bit of the dividend policy timeline before the cycle begins again.
(c) Briefly explain the meaning of the following four terms
Open-market Repurchase
This refers to a situation where a firm repurchases outstanding shares with the main aim of reducing the number of shares on the market. Some companies buy back shares (especially ownership shares) so that they can increase the value of shares that are still accessible. Furthermore, repurchasing in the open market is sometimes aimed at eliminating and potential threats and risks posed by shareholders who, on the other hand, may be seeking for a controlling stake in the shares. During repurchase in the open market, the firm always buys these shares directly.
Fixed Price Tender Offer
This is somewhat different from open-market repurchases. It refers to a one occasion offer that a firm seeks to acquire another firm. This involves any potential desires to purchase a specific amount of shares at a given price. Tender offers are particularly used by bidders in takeovers to purchase stock of a given firm. Bidders, in this case, refer to the acquiring firm while takeovers, in this case, could be used to refer to either mergers or full acquisitions. The stock being purchased belongs to the company that is being acquired.
Dutch-Auction Self-tender Offer
The Dutch auction self-tender offer is quite comparable to the fixed-price self-tender offer. However, in this particular case, when the firm announces the offer, it normally commits itself towards buying back its shares. In other words, the firm establishes a range of prices that define its commitment towards repurchasing the shares. However, the other defining characteristics of the Dutch auction self-tender offer are similar to the fixed-price self-tender offer with an exception of the above distinction. It should be noted that the commitment by the firm to repurchase shares is entirely based on the price ranges determined.
Targeted Repurchase
This is quite different from the first three offers discussed. This is because, in this case, the firm, when repurchasing stock, it does not target the entire shareholder fraternity but, a specific group of the shareholder. This aims at thwarting the efforts of an aggressive takeover. The firm repurchases stock from a hostile bidder, normally, at a price above the stock’s market value.
Part Six
(a) Payouts allow insiders to signal favorable private information to uninformed outside investors
One significant factor to note is that insiders always have an upper hand in having the most up-to-date and relevant information about the future of a firm’s cash flow. Furthermore, dividends act as means through which the information about a company’s prospects is portrayed. This basis defined the nature through which payouts allow insiders to signal favorable private information to uninformed external investors (Lease, et al., 2000). Notably, best quality companies always realistically signal their quality without possibilities of costs incurred. The underlying implication is that a signal is costless; the dire firms will always attempt to emulate the best-quality ones. Notably, despite the fact that dividend payments are costly for either firm, they are costlier to bad companies. Hence, the value of information to investors evidently becomes a major factor of consideration.
As payouts, when dividend payments increase, a firm always strives to reveal its quality because it is practically costly for a dire firm to emulate. Uninformed outsiders sometimes rely on costless public audits to determine the use of funds by a firm. Although this allows for full observations, outsiders are not able to view, assess or measure complete production technology. Instead, it is only through dividends (payouts) that insiders will try to provide this information to outsiders. Signaling equilibrium is a crucial provision in this case as insiders depend on the balanced scoreboard to provide outsiders with information about the firm through dividends. It is fundamental to notes that the signaling equilibrium is in existence owing to the marginal benefit that an insider receives (Lease, et al., 2000). Some firms, however, have sensitive and valuable inside information that cannot be revealed to the outsiders. In such a case, the firm guarantees that the premium paid for the stock has slightly larger dividends.
This reduces the dilution for existing shareholders. However, it should also be noted that there are also firms with less favorable information. Hence, in determining the consequent signaling equilibrium, companies that have more favorable internal information tend to pay optimally higher dividends ceteris paribus so that they can obtain a high price for the stock. This is always in a bid to thwart dilution of information into the market and among external investors. Notably, changes in dividends are likely to spark changes in the price of stock including significant changes in net cash flow (earnings). All the same, insiders use payouts as a means of revealing favorable and valuable information to outsiders.
(b) Payouts reduce the agency conflict between managers and shareholders
Usually, agency conflicts occur when the agent’s incentives fail to align with and match with those of the principal. The agent, in this case, refers to the shareholder, who has been entrusted by the agents (the shareholders) to act on their behalf. Notably, the differences between the two parties are the major reason the agency conflict may exist between them. These differences may arise as a result of difficulties in motivating one party to make actions on behalf of another. The difference in information held by one party including all the asymmetric information is basically the center of agency conflicts.
Nevertheless, the reduction of agency conflicts between the management and shareholders has been attributed to the corporate governance and control systems within organizations. These systems have helped align the management’s enticement with that of shareholders. Dividends have been the central focus in these systems. The giving out of dividend payments to shareholders has helped find a common balanced ground where both management and shareholder needs can be addressed effectively for the benefit of either party. Payouts, in other words, reduce the agency costs that are sometimes incurred when there is a deviation from the principals’ interest. Best quality firms always ensure that their actions are in the best interest of shareholders by coming up with dividend policies that are attractive enough to warrant the much-needed trust from investors.
It is important to notes that payouts are a significant way through which convergence in control is established. Convergence in control implies that there is little or no ownership separation at all. In other words, the objectives of the management and those of the shareholders converge to a point where both parties act to achieve a common goal that, in this case, is an organizational success for increased profitability. While the role of dividend policies might be limited to organizational formalities, it is the best way of ensuring management and shareholder interests match. Even in special cases where either party can have multiple interests, payouts have played a significant role in mitigating any possible conflicts of interests between parties. As such, it is not advisable to limit the role of payouts to organizational formalities but, rather, to view payouts as the best means through which agency conflicts can be avoided, eliminated and mitigated well. Conclusively, best-quality firms always take the initiative of working hand in hand with investors. The more the interests converge is, the more successful a company will be.
Part Seven
(a) Do companies follow a residual or a managed payout policy? Discuss in the light of empirical evidence on dividends and share repurchases.
Most companies do not follow a residual payout policy. Instead, most companies have a preference for managed payout policies. Although there is empirically a strong argument for residual payouts, most companies never follow a residual dividend policy. The residual dividend policy is aimed at optimizing the efficacy of corporate resource use while the managed dividend policy aims at dividend smoothing. The managed dividend policy in most cases involves a situation where cash may be retained beyond the investments needs in specific periods of time (Lease, et al., 2000). Furthermore, this policy allows for short-term borrowing to meet transitory cash-flow shortages. Empirically, on a managerial point of view, it is irrational to return cash to shareholders in the short run. Thus, it is more advisable to uphold a knowable dividend series which is characterized by no omissions and no cuts. The managed dividend policy evidently offers the firm such kinds of benefits that are crucial for success and quality performance.
With a managed dividend policy, there are no up-front fees and the minimum investment is relatively high compared to the residual dividend policy. Given the rationality of both management and shareholders, it is quite evident that a managed dividend policy is the best strategy despite the strong empirical evidence for residual dividend policy. With a comparatively high minimum investment, the management can take control of the principal. Furthermore, there is an allowance of cashing out and moving money to another investment. Companies also employ this policy owing to how shareholders have fewer hands involved in the investment of their money.
Based on Lintner’s findings, it can be noted that, practically, most managers prioritize on significant changes in dividend payments rather than the level of dividend payments as related to the residual dividend policy. When managing dividend policy, managers always think on the best strategy forward. With a managed dividend policy, managers are always able to determine differences between the level of future payment and the corresponding previous dividend payments. This evaluation allows the managers to come up with the best management strategy that guarantees maximum viability (Lease, et al., 2000). A strong preference for stable dividend payments is also another major rationale why firms prefer the managed dividend policy. Despite the existence of empirical evidence supporting residual dividend policy, companies are unwilling to change from the managed dividend policy owing to the relatively stable and consistent growth of dividend payments.
(b) Discuss whether and how taxes might affect the payout policies of companies. 400 words
The effect of taxes on payout policies has been subject to debates among scholars and economists. However, empirically, over the past decade, there has been enough effort to test the effect of taxes on dividend policies. It is significant to approach the effects of a tax on payout policies from a practical point of view to determine the real picture on the ground. Theoretically, it is hard to determine how tax influences payouts as there are other significant risk factors that are worth considering. Hence, taking the JGTRRA reform in the USA as the practical basis, this section explores the effect of taxes on payout policies by companies. In the USA, for instance, the JGTRRA reform saw the dividend tax rate reduced significantly by up to 23%. This tax relief notably applied to all firms in the country and most of the foreign companies. Notably, after the relief, shareholders in US firms were subject to receive equity returns in dividend form. In other words, it can be seen that dividend behavior significantly changed basing on the changes in taxation. The results of the tax cuts were spread across the positive response of dividends and payouts made by firms in the country. By and large, the positivity of the response implies that tax cuts lead to an improved payment rate on dividends.
Furthermore, it should be noted that after the tax reliefs there was the initiation and introduction of new dividend payments by firms. The introduction of these new dividends has got only one implication; reduced tax rates positively influence payouts by companies. Although analysts point towards different directions, the casual impact of tax relief on dividends was felt in US companies. Tax cuts also greatly influence agency relations between management and shareholders. Considering the case of USA, it can be seen that the response by firms on dividend policies was determined by the role of agency influences. For high-dividend firms, after the tax cuts, the stock prices rose significantly compared to low-dividend firms. Another effect on dividend policy is the nature of equity returns after the relief. Tax reductions eventually led to a situation where investor’s preferences would be to hold equity and relatively, not debt (Lease, et al., 2000). In essence, tax cuts led to investors holding more equity. Conversely, increases in taxes can be predicted basing on how US firms reacted to tax reductions. Increases in tax could reduce the stock price for high-dividend firm leading to low dividend payments rates.
Part Eight
(a) What is the main difference between a residual and a managed payout policy? Provide a numerical example to highlight this difference.
The residual dividend policy is built on the theory that a company’s investment, dividend policies, and any related financing should be interconnected and unified even in the short-run. On the other hand, the managed dividend policy involves a situation where cash may be retained beyond the investments needs in specific periods of time. Furthermore, this policy allows for short-term borrowing to meet transitory cash-flow shortages. While the residual dividend policy may be aimed at optimizing the efficacy of corporate resource use while the managed dividend policy is more concerned with dividend smoothing. In residual dividend policy, the remaining cash flows after new investments have been made determine the size of dividend payments. On the other hand, for a managed dividend policy, managers always determine the size of the dividend from any possible changes in dividend payments in a specific period.
Under residual dividend policy, manages aim at investing depending on the extent of the positivity of the net present value of investments available. In this case particularly, after all opportunities have been exhausted, the company will start paying the residual cash as a dividend. This is the basis of the term residual dividend policy. Conversely, the managed dividend policy assumes a situation where cash may be retained beyond the investments needs in specific periods of time (Lease, et al., 2000). This policy allows for short-term borrowing to meet transitory cash-flow shortages. The retention of cash and the short-term borrowing make up the basis of coming up with dividends. Notably, the differences across these dividend policies spread across principal relations with the management according to the agency theory. Further, the decision to employ a specific policy remains independent depending on the contextual, organizational environment and its corresponding viability.
Empirically, taking the illustration of a firm that has an internal cash flow of say $100 and 85 desirable investment opportunities the differences between a residual dividend policy and a residual dividend policy clearly emanate. If the excess free cash flow is 15, then most definitely, for that year, the dividend under a residual policy will be 15 while the dividend under a managed policy will be five where the excess cash of 10 is retained. Analytically, given the empirical evidence supporting the viability of a residual dividend policy, managers who have employed the managed policy are likely to make unwise decisions in that year. This numerical example elucidates more on why the residual dividend policy is more recommended although most firms have chosen the managed dividend policy.
(b) What do academics means when they say the companies cater to a particular “payout clientele” when paying out cash to their shareholders?
The clientele in dividend transactions refers to a group of investors who have similar preferences. The corresponding clientele effect, on the other hand, refers to the tendency that funds have to be pursued by a specific group of investors who are characterized by similar preferences. This case is prevalent in firms that pursue a specific fiscal policy. When different securities attract different investors, it largely depends on the dividend policy of the firm (Lease, et al., 2000). Hence when academicians say that companies cater to a particular payout clientele when paying out cash to their shareholders, they imply that firms simply make provision for the clientele effect by considering the specific group of investors first.
Changes in the firm’s policies are likely to spark changes in the stock price of the firm. F or instance, if a firm raises its dividend, then most likely, investors are bound to buy the stock in large quantities. This, on the other hand, increases the chances price increment. However, if a firm has a huge amount of debt, investors are likely bound to shy off leading to a reduction in the stock price. Essentially, as the demand rises due to increased dividends, so does the stock price and vice versa. As such, the clientele effect can be seen to hold more significance compared to the capital structure of a firm. Thus, during the payments to shareholders, the firm has to cater for payout clientele to guarantee maximum compliance to maintaining a strong principal-agent relationship.
Notably, it is significant to cater for the needs of the specific group of investors differently because their interests are quite different and make up a sensitive part of the entire firm. Although analysts predict that the clientele effect can sometimes be damaging to a firm, it is advisable that managers make that provision during the cashing out of payments. Like any other principal, investors are quite rational with their money and hence, always seek value for their money. It would be prudent for a firm to guarantee these provisions to avoid agency conflicts that might compromise the firm’s capabilities.

References
Gregoriou N. G., (2005). Initial Public Offerings (IPO): An International Perspective of IPOs (Quantitative Finance). London; Butterworth-Heinemann
Lease, R., et al., (2000).Dividend Policy: It’s Impact on firm value. Oxford: Oxford University Press.

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