Question.3255 - Answer the following questions in at least a paragraph. 1. The evidence of IPO sales is varied from issue to issue, but there are three common themes; underpricing, underperformance, and the reasons for going public. Explain these three items and provide at least two examples for each. 2. Different countries have different sources of funds. For example, in the United States, internally generated funds count for over 4/5 of all funds while in Japan, it is about ½ with externally generated funds making up the remainder. The disparities are less in the United Kingdom and Germany, with about 2/3 of funds coming from internal sources. Discuss this disparity and why it might exist. 3. The Neptune Company offers network communications systems to computer users. The company is planning a major investment expansion but is unsure of the correct measure of equity capital as it has no traded equity. Your job is to determine the basis of the equity cost. List and explain the steps you will need to take.
Answer Below:
1) IPO The main reasons for companies going for IPO are to raise fund when the companies are in need of money. Sometimes when the performance of the companies is not good or when there is cash-crunch, then also the companies go for IPO. Although it is a bad signal to investors when an entrepreneur sells his own shares, it still makes sense for many entrepreneurs to cash out some of their wealth to diversify or just to enjoy life. Public firms tend to have higher profiles than private firms. This is important in industries where success requires customers and suppliers to make long-term commitments. For example, software requires training and no manager wants to buy software from a firm that may not be around for future upgrades, improvements, bug fixes, etc. Indeed, the suppliers' and customers' perception of company success is a self- fulfilling prophesy. However, there are some disadvantages for companies going for IPO, like profit needs to be distributed among large group of shareholders. There is a loss of confidentiality and the companies’ needs to comply with large number of compliances and has to fulfill large statutory responsibilities and there is a loss of control on the organization. Example of recent companies who has gone for IPOs are EXONE Co, Boise Cascade Co. etc 2) Internally Generated fund These are those funds which are internally generated in the business through the day-to day operations of the business like Cash reinvested in the firm; depreciation plus earnings not paid out as dividends etc. Internal capital is a major source of funds for financing corporate investments. This reliance on self-generated cash as a source of investment funds has prompted researchers to investigate the relationship between firm’s investment decisions and internal resources. In a world where capital markets are perfect and all firms have free access to external sources of financing, and investment decisions would be based solely on expected future profitability and thus not be affected by the availability of internally generated funds. However, in the real world, however, capital market imperfections exist, making internal funds less costly and therefore more attractive than external funds. This reliance on internal funds should be stronger for firms facing greater capital market imperfections, i.e., firms in countries where external capital markets are less developed. The interesting empirical question that arises therefore is whether corporate investments are indeed more sensitive to the availability of internal funds for firms in less developed economies. Thus, in developed countries like USA, internally generated funds count for over 4/5 of all funds while in Japan, it is about ½ with externally generated funds making up the remainder. The disparities are less in the United Kingdom and Germany, with about 2/3 of funds coming from internal sources. 3) Cost of Equity In listed companies, it is very easy to measure the cost of equity as the market price of the stock is easily available as the stocks are freely traded in the market. However, for unlisted/ non traded companies, it is difficult to measure the cost of equity. There are some methods of valuing the cost of equity. Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise." Opportunity cost is what you give up as a consequence of your decision to use a scarce resource in a particular way. All capital invested is the total amount of cash invested into a business. In an enterprise this refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity. Calculation a Company's Weighted Average Cost of Capital We calculate a company's weighted average cost of capital using a 3 step process: Step-1: Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity. A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically: The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %) We enter the marginal corporate tax rate in the worksheet "WACC." B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital. We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity shareholders demand a minimum rate of return equal to the return from a risk- free investment plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is equivalent to the risk premium of the market as a whole time a multiplier--called "beta"—that measures how risky a specific security is relative to the total market. Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium). Step-2: Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return. Step-3: Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.More Articles From Finance
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