Capital Budgeting Process - Assignment Example

Introduction Going public through an initial public offering (IPO) is a very important decision to make for a company. This means it will have to alter financial reporting and other operating policies to conform to government policies and at the same time satisfy the requirements of a new set of owners, the dispersed shareholders who bought into the public offering. It is quite a matter of magnitude and importance to go through the whole time-consuming process and a company has only one chance to do it right. It demands meticulous preparations (Draho 182). This means the decision to go through with the public offering had been settled already and a final commitment towards using this funding source was made long ago. The foremost reason for going public is to raise additional capital by issuing shares to the general investing public. This means other funding sources such as internally generated profits or financing through bank loans had been considered and set aside in favor of an IPO. Owners of private companies will now have to contend with the fact that they will lose some control by the issuance of new shares but they have other compensation in return for doing it such as new funds for expansion (new products and new markets), increased liquidity for the current shareholders by creating an active market for the stock to trade and change hands, the stock itself can become a valuable currency to fund new acquisitions (some mergers are made using company stock instead of cash payment), increase employee motivation through stock options to compensate good performance and in general enhance a company's reputation via a well-executed IPO process from start to end. Preparations are made long before the actual IPO itself and it involves three main participants: the issuing firm, the underwriter and the public. Discussion The initial public offering can become a difficult and contentious issue if not handled properly because of the conflicting claims and interests of the three main parties mentioned. An important factor that determines if an IPO is successful is correct timing. As they say, timing is everything, from setting an ideal price range that maximizes the funds that will be generated to the market's reception of the offering. If a decision had been made to go through with the IPO, there are two considerations to be made regarding correct timing: firstly is the stage of the firm's development (such as an aggressive start-up or as a mature existing firm) and secondly, the overall market conditions that will assure a good reception for new shares. A good IPO is a true mark of success of any firm; it means its revenues and profitability are now good enough to warrant generous interest from the general investing public (Bragg 245). The actual process of preparing for an IPO can be divided into two categories or sets of actions needed to be performed by the firm: internal and external. The internal preparations usually take two to three years to be sufficient because it requires the company to put its own house in order, so to speak. This long lead-time can be explained by the necessity of having at least a three-year record of financial performance as attested to by a reputable accounting firm that guarantees the accuracy of these financial statements. In this regard, a minimum of three annual income statements and at least two years of balance sheets are required (preferably 3). The whole point of hiring an independent third-party external auditor is to reassure all potential investors about the financial health of the issuing company. It alleviates concerns in regards to transparency, accuracy and relevancy. There are other necessary steps that need to be taken such as improving the quality of the management team (hiring competent people), a new reward or compensation system is created to encourage all personnel to improve their performance to boost key business areas and hiring a top law firm with securities experience to handle legal aspects of planned IPO such as changing the company’s structure and by-laws. On the other hand, the external preparations for the actual IPO take about 4-5 months prior to the IPO itself. Below is the timeline for all the important steps in number of days: (120-150) days prior to IPO - underwriter is selected (the investment bank) - Letter of Intent is signed with underwriter and advisors - Quiet period begins (people not to talk about the stock) (110-115) days prior – General meeting with all parties concerned such as underwriter personnel, legal adviser and external auditors to thresh out issues related to the offering (110-60) days prior – Registration statement and other legal requirements prepared (60) days prior – Registration statement is filed with Security and Exchange Comm. (30) days prior – SEC issues letter of comment about the registration statement to include areas which might need further refinements or revisions (or amendments, if any) (27-20) days prior – Registration statement is amended to comply with SEC letter (20) days prior – Investment prospectus distributed to all interested investors and the road show begins in earnest (this is a presentation to securities analysts, fund managers and potential investors to include media conferences, slide shows and Q & A forums by going around big cities to drum up investor interest in the proposed IPO). A good road show will determine the eventual success of the offering itself such as generating the highest possible price for the shares based on market interest and estimated potential demand for them. (10) days prior – Underwriting syndicate is formed and “tombstone ads” placed in all major newspapers. The advertisements contain only minimal information and the order of all underwriting partners in their order of importance. Although it should be done prior to IPO, today’s practices now allow “tombstone ads” after the IPO itself as a matter of record only. (1) day prior – Final registration filed with the SEC and shares are priced accordingly (0) – Actual IPO begins with shares allocated and trading in the exchange begins (1- 40) days after – “Quiet periods” officially ends and firm can issue releases again Conclusion It is the job of the chief financial officer (CFO) to take all the necessary steps to make an IPO successful by taking a long-term view of the preparatory process (3 years backwards). In earlier times, this was the job of the treasurer, then that position was upgraded to that of the comptroller and now the CFO. The temporary “window of opportunity” for a successful IPO can vary a great deal from the time an IPO is decided to the actual IPO itself (Gregoriou 122). However, after the new shares have been listed on the stock exchange and actually traded (changed hands between buyers and sellers of the company stock), there are two other issues that need to be discussed here to acquaint readers. The first is the support that can be extended by the underwriting syndicate by buying shares sold on the exchange so that prices will not go tumbling down. This is like creating an artificial demand until such time the stock price has stabilized with buying support. This support is crucial to prevent the stock’s price from plummeting known as the cascade effect (University of Rochester 203) and collapsing. The second important issue is the so-called “lock-up period” which is a legal binding agreement between the underwriters and company insiders not to sell their stock for a period of time after the IPO. This period is usually 120-180 days after the stock’s listing to prevent insiders such as managers, employees, top executives and venture capitalists from selling the stock and increase suddenly the supply of free shares, thereby depressing its price. General public investors would not look kindly if insiders sell their stock which might mean they had no faith in their own company. This is all part of corporate governance procedures designed to enhance or protect shareholder interests (Reuvid 183). The use of underwriter and insider lock up agreements have received considerable attention in the media lately to prevent abuses in the entire IPO process and preserve its integrity (Gompers & Lerner 455). Its use is to prevent moral hazard problems such as firms exaggerating performance although it is unprofitable. Works Cited Bragg, Steven M. The New CFO Financial Leadership Manual. Hoboken, NJ, USA: John Wiley & Sons, 2007. Print. Draho, Jason. The IPO Decision: Why and How Companies Go Public. Northampton, MA, USA: Edward Elgar Publishing, 2004. Print. Gompers, Paul Alan & Lerner, Joshua. The Venture Capital Cycle. Hoboken, NJ, USA: MIT Press, 2004. Print. Gregoriou, Greg N. Initial Public Offerings: An International Perspective. Burlington, MA, USA: Butterworth-Heinemann, 2006. Print. Reuvid, Jonathan. Floating Your Company: The Essential Guide to Going Public. Philadelphia, PA, USA: Kogan Page Publishers, 2008. Print. University of Rochester Graduate School of Management. Journal of Financial Economics. 58.1-3 (2000): 203-214. Print. Read More