Corporate Finance of Prudential Insurance Company - Assignment Example

? Corporate Finance the corporate form and initial public offerings Table of Contents Ans. (b) 4 Ans. (c) 6 Ans. (d) 8 References 10 Ans. (a) Initial Public Offering is the process of offering the stocks and shares by a company to the general public which intends to raise capital for the first time. Sometimes the owner of a company who holds most of the shares of a company sells his holdings in the market to raise money for himself by making an offer for sale of shares this is also referred to as initial; public offering (Geddes, 2003, p.1). Initial Public Offering is characterized by information asymmetric which means that the buyer and the sellers have different levels of information in hand. The sellers are more knowledgeable than the buyers so for the convenience of the buyers they are supported by intermediaries who are trustworthy and who would advice the buyers whether the sellers are reliable or not. Such intermediaries are popularly known as underwriters. Corneilli and Glodreich observed that the information knowledge of the buyers and sellers are very different, this difference in information is known as information asymmetric. These asymmetric can be removed by the book building method. Book Building is one of the ways in which the shares can be offered to the public. This process generates captures and records investor demands for shares during the initial public offering. In this method the issuer basically appoints an investment bank to act as an underwriter (Gregoriou, 2011, p.219). It is the process in which an underwriter “build a book” by taking orders from the fund manager or from the buyers or the institutional investors indicating the number of shares and the price they are willing to pay for the shares. By this the price is set according to the coordination and the knowledge of both the parties namely the buyer and the seller. The investment bankers offer more shares to the bidders who provide maximum information in their bids. The regular investors are given an edge in allocations mainly on occasions when the issue is oversubscribed heavily. From this it is evident that information asymmetric in initial public offering will be mi minimized by using the book building method of IPO. Ans. (b) Researchers have observed that shares are under priced in short term and over priced in long term. The under pricing of IPO’s are the most extensively investigated empirical topics in finance literature. Under pricing can be defined as the phenomenon of difference between the offered price and the market price during the period of first trading in the secondary market. Empirical studies have shown enormous difference between the countries and their time periods. As for example the under pricing of IPO’s of Denmark between the years 1984 to 1998 war 5% whereas under pricing of the IPO’s of China between the periods 1990 to 2000 was greater than 250%. The variation among the countries in different periods is quite large. Different researchers have developed different models for providing an explanation for the under pricing of the initial public offering. Jenkinson has come up with 60 theories to explain the concept of under pricing. They can be categorized into four broad categories namely I) asymmetrical information amongst different parties namely the underwriters, issuers and investors who are involved in the process of IPO and which brings about uncertainty with respect to value of the firm. Ii) Institutional Theories which emphasize on factors of legal liability and stabilization of price. Iii) Considerations which focus on the control of the firm and issues of corporate governance. iv)The behavioural approach which assume the presence of investors who are irrational. The most effective theory in the asymmetric models is the Winner’s Curse of Rock. Asymmetric information happens when one individual or an organization knows more than the other individual or organization. This model assumes that some of the investors have better information available related to the value of the firm as compared to others. This group comprises of the informed investors while the uninformed investors comprise of the group that has less information in hand. The investor who is uninformed shall buy new shares of every IPO whereas the investor who is informed shall buy only those shares that are attractive. Generally the number of shares the firm issues is restricted. The investors who are less informed shall receive the demand of unattractive IPO’s but will receive only a part of the attractive IPO because there shares are oversubscribed as the informed investors shall subscribe them as well. The result is that the uninformed investors get a return that is lower than the average under pricing. If there was no under pricing the returns expected by the investor who is not informed will be negative and he shall not bid for IPO allocation in the near future. The initial public offering would only comprise of informed investors. Rock makes the assumption that the market in IPO requires the demand of uninformed investors as the demand of investors who are informed is not sufficient. The empirical effect of the winner’s curse model is that the relation between the degree of under pricing and the uncertainty related to the value of the firm. According to empirical researchers the firms have more risk related to the growth opportunities and the value of the firm have in an average a higher degree of under pricing as compared to the other firms. The internet and technology firms are a good example. Another group of asymmetric model is the signalling models. In such models there are asymmetric information in between the investor and issuer. The issuer definitely has better information with regards to the value and risk of the firm. The issuer with this information advantage can make use of the degree of under pricing as a signal which measures the value of the firm (Su & Fleisher, 1997, p.11). There are two types of firms one is the high quality firm that tries to signal that it is a high quality firm and one is the low quality firm that tries to mimic the low quality firms. There is a chance that the quality of the firm is identified before any seasoned offering. When this happens, the advantage of the low quality firm vanishes and the cost gets higher by a higher degree of under pricing (Engelen, 2007, p.3). The other categories of measurement of under pricing are institutional theories, behavioural and control theories. The institutional theory explains under pricing as insurance for legal liability. Through under pricing the chances of lawsuits and missing information is minimized. The control theories explain under pricing as a means have control of the firm and to safeguard its private benefits. The behavioural theories try to explain under pricing by behavioural reasons. They explain under pricing by the irrational behaviour of the investor or the behavioural bias of the investors. The empirical explanation of this subject is still in its nascent stage (Hamer, 2008, p.8). There are basically two reasons of underperformance after an initial public offering. One reason for it is that the expected return for the asset in the short run is less than the expected return in the long run (Pritsker, 2006, p.18). Ans. (c) The reasons for which the companies want to issue their shares in the overseas are mentioned as follows. The listing of the shares in the foreign market increases the volume of trading on an average and it also enhances the trading volume in the home market as well. Another advantage of issuing shares in the foreign market is that there is advantage of diversification of the investment portfolio The liquidity in the trading of the shares improves overall but however depends on the increase in the total trading volume, the location of listing and the restriction of the foreign ownership in the domestic market. American Depository Receipts are a very effective means to diversify the investment programs globally. American Depository Receipts are issued by the American Depository Banks and they help the investors to trade their shares in the foreign market. The issue of shares in the foreign market reduces the company’s cost of capital because in the home market efficient frontier is being determined by the assets of the domestic company ( Karolyi, 1998, p.1). The prices of shares react more suitably in cross borders in the first month when it is listed. The improved liquidity of the company’s existing shares broadens the stockholder’s base as well as reduces the chances of takeovers. The issue of shares in the overseas shall increase the visibility and the political acceptability of their suppliers, customers and the government. A recently introduced bonding hypothesis states that the managers will follow the regulatory regimes more strictly if they are cross listed because under such circumstances that face the regulations and the corporate governance code of both the foreign as well as home country. Ans. (d) The key characteristic of the UK Corporate Governance Code is the rule” comply or give explanation”. The listed companies must adhere to the code’s provisions or otherwise they need to explain why they are not complying with it. One cannot ignore the code but one can provide good reasons for non compliance of these terms and the members and the shareholders will decide whether the reason provided is good enough (Quiry,Dallocchio,Le Fur & salvi, 2009, p.282). So not complying with the terms of the code is not a breach. If one can talk with the shareholders and explain that the deviations from the Code’s provisions are in line with the principles and are in favour of the company’s best interest, then non compliance of the code shall not become a great issue (Calder, 2008, p.8). The shareholders shall have no sanction in case they do not approve what one is doing. A voting is considered against issues of director’s remuneration, boardroom pay, voting the directors out of the board etc. In case the shareholders are small in number and are not well organized to exert too much of pressure or are not willing to take opportunities then the board can decide upon how much the listed companies comply. The main point is that the provisions of the Code are not compulsory and they are made available for giving guidelines. The requirements of UK code of corporate Governance for its individual investors are the board must consist of directors who have the right kind of skills, knowledge, experience and independence which will enable the company to execute its duties and responsibilities most effectively. The provisions under this states that the board should have a composition of both executive and non executive directors such that no individual or a small group can dominate the decision making process. At least more than half of the board should be independent directors. There is however an exception for smaller firms. The smaller firms asked to have two or more than two independent directors. These principles are however only for guidance the company can have the freedom to explain why it thinks that such number of directors is not right for the company. The code states that that the board must choose one independent director as the senior independent director. The senior director will act as link between the major shareholders who have discussions with the chairman or the chief executive. He also participates in the annual appraisal of chairman ( Fernando, 2009, p.205). References Calder, A., 2008. Corporate Governance: A Practical Guide to the Legal Frameworks and International Codes of Practice. Kogan Page Publishers. Engelen, P. J. , 2007. Underpricing of IPOs and Investor Protection Around the World – Country-Level Evidence. [online]. Available at: www.cbs.dk/content/download/67257/.../Peter-Jan%20Engelen.doc. [Assessed on 30 January, 2013]. Fernando, A. C., 2009. Corporate Governance: Principles, Policies and Practices. Pearson Education India. Geddes, R., 2003. IPOs and Equity Offering. Butterworth-Heinemann. Gregoriou, G. N., 2011. Initial Public Offerings (IPO): An International Perspective of IPOs. Butterworth-Heinemann . Hamer, M., 2008. Empirical Evidence on Ipo-Underpricing. GRIN Verlag. Pritsker, M., 2006. A Fully-Rational Liquidity-Based Theory of IPO Underpricing And Underperformance. [Pdf]. Available at: http://www.federalreserve.gov/pubs/feds/2006/200612/200612pap.pdf. [Assessed on 30 January, 2013]. Su, Dongwei & Fleisher. 1997. An Empirical Investigation of Underpricing in Chinese IPOs. [pdf]. Available at: http://economics.sbs.ohio-state.edu/pdf/fleisher/iporevis.pdf. [Assessed on 30 January, 2013]. Karolyi, G. A., 1998. Why Do Companies List Abroad? A Survey of the Evidence and its Manegerial Implication. Blackwell Publisher. Quiry, P., Dallocchio, M. Le Fur, Y. & Salvi, A. 2009. Corporate Finance(second edition). Wiley & Sons Limited. Read More