Initial Public Offering Issues - Essay Example

Corporate finance Contents Contents 2 Part 3 Introduction 3 Discussion 3 Conclusion 6 Part 2 6 Asymmetric Information 6 Agency Costs 7 Part 3 10 Cost of higher education 10 Relationship between interest rates and no. of students enrolling for higher education 11 What adjustment should you make in order to take into account this comment when assessing the value of a university degree? 12 1. Visionary 12 2. Intrepid 12 3. Team Builder and team worker 13 References 14 Part 1 Introduction IPO refers to initial public offering where a company decides to go public for the first time and offers its shares to the general public. The company generally goes in for IPO through the help of an investment bank or underwriter. The issuer company generally goes in for a contract with the underwriter and the underwriter takes in all the responsibilities leading to IPO including proper valuations of the shares, to selling it through proper channels in exchange of fees. But sometimes the investment banker indulges in what can be called spinning of IPO. In this process the underwriter sells the shares of the company at a discount to the senior executives of a third party company in exchange of some future business opportunities or some other benefits that it hopes to receive from that company. How this conflict of interest arises and how it can be solved is discussed in the following pages. Discussion When the company goes in for an IPO by using the services of an underwriter in exchange of some fees that the underwriter charges the company is in essence acting as principal and the underwriter is acting as an agent. Hires Performs The problem in a principal agent relationship arises when either the principal or the agent are guided by self interests. The problem is aggravated when there is information asymmetry such that the agent has more information than the principal available with it. In such cases the principal is not sure whether the agent is actually working to serve in the best interest of the Principal. In this particular case for example the agent that is underwriter of the shares, has more information available to it than the company. The investment banker has several interests over here to look into like looking into its own future interests and just to ensure that the company’s share can sell at higher price. Its primary goal is to show the company that it has sold the IPO by the company at a very high price and thus is able to command a huge price tag for its services. The second interest guiding the investment bankers is to open the doors of future business prospects. By the act of spinning the investment banker (acting as underwriter) is able to achieve both its objectives. A research into the field by Prof. J. R. Ritter and X. Liu in the year 2009 showed that the IPOs in which spinning was involved in by the investment bankers generated 23% higher first day returns as compared to other IPOs (Liu and Ritter, 2010). Secondly companies of the executives who were offered the shares of the IPO at discount were most likely to choose the service of the underwriter for their underwriting business in future. In fact there are only 6% of cases where the company has chosen the service of a different underwriter. This act of spinning is actually equivalent to bribing because the underwriter or investment banker is offering the shares of his current client at discount to secure future business for itself. Actually over here there is a conflict of interest because its secondary interest of securing future business for itself is undermining its primary interest and its employment as an agent in acting in the interest of its current client. Since in this case the secondary interests are given greater priority than the primary interest, it is objectionable. The other major objections of spinning are as follows: 1. The shareholders of the 3rd party concern who are non executives are not able to get same benefits and the executives which is a violation of fiduciary duty to the shareholders by the executives. 2. The retail investors are often forced to buy the shares of the IPO at a very high price due to this fraudulent practice which is unfair. To prevent spinning several actions can be taken up. The ten major investment banks entered into an agreement to prevent the practice of spinning. To prevent the practice of spinning NYSE/NASD IPO advisory committee had recommended the IPO shares cannot be allocated by the underwriting firm to the executives of the company with which the Investment banker has business relationship. Other ways by which spinning can be prevented is if the company or the principal in this case who is going for the IPO sets a uniform price below which its shares cannot be sold. If this practice of fixing the lower price of the shares of a particular company is adopted then the investment banker won’t be able to sell the shares to the executives of a third party company at a discount. The company may adopt other methods to sell its shares like auction selling. The major problem in valuation of an IPO and thereby setting its price because nobody can predict with certainty the future cash flows that the firm will be able to generate. The investment bankers who are hired as underwriter for the IPO often undertake a strategy in which to determine the value of the current client they compare it with price multiples of a similar sized firm (Barberis, Nicholas and Thaller, 2003). For example if the general price earning multiple is 10 and the company has earnings of $1 million before going in for the public issue then it should be valued at $ 10 million. So if the future valuation of the shares of the company can be accurately predicted in advance and the gathered information is spread evenly amongst the masses then there is a chance that the executives will not buy the shares in a lot because then won’t be able to earn substantial profits by selling them. Conclusion In analysing spinning it was found that agency problem and conflict of interest by the agent, here underwriter as the main reason behind spinning. In order to solve the problem of spinning several approaches may be taken each with some advantages and some disadvantages. But one of the approach will definitely revolved around information economics because information asymmetry can be identified to be one of the main reasons behind spinning. Part 2 Asymmetric Information Asymmetric information is a situation under which one entity has more information than the other entities. Asymmetric information is not at all desirable in the context of the modern corporation. Asymmetric information creates imbalances of power. This kind of imbalances and biased information is significantly detrimental for the perfect competition environment. Asymmetric information is significantly relevant for the modern corporations. Modern corporations across the world invest their money for the market intelligence. Market intelligence allows the modern organizations to gain extra and secret information. On the basis of that organizations across the world invest their money and enjoy high profitability. Share prices of the modern corporation can fluctuate with the help of asymmetric information. It is being observed that in the equity market asymmetric information is always present. In financial markets naturally some person will have additional information; with that additional information investors can value equity of a company. All those additional information can make or break the business perspective of the company. In the modern world organizations are acquiring lots of similar kinds of companies. More than one company are trying to acquire one company. But it is being observed that, the company which has more information they are quoting right valuation and the other competing organizations are failing. That means asymmetric information is highly relevant in modern corporations. It creates moral hazards (Graham, Campbell and Harvey, 2001). It is often being noticed that asymmetric information provides imperfect knowledge and due to imperfect knowledge modern corporations can lose their money in risky projects. Asymmetric information can create adverse selection for the corporations. A particular area where the effect of asymmetric information is fairly profound is equity market. In the equity market the market players’ especially large institutional investors search for asymmetric information so that they can purchase or sell a share of a particular company before others and rake in huge amounts of profit. In many case the traders in order to gain insane amount of profits through asymmetric information indulge in insider trading. A case in point can be involving CITY bank’s managing director Rajat Gupta and hedge fund trader Raj rajaratnam. In that particular case Gupta allegedly disclosed insider information regarding an investment by Goldman Sachs into CITY bank. Raj rajatratnam as a result of this information available to him before other purchased a huge amount of the shares of CITY bank and hoped to gain in huge amount as a result. Asymmetric information is severely detrimental to the health of any organization in the long run. To counter the effect of asymmetric information economics should be carefully used to decimate true and correct information among the stakeholders of the company. Agency Costs Agency cost arises particularly in a principal agent relationship. For his purpose and his benefit the principal generally hires an agent. But both the principal and the agent are guided by their own self interests. In addition there is asymmetric information that influences the scenario. The problem arises when there is a conflict of interest. That is the agent is guided in his or her action by more than one interest. There is no harm for the agent in having a primary and a secondary interest but the problem arises when the agent starts giving more priority to the secondary interest in place of the primary interest. The deviation from the principal’s interest by the agent in his duty while serving the interest of the agent is known as agency costs. To understand the scenario for an agency problem let’s take an example. Suppose a man has a dental problem and he goes to the dentist to have his problem rectified. Now the dentist has his own self interest that is to gain money in exchange of the service that he will provide and also another to serve the patient. Now if the dentist’s secondary priority takes the centre stage and he focuses just on extracting more money from his patient then he will be acting in conflict of interest. This particular scenario will constitute agency cost for the principal. Agency cost theory has significant relevance in the context of company’s share price. Agency cost theory has adverse effects on those share prices where high levels of debts are involved. That means the organizations which have higher level of debts; agency cost is significantly detrimental for those organizations. In the organizational context shareholders and the management have significant conflicts of interests. Figure 1: Agency cost and its impacts on the organizations The above graph is indicating that, with the increasing size of the firm complexity also grows. It is being observed that with the growth of firm agency cost of the firm also increases. Agency costs are quite natural and inevitable into the modern corporation. In most of the modern day big corporations, principles are not having complete controls. Providing material incentives are highly common into those organizations. It is often being noticed that for material incentive stock options and performance bonuses are being awarded to the agents i.e. mangers of the organizations (Brav, Graham, Harvey and Michaely, 2005). To offer all those things the corporations have to pay lots of costs. That means agency costs have high degree of relevance in modern corporations. This cost is generally being found with publicly held organizations and it is a resultant of the conflicts between company’s management and shareholders. It is often being noticed that agents i.e. mangers of the corporations use organizational resources for their own personal benefits. This creates agency cost. All the above discussions and arguments are indicating that, agency cost has enough relevance for the modern corporations. To solve the agency problem the company must indulge in information economics or in other words it should ensure that all information are available with ever involved stakeholder so that there is no occurrence of asymmetric information or in other words one individual does not have more information than the other. If this is ensured then it will be ensured that no one will be able to abuse extra information available to them (especially the agent) and agency problem will be solved to a great extant. Part 3 Cost of higher education Evidence suggests that investments in higher education stand to gain a lot in later stages of life through higher salary and other non monetary benefits such as respect. But everybody is aware higher education comes with a price tag. Not only for the costs involved while perusing higher education but also the opportunity cost of other activity the particular individual could involve in if he wasn’t pursuing higher education. If both of these costs are taken into consideration, then the total cost is not easy to neglect. To analyse the cost of higher education, it should be analysed on the cost benefit analysis of higher education. As a first step the monetary benefits of higher education especially in the context of a secured and high paying job in the future should be compared with a low paying job which the candidate can get without a degree should be compared. It should be analysed which decision would be more effective especially in the long run. Second it should be analysed on cost basis that is in which method the cost involved is higher? If the benefits of an alternative are higher than the cost involved in case of that alternative then that method should be chosen. Another way to analyse two different alternatives is through cost-effectiveness method. Since higher education does not only give monetary benefits but several other non-monetary benefits so cost effectiveness analysis can be implemented to analyse going in for higher education against not deciding for higher education. In analysing the benefits of higher education Net present value method should be used since the benefits accrued from higher education is scheduled to come in future against the benefits of some other occupation which can be received immediately. If however the money ought to be required for higher education is kept in the banks and an interest is expected to be received then IRR method should be used to compute the benefits of higher education. While using IRR it should be analyzed whether the rate of return which will be received by going in for the higher education is greater than the rate of interest received from the bank by keeping the money in form of fixed deposit. Relationship between interest rates and no. of students enrolling for higher education Since there is a substantial costs involved in the process of higher education most of the candidates will go in for some loans to finance their higher education. To understand the relationship of interest rate of loans with number of students enrolling for higher education the best way to analyse the two is through evaluating IRR or internal rate of return and comparing it with the interest rate of loans. To calculate the IRR of a higher education degree, the future benefits to be accrued from the higher education should be converted to monetary terms in the first place. The future monetary benefits or cash flow should be discounted to be analysed in the present scenario because money received today is far more essential that the money received after 3-4 years. Then the internal rate of return of assumed future monetary benefits of higher education should be calculated. The internal rate of return of the higher education should be compared with the interest rate prevalent in loan. If the interest rate in loan is higher than the IRR of the benefits of higher education then higher education should not be pursued. On the other hand if the interest rate on loan is lower than IRR of higher education then higher education should be enrolled in. Additionally cost benefit analysis of going into or enrolling for a higher education can be analysed with not opting for one. The benefits in this case will be the assumed monetary benefits of higher education that is perceived from the present view point. This cost benefit analysis can be taken into consideration based on two cases. The first case can be of current interest rate and the second case can be of higher interest rates. If the benefits to be accrued from higher education are found to be greater than the costs involved then higher education should be pursued otherwise not. However if normal human perception is considered then it is obvious that if the interest rates on loans increases then fewer people will be enrolling for higher education. What adjustment should you make in order to take into account this comment when assessing the value of a university degree? While getting a MBA degree is a good shot in landing a candidate a good job in a company but it is not an assurance of landing the job of a CEO. In fact in many cases it is seen that the CEO of certain companies do not even have a college degree. The famous examples are CEOs of Apple, Microsoft and Face book. The qualities normally found in a CEO are 1. Visionary Most CEOs have the quality that they are visionary or in other words they can look into the future far before any other can. Bill gates understood the value of computers, Steve Jobs understood the value of mobile and Face book understood the value of social network before others could. 2. Intrepid The ability to perform effectively in complex difficult situations Calculated Risk taking The CEOs aren’t afraid to take risks. Optimistic CEOs are in general more optimistic about the future 3. Team Builder and team worker Efficient reader of people The CEO s have the ability to effective read other peoples thoughts and select who will be the best to work for them in a particular scenario. A CEO is good or bad as long as his or her team is. Displays emotion but can maintain control at the same time. The CEO has good financial knowledge and domain expertise. They know their field of business too well. References Barberis, Nicholas and Thaller, R. 2003. A survey of behavioural finance, handbook of economics of finance, Amsterdam: North-Holland. Brav. A., Graham. J. R, Harvey, C. R. and Michaely, R., 2005. Payout Policy in the 21st Century", Journal of Financial Economies, 77, pp 483 - 527. Graham J. R., Campbell, R. and Harvey., 2001. "The theory and practice of corporate finance:evidence from the field", Journal ofFinancial Economies, 60, pp 187 - 243. Liu, X and Ritter, J. 2010. The Economic Consequences of IPO Spinning: Review of Financial Studies, 23(5). pp. 2024-2059. Read More