Questions

1) Is the expected return for stocks equal to zero in an efficient market?

No. Stocks are expected to earn a non-zero rate of return consistent with their risk. The expected
abnormal or excess return is zero in an efficient market.

2) Which hypothesis is being tested if a researcher examines stock price performance based
on a 50-day and 200-day moving average of prices?
The moving averages are determined using past prices so the researcher is testing for weak form efficiency.
3) Which hypothesis is being tested if a researcher examines stock price performance
following earnings announcements?
Earnings announcements are public information so the researcher is testing for semi-strong form efficiency.

4) Why might a stock’s price not reflect everything management knows about their company?
Insider trading laws prohibit management from trading on private information. Thus, private information is
not likely reflected in the stock price.
1) If markets are efficient, what should be the correlation coefficient between stock returns of
two consecutive periods?
Zero, otherwise returns from the prior period could be used to predict returns in the
subsequent period.
Problem 3

 Buy it
 This is a “Value Investment” where you believe the stock will
perform better than the market and if you are correct you will
earn a positive abnormal return.
 Market Pricing Anomalies

Market
efficiency

Existence of
market pricing
anomalies

A market anomaly occurs if a change in the price of an asset or security

cannot directly be linked to existing or new information. Market
anomalies, if persistent, are exceptions to the notion of market efficiency.
 Other Calendar-Based Anomalies

Anomaly Observation
Turn-of-the-month Returns tend to be higher on the last trading day of the month and
effect the first three trading days of the next month.
Day-of-the-week effect The average Monday return is negative and lower than the average
returns for the other four days, which are all positive.
Weekend effect Returns on weekends tend to be lower than returns on weekdays.
Holiday effect Returns on stocks in the day prior to market holidays tend to be
higher than other days.
 Anomalies
 The low PE effect: Some evidence indicates that low PE stocks
outperform higher PE stocks of similar risk.
 Low-priced stocks: Many people believe that the price of every stock
has an optimum trading range.
 The small firm effect: Small firms seem to provide superior risk-
adjusted returns.
 The neglected firm effect: Neglected firms seem to offer superior
returns with surprising regularity.
The January effect: In January, stock returns are inexplicably high,
and small firms’ stocks do better than large firms’.
 The weekend effect: It is observed that security price changes tend
to be negative on Mondays and positive on the other days of the week,
with Friday being the best of all.
 The persistence of technical analysis: If the EMH is true, technical
analysis should be useless. Each year however, an immense amount
of literature based in varying degrees on the subject is printed.
Behavioral finance is a field of financial thought that examines investor
behavior and how this behavior affects what is observed in the financial
markets. The behavior of individuals, in particular their cognitive biases,
has been offered as a possible explanation for a number of pricing
anomalies.

Behavioral Finance versus Traditional Finance

Behavioral Finance Traditional Finance
Assumes: Assumes:
• Investors suffer from • Investors behave rationally.
cognitive biases that may lead • Investors process new
to irrational decision making. information quickly and
• Investors may overreact or correctly.
under-react to new
information.
The Behavioral Challenge
 Rationality
 People are not always rational.
 Many investors fail to diversify, trade too much, and seem to
loose by selling winners and holding losers.

 Deviations from Rationality

 Psychologists argue that people deviate from rationality in
predictable ways:
Loss Aversion
 Behavioral Biases

Representativeness: investors assess outcomes depending on how similar they are to the current
state. drawing conclusions from too little data
Gambler’s fallacy: recent outcomes affect investors’ estimates of future probabilities.
Mental accounting: investors keep track of the gains and losses for different investments in
separate mental a/cs.
Conservatism: investors tend to be slow to react to changes.
Disposition effect: investors tend to avoid realizing losses but, rather, seek to realize gains.
Narrow framing: investors focus on issues in isolation.

The basic idea behind the noted behavioral biases is that investors are humans and, therefore, imperfect
and that the beliefs they have about a given asset’s value may not be homogeneous. These behaviors help
explain observed pricing anomalies.
 Information Cascades
• Herding is clustered trading that may or may not be based on
information. A participant’s trading decision does not necessarily
influence the decisions of others.

Informed Uninformed
Release of
1 2 traders 3 traders imitate
information
trade informed traders

• An information cascade is the transmission of information from those

participants who act first and whose decisions influence the decisions of
others. Information cascades may result in serial correlation of stock
returns, which is consistent with overreaction anomalies.

• Are information cascades rational? If the informed traders act first and
uninformed traders imitate the informed traders, this behavior is
consistent with rationality. The imitation trading by the uninformed
traders helps the market incorporate relevant information and improves
market efficiency. The empirical evidence is consistent with the idea
that information cascades are greater for a stock when the information
quality regarding the company is poor.
 Implications for Corporate Finance
 If information is reflected in security prices quickly, investors should
only expect to obtain a normal rate of return.
 Awareness of information when it is released does an investor little
good. The price adjusts before the investor has time to act on it.
 Firms should expect to receive the fair value for securities that they
sell.
 Fair means that the price they receive for the securities they issue is the
present value.
 Thus, valuable financing opportunities that arise from fooling investors
are unavailable in efficient markets.
 The price of a company’s stock cannot be affected by a
change in accounting.
-- Why has been Netscape so successful to date? What appears to
be its strategy?

--Does Netscape need to go public to satisfy its capital needs?

-- Why, in general, do companies go public? What are the

advantage and disadvantages of public ownership?

-- Can the recommended offering price of $28 per share for

Netscape be justified?
 Netscape Communications

Does fundamentals support $1 billion

for a loss-making company
with a book value of $6 million?

Problems associated with the valuation of small, rapidly-growing high-

tech stocks when few comparable firms to benchmark against.
Netscape IPO – Prospectus -> $14.0
 Netscape Communications Corporation
 Founded in April 1994
 Business – Comprehensive line of client, server, and integrated
applications software for communications and commerce on the
internet and private Internet Protocol (IP) networks
 Financial Highlight – Losses of $4.3 million on total revenues
worth $16.6 million during the first two quarters
Entrance in the Internet Market
(December 1994)
 It entered through its flagship browser, Netscape Navigator
 Netscape’s Strengths at this time –
1. Original Mosaic Code – by paying $2.4 million
2. Jim Clark’s Management Experience
3. $3 Million in Seed Money
4. Mark Andreessen’s Technical Expertise – creator of Mosaic
 Challenges at this time –
1. It had to set a new industry standard – immediate concern
2. It had to make money
Competitors and Market Leadership
 Netscape – Market leader in the Internet Browser market
with a 75 % market share by mid 1995
 Nearest Competitors
1. Spyglass – owner of Mosaic
2. Microsoft – Windows
3. AOL and Prodigy – transformation from online platform
to internet platform (market)
Objective of Netscape’s IPO
 Increasing Global Competition
 Fund expected future growth – Investment in R&D
 To stockpile cash reserves for potential acquisitions
 To gain visibility and credibility within the industry
 To sustain in this dynamic and nascent market
General Options to Capitalize

• A private equity transaction

• Another debt transaction
• A public equity transaction – IPO
• Joint venture with another firm
Fund Raising at Different Stages of a Life Cycle
Investors and Instrument issued depend on the option and the stage of lifecycle
Depository Shares
Receipts with
the underlying Strategic
Foreign being Shares Investment
Currency Bond
Depository convertible into
ADR Customer, Supplier,
Receipts with Shares Competitor
the
underlying US QIB
FCCB
being Shares

GDR Hedge Funds and FIIs

Shares

Shares / PCD
QIP FII
/ FCD

Rights QIB
Shares Issue
Shares /
Warrants / Follow-on
Public Existing Shareholders
FCD / PCD
Issue
Private FIIs, FI, Banks, Insurance Cos, MF,
Shares Placement HNI, Individuals including NR

IPO Promoters, Financial Investor,

Shares Strategic Investor
Warrants /
Private FIIs, FI, Banks, Insurance Cos, MF,
Shares
Equity HNI, Individuals including NR
Venture
Private Equity investors
Shares Capital IPO: Initial Public Offer

Seed Venture Capitalist QIP: Qualified Institutions Placement

Capital GDR: Global Depository Receipts
Personal Contribution, FCCB: Foreign Currency Convertible Bond
Family, Friends, Angel
Investors ADR: American Depository Receipts
Benefits of Listing
Benefits Description

 Indian Stock Exchanges have a high number of listed companies and provide significant liquidity
High Liquidity and Depth
 Additional recognition in case of presence in Sensex/ Nifty/ Index constituents

Flexibility for future

capital raising  Multiple choice: QIP, Rights, Follow-on public issue, GDR, ADR, FCCB
opportunities

 Sharing history, business operations, strategy and growth plans helps develop franchise value
Establishes profile  Enables branding and customer awareness; provides access to retail investors; lenders have higher
comfort with listed entities

Positive impact on  Greater awareness amongst research analysts, fund managers, investment advisors
valuation  Creates greater liquidity and market if part of the derivatives segment

 Ability to create wealth for promoters and shareholders

Wealth creation
 Provides a benchmark for Company valuation

 Ability to create currency for strategic initiatives

Creation of currency
 Leverage as currency for M&A, alliance etc.

 Ability to serve HR initiatives; serves as an incentive mechanism for management and employees e.g.:
Employee incentivization ESOS/ ESPS
 Mechanism for tracking management performance
Costs of going public!
 Costs of reporting
 Filing quarterly and annual reports to SEBI & SEs
 Compliance with SEBI / Govt  expensive for SMEs
 Disclosure and auditing
 Mgmt may not like the idea of reporting operating
data,
 Holdings of insiders is known  they mayn’t like it
 Self-dealings of insiders is hard to arrange
 Payment of high salaries, personal transactions with
the business (such as a leasing arrangement), and
not-truly-necessary fringe benefits.
Costs of going public!
 Inactive market/low price.
 For small firms with infrequent trading, the market price
may not represent true value.
 Security analysts and stockbrokers simply will not follow
the stock <== there will not be sufficient trading activity
to generate enough brokerage commissions to cover the
costs of following the stock.
 Investor relations.
 Public companies must keep investors abreast of current
developments.
 Many CFOs of public firms spend two full days a week
talking with investors and analysts.
 Takeover threat from hostile bidders (control)
 Managers who do not have voting control must be
concerned about maintaining control.
 There is pressure on such managers to produce
annual earnings gains, even when it might be in the
shareholders’ best long-term interests to adopt a
strategy that reduces short-term earnings but raises
them in future years. (Short-termism)
 Potential shareholder lawsuits
 Very expensive transaction
IPO Process
 Underwriter is to be chosen (an important decision!)
 Begins with an initial prospectus, an initial price range ($12 – 14 in
this case) and an initial range for no. of shares to offer (3.5 million in
this case)

 Road shows to stimulate the interest in the stock!

 Both UW and mgmt make presentations to investors
 An order book of indications of interest is assembled (Grey market) used to
help establish a final offering price!
 Distribution takes place through syndicate of IBs
 Underwriters usually make a market in the stock
 Assigns analysts to track the stock
 Provide liquidity support for initial period
Key Parties and Responsibilities for an IPO
Intermediary Structure

Book Runners’
BRLM Broker / Syndicate
Legal Counsel

Legal IPO Grading Advertising

Registrars Bankers Printers
Counsels Agency Agency

Issuer Company /
Selling Shareholder
Arrangement
Coordination
Role Played By Book Running Lead Manager
 Suggesting optimal Capital structure for the Company

 Appropriately positioning the Company vis-à-vis its peers

 Advising on all critical aspects related to the Issue

 Overall transaction management responsibility

 Navigating transaction strategy, including structuring, timeline and execution

 Conducting due-diligence and participating in the Drafting sessions

 Co-ordination with all parties involved in the transaction; liaison with SEBI
and Stock Exchanges

 Issue marketing, including co-ordination of Research briefing and

management road shows

 Managing the Book, advice on pricing and allocation and assisting in post-
issue management
Issue Sizing Considerations
A correct IPO size has a favourable impact on quality of
IPO Size
demand, achievable price and aftermarket performance
Motivation for a Small Motivation for a Large
Offering Requirement Offering Recommendation Key Considerations

Minimise Dilution Use of Proceeds  Large enough float to attract

good quality institutional
 Expectation of better  Significant improvement investors and have adequate
valuation in future, to the balance sheet Net Public Offer liquidity
especially as operations IPO Size size
and cashflows improve  Funding requirements  Meet additional investment
over the next 2 – 3 requirements
years
Potential
Key Considerations
Scarcity perception Minimum Float Liquidity Distribution Plan

 Limit supply to achieve  In a Book Built IPO,  Optimising size for Minimum 60%* to  In accordance with SEBI
best pricing Institutional Investors liquidity, which is an Qualified guidelines; 5% of the 60%
prefer a minimum important consideration Institutional Buyers reserved for domestic mutual
investment size for most investors
(QIBs) funds
 Regulations allow a
minimum of 25%
 Significant enough retail
dilution, subject to
adherence to certain 10%* to Corporate/ distribution to enhance liquidity;
conditions, chiefly min. HNI and 30%* to but not so much as to affect
60% allocation to QIBs Retail Investors immediate aftermarket
adversely
Net Public Offer: Total Issue Size less firm allotments and /or reservations
* Assuming a dilution of less than 25%. If dilution is more than 25%, distribution plan shall be as follows: Up to 50% to QIBs, not less than 15% to HNI and not less than 35% to Retail Investors
Day-1 of trading
 The day-1 is wild and exciting
 Large returns and sustained, for many
 Some have a sharp run-up and then fall back by the end of the
day.
 A few IPOs actually end day-1 with a loss.
 why is the offering price so low?
 you probably can’t get the chance to buy an IPO at its offering
price, especially not a “hot” one.
 underpricing increases the likelihood of oversubscription ==>
reduces the risk to the underwriter.
 Most investors who get to purchase the IPO are preferred
customers of the investment bank,
 U/w needs an honest indication of interest when building the
book prior to the offering. UNDERPRICING is a possible way
to secure this information from the institutional investors.
 Most issuers seem content to leave some
money on the table!
 the company wants to create excitement, and a
price run-up on the first day does that;
 only a small percentage of the company’s stock is
generally offered to the public ==> current
stockholders give away less due to underpricing
than appears at first glance; and
 IPO companies generally plan to have further
offerings in the future, and the best way to ensure
future success is to have a successful IPO, which
underpricing guarantees.
 Netscape IPO
The Investment bankers and Underwriters determined the price
@ $14 per share for the public issue of 3.5 million shares

Road show – The underwriters inferred the demand for

Netscape’s share to be very high

Thus, they proposed to the management to issue 5 million shares

at a price that was 100 % higher

Board’s dilemma: To justify the proposed increase in price by

100%; Proposed valuation to $1B from book value of $16mlns
Can recommended $28 price per share justified?
( Under Assumptions )
 Total cost of revenues at 10.4% of total revenues
 R&D remains at 36.8% of total revenues
 Other optg expenses (as % of revenues) decline on a st. line basis from
80.9% of revenues (in 1995) to 20.9% (in 2001)
 This would give Netscape a ratio of optg expr to revenues close to Microsoft’s,
which is about 34%)
 Capex decline from 45.8% of revenue (in 1995) to 10.8% of revenue
by 2001 (Microsoft’s experience!)
 Depreciation is held constant at 5.5% of revenue
 Changes in NWC of essentially zero;
 Discount rate of 12%;
 Long-term steady-state growth of 4% annually after 2005
Start from current sales base of $16.625M. How fast must Netscape grow on an annual basis
over next ten years to justify a $28 share value?
Netscape….postfacto…contd…
Brief Overview / Review of Fin-1
 S1 -- Financing, Investment and Dividend Decisions; Firm Value Max
 S2 -- Accounting to Finance view; NOPAT, FCF, EVA, MVA,
 S3 -- Financial Planning and Forecasting; AFN formula – Tire City case
 S4 -- Tire City Contd… Forecasting Financial Statements
 S5 -- Working Capital – Credit terms – Multitech exercise
 S6 -- Working Capital – CCC -Dell case – Efficient use of WC Fuel
 S7 -- Time Value of Money – Various streams of cash flows
 S8 -- Bond Valuation – YTM, Interest rate sensitivity
 S9 -- Stock Valuation – DCF approach – Forecasting FCF --Ranger Sports
 S10n11-- Overview of Financial System & Markets –Market Structure of NSE
 S12 -- Risk – Return – Portfolios
 S13 -- Portfolio diversification – Beta -- Relevant risk of stock -- CAPM
 S14 -- Market Efficiency – various forms; Insider Trading Strategy
 S15 -- Behavioral Finance – Anomalies - Netscape IPO -- Review
At Market Equilibrium: Intrinsic Value = Market Price
End Term Exam format
 Part A ~ approx. 30% weight ~ conceptual questions
 Part B ~ approx. 40% weight ~ Short problems
 Part C ~ approx. 30% weight ~ Comprehensive problems
 Duration about 180minutes

 Good luck n See you in Finance Electives 