Stock/Equity Qs How Good Is the Long-Run Essay

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Stock/Equity Qs

How good is the long-run performance of IPO firms? How is holding on to IPO stocks is a risky proposition? Explain.

All publicly traded companies have some form of initial public offerings, and thus judging the truly long-term performance of IPO value means assessing stock market value. In shorter terms, however, most IPO purchases end up lagging behind market averages, and ultimately many newer companies fail (Goldberg, 1999). This means holding onto IPO-purchased stock runs the risk of lower rates of return on the investment than could be achieved by selling and purchasing more established stocks, or even of having the value of the investment completely eroded through a company closure or bankruptcy (Koch & Johnson, 2009). Selling quickly is typically the best way to reap rewards from these stocks, and for the average investor trying to purchase an IPO usually isn't worthwhile (Goldberg, 1999; Koch & Johnson, 2009).

What are some possible reasons why the price of stock drops on the announcement of a new equity issue?

An issue of new equity is essentially a dilution of the amount of value the company holds, which automatically means (all else being equal) that each share of the company is literally and directly worth less (Reilly & Brown, 2011). If a pie is cut into six pieces, each of the pie is smaller -- has less value -- than if the pie were cut into four pieces. A new equity issue increases the number of available shares in the company, essentially splitting up the pie into more -- and smaller -- pieces. Investors might also take this as a sign that the company needs more cash, and unless this is for a clearly warranted and likely successful growth opportunity this is unlikely to be seen as a positive element of the company and stock value.

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Explain why we might expect a firm with a positive NPV investment to finance it with debt instead of equity?

A firm with a positive NPV investment is expecting positive cash flows and profitability for the foreseeable future, and is in a position to create substantial value for its shareholders (current equity financers, in a sense) through both share price increases and dividends. Equity financing dilutes share value and makes dividend increases less possible, and with a positive NPV investment the debt rating of the company is likely to be quite low -- meaning borrowing would be cheap -- and rather than diluting value like equity financing debt financing simply leads to increased expenditures (Reilly & Brown, 2011). This would lead to greater profitability for the company and for shareholders, both of which would be incentives for this course of action for the company as a whole and for its decision-makers.

What is the relation between Stock prices and new equity is issued? What will increase or decrease? How this will affect the firm's raising capital and the company and investors?

As described above, when new equity is issued the stock price generally decreases because the value that exists in the company is diluted by "splitting up the pie." Numerous other specific changes will help contribute to this change or coincide with this change; earnings-per-share will decrease as these will also be diluted with the increase in the number of shares just like the simple value of equity will (Koch & Johnson, 2009; Reilly & Brown, 2011). The price-to-earnings ratio would be expected to drop as the stock price would likely drop further….....

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