Spring 2022 End-of-Semester Finance Exam Solutions for the Topic-Going Public- North Carolina University
Below are the questions asked on the finance exam done in Spring 2022 at North Carolina University. These questions are designed to help you study for and prepare to do your tests on going public for companies. Find detailed answers below that will show you how best to answer end of semester test questions. You can also hire us to complete your finance exams on any topic.Exam Question:
Discuss the key points that companies have to consider when determining if going public is a realistic prospect for them.
Exam Solution: After weighing up the advantages and disadvantages of going public, the promoters may have decided they wish to proceed. They next need a checklist of key points against which to consider how realistic the prospects are. They should also assess what structural changes may be necessary and whether they are feasible.
A list of criteria to judge whether a flotation is a practical proposition or not is set out in 'I Criteria' below. Changes which may be needed in the organisation of the group and in its gearing, voting arrangements and issued share capital are discussed in 'Il Structure' below. In some countries, a hierarchy of markets has emerged. There may for example be a major stock market, an unlisted securities market and an over-the-counter market. This chapter deals mainly with the requirements for going public on a major stock market where a company would be bound by a full listing agreement. The points discussed apply also to a company considering alternative markets, the main difference being the degree of compliance.
A convenient starting point is to review recently issued flotation documents. This exercise serves to identify the main categories of information which need to be given and to see how the group compares. Companies in a similar sector should be chosen if possible. While some elements in a prospectus are common to all flotation, critical factors and the emphasis which is placed on them vary from sector to sector. What is required for a flotation of a retailing chain will not necessarily ensure success for a computer company. A useful checklist would include the following points:
- Size and period of existence
- Profit trend and prospects
- Balance sheet
- Image and management
- Relationships with existing shareholders/directors
Most stock exchanges impose a minimum size for the aggregate value of securities they are prepared to consider for listing. Size will be measured by the market value at the flotation price of the securities to be listed and is based on the whole class of such securities, not just the percentage in public hands. The purpose of the minimum size criterion is to ensure reasonable marketability in the security. Marketability is largely a subjective concept, so that the minimum size force may be somewhat arbitrary. It depends in part on the type of security and varies widely from market to market. Within individual markets, the size criterion is updated periodically by the stock exchange authorities and is most easily found by aspiring promoters by enquiry through a stockbroker or merchant bank.
Many markets require a company to have existed or to have recorded profits for a minimum period of time, say three to five years, but this is not always the case. A recently incorporated top company used to reorganise a group prior to flotation is considered to inherit the track record of its subsidiaries.
If the company is likely to be primarily assessed on an earnings basis, the audited profits for, say, the last five years will be critical, together with a forecast for the current year. A smooth progression of profits is desirable. If there are departures from the trend, can they be readily explained? Are they due to cycles in the general economy or sector, or are they attributable to some special circumstances in the company? If a loss has been incurred, can the problem be clearly identified and factors responsible shown to have been isolated and remedied?
What sector or industry would the company expect to be classified under? Is this sector in favour with investors? Are the prospects for the sector regarded as encouraging?
If a particular market sector is depressed, it may be virtually impossible for even a sound company in that sector to go public on acceptable terms. On the other hand, when for example the high technology sector is in vogue, flotation of a company with little more than a few promising projects on the drawing board is quite possible. Indeed, it seems that promise - allowing investors full range to their imaginations - is frequently preferred to performance.
Does an analysis of the balance sheet reveal any areas of weakness? The levels of gearing and the requirements for working capital should be examined to see if they are out of line with other companies in similar businesses. Are there any contingent liabilities, guarantees or litigation outstanding which could increase the company's financial obligations? Is lack of capital likely to be a constraint on growth?
Does the company have some feature which will serve to identify it in the minds of investors? If not, is there some way that the company's attractions can be described so that it will be differentiated from existing investment opportunities? How can the promoters counteract the inertia which prompts investors to stick to more familiar shares? Is the management known at all to the general public? Does it have a reputation for competence and integrity among its peers and in financial circles? Are there any non-executive directors of standing? Are there any obvious gaps in management competence, particularly as regards the finance and control functions?
Major areas of are likely to act as a significant barrier to investment. The market likes the extent of the risk of a new investment to be clearly established. If there is uncertainty for example in the outcome of litigation, the most likely reaction of financial institutions is to suggest a delay until the problem is resolved or at least until the maximum exposure can be quantified.
A prospectus requires the inclusion of audited accounts. In many markets, these should be not more than six months' old. Even if the audit can be completed promptly, the available 'window' is quite narrow. A profit forecast is also likely to be needed. For prudence, management may wish to see some months' actual results and a reasonable level of business and orders on hand before committing itself for the whole year. Management may be torn between the need to be certain of their forecast and the flotation deadline. Other factors affecting timing are more general, such as the state of the market and any queue of pending issues, with a danger of 'crowding out'.
Are there any dealings between existing shareholders, directors and other related parties and the group which might be inappropriate in a public company but would be difficult to unwind? For example, any material amounts owing by such parties to the company should be cleared prior to the flotation. The need for the public group and private interests to deal with each other on an arms-length basis may involve unacceptable levels of complexity and expense. If a reasonably clean bill of health can be given under headings (i)-(viii) above, it will be worth proceeding to the next stage, reviewing the structure of the group to see what changes may be required for flotation.
Explain the structural changes that will happen in the company when going public
Exam Solution: Formal changes must be considered in the corporate organisation of the group. Market preferences on gearing, voting arrangements and share price must also be taken into account.
- Corporate organization of the group
- Voting structure
- Share price
A business built up by an individual or family may grow in size and complexity in a rather haphazard manner. A series of companies may be established as is most convenient at the time. These companies may well be owned by the same or very similar sets of shareholders. The result is a number of private companies with common ownership and related lines of business which have not been formed number of subsidiaries or associates in an orderly family tree.
If the decision is taken to go public, a single company will have to be selected to have its shares listed on the exchange. A choice must therefore be made as to what company should be used. The largest or most well-known company may acquire all or some of the other companies or businesses and serve as the company which goes public. Alternatively, a new top holding company may be established which acquires the companies chosen to form the public group. This company will derive its track record from its new subsidiaries. Care must be taken over transfer of ownership of a company holding a valuable licence or agency agreement. The change of control may well require time- consuming consents to be obtained. In some circumstances, it could jeopardise continuance of the arrangements or lead to renegotiation of their terms. The method used for forming the group will normally be an exchange of shares.
The companies acquired will become subsidiaries of the new top holding company by their shareholders exchanging their shares for new shares in the holding company. Depending on the gearing of the new holding company and the preferences of the vendor shareholders, some subsidiaries may be acquired for cash. Cash may be provided from the company's own resources, by identifying cash subscribers for new holding company shares or by bank borrowings. In general, it is preferable not to leave minorities outstanding so that the holding company may have complete control over its new subsidiaries and full access to their assets and cash flow. In some cases, the managing director of an operating company may have a shareholding in that company as a performance incentive which it may be better to leave in place. The incentive will be weakened if he exchanges shares in the company he runs for shares in a holding company with interests in companies he is unable to influence. A reorganisation of this type is likely to involve heavy expenses for capital duty on the share capital of the new holding company and transfer duty on acquisitions of subsidiaries or assets. The capital duty element is largely unavoidable when new shares are created and issued. In certain jurisdictions, it may be possible to reduce or largely eliminate the transfer duty. A change of control may be effected by subscription of new shares. Existing shares will only be transferred after drastic changes in their rights bring about a corresponding reduction in their value. Schemes of this type may be vulnerable to attack from tax authorities.
The financial structure of the new holding company on an unconsolidated and consolidated basis should be reviewed. High gearing is a major reason for going public via a new issue to raise capital to retire corporate debt rather than offering existing shares for sale, with the proceeds going to the original shareholders. A group which is unusually highly geared may not be suitable for flotation at all until the level of borrowing can be reduced.
The appropriate level of gearing depends on a number of factors. An asset based group, such as a shipping or property concern, or one which has highly predictable cash flows such as a utility, will be able to support a higher level of gearing than a business with unpredictable cash flows and little asset backing. The level of gearing in the group to be floated may be measured against existing listed companies in the same industry sector.
Market attitude to gearing can vary widely. At times when sentiment is positive, fairly high borrowing can be interpreted as an encouraging sign that an aggressive management is using the capital structure to increase shareholders' returns. At other times, particularly during or soon after a financial crisis, even modest amounts of borrowing are seen to be risky and a company with an ungeared balance sheet is given a premium rating.
Private companies will sometimes include in their capital structure founders' shares or some other special class of ordinary shares designed to ensure that control remains with the original shareholders. The articles of association may restrict the interest of any individual shareholder to a certain percentage (sometimes as low as 2%).
It is not normally acceptable to investors and the stock exchange for a company going public to have ordinary shares with unequal voting rights. Prior to flotation, new articles of association will be adopted so that all ordinary shares carry the same voting rights and any restrictions on holdings or transfer are eliminated.
This approach is justified because control is a valuable commodity. This is most obviously seen in the premium offered for control of a company compared with the prevailing market price for a share transaction of ordinary size. All shareholders who run the ultimate risk of financing a business should participate in the benefits of control. They should also be able to exercise their voting rights as a check on management.
An exception with which stock exchanges would sympathise would be a nationalised concern which the government of the day wishes to privatise. It may not be 'in the national interest' for the company to be controlled by any particular group, at least for a minimum period of years. In such a case, the government may be issued with a 'golden' share conferring certain preferential rights regarding control, for example as regards votes cast at a general meeting or over the composition of the board of directors. Older established companies may have gained listings at periods when voting rights were not such a sensitive matter to stock exchange authorities and major investors. Although it is unlikely that existing listings would be cancelled because of refusal to change the voting structure, there are a number of examples where institutional investors have brought pressure to bear on the directors to propose that voting rights should be made equal. As compensation, a small bonus issue of shares (say on the basis of one-for-ten) may be given to the class of shareholders foregoing the preferential rights.
Companies with existing listings may seek to introduce a new class of ordinary shares with superior voting rights as a defence against hostile takeover bids. This action is likely to be highly controversial and brings a risk of de-listing of the shares.
For reason of historical accident or to save capital duty, private companies may have relatively few shares in issue. This would translate into a very high price per share if no changes were made prior to flotation. Many markets have a favored price range at which popular shares tend to trade. Within markets, an appropriate price may vary depending on investor sentiment at the time and on industry sectors. A group intending to go public is often advised to aim at a share price in line with other similar public companies.
The expected market price of the share is found by dividing the valuation placed on the company by the number of shares in issue. The valuation will be negotiated between the promoters and the merchant bank and so for this purpose is a constant. The share price at flotation can only be reduced by increasing the shares in issue.
In order to achieve this, a number of measures may be taken. If the shareholders or other related parties have advanced money to a company under a loan account this loan account may be capitalized, i.e. cancelled in exchange for the issue of new shares. If the shares have a par value and this is relatively high, the shares may be subdivided so that, for example, one share of $10 may be converted into ten shares of $1 each. In addition, if there is a share premium account or reserves which can be paid up as a bonus issue, this may also be used to achieve the desired reduction in price. It may even be possible to use a share premium account created on the sale of new shares to pay up a bonus issue for which only the shareholders of record prior to the flotation are eligible.