Ipo Process

Department of Finance College of Business University of Illinois at Urbana-Champaign Prof. George Pinteris Finance 322 – Fall 2003

Notes on Initial Public Offerings and Firm Valuation

This handout reviews the process of raising capital by firms. Firms can raise capital either through private sources, such as venture capitalists or private equity investors, or by accessing the financial markets either through an initial public offering (IPO) or by raising additional financing after having become publicly traded. We will examine the firm’s financing choices and discuss the IPO process. A main issue in this process is the pricing of the firm’s shares. Thus, we will also consider a number of widely used approaches for stock and firm valuation. A Firm’s Financing Choices Firms that want to pursue projects with positive NPVs are faced with two general financing choices: internal or external financing. Internal financing refers to the retained cash flows (retained earnings) that are generated by a firm’s assets. Evidence from US non-financial firms during the past 25 years shows that they meet almost 70% of their financing from internal sources. External financing refers to outside sources of funds that can be either private or raised in financial markets. This type of financing can, in general, be either in the form of debt or equity. Due to increased financial innovation, hybrid securities that have both debt and equity features, such as convertible bonds or warrants, have become financing alternatives for many firms in recent years. For example, a convertible bond has the feature that it can be converted into a predetermined number of common shares at the discretion of the bondholder. Even though there exists a wide range of financing choices (instruments) in economies with advanced financial systems, such as the US, this range is not the same for all firms. Typically, private firms are faced with a narrower range of choices compared to publicly traded firms. As...