Question

a) What are costs associated of going public (both direct and indirect)? Why are costs higher for IPO than for SEO? Why are the cost of raising equity capital higher than that of debt? Who bears these costs of raising capital? Explain

c) Which market imperfections lead a cost of outside capital? How do the availability and cost of outside capital affect payout (dividend) policy?

d ) Explain the logic of the residual payout (dividend) model and the steps a firm would take to implement it.

e) Many companies that go public with an IPO don’t actually need additional cash (AFN = 0). Why might such a firm decide to go public? Provide 4 key reasons according to survey data.

Answer 1

a) Going public is a undertaking related to IPO process. Companies provide its shares to be bought by shareholders and in exchange of that they they get part in the ownership of the company.

It consists of costs which are of both direct and indirect nature.

Let us first look at the direct costs. The offer is initially being made to the public here, which is being charged by the underwriter about seven percent of the offer price being made. Some direct costs also include the direct costing to the printers, lawyer or accountants and others.

So, these are all the costs that include direct costs.

Now let us discuss the indirect costs. They include money which has been on the table left over as the difference between the offer price and the end of first day price and then multiplying it by the number of total shares. They also include restructuring costs ; cost of making various financial statements, etc.

These costs can be catogorized into four catogories:

• Pre - IPO direct costs
• Pre - IPO indirect costs
• Post IPO recurring costs
• Post IPO one time costs

Among these the first two costs are related to before an IPO is being made and they fall in the direct and indirect costs which are discussed above.

The costs are higher for the IPO than for SEO because, in IPO the companies are issuing their shares for the first time that is they have never been issued before, but in SEO, it is a secondary market, where companies have already been issuing its share in past and is issuing a new share now. Therefore their prices are low than the IPO where companies trade their shares for the first time.

As we know that there is more risks to the equity holders than to the debts holder because creditors and debt holders get paid first once the company starts distributing the profits among them. And the equity holders are getting dividends at the last. It is also possible that due to certain fluctuations in profit, they do not receive any dividends. Thus, as the risk is higher for the equity holders so the cost of equity should also be higher than the cist if debt.

The cost of raising capital, be it any means, equity or debt is paid by the company itself. The companies bears this cost of capital. As the capital is raised for the various purposes to be going on in the company, thus cost of raising capital should also be fulfilled by the company. These capital raised helps the company in the completion of their projects and various other works going on in the company.

So, it is the company and management who should be bearing for the costs.