• 20 Marks

FM – Nov 2014 – L3 – SB – Q4 – Financing Decisions and Capital Markets

Compare bond issuance methods, steps for IPO success, and Efficient Market Hypothesis application.

A pharmaceutical company wholly owned by the family of Chief Adedutan Jolomi has been in business for many years. The directors have decided to seek quotation on the Alternative Securities Market (ASEM).

A new drug on Ebola Virus Disease (EVD) was developed by the company. The production of the new drug will require more funding since short-term finance will not be sufficient. They believed it was time to introduce the drug into the market.

The directors of the company believed that launching the product would significantly increase the company’s share of the market because the country was anxiously looking forward to an effective EVD drug. Production and launch of this product is costly, and the company’s shareholders may not be able to raise such funds. This informed the directors’ decision to seek additional finance to be sourced partly in corporate bond and partly by the issue of shares.

They plan to issue the corporate bond in the first quarter of 2015 and the shares through an Initial Public Offer (IPO) towards the end of the year 2015. To decide on the appropriate method for the offer, the directors are interested in being educated on the issue.

Required:

(a) Compare and contrast the methods of issuing bonds through private placement and by public offer. State their advantages and advise on which method would be more appropriate in the above situation. (12 Marks)
(b) Advise the directors on the steps that need to be taken to improve the chances and success of its proposed Initial Public Offer (IPO). (4 Marks)
(c) Explain the three forms of Efficient Market Hypothesis (EMH), indicating which of them is most likely to apply in practice. (4 Marks)

Comparison of Private Placement and Public Offer for Issuing Bonds (12 Marks)

Criteria Private Placement Public Offer
Definition Bonds are sold directly to a limited number of investors, typically institutional or high-net-worth individuals. Bonds are offered to the general public through a regulated process.
Process Requires less regulatory approval and documentation. Requires detailed regulatory filings and prospectus preparation.
Cost Lower issuance costs (legal, underwriting, marketing). Higher costs due to extensive regulatory compliance and marketing.
Speed Faster to execute due to fewer regulatory requirements. Slower process due to regulatory and marketing steps.
Investor Base Limited to sophisticated investors with large funds. Broad investor base, including retail investors.
Flexibility Terms can be negotiated directly with investors. Terms are standardized and publicly disclosed.
Market Perception May be perceived as less transparent. Enhances market credibility and transparency.

Advantages of Private Placement:

  1. Faster execution and fewer regulatory requirements.
  2. Cost-effective for raising smaller amounts.
  3. Customized terms that suit both issuer and investors.

Advantages of Public Offer:

  1. Broader investor participation increases capital access.
  2. Enhances the company’s market visibility and credibility.
  3. Creates a benchmark for the company’s future financing needs.

Recommendation:
In the given scenario, Private Placement is more appropriate for the bond issuance because:

  1. The company needs funds urgently to launch the EVD drug. Private placement allows for quicker execution.
  2. Issuance costs are lower, which suits the company’s immediate financing needs.
  3. Investors in private placement (institutional investors) are more likely to understand the risks associated with funding a new drug launch.

(b) Steps to Improve the Success of the Proposed IPO (4 Marks)

  1. Strengthen Financial Records: Ensure the company’s financial statements are audited and comply with regulatory standards. Transparency builds investor confidence.
  2. Engage Experienced Advisors: Hire reputable underwriters, legal counsel, and financial advisors to structure the IPO.
  3. Develop a Strong Prospectus: Prepare a compelling prospectus highlighting the company’s competitive edge, EVD drug potential, and market growth projections.
  4. Investor Roadshows: Conduct targeted roadshows to create awareness among potential institutional and retail investors.
  5. Corporate Governance: Establish robust governance structures to enhance credibility and attract investors.
  6. Marketing and Publicity: Use multiple channels to promote the IPO and educate investors about the company’s growth potential.

(c) Explanation of the Three Forms of Efficient Market Hypothesis (EMH) (4 Marks)

  1. Weak Form Efficiency:
    • Definition: Market prices reflect all past trading information (e.g., historical prices and volumes).
    • Implication: Technical analysis cannot generate excess returns, but fundamental analysis may still uncover undervalued stocks.
    • Application: Common in less developed markets with low liquidity and transparency.
  2. Semi-Strong Form Efficiency:
    • Definition: Market prices reflect all publicly available information, including financial statements, news, and announcements.
    • Implication: Neither technical nor fundamental analysis can generate excess returns, but insider information could.
    • Application: Likely in moderately developed markets with adequate regulatory frameworks.
  3. Strong Form Efficiency:
    • Definition: Market prices reflect all information, both public and private (insider information).
    • Implication: No investor can consistently achieve excess returns, even with insider knowledge.
    • Application: Rarely seen in practice due to regulatory limitations on insider trading.

Most Likely to Apply in Practice:
The Semi-Strong Form Efficiency is most applicable in practice, especially in well-regulated markets, as it accounts for publicly available information while acknowledging the potential for insider advantages.

Conclusion

The company should consider private placement for bond issuance to meet its immediate funding needs efficiently. Additionally, to ensure the success of its IPO, the directors should focus on financial transparency, professional advisory support, and investor awareness campaigns. The Semi-Strong Form of EMH is the most practical framework for understanding market behavior during the IPO process.

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