Initial Public Offering (IPO) Explained

What is an Initial Public Offering (IPO)? How does it help a company grow?

An Initial Public Offering (IPO) refers to the first time that an organization sells stock to the general public. An IPO allows an organization to sell securities in exchange for cash to invest in new projects. These securities provide funds for the organization to invest but require a rate of return to investors, which will be a future cost to the organization. An IPO allows an organization to grow financially because it provides immediate funds for the organization to use for new projects that will produce revenue-generating assets. This immediate availability of funds allows the organization to grow more rapidly than it would be able limited to its own revenue generating capabilities and limited access to immediate funds necessary to implement new projects.

A merger or acquisition may be a more appropriate way to grow due to combination of resources, tax benefits, debt potential, and market power. An IPO provides immediate cash to an organization but may not provide a significant advancement in the current stance of the organization. A merger or acquisition may provide the ability for an organization to eliminate ineffective management, combine resources, and utilize similar trade conduits. This restructuring may allow the organization to increase its financial position without using outside resources. The increase in size and unused debt potential associated with a merger may provide tax benefits that the two separate organizations did not receive that provide a significant savings for the organization. Finally, the merger may provide a significant increase in market share that increases the revenue of the organization faster than an IPO alone. Ultimately, acquiring or merging with another organization that already has projects and a structure in place that the other organization is looking at establishing can allow the organization to expedite their stance without using an IPO.

Weighted Average Cost of Capital WACC

What is the Weighted Average Cost of Capital?

The weighted average cost of capital assignes a weight proportional to the firms capital structure. That is, a percentage of each type of capital owned by the firm. For example, if the firm has $250 in bonds, $250 in preferred stock, and $500 in common stock, the weights would by .25, .25, and .50 respectively. This allows the firm to establish a benchmark as to what discount or rate of return is neccessary to cover both debt and equity required rates of return. Sometimes companies will use exact dollar figures to caculate these weights; however, many companies simply use the percentages as weights.

The components of WACC are both debt and equity financing. It is calculated by multiplying the after-tax cost of debt times the proportion of debt financing plus the cost of equity times the proportion of equity financing. The reason the WACC is more appropriate for capital budgeting is because, as stated previously, it gives the firm an idea of the amount or discount rate require to satisfy the required rate of return on both debt and equity securities held by lenders and shareholders.

When a organization needs to raise long-term capital, oftentimes this capital will be mixed with other sources of capital. Therefore, calculating the NPV using the correct discount rate may be difficult. However, WACC makes possible such calculations, especially when dollar amounts are used as opposed to percentages.

Definition of Working Capital

How would you define working capital? What could happen if an organization neglected to manage its working capital?

What working capital techniques would you recommend for your organization? Why?

Working capital is a firm's current investment in assets or assets expected to be turned into cash in less than one year. This definition is not as familiar as the term net working capital that refers to the difference between a firm's current assets and current liabilities. The text states that many people state use the term working capital even though they are referring to net working capital, which is the case for my organization. If an organization was to neglect its working capital, then the organization could find itself with greater current liabilities than it is able to repay. Additionally, the interest rate for short-term liabilities can fluctuate making it difficult to plan or manage effectively.

The working capital techniques that I would recommend to my organization are the hedging principle and TVM. The hedging principle follows that short-term liability requiring financing should come due at the same time the assets purchased with that financing produce cash flow for the organization. The TVM follows that when there is excess capital the organization should invest those funds to strengthen their position for times when financing may be needed. The investments should be in securities that can be made available as needed. The use of these techniques can help the organization grow funds and eliminate unnecessary short-term liabilities. The use of these methods require the organization to be pro-active in their monitoring practices.

What is the Breakeven Point in Finance?

The breakeven point refers to the amount of goods or services an organization must provide during a given period in order for receipts and disbursements to be equal. Any organization is concerned about how much money they are going to have to make in order to breakeven. This breakeven point is different depending on the industry but is a crucial point in setting a goal for the organization to achieve. For example, the breakeven point refers to how many videos the local video store must rent in order to cover operating expenses for the month or how many cars a car dealer must sell to cover their operating expenses. A company not reaching their breakeven point is operating in the red while a company that reaches the breakeven point will begin operating in the black.

The breakeven point is crucial for a business to know. This breakeven point allows a business to determine the point at which to set prices for their goods or services based on supply and demand and to set marketing and sales goals to reach levels at that point or higher. The breakeven point helps a business determine appropriate sale volume, capital purchasing needs, and financing decisions. A business that is deciding whether to make changes to the current cost/sales structure associated with a good or service can use various strategies to determine whether the change will increase or decrease the breakeven point of the item. The breakeven point may provide insight to the business about whether the change is a good one for the organization to make or not.

The Time Value of Money

How is TVM used in business?

The time value of money is the concept that money received today has a greater value that money received in the future. This is true because money you have today can be invested, which can appreciate or earn interest. The calculations of the time value of money are important because they give companies the ability to compare investment options. This can help improve return on equity and increase shareholder wealth. The most simple example of the time value of money is a savings account. When a person deposits money into a savings account it will generate interest. This simple opportunity makes money worth more now than it would be in the future. TVM is calculated by comparing the future value of money (FV) to its present value (PV). This can be used to determine the present and future value of annuities, as well as simple interesting earning accounts, such as the saving account. When making calculations it is important that the correct discount rate is used. If the rate is not accurate it will cause the resulting calculations to be inaccurate as well. The formulas for present value and future value can be arranged to solved for any variable in the equation.

The Cash Budget

What information is needed in order to prepare a cash budget? What is the relationship between an operating budget and a cash budget?

There are four main parts needed to prepare a cash budget with include: cash receipts, cash disbursements, net change in cash for the period, and new financing needed. The cash budget is primarily used to control cash flow for a specific period of time. Companies need to know what there cash receipts will be for a specific period of time to determine if additional financing will be needed to cover their expenses. The operating budget is a prediction of the revenue and expenses from the company's main operations over a set period of time. Some of the items you would find on the operating budget would be cost of goods sold, supplies, rent, etc. These items are directly related to the cost of operating the business and are essential for financial managers to know. This is related to the cash budget because cash flow will need to be determined if these expenses will be sufficiently covered. If not, the company will need to arrange additional financing. Since "cash is king" it is always important to know if there will be sufficient cash flow to cover expenses. Even profitable companies can become insolvent due to a lack of cash flow.

Primary and Secondary Capital Markets

What is the capital market? How is the primary market different from the secondary market?

The capital market refers to the trade of financial securities, such as stocks and bonds, with a long-term maturity date between individuals and institutions. The capital market is comprised of the primary and secondary market. The primary market is where new securities are traded while the secondary market is where used, or previously traded, securities are traded. The capital market relies on the timely interaction between corporations and investors in the primary and secondary market for an efficient system.

In the capital market, the initial step is the selling of financial securities, such as stocks and bonds, to investors by a corporation in order to raise funds through the primary market. A corporation only receives money for its securities the first time they are issued. An initial public offering, or IPO, is the first time a corporation makes its securities available to the public while seasoned new issue refers to additional securities being made available to the public of a corporation that has previously released securities to the public. The corporation then uses the funds that have been raised from the sale of these securities to invest in the organization generating new assets and increasing operations. The cash flow generated from the new assets and increased operations is then reinvested in the organization, paid back to investors (dividends), or paid to the government in the form of taxes.

Once the new securities are traded by the corporation on the primary market, the securities are thereafter traded on the secondary market. The securities are no longer handled by the corporation but are traded among investors. An investor selling a security receives the money for the security and not the original corporation. As stated previously, the corporation would only receive money for the initial sale on the primary market. The securities traded by investors in an efficient market are supposed to represent the expected earnings and risks of the corporation and thus reflect the true value of that corporation.

Sarbanes-Oxley and the SEC

What are three primary roles of the SEC? How does the Sarbanes Oxley Act augment the SEC’s role in managing financial governance?



The three primary roles of the U.S. Securities and Exchange Commission (SEC) are to protect investors, maintain efficient markets, and facilitate capital. The SEC works to protect investors by maintaining oversight of the capital market to insure that as more and more people use the market to invest to increase the livelihood of their families that these investments are protected. The capital market involves securities that have the ability to gain and lose value, which means that investors have the ability to gain and lose money. The SEC monitors and works to maintain the efficiency of the market to protect investors from inaccurate information, unfair trading practices, and unorganized trading.

The Sarbanes-Oxley Act augments the SEC's role in managing financial governance by review of financial statements, enhancing the enforcement program, increased frequency of reviews of investment advisers and companies, and conducts more broker/dealer examinations (SEC, 2003). The Sox Act increases the review of each registrant's financial statements to a minimum of every three years. The Sox Act increases the amount of enforcement allowed so that investigations can occur more quickly and be resolved sooner. The Act increases the frequency of financial reviews of investment advisers and investment companies based on the risk criteria associated with the company. Finally, the Act increases the examinations of brokers and dealers and related branches and offices to maintain monitoring effectiveness.

The Sarbanes-Oxley Act seems to have allowed the SEC to increase effectiveness in the three primary roles of the SEC. The Act increased the ability to protect, regulate, and enforce the three areas allowing the SEC to be increasingly effective in the three primary roles. This increased ability allows the SEC to increase oversight through multiple facets with increased effectiveness and efficiency to further strengthen the capital market.

LLCs and LLPs

What is a limited liability corporation? Limited liability partnership? What are the differences? What are the advantages and disadvantages of each?

LLCs are business structures that insulate owners from personal liability for debts, obligations and other liabilities of the business. LLCs also have pass through taxation, meaning that the business is only taxed once and the members and the business are not both taxed.

LLPs are business structures that insulate owners from the liabilities resulting from other owner's wrongful acts, omissions or negligence. Sometimes, depending on the state, LLPs afford further protections to the owners such as those of an LLC. LLPs also have pass through taxation.

The major difference in most states is that an LLP does not prevent owners of the business from being personally liable for the debts, obligations or liabilities of the business (unless those debts, liabilities or obligation was caused by the acts of another owner). However, an LLC provides protection to the owners from being personally liable for any debts, liabilities or obligations. Another difference is that an LLC is formed by filing articles of organization with the Secretary of State of most states while an LLP is formed by filing a Certificate of Limited Liability Partnership with the Secretary of State.

Advantages of both include the fact that they have pass through taxation, meaning that members of the LLP or LLC are not taxed twice as a business and as individuals. Another advantage of the LLC includes personal liability protection. This along with the pass through taxation, make this a great option for group practices, especially in law and medicine, because it insulates the members' from personal liability in case something occurs which may cause the business to have to pay out a lot of money.
A disadvantage of an LLP is that in most states they do not provide personal liability protection. A disadvantage of an LLC includes the fact that most states have different rules for LLCs so uniformity is lost.

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Can a Company Operate Without Current Liabilities?

What is an Asset? Liability? And how do they differ?

An asset can be defined as any item that adds value to a company. In general, they are divided into current assets (Less then 1 year) and long term (Greater than 1 year). Some examples of assets are inventory, buildings, vehicles, cash, etc. A liability is the opposite of an asset, and can be defined as anything that a company is obligated to contribute assets to resolve. The most common example of a liability is a loan. A loan will allow initially provide a company with cash, but will have to pay it off at a later date with interest. The main difference between assets and liabilities it that assets add value, while liabilities take away value. A company that has more assets than liabilities will have positive equity.

Can a Company Operate Without Current Liabilities?

Although it is unlikely, it is possible for a company to operate without any current liabilities. A company that has ample cash reserves would be able to pay for all assets at the time of purchase. This is not typical because the time value of money prompts companies to invest their cash reserves. Another method of operating with without current liabilities would be financing all assets with long term liabilities. This is also not typical because a company can usually save money on financing costs by utilizing short term loans for seasonal needs.

The Finance Press

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