MCQ Quiz

<h3>First Principles Thinking: Market Definitions</h3><p><strong>B is correct.</strong> The **primary market** is the market where an issuer (corporation or government) first sells its securities to investors and receives the proceeds[cite: 7, 91]. These include IPOs (first time sales) and seasoned offerings (sales of additional units of previously issued securities)[cite: 8, 10, 11]. The **secondary market** is where securities are traded among investors after the initial sale, and the issuer is not directly involved[cite: 12, 95].</p><p>A is incorrect: This reverses the definitions. Trades between investors occur in the secondary market; sales from the issuer to investors occur in the primary market [cite: 7, 12].</p><p>C is incorrect: Primary markets include both **Initial Public Offerings (IPOs)** and **seasoned offerings** (the sale of additional units of a previously issued security)[cite: 8, 10, 11]. Secondary markets facilitate trades of *all* securities, regardless of whether they were originally an IPO or a seasoned offering[cite: 12].</p>

<h3>First Principles Thinking: Underwriting Commitment</h3><p><strong>C is correct.</strong> In an **underwritten offering** (or firm commitment offering), the investment bank acts as a **principal**, guarantees the sale of the issue at a negotiated price, and buys any undersubscribed securities[cite: 26, 27, 98]. In a **best effort offering**, the investment bank acts only as a **broker** (an agent) and promises to use its best efforts to sell the issue but does *not* guarantee a specific amount will be sold[cite: 32, 33, 101].</p><p>A is incorrect: This statement is the opposite of the fact. The guarantee exists in an underwritten offering, not a best effort offering [cite: 26, 32].</p><p>B is incorrect: In an underwritten offering, the bank acts as a principal, not an agent who guarantees the sale[cite: 26, 98]. The best effort offering correctly describes the bank as a broker (agent)[cite: 32].</p>

<h3>First Principles Thinking: Underwriter Incentives</h3><p><strong>C is correct.</strong> The investment bank has dual roles. As **agents for the issuer**, they should seek a high price to raise the most money[cite: 39]. However, as **underwriters**, they have strong incentives to choose a low price. A low price allows them to allocate valuable shares to benefit their clients[cite: 41]. A high price exposes them to the direct cost of having to buy overvalued, undersubscribed shares and potentially providing price support in the secondary market[cite: 40, 42]. This conflict tends to lower initial offering prices [cite: 43].</p><p>A is incorrect: The underwriting fee is typically a percentage of the gross proceeds, so a high price would increase the fee, not reduce it [cite: 30, 31].</p><p>B is incorrect: A high price increases the risk of the issue being undersubscribed, forcing the underwriter to buy shares and increasing the cost of price support[cite: 42]. A low price benefits preferred clients[cite: 41].</p>

<h3>First Principles Thinking: Liquidity and Cost of Capital</h3><p><strong>C is correct.</strong> **Liquid secondary markets** allow traders to buy or sell securities with low transaction costs and small price concessions[cite: 87]. Because investors value the ability to easily sell their securities (liquidity), they are willing to pay **more** for securities that trade in liquid markets[cite: 88, 89]. This higher price at the time of issuance translates directly into a **lower cost of capital** for the corporation or government issuing the security in the primary market [cite: 86, 90].</p><p>A is incorrect: Secondary markets do not inherently guarantee a price floor; the underwriter may temporarily support the price, but this is a primary market service related to the IPO, not the market's general function [cite: 28].</p><p>B is incorrect: While trading in the secondary market helps identify the proper price for seasoned offerings[cite: 44], the primary benefit is that liquidity makes investors willing to pay *more*, not that it allows issuers to set a *lower* price. A lower price would increase the cost of capital[cite: 89, 90].</p>

<h3>First Principles Thinking: Private Placement Mechanics</h3><p><strong>B is correct.</strong> In a **private placement**, corporations sell securities directly to a **small group of qualified investors**[cite: 56]. Qualified investors are those with sufficient knowledge, experience, and wealth to recognize and assume the risks[cite: 57]. Most countries allow private placements to occur **without nearly as much public disclosure** as is required for public offerings [cite: 58].</p><p>A is incorrect: Private placements generally require *less* public disclosure than public offerings, which makes them cheaper, not more expensive [cite: 58, 59].</p><p>C is incorrect: A key drawback of private placements is that the buyers generally require **higher returns** (lower purchase prices) because they **cannot subsequently trade the securities in an organized secondary market** (i.e., they are illiquid)[cite: 59].</p>

<h3>First Principles Thinking: Rights Offering and Dilution</h3><p><strong>B is correct.</strong> A **rights offering** distributes rights to existing shareholders to buy stock at a fixed, favorable price (below market)[cite: 67, 69]. Because the new stock is issued below the current market price, the existing shares will experience **dilution** in value[cite: 70]. The shareholders can offset this loss by **exercising their rights** (buying the stock at the favorable price) or by **selling the rights** to others who will exercise them [cite: 71].</p><p>A is incorrect: The dilution loss can be offset by *either* exercising the rights or selling them [cite: 71].</p><p>C is incorrect: The issuance of new shares below the current market price causes a **loss** of value due to dilution for the existing shares, even though the right itself is profitable if exercised[cite: 70].</p>

<h3>First Principles Thinking: Offering Procedures</h3><p><strong>B is correct.</strong> The process where the investment bank lines up subscribers who will buy the security and compiles a 'book' of orders is specifically called **book building**[cite: 16, 18, 96]. The investment bank attempts to build a book of orders to sell the offering to [cite: 18].</p><p>A is incorrect: Underwriting syndication is the formation of a **syndicate**—a group of investment banks and broker-dealers—that helps the lead underwriter build the book for large issues[cite: 29]. It is not the process of compiling the list itself.</p><p>C is incorrect: An accelerated book build is a *type* of offering used in Europe when time is critical, where the offering is arranged in only one or two days[cite: 21, 97]. It is the speed of the offering, not the name of the process of compiling the list.</p>

<h3>First Principles Thinking: Specialized Offering Mechanisms</h3><p><strong>B is correct.</strong> An **accelerated book build** (ABB) is a method used when **time is of the essence**, particularly by European issuers, in which the investment bank arranges the offering in **only one or two days**[cite: 21, 97]. Due to the speed and abbreviated marketing period, such sales often occur at **discounted prices** [cite: 22].</p><p>A is incorrect: The process is accelerated because time is of the essence, which suggests a *less* lengthy due diligence process than a regular public offering, and the sales often occur at *discounted*, not guaranteed highest, prices[cite: 21, 22].</p><p>C is incorrect: While it sells the entire issue in a single (very short) transaction, it is a fast process and often conducted as an underwritten (guaranteed) offering, not a 'best effort' over weeks. Selling shares over time is typical of a shelf registration[cite: 21, 62].</p>

<h3>First Principles Thinking: Fair Dealing and Allocation</h3><p><strong>B is correct.</strong> If the offering price is set too low, the offering will be **oversubscribed**[cite: 36]. In this case, the securities are often allocated to **preferred clients or on a pro-rata basis**[cite: 36]. CFA Standard of Professional Conduct III.B (Fair Dealing) requires that the allocation be based on a written policy disclosed to clients and *suggests* they be offered on a pro-rata basis among clients with comparable relationships [cite: 37].</p><p>A is incorrect: The offering price is usually set jointly by the issuer and the bank following negotiation, and all subscriptions are at that price, not based on a high-bid auction [cite: 34].</p><p>C is incorrect: The standard **suggests** a pro-rata basis but requires a written policy disclosed to clients, allowing for allocation to preferred clients as long as the policy is followed and disclosed[cite: 36, 37]. It is not an *exclusive* requirement.</p>

<h3>First Principles Thinking: Types of Public Offerings</h3><p><strong>B is correct.</strong> A **seasoned security** is one that an issuer has already issued[cite: 9]. If the issuer sells additional units of a previously issued security, this is called a **seasoned offering** (sometimes called a secondary offering)[cite: 10, 93]. Both IPOs and seasoned offerings take place in the primary market [cite: 11].</p><p>A is incorrect: An **Initial Public Offering (IPO)** (or placing) is when the issuer sells a security to the public for the *first* time [cite: 8, 92].</p><p>C is incorrect: A private placement is a sale to a small group of qualified investors on an unregulated basis, not necessarily a sale to the public of previously issued securities[cite: 56, 102].</p>

<h3>First Principles Thinking: Shelf Registration Utility</h3><p><strong>A is correct.</strong> In a **shelf registration**, the corporation makes a single, comprehensive public disclosure that covers a series of issues, but it does *not* sell all the shares in a single transaction[cite: 60, 61, 104]. Instead, it sells the shares **directly into the secondary market over time**, generally when it needs capital, providing flexibility in the timing of transactions [cite: 62, 63].</p><p>B is incorrect: The corporation makes *all* public disclosures required for a regular offering[cite: 61]. Avoiding public disclosure is a feature of private placements [cite: 58].</p><p>C is incorrect: Selling the shares over time, not in a single large transaction, is the defining feature that provides flexibility and alleviates downward price pressure[cite: 62, 63].</p>

<h3>First Principles Thinking: Information Asymmetry and Pricing</h3><p><strong>B is correct.</strong> The tendency for initial prices to be lower (and subsequently rise) is due to the **underwriter's conflict of interest** and the first-time issuer's fear of an undersubscribed IPO conveying unfavorable information[cite: 40, 43, 45]. This dynamic is **less important in a seasoned offering** because **trading in the secondary market helps identify the proper price** for the offering, reducing the information asymmetry and pricing uncertainty [cite: 44].</p><p>A is incorrect: While seasoned offerings may have lower costs, the primary reason for the price difference is the level of information asymmetry and the existing secondary market price discovery [cite: 44].</p><p>C is incorrect: Undersubscribed IPOs convey unfavorable information, which issuers try to avoid by setting a low price, but IPOs are *not* always undersubscribed[cite: 35, 45]. Oversubscription or undersubscription can happen in both IPOs and seasoned offerings[cite: 35, 36].</p>

<h3>First Principles Thinking: Underwriting Compensation</h3><p><strong>B is correct.</strong> The underwriting fee, which is usually around **7 percent** for the various services provided by the investment bank (including book building, guaranteeing the sale, and sometimes providing market support), is considered a **placement cost of the offering**[cite: 30, 31]. This fee compensates the underwriter for the risk and work involved in the primary market transaction.</p><p>A is incorrect: The text defines it specifically as a **placement cost**[cite: 31]. While the *accounting* treatment may involve deferral, the economic classification within the context is placement cost.</p><p>C is incorrect: The fee covers various services[cite: 30]. The *cost* of price support (if the underwriter has to buy shares) is a potential liability for the bank, but the fee is the compensation paid by the *issuer* for the service[cite: 30, 42].</p>

<h3>First Principles Thinking: IPO Structure</h3><p><strong>C is correct.</strong> The first public offering of common stock (IPO) in a company consists of **newly issued shares** that the company sells to raise capital[cite: 23]. It **may also include shares** that the founders and other early investors in the company seek to sell, providing these existing investors with a means of liquidating their investments [cite: 24, 25].</p><p>A is incorrect: While newly issued shares are central, the offering can also include shares sold by existing early investors for liquidity [cite: 24, 25].</p><p>B is incorrect: The IPO is primarily a capital-raising transaction for the company (new shares), but also offers a liquidation channel for early investors (existing shares)[cite: 23, 25].</p>

<h3>First Principles Thinking: Dilution Mechanism</h3><p><strong>B is correct.</strong> A rights offering involves issuing new stock to existing shareholders at an **exercise price set below the current market price** of the stock[cite: 67, 69]. The new, lower-priced shares dilute the value of the existing shares because the same total firm value (or a slightly higher value from the new cash) is now spread over a greater number of shares, dragging the average share price down toward the offering price [cite: 70].</p><p>A is incorrect: The exercise price is intentionally set **below** the current market price so that buying stock with the rights is immediately profitable, ensuring the rights have value [cite: 69].</p><p>C is incorrect: While financial analysts recognize rights as short-term stock warrants [cite: 73], the *reason* for the dilution is the issuance of shares below market value, not just the classification of the security[cite: 70].</p>

<h3>First Principles Thinking: Sovereign Issuance Methods</h3><p><strong>B is correct.</strong> The national governments of financially strong countries generally issue their debt securities (bonds, notes, and bills) in **public auctions organized by a government agency** (like the finance ministry)[cite: 74]. They may also sell them **directly to dealers** [cite: 75].</p><p>A is incorrect: Financially strong governments rely on transparent public auctions, and many governments are required by law to auction their securities[cite: 74, 77]. Private placements are more typical for corporations [cite: 56].</p><p>C is incorrect: Underwritten offerings are more common for **smaller and less financially secure** national governments and most regional governments, who often contract with investment banks for help[cite: 76]. Strong governments typically use direct auctions.</p>

<h3>First Principles Thinking: Adverse Signaling</h3><p><strong>B is correct.</strong> First-time issuers are highly vulnerable to public opinion[cite: 45]. They generally accept lower offering prices because they and others believe that an **undersubscribed IPO conveys very unfavorable information** to the market about the company's future prospects[cite: 45]. Their fear is that this negative signal will make it substantially harder to raise additional capital through subsequent seasoned offerings [cite: 46].</p><p>A is incorrect: In an underwritten offering, the bank buys the undersubscribed securities, completing the offering[cite: 27]. In a best-effort offering, the offering proceeds but sells less[cite: 33]. The offering is not typically withdrawn.</p><p>C is incorrect: Undersubscription (selling too few shares) is a pricing error, not a direct violation of the fair dealing standard, which is concerned with the *allocation* of shares when the offering is oversubscribed[cite: 35, 37].</p>

<h3>First Principles Thinking: ABB Trade-offs</h3><p><strong>C is correct.</strong> An accelerated book build is arranged in only one or two days when time is of the essence[cite: 21]. This rapid execution, without the usual time for extensive marketing and due diligence, typically results in the sales occurring at **discounted prices**[cite: 22]. The discount compensates buyers for the reduced information and rapid decision-making required.</p><p>A is incorrect: The sales often occur at *discounted*, not higher, prices [cite: 22].</p><p>B is incorrect: While there is a risk, the discount is often applied to ensure the deal is fully subscribed, mitigating the risk of undersubscription[cite: 22]. The primary and intended consequence is the sale at a discount, which allows for the rapid execution[cite: 21, 22].</p>

<h3>First Principles Thinking: DRIP Mechanics</h3><p><strong>B is correct.</strong> A primary market transaction is one where the issuer first sells its securities to investors and receives the proceeds[cite: 7, 91]. A DRP specifies that the corporation **issue new shares** for the plan rather than purchasing them on the open market[cite: 64]. By issuing new shares and selling them to existing shareholders (who reinvest their dividends), the corporation is essentially raising new capital, which defines it as a primary market transaction [cite: 64].</p><p>A is incorrect: If the corporation were to purchase shares on the open market, it would be a secondary market transaction, but the defining characteristic of this type of DRP is the issuance of *new* shares [cite: 64].</p><p>C is incorrect: This describes a private placement[cite: 102]. DRPs are offered to all shareholders, which is a broader group than the 'small group of qualified investors' in a private placement[cite: 64].</p>

<h3>First Principles Thinking: Best Effort Offering Risk</h3><p><strong>B is correct.</strong> In a **best effort offering**, the investment bank acts only as a broker (agent) and makes no guarantee of sale[cite: 32, 101]. If the offering is undersubscribed (not enough demand at the set price), the **issuer will not sell as much as it hoped to sell**[cite: 33]. This exposes the issuer to the risk of failing to raise the desired amount of capital. In an underwritten offering, this risk is borne by the bank [cite: 27].</p><p>A is incorrect: The incentive to set a low price is the primary risk for the *underwriter* in an underwritten offering, as it reduces the potential gross proceeds for the issuer [cite: 40].</p><p>C is incorrect: The bank is **not** required to buy unsold securities in a best effort offering; that is the defining commitment of an underwritten offering[cite: 27, 32].</p>

<h3>First Principles Thinking: Pricing Outcomes</h3><p><strong>B is correct.</strong> The issuer and the investment bank jointly set the offering price[cite: 34]. If they set a price that buyers consider **too high**, the offering will be **undersubscribed**, meaning they will fail to sell the entire issue at that price[cite: 35]. Conversely, if the price is set too low, the offering will be oversubscribed [cite: 36].</p><p>A is incorrect: Setting the price **too low** will result in the offering being **oversubscribed**, not undersubscribed [cite: 36].</p><p>C is incorrect: The underwriter's market-making commitment (providing liquidity/price support after the IPO) is a related service, but the initial undersubscription is a consequence of the price being too high relative to market demand[cite: 28, 35].</p>