Table of contents

Serial No. Particulars Page No.

1. IPO – An Introduction 7

2. Significance of IPO 9

3. Analyzing an IPO investment 14

4. IPO Investment Strategies 16

5. Pricing of an IPO 18

6. Principal steps in an IPO 20

7. Book-building Process 24

8. Case study: Hughes Software Solutions 31

9. Case study: HDIL IPO Valuation 34

10. Past IPO Performance 50

11. IPO Glossary 52

12. Bibliography 56

1
INITIAL PUBLIC OFFERING (IPO)

The first public offering of equity shares or convertible securities by a company, which is
followed by the listing of a company’s shares on a stock exchange, is known as an ‘Initial
Public Offering’. In other words, it refers to the first sale of a company’s common shares to
investors on a public stock exchange, with an intention to raise new capital.

The most important objective of an IPO is to raise capital for the company. It helps a company
to tap a wide range of investors who would provide large volumes of capital to the company for
future growth and development. A company going for an IPO stands to make a lot of money
from the sale of its shares which it tries to anticipate how to use for further expansion and
development. The company is not required to repay the capital and the new shareholders get a
right to future profits distributed by the company.

Companies fall into two broad categories: Private and Public.

A privately held company has fewer shareholders and its owners don't have to disclose much
information about the company. When a privately held corporation needs additional capital, it
can borrow cash or sell stock to raise needed funds. Often "going public" is the best choice for a
growing business. Compared to the costs of borrowing large sums of money for ten years or
more, the costs of an initial public offering are small. The capital raised never has to be repaid.
When a company sells its stock publicly, there is also the possibility for appreciation of the share
price due to market factors not directly related to the company. Anybody can go out and
incorporate a company: just put in some money, file the right legal documents and follow the
reporting rules of jurisdiction such as Indian Companies Act 1956. It usually isn't possible to buy
shares in a private company. One can approach the owners about investing, but they're not
obligated to sell you anything. Public companies, on the other hand, have sold at least a portion

2
of themselves to the public and trade on a stock exchange. This is why doing an IPO is also
referred to as "going public."

Why go public??

Before deciding whether one should complete an IPO, it is important to consider the
positive and negative effects that going public may have on their mind. Typically, companies go
public to raise and to provide liquidity for their shareholders. But there can be other benefits.
Going public raises cash and usually a lot of it. Being publicly traded also opens many financial
doors:

 Because of the increased scrutiny, public companies can usually get better rates when
they issue debt.

 As long as there is market demand, a public company can always issue more stock. Thus,
mergers and acquisitions are easier to do because stock can be issued as part of the deal.

 Trading in the open markets means liquidity. This makes it possible to implement things
like employee stock ownership plans, which help to attract top talent.

 Going public can also boost a company’s reputation which in turn, can help the company
to expand in the marketplace.

3
SIGNIFICANCE OF IPO

Investing in IPO has its own set of advantages and disadvantages. Where on one hand, high
element of risk is involved, if successful, it can even result in a higher rate of return. The rule is:
Higher the risk, higher the returns.

The company issues an IPO with its own set of management objectives and the investor looks for
investment keeping in mind his own objectives. Both have a lot of risk involved. But then
investment also comes with an advantage for both the company and the investors.

The significance of investing in IPO can be studied from 2 viewpoints – for the company and for
the investors. This is discussed in detail as follows:

SIGNIFICANCE TO THE COMPANY:

When a privately held corporation needs additional capital, it can borrow cash or sell stock to
raise needed funds. Or else, it may decide to “go public”. "Going Public" is the best choice for a
growing business for the following reasons:

 The costs of an initial public offering are small as compared to the costs of borrowing large
sums of money for ten years or more,

4
  The capital raised never has to be repaid.

 When a company sells its stock publicly, there is also the possibility for appreciation of the
share price due to market factors not directly related to the company.

 It allows a company to tap a wide pool of investors to provide it with large volumes of
capital for future growth.

SIGNIFICANCE TO THE SHAREHOLDERS:

The investors often see IPO as an easy way to make money. One of the most attractive features
of an IPO is that the shares offered are usually priced very low and the company’s stock prices
can increase significantly during the day the shares are offered. This is seen as a good
opportunity by ‘speculative investors’ looking to notch out some short-term profit. The
‘speculative investors’ are interested only in the short-term potential rather than long-term gains.

5
THE RISK FACTOR

Investing in IPO is often seen as an easy way of investing, but it is highly risky and many
investment advisers advise against it unless you are particularly experienced and knowledgeable.
The risk factor can be attributed to the following reasons:

 UNPREDICTABLE:

The Unpredictable nature of the IPO’s is one of the major reasons that investors advise
against investing in IPO’s. Shares are initially offered at a low price, but they see
significant changes in their prices during the day. It might rise significantly during the
day, but then it may fall steeply the next day.

 NO PAST TRACK RECORD OF THE COMPANY:

No past track record of the company adds further to the dilemma of the shareholders as to
whether to invest in the IPO or not. With no past track record, it becomes a difficult

6
 choice for the investors to decide whether to invest in a particular IPO or not, as there is
basis to decide whether the investment will be profitable or not.

 POTENTIAL OF STOCK MARKET:

Returns from investing in IPO are not guaranteed. The Stock Market is highly volatile.
Stock Market fluctuations widely affect not only the individuals and household, but the
economy as a whole. The volatility of the stock market makes it difficult to predict how
the shares will perform over a period of time as the profit and risk potential of the IPO
depends upon the state of the stock market at that particular time.

RISK ASSESSMENT:

The possibility of buying stock in a promising start-up company and finding the next
success story has intrigued many investors. But before taking the big step, it is essential
to understand some of the challenges, basic risks and potential rewards associated with
investing in an IPO.

This has made Risk Assessment an important part of Investment Analysis. Higher the
desired returns, higher would be the risk involved. Therefore, a thorough analysis of risk
associated with the investment should be done before any consideration.

For investing in an IPO, it is essential not only to know about the working of an IPO, but
we also need to know about the company in which we are planning to invest. Hence, it is
imperative to know:

 The fundamentals of the business

 The policies and the objectives of the business

 Their products and services

7
  Their competitors

 Their share in the current market

 The scope of their issue being successful

It would be highly risky to invest without having this basic knowledge about the company.

There are 3 kinds of risks involved in investing in IPO:

 BUSINESS RISK:

It is important to note whether the company has sound business and management
policies, which are consistent with the standard norms. Researching business risk
involves examining the business model of the company.

 FINANCIAL RISK:

Is this company solvent with sufficient capital to suffer short-term business setbacks? The
liquidity position of the company also needs to be considered. Researching financial risk
involves examining the corporation's financial statements, capital structure, and other
financial data.

8
  MARKET RISK:

It would beneficial to check out the demand for the IPO in the market, i.e., the appeal of
the IPO to other investors in the market. Hence, researching market risk involves
examining the appeal of the corporation to current and future market conditions.

ANALYSING AN IPO INVESTMENT

POTENTIAL INVESTORS AND THEIR OBJECTIVES:

Initial Public Offering is a cheap way of raising capital, but all the same it is not considered as
the best way of investing for the investor. Before investing, the investor must do a proper
analysis of the risks to be taken and the returns expected. He must be clear about the benefits he
hope to derive from the investment. The investor must be clear about the objective he has for
investing, whether it is long-term capital growth or short-term capital gains.

The potential investors and their objectives could be categorized as:

 INCOME INVESTOR:

9
 An ‘income investor’ is the one who is looking for steadily rising profits that will be
distributed to shareholders regularly. For this, he needs to examine the company's
potential for profits and its dividend policy.

 GROWTH INVESTOR:

A ‘growth investor’ is the one who is looking for potential steady increase in profits that
are reinvested for further expansion. For this he needs to evaluate the company's growth
plan, earnings and potential for retained earnings.

 SPECULATOR:

A ‘speculator’ looks for short-term capital gains. For this he needs to look for potential of
an early market breakthrough or discovery that will send the price up quickly with little
care about a rapid decline.

INVESTOR RESEARCH:

It is imperative to properly analyze the IPO the investor is planning to invest into. He needs to
do a thorough research at his end and try to figure out if the objective of the company match his
own personal objectives or not. The unpredictable nature of IPO’s and volatility of the stock
market adds greatly to the risk factor. So, it is advisable that the investor does his homework,
before investing.

The investor should know about the following:

 BUSINESS OPERATIONS:

• What are the objectives of the business?

• What are its management policies?

10
 • What is the scope for growth?

• What is the turnover of the labour force?

• Would the company have long-term stability?

 FINANCIAL OPERATIONS:

• What is the company’s credit history?

• What is the company’s liquidity position?

• Are there any defaults on debts?

• Company’s expenditure in comparison to competitors.

• Company’s ability to pay-off its debts.

• What are the projected earnings of the company

 MARKETING OPERATIONS:

• Who are the potential investors?

• What is the scope for success of the IPO?

• What is the appeal of the IPO for the other investors?

• What are the products and services offered by the company?

• Who are the strongest competitors of the company?

IPO INVESTMENT STRATEGIES

11
Investing in IPOs is much different than investing in seasoned stocks. This is because there is
limited information and research on IPOs, prior to the offering. And immediately following the
offering, research opinions emanating from the underwriters are invariably positive.

There are some of the strategies that can be considered before investing in the IPO:

 UNDERSTAND THE WORKING OF IPO:

The first and foremost step is to understand the working of an IPO and the basics of an
investment process. Other investment options could also be considered depending upon
the objective of the investor.

 GATHER KNOWLEDGE:

It would be beneficial to gather as much knowledge as possible about the IPO market, the
company offering it, the demand for it and any offer being planned by a competitor.

 INVESTIGATE BEFORE INVESTING:

The prospectus of the company can serve as a good option for finding all the details of
the company. It gives out the objectives and principles of the management and will also
cover the risks.

 KNOW YOUR BROKER:

This is a crucial step as the broker would be the one who would majorly handle your
money. IPO allocations are controlled by underwriters. The first step to getting IPO
allocations is getting a broker who underwrites a lot of deals.

12
 MEASURE THE RISK INVOLVED:

IPO investments have a high degree of risk involved. It is therefore, essential to measure
the risks and take the decision accordingly.

 INVEST AT YOUR OWN RISK:

Finally, after the homework is done, and the big step needs to be taken. All that can be
suggested is to ‘invest at your own risk’. Do not take a risk greater than your capacity.

13
PRICING OF AN IPO

The pricing of an IPO is a very critical aspect and has a direct impact on the success or failure of
the IPO issue. There are many factors that need to be considered while pricing an IPO and an
attempt should be made to reach an IPO price that is low enough to generate interest in the
market and at the same time, it should be high enough to raise sufficient capital for the company.

The process for determining an optimal price for the IPO involves the underwriters arranging
share purchase commitments from leading institutional investors.

PROCESS:

Once the final prospectus is printed and distributed to investors, company management meets
with their investment bank to choose the final offering price and size. The investment bank tries
to fix an appropriate price for the IPO depending upon the demand expected and the capital
requirements of the company.

The pricing of an IPO is a delicate balancing act as the investment firms try to strike a balance
between the company and the investors. The lead underwriter has the responsibility to ensure
smooth trading of the company’s stock. The underwriter is legally allowed to support the price
of a newly issued stock by either buying them in the market or by selling them short.

IPO PRICING DIFFERENCES:

It is generally noted, that there is a large difference between the price at the time of issue of an
Initial Public Offering (IPO) and the price when they start trading in the secondary market.

These pricing disparities occur mostly when an IPO is considered “hot”, or in other words, when
it appeals to a large number of investors. An IPO is “hot” when the demand for it far exceeds the
supply.

This imbalance between demand and supply causes a dramatic rise in the price of each share in
the first day itself, during the early hours of trading.

14
UNDERPRICING AND OVERPRICING OF IPO’s

UNDERPRICING:

The pricing of an IPO at less than its market value is referred to as ‘Underpricing’. In other
words, it is the difference between the offer price and the price of the first trade.

Historically, IPO’s have always been ‘underpriced’. Underpriced IPO helps to generate
additional interest in the stock when it first becomes publicly traded. This might result in
significant gains for investors who have been allocated shares at the offering price. However,
underpricing also results in loss of significant amount of capital that could have been raised had
the shares been offered at the higher price.

OVERPRICING:

The pricing of an IPO at more than its market value is referred to as ‘Overpricing’. Even
“overpricing” of shares is not as healthy option. If the stock is offered at a higher price than what
the market is willing to pay, then it is likely to become difficult for the underwriters to fulfill
their commitment to sell shares. Furthermore, even if the underwriters are successful in selling
all the issued shares and the stock falls in value on the first day itself of trading, then it is likely
to lose its marketability and hence, even more of its value.

15
 PRINCIPAL STEPS IN AN IPO

 Approval of BOD: Approval of BOD is required for raising capital from the public.

 Appointment of lead managers: the lead manager is the merchant banker who orchestrates the
issue in consultation of the company.

 Appointment of other intermediaries:

- Co-managers and advisors

- Underwriters
- Bankers
- Brokers and principal brokers
- Registrars

• Filing the prospectus with SEBI: The prospectus or the offer document communicates
information about the company and the proposed security issue to the investing public. All the
companies seeking to make a public issue have to file their offer document with SEBI. If SEBI
or public does not communicate its observations within 21 days from the filing of the offer
document, the company can proceed with its public issue.

• Filing of the prospectus with the registrar of the companies: once the prospectus have been
approved by the concerned stock exchanges and the consent obtained from the bankers, auditors,
registrar, underwriters and others, the prospectus signed by the directors, must be filed with the
registrar of companies, with the required documents as per the companies act 1956.

16
• Printing and dispatch of prospectus: After the prospectus is filed with the registrar of
companies, the company should print the prospectus. The quantity in which prospectus is printed
should be sufficient to meet requirements. They should be send to the stock exchanges and
brokers so they receive them atleast 21 days before the first announcement is made in the news
papers.

• Filing of initial listing application: Within 10 days of filing the prospectus, the initial listing
application must be made to the concerned stock exchanges with the listing fees.

• Promotion of the issue: The promotional campaign typically commences with the filing of the
prospectus with the registrar of the companies and ends with the release of the statutory
announcement of the issue.

• Statutory announcement: The issue must be made after seeking approval of the stock
exchange. This must be published atleast 10 days before the opening of the subscription list.

• Collections of applications: The Statutory announcement specifies when the subscription would
open, when it would close, and the banks where the applications can be made. During the period
the subscription is kept open, the bankers will collect the applications on behalf of the company.

• Processing of applications: Scrutinizing of the applications is done.

• Establishing the liability of the underwriters : If the issue is undersubscribed, the liability of
the underwriters has to be established.

• Allotment of shares: Proportionate system of allotment is to be followed.

17
• Listing of the issue: The detail listing application should be submitted to the concerned stock
exchange along with the listing agreement and the listing fee. The allotment formalities should
be completed within 30 days.

Book building is the process of price discovery (Basic concept)

• The company does not come out with a fixed price for its shares; instead, it indicates a price
band that mentions the lowest (referred to as the floor) and the highest (the cap) prices at which a
share can be sold.

• Bids are then invited for the shares. Each investor states how many shares s/he wants and what
s/he is willing to pay for those shares (depending on the price band). The actual price is then
discovered based on these bids. As we continue with the series, we will explain the process in
detail.

• According to the book building process, three classes of investors can bid for the shares:

1. Qualified Institutional Buyers: Mutual funds and Foreign Institutional Investors.

2. Retail investors: Anyone who bids for shares under Rs 50,000 is a retail investor.

3. High net worth individuals and employees of the company.

• Allotment is the process whereby those who apply are given (allotted) shares. The bids are first
allotted to the different categories and the over-subscription (more shares applied for than shares
available) in each category is determined. Retail investors and high net worth individuals get
allotments on a proportional basis.

18
Example 1:

Assuming you are a retail investor and have applied for 200 shares in the issue, and the
issue is over-subscribed five times in the retail category, you qualify to get 40 shares (200
shares/5). Sometimes, the over-subscription is huge or the issue is priced so high that you can't
really bid for too many shares before the Rs 50,000 limit is reached. In such cases, allotments are
made on the basis of a lottery.

Example 2:

Say, a retail investor has applied for five shares in an issue, and the retail category has
been over-subscribed 10 times. The investor is entitled to half a share. Since that isn't possible, it
may then be decided that every 1 in 2 retail investors will get allotment. The investors are then
selected by lottery and the issue allotted on a proportional basis. That is why there is no way you
can be sure of getting an allotment.

19
BOOK BUILDING PROCESS

Book Building is basically a capital issuance process used in Initial Public Offer (IPO) which
aids price and demand discovery. It is a process used for marketing a public offer of equity
shares of a company. It is a mechanism where, during the period for which the book for the IPO
is open, bids are collected from investors at various prices, which are above or equal to the floor
price. The process aims at tapping both wholesale and retail investors. The offer/issue price is
then determined after the bid closing date based on certain evaluation criteria.

20
The Process:

 The Issuer who is planning an IPO nominates a lead merchant banker as a 'book runner'.

 The Issuer specifies the number of securities to be issued and the price band for orders.

 The Issuer also appoints syndicate members with whom orders can be placed by the
investors.

 Investors place their order with a syndicate member who inputs the orders into the
'electronic book'. This process is called 'bidding' and is similar to open auction.

 A Book should remain open for a minimum of 5 days.

 Bids cannot be entered less than the floor price.

 Bids can be revised by the bidder before the issue closes.

 On the close of the book building period the 'book runner evaluates the bids on the basis
of the evaluation criteria which may include -

• Price Aggression

• Investor quality

• Earliness of bids, etc.

21
  The book runner the company concludes the final price at which it is willing to issue the
stock and allocation of securities.

 Generally, the numbers of shares are fixed; the issue size gets frozen based on the price
per share discovered through the book building process.

 Allocation of securities is made to the successful bidders.

 Book Building is a good concept and represents a capital market which is in the process
of maturing.

Book-building is all about letting the company know the price at which you are willing to buy
the stock and getting an allotment at a price that a majority of the investors are willing to pay.
The price discovery is made depending on the demand for the stock.

The price that you can suggest is subject to a certain minimum price level, called the floor price.
For instance, the floor price fixed for the Maruti's initial public offering was Rs 115, which
means that the price you are willing to pay should be at or above Rs 115.

In some cases, as in Biocon, the price band (minimum and maximum price) at which you can
apply is specified. A price band of Rs 270 to Rs 315 means that you can apply at a floor price of
Rs 270 and a ceiling of Rs 315.

If you are not still very comfortable fixing a price, do not worry. You, as a retail investor, have
the option of applying at the cut-off price. That is, you can just agree to pick up the shares at the
final price fixed. This way, you do not run the risk of not getting an allotment because you have
bid at a lower price. If you bid at the cut-off price and the price is revised upwards, then the
managers to the offer may reduce the number of shares allotted to keep it within the payment

22
already made. You can get the application forms from the nearest offices of the lead managers to
the offer or from the corporate or the registered office of the company.

How is the price fixed?

All the applications received till the last date are analysed and a final offer price, known as the
cut-off price is arrived at. The final price is the equilibrium price or the highest price at which all
the shares on offer can be sold smoothly.

If your price is less than the final price, you will not get allotment. If your price is higher than the
final price, the amount in excess of the final price is refunded if you get allotment. If you do not
get allotment, you should get your full refund of your money in 15 days after the final allotment
is made. If you do not get your money or allotment in a month's time, you can demand interest at
15 per cent per annum on the money due.

How are shares allocated?

• As per regulations, at least 25 per cent of the shares on offer should be set aside for retail
investors. Fifty per cent of the offer is for qualified institutional investors. Qualified
Institutional Bidders (QIB) are specified under the regulation and allotment to this class is
made at the discretion of the company based on certain criteria.

• QIBs can be mutual funds, foreign institutional investors, banks or insurance companies. If
any of these categories is under-subscribed, say, the retail portion is not adequately
subscribed, then that portion can be allocated among the other two categories at the
discretion of the management. For instance, in an offer for two lakh shares, around 50,000
shares (or generally 25 per cent of the offer) are reserved for retail investors. But if the bids
from this category are received are only for 40,000 shares, then 10,000 shares can be
allocated either to the QIBs or non-institutional investors.

• The allotment of shares is made on a pro-rata basis. Consider this illustration: An offer is
made for two lakh shares and is oversubscribed by times times, that is, bids are received for

23
 six lakh shares. The minimum allotment is 100 shares. 1,500 applicants have applied for 100
shares each; and 200 applicants have bid for 500 shares each. The shares would be allotted in
the following manner:

• Shares are segregated into various categories depending on the number of shares applied for.
In the above illustration, all investors who applied for 100 shares will fall in category A and
those for 500 shares in category B and so on.

• The total number of shares to be allotted in category A will be 50,000 (100*1500*1/3). That
is, the number of shares applied for (100)* number of applications received (1500)*
oversubscription ratio (1/3). Category B will be allotted 33,300 shares in a similar manner.

• Shares allotted to each applicant in category A should be 33 shares (100*1/3). That is, shares
applied by each applicant in the category multiplied by the oversubscription ratio. As, the
minimum allotment lot is 100 shares, it is rounded off to the nearest minimum lot. Therefore,
500 applicants will get 100 shares each in category A — total shares allotted to the category
(50,000) divided by the minimum lot size (100).

• In category B, each applicant should be allotted 167 shares (500/3). But it is rounded off to
200 shares each. Therefore, 167 applicants out of 200 (33300/200) would get an allotment of
200 shares each in category B.

• The final allotment is made by drawing a lot from each category. If you are lucky you may
get allotment in the final draw.

• The shares are listed and trading commences within seven working days of finalisation of the
basis of allotment. You can check the daily status of the bids received, the price bid for and
the response form various categories in the Web sites of stock exchanges. This will give you
an idea of the demand for the stock and a chance to change your mind. After seeing the

24
 response, if you feel you have bid at a higher or a lower price, you can always change the bid
price and submit a revision form.

• The traditional method of doing IPOs is the fixed price offering. Here, the issuer and the
merchant banker agree on an "issue price" - e.g. Rs.100. Then one have the choice of filling
in an application form at this price and subscribing to the issue. Extensive research has
revealed that the fixed price offering is a poor way of doing IPOs. Fixed price offerings, all
over the world, suffer from `IPO underpricing'. In India, on average, the fixed-price seems to
be around 50% below the price at first listing; i.e. the issuer obtains 50% lower issue
proceeds as compared to what might have been the case. This average masks a steady stream
of dubious IPOs who get an issue price which is much higher than the price at first listing.
Hence fixed price offerings are weak in two directions: dubious issues get overpriced and
good issues get underpriced, with a prevalence of underpricing on average.
What is needed is a way to engage in serious price discovery in setting the price at the IPO. No
issuer knows the true price of his shares; no merchant banker knows the true price of the shares;
it is only the market that knows this price. In that case, can we just ask the market to pick the
price at the IPO?

Imagine a process where an issuer only releases a prospectus, announces the number of shares
that are up for sale, with no price indicated. People from all over India would bid to buy shares in
prices and quantities that they think fit. This would yield a price. Such a procedure should
innately obtain an issue price which is very close to the price at first listing -- the hallmark of a
healthy IPO market.

Recently, in India, there had been issue from Hughes Software Solutions which was a milestone
in our growth from fixed price offerings to true price discovery IPOs. While the HSS issue has
many positive and fascinating features, the design adopted was still riddled with flaws, and we
can do much better.

25
Documents Required:

• A company coming out with a public issue has to come out with an Offer Document/
Prospectus.

• An offer document is the document that contains all the information you need about the
company. It will tell you why the company is coming is out with a public issue, its financials
and how the issue will be priced.

• The Draft Offer Document is the offer document in the draft stage. Any company making a
public issue is required to file the draft offer document with the Securities and Exchange
Board of India, the market regulator.

• If SEBI demands any changes, they have to be made. Once the changes are made, it is filed
with the Registrar of Companies or the Stock Exchange. It must be filed with SEBI at least
21 days before the company files it with the RoC/ Stock Exchange. During this period, you
can check it out on the SEBI Web site.

• Red Herring Prospectus is just like the above, except that it will have all the information as
a draft offer document; it will, however, not have the details of the price or the number of
shares being offered or the amount of issue. That is because the Red Herring Prospectus is
used in book building issues only, where the details of the final price are known only after
bidding is concluded.

Players:

• Co-managers and advisors

• Underwriters

• Lead managers
26
• Bankers

• Brokers and principal brokers

• Registrars

• Stock exchanges.

CASE STUDY: HUGHES SOFTWWARE SOLUTIONS

Recently, in India, there had been issue from Hughes Software Solutions which was a milestone
in growth from fixed price offerings to true price discovery IPOs. While the HSS issue has many
positive and fascinating features, the design adopted was still riddled with flaws, and we can do
much better.

How did the Hughes issue work?

The Merchant Bankers selected "syndicate members" who helped in selling the issue.Orders
were collected by the merchant bankers or syndicate members (only), and submitted using the
computerised IPO system created by NSE. The NSE system only accepted these orders; it did not
reveal any information to investors.

Investors could place, modify or delete orders in the "book building period" -- however they
were doing this in the blind since the system gave them no information. The NSE system
revealed information to the merchant bankers. The full database of orders was passed on by NSE
to the merchant bankers, who could then use this for discretionary allocation of shares.
27
Numerous flaws in this:

From a basic economic perspective, the IPO is a relationship between the issuer (Hughes) and
investors. It is hard to justify the requirement that orders only go to merchant bankers or
syndicate members; this greatly shrinks the extent to which the IPO harnesses NSE's remarkable
distribution machinery. A superior IPO process would involve investors going to any NSE
terminal and placing orders.

The essence of modern market design is superior information display for superior price
discovery. Investors should be able to continuously see how many shares have been bid for; the
shape of the demand function; the cutoff price, etc. Using this information they would be able to
think more effectively about order revisions, cancellations, fresh order placement, etc. The
Hughes IPO, done through the space age VSAT technology of NSE, uses standards of
transparency associated with a 19th century market design. In the Hughes IPO, the merchant
bankers specified a band, from Rs.480 to Rs.630, in which orders had to fall. The merchant
bankers proved to be wrong, and the IPO suffered from severe underpricing. If we take price
discovery seriously, we should let the market set the price.

The Hughes IPO process was too elongated in time. The IPO process should obtain price
discovery in a short time-period where everyone interested in the issue is trading on the screen at
the same time. An issue that lasts for more than an hour raises the cost for participants to
constantly monitor the order book and revise orders.

The sale of part of the issue at a fixed price (discovered at the auction) reduces the size of the
auction and raises the probability of market manipulation at the auction. There should be no
discretionary allocation of shares; instead shares should be allocated purely by price--time
priority.

28
Ideal IPO Process:

On Monday morning, the newspaper should carry an advertisement which is the prospectus of
the IPO, which only talks about the firm and is silent on valuation.

The IPO should take place on Tuesday evening, from 4 PM to 5 PM. The auction should be a
simple uniform-price auction with full transparency. A picture of the demand schedule, and the
cutoff price, should update on the screen in realtime.

Investors should be able to go to any NSE terminal and place orders into the auction. This
harnesses 10,000 odd computer screens in 300 cities all over India in the auction process. From
the issuers perspective, NSCC should perform the credit enhancement exactly as it does on the
equity market. At a legal level, all orders on the screen should be placed by NSCC, thus shielding
the issuer from the credit risk associated with anonymous order placement.

There should be no fragmentation of the shares on offer. All shares to be sold should go through
a single auction. If a retail investor wanted to "access the IPO at prices close to the offer price"
she would just place non--competitive bids at the IPO, where she bids to buy (say) 100 shares at
the IPO price, whatever it proves to be.

Allocation of shares in the depository should take place on Tuesday itself. There should be no
physical shares. Trading on NSE should start on Wednesday (the next day). This gives us a one--
day lag between the IPO and the start of trading.

29
This proposed IPO process sounds startlingly effective. To put it in perspective, it is part of the
same disintermediation process that we have seen in other areas of the financial markets. With
anonymous, electronic trading on the equity market, the broker/dealer has been fundamentally
disintermediated out of secondary market trading, which is now dominated by the actions of
buyers and sellers (and not intermediaries). In that same fashion, the IPO process proposed here
uses technology to link up the issuer and the investor with a transparent pricing mechanism, and
eliminates the traditional overheads of intermediation.

HDIL
IPO VALUATION

30
ABOUT HDIL:

HOUSING DEVELOPMENT AND INFRASTRUCTURE LIMITED (HDIL) is a part of

the Wadhawan Group (formerly known as the Dheeraj Group), which has been involved in real
estate development in the Mumbai Metropolitan Region for almost three decades.

Since 1996, HDIL has been satisfying the diverse needs of scores of home seekers in Mumbai
Metropolitan region. Their business focuses on real estate development, including construction
and development of residential projects, commercial, retail and slum rehabilitation projects.

A sincere study of the market and a strong feeling to meet the needs of the lower and the middle
income group prompted HDIL to help these people tide over difficult times and harrowing
experiences of buying a home.

HDIL had acted pro-actively in identifying the intricate needs of its residents and offered them
just what they needed. It provided and still provides all services under one roof through tie-ups
with banks and HFC’s.

31
With numerous projects to its credit and lakhs of happy and satisfied home buyers, HDIL has
carved a niche for itself in the real estate industry and has made its mark in the hearts of millions
of people.

HDIL’s Board of Directors :

In tune with its efforts to evolve into a professionally managed Corporate Structure, HDIL has
broaden its Board composition by inducting people of high standing from the banking industry,
legal and the audit profession as Independent Directors.

The Company now has an ideal mix of Executive and Independent Directors, which gives it an
advantage of expertise of various fields in effective management and consistent growth.

MISSION:

HDIL is committed to creating microstructures, megastructures and infrastructure for the nation
and creating value for our customers, investors, employees & society at large.

Their mission is to be an icon in Infrastructure & Real Estate Development, defining:

 QUALITY – Conforming to standards

 MARKMANSHIP – Par Excellence

 CUSTOMER SATISFACTION – Their Motto to deliver the best at all time

FINANCE:

Finance for buying flats in any of the HDIL projects can be obtained through any one of the
following Housing Finance Companies:

 HDFC
32
  LIC
 GIC
 Dewan Housing Finance Corporation Limited
 VYSYA Bank Housing Finance

Housing Development and Infrastructure Ltd – IPO

HDIL IPO - opened for subscription on 28 June, 2007 and closed on July 03, 2007.

About the Company:

Since 1978, HDIL has been satisfying the diverse needs of scores of home seekers in Mumbai,
the commercial capital of India and Bangalore. It was not just the intention of doing business by
being responsible for marketing affordable homes; the very inclination was to give the best to the
home seeker fraternity at large.

Issue Details :
Issue of Equity Shares# 30,000,000 Equity Shares of which
Employee Reservation Portion# 600,000 Equity Shares
Net Issue# 29,400,000 Equity Shares Of which:
Qualified Institutional Buyers (QIBs) Portion At least 17,640,000 Equity Shares* of which
Available for Mutual Funds only 882,000 Equity Shares*
Balance of QIB Portion (available for QIBs including Mutual Funds) : 16,758,000 Equity
Shares*
Non-Institutional Portion 2,940,000 Equity Shares*
Retail Portion 8,820,000 Equity Shares*
Green Shoe Option Portion1 Up to 4,500,000 Equity Shares
The Issue and Green Shoe Option Portion Up to 34,500,000 Equity Shares
Pre and post-Issue Equity Shares:
Equity Shares outstanding prior to the Issue : 180,000,000 Equity Shares
33
Equity Shares outstanding after the Issue (excluding the exercise of the Green Shoe Option) :
210,000,000 Equity Shares
Equity Shares outstanding after the Issue (including the exercise of the Green Shoe Option in
full) : 214,500,000 Equity Shares

IPO VALUATION: DCF ANALYSIS

INTRODUCTION:

In simple terms, discounted cash flow tries to work out the value of a company today, based on
projections of how much money it's going to make in the future. DCF analysis says that a
company is worth all of the cash that it could make available to investors in the future. It is
described as "discounted" cash flow because cash in the future is worth less than cash today.

For example, let's say someone asked you to choose between receiving Rs100 today and
receiving Rs100 in a year. Chances are you would take the money today, knowing that you could
invest that Rs100 now and have more than Rs100 in a year's time. If you turn that thinking on its
head, you are saying that the amount that you'd have in one year is worth Rs100 today - or the
discounted value is Rs100. Make the same calculation for all the cash you expect a company to
produce in the future and you have a good measure of the company’s revenue. There are several
tried and true approaches to discounted cash flow analysis; we will use the free cash flow to
firm approach commonly used by Street analysts to determine the "fair value" of companies.

34
The Forecast Period:

The table below shows good guidelines to use when determining a company's excess return
period/forecast period:

Excess Return/Forecast
Company Competitive Position
Period

Slow-growing company; operates in

1 year
highly competitive, low margin industry

Solid company; operates with advantage

such as strong marketing channels,
5 years
recognizable brand name, or regulatory
advantage

Outstanding growth company; operates

with very high barriers to entry, dominant 10 years
market position or prospects

How far in the future should we forecast? Let's assume that the company is keeping itself busy
meeting the demand for its Infrastructure development. Thanks to strong marketing channels and
upgraded technology and HDIL has been satisfying the diverse needs of scores of home seekers
in Mumbai Metropolitan region. Their business focuses on real estate development, including
construction and development of residential projects, commercial, retail and slum rehabilitation
projects. There is enough demand for Infrastructure development to maintain five years of strong
growth, but after that the market will be saturated as new competitors enter the market. So, from
the above table, we will project cash flows for the next five years of business.

35
Growth Rate:

HDIL is expected to grow at to have CAGR of 42 %( source: Emkay Research). We take fixed
growth rate of 42% for DCF valuation for coming 5 years.

Reinvestment Rate:

If we relax the assumption that the only source of equity is retained earnings, the growth in net
income can be different from the growth in earnings per share. Intuitively, note that a firm can
grow net income significantly by issuing new equity to fund new projects while earnings per
share stagnate. To derive the relationship between net income growth and fundamentals, we need
a measure of how investment that goes beyond retained earnings. One way to obtain such a
measure is to estimate directly how much equity the firm reinvests back into its businesses in the
form of net capital expenditures and investments in working capital.

Equity Reinvestment Rate = Growth Rate / ROE

= 42/76

= 55.26 %

Forecasting Free Cash Flows:

Free cash flow is the cash that flows through a company in the course of a quarter or a year once
all cash expenses have been taken out. Free cash flow represents the actual amount of cash that a
company has left from its operations that could be used to pursue opportunities that enhance
shareholder value - for example, developing new products, paying dividends to investors or
doing share buybacks.

36
 Free cash flow = EBIT (1-tax) – [EBIT (1-tax) × Reinvestment Rate]

EBIT (1-tax) nth year = EBIT (1-tax) n-1 year × (1 + growth rate)

Rs in mn

Current
Year 2008 2009 2010 2011 2012

Expected Growth Rate - 42% 42% 42% 42% 42%

EBIT (1-tax) 6181 8777 12463 17698 25131 35686

Equity Reinvestment
Rate - 55.26% 55.26% 55.26% 55.26% 55.26%

FCFE - 22185 30394 41639 57046 78153

Calculating the Discount Rate

A wide variety of methods can be used to determine discount rates, but in most cases, these
calculations resemble art more than science. Still, it is better to be generally correct than
precisely incorrect, so it is worth your while to use a rigorous method to estimate the discount
rate. A good strategy is to apply the concepts of the weighted average cost of capital (WACC).
The WACC is essentially a blend of the cost of equity and the after-tax cost of debt.

37
Cost of Equity (Re):

Unlike debt, which the company must pay at a set rate of interest, equity does not have a
concrete price that the company must pay. But that doesn't mean that there is no cost of equity.
Equity shareholders expect to obtain a certain return on their equity investment in a company.
From the company's perspective, the equity holders' required rate of return is a cost, because if
the company does not deliver this expected return, shareholders will simply sell their shares,
causing the price to drop. Therefore, the cost of equity is basically what it costs the company to
maintain a share price that is satisfactory (at least in theory) to investors. The most commonly
accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset
pricing model (CAPM), where:

Cost of Equity = RF + Beta (Rm-Rf)

Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free
from credit risk, such as government bonds from developed countries. The interest rate of
government bonds is frequently used as a proxy for the risk-free rate.

ß - Beta - This measures how much a company's share price moves against the market as a
whole. A beta of one, for instance, indicates that the company moves in line with the market. If
the beta is in excess of one, the share is exaggerating the market's movements; less than one
means the share is more stable.We take Beta of comparable firm i.e Unitech which is having beta
of 1.1

(Rm – Rf) Equity Market Risk Premium - The equity market risk premium (EMRP) represents
the returns investors expect, over and above the risk-free rate, to compensate them for taking
extra risk by investing in the stock market. In other words, it is the difference between the risk-
free rate and the market rate.

38
Cost of Debt (Rd):

As companies benefit from the tax deductions available on interest paid, the net cost of the debt
is actually the interest paid less the tax savings resulting from the tax-deductible interest
payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).

Weighted Average Cost Of Capital (WACC):

The WACC is the weighted average of the cost of equity and the cost of debt based on the
proportion of debt and equity in the company's capital structure. The proportion of debt is
represented by D/V, a ratio comparing the company's debt to the company's total value (equity +
debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to
the company's total value (equity + debt). The WACC is represented by the following formula:

WACC = Cost of Equity + Cost of Debt

= E/V x Re + Rd x (1 - corporate tax rate) x D/V.

E/V 0.66 Rf 7.44

Corporate tax 30% Beta 1.1

D/V 0.34 Rm 13.5

Cost of Debt Cost of Equity

D/V x (1 - corporate tax rate) E/V x [Rf + Beta (Rm-Rf)]

0.34 [1-0.30] 0.66 [7.44 + 1.1 x 6]

WACC = Cost of Debt + Cost of Equity = 9.5%

Present Value:

The present value of a single or multiple future payments (known as cash flows) is the nominal
amounts of money to change hands at some future date, discounted to account for the time value

39
of money, and other factors such as investment risk. A given amount of money is always more
valuable sooner than later since this enables one to take advantage of investment opportunities.
Present values are therefore smaller than corresponding future values.

When future cash flow of the company is divided by the discount rate we get the present value of
that predicted years cash flow.

Present Value n = Predicted cash flow n / (1+ discount rate)n

Where, n = year

Rs in mn

2008 2009 2010 2011 2012

3927 5576 7918 11243 15965
Free Cash Flow
(1.095) (1.095)
Discount rate 1.095 ² ³ (1.095)4 (1.095)5
3586 4650 6030 7820 10141
Present value

TERMINAL VALUE

Perpetuity Growth Model:

40
 The Perpetuity Growth Model accounts for the value of free cash flows that continues
into perpetuity in the future, growing at an assumed constant rate. Here, the projected free cash
flow in the first year beyond the projection horizon (N+1) is used.

We have assumed perpetuity growth rate for HDIL as 6%

Beyond 2012 HDIL is expected to grow at 6% p.a i.e. at its perpetuity rate, hence net income for
the year 2013 will be:

Net income of 2012 × (1+ perpetuity growth rate)

= 35686 × (1+0.06)
= Rs. 37827 mn

Reinvestment rate after 2012 (Terminal Point):

Reinvestment rate = Perpetuity Growth rate / Return on Equity

Here, return on equity is rate at which company expect to get returns on its investments after
terminal point i.e. 2012.

Return on equity will drop to the stable period cost of capital of 9.5%.

Reinvestment rate (terminal point) = 6/9.5

= 63%

Free cash flow = EBIT (1-tax) – [EBIT (1-tax) x Reinvestment Rate]

Therefore,
41
Free cash flow 2013 = 37827 – [37827 x 52%]
= Rs. 13936 mn

Gordon Growth Model:

There are several ways to estimate a terminal value of cash flows, but one well-worn method is
to value the company as a perpetuity using the Gordon Growth Model. The model uses this
formula:

Free cash flow of the year after the terminal year

(Discount Rate –Perpetuity Growth Rate)

The formula simplifies the practical problem of projecting cash flows far into the future.
Therefore,

Terminal Value = 13936 × 100

9.5 – 6

= Rs 146099 mn

Present value of = 146099 / (1.095)6

Terminal year

= Rs. 84754 mn

Calculating Total Enterprise Value:

Total Enterprise = Sum of Present value for 5 years + Present valueOf Terminal
Year + Cash – Debt

42
 = 32228 + 84754 + 1949 - 3756
= Rs. 115175 mn

Fair value = Rs 115175 mn

Number of outstanding shares = 214 mn
Fair value of the HDIL per share = Rs 538

SENSITIVITY ANALYSIS

Sensitivity analysis is the investigation of how the projected performance varies along with
changes in the key assumptions on which the projections are based.

The sensitivity analysis of the above DCF model can be done as follows:

Discount Rate
9% 9.5% 10%

Perpetuity Growth 5.5% 596 592 585

6% 533 538 537

Rate
6.5% 469 483 489

HDIL IPO

Particulars Figures
Issue of Equity shares 30,000,000
Equity Shares outstanding prior to the 180,000,000
Issue
Equity Shares outstanding after the 210,000,000
Issue
Price Band Rs. 430 to Rs.500
Issue Price Rs. 500
Listing Price Rs. 538
43
 3 Days High Rs.634
3 Days Low Rs.535
Close Price (26th July 2007) Rs. 621
DCF Valuation Rs. 538

NSE Data

Total Trd
Date Prev Close Open High Low Close Qty Turnover in Lacs

24-Jul-07 500 538.6 575.95 535 559.35 28590806 160030.8

25-Jul-07 559.35 549.4 587.4 545.3 580.1 8552244 48465.14

26-Jul-07 580.1 585.6 634.3 585.6 621.4 9125757 55976.88

It can be seen that per share value of the HDIL comes to Rs. 538 and the listing price is
Rs.538. Close Price as of 26th July 2007 is Rs.621. Hence it is buying opportunity of the
investors.

HDIL IPO NEWS TRIVIA:

 According to CLSA, HDIL IPO had been priced at a 20-30% discount to its forward
NPV. The IPO is good but the only concern here is the fall in retail demand for
property because of high interest rates.

 The HDIL IPO had performed pretty well.

 It had been subscribed by 6.6 times (oversubscribed 5.6 times).

44
  Retail category has been subscribed by only 1.59 times (oversubscribed by 0.59
times).

 Institutional investor category in the HDIL IPO had been subscribed by over 10.13
times (oversubscribed 9.13 times)

 The High Networth Individual category had been subscribed by 1.78 times
(oversubscription ratio: 0.78 times).

PAST IPO PERFORMANCE

45
Equity Issue Price Closing Price % Gain/Loss
as on
11/04/2008)

April 2008

Sita Shree Food products 30 43.1 43.67

Limited

Gammon Infrastructure 167 164.2 -1.68

Projects Limited

March 2008

V-Guard Industries Limited 82 66.95 18.35

Rural Electrification 105 111.6 6.29

Corporation Limited

GSS America Infotech Limited 400 410.65 2.66

February 2008

Manjushree Extrusions 45 23.7 -47.33

Limited

Tulsi Extrusions Limited 85 76.75 -9.71

IRB Infrastructure Developers 185 182.5 -1.35

Limited

Bang Overseas Limited 207 165.1 -20.24

Shriram EPC Limited 300 226 -24.67

Onmobile Global Limited 440 599.6 36.27

KNR Constructions Limited 170 90.7 -46.65

Cords Cable Industries 135 89.55 -33.67

Limited

J Kumar Infraprojects Limited 110 91.45 -16.86

Reliance Power Limited 450 361.35 -19.70

Future Capital Holdings 765 561.1 -26.65

Limited

46
IPO IN PIPELINE:
Open

From
To
Offer Price 
Issue Name  Min. Invst (Rs)
(Rs.)
47

Aishwarya Telecom Limited 15-APR-08 17-APR-08 32-35 6400

IPO CLOSED BUT YET TO BE LISTED:

Retail 
Likely Date of 
Issue Name Sector  Cut Off Price Subscription 
Listing
(times)
Vimal Oil & Foods Limited Food Products N/A N/A N/A
Tubeknit Fashions Limited Textiles 108 0.17 N/A
Ammana Bio Pharma Limited Chemicals 14 0.37 N/A
Printing and
SVPCL Limited 45 2.24 N/A
Stationery
Kiri Dyes and Chemicals
Chemicals 150 2.38 N/A
Limited
Titagarh Wagons Limited Engineering 610 0.98 N/A

IPO GLOSSARY

A
Allocation
This is the amount of stock in an initial public offering (IPO) granted by the underwriter
to an investor.

48
Aftermarket
Trading in the IPO subsequent to its offering is called the aftermarket.

Board of Directors
The composition of the Board of Directors is particularly critical for an IPO. Typically, a
board is composed of inside and outside directors.

Broken IPOs
If an IPO trades below its IPO price in the aftermarket, it is said to be a broken IPO.

Calendar
This refers to upcoming IPOs and secondary offerings. Brokerage houses have equity
calendars, bond calendars and municipal calendars.

Clearing Price
The price at which all shares of an IPO can be sold to investors in a Dutch Auction.
Sometimes referred to as the “market clearing price”.

F
First Day Close
The closing price at the end of the first day of trading reflects not only how well the lead
manager priced and placed the deal, but what the near-term trading is likely to be.

Float
When a company is publicly traded, a distinction is made between the total number of
shares outstanding and the number of shares in circulation, referred to as the float. The
float consists of the company's shares held by the general public.

Green Shoe
A typical underwriting agreement allows the underwriters to buy up to an additional 15%
of shares at the offering price for a period of several weeks after the offering. This option
49
 is also called the overallotment and is exercised when the IPO is oversubscribed and
trading above its offer price. The term comes from the Green Shoe Company, which was
the first to have this option.

Hot Issue
When there is significantly more demand than supply for an IPO it is said to be a hot
issue.

Initial Public Offering

This is the event of a company first selling its shares to the public.

Insiders
Management, directors and significant stockholders are regarded as insiders because they
are privy to information about the operations of a company not known to the general
public.

IPO Price
Individual investors often ask why the price at which an IPO starts trading is different
from its offer price. This occurs because the offer price is set by the underwriters before
the stock starts trading. Once the stock starts trading, the price is determined by actual
supply and demand and can be higher or lower.

IPO Research
Prior to the offering, the underwriters involved in the IPO are prohibited from issuing
research or recommendations for forty days. Following the IPO, the underwriter is
allowed to issue a research report

M-N

Market Capitalization
The total market value of a firm. It is defined as the product of the company's stock price
per share and the total number of shares outstanding

Market Value
The market value of a company is determined by multiplying the number of shares
outstanding by the current price of the stock.

50
O

Offering Price
This is the price at which the IPO is first sold to the public. It is set by the lead manager,
usually after the close of stock market trading the night before the shares are distributed
to IPO buyers. In the case of some foreign IPOs, the pricing occurs over the weekend.

Oversubscribed
When a deal has more orders than there are shares available it is said to be
oversubscribed.

Preliminary Prospectus
This is the offering document printed by the company containing a description of the
business, discussion of strategy, presentation of historical financial statements,
explanation of recent financial results, management and their backgrounds and
ownership.

Proceeds
Companies go public to raise money. The money raised is referred to as proceeds.

Red Herring
This is the term of art for the preliminary prospectus. It gets its name from the printed red
disclaimer on the left side of the prospectus.

U-V

Underwriter
This is a brokerage firm that raises money for companies using public equity and debt
markets. Underwriters are financial intermediaries that buy stock or bonds from an issuer
and then sell these securities to the public.

Venture Capital
Funding acquired during the pre-IPO process of raising money for companies. It is done
only by accredited investors.

51
BIBLIOGRAPHY

 www.ipohome.com

 www.essortment.com

 www.investopedia.com

52
 www.ipoavenue.com

 www.moneycontrol.com

 www.wikipedia.com

 www.moneycentral.hoovers.com

 www.bullishindian.com

 www.rupya.com

 www.investorguide.com

 www.hdil.in/

53