An Overview of Small Business Economics

Discussion Question 2

Having successfully brought a new product to market, you are now ready to take your company public. Discuss how each of the following economic indicators may affect the environment for the launching of your initial public offering (IPO). Overall, how soon should you launch a public offering given the cyclic nature of the economy?

1. Nominal Gross Domestic Product (NGDP): The nominal gross domestic product is increasing at the rate of 2.6% annually, while the Real Gross National Product (RGNP) is rising only 2.3%.

2. Consumer Price Index (CPI): The Consumer Price Index has been rising at a fraction of a percent per quarter for each of the last four (4) quarters.

3. Discount Rate: The Federal Reserve has announced a reduction in the discount rate of 0.5% and hinted that further cuts may be forthcoming.

4. Unemployment Rate: The rate of unemployment is holding steady, although the rate of new claims is declining somewhat.

ANSWER

An Overview of Small Business Economics

Consumer Price Index (CPI)

CPI allows us to gauge and measure the cost of living. It reflects how the lifestyle of the consumer is affected by prices of common consumer products (All Answers Ltd, 2018). More spending means that the consumer will be moderate on their saving and spending decisions. This affects the stock market since the consumer will be less willing to spend much on stocks. This directly implies that public companies have lower earnings from stocks and low stock prices. Thus, when CPI is rising over the last four quarters by a fraction of a percentage, the consumer is spending more and will have less disposable income to invest in stocks. Launching an Initial Public Offering at this time may mean that the price of our shares would have to begin low to attract investors.

Unemployment rate

The response of the stock market to unemployment rate is determined by whether the economy is contracting or expanding. The stock market’s response to rising unemployment rate is positive when the economy is expanding. Stock prices increase. The response is negative when the economy is contracting. This odd response can be explained by the impact of unemployment on interest rates, expected growth rate of dividends and corporate earnings, and equity risk premium (Boyd, Hu, & Jagannathan, 2005). The unemployment rate in this case is steady but the rate of new cases of unemployment is decreasing, Growth in RGDP and NGNP indicates an expanding economy so a decline in unemployment rate means that the stock market may not do well in the near future. This factor is unfavourable for an IPO.

Discount rate

Discount rate changes have no significant impact on stock prices and returns. However, the period immediately following an announcement of huge discount rate changes is characterized by voluminous trading. An announcement is likely to influence trading in the current period only, not in other periods. Research shows that a decrease in discount rates leads to more trading as compared to an increase in discount rates (Chen, Mohan, & Steiner, 1999). In this case, a decrease in discount rates of 0.5% and more reduction expected is likely to lead to more trading by investors in the stock market. It is, thus, expected that a gradual increase in the level of trading will occur. This environment is favourable for an IPO.

Real GNP and nominal GDP

Real GNP growth in the long-term does not necessarily result in growth in real earnings in the long term. This is mainly because in the stock market, returns are not only affected by factors in the local market but also in the global market. Also, GNP growth is diluted before shareholders benefit from it. Expected GNP and economic growth may already be captured in the prices of stocks (Barra, 2010). For nominal GDP, changes in the stock market tend to occur before developments in the economy. This applies where expected GDP growth is based on today’s stock market valuations, thus nominal GDP. In this case, growth in nominal GDP by 2.6% and real GNP by 2.3% means that the GDP is growing faster than the GNP. Expansion in the economy is favourable as it reflects the economic status of the investors, though indirectly. It is, therefore, a good environment to launch an IPO.

When to launch an IPO

Considering the cyclic nature of the economy, the stock market is highly volatile. The best time to go public is when the Volatility Index (VIX) is low. VIX is a market indicator for market volatility. When it is low, IPOs are likely to have low discounts and trade. Higher VIX makes it difficult for companies to launch IPOs. In addition to this, a company should benchmark companies in the same industry who have already launched their IPOs. Based on when the company projects to meet the set targets compared to the benchmark, the company should launched about two years before the time projected to hit the target (Deloitte, 2016).

References

All Answers Ltd. (November 2018). Impact of CPI on Stock Return. Retrieved from             https://ukdiss.com/litreview/impact-of-consumer-price-index-on-stock-return-        finance.php?vref=1

Barra, M. S. C. I. (2010). Is there a link between GDP growth and equity returns?. Research         Bulletin.

Boyd, J. H., Hu, J., & Jagannathan, R. (2005). The stock market’s reaction to unemployment        news:   Why bad news is usually good for stocks. The Journal of Finance, 60(2), 649-    672.

Chen, C. R., Mohan, N. J., & Steiner, T. L. (1999). Discount rate changes, stock market    returns, volatility, and trading volume: Evidence from intraday data and           implications for market efficiency. Journal of Banking & Finance, 23(6), 897-924.

Deloitte. (2016). Private company IPOs: Is timing everything? [Ebook]. Retrieved from             https://www2.deloitte.com/content/dam/Deloitte/us/Documents/audit/us-audit-private-      company-ipos-is-timing-everything.pdf