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The Capital MarketThe Capital MarketThe Capital MarketThe Capital Market

WI

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After studying, you should After studying, you should be able to:be able to:

Understand the characteristics of the capital market and the difference between a primary and a secondary market.

Describe the three primary methods used by companies to raise external long-term funds -- public issue, privileged subscription, and private placement.

Explain the role of investment bankers in the process of issuing new securities, including traditional underwriting, best efforts offering, shelf registration, and standby arrangements.

Calculate the theoretical value of a (subscription) right and describe the relationships among the market price of the stock, the subscription price, and the value of the right.

Understand the Securities and Exchange Commission (SEC) registration process, including the role played by the registration statement, red herring, prospectus, and tombstone advertisement.

Understand the roles that venture capital and an initial public offering (IPO) play in financing the early stages of a company’s growth.

Discuss the potential signaling effects that often accompany the issuance of new long-term securities.

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The Capital MarketThe Capital Market

Public Issue Privileged Subscription Regulation of Security Offerings Private Placement Initial Financing Signaling Effects The Secondary Market

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Deja Vu All Over AgainDeja Vu All Over Again

Capital MarketCapital Market -- The market for relatively long-term (greater than one year original maturity) financial instruments.

Primary MarketPrimary Market -- A market where new securities are bought and sold for the first time (a “new issues” market).

Secondary MarketSecondary Market -- A market for existing (used) securities rather than new issues.

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Deja Vu All Over AgainDeja Vu All Over Again

INVESTMENT SECTOR

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SAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

Public issue

Privilegedsubscription

Privateplacement

Indicates the possiblepresence of a “standby arrangement”

Indicates the financialintermediaries’ ownsecurities flow to thesavings sector

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Public IssuePublic Issue

Securities are sold to hundreds, and often thousands, of investors under a formal contract overseen by federal and state regulatory authorities.

When a company issues securities to the general public, it is usually uses the services of an investment bankerinvestment banker.

Public Issue Public Issue -- Sale of bonds or stock to the general public.

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Investment BankerInvestment Banker

Investment banker receives an underwriting spread underwriting spread when acting as a middleman in bringing together providers and consumers of investment capital.

Underwriting spread Underwriting spread -- the difference between the price the investment bankers pay for the security and the price at which the security is resold to the public.

Investment Banker Investment Banker -- A financial institution that underwrites (purchases at a fixed price on a

fixed date) new securities for resale.

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Investment BankerInvestment Banker

Thus, the services can be provided at a lower cost lower cost to the firm than the firm can perform the same services internally.

Three primary means companies use to offer Three primary means companies use to offer securities to the general publicsecurities to the general public:: Traditional (firm commitment) underwriting Best efforts offering Shelf registration

Investment bankers have expertise, contacts, and the sales organization to efficientlyefficiently market securities to investors.

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Traditional UnderwritingTraditional Underwriting

If the security issue does not sell well, either because of an adverse turn in the market or because it is overpriced, the underwriterthe underwriter, not the company, takes the loss.

Underwriting Underwriting -- Bearing the risk of not being able to sell a security at the established price

by virtue of purchasing the security for resale to the public; also known as firm firm

commitment underwritingcommitment underwriting.

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A.A. Competitive-bid Competitive-bid The issuing company specifies the date that

sealed bids will be received.

Competing syndicates submit bids.

The syndicate with the highest bid wins the security issue.

Underwriting Syndicate Underwriting Syndicate -- A temporary combination of investment banking firms

formed to sell a new security issue.

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The issuing company selects an investment banking firm and works directly with the firm to determine the essential features of the issue.

Together they discuss and negotiate a price for the security and the timing of the issue.

Depending on the size of the issue, the investment banker may invite other firms to join in sharing the risk and selling the issue.

Generally used in corporate stock and most corporate bond issues.

B.B. Negotiated OfferingNegotiated Offering

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Best Efforts Offering Best Efforts Offering -- A security offering in which the investment bankers agree to use only their best

efforts to sell the issuer’s securities. The investment bankers do not commit to purchase any

unsold securities.

Shelf Registration Shelf Registration -- A procedure whereby a company is permitted to register securities it plans to sell over the next two years; also called SEC Rule SEC Rule

415415. These securities can then be sold piecemeal whenever the company chooses.

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Shelf Registration: Flotation Shelf Registration: Flotation Costs and Other AdvantagesCosts and Other Advantages

This competition reduces underwriting spreads.

The total fixed costs (legal and administrative) of successive public debt issues are lower with a single shelf registration than with a series of traditional registrations.

The amount of “free” advice available from underwriters is less than before shelf registration was an alternative to firms.

A firm with securities sitting “on the shelf” can require that investment banking firms competitively bid for its underwriting business.

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Privileged SubscriptionPrivileged Subscription

Privileged Subscription Privileged Subscription -- The sale of new securities in which existing shareholders are given a

preference in purchasing these securities up to the proportion of common shares that they already own;

also known as a rights offeringrights offering.

Preemptive Right Preemptive Right -- The privilege of shareholders to maintain their proportional company ownership by purchasing a proportionate share of any new issue

of common stock, or securities convertible into common stock.

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Terms of OfferingTerms of Offering

Terms specifyTerms specify::

the number of rights required to subscribe for an additional share of stock

the subscription price per share

the expiration date of the offering

RightRight -- A short-term option to buy a certain number (or fraction) of securities from the issuing

corporation; also called a subscription rightsubscription right.

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Subscription RightsSubscription Rights

Generally, the subscription Generally, the subscription period is three weeks or less.period is three weeks or less.

Options available to the holder of rightsOptions available to the holder of rights:: Exercise the rights and subscribe for

additional shares Sell the rights (they are transferable) Do nothing and let the rights expire

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Subscription RightsSubscription Rights

The shareholder can then purchase 7 shares (use 70 rights) and still retain the 7 remaining

rights. Thus, the shareholder needs to Thus, the shareholder needs to purchase an additional 3 rights.purchase an additional 3 rights.

A shareholder who owns 77 shares and just received 77 rights would like to

purchase 8 new shares. It takes 10 rights for each new share. What action should What action should

the shareholder take?the shareholder take?

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Value of RightsValue of Rights

A right allows you to buy new stock at a discount that typically ranges between 10 to 20

percent from the current market price.

The market value of a right is a function ofThe market value of a right is a function of:: the market price of the stock

the subscription price

the number of rights required to purchase an additional share of stock

What gives a right its value?What gives a right its value?

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PP00 - RR00 = [ (RR00)(NN) + SS ], therefore

RR00 = PP00 - [ (RR00)(NN) + SS ]

RR00 = the market price of one right when the stock is selling “rights-on”

PP00 = the market price of a share of stock selling “rights-on”

SS = the subscription price per shareNN = the number of rights required to purchase one

share of stock

How is the Value of a How is the Value of a Right Determined?Right Determined?

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Solving for RR00.


PP00 - SS

NN + 1RR0 0 =

PPXX = PP00 - RR00 = [ (RR00)(NN) + SS ]

By substitution for RR00, we can solve the

““ex-rights” value of one share of stock, Pex-rights” value of one share of stock, PXX.

(PP0 0 )(NN) + SS

NN + 1PPX X =

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Example of the Example of the Valuation of a RightValuation of a Right

Assume the following informationAssume the following information: The current market price current market price of a stock

“rights-on” is $50.$50.

The subscription price is $40.subscription price is $40.

It takes nine rights nine rights to buy an additional share of stock.

What is the value of a right when the stock is What is the value of a right when the stock is selling “rights-on”? selling “rights-on”? What is the value of one What is the value of one

share of stock when it goes “ex-rights”?share of stock when it goes “ex-rights”?

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Solving for RR00.

Solving for PPXX.


$50$50 - $40$40

99 + 1RR0 0 =

RR00 = $1$1

($50$50 )(99) + $40$40

99 + 1PPX X =

PPX X = $49$49

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Theoretical versus Theoretical versus Actual Value of RightsActual Value of Rights

Transaction costs Speculation Irregular exercise and sale of rights

over the subscription period

Arbitrage acts to limit the deviation of Arbitrage acts to limit the deviation of the actual right value from the the actual right value from the

theoretical value.theoretical value.

Why might the actual value of a right Why might the actual value of a right differ from its theoretical value?differ from its theoretical value?

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Standby ArrangementStandby Arrangement

Fee often composed of a flat fee and an additional fee for each unsold share of stock.

The greater the risk of an unsuccessful rights offering, the more desirable a standby arrangement.

Standby ArrangementStandby Arrangement -- A measure taken to ensure the complete success of a rights

offering in which an investment banker or group of investment bankers agrees to

“stand by” to underwrite any unsubscribed (unsold) portion of the issue.

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Oversubscription PrivilegeOversubscription Privilege

For example, shareholders subscribe for 450,000 shares of a 500,000-share rights offering. Let us assume that some shareholders would like more shares and oversubscribe by 80,000 shares.

As a result, each shareholder oversubscribing receives 5/8ths (50,000 / 80,000) of a share for each share oversubscribed.

Oversubscription Privilege Oversubscription Privilege -- The right to purchase, on a pro rata basis, any

unsubscribed shares in a rights offering.

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Privileged Subscription Privileged Subscription versus Underwritten Issueversus Underwritten Issue

Investors are familiar with the firm’s operations when using a rights offering.

The principal sales tool is a discounted price (rights offering) and the investment banking organization (underwriting).

A disadvantage of a rights offering is that the shares will be sold at a lower price.

There is greater dilution with a rights offering which many firms attempt to avoid.

There is a wider distribution of shares with a public offering.

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Regulation of Security Regulation of Security Offerings -- FederalOfferings -- Federal

Securities Exchange Act of 1934 Securities Exchange Act of 1934 -- Regulates the secondary market for long-term securities -- the securities exchanges

and the over-the-counter market.

Securities Act of 1933 Securities Act of 1933 -- Generally requires that public offerings be registered with the

federal government before they may be sold; also known as Truth in Securities ActTruth in Securities Act.

Securities and Exchange Commission (SEC) enforces both of these acts.

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Part 1Part 1: : Prospectus Prospectus -- Discloses information about the issuing company and its new offering and is distributed to investors.

Part 2Part 2: Additional information required by the SEC that is not part of the printed prospectus.

Registration Statement Registration Statement -- The disclosure document filed with the SEC in order to

register a new securities issue.

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Red HerringRed Herring

SEC reviews the registration statement to see that all the required information is presented and that it is not misleading.

Deficiencies are communicated in a comment lettercomment letter.

Once the SEC is satisfied, it approves the registration. If not, it issues a stop orderstop order.

Red Herring Red Herring -- The preliminary prospectus. It includes a legend in red ink on the cover

stating that the registration statement has not yet become effective.

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Registration statements become effective on the 20th day after filing (or on the 20th day after filing the last amendment).

The SEC, at its discretion, can advance the date. Typical time from filing to approval is 40 days.

Registration Statement Effective DateRegistration Statement Effective Date

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A shelf registration allows a company to register with the SEC “in advance” of a security offering.

The company can sell “off the shelf” by filing a simple amendment and having the SEC accelerate the “normal” 20-day waiting period accorded amendments.

Typically, the waiting period following this simple amendment is only a day or two.

Impact with shelf registration:Impact with shelf registration:

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The term reflects the stark, black-bordered look of the ad.

Includes the company’s name, a brief description of the security, the offering price, and the names of the investment bankers in the underwriting syndicate.

Tombstone Advertisement Tombstone Advertisement -- An announcement placed in newspapers and

magazines giving just the most basic details of a security offering.

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Sarbanes-Oxley Sarbanes-Oxley Act of 2002Act of 2002

Most important security law reform since 1930s. Establishes:

an oversight board to regulate public accounting firms that audit public companies

New audit and audit committee standards Executive officers of public companies must certify the

company’s SEC reports Increases liability for violations of federal security laws

Sarbanes-Oxley Act of 2002 (SOX) Sarbanes-Oxley Act of 2002 (SOX) – Addresses, among other issues, corporate

governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information.

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Regulation of Security Regulation of Security Offerings -- StateOfferings -- State

Individual states have security commissions that regulate securities in their states.

These laws are particularly important when a security issue is sold entirely to people within the state and may not be subject to SEC regulation.

Important if the SEC provides only limited review.

States vary on the strictness of their regulation.

Blue Sky Laws Blue Sky Laws -- State laws regulating the offering and sale of securities.

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Private PlacementPrivate Placement

Eliminates the underwriting function of the investment banker.

The dominant private placement lender in this group is the life-insurance category (pension funds and bank trust departments are very active as well).

Private (or Direct) Placement Private (or Direct) Placement -- The sale of an entire issue of unregistered securities (usually bonds) directly to one purchaser or a group of purchasers (usually financial intermediaries).

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Private Private Placement FeaturesPlacement Features

Allows the firm to raise funds more quickly.

Eliminates risks with respect to timing.

Eliminates SEC regulation of the security.

Terms can be tailored to meet the needs of the borrower.

Flexibility in borrowing smaller amounts more frequently rather than a single large amount.

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Private Placement and Private Placement and Other DevelopmentsOther Developments

Qualified Institutional Buyers (QIBs)Qualified Institutional Buyers (QIBs) -- Eligible purchasers, by SEC Rule 144a, of previous securities from a private placement without having to go through a public market registration.

Event RiskEvent Risk -- The risk that existing debt will suffer a decline in creditworthiness because of the issuance of additional debt securities, usually in connection with corporate restructuring.

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Private Placement and Private Placement and Other DevelopmentsOther Developments

Underwritten Rule 144a Private PlacementUnderwritten Rule 144a Private Placement – The issuer sells its securities initially to an investment bank that resells them to the same institutional buyers that are candidates for a regular private placement. Often includes registration rights.

Private Placement with Registration RightsPrivate Placement with Registration Rights – It combines a standard private placement with a contract requiring the issuer to register the securities with the SEC for possible resale in the public market.

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Initial Financing -- Initial Financing -- Venture CapitalVenture Capital

Wealthy investors and financial institutions are the primary providers of funds for a new enterprise (usually common stock).

Rule 144 and the 1933 Act require privately placed securities to be held for at least two years or be registered before they can be resold.

Letter stockLetter stock * -- Privately placed common stock that cannot be immediately resold.

* Note: Under SEC Rule 144a, however, letter stock could be sold to qualified institutional buyers (QIBs) without a waiting period.

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Initial Public Offering (IPO) Initial Public Offering (IPO) -- A company’s first offering of common stock to the general public.

Initial Financing -- Initial Financing -- Initial Public OfferingsInitial Public Offerings

Often prompted by venture capitalists who wish to realize a cash return on their investment.

Founders of the firm may wish to go through an IPO to establish a value for their company.

There exists greater price uncertainty with an IPO than with other new public stock issues.

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Signaling EffectsSignaling Effects

Negative stock price reaction to common stock or convertible issues.

Straight debt and preferred stock do not tend to show statistically significant effects.

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Relative AbnormalRelative AbnormalStock Returns for aStock Returns for aNew Equity IssueNew Equity Issue

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Possible Explanations Possible Explanations for Price Reactionsfor Price Reactions

Asymmetric (Unequal) InformationAsymmetric (Unequal) Information Potential investors have less information than

management (particularly for common stock).

Exchanges of different types of securities show that increases (decreases) in financial leverage are associated with positive (negative) abnormal returns.

Expectations of Future Cash FlowsExpectations of Future Cash Flows The unexpected sale of securities may be associated

with lower than expected operating cash flows and interpreted as bad news. Hence, the stock price might suffer accordingly.

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The Secondary MarketThe Secondary Market

Purchases and sales of existing stocks and bonds occur in the secondary market.

Transactions in the secondary market do not provide additional funds to the firm.

The secondary market increases the liquidity of securities outstanding and lowers the required returns of investors.

Composed of organized exchanges like the New York Stock Exchange and American Stock Exchange plus the over-the-counter (OTC) market.

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Economy & Finance

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