2011 Finance Lecture 1

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Financial Instruments and MarketsMBA, MSc slides

Equity MarketsDebt Markets

MBA – Week 1Financial Instruments and Markets

Gavin Kretzschmar1, 2 Business School2

1Accounting and Finance Group

2University of EdinburghTHE

U NI V E R S

I TY

OF

ED I N B U

RGH

THE

U NI V E R S

I TY

OF

ED I N B U

RGH

2010 - 2011

1 / 26 Gavin Kretzschmar Financial Instruments and Markets

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Sequence today

Course Booklet - accounting and financeEquityDebtOdd numbers for tutorialsIntroduction - Chapter 5, Higgins (2009).


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Equity, Debt and Efficiency in Capital Markets

IntroductionsEquityDebtOdd Numbers for practice


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Key Differences between F &A

As Financiers - we are concerned with the market value of debtand equityThe market cost of debt and equityThe capital decisionThe investment decisionThe financing decisionAccountants are concerned with all of the above - but at Historiccost...Lets consider an asset base of 150 with 40 percent equity.....


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Equity MarketsPrivate EquityInitial Public Offerings

Outline

3 Equity MarketsEquity MarketsPrivate EquityInitial Public Offerings


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Equity Capital Markets

A key distinction is between:Primary Markets - where companies sell new shares to investorsSecondary Markets - where investors trade already issuedshares with other investorsWe can also make a distinction between listed and unlistedequity shares. The former are traded on a stock exchange, thelatter are not


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Financing a business

A business can be financed by: - Internal funds - Bank loans -Bond issues - Equity issuesThe initial founders of a business may lack enough capital todevelop the business to the point of profitabilityWith limited capacity to borrow, many new companies turn toventure capital firms for initial equity fundingThe VC firm takes a stake in the start-up business, helpsmanage it, and hopes to be able to sell out at a profit


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Outline



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Private Equity

We can make a distinction between: - Private companies - who’sshares are tightly held - Public companies - who’s shares tradeon public marketsPrivate equity funds make equity investments in unquotedsecurities, ie those not traded on a public marketVenture capital funds provide finance to start-up and early-stagebusinessesBuy-out funds take public business private again, seeking toimprove management and financingBuyout funds typically use a lot of leverage, ie they increase thedebt held by the companies they buy


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Outline



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Initial Public Offerings

When a company sells its shares to investors for the first time,this is called an "initial public offering" or "IPO"The IPO can be used to: - Raise new money for the company -Allow VC firms to realise their investment - Allow the founders torealise their investment - Or, some combination of these threeThe IPO is a costly and complex process involving a number ofspecialist advisers


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Listing Requirements

In most markets, companies have to meet certain criteria in orderto have their shares traded on the marketIn the UK, the Financial Services Authority is responsible forsetting these "listing requirements"The main requirements are: - A three year trading history - Anexpected market value of GBP 700,000+ - At least 25% ofshares made available to the publicA junior market exists for newer companies that don’t meet theserequirements - the "Alternative Investment Market" (AIM)


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Underwriters

An investment bank usually plays a key role in the IPO processas the "underwriter" or "sponsor"The bank will provide the company with procedural and financialadviceIt will then take on the responsibility for distributing the shares toinvestorsThe bank may act as principal, buying the shares to resell toinvestors, or it may act as agent, selling to investors on behalf ofthe company


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The IPO Process

The company applies to have its shares listed on the marketThe investment bank does ’due diligence’ and prepares a"prospectus" that outlines key facts about the company and theshare issueThe investment bank markets the shares to investors, then setsthe price for the issue and distributes the shares to investorsThe shares are admitted to the market and trading begins


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Pricing an IPO

The investment bank will set the price with reference to thevaluation of comparable shares, e.g. using P/E ratioThe bank will also discuss the issue with investors in order togauge the likely level of demand (book-building)There is substantial evidence that IPOs are, on average,underpriced - i.e. the issue price is below the price that holds onthe first day of trading (Ritter 1998)


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Average Initial Return

US - Ibbotson et al 1960-96 15.8%UK - Dimson & Levis 1959-90 12.0%India- Krishnamurti & Kumar 1992-93 35.3%China - Datar & Mao 1990-96 388.0%


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Bond and Money MarketsGovernment BondsCorporate Bonds

Outline

4 Debt MarketsBond and Money MarketsGovernment BondsCorporate Bonds


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Bond and Money Markets Debt Markets

A bond is like a loan, where the borrower is committed to payinterest (coupons) and to return the principal at a set date in thefutureUnlike a traditional bank loan, a bond is tradable on thesecondary marketWe will look at bonds issued by governments and bonds issuedby companiesWe will take for granted that you know how to price a bond (PV offuture cashflows) and calculate the redemption yield (IRR)


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Outline



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Government Bonds

Gilts in the UK, or Treasury bonds in the USThe government seeks to meet its borrowing requirements - e.g.to fund infrastructure investment - by selling bonds to investorsGilts typically have maturities from 1 year to 30 years. Themoney market deals with borrowing less than 1 yrGovernment bonds are usually regarded as being free fromcredit risk. This is because governments have the power oftaxation


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Examples of Gilts Gilt Auctions

Since 1998 the Debt Management Office (DMO)has beenresponsible for gilt issuesIts objective is "to minimise over the long term the cost ofmeeting the government’s financing needs, taking into accountrisk, while ensuring that the debt management policy isconsistent with the objectives of monetary policy."Most gilts are sold by auction, typically 300m - 3bn.Bond dealers and large investors can make competitive bids(1m+) and, if successful, pay the price they bidIndividuals can make non-competitive bids, and pay the averageprice from the auction


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Outline



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Corporate Bonds

Corporate bonds come in a variety of forms: - Secured bonds(debentures / mortgage bonds) - Unsecured loan stock -Convertible bonds (convertible to equity shares)The key difference between corporate bonds and those issuedby government is in the probability of defaultCredit rating agencies exist to provide investors with guidance onthe probability an issuer will defaultGenerally, you would expect corporate bonds to yield more thangovernment bonds and this ’yield spread’ will be higher the lowerthe bond’s credit rating


2011 Finance Lecture 1

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