9-2The Capital MarketThe Capital MarketPublic IssuePrivileged SubscriptionRegulation of Security OfferingsPrivate PlacementInitial FinancingSignaling EffectsThe Secondary Market
9-3Deja Vu All Over AgainDeja Vu All Over AgainCapital MarketCapital Market -- The market for relativelylong-term (greater than one year originalmaturity) financial instruments.Primary MarketPrimary Market -- A market where newsecurities are bought and sold for thefirst time (a “new issues” market).Secondary MarketSecondary Market -- A market for existing(used) securities rather than new issues.
9-4Deja Vu All Over AgainDeja Vu All Over AgainINVESTMENT SECTORFINANCIALINTERMEDIARIESSAVINGS SECTORFINANCIAL BROKERSSECONDARY MARKETPublic issuePrivilegedsubscriptionPrivateplacementIndicates the possiblepresence of a“standby arrangement”Indicates the financialintermediaries’ ownsecurities flow to thesavings sector
9-5Public IssuePublic IssueSecurities are sold to hundreds, and oftenthousands, of investors under a formalcontract overseen by federal and stateregulatory authorities.When a company issues securities to thegeneral public, it is usually uses theservices of an investment bankerinvestment banker.Public IssuePublic Issue -- Sale of bonds or stockto the general public.
9-6Investment BankerInvestment BankerInvestment banker receives an underwriting spreadunderwriting spreadwhen acting as a middleman in bringing togetherproviders and consumers of investment capital.Underwriting spreadUnderwriting spread -- the difference between theprice the investment bankers pay for the securityand the price at which the security is resold to thepublic.Investment BankerInvestment Banker -- A financial institution thatunderwrites (purchases at a fixed price on afixed date) new securities for resale.
9-7Investment BankerInvestment BankerThus, the services can be provided at a lower costlower costto the firm than the firm can perform the sameservices internally.Three primary means companies use to offerThree primary means companies use to offersecurities to the general publicsecurities to the general public::Traditional (firm commitment) underwritingBest efforts offeringShelf registrationInvestment bankers have expertise, contacts, andthe sales organization to efficientlyefficiently marketsecurities to investors.
9-8Traditional UnderwritingTraditional UnderwritingIf the security issue does not sell well,either because of an adverse turn in themarket or because it is overpriced, thetheunderwriterunderwriter, not the company, takes theloss.UnderwritingUnderwriting -- Bearing the risk of not beingable to sell a security at the established priceby virtue of purchasing the security forresale to the public; also known as firmfirmcommitment underwritingcommitment underwriting.
9-9Traditional UnderwritingTraditional UnderwritingA.A. Competitive-bidCompetitive-bidThe issuing company specifies the date thatsealed bids will be received.Competing syndicates submit bids.The syndicate with the highest bid wins thesecurity issue.Underwriting SyndicateUnderwriting Syndicate -- A temporarycombination of investment banking firmsformed to sell a new security issue.
9-10Traditional UnderwritingTraditional UnderwritingThe issuing company selects an investmentbanking firm and works directly with the firm todetermine the essential features of the issue.Together they discuss and negotiate a price for thesecurity and the timing of the issue.Depending on the size of the issue, the investmentbanker may invite other firms to join in sharing therisk and selling the issue.Generally used in corporate stock and mostcorporate bond issues.B.B. Negotiated OfferingNegotiated Offering
9-11Traditional UnderwritingTraditional UnderwritingBest Efforts OfferingBest Efforts Offering -- A security offering in whichthe investment bankers agree to use only their bestefforts to sell the issuer’s securities. Theinvestment bankers do not commit to purchase anyunsold securities.Shelf RegistrationShelf Registration -- A procedure whereby acompany is permitted to register securities it plansto sell over the next two years; also called SEC RuleSEC Rule415415. These securities can then be sold piecemealwhenever the company chooses.
9-12Shelf Registration: FlotationShelf Registration: FlotationCosts and Other AdvantagesCosts and Other AdvantagesThis competition reduces underwriting spreads.The total fixed costs (legal and administrative) ofsuccessive public debt issues are lower with asingle shelf registration than with a series oftraditional registrations.The amount of “free” advice available fromunderwriters is less than before shelf registrationwas an alternative to firms.A firm with securities sitting “on the shelf” canrequire that investment banking firmscompetitively bid for its underwriting business.
9-13Privileged SubscriptionPrivileged SubscriptionPrivileged SubscriptionPrivileged Subscription -- The sale of new securitiesin which existing shareholders are given apreference in purchasing these securities up to theproportion of common shares that they already own;also known as a rights offeringrights offering.Preemptive RightPreemptive Right -- The privilege of shareholders tomaintain their proportional company ownership bypurchasing a proportionate share of any new issueof common stock, or securities convertible intocommon stock.
9-14Terms of OfferingTerms of OfferingTerms specifyTerms specify::the number of rights required to subscribefor an additional share of stockthe subscription price per sharethe expiration date of the offeringRightRight -- A short-term option to buy a certainnumber (or fraction) of securities from the issuingcorporation; also called a subscription rightsubscription right.
9-15Subscription RightsSubscription RightsGenerally, the subscriptionGenerally, the subscriptionperiod 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 foradditional sharesSell the rights (they are transferable)Do nothing and let the rights expire
9-16Subscription RightsSubscription RightsThe shareholder can then purchase 7 shares(use 70 rights) and still retain the 7 remainingrights. Thus, the shareholder needs toThus, the shareholder needs topurchase an additional 3 rights.purchase an additional 3 rights.A shareholder who owns 77 shares andjust received 77 rights would like topurchase 8 new shares. It takes 10 rightsfor each new share. What action shouldWhat action shouldthe shareholder take?the shareholder take?
9-17Value of RightsValue of RightsA right allows you to buy new stock at adiscount that typically ranges between 10 to 20percent 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 stockthe subscription pricethe number of rights required to purchase anadditional share of stockWhat gives a right its value?What gives a right its value?
9-18PP00 - RR00 = [ (RR00)(NN) + SS ], thereforeRR00 = PP00 - [ (RR00)(NN) + SS ]RR00 = the market price of one right when the stock isselling “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 oneshare of stockHow is the Value of aHow is the Value of aRight Determined?Right Determined?
9-19Solving for RR00.How is the Value of aHow is the Value of aRight Determined?Right Determined?PP00 - SSNN + 1RR00 =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.(PP00 )(NN) + SSNN + 1PPXX =
9-20Example of theExample of theValuation of a RightValuation of a RightAssume the following informationAssume the following information:The current market pricecurrent market price of a stock“rights-on” is $50.$50.The subscription price is $40.subscription price is $40.It takes nine rightsnine rights to buy anadditional share of stock.What is the value of a right when the stock isWhat is the value of a right when the stock isselling “rights-on”?selling “rights-on”? What is the value of oneWhat is the value of oneshare of stock when it goes “ex-rights”?share of stock when it goes “ex-rights”?
9-21Solving for RR00.Solving for PPXX.How is the Value of aHow is the Value of aRight Determined?Right Determined?$50$50 - $40$4099 + 1RR00 =RR00 = $1$1($50$50 )(99) + $40$4099 + 1PPXX =PPXX = $49$49
9-22Theoretical versusTheoretical versusActual Value of RightsActual Value of RightsTransaction costsSpeculationIrregular exercise and sale of rightsover the subscription periodArbitrage acts to limit the deviation ofArbitrage acts to limit the deviation ofthe actual right value from thethe actual right value from thetheoretical value.theoretical value.Why might the actual value of a rightWhy might the actual value of a rightdiffer from its theoretical value?differ from its theoretical value?
9-23Standby ArrangementStandby ArrangementFee often composed of a flat fee and an additionalfee for each unsold share of stock.The greater the risk of an unsuccessful rightsoffering, the more desirable a standby arrangement.Standby ArrangementStandby Arrangement -- A measure taken toensure the complete success of a rightsoffering in which an investment banker orgroup of investment bankers agrees to“stand by” to underwrite any unsubscribed(unsold) portion of the issue.
9-24Oversubscription PrivilegeOversubscription PrivilegeFor example, shareholders subscribe for 450,000shares of a 500,000-share rights offering. Let usassume that some shareholders would like moreshares and oversubscribe by 80,000 shares.As a result, each shareholder oversubscribingreceives 5/8ths (50,000 / 80,000) of a share for eachshare oversubscribed.Oversubscription PrivilegeOversubscription Privilege -- The right topurchase, on a pro rata basis, anyunsubscribed shares in a rights offering.
9-25Privileged SubscriptionPrivileged Subscriptionversus Underwritten Issueversus Underwritten IssueInvestors are familiar with the firm’s operationswhen using a rights offering.The principal sales tool is a discounted price(rights offering) and the investment bankingorganization (underwriting).A disadvantage of a rights offering is that theshares will be sold at a lower price.There is greater dilution with a rights offeringwhich many firms attempt to avoid.There is a wider distribution of shares with apublic offering.
9-26Regulation of SecurityRegulation of SecurityOfferings -- FederalOfferings -- FederalSecurities Exchange Act of 1934Securities Exchange Act of 1934 --Regulates the secondary market for long-term securities -- the securities exchangesand the over-the-counter market.Securities Act of 1933Securities Act of 1933 -- Generally requiresthat public offerings be registered with thefederal 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.
9-27Regulation of SecurityRegulation of SecurityOfferings -- FederalOfferings -- FederalPart 1Part 1:: ProspectusProspectus -- Discloses informationabout the issuing company and its newoffering and is distributed to investors.Part 2Part 2: Additional information required by theSEC that is not part of the printedprospectus.Registration StatementRegistration Statement -- The disclosuredocument filed with the SEC in order toregister a new securities issue.
9-28Red HerringRed HerringSEC reviews the registration statement to see thatall the required information is presented and that itis not misleading.Deficiencies are communicated in a comment lettercomment letter.Once the SEC is satisfied, it approves theregistration. If not, it issues a stop orderstop order.Red HerringRed Herring -- The preliminary prospectus. Itincludes a legend in red ink on the coverstating that the registration statement has notyet become effective.
9-29Regulation of SecurityRegulation of SecurityOfferings -- FederalOfferings -- FederalRegistration statements becomeeffective on the 20th day after filing(or on the 20th day after filing thelast amendment).The SEC, at its discretion, canadvance the date. Typical time fromfiling to approval is 40 days.Registration Statement Effective DateRegistration Statement Effective Date
9-30Regulation of SecurityRegulation of SecurityOfferings -- FederalOfferings -- FederalA shelf registration allows a company toregister with the SEC “in advance” of asecurity offering.The company can sell “off the shelf” by filinga simple amendment and having the SECaccelerate the “normal” 20-day waitingperiod accorded amendments.Typically, the waiting period following thissimple amendment is only a day or two.Impact with shelf registration:Impact with shelf registration:
9-31Regulation of SecurityRegulation of SecurityOfferings -- FederalOfferings -- FederalThe term reflects the stark, black-borderedlook of the ad (see Slide 19-32).Includes the company’s name, a briefdescription of the security, the offeringprice, and the names of the investmentbankers in the underwriting syndicate.Tombstone AdvertisementTombstone Advertisement -- Anannouncement placed in newspapers andmagazines giving just the most basic detailsof a security offering.
9-32Regulation of SecurityRegulation of SecurityOfferings -- StateOfferings -- StateIndividual states have security commissions thatregulate securities in their states.These laws are particularly important when asecurity issue is sold entirely to people within thestate 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 LawsBlue Sky Laws -- State laws regulating theoffering and sale of securities.
9-33Private PlacementPrivate PlacementEliminates the underwriting function of theinvestment banker.The dominant private placement lender in thisgroup is the life-insurance category (pensionfunds and bank trust departments are veryactive as well).Private (or Direct) PlacementPrivate (or Direct) Placement -- The sale of anentire issue of unregistered securities (usuallybonds) directly to one purchaser or a group ofpurchasers (usually financial intermediaries).
9-34PrivatePrivatePlacement FeaturesPlacement FeaturesAllows 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 ofthe borrower.Flexibility in borrowing smaller amountsmore frequently rather than a single largeamount.
9-35Private Placement andPrivate Placement andOther DevelopmentsOther DevelopmentsQualified Institutional Buyers (QIBs)Qualified Institutional Buyers (QIBs) --Eligible purchasers, by SEC Rule 144a, ofprevious securities from a privateplacement without having to go through apublic market registration.Event RiskEvent Risk -- The risk that existing debtwill suffer a decline in creditworthinessbecause of the issuance of additional debtsecurities, usually in connection withcorporate restructuring.
9-36Private Placement andPrivate Placement andOther DevelopmentsOther DevelopmentsUnderwritten Rule 144a Private PlacementUnderwritten Rule 144a Private Placement –The issuer sells its securities initially to aninvestment bank that resells them to thesame institutional buyers that are candidatesfor a regular private placement. Oftenincludes registration rights.Private Placement with Registration RightsPrivate Placement with Registration Rights –It combines a standard private placementwith a contract requiring the issuer toregister the securities with the SEC forpossible resale in the public market.
9-37Initial Financing --Initial Financing --Venture CapitalVenture CapitalWealthy investors and financial institutions are theprimary providers of funds for a new enterprise(usually common stock).Rule 144 and the 1933 Act require privately placedsecurities to be held for at least two years or beregistered before they can be resold.Letter stockLetter stock * -- Privately placed common stock thatcannot be immediately resold.* Note: Under SEC Rule 144a, however, letter stock couldbe sold to qualified institutional buyers (QIBs) without awaiting period.
9-38Initial Public Offering (IPO)Initial Public Offering (IPO) -- A company’s firstoffering of common stock to the general public.Initial Financing --Initial Financing --Initial Public OfferingsInitial Public OfferingsOften prompted by venture capitalists whowish to realize a cash return on theirinvestment.Founders of the firm may wish to go throughan IPO to establish a value for their company.There exists greater price uncertainty with anIPO than with other new public stock issues.
9-39Signaling EffectsSignaling EffectsNegative stockprice reaction tocommon stock orconvertibleissues.Straight debt andpreferred stockdo not tend toshow statisticallysignificanteffects.-10 -8 -6 -4 -2 0 2 4 6 80-1-2-3-4321CumulativeAverageAbnormalReturn(%)Time Around Announcement (in days)Relative AbnormalRelative AbnormalStock Returns for aStock Returns for aNew Equity IssueNew Equity Issue
9-40Possible ExplanationsPossible Explanationsfor Price Reactionsfor Price ReactionsAsymmetric (Unequal) InformationAsymmetric (Unequal) InformationPotential investors have less information thanmanagement (particularly for common stock).Exchanges of different types of securities show thatincreases (decreases) in financial leverage areassociated with positive (negative) abnormal returns.Expectations of Future Cash FlowsExpectations of Future Cash FlowsThe unexpected sale of securities may be associatedwith lower than expected operating cash flows andinterpreted as bad news. Hence, the stock pricemight suffer accordingly.
9-41The Secondary MarketThe Secondary MarketPurchases and sales of existing stocks and bondsoccur in the secondary market.Transactions in the secondary market do not provideadditional funds to the firm.The secondary market increases the liquidity ofsecurities outstanding and lowers the requiredreturns of investors.Composed of organized exchanges like the New YorkStock Exchange and American Stock Exchange plusthe over-the-counter (OTC) market.