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  1. 1. Common Stock and the Investment Banking Process Besley Chapter 16
  2. 2. Balance Sheet Accounts and Definitions <ul><li>Common Equity </li></ul><ul><ul><li>The sum of the firm’s common stock, paid in capital, and retained earnings, which equals the common stockholders’ total investment in the firm, stated at book value </li></ul></ul><ul><li>Par Value </li></ul><ul><ul><li>The nominal or face value of a stock or bond </li></ul></ul>
  3. 3. Balance Sheet Accounts and Definitions <ul><li>Retained Earnings </li></ul><ul><ul><li>The balance sheet account that indicates the total amount of earnings the firm has not paid out as dividends throughout its history </li></ul></ul><ul><li>Additional Paid-In Capital </li></ul><ul><ul><li>Funds received in excess of par value when a firm issues new stock </li></ul></ul>
  4. 4. Common Equity Accounts as of December 31 <ul><li>(in millions of dollars, except per share data) </li></ul><ul><li>2000 1999 </li></ul><ul><li>Common Stock (40 million sh. </li></ul><ul><li>authorized, 25 million sh. out, $1par) $25.0 $25.0 </li></ul><ul><li>Additional paid-in Capital 105.0 105.0 </li></ul><ul><li>Retained Earnings 285.0 260.0 </li></ul><ul><li>Total Common Stockholder Equity 415.0 390.0 </li></ul><ul><li>Book Value per Share $16.60 $15.60 </li></ul>
  5. 5. Balance Sheet Accounts and Definitions <ul><li>Book Value Per Share </li></ul><ul><ul><li>The accounting value of a share of common stock </li></ul></ul>Book Value is based on historic value and may differ greatly from market value. <ul><ul><li>Common stock + Paid-in capital + Retained earnings </li></ul></ul><ul><ul><li>Number of shares outstanding </li></ul></ul>=
  6. 6. Control of the Firm <ul><li>Stockholders elect the firm’s directors, who select the officers that manage the business. </li></ul><ul><li>Normally, each share entitles the owner to one vote. </li></ul><ul><li>Proxy - A document giving one person the authority to act for another, typically the power to vote shares of common stock. </li></ul>Legal Rights and Privileges of Common Stockholders
  7. 7. Control of the Firm <ul><li>Proxy Fight - An attempt by a person or group to gain control of a firm by getting its stockholders to grant the person or group the authority to vote their shares in order to elect a new management team. </li></ul>Legal Rights and Privileges of Common Stockholders
  8. 8. Control of the Firm <ul><li>Takeover - An action whereby a person or group succeeds in ousting a firm’s management and taking control of the company. </li></ul><ul><li>Management attempts to prevent takeovers include: </li></ul><ul><ul><li>Stagger Director elections – elect 1/3 of the directors each year. </li></ul></ul><ul><ul><li>Shareholder approvals - Require 75% of the shareholders to approve a merger (rather than 50%). </li></ul></ul><ul><ul><li>“ Poison Pills” – provision that allows shareholders, during a take over, to purchase additional shares at a discounted rate (which makes the take over undesirable). </li></ul></ul>Legal Rights and Privileges of Common Stockholders
  9. 9. The Preemptive Right <ul><li>A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities). </li></ul>Legal Rights and Privileges of Common Stockholders
  10. 10. Types of Common Stock <ul><li>Classified Stock - Common stock that is given a special designation, such as Class A, Class B, etc., to meet the special needs of the company </li></ul><ul><li>Founder’s Shares - The class of stock owned by the firm’s founders who have sole voting rights </li></ul>
  11. 11. From the Corporation’s Viewpoint <ul><li>Advantages </li></ul><ul><li>Common stock does not obligate the firm to make payment to shareholders. </li></ul><ul><li>Carries no fixed maturity date. </li></ul><ul><li>Generally increases a firm’s creditworthiness, raises bond rating, lowers cost of capital. </li></ul><ul><li>When a firm’s future appears positive, common stock can be sold for on better terms. </li></ul><ul><li>Disadvantages </li></ul><ul><li>Gives voting rights and perhaps control to new shareholders. </li></ul><ul><li>Dilution of Profits (especially when compared to debt financing) </li></ul><ul><li>Higher issuance costs </li></ul><ul><li>Where the firm has exceeded it optimal capital structure, the cost of capital will be higher than necessary. </li></ul><ul><li>Non-deductability of dividends for tax purposes </li></ul>Evaluation of Common Stock as a Source of Funds
  12. 12. From a Social Viewpoint <ul><li>Common stock does not require periodic fixed payments, which may add additional financial pressure during times of hardship. </li></ul>Evaluation of Common Stock as a Source of Funds
  13. 13. Corporations and Markets <ul><li>Closely Held Corporation - One that is owned by a few individuals who are typically associated with the firm’s management </li></ul><ul><li>Publicly Owned Corporation - One that is owned by a relatively large number of individuals who are not involved in its management </li></ul><ul><li>Over-The-Counter (OTC) Market - The network of dealers that provides for trading securities not listed on the organized exchanges (these stocks are generally said to be unlisted ) </li></ul><ul><li>Organized Security Exchange - A formal organization having a tangible physical location, that facilitates trading in “listed” securities: NYSE, AMEX </li></ul>The Market for Common Stock
  14. 14. Corporations and Markets <ul><li>Companies generally first list on a regional exchange (such as the Chicago, or Midwest Exchange) </li></ul><ul><li>As the company grows it will move up to the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE) </li></ul><ul><li>Most Companies are traded on the OTC market (5,000 to 8,000 actively traded stocks), however, the NYSE (which lists approximately 3,000 stocks) accounts for about 60% of the daily transactions. </li></ul><ul><li>Institutional investors (which include pension trusts; insurance companies; and mutual funds) own approximately 45 – 50% of all common stock and account for more than 75% of the trading volume. </li></ul>The Market for Common Stock
  15. 15. Types of Stock Market Transactions <ul><li>Primary Markets : </li></ul><ul><li>New public offerings by privately held firms </li></ul><ul><ul><li>Initial Public Offering (IPO) Market - The market consisting of stocks that have just gone public </li></ul></ul><ul><ul><li>Going Public - The act of selling stock to the public at large by a closely held corporation or its principal stockholders </li></ul></ul><ul><li>Additional shares sold by established, publicly owned companies </li></ul><ul><li>The Secondary Market - Trading in the outstanding shares of established, publicly owned companies </li></ul>The Market for Common Stock
  16. 16. Types of Stock Market Transactions <ul><li>The need for additional capital prompts companies to “go public.” </li></ul><ul><li>A firm will look to the equity markets when its growth can no longer be financed by solely by additional debt and the existing stockholder base. </li></ul><ul><li>The additional financing opportunities provided by the markets do require strict financial reporting and disclosure as well as adherence security regulations. </li></ul>The Market for Common Stock
  17. 17. The Decision to List the Stock <ul><li>To have its stock listed, a company must: </li></ul><ul><ul><li>Apply to the exchange </li></ul></ul><ul><ul><li>Pay a relatively small fee </li></ul></ul><ul><ul><li>Meet the exchange’s minimum requirements </li></ul></ul><ul><ul><ul><li>Net Income </li></ul></ul></ul><ul><ul><ul><li># of shares outstanding and held by outsiders </li></ul></ul></ul><ul><li>Benefits of listing: </li></ul><ul><ul><li>Listed companies receive free advertising and publicity </li></ul></ul><ul><ul><li>Status as a listed company enhances their prestige </li></ul></ul>The Market for Common Stock
  18. 18. The Decision to List the Stock The Market for Common Stock
  19. 19. Regulation of Securities Markets <ul><li>Securities Exchange Commission </li></ul><ul><li>The U.S. Government agency that regulates the issuance and trading of stocks and bonds </li></ul><ul><li>Registration Statement </li></ul><ul><li>A statement of facts filed with the SEC about a company that plans to issue securities </li></ul><ul><li>Prospectus </li></ul><ul><li>A document describing a new security issue and the issuing company </li></ul><ul><li>SEC lawyers and accountants analyze both the registration statement and the prospectus; if the information is inadequate or misleading, the SEC will delay or stop the public offering. </li></ul>The Market for Common Stock
  20. 20. Regulation of Securities Markets <ul><li>Securities Exchange Commission Regulations: </li></ul><ul><ul><li>Ensure investors receive fair financial disclosure from publicly traded companies </li></ul></ul><ul><ul><li>Discourage fraudulent and misleading behavior by the firm’s investors, owners, and employees with the intent of manipulating the stock’s price </li></ul></ul>The Market for Common Stock
  21. 21. Regulation of Securities Markets <ul><li>Elements of SEC regulation: </li></ul><ul><li>Jurisdiction over all interstate offerings of new securities to the general public in amounts of $1.5 million or more. </li></ul><ul><li>Regulates all national securities exchanges, and companies whose securities are listed on an exchange must file annual reports similar to the registration statement with both the SEC and the exchange. </li></ul>The Market for Common Stock
  22. 22. Regulation of Securities Markets <ul><li>Elements of SEC regulation: </li></ul><ul><li>Reviews stock trades by corporate insiders. </li></ul><ul><ul><li>Insiders must file monthly reports of changes in their holdings of the firm’s stock. </li></ul></ul><ul><ul><li>Insiders: Officers, directors, major shareholders, or others who might have inside, or privileged information on a company’s operations. </li></ul></ul><ul><li>Power to prohibit manipulation </li></ul><ul><li>Control over the form of the proxy and the way the company uses it to solicit votes. </li></ul>The Market for Common Stock
  23. 23. Regulation of Securities Markets <ul><li>The Board of Governors of the Federal Reserve System controls the flow of credit into securities transactions through: </li></ul><ul><ul><li>Margin Requirements - The percentage of a security’s purchase price that must be deposited by investors (currently 50%) </li></ul></ul><ul><ul><li>Margin Call - a call from a broker asking for more money to support a stock purchase loan </li></ul></ul><ul><ul><li>Blue Sky Laws - State laws that prevent the sale of securities that have little or no asset backing </li></ul></ul>The Market for Common Stock
  24. 24. Regulation of Securities Markets <ul><li>The Board of Governors of the Federal Reserve System controls the flow of credit into securities transactions through: </li></ul><ul><ul><li>Margin Requirements - The percentage of a security’s purchase price that must be deposited by investors (currently 50%) </li></ul></ul><ul><ul><li>Margin Call - a call from a broker asking for more money to support a stock purchase loan </li></ul></ul><ul><ul><li>Blue Sky Laws - State laws that prevent the sale of securities that have little or no asset backing </li></ul></ul>The Market for Common Stock
  25. 25. American Depository Receipts (ADRs) <ul><li>Certificates presenting ownership in stocks of foreign companies; held in trust by a bank in the country in which the stock is traded, and traded on U.S. markets </li></ul>Financial Instruments in International Markets Foreign Equity Instruments Euro Stock - a stock that is traded in countries other than the home country of the company Yankee Stock - stock issued by foreign companies that is traded in the United States
  26. 26. Investment Banker <ul><li>An organization that underwrites and distributes new issues of securities </li></ul><ul><li>Helps businesses and other entities obtain needed financing </li></ul>The Investment Banking Process
  27. 27. Raising Capital: Stage I Decisions <ul><li>Dollars to be raised </li></ul><ul><li>2. Type of securities used </li></ul><ul><li>3. Competitive bid versus negotiated deal </li></ul><ul><li>4. Selection of an investment banker </li></ul>The Investment Banking Process
  28. 28. Raising Capital: Stage II Decisions <ul><li>Reevaluating the initial decisions </li></ul><ul><li>Best efforts or underwritten issues </li></ul><ul><ul><li>Underwritten Arrangement - agreement for the sale of securities in which the investment bank guarantees the sale by purchasing the securities from the issuer </li></ul></ul><ul><ul><li>Best Effort Arrangement - investment bank handling the transaction gives no guarantee that the securities will be sold </li></ul></ul><ul><li>Issuance Costs </li></ul><ul><ul><li>Underwriter’s Spread - The difference between the price at which the investment banking firm buys an issue from the company and the price at which the securities are sold in the primary market </li></ul></ul><ul><ul><li>Flotation Costs - The costs associated with issuing new stocks or bonds </li></ul></ul><ul><li>Setting the offering price </li></ul><ul><ul><li>Offering Price - The price at which common stock is sold to the public </li></ul></ul>The Investment Banking Process
  29. 29. Selling Procedures <ul><li>Underwriting Syndicate </li></ul><ul><ul><li>A syndicate of investment firms formed to spread the risk associated with the purchase and distribution of a new issuance of securities </li></ul></ul><ul><li>Lead or Managing Underwriter </li></ul><ul><ul><li>The member of an underwriting syndicate who actually manages the distribution and sale of a new security offering </li></ul></ul><ul><li>Selling Group </li></ul><ul><ul><li>A group (network) of brokerage firms formed for the purpose of distributing a new issuance of securities </li></ul></ul>The Investment Banking Process
  30. 30. Shelf Registrations <ul><li>Securities are registered with the SEC for sale at a later date </li></ul><ul><li>They are held “on the shelf” until the sale </li></ul>The Investment Banking Process
  31. 31. Maintenance of the Secondary Market <ul><li>When a company is going public for the first time the investment banker is obligated to maintain a market for the shares after the issue has been completed </li></ul><ul><li>The lead underwriter agrees to “make a market” in the stock and keep it reasonably liquid </li></ul>The Investment Banking Process

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