Securities Operations(25)


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Securities Operations(25)

  1. 1. 25 Securities Operations
  2. 2. Chapter Objectives <ul><li>Review and evaluate the key functions of investment banking firms </li></ul><ul><li>Describe the services provided by investment banking firms when they assist in issuing new stock issues </li></ul><ul><li>Analyze the risks of securities firms </li></ul><ul><li>Evaluate the key functions of brokerage firms </li></ul><ul><li>Evaluate the key factors impacting the value of securities firms </li></ul>
  3. 3. Investment Banking Services <ul><li>Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments </li></ul><ul><li>IBF’s serve both financing entities and investors: </li></ul><ul><ul><li>Serve as an intermediary buying securities (promise to pay) from issuing companies and selling them (securities) to investors </li></ul></ul><ul><ul><li>Generate fees for services rather than interest income </li></ul></ul><ul><ul><li>Sell investing services to institutional and other investors </li></ul></ul><ul><ul><li>Advise companies on mergers and acquisitions </li></ul></ul><ul><ul><ul><li>Value companies for sale or purchase </li></ul></ul></ul><ul><ul><ul><li>In recent years, loaned funds for mergers and acquisitions </li></ul></ul></ul>
  4. 4. Investment Banking Services Investment Banking Services Origination Underwriting Distribution Advising
  5. 5. How IBFs Facilitate New Stock Issues <ul><li>Origination </li></ul><ul><ul><li>Company wishes to issue additional stock or issue stock for the first time contacts IBF </li></ul></ul><ul><ul><ul><li>Gets advice on the amount to issue </li></ul></ul></ul><ul><ul><ul><li>Helps determine stock price for first-time issues </li></ul></ul></ul><ul><ul><li>IBF assists with SEC filings </li></ul></ul><ul><ul><ul><li>Registration statement </li></ul></ul></ul><ul><ul><ul><li>Prospectus—summary of registration statement given to prospective investors </li></ul></ul></ul>
  6. 6. How IBFs Facilitate New Stock Issues <ul><li>Underwriting stock </li></ul><ul><ul><li>Issuer and investment bank negotiate the underwriting spread </li></ul></ul><ul><ul><ul><li>The difference between the net price given the company and the selling price to investors </li></ul></ul></ul><ul><ul><ul><li>Incentive to under-price IPO’s </li></ul></ul></ul><ul><ul><li>The lead investment bank usually forms an underwriting syndicate </li></ul></ul><ul><ul><ul><li>Other IBFs underwrite a part of the security offering </li></ul></ul></ul><ul><ul><ul><li>Helps spread the underwriting risk among IBFs </li></ul></ul></ul>
  7. 7. How IBFs Facilitate New Stock Issues <ul><li>Distribution of stock </li></ul><ul><ul><li>Full underwriting vs. best efforts </li></ul></ul><ul><ul><li>IBFs in the syndicate have retail brokerage operations </li></ul></ul><ul><ul><li>Other IBF added as part of selling group </li></ul></ul><ul><ul><li>Corporation incurs flotation costs </li></ul></ul><ul><ul><ul><li>Underwriting spread </li></ul></ul></ul><ul><ul><ul><li>Direct issuance costs—accounting, legal fees, etc. </li></ul></ul></ul>
  8. 8. How IBFs Facilitate New Stock Issues <ul><li>Advising </li></ul><ul><ul><li>The IBF acts as an advisor throughout the process </li></ul></ul><ul><ul><ul><li>Corporations do not have the in-house expertise </li></ul></ul></ul><ul><ul><ul><li>Includes advice on: </li></ul></ul></ul><ul><ul><ul><ul><li>Timing </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Amount </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Terms </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Type of financing </li></ul></ul></ul></ul>
  9. 9. How IBFs Facilitate New Bond Issues <ul><li>Origination </li></ul><ul><ul><li>IBF may suggest a maximum amount of bonds that should be issued based on firm characteristics </li></ul></ul><ul><ul><li>Decisions on coupon rate, maturity </li></ul></ul><ul><ul><ul><li>Benchmark with market prices of bonds of similar risk </li></ul></ul></ul><ul><ul><ul><li>Credit rating </li></ul></ul></ul><ul><ul><li>Bond issuers must register with the SEC </li></ul></ul><ul><ul><ul><li>Registration Statement </li></ul></ul></ul><ul><ul><ul><li>Prospectus </li></ul></ul></ul>
  10. 10. How IBFs Facilitate New Bond Issues <ul><li>Underwriting bonds </li></ul><ul><ul><li>Public utilities often use competitive bids to select an IBF, versus….. </li></ul></ul><ul><ul><li>Corporations typically select an IBF based on reputation and prior working experience </li></ul></ul><ul><ul><li>The underwriting spread on bonds is lower than that for stocks </li></ul></ul><ul><ul><ul><li>Can place large blocks with institutional investors </li></ul></ul></ul><ul><ul><ul><li>Less market risk </li></ul></ul></ul>
  11. 11. How IBFs Facilitate New Bond Issues <ul><li>Distribution of bonds </li></ul><ul><ul><li>Prospectus </li></ul></ul><ul><ul><li>Advertisements to public </li></ul></ul><ul><ul><li>Flotation costs are typically in the range of 0.5 percent to 3 percent of face value </li></ul></ul>
  12. 12. How IBFs Facilitate New Bond Issues <ul><li>Private placement of bonds </li></ul><ul><ul><li>Avoids underwriting and SEC registration expenses </li></ul></ul><ul><ul><li>Potential purchaser may buy the entire issue </li></ul></ul><ul><ul><ul><li>Insurance companies </li></ul></ul></ul><ul><ul><ul><li>mutual funds </li></ul></ul></ul><ul><ul><ul><li>commercial banks </li></ul></ul></ul><ul><ul><ul><li>pension funds </li></ul></ul></ul><ul><ul><li>Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm </li></ul></ul><ul><ul><li>Investment banks may be involved to provide advice and find potential purchasers </li></ul></ul>
  13. 13. How IBFs Facilitate Leveraged Buyouts <ul><li>IBFs facilitate LBOs in three ways: </li></ul><ul><ul><li>They assess the market value of the LBO firm </li></ul></ul><ul><ul><li>They arrange financing </li></ul></ul><ul><ul><li>Purchase outstanding stock held by public </li></ul></ul><ul><ul><li>Often invest in the deal themselves </li></ul></ul><ul><ul><li>Provide advice </li></ul></ul>
  14. 14. How IBFs Facilitate Arbitrage <ul><li>Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price </li></ul><ul><li>IBFs work with arbitrage firms to search for undervalued firms </li></ul><ul><li>Asset stripping </li></ul><ul><ul><li>A firm is acquired, and then its individual divisions are sold off </li></ul></ul><ul><ul><li>Sum of the parts is greater than the whole </li></ul></ul><ul><ul><ul><li>Kohlberg, Kravis, and Roberts </li></ul></ul></ul>
  15. 15. How IBFs Facilitate Arbitrage <ul><li>IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity </li></ul><ul><li>IBFs also provide bridge loans </li></ul><ul><ul><li>When fund raising is not expected to be complete when the acquisition is initiated </li></ul></ul><ul><li>IBFs provide advice on takeover defense maneuvers </li></ul>
  16. 16. How IBFs Facilitate Arbitrage <ul><li>History of arbitrage activity </li></ul><ul><ul><li>Greenmail is when a target company buys back stock from arbitrage firm at a premium over market price </li></ul></ul><ul><ul><li>Arbitrage activity has been criticized </li></ul></ul><ul><ul><ul><li>Results in excessive financial leverage and risk for corporations </li></ul></ul></ul><ul><ul><ul><li>Restructuring sometimes results in layoffs </li></ul></ul></ul><ul><ul><li>Arbitrage helps remove managerial inefficiencies </li></ul></ul><ul><ul><li>Target shareholders can benefit from higher share prices </li></ul></ul>
  17. 17. Brokerage Services <ul><li>Full-service versus discount brokerage services </li></ul><ul><ul><li>Full-service firms provide investment advice as well as executing transactions </li></ul></ul><ul><ul><li>Discount brokerage firms only execute security transactions upon request </li></ul></ul><ul><ul><li>Online brokerage firms </li></ul></ul>
  18. 18. Allocation of Revenue Sources <ul><li>Importance of brokerage commissions has declined in recent years </li></ul><ul><li>Largest source of revenue has been trading and investment profits </li></ul><ul><li>Underwriting and margin interest also make up a significant portion of revenue </li></ul><ul><li>Revenue from fees earned on advising and executing acquisitions has increased over time </li></ul>
  19. 19. Regulation of Securities Firms <ul><li>Regulated by the National Association of Securities Dealers (NASD) and securities exchanges </li></ul><ul><li>The SEC regulates the issuance of securities and specifies disclosure rules for issuers </li></ul><ul><ul><li>Also regulates exchanges and brokerage firms </li></ul></ul><ul><li>SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties </li></ul>
  20. 20. Regulation of Securities Firms <ul><li>The Federal Reserve determines the credit limits (margin requirements) on securities purchased </li></ul><ul><li>The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts </li></ul><ul><ul><li>Insured up to $500,000 </li></ul></ul><ul><ul><li>Brokers pay premiums to SIPC to maintain the fund </li></ul></ul><ul><ul><li>Boosts investor confidence, increasing economic efficiency </li></ul></ul>
  21. 21. Regulation of Securities Firms <ul><li>Financial Services Modernization Act of 1999 </li></ul><ul><ul><li>Permitted banking, securities activities, and insurance to be offered by a single firm </li></ul></ul><ul><ul><li>Varied financial services organized as subsidiaries under special holding company </li></ul></ul><ul><ul><li>Financial holding companies regulated by the Federal Reserve </li></ul></ul>
  22. 22. Risks of Securities Firms Exchange Rate Risk Market Risk Interest Rate Risk Credit Risk
  23. 23. Risks of Securities Firms <ul><li>Market risk </li></ul><ul><ul><li>Securities firms’ activities are linked to stock market conditions </li></ul></ul><ul><ul><li>When stock prices are rising: </li></ul></ul><ul><ul><ul><li>Greater volume of stock offerings </li></ul></ul></ul><ul><ul><ul><li>Increased secondary market transactions </li></ul></ul></ul><ul><ul><ul><li>More mutual fund activity </li></ul></ul></ul><ul><ul><ul><li>Securities firms take equity positions which are bolstered when prices rise </li></ul></ul></ul>
  24. 24. Risks of Securities Firms <ul><li>Interest rate risk </li></ul><ul><ul><li>Performance of securities firms can be sensitive to interest rate movements because: </li></ul></ul><ul><ul><ul><li>Market values of bonds held as investments increase as interest rates fall </li></ul></ul></ul><ul><ul><ul><li>Lower rates can encourage investors to withdraw money from banks and invest in stocks </li></ul></ul></ul><ul><li>Exchange rate risk </li></ul><ul><ul><li>Operations in foreign countries </li></ul></ul><ul><ul><li>Investments in securities denominated in foreign currency </li></ul></ul>
  25. 25. Valuation of Securities Firms <ul><li>Value of a securities firm depends on its expected cash flows and required rate of return </li></ul> V = f [  E(CF),  k]  V = Change in value of the securities firm  k = Change in required rate or return Where:  E(CF) = Change in expected cash flows +
  26. 26. Valuation of Securities Firms <ul><li>Factors that affect cash flows </li></ul>E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions Where:  E(CF)= f (  ECON,  R f ,  INDUS,  MANAB) ECON = Economic growth MANAB = The ability of the security firm’s management + + ?
  27. 27. Valuation of Securities Firms <ul><li>Investors required rate of return </li></ul> k = f (  R f ,  RP) + + R f = Risk free interest rate Where: RP = Risk premium
  28. 28. Interaction With Other Financial Institutions <ul><li>Offer investment advice and execute security transactions for financial institutions that maintain security portfolios </li></ul><ul><li>Compete against financial institutions that have brokerage subsidiaries </li></ul><ul><li>Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms </li></ul><ul><li>Financial Services Modernization Act of 1999 </li></ul><ul><ul><li>Effectively repealed Glass-Steagall </li></ul></ul><ul><ul><li>Commercial banks, securities firms, and insurance companies will increasingly offer similar services </li></ul></ul>
  29. 29. Globalization of Securities Firms <ul><li>Securities firms have increased their presence in foreign countries </li></ul><ul><ul><li>Merrill Lynch has more than 500 offices spread across the world </li></ul></ul><ul><ul><ul><li>Allows them to place securities in various markets for corporations or governments </li></ul></ul></ul><ul><ul><ul><li>International M&A </li></ul></ul></ul><ul><ul><ul><li>Ability to handle transactions with foreign securities </li></ul></ul></ul>
  30. 30. Globalization of Securities Firms <ul><li>Growth in international securities transactions </li></ul><ul><ul><li>Created more business for large securities firms </li></ul></ul><ul><ul><ul><li>International stock offerings </li></ul></ul></ul><ul><ul><ul><li>Increased liquidity for issuing firm, avoiding downward price pressure </li></ul></ul></ul><ul><ul><li>Growth in Latin America </li></ul></ul><ul><ul><ul><li>Increased business due to NAFTA </li></ul></ul></ul><ul><ul><li>Growth in Japan </li></ul></ul><ul><ul><ul><li>Some barriers to foreign securities firms still exist </li></ul></ul></ul>