Financial Management Chapter 14 IM 10th Ed

8/2/2019 Financial Management Chapter 14 IM 10th Ed

1/10

Prof. Rushen Chahal

CHAPTER 14

Raising Capitalin the Financial Markets

CHAPTER ORIENTATION

This chapter considers the market environment in which long-term capital is raised. Theunderlying rationale for the existence of security markets is presented, investment bankingservices and procedures are detailed, private placements are discussed, and security market

regulation is reviewed.

CHAPTER OUTLINE

I. The mix of corporate securities sold in the capital market.

A. When corporations raise cash in the capital market, what type of financingvehicle is most favored? The answer to this question is corporate bonds. Thecorporate debt markets clearly dominate the corporate equity markets whennew (external) funds are being raised.

B. From our discussion on the cost of capital, we understand that the U.S. taxsystem inherently favors debt as a means of raising capital. During the 1999-2001 period, bonds and notes accounted for about 76.9 percent of newcorporate securities sold for cash.

II. Why financial markets exist

A. Financial markets consist of institutions and procedures that facilitatetransactions in all types of financial claims.

B. Some economic units spend more than they earn during a given period oftime. Some economic units spend less than they earn. Accordingly, amechanism is needed to facilitate the transfer of savings from those economicunits that have a savings surplus to those that have a savings deficit. Financialmarkets provide such a mechanism.

C. The function of financial markets then is to allocate savings in an economy tothe ultimate demander (user) of the savings.

D. If there were no financial markets, the wealth of an economy would belessened. Savings could not be transferred to economic units, such as businessfirms, which are most in need of those funds.

88


2/10

Prof. Rushen Chahal

III. Financing business: The movement of funds through the economy.

A. In a normal year the household sector is the largest net supplier of funds to thefinancial markets. We call the household sector then a savings-surplus sector.

1. The household sector can also be a savings-deficit sector.

2. From 1995 1999, the household sector was a net user of financialcapital as a result of taking advantage of low interest rate mortgages.

B. In contrast, the nonfinancial business sector is typically a savings-deficitsector.

1. The nonfinancial business sector can also be a savings-surplus sector.

2. Economic conditions and corporate profitability influence the abilityof this sector to provide funds to the financial market.

C. In recent years, the foreign sector has become a major savings-surplus sector.

D. Within the domestic economy, the nonfinancial business sector is dependent

on the household sector to finance its investment needs.

E. The movement of savings through the economy occurs in three distinct ways:

1. The direct transfer of funds

2. Indirect transfer using the investment banker

3. Indirect transfer using the financial intermediary

IV. Components of the U.S. financial market system

A. Public offerings can be distinguished from private placements.

1. The public (financial) market is an impersonal market in which both

individual and institutional investors have the opportunity to acquiresecurities.

a. A public offering takes place in the public market.

b. The security-issuing firm does not meet (face-to-face) theactual investors in the securities.

2. In a private placement of securities, only a limited number of investorshave the opportunity to purchase a portion of the issue.

a. The market for private placements is more personal than itspublic counterpart.

b. The specific details of the issue may actually be developed ona face-to-face basis among the potential investors and theissuer.

89


3/10

Prof. Rushen Chahal

c. Venture capital

(1) Start-up firms often turn to venture capitalists to raisefunds.

(a) Broader public markets find these firms too

risky.(b) Venture capitalists are willing to accept the

risks because of an expectation of higherreturns.

(1) Venture capital firms that acquire equity in a start-upfirm manage risk by sitting on the firms board ofdirectors or actively monitoring managementsactivities.

(2) Venture capital is often provided by established non-venture-capitalist firms that take a minority investment

position in an emerging firm or create a separateventure capital subsidiary.

(a) The investment approach allows the establishedfirm to gain access to new technology and tocreate strategic alliances.

(b) The subsidiary approach allows the establishedfirm to retain human and intellectual capital.

B. Primary markets can be distinguished from secondary markets.

1. Securities are first offered for sale in a primary market. For example,the sale of a new bond issue, preferred stock issue, or common stockissue takes place in the primary market. These transactions increasethe total stock of financial assets in existence in the economy.

2. Trading in currently existing securities takes place in the secondarymarket. The total stock of financial assets is unaffected by suchtransactions.

C. The money market can be distinguished from the capital market.

1. The money market consists of the institutions and procedures thatprovide for transactions in short-term debt instruments which aregenerally issued by borrowers who have very high credit ratings.

a. "Short-term" means that the securities traded in the moneymarket have maturity periods of not more than 1 year.

b. Equity instruments are not traded in the money market.

c. Typical examples of money market instruments are (l) U.S.Treasury bills, (2) federal agency securities, (3) bankers'acceptances, (4) negotiable certificates of deposit, and (5)commercial paper.

90


4/10

Prof. Rushen Chahal

2. The capital market consists of the institutions and procedures that provide for transactions in long-term financial instruments. Thismarket encompasses those securities that have maturity periodsextending beyond 1 year.

D. Organized security exchanges can be distinguished from over-the-counter

markets.

1. Organized security exchanges are tangible entities whose activities aregoverned by a set of bylaws. Security exchanges physically occupyspace and financial instruments are traded on such premises.

a. Major stock exchanges must comply with a strict set ofreporting requirements established by the Securities andExchange Commission (SEC). These exchanges are said to beregistered.

b. Organized security exchanges provide several benefits to bothcorporations and investors. They (l) provide a continuous

market, (2) establish and publicize fair security prices, and (3)help businesses raise new financial capital.

c. A corporation must take steps to have its securities listed on anexchange in order to directly receive the benefits noted above.Listing criteria differ from exchange to exchange.

2. Over-the-counter markets include all security markets except theorganized exchanges. The money market is a prominent example.Most corporate bonds are traded over-the-counter.

a. NASDAQ, a telecommunication system providing aninformation link among brokers and dealers in the OTC

markets, accounted for 43% of the national exchange equitymarket trading in the U.S., measured in dollar volume for theyear 1998.

Nasdaq Stock Market, Inc. trades securities of over 3,600public companies as of 2002.

V. The Investment Banker

A. The investment banker is a financial specialist who acts as an intermediary inthe selling of securities. The investment banker works for an investmentbanking house (firm).

B. Three basic functions are provided by the investment banker:

1. The investment banker assumes the risk of selling a new security issueat a satisfactory (profitable) price. This is called underwriting.Typically, the investment banking house, along with the underwritingsyndicate, actually buys the new issue from the corporation that israising funds. The syndicate (group of investment banking firms) thensells the issue to the investing public at a higher (hopefully) price thanit paid for it.

91


5/10

Prof. Rushen Chahal

2. The investment banker provides for the distribution of the securities tothe investing public.

3. The investment banker advises firms on the details of sellingsecurities.

C. Several distribution methods are available for placing new securities into thehands of final investors. The investment banker's role is different in each case.

1. In a negotiated purchase, the firm in need of funds contacts aninvestment banker and begins the sequence of steps leading to thefinal distribution of the securities that will be offered. The price thatthe investment banker pays for the securities is "negotiated" with theissuing firm.

2. In a competitive-bid purchase, the investment banker andunderwriting syndicate are selected by an auction process. Thesyndicate willing to pay the greatest dollar amount per new security tothe issuing firm wins the competitive bid. This means that it will

underwrite and distribute the issue. In this situation, the price paid tothe issuer is not negotiated; instead, it is determined by a sealed-bidprocess much on the order of construction bids.

3. In a commission (or best-efforts), offering the investment banker doesnot act as an underwriter but rather attempts to sell the issue in returnfor a fixed commission on each security that is actually sold. Unsoldsecurities are simply returned to the firm hoping to raise funds.

4. In a privileged subscription, the new issue is not offered to theinvesting public. It is sold to a definite and limited group of investors.Current stockholders are often the privileged group.

5. In a direct sale, the issuing firm sells the securities to the investingpublic without involving an investment banker in the process. This isnot a typical procedure.

VI. More on Private placements: The Debt Side

A. Each year billions of dollars of new securities are privately (directly) placedwith final investors. In a private placement, a small number of investorspurchase the entire security offering. Most private placements involve debtinstruments.

B. Large financial institutions are the major investors in private placements.These include (l) life insurance firms, (2) state and local retirement funds, and

(3) private pension funds.

C. The advantages and disadvantages of private placements as opposed to publicofferings must be carefully evaluated by management.

1. The advantages include (a) greater speed than a public offering inactually obtaining the needed funds, (b) lower flotation costs than areassociated with a public issue, and (c) increased flexibility in thefinancing contract.

92


6/10

Prof. Rushen Chahal

2. The disadvantages include (a) higher interest costs than are ordinarilyassociated with a comparable public issue, (b) the imposition ofrestrictive covenants in the financing contract, and (c) the possibilitythat the security may have to be registered some time in the future atthe lender's option.

VII. Flotation costs

A. The firm raising long-term capital typically incurs two types of flotation costs:(l) the underwriter's spread and (2) issuing costs. The former is typically thelarger.

1. The underwriter's spread is the difference between the gross and netproceeds from a specific security issue. This absolute dollar differenceis usually expressed as a percent of the gross proceeds.

2. Many components comprise issue costs. The two most significant are(l) printing and engraving and (2) legal fees. For comparison purposes,these are usually expressed as a percent of the issue's gross proceeds.

B. SEC data reveal two relationships about flotation costs.

1. Issue costs (as a percent of gross proceeds) for common stock exceedthose of preferred stock, which exceed those of bonds.

2. Total flotation costs per dollar raised decrease as the dollar size of thesecurity issue increases.

VIII. Regulation

A. The primary market is governed by the Securities Act of 1933.

1. The intent of this federal regulation is to provide potential investorswith accurate and truthful disclosure about the firm and the newsecurities being sold.

2. Unless exempted, the corporation selling securities to the public mustregister the securities with the SEC.

3. Exemptions allow follow for a variety of conditions. For example, ifthe size of the offering is small enough (less than $1.5 million), theoffering does not have to be registered. If the issue is already regulatedor controlled by some other federal agency, registration with the SECis not required. Railroad issues and public utility issues are examples.

4. If not exempted, a registration statement is filed with the SECcontaining particulars about the security-issuing firm and the newsecurity.

5. A copy of the prospectus, a summary registration statement, is alsofiled. It will not yet have the selling price of the security printed on it;it is referred to as a red herring and called that until approved by theSEC.

6. If the information in the registration statement and prospectus issatisfactory to the SEC, the firm can proceed to sell the new issue. If

93


7/10

Prof. Rushen Chahal

the information is not satisfactory, a stop order is issued whichprevents the immediate sale of the issue. Deficiencies have to becorrected to the satisfaction of the SEC before the firm can sell thesecurities.

7. The SEC does not evaluate the investment quality of any issue. It is

concerned instead with the presentation of complete and accurateinformation upon which the potential investor can act.

B. The secondary market is regulated by the Securities Exchange Act of 1934.This federal act created the SEC. It has many aspects.

1. Major security exchanges must register with the SEC.

2. Insider trading must be reported to the SEC.

3. Manipulative trading that affects security prices is prohibited.

4. Proxy procedures are controlled by the SEC.

5. The Federal Reserve Board has the responsibility of setting marginrequirements. This affects the proportion of a security purchase thatcan be made via credit.

C. The Securities Acts Amendments of 1975 touched on three important issues.

1. Congress mandated the creation of a national market system (NMS).Implementation details of the NMS were left to the SEC. Agreementon the final form of the NMS is yet to come.

2. Fixed commissions (also called fixed brokerage rates) on publictransactions in securities were eliminated.

3. Financial institutions, like commercial banks and insurance firms,

were prohibited from acquiring membership on stock exchangeswhere their purpose in so doing might be to reduce or savecommissions on their own trades.

D. In March 1982, the SEC adopted "Rule 415." This process is now known as ashelf registration or a shelf offering.

1. This allows the firm to avoid the lengthy, full registration process eachtime a public offering of securities is desired.

2. In effect, a master registration statement that covers the financingplans of the firm over the coming two years is filed with the SEC.After approval, the securities are sold to the investing public in a

piecemeal fashion or "off the shelf."3. Prior to each specific offering, a short statement about the issue is

filed with the SEC.

94


8/10

Prof. Rushen Chahal

E. Congress passed in July 2002 the Public Company Accounting Reform andInvestor Protection Act. The short name for the act became the Sarbanes-Oxley Act of 2002.

1. The Sarbanes-Oxley Act was passed as the result of a large series ofcorporate indiscretions.

2. The act contains 11 titles which tightened significantly the latitudesgiven to corporate advisors (like accountants, lawyers, companyofficers, and boards of directors) who have access to or influencecompany decisions.

3. The initial title of the act created the Public Company AccountingOversight Board. This boards purpose is to regulate the accountingindustry relative to public companies that they audit. Members areappointed by the SEC.

4. As recently June of 2003, the oversight board itself published a set ofethics rules to police its own set of activities.

IX. The Multinational Firm: Efficient Financial Markets and Intercountry Risk

A. The United States highly developed, complex and competitive financialmarkets facilitate the transfer of savings from the saving-surplus sector to thesaving-deficit sector.

B. Multinational firms are reluctant to invest in countries with ineffectivefinancial systems.

1. Financial and political systems lacking integrity will often be rejectedfor direct investment by multinational firms.

2. Countries that experience significant devaluation of its currency mayalso be considered too risky for investment.

ANSWERS TOEND-OF-CHAPTER QUESTIONS

14-1. Financial markets are institutions and procedures that facilitate transactions in alltypes of financial claims. Financial markets perform the function of allocatingsavings in the economy to the ultimate demander(s) of the savings. Without thesefinancial markets, the total wealth of the economy would be lessened. Financial

markets aid the rate of capital formation in the economy.

14-2. A financial intermediary issues its own type of security which is called an indirectsecurity. It does this to attract funds. Once the funds are attracted, the intermediarypurchases the financial claims of other economic units in order to generate a returnon the invested funds. A life insurance company, for example, issues life insurancepolicies (its indirect security) and buys corporate bonds in large quantities.

95


9/10

Prof. Rushen Chahal

14-3. The money market consists of all institutions and procedures that accomplishtransactions in short-term debt instruments issued by borrowers with (typically) highcredit ratings. Examples of securities traded in the money market include U.S.Treasury Bills, bankers acceptances, and commercial paper. Notice that all of theseare debt instruments. Equity securities are not traded in the money market. It is

entirely an over-the-counter market. On the other hand, the capital market providesfor transactions in long-term financial claims (those claims with maturity periodsextending beyond one year). Trades in the capital market can take place onorganized security exchanges or over-the-counter markets.

14-4. Organized stock exchanges provide for:

(1) A continuous market. This means a series of continuous security prices isgenerated. Price changes between trades are dampened, reducing pricevolatility, and enhancing the liquidity of securities.

(2) Establishing and publicizing fair security prices. Prices on an organizedexchange are determined in the manner of an auction. Moreover, the prices

are published in widely available media like newspapers.

(3) An aftermarket to aid businesses in the flotation of new security issues. Thecontinuous pricing mechanism provided by the exchanges facilitates thedetermination of offering prices in new flotations. The initial buyer of thenew issue has a ready market in which he can sell the security should he needliquidity rather than a financial asset.

14-5. The criteria for listing can be labeled as follows: (1) profitability; (2) size; (3) marketvalue; (4) public ownership.

14-6. Most bonds are traded among very large financial institutions. Life insurancecompanies and pension funds are typical examples. These institutions deal in large

quantities (blocks) of securities. An over-the-counter bond dealer can easily bringtogether a few buyers and sellers of these large quantities of bonds. By comparison,common stocks are owned by millions of investors. The organized exchanges arenecessary to accomplish the "fragmented" trading in equities.

14-7. The investment banker is a middleman involved in the channeling of savings intolong-term investment. He performs the functions of: (1) underwriting; (2)distributing; (3) advising. By assuming underwriting risk, the investment banker andhis syndicate purchase the securities from the issuer and hope to sell them at a higherprice. Distributing the securities means getting those financial claims into the handsof the ultimate investor. This is accomplished through the syndicate's selling group.Finally, the investment banker can provide the corporate client with sound advice on

which type of security to issue, when to issue it, and how to price it.

14-8. In a negotiated purchase, the corporate security issuer and the managing investmentbanker negotiate the price that the investment banker will pay the issuer for the newoffering of securities. In a competitive-bid situation, the price paid to the corporatesecurity issuer is determined by competitive (sealed) bids, which are submitted byseveral investment banking syndicates hoping to win the right to underwrite theoffering.

96


10/10

Prof. Rushen Chahal

14-9. Investment banking syndicates are established for three key reasons: (1) theinvestment banker who originates the business probably cannot afford to purchase theentire new issue himself; (2) to spread the risk of loss among several underwriters; (3)to widen the distribution network.

14-10. Several positive benefits are associated with private placements. The first is speed.

Funds can be obtained quickly, primarily due to the absence of a required registrationwith the SEC. Second, flotation costs are lower as compared to public offerings ofthe same dollar size. Third, greater financing flexibility is associated with the privateplacement. All of the funds, for example, need not be borrowed at once. They can betaken over a period of time. Elements of the debt contract can also be renegotiatedduring the life of the loan.

14-11. As a percent of gross proceeds, flotation costs are inversely related to the dollar sizeof the new issue. Additionally, common stock is more expensive to issue thanpreferred stock, which is more expensive to issue than debt.

14-12. The answer on this is clear. The corporate debt markets dominate the corporate

equity markets when new funds are raised. The tax system of the U.S. economyfavors debt financing by making interest expense deductible from income whencomputing the firm's federal tax liability. Consider all corporate securities offeredfor cash over the period 1999-2001. The percentage of the total represented by bondsand notes was 76.9 percent compared to 23.1 percent equity.

14-13. The household sector is the largest net supplier of savings to the financial markets.Foreign financial investors have recently been net suppliers of savings to the financialmarkets. On the other hand, the nonfinancial corporate business sector is most oftena savings-deficit sector. The U.S. Government sector too is a deficit sector in mostyears.

14-14. First, there may be a direct transfer of savings from the investor to the borrower.

Second, there may be an indirect transfer that used the services provided by aninvestment banker. Third, there may be an indirect transfer that uses the services of afinancial intermediary. Private pension funds and life insurance companies areprominent examples of the latter case.

97

Documents

Financial Management Chapter 14 IM 10th Ed