FINANCIAL MARKET

The Capital Market represents the market of the financial long-term titles.
The titles could be on short term, when they facilitate financing or for periods less than one year,
and on long term, also for financing and for periods more than one year. Titles on long term
mainly consist of bonds and shares; they are negotiated on the capital market.
Financial titles on long term with fixed income: bonds and preferred shares (stocks).
Financial titles on long term with variable income: common shares (stocks).
The bond is a certificate issued usually by a government or large institution as evidence of a
loan received. Usually the bond will state the date of repayment and the interest payable
The bond is a title of credit:
 the bond's issuer is the debtor, and
 the holder of the bond is the creditor.
The holder of the bond is therefore a simple creditor, not an associate ( a business partner).
There are 2 categories of rights involved in holding a bond:
 the right to cash in regularly the bonds which is the fixed income;
 the right to receive, at a certain term called the maturity, (the tenor),
the nominal value of the bond, which is in fact the amount that the issuer was credited with.
The share is a title in a commercial corporation.
It proves the participation of its holder to the equity.
The income earned by a share is called dividend and consists of a part of the profits distributed
by the company.
The dividend is money paid to a shareholder as a return on investment. Dividends are paid out of
profits and are expressed as a percentage of the nominal value of the share.
There are two kinds of shares:
 The preferred share is a share in a company which may entitle its owner to a specified
rate of dividend from the profit. Any remaining profit is then used to pay dividends to ordinary
share holders. Also in the event of the company winding up, preference shareholders may be
preferential to ordinary shareholders in the repayment of their capital.
 The common share is a fixed and indivisible part of the capital of a company which
entitles its owner (a shareholder) to a share of any profit and/or repayment of capital of
liquidation.
 If the share is preferred, then the share-holder has the right to get a fixed dividend,
not depending on the size of the profits of that year.
 If the share is common, then the share holder gets a dividend, depending on the size
of the profits.
Preferred shares are different from the ordinary shares by the unequal access to decision, profits,
etc. Preferred shares have a priority when voting and when profits are distributed. When a
general partnership is going to be winded up, preference shares are the first with the right to be
indemnified.
There are two kinds of markets that make up the capital market:
 the primary market, where new issues of long-term financial titles are sold and bought;
 the secondary market, where the financial titles previously issued are negotiated.
On the primary market, long-term financial titles are issued in order to be placed;
the new titles are bought by some economic agents who own money. Most of the joint stock
companies appeal to some intermediaries who regularly subscribe to the issue for a certain
commission or they can buy all the new titles in order to sell them subsequently to the public.

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The secondary market consists of the Stock Exchange and the markets of long-term titles
previously issued and which do not make the object of transactions at the Stock Exchange
(further called S. E.).
 The S. E. is the main institution for selling and purchasing financial titles on the secondary
market. Titles are sold and bought at prices established on the basis of the supply and demand
during the auction sessions (meetings), at the S. E.
 The S. E. provides the operative transformation and in a short term, of the real capital into
peculiar capital, the rapid mobilisation of an important source of investment activity.
 The S. E. facilitates the process of economic power concentration, control over a share-
holding being provided by getting the control stock, by which we understand the minimum
number of shares that provides the owner with the possibility to hold the majority of the votes in
the Share-Holders General Meeting.
 The S. E. is also an extremely sensitive barometer of the shape of the economy, the volume
of transactions and the development of the rate of exchange, suddenly reacting, sometimes
anticipating, to economic conjuncture changes.

Read the text below. Find answers to the following questions: Reading
1. How does the hedge against the inflation operate?
2. What do usually the directors of the company wish to be done before the dividends are
paid?
Before a business can function two ingredients are essential: people and money.
Without either, no business could flourish. For the limited company, funds are initially
provided by the shareholders. Ordinary stocks (or shares) are commonly described as ‘equities’,
including that the holders are entitled to what is left of the assets and profits, after certain
claims have been met.
The dividends on ordinary stocks will be related to the profits made by the company. Thus, if the
profits are good the ordinary stockholder can expect to receive an attractive dividend. However,
before the dividend is paid the directors of the company may wish to recommend part of the
profits being ploughed back into the business.
The fact that dividends normally vary in line with profits gives the person who holds ordinary
stocks some possible protection against the falling value of money - another description for
inflation. This hedge against inflation operates in the following manner. In the case of a typical
manufacturing company, where there is a rise in the cost of raw materials and wages, the
company can usually compensate for this by raising the price of its finished goods. In this way
its profits can be increased, wholly or partially, in line with the general rate of inflation.
Ordinary stocks normally, but not invariably, carry voting power. Some stock units are even
issued which give more than one vote per stock unit. Some investors are willing to accept non-
voting ordinary stock as they do not wish to exercise voting power in any case. However, when
there is a take-over in the offing, the voting stocks will become more valuable and, for this
reason, the market price of the voting stocks would be expected to stand at a premium in
relation to the price of the non-voting stocks. Whoever owns more than 50% of the voting stock
is sure of controlling the elections to the board of directors. Yet many boards own much less
than this proportion of voting stock between them. They are still able to select their own
replacements for any directors who die or retire, since other groups of shareholders will be
disorganised and unaware of the issues and personalities involved. The existing board of
directors in a large public limited company (PLC) are likely to remain in effective control so
long as the company’s performance satisfies the majority of the voting shareholders. But if the
company falters there could be a stockholders’ revolt leading to the replacement of the existing
board - or at least elements of it.
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BONDS
Why do most companies use a mixture of debts and equity financing ?
Why do governments issue bonds?

Companies finance most of their activities by way of internally generated cash flows. If they
need more money they can either sell shares or borrow, usually by issuing bonds. More and
more companies now issue their own bonds rather than borrow from banks, because this is often
cheaper: the market may be a better judge of the firm’s creditworthiness than a bank, i.e. it may
lend money at a lower interest rate. This is evidently not a good thing for the bank, which now
has to lend large amounts of money to borrowers that are much less secure than blue chip
companies.
Bond-issuing companies are rated by private ratings companies and given an ‘investment grade’
according to their financial situation and performance. Obviously, the higher the rate, the lower
the interest rate at which a company can borrow.
Most bonds are bearer certificates, so after being issued (on the primary market), they can be
traded on the secondary bond market until they mature. Bonds are therefore liquid, although of
course their price on the secondary market fluctuates according to changes in interest rates.
Consequently, the majority of bonds on the secondary market are traded either above or below
par. A bond’s yield at any particular time is thus its coupon (the amount of interest it pays)
expressed as a percentage of its price on the secondary market.
For companies, the advantage of debt financing over equity financing is that bond interest is tax
deductible. In other words, a company deducts its interest payments from its profits before
paying tax, whereas dividends are paid out of already-taxed profits. Apart from this ‘tax shield’,
it is generally considered to be a sign of good health and anticipated higher future profits if a
company borrows.
On the other hand, increasing debt increases financial risk: bond interest has to be paid, even in a
year without any profits from which to deduct it, and the principal has to be repaid when the
debt matures, whereas companies are not obliged to pay dividends or repay share capital. Thus
companies have a debt-equity ratio that is determined by balancing tax savings against the risk
of being declared bankrupt by creditors.
Governments, of course, unlike companies, do not have the option of issuing equities.
Consequently they issue bonds when public spending exceeds receipts from income tax, VAT,
and so on. Long-term government bonds are known as gilt-edged securities, or simply Gilts, in
Britain, and Treasury Bonds in the US. The British and American central banks also sell and buy
short-term (three month) Treasury Bills as a way of regulating the money supply. To reduce the
money supply, they sell these bills to commercial banks, and withdraw the cash received from
circulation; to increase the money supply they buy them back, paying with newly created money
which is put into circulation in this way.

Match up the expressions on the left with the definitions on the right.
1) equity financing a) a security whose owner is not registered with the issuer
2) debt financing b) easily sold (turned into cash)
3) bearer certificate c) the rate of interest paid by a fixed interest security
4) liquid d) issuing bonds
5) par e) issuing shares
6) coupon f) nominal or face value (100%)
7) yield g) the rate of income an investor receives taking into account
a security’s current price

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Discuss in pairs or small groups

For what purpose: companies buy and sell shares

Since quoted shares are freely transferable, they can be acquired by anyone who is prepared to
pay the market price for them. However, there are certain rules to be observed. The basic rule is
that shareholders must be treated equally, and when an offer is announced, the share transactions
must be reported by all parties
If the ground rules for take-overs are negotiable, the reasons for the voting shares in a company
gives one the power to appoint directors and thereby control polices of that company.

a) To buy shares at a bargain price. If shares are good value it seems logical to buy as
many as possible. This could lead to asset-stripping where the break-up value of the company is
higher than the price of the shares.
b) To enjoy economies of scale as a result of the enlarged operations. If unit costs can be
reduced, pricing policies can be more flexible and profits increased.
c) To eliminate competition. For example, newspapers  and  may be in competition with
each other.  finds that  is eroding its market share. With the financial backing of its bankers 
takes over . It then has two basic options. It can either close down  or segment the market so
that for example  goes for upmarket readers, leaving the downmarket for . Or  can go for
family readers, leaving  to go for sports and politics, and so on.
d) To secure future supplies at a reasonable price. Thus, a company owning a chain of
supermarkets may take over a factory processing a variety of foods. This is called backward
integration.
e) To ensure markets for the goods or services of the parent company. This might be
where a company making shoes, takes over one owning a chain of shoe shops. This is called
forward integration.
f) To benefit from a policy of diversification, a company becoming involved in a wide
variety of activities.
g) To rescue an ailing company, in which case the impetus for the take-over might come
from the company which is seeking to take over. Management buy-outs might be included in
this category.
A merger is when two companies
A take-over is when one company combine as equals, by mutual
buys more than 50% of the shares in agreement. Companies may work
another from its existing shareholders together in a particular area by forming
and thereby obtains a controlling an alliance or venture, perhaps
interest. A company that often takes forming a new company in which they
over or acquires is said to be both have a stake. Mergers are fraught
acquisitive (a predator). The with difficulty and for a variety of
companies it buys are acquisitions (a reasons often fail, even where the
prey). When a company buys others merge involves two companies in the
over a period of time, a group, same country. One of the companies
conglomerate or combine forms, will always behave as the dominant
containing a parent company with a partner.
number of subsidiaries.
Read the text below.
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Study the advantages and disadvantages of take-overs and mergers.

TAKEOVERS and MERGERS The existing owner of a take-over target can realise the
value of the company by selling it and use the proceeds to start another company (or to retire).
New owners may not fully understand how the company they are buying works. Especially if
they are unfamiliar with the industry it is in. You can buy the shares, but that doesn’t change the
‘culture’ of the company.
A company taken over may get a new lease of life in the form of new management and access to
new markets: ones that the acquiring company is in. It may gain better access to investment
finance because of the increased size of the new company, making it more attractive for
investors. The acquiring company may gain new products to sell, and new markets to sell them
in, ones where the company taken over is already present.
Employees of a company that is taken over might benefit from an increases number of career
opportunities in the large company, but usually the story is one of redundancies through cost-
cutting. To go back to the human resources department example, the new owners might close the
department of the company being administered by its own human resources department. The
people in the human resources department of the take-over target will probably lose their jobs.
Benefits promised to shareholders often include lower costs, lower overheads. For instance, the
human resources department of a company of 4,000 employees doesn’t need to be much bigger
than one of 2,000 employees, so the same general costs can be spread wider, meaning increased
profitability. New owners may damage the morale of previously motivated managers and
employees, perhaps by putting their own senior managers in charge of the company, or by
undervaluing the skills and experience of the existing staff. The companies involved in take-
overs and mergers will talk about new products, lower prices and so on, but the authorities often
intervene to see if the consumer will really benefit. There may a long approval process. The US,
the EU and individual countries all have bodies to decide if mergers should go ahead. They may
stop a take-over or merger going ahead because they believe that industry will end up being
dominated by one or two very large companies in a quasi-monopoly situation.
 Many of the points above also apply to mergers. The partnership will almost be unequal,
and the dominant partner will often behave like an acquiring company

Exercise 9 Discuss with your colleagues advantages and disadvantages

of take-overs. Write down them

advantages

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 FINANCIAL MARKET

disadvantages

Why mergers fail

Read the article from the Financial Times.

Answer the following questions:
1. Why do so many mergers fail?
2. Whose shareholders benefit more in a take-over:
those of the acquiring company or those of the one that is being acquired?
3. Whose shareholders benefit most in a take-over, according to the article?
4. What is corporate culture? How might it affect the success or failure of a merger?
5. What do acquiring companies need to do to ensure success

The collapse of the planned Deutsche-Dresdner Bank merger tarnished the reputation of
both parties. Deutsche- Bank’s management was exposed as divided and confused. But even if
the take-over had gone ahead, it would probably still have claimed its victims.
Most completed take-overs damage one party - the company making the acquisition. A long list
of studies have all reached the same conclusion: the majority of take-overs damage the interests
of the shareholders of the acquiring company. They do, however, often reward the shareholders
of the acquiring company, who receive more for their shares than they were worth before the
take-over was announced.
Mark Sirower, visiting professor at New York University, says surveys have repeatedly shown
that 65 per cent of mergers fail to benefit acquiring companies, whose shares subsequently
under-perform their sector.
Why do so many mergers and acquisitions fail to benefit shareholders?
Colin Price, a partner at McKinsey, the management consultants, who specialises in mergers and
acquisitions, says the majority suffer from poor implementation. And in about half of those,
senior management failed to take account of the different cultures of the companies involved.
Melding corporate cultures take time, which senior management does not have after a merger.
Mr Price says. ‘most mergers are based on the idea of “let’s increase revenues”, but you have to
have a functioning management team to manage that process. The nature of the problem is not
so much that there’s open warfare between the two sides. It’s that the culture don’t meld quickly
enough to take advantage of the opportunities. In the meantime, the marketplace has moved on.
Many consultants refer to how little time companies spend before a merger thinking about
whether their organisations are compatible. The benefits of mergers are usually couched in

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financial or commercial terms: cost-savings can be made or the two sides have complementary
businesses that will allow them to increase revenues.
Mergers are about compatibility, which means agreeing whose values will prevail and who will
be the dominant partner. So it is no accident that mangers as well as journalists reach for
marriage metaphors in describing them. Merging companies are said to ‘tie the knot’. When
mergers are called off, the two companies fail to make it up the aisle’ or their relationship
remains ‘unconsummated’. Yet the metaphor fails to convey the scale of risk companies run
when they launch acquisitions or mergers. Even in countries with high divorce rates, marriages
have better success rate than mergers.
Mark Sirower asks. “Why should managers pay premium to makes an acquisition when
their shareholders could invest in the target company themselves?”
Mark Sirower denies he is saying companies should never make acquisitions. If 65 per cent of
mergers fail to benefit shareholders, 35 per cent are successful.
How can acquirers try to ensure they are among the successful minority?
Ken Favaro, managing partner of Marakon, a consultant which has worked for Coca-Cola,
Lloyds STB and Boeing, suggests two conditions for success.
The first is to define what success means. ‘The combined entities have to deliver better returns to
the shareholders than they would separately. It’s amazing how often that’s not the pre-agreed
measure of success’, Mr Favaro says.
Second, merging companies need to decide in advance which partner’s way of doing things will
prevail. ‘Mergers of equals can be so dangerous because it is not clear who is in charge’, Mr
Favaro says. Mr Sirower adds that managers need to ask what advantages they will bring to the
acquired company that competitors will find difficult to replicate.
Managers need to remember that competitors are not going to hang around waiting for them to
improve the performance of their new acquisition. Announcing a take-over will have alerted
competitors to the acquiring company’s strategy. Given how heavily the odds are stacked against
successful mergers, managers should consider whether their time and shareholders’ money
would not be better employed elsewhere.

Discuss in pairs or small groups

What essential preparatory steps should a company take

to make a successful acquisition?
What are the common problems associated with some advantages and disadvantages of
take-overs and mergers?
What common mistakes do the managers make?
The supplementary text given below will help you to point out the common mistakes that
managers make.

The managers must have a very clear strategy.

 The mangers need to know where they want to compete, which markets; how they want to
compete; and how they will get competitor advantage over the other players in the market. From
that strategy the managers should understand which other companies in the market will help
them achieve their objectives.

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 FINANCIAL MARKET

 The other alternative is not to buy another company, but try and build a successful position
on their own, through investment.
 Assuming that the mangers can find a candidate that they would like to acquire, their first
step is to analyse that company - to understand its products, where it gets its sales from, who its
customers (clients) are, and what its cost structure is. The next step is to think how, if they own
that company, they would invest in it, and what the financial consequences of that would be. The
third step is to essentially work out how much this company is worth. The managers need to
worry about two prices there. The first is what is it worth to the current owners, and the second
is what is it worth to them? And the difference should be driven by the synergy that the
managers see, that is, the benefits that they can bring to the company through their ownership.
The managers spend lots of time analysing the projections for the company to try and arrive at a
valuation. The final step is working out their tactics as to how the managers are going to buy this
company - whether it be their pricing tactics or the way in which they approach the current
owners.
And once the acquisition has happened. What needs to be done to ensure the successful
integration of the new business?
 The first thing the managers should do, even before they take ownership, is to plan what
they do when they take ownership of the company. That means working out exactly how they
are going to combine that company with their own. Through every single function, the managers
need to have a plan as to what they do with the people, what they do with the facilities, what
they do with the assets and how they handle the customers.
 The second thing that the managers should do is to worry about the people. Who are the
most important managers and staff that they need to keep on-side during this process, because
this will be the time of uncertainty for them.
 The third step towards a successful integration is to make sure that they move quickly. Too
many companies take too long to plan and to implement. The uncertainty around this process
can cause many problems.

DO YOU KNOW?

Some 1,500 to 2,000 mergers and acquisitions are completed per year worldwide, of which
around half are in the US.
A company taken over may get a new lease of life in the form of new management and access
to new markets: ones that the acquiring company is in. It may gain better access to investment
finance because of the increased size of the new company, making it more attractive for
investors.
The acquiring company may gain new products to sell, and new markets to sell them in, ones
where the company taken over is already present.
Employees of a company that is taken over might benefit from an increases number of career
opportunities in the large company.
The benefits of mergers are usually couched in financial or commercial terms. But improving
earnings and asset growth are not the only goals in takeovers. There is no doubt that mergers
and acquisition is a risky business. The parties concerned in the successful merger should cover
all aspects of the conception: planning, due diligence (investigation of a company’s activities and
finances before investment or acquisition), negotiation and integration stages. The management
has to have a functioning management team to manage this process. Companies spend very
little time before merger thinking about whether their organisations are compatible.

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Most mergers are based on the idea of “let’s increase revenues, but not on about their newest
assets – the people in the company they have just bought or merged with.
Mergers based on wanting to build too big an empire, too quickly, and overextending the
financial, commercial and human capacity of the organisation will certainly end in their
collapse.
Ted Austin from the Delaney School of Business draws some of the most common acquirer
errors: over-valuation, over-confidence, under-communicating, and underestimating the value
of the newest assets – the people in the company you have just bought.
How can you make sure the merger goes smoothly?
The most important thing is to look after your people –employees, management and, of
course, customers, especially employees. First of all you have to keep them focused and
productive. A merger is a wonderful opportunity for the competition to jump in and take the
market share from both companies. There are five points that you should look at before
examining possible acquisition or merger.
Ted Austin proposes five Gs – five points in choosing the right company to acquire.
 Goals
You must think whether your goals are compatible. Are both companies trying to achieve
something similar? If not – keep looking.
 Gains
You must consider whether your gains are going to be real gains in terms of economies of
scale. Being bigger is not always better.
 Genes
By this company culture is meant. There is no point in trying to merge traditional hierarchical
family business with a moving start-up with a lay back (neprofesionalus) management style. It
just won’t work. There has to be a real synergy in culture and in personnel.
 Geography
Are the companies based in the same city or geographical area? If not – communication
between headquarters is much more difficult and the gains are hard to achieve.
 Growth
Will the merger provide technology or skills that you don’t have now which will take too
long to develop yourself? And which will allow your company to grow? The merger will be
successful if it is up in new markets which will be otherwise inaccessible than it makes sense.

Explain each of the points summarised by the five Gs.

1. What opportunity does a merger offer?

2. What are good reasons for mergers?
3. What benefits do merging companies gain?
4. What are the common problems associated with some advantages
and disadvantages of a merger?

What common mistakes do the managers make?

Discuss the conditions necessary for a successful merger.

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