BF430-CORPORATE & MERCHANT BANKING

LECTURE TWO - FINANCIAL MARKETS

Lecture Outline;
- Introduction
- Features of good financial market
- Breakdown of financial markets
 Money markets-primary & secondary
 Capital markets-primary & secondary
 Loan market.
 Foreign exchange markets
- Corporate finance & it’s relationship with corporate & merchant banking
- Investment advisory & it’s relationship with corporate & merchant banking
INTRODUCTION

A financial system is made up of financial markets, financial institutions, and Investors &
Financial assets.

A financial market is defined as a medium through which financial assets are bought
and sold. In order for a financial market to exist three (3) things need to be in place and
these are:

 Communication
 Readily available goods and services
 Physical structure (not always a must)
Features of a good financial market include;

1) Externally efficient - Information should flow unabated (without reduction in

intensity or strength), and without any entity monopolizing it. Everyone should have
equal access to that information. A buyer or seller wants the prevailing market price
to adequately reflect all the information available regarding supply and demand
factors in the market. If such conditions change as a result of new information, the
price should change accordingly.

Therefore, participants want prices to adjust quickly to new information regarding

supply or demand, which means that prices reflect all available information about the
asset.

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2) Internally efficient - The transactions in the market should be performed at the
lowest possible cost. Lower costs (as a percent of the value of the trade) make for a
more efficient market. An individual comparing the cost of a transaction between
markets would choose a market that charges 2 percent of the value of the trade
compared with one that charges 5 percent.

3) Provide liquidity. This is the ability to buy or sell an asset quickly and at a known
price—that is, a price not substantially different from the prices for prior transactions,
assuming no new information is available. An asset’s likelihood of being sold quickly,
sometimes referred to as its marketability, is a necessary, but not a sufficient,
condition for liquidity. The expected price should also be fairly certain, based on the
recent history of transaction prices and current bid-ask quotes especially true for
securities in the stock markets.

4) Price continuity - The market should have price continuity, meaning prices should
not change too significantly, but rather they should change marginally. Price
continuity is a component of liquidity, which means that prices do not change much
from one transaction to the next unless substantial new information becomes
available. Suppose no new information is forthcoming and the last transaction was at
a price of K6; if the next trade were at K6.05, the market would be considered
reasonably continuous. A continuous market without large price changes between
trades is a characteristic of a liquid market.

A market with price continuity requires depth, which means that numerous potential
buyers and sellers must be willing to trade at prices above and below the current
market price. These buyers and sellers enter the market in response to changes in
supply and demand or both and thereby prevent drastic price changes. In summary,
liquidity requires marketability and price continuity, which, in turn, requires depth.

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BREAKDOWN OF FINANCIAL MARKETS:
Financial markets are made up of money and capital markets. Within the money and capital
markets we have the primary and secondary markets.
A primary market is where securities are traded for the very first time, whose proceeds go
to the issuer of the security.
The secondary market is where securities are traded after a primary issuance, and proceeds
do not go to the issuer, but to the investor holding such a security after the primary issuance.

1. MONEY MARKETS

This is where financial assets of short term maturities are traded, maturity up to one year. The
money market may be subdivided into four. They are:

(i) Call money market

(ii) Commercial bills market

(iii) Treasury bills market

(iv) Short term loan market

1.1 Call Money Market: The call money market is a market for extremely short period loans
say one (1) day to fourteen (14) days. So, it is highly liquid. The loans are repayable on
demand at the option of either the lender or the borrower. Call money markets are associated
with the presence of stock exchanges. The special feature of this market is that the interest
rate varies from day to day and even from hour to hour. It is very sensitive to changes in
demand and supply of call loans.

1.2 Commercial Bills Market: It is a market for bills of exchange arising out of genuine
trade transactions. In the case of credit sale, the seller may draw a bill of exchange on the
buyer. The buyer accepts such a bill promising to pay at a later date specified in the bill. The
seller need not wait until the due date of the bill. Instead, he can get immediate payment by
discounting the bill. The commercial banks play a significant role in this market.

1.3 Treasury Bills Market: It is a market for treasury bills which have ‘short-term’ maturity.
A treasury bill is a promissory note or a finance bill issued by the Government. It is highly
liquid because its repayment is guaranteed by the Government. It is an important instrument

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for short term borrowing of the Government. Financial intermediaries can park their
temporary surpluses in these instruments and earn income.

1.4 Short-Term Loan Market: It is a market where short-term loans are given to corporate
customers for meeting their working capital requirements. Commercial banks play a
significant role in this market. Commercial banks provide short term loans in the form of cash
credit and overdraft. Overdraft facility is mainly given to business people whereas cash credit
is given to industrialists. Overdraft is purely a temporary accommodation and it is given in
the current account itself. But cash credit is for a period of one year and it is sanctioned in a
separate account.

Money market instruments;

The financial instruments/assets traded here include:

a) Treasury bills (90 day TBs, 120 TBs)

Treasury bills are obligations of government, which are issued through the central bank
to cover government budget deficits.

- In addition, TBs are issued to refinance maturing government debt.

- A predetermined quantity of securities is offered for sale (at times it is oversubscribed

or undersubscribed). A rate is then determined for the treasury bills.

- TBs can be traded in the secondary market.

- TBs can also have international bidders and players.

b) Certificates of Deposits

This is a financial instrument issued by a bank documenting a deposit, with principal and
interest repayable to the bearer at a specified future date.

c) Bankers Acceptance

This is a time draft (post-dated instrument) payable to a seller of goods/services, with

payment guaranteed by a bank. In other words a Banker’s Acceptance is a bill of
exchange used in financing trade that has been endorsed by the bank. It constitutes a
guarantee that payment will be forthcoming from it, if not from the buyer. Acceptance by
a first class bank would enable the merchant/exporter to sell it at discount and get
immediate payment for the goods sold/exported.
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d) Commercial Papers

- Commercial paper is a short term unsecured promissory note issued by corporations and
foreign governments.
- This an unsecured short-term note sold by corporates on a discount basis with a fixed
maturity of 15 days to 180 days.
- For many large, creditworthy issuers, commercial paper is a low cost alternative to bank
loans.
- Issuers of commercial paper are able to efficiently raise large amounts of funds quickly
and without expensive Securities and Exchange Commission registration by selling paper
either directly or through independent dealers.

e) Repurchase Orders (REPOS)

- Repos are agreements to sell securities and later to reverse the sale.

- The transaction commonly involves treasury securities.

- Repos are essentially collateralized loans.

- They are short term overnight securities.

CHARACTERISTICS OF MONEY MARKET INSTRUMENTS;

a) Liquidity - ability to convert an asset into cash with relative ease while not
significantly depressing its price in the process.

b) Low default risk - risk of non-payment of principal or interest must be minimal in

order for the security to be considered a safe haven for excess liquidity.

c) Short time to maturity - helps to ensure that interest rate changes will not affect the
securities market value materially.

ADVANTAGES OF MONEY MARKETS

1) Money markets provide negotiable instruments that are readily available.

2) Some of the tradable instruments are considered to be ‘risk-free’ (low risk). For
instance, the treasury bills that government issues through the Central bank.

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 3) Bank guaranteed payment

For instance, for Commercial Paper the bank guarantees that CP will be honoured at
maturity. CP is supported by the issuers maintaining lines of credit provided by banks
upon payment of fees.

Banks also guarantee Bank Acceptances, which are normally issued by investors who
trade in imported goods.

4) High caliber of investors such as individuals, households and Corporate Institutional

investors.

2. CAPITAL MARKETS

The capital market is the market in which longer-term debt (generally those with
original maturity of more than one year) and equity instruments are traded. The issues
traded include, bonds, preferred stock, and common stock.

Capital market securities (stocks and long-term bonds), are often held by financial
intermediaries such as insurance companies and pension funds, which have little
uncertainty about the amount of funds they will have available in the future.

Capital markets participants include;

- Corporations who issue corporate bonds, preferred stock and common stock.

- Banks (corporate or merchant banks). Merchant bankers facilitate the issuance of

these issues.

- Institutional investors (insurance & pension houses) - Institutional investors buy

issues.

- Government (through government bonds).

- Municipalities (through municipal bonds, commonly known as munis).

PRIMARY MARKET OF CAPITAL MARKETS

This is the market where financial issues (equity and debt) are traded for the first time. The
primary markets for securities are not well known to the public because the selling of
securities to initial buyers often takes place behind closed doors. Trading in the primary
market can be either through any of the following two:

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 a) Financial Intermediation with the help of a merchant banker, or

b) Direct Placement or Private Placement also with the help of a merchant banker.

Let us understand other functions that investment banks play in helping their corporate clients
raise capital. Various companies need cash in order to grow or finance certain projects or
simply to expand their space from national to international or global presence, so for
these needs they approach their investment banks.

ROLE OF INVESTMENT BANK IN RAISING CAPITAL

1. Access to investors

For companies that want to raise funds through the capital markets i.e. listing of new
securities the investment bank will match investors of securities on one side with the
companies intending to raise funds. By doing so the investment bank then earns an advisory
fee or the commission. Companies use investment banks because they have access to a wider
pool of individual as well as institutional investors located in different markets such as New
York, Singapore, Hong-Kong or Sydney and London. Investment banks also have key
network access to investors who may be interested in certain set of securities or investment in
certain companies.

2. Expertise in valuations

Investment banks have the expertise in enterprise valuation. If a company wants to raise
capital they may share their own set of equities but how then do they price their shares? The
investment bank brings in their expertise to determine the value of the company and the price
at which the shares can be sold at.

3. Experience

Through their gained experience the investment bank is essentially the expert negotiator on
the buyer and seller side as they come to market. For instance when a company decides that
they would like to raise funds from the public there is a certain procedure that needs to be
followed or regulatory aspects that needs to be looked at. Will the company be able to do it
on their own with delimited staff? In most cases the company may not be equipped with the
right skill to actually go to the market hence the investment bank will represent the company
in the market.

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INITIAL PUBLIC OFFER (IPO)

What Is Initial Public Offer (IPO)?

Initial public offering (IPO) is the primary offering of a company that has never before
offered a particular type of security to the public, meaning the security is not currently trading
in the secondary market; an unseasoned offering.
An offering can be either a public offering or a private placement. If a company decides to
make a public offering, it must then decide whether to have the issue underwritten or sold
through a best-efforts offering.

As the terms imply, in an underwritten issue, the investment banker is guaranteeing (or
underwriting) that the issuer receives a fixed amount of money whether the securities are
all sold to investors or not.
In a best-efforts issue, the investment banker makes no such guarantee and instead
promises only to make its best sales effort.
In this case, the Investment banker does not take on the risk associated with underwriting,
and compensation is based on the number of securities sold. Not surprisingly, most issuing
companies prefer underwritten to best-efforts contracts, so the actual decision on issue type
falls to the investment banker, who usually forces only the smallest and riskiest issues to be
handled on a best-efforts basis.

Another decision that must be made by a company is whether to solicit investment-banking

services through competitive bidding. With competitive bidding, the issuer publicly
announces a desire to sell securities and solicits offers from several investment-banking
firms. The alternative is direct negotiation with a single investment banker. Almost all
companies that have a real choice (utilities frequently are legally required to use competitive
bidding) choose negotiated offering procedures.

The seemingly irrational choice of negotiated offerings can be explained by the fact that
investment bankers must invest in performing due diligence examinations of potential
security issuers. This means that they are legally required to diligently search out and
disclose all relevant information about an issuer before securities are sold to the public, or the
underwriter can be held legally responsible for investor losses that occur after the issue is
sold.

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Because investors understand that the most prestigious investment bankers have the most to
lose from inadequate due diligence, the mere fact that these firms are willing to underwrite an
issue provides valuable certification that the issuing company is in fact disclosing all material
information. With so much to lose, top-tier investment bankers are unlikely to be enticed by
competitive bid issues that entail the same risk, but far less profit, as negotiated bids. Thus,
issuing firms are willing to pay the higher direct issuance costs of a negotiated bid to obtain
the services of a prestigious underwriter.

One of the problems investment bankers face with IPOs is how to price them because
they are securities that have never been traded. The price for which a security is sold is
important to the issuer because the higher the price, the more money the company gets. If the
security is priced too high, however, there may not be sufficient demand for the security, and
the offering may be cancelled or the underwriter may not be able to sell the issue at the
proposed offering price. In this case, the investment banker suffers a loss.

The average IPO suffers from underpricing. Shares are typically sold to investors at an
offering price that is, on average, about 15% below the closing price of the shares after the
first day of trading. This implies that underwriters deliberately (and consistently) sell shares
to investors for only six-sevenths of their value.

In bringing securities to market, investment bankers take clients through three steps:
Origination, Underwriting (Risk Bearing), And Distribution. Depending on the method of
sale and the client’s needs, an investment banker may provide these services.

a. Origination.
During the origination of a new security issue, the investment banker can help the issuer
analyse the feasibility of the project and determine the amount of money to raise; decide
on the type of financing needed (debt, equity); design the characteristics of securities to
be issued, such as maturity, coupon rate for debt securities, and the presence of a call
provision and/or sinking fund for debt issues; and provide advice on the best sale date so
that the issuer can get the highest possible price.

Once the decision to issue the securities is made, the investment banker can help the
client prepare the official sale documents. If the securities are to be sold publicly, security

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 laws require that a registration statement be filed with the Securities and Exchange
Commission (SEC).
A portion of this statement, called the preliminary prospectus, contains detailed
information about the issuer’s financial condition, business activities, industry
competition, management and their experience, the project for which the funds will be
used, the characteristics of the securities to be issued, and the risks of the securities. After
approval by the SEC, the final prospectus is reproduced in quantity and distributed to all
potential investors.
By law, investors must have a final prospectus before they can invest.
The information in the prospectus allows investors to make intelligent decisions about the
proposed project and its risk. SEC approval implies only that the information presented is
timely and fair; approval is not an endorsement by the SEC as to investment quality.

During the registration process for a DEBT ISSUE, the investment banker can also help
secure a credit rating; coordinate the activities of a bond counsel, who passes an
opinion about the legality of the security issue; select a transfer agent for secondary
market sales; select a trustee, who sees that the issuer fulfils its obligation under the
security contract; and arrange for printing of the securities so that they can be
distributed to investors.
For an EQUITY ISSUE, the investment banker can arrange for the securities to be listed
on a stock exchange or traded in the over-the-counter market.

b. Underwriting.
Underwriting, or bearing price risk, is what most people think that investment bankers do
in a firm-commitment offering. Underwriting is the process whereby the investment
banker guarantees to buy the new securities for a fixed price. The risk exists between
the time the investment banker purchases the securities from the issuer and the time they
are resold to the public. The risk (inventory risk) is that the securities may be sold for less
than the underwriting syndicate paid for them. In seasoned offerings, there is a risk of
unforeseen price changes as a result of changes in market conditions.

For example, in October 1979, IBM issued $1 billion in bonds through a syndicate of
underwriters. As the issue was coming to market, interest rates suddenly jumped upward,

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 causing bond prices to tumble, and the underwriters lost in excess of $10 million. In
unseasoned offerings, there is no prior market price on which to base the offering price.
To decrease the price risk of any one primary issue, underwriters form syndicates
comprising other investment-banking firms. Each member of the syndicate is responsible
for it’s pro rata share of the securities being issued. By participating in the syndicate, each
underwriter receives a portion of the underwriting fee as well as an allocation of the
securities being sold that it can sell to its own customers. In addition, other investment-
banking firms, known as the selling group, can be enlisted to assist in the sale of the
securities being issued. Members of the selling group bear no underwriting responsibility
but receive a commission for whatever securities they sell.

c. Distribution
Once the investment banker purchases the securities, they must be resold to investors.
The syndicate’s primary concern is to sell the securities as quickly as possible at the
offering price. If the securities are not sold within a few days, the underwriting syndicate
disbands, and members sell the securities at whatever price they can get.
The sales function is divided into institutional sales and retail sales. Retail sales involve
selling the securities to individual investors and firms that purchase in small quantities.
Institutional sales involve the sale of a large block of securities to institutional purchasers,
such as pension funds, insurance companies, endowment trusts, or mutual funds.

Private Placements. A private placement is a method of issuing securities in which the

issuer sells the securities directly to the ultimate investors. Because there is usually no
underwriting in a private placement deal, the investment banker’s role is to bring buyer
and seller together, help determine a fair price for the securities, and execute the
transaction. For these services, the investment banker earns a fee.

Private Placement or Direct Placement to identified investors, or can be done through

intermediation, involving an (stock) exchange or one or more bank(s). Private placement
is the sale of issues to a few large institutional investors without registering with SEC. A
private placement memorandum must be filed with SEC. The new issue is not sold
publicly.

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 Firms choose between a private placement and public sale depending on which method of
sale offers to the issuer the highest possible price for the securities after transaction costs.

Private placements have several advantages over public securities offerings.

They are less costly in terms of time and money than registering with the SEC, and the
issuers do not have to reveal confidential information. Also, because there are typically
far fewer investors, the terms of a private placement are easier to renegotiate, if
necessary.
Smaller firms are more likely to use the services of an investment bank, which helps to
locate investors, negotiate the deal, and handle the legal aspects of the transaction. Major
advantage of a private placement is the speed at which funds can be raised and the low
transaction costs.

The disadvantage of private placements is that the securities have no readily available
market price, they are less liquid, and there is a smaller group of potential investors
compared to the public market.
Another disadvantage is that privately placed securities cannot legally be sold in the
public markets because they lack SEC registration. As a result, private placement
securities are less marketable than a comparable registered security.

Secondary Market of the Capital markets

This is the market for the already existing financial issues such as shares, loans, bonds
and other financial assets with long term maturities.

- When an individual buys a security in the secondary market, the person who has sold
the security receives money in exchange for the security, but the corporation that
issued the security acquires no new funds.

- A corporation acquires new funds only when its securities are first sold in the primary
market.

Important functions of the secondary market.

 First, they make it easier and quicker to sell these financial instruments to raise cash;
that is, they make the financial instruments more liquid.

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 - The increased liquidity of these instruments then makes them more desirable and thus
easier for the issuing firm to sell in the primary market.

 Second, they determine the price of the security that the issuing firm/corporations
sells in the primary market. The investors that buy securities in the primary market
will pay the issuing corporation no more than the price they think the secondary
market will set for this security.

- The higher the security’s price in the secondary market, the higher will be the price
that the issuing firm will receive for a new security in the primary market, and hence
the greater the amount of financial capital it can raise.

- Conditions in the secondary market are therefore the most relevant to corporations
issuing securities.

Secondary markets can be organized in two ways;

i. One is to organized exchanges, where buyers and sellers of securities (or their agents or
brokers) meet in one central location to conduct trades.

The London stock exchange or Lusaka stock exchange for stocks and the London metals
exchange for commodities/minerals (copper) are examples of organized exchanges.

ii. The other method of organizing a secondary market is to have an over-the counter
(OTC) market, in which dealers at different locations who have an inventory of
securities stand ready to buy and sell securities “over the counter” to anyone who comes
to them and is willing to accept their prices.

Because over-the-counter dealers are in computer contact and know the prices set by one
another, the OTC market is very competitive and not very different from a market with
an organized exchange.

3. LOAN MARKET.

The Loans Market can be classified into Term Loans and Mortgages.

(i) TERM LOANS – This is the finance given to companies for supporting their
modernization and growth. Some of the loans can be syndicated. Loan syndication is
the process of sharing risks among providers of finance to a corporate entity. It is part
of the Term Loan.

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Term loans normally go with an aspect of guarantee just like other loans that a
financial institution may provide.

A Bank Guarantee is one of the services rendered by a corporate banker as well as a

merchant banker. A guarantee is a contract to discharge the liability of a third party
in case of his/her default. Guarantees act as a security from the creditor’s point of
view. It is a security in the sense that in case the borrowers fail to pay the loan, the
liability falls on the guarantor. This means that the guarantor must have the ability to
discharge his liability.

Commitments and Guarantees

Commitments relate to services where a bank commits to provide funds to a company
at a later date for which it receives a fee. Such services include unused overdraft
facilities and the provision of credit lines. Banks also provide facilities that enable
companies to raise funds by issuing marketable short-term instruments such as
commercial paper, Euronotes and (for longer maturities) medium-term notes.
In the United States many large companies issue commercial paper to raise short-term
funds and these facilities are almost always backed-up by a line of credit from a bank.
In other words, the bank has a commitment to provide credit in case the issuance of
commercial paper is not successful.

Guarantees relate to where a bank has underwritten the obligations of a third party
and currently stands behind the risk of the transaction. Default by a counterparty on
whose behalf a guarantee has been written may cause an immediate loss to the bank.
Examples include such things as a standby letter of credit. This is an obligation on
behalf of the bank to provide credit if needed under certain legally pre-arranged
circumstances.
Commercial letters of credit are widely used in financing international trade. This is a
letter of credit guaranteeing payment by a bank in favour of an exporter against
presentation of shipping and other trade documents. In other words it is a guarantee
from the importers’ bank ensuring that payment for the goods can be made.
A major attraction for banks to provide services like commitments, guarantees,
securities underwriting services are that they are all fee-based and off-balance sheet.
The above services earn banks commissions and fees. In addition, they do not relate to

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 any asset (e.g., a loan or investment) that has to be booked on the bank’s balance
sheet – hence the term ‘off-balance sheet”.

(ii) MORTGAGE - A mortgage is a loan against the security of an immovable property

or asset. The transfer of interest in a specific immovable property to secure a loan is
called a mortgage, and the type of loan is called a mortgage Loan.

- This mortgage can be either an equitable mortgage or legal mortgage.

- An Equitable mortgage is created by a mere possession of the property’s Title. The

property is legally transferred to the lender by the borrower.

4. FOREIGN EXCHANGE MARKET

The term foreign exchange refers to the process of converting home/national currencies into
foreign currencies and vice versa. As well as transferring money from one country to
another.

The market where foreign exchange transactions take place is called a foreign exchange
market. It does not refer to a market place in the physical sense of the term. In fact, it consists
of a number of dealers, banks and brokers engaged in the business of buying and selling
foreign exchange. It also includes the central bank and the treasury authorities who enter into
this market as controlling authorities.

Functions:

The most important functions of this market are:

i. To make necessary arrangements to transfer purchasing power from one country to

another.
ii. To provide adequate credit facilities for the promotion of foreign trade.
iii. To cover foreign exchange risks by providing hedging facilities.

Foreign exchange business has a three-tiered structure consisting of:

a. Trading between banks and their commercial customers.

b. Trading between banks through authorized brokers.
c. Trading with banks abroad.

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 Brokers play a significant role in the foreign exchange market in Zambia. Apart from
authorised dealers, the Central Bank has permitted licensed hotels and individuals (known as
Authorised Money Changers) to deal in foreign exchange business. The Foreign Exchange
Markets help to smoothen the flow of foreign currency and to prevent any misuse of foreign
exchange which is a scarce commodity.

How is corporate finance linked to corporate and merchant banking?

Firstly we are aware that corporate finance involves raising capital, managing funds and
making the firm grow with a view of increasing shareholders wealth. In order to raise
capital, a company can go through: Equity financing – selling a part of the company through
shares or stock. Debt Financing – covering bonds, debentures and preferred stock. These are
fixed income securities.

Other equity financing/offering can be done through the following ways;

a) Rights issue by way of Private Placement or through the Stock Exchange

When a company requires to a capital increase they issue the new capital in the form of rights
to protect existing shareholders from the dilution of their ownership stake.
Shareholders are therefore entitled to purchase new shares in the proportion that they hold at
the time of the offering. The rights are issued to the existing shareholders at a certain ratio
and at discount relative to the current market price.

Moreover, the rights trade on the same stock exchange as the shares. If a shareholder does not
exercise his rights during the subscription period (usually two weeks), the issuer will still
receive some proceeds through the so called “rump placement,” where unexercised rights are
sold to investors. The rump is priced at current prevailing market levels and not at the
subscription price. The firm receives proceeds up to the subscription price and the investors
who did not exercise their rights will receive the balance.

b) Seasonal Equity offering/New seasonal right issue

SEOs can be either primary (new shares, thus raising fresh capital) or secondary (old shares,
thus reducing the existing shareholders’ position). In most of the cases SEO’s are completed
through either a bought deal or an accelerated book-building. A bought deal involves a bank
buying shares, then selling the shares as quickly as possible to institutional investors.

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The difference between the buying and the selling price is the investment bank’s profit. The
issuer does not pay any fee.

A bought deal entails greater risk for an investment bank (compared to a marketed offering).
Accelerated book-building involves targeted marketing to a small group of investors: the
book-building occurs over a shortened interval. SEOs logically follow a period of strong
stock performance by the as well as the market as a whole.

However, share price usually drops of about 3% when an equity offering is announced. SEOs
convey negative message to investors: a manager will launch an equity offering when he
believes the firm’s current stock price is too high. In the US the average dollar value of the
price drop is equal to about 30% of the dollar value of the issue itself. For example imagine a
firm with a market capitalization of $1 billion announces a $100 million SEO. Assume its
share price declines by the average 3%. This would cut $30 million from the firm’s market
capitalization. Note that $30 million is 30% of the new offering. This result implies that a
substantial portion of the proceeds of an equity issue comes out of the pockets of old
shareholders. It is quite easy to understand that in secondary SEO (where existing
shareholders sell) the market reaction is even worse: the average drop in market capitalization
is about 80%, and in many cases the firm’s value fell by more than the proceeds of the
offering.

How is investment advisory related to corporate and merchant banking?

The merchant banker, just like a corporate banker will come in on issues of equity and debt
financing. Another avenue of corporate finance is working capital management which is
basically a matter of managing the funds of the company.

In line with managing funds, if a corporate client/firm has excess funds/surplus funds the
corporate banker will come in and advise on good short-term investment options.

In other words, if the cash is in excess the corporate banker provides the instruments in which
the firm can invest. And if there is a shortage of cash, the corporate banker will provide
liquidity, through Overdrafts and Cash Credits, so that the company can continue in its bid to
grow and achieve its objectives.

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Investment advisory services offered by merchant bankers are concerned with the
following:

What to buy or sell and when to buy or sell amongst the following listed instruments:

- Shares (stocks)
- Bonds - corporate, municipal or government
- Preferred stock
- Derivative products such as options or futures
- Commodities
- Real estate

- Advisory services will also look at the kind of portfolios client might be interested in
constructing.

- It also aims at offering advice on the kind of portfolio management strategies, whether
they be active or passive management strategies, or which index to track.

- The credit rating business is part of Merchant/Investment Banking, so are Unit Trust
Management, and Pension Funds Management.

- In this vein a client’s major source of information on investment matters will be their
corporation merchant banker.

WORKSHEET;

How do Zambian companies raise funds through the financial market? Support your answer
with examples. What are the pre-and post-issue obligations of each party? How are banks
involved?

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