The Capital Market

 Public Issue
 Privileged Subscription
 Regulation of Security Offerings
 Private Placement
 Initial Financing
 Signaling Effects
 The Secondary Market
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 Deja Vu All Over Again
Capital Market -- The market for relatively
long-term (greater than one year original
maturity) financial instruments.
Primary Market -- A market where new
securities are bought and sold for the
first time (a “new issues” market).
Secondary Market -- A market for existing
(used) securities rather than new issues.
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 Deja Vu All Over Again

INVESTMENT SECTOR Public issue

Privileged

INTERMEDIARIES
subscription
Private

FINANCIAL
FINANCIAL BROKERS
placement
Indicates the possible
presence of a
SECONDARY MARKET “standby arrangement”
Indicates the financial
intermediaries’ own
SAVINGS SECTOR securities flow to the
savings sector

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 Public Issue
Public Issue -- Sale of bonds or stock
to the general public.
 Securities are sold to hundreds, and often
thousands, of investors under a formal
contract overseen by federal and state
regulatory authorities.
 When a company issues securities to the
general public, it is usually uses the
services of an investment banker.
banker
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 Investment Banker
Investment Banker -- A financial institution that
underwrites (purchases at a fixed price on a
fixed date) new securities for resale.
 Investment banker receives an underwriting spread
when acting as a middleman in bringing together
providers and consumers of investment capital.
 Underwriting spread -- the difference between the
price the investment bankers pay for the security
and the price at which the security is resold to the
public.
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 Investment Banker
 Investment bankers have expertise, contacts, and
the sales organization to efficiently market
securities to investors.
 Thus, the services can be provided at a lower cost
to the firm than the firm can perform the same
services internally.
 Three primary means companies use to offer
securities to the general public:
 Traditional (firm commitment) underwriting
 Best efforts offering
 Shelf registration
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 Traditional Underwriting
Underwriting -- Bearing the risk of not being
able to sell a security at the established price
by virtue of purchasing the security for
resale to the public; also known as firm
commitment underwriting.
underwriting
 If the security issue does not sell well, either
because of an adverse turn in the market or
because it is overpriced, the underwriter,
underwriter not
the company, takes the loss.

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 Traditional Underwriting
Underwriting Syndicate -- A temporary
combination of investment banking firms
formed to sell a new security issue.
A. Competitive-bid
 The issuing company specifies the date that
sealed bids will be received.
 Competing syndicates submit bids.
 The syndicate with the highest bid wins the
security issue.
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 Traditional Underwriting
B. Negotiated Offering
 The issuing company selects an investment
banking firm and works directly with the firm to
determine the essential features of the issue.
 Together they discuss and negotiate a price for the
security and the timing of the issue.
 Depending on the size of the issue, the investment
banker may invite other firms to join in sharing the
risk and selling the issue.
 Generally used in corporate stock and most
corporate bond issues.
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 Traditional Underwriting
Best Efforts Offering -- A security offering in which
the investment bankers agree to use only their best
efforts to sell the issuer’s securities. The
investment bankers do not commit to purchase any
unsold securities.

Shelf Registration -- A procedure whereby a

company is permitted to register securities it plans
to sell over the next two years; also called SEC Rule
415.
415 These securities can then be sold piecemeal
whenever the company chooses.

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 Shelf Registration: Flotation
Costs and Other Advantages
 A firm with securities sitting “on the shelf” can
require that investment banking firms
competitively bid for its underwriting business.
 This competition reduces underwriting spreads.
 The total fixed costs (legal and administrative) of
successive public debt issues are lower with a single
shelf registration than with a series of traditional
registrations.
 The amount of “free” advice available from
underwriters is less than before shelf registration was
an alternative to firms.
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 Privileged Subscription
Privileged Subscription -- The sale of new securities
in which existing shareholders are given a
preference in purchasing these securities up to the
proportion of common shares that they already own;
also known as a rights offering.
offering

Preemptive Right -- The privilege of shareholders to

maintain their proportional company ownership by
purchasing a proportionate share of any new issue
of common stock, or securities convertible into
common stock.

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 Terms of Offering
Right -- A short-term option to buy a certain
number (or fraction) of securities from the issuing
corporation; also called a subscription right.
right
Terms specify:
 thenumber of rights required to subscribe
for an additional share of stock
 the subscription price per share
 the expiration date of the offering
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 Subscription Rights
Options available to the holder of rights :
 Exercise the rights and subscribe for
additional shares
 Sell the rights (they are transferable)
 Do nothing and let the rights expire

Generally, the subscription

period is three weeks or less.
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 Subscription Rights
A shareholder who owns 77 shares and
just received 77 rights would like to
purchase 8 new shares. It takes 10 rights
for each new share. What action should
the shareholder take?
The shareholder can then purchase 7 shares
(use 70 rights) and still retain the 7 remaining
rights. Thus, the shareholder needs to
purchase an additional 3 rights.
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 Value of Rights
What gives a right its value?
A right allows you to buy new stock at a
discount that typically ranges between 10 to 20
percent from the current market price.
The market value of a right is a function of:
 the market price of the stock
 the subscription price
 the number of rights required to purchase an
additional share of stock
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 How is the Value of a
Right Determined?

P0 - R0 = [ (R0)(N) + S ], therefore

R0 = P0 - [ (R0)(N) + S ]

R0 = the market price of one right when the stock is

selling “rights-on”
P0 = the market price of a share of stock selling
“rights-on”
S = the subscription price per share
N = the number of rights required to purchase one
share of stock
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 How is the Value of a
Right Determined?
P0 - S
Solving for R0. R0 =
N+1

PX = P0 - R0 = [ (R0)(N) + S ]
By substitution for R0, we can solve the
“ex-rights” value of one share of stock, PX.
(P0 )(N) + S
PX =
N+1
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 Example of the
Valuation of a Right
What is the value of a right when the stock is
selling “rights-on”? What is the value of one
share of stock when it goes “ex-rights”?
 Assume the following information:
information
 The current market price of a stock
“rights-on” is $50.
 The subscription price is $40.
 It takes nine rights to buy an
additional share of stock.
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 How is the Value of a
Right Determined?
$50 - $40
Solving for R0. R0 =
9+1

R0 = $1

($50 )(9) + $40

Solving for PX. PX =
9+1

PX = $49
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 Theoretical versus
Actual Value of Rights
Why might the actual value of a right
differ from its theoretical value?
 Transaction costs
 Speculation
 Irregular exercise and sale of rights
over the subscription period
Arbitrage acts to limit the deviation of
the actual right value from the
theoretical value.
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 Standby Arrangement
Standby Arrangement -- A measure taken to
ensure the complete success of a rights
offering in which an investment banker or
group of investment bankers agrees to
“stand by” to underwrite any unsubscribed
(unsold) portion of the issue.
 Fee often composed of a flat fee and an additional
fee for each unsold share of stock.
 The greater the risk of an unsuccessful rights
offering, the more desirable a standby arrangement.
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 Oversubscription Privilege
Oversubscription Privilege -- The right to
purchase, on a pro rata basis, any
unsubscribed shares in a rights offering.

 For example, shareholders subscribe for 450,000

shares of a 500,000-share rights offering. Let us
assume that some shareholders would like more
shares and oversubscribe by 80,000 shares.
 As a result, each shareholder oversubscribing
receives 5/8ths (50,000 / 80,000) of a share for each
share oversubscribed.
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 Privileged Subscription
versus Underwritten Issue
 Investors are familiar with the firm’s operations
when using a rights offering.
 The principal sales tool is a discounted price
(rights offering) and the investment banking
organization (underwriting).
 A disadvantage of a rights offering is that the
shares will be sold at a lower price.
 There is greater dilution with a rights offering
which many firms attempt to avoid.
 There is a wider distribution of shares with a
9-24 public offering.
 Regulation of Security
Offerings -- Federal
Securities Act of 1933 -- Generally requires
that public offerings be registered with the
federal government before they may be
sold; also known as Truth in Securities Act.
Act
Securities Exchange Act of 1934 -- Regulates
the secondary market for long-term securities
-- the securities exchanges and the over-the-
counter market.

Securities and Exchange Commission (SEC)

enforces both of these acts.
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 Regulation of Security
Offerings -- Federal
Registration Statement -- The disclosure
document filed with the SEC in order to
register a new securities issue.
Part 1: Prospectus -- Discloses information
about the issuing company and its new
offering and is distributed to investors.
Part 2:
2 Additional information required by the
SEC that is not part of the printed
prospectus.
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 Red Herring
Red Herring -- The preliminary prospectus. It
includes a legend in red ink on the cover
stating that the registration statement has not
yet become effective.
 SEC reviews the registration statement to see that
all the required information is presented and that it
is not misleading.
 Deficiencies are communicated in a comment letter.
letter
 Once the SEC is satisfied, it approves the
registration. If not, it issues a stop order.
order
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 Regulation of Security
Offerings -- Federal
Registration Statement Effective Date
 Registration statements become
effective on the 20th day after filing
(or on the 20th day after filing the
last amendment).
 The SEC, at its discretion, can
advance the date. Typical time from
filing to approval is 40 days.
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 Regulation of Security
Offerings -- Federal
Impact with shelf registration:
 A shelf registration allows a company to
register with the SEC “in advance” of a
security offering.
 The company can sell “off the shelf” by filing
a simple amendment and having the SEC
accelerate the “normal” 20-day waiting period
accorded amendments.
 Typically, the waiting period following this
simple amendment is only a day or two.
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 Regulation of Security
Offerings -- Federal
Tombstone Advertisement -- An
announcement placed in newspapers and
magazines giving just the most basic details
of a security offering.
 The term reflects the stark, black-bordered
look of the ad (see Slide 19-32).
 Includes the company’s name, a brief
description of the security, the offering
price, and the names of the investment
bankers in the underwriting syndicate.
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 Regulation of Security
Offerings -- State
Blue Sky Laws -- State laws regulating the
offering and sale of securities.
 Individual states have security commissions that
regulate securities in their states.
 These laws are particularly important when a
security issue is sold entirely to people within the
state and may not be subject to SEC regulation.
 Important if the SEC provides only limited review.
 States vary on the strictness of their regulation.

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 Private Placement
Private (or Direct) Placement -- The sale of an
entire issue of unregistered securities (usually
bonds) directly to one purchaser or a group of
purchasers (usually financial intermediaries).
 Eliminates the underwriting function of the
investment banker.
 The dominant private placement lender in this
group is the life-insurance category (pension
funds and bank trust departments are very
active as well).
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 Private
Placement Features
 Allows the firm to raise funds more quickly.
 Eliminates risks with respect to timing.
 Eliminates SEC regulation of the security.
 Terms can be tailored to meet the needs of
the borrower.
 Flexibility in borrowing smaller amounts
more frequently rather than a single large
amount.
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 Private Placement and
Other Developments
 Event Risk -- The risk that existing debt
will suffer a decline in creditworthiness
because of the issuance of additional debt
securities, usually in connection with
corporate restructuring.
 Qualified Institutional Buyers (QIBs) --
Eligible purchasers, by SEC Rule 144a, of
previous securities from a private
placement without having to go through a
public market registration.
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 Private Placement and
Other Developments
 Private Placement with Registration Rights –
It combines a standard private placement
with a contract requiring the issuer to
register the securities with the SEC for
possible resale in the public market.
 Underwritten Rule 144a Private Placement –
The issuer sells its securities initially to an
investment bank that resells them to the same
institutional buyers that are candidates for a
regular private placement. Often includes
registration rights.
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 Initial Financing --
Venture Capital
 Wealthy investors and financial institutions are the
primary providers of funds for a new enterprise
(usually common stock).
 Rule 144 and the 1933 Act require privately placed
securities to be held for at least two years or be
registered before they can be resold.
 Letter stock * -- Privately placed common stock that
cannot be immediately resold.
* Note: Under SEC Rule 144a, however, letter stock could
be sold to qualified institutional buyers (QIBs) without a
waiting period.
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 Initial Financing --
Initial Public Offerings
Initial Public Offering (IPO) -- A company’s first
offering of common stock to the general public.
 Often prompted by venture capitalists who
wish to realize a cash return on their
investment.
 Founders of the firm may wish to go through
an IPO to establish a value for their company.
 There exists greater price uncertainty with an
IPO than with other new public stock issues.
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 Signaling Effects
 Negative stock
price reaction to 3 Relative Abnormal
common stock or Stock Returns for a

Abnormal Return (%)

2
convertible Cumulative Average New Equity Issue
issues. 1

0
 Straight debt and
-1
preferred stock
do not tend to -2
show statistically -3
significant -4
effects. -10 -8 -6 -4 -2 0 2 4 6 8
Time Around Announcement (in days)
9-38
 Possible Explanations
for Price Reactions
Expectations of Future Cash Flows
 The unexpected sale of securities may be associated
with lower than expected operating cash flows and
interpreted as bad news. Hence, the stock price
might suffer accordingly.
Asymmetric (Unequal) Information
 Potential investors have less information than
management (particularly for common stock).
 Exchanges of different types of securities show that
increases (decreases) in financial leverage are
associated with positive (negative) abnormal returns.
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 The Secondary Market
 Purchases and sales of existing stocks and bonds
occur in the secondary market.
 Transactions in the secondary market do not provide
additional funds to the firm.
 The secondary market increases the liquidity of
securities outstanding and lowers the required
returns of investors.
 Composed of organized exchanges like the New York
Stock Exchange and American Stock Exchange plus
the over-the-counter (OTC) market.

9-40