Professional Documents
Culture Documents
The
The Capital
Capital Market
Market
19.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 19,
you should be able to:
• Understand the characteristics of the capital market and the difference
between a primary and a secondary market.
• Describe the three primary methods used by companies to raise external
long-term funds – public issue, privileged subscription, and private
placement.
• Explain the role of investment bankers in the process of issuing new
securities, including traditional underwriting, best efforts offering, shelf
registration, and standby arrangements.
• Calculate the theoretical value of a (subscription) right, and describe the
relationships among the market price of the stock, the subscription price,
and the value of the right.
• Understand the Securities and Exchange Commission (SEC) registration
process, including the role played by the registration statement, red
herring, prospectus, and tombstone advertisement.
• Understand the roles that venture capital and an initial public offering (IPO)
play in financing the early stages of a company’s growth.
• Discuss the potential signaling effects that often accompany the issuance
of new long-term securities.
19.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The Capital Market
• Public Issue
• Privileged Subscription
• Regulation of Security Offerings
• Private Placement
• Initial Financing
• Signaling Effects
• The Secondary Market
19.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Déjà 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.
19.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Déjà Vu All Over Again
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
19.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
19.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
19.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 that allows a
company to register securities in advance that it may
want to sell and then put that registration ‘on the shelf’
until it makes a sales offering; also called SEC Rule
415.
415 These securities can then be sold piecemeal
whenever the company chooses.
19.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
19.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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:
• the number of rights required to subscribe
for an additional share of stock
• the subscription price per share
• the expiration date of the offering
19.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Subscription Rights
P0 – R0 = [ (R0)(N) + S ], therefore
R0 = P0 – [ (R0)(N) + S ]
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
19.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
How is the Value of a
Right Determined?
$50 – $40
Solving for R0. R0 =
9+1
R0 = $1
PX = $49
19.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Oversubscription Privilege
Oversubscription Privilege – The right to
purchase, on a pro rata basis, any
unsubscribed shares in a rights offering.
19.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Security Offerings Reform
• SEC adopted new rules to improve registration,
communications and the offering process. This is due,
in large part, to technological advances.
• Divided public companies into tiered groups of a) well-
known seasoned issuers (WKSI), b) seasoned issuers,
c) unseasoned issuers, d) non-reporting issuers and e)
ineligible issuers.
• WKSIs (approximately 30% of issuers) are most widely
followed in capital markets
WKSI – Well-known seasoned issuer. Essentially large, actively
traded companies with established US public track records.
19.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Security Offerings Reform
Automatic shelf registration – A more flexible form of
shelf registration only available to WKSIs that become
automatically effective upon filing with the SEC.
19.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Signaling Effects
• Negative stock
price reaction to 3 Relative Abnormal
common stock or Stock Returns for a
Cumulative Average
convertible 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)
19.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
19.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.