Get documents about "Raising Capital Through Debt and Equity
Description
Raising Capital Through Debt and Equity document sample
Document Sample
CHAPTER 14
Raising Capital
in the Financial Markets
CHAPTER ORIENTATION
This chapter considers the market environment in which long-term capital is raised. The
underlying rationale for the existence of security markets is presented, investment banking
services and procedures are detailed, private placements are discussed, and security market
regulation is reviewed.
CHAPTER OUTLINE
I. The mix of corporate securities sold in the capital market.
A. When corporations raise cash in the capital market, what type of financing
vehicle is most favored? The answer to this question is corporate bonds. The
corporate debt markets clearly dominate the corporate equity markets when
new (external) funds are being raised.
B. From our discussion on the cost of capital, we understand that the U.S. tax
system inherently favors debt as a means of raising capital. During the 1999-
2001 period, bonds and notes accounted for about 76.9 percent of new
corporate securities sold for cash.
II. Why financial markets exist
A. Financial markets consist of institutions and procedures that facilitate
transactions in all types of financial claims.
B. Some economic units spend more than they earn during a given period of
time. Some economic units spend less than they earn. Accordingly, a
mechanism is needed to facilitate the transfer of savings from those economic
units that have a savings surplus to those that have a savings deficit. Financial
markets provide such a mechanism.
C. The function of financial markets then is to allocate savings in an economy to
the ultimate demander (user) of the savings.
D. If there were no financial markets, the wealth of an economy would be
lessened. Savings could not be transferred to economic units, such as business
firms, which are most in need of those funds.
344
III. Financing business: The movement of funds through the economy.
A. In a normal year the household sector is the largest net supplier of funds to
the financial markets. We call the household sector then a savings-surplus
sector.
1. The household sector can also be a savings-deficit sector.
2. From 1995 – 1999, the household sector was a net user of financial
capital as a result of taking advantage of low interest rate mortgages.
B. In contrast, the nonfinancial business sector is typically a savings-deficit
sector.
1. The nonfinancial business sector can also be a savings-surplus sector.
2. Economic conditions and corporate profitability influence the ability
of this sector to provide funds to the financial market.
C. In recent years, the foreign sector has become a major savings-surplus sector.
D. Within the domestic economy, the nonfinancial business sector is dependent
on the household sector to finance its investment needs.
E. The movement of savings through the economy occurs in three distinct ways:
1. The direct transfer of funds
2. Indirect transfer using the investment banker
3. Indirect transfer using the financial intermediary
IV. Components of the U.S. financial market system
A. Public offerings can be distinguished from private placements.
1. The public (financial) market is an impersonal market in which both
individual and institutional investors have the opportunity to acquire
securities.
a. A public offering takes place in the public market.
b. The security-issuing firm does not meet (face-to-face) the
actual investors in the securities.
2. In a private placement of securities, only a limited number of
investors have the opportunity to purchase a portion of the issue.
a. The market for private placements is more personal than its
public counterpart.
b. The specific details of the issue may actually be developed on
a face-to-face basis among the potential investors and the
issuer.
345
c. Venture capital
(1) Start-up firms often turn to venture capitalists to raise
funds.
(a) Broader public markets find these firms too
risky.
(b) Venture capitalists are willing to accept the
risks because of an expectation of higher
returns.
(1) Venture capital firms that acquire equity in a start-up
firm manage risk by sitting on the firm’s board of
directors or actively monitoring management’s
activities.
(2) Venture capital is often provided by established non-
venture-capitalist firms that take a minority investment
position in an emerging firm or create a separate
venture capital subsidiary.
(a) The investment approach allows the established
firm to gain access to new technology and to
create strategic alliances.
(b) The subsidiary approach allows the established
firm to retain human and intellectual capital.
B. Primary markets can be distinguished from secondary markets.
1. Securities are first offered for sale in a primary market. For example,
the sale of a new bond issue, preferred stock issue, or common stock
issue takes place in the primary market. These transactions increase
the total stock of financial assets in existence in the economy.
2. Trading in currently existing securities takes place in the secondary
market. The total stock of financial assets is unaffected by such
transactions.
C. The money market can be distinguished from the capital market.
1. The money market consists of the institutions and procedures that
provide for transactions in short-term debt instruments which are
generally issued by borrowers who have very high credit ratings.
a. "Short-term" means that the securities traded in the money
market have maturity periods of not more than 1 year.
b. Equity instruments are not traded in the money market.
c. Typical examples of money market instruments are (l) U.S.
Treasury bills, (2) federal agency securities, (3) bankers'
acceptances, (4) negotiable certificates of deposit, and (5)
commercial paper.
346
2. The capital market consists of the institutions and procedures that
provide for transactions in long-term financial instruments. This
market encompasses those securities that have maturity periods
extending beyond 1 year.
D. Organized security exchanges can be distinguished from over-the-counter
markets.
1. Organized security exchanges are tangible entities whose activities are
governed by a set of bylaws. Security exchanges physically occupy
space and financial instruments are traded on such premises.
a. Major stock exchanges must comply with a strict set of
reporting requirements established by the Securities and
Exchange Commission (SEC). These exchanges are said to be
registered.
b. Organized security exchanges provide several benefits to both
corporations and investors. They (l) provide a continuous
market, (2) establish and publicize fair security prices, and (3)
help businesses raise new financial capital.
c. A corporation must take steps to have its securities listed on an
exchange in order to directly receive the benefits noted above.
Listing criteria differ from exchange to exchange.
2. Over-the-counter markets include all security markets except the
organized exchanges. The money market is a prominent example.
Most corporate bonds are traded over-the-counter.
a. NASDAQ, a telecommunication system providing an
information link among brokers and dealers in the OTC
markets, accounted for 43% of the national exchange equity
market trading in the U.S., measured in dollar volume for the
year 1998.
Nasdaq Stock Market, Inc. trades securities of over 3,600
public companies as of 2002.
V. The Investment Banker
A. The investment banker is a financial specialist who acts as an intermediary in
the selling of securities. The investment banker works for an investment
banking house (firm).
B. Three basic functions are provided by the investment banker:
1. The investment banker assumes the risk of selling a new security issue
at a satisfactory (profitable) price. This is called underwriting.
Typically, the investment banking house, along with the underwriting
syndicate, actually buys the new issue from the corporation that is
raising funds. The syndicate (group of investment banking firms) then
sells the issue to the investing public at a higher (hopefully) price than
it paid for it.
347
2. The investment banker provides for the distribution of the securities to
the investing public.
3. The investment banker advises firms on the details of selling
securities.
C. Several distribution methods are available for placing new securities into the
hands of final investors. The investment banker's role is different in each
case.
1. In a negotiated purchase, the firm in need of funds contacts an
investment banker and begins the sequence of steps leading to the
final distribution of the securities that will be offered. The price that
the investment banker pays for the securities is "negotiated" with the
issuing firm.
2. In a competitive-bid purchase, the investment banker and
underwriting syndicate are selected by an auction process. The
syndicate willing to pay the greatest dollar amount per new security to
the issuing firm wins the competitive bid. This means that it will
underwrite and distribute the issue. In this situation, the price paid to
the issuer is not negotiated; instead, it is determined by a sealed-bid
process much on the order of construction bids.
3. In a commission (or best-efforts), offering the investment banker does
not act as an underwriter but rather attempts to sell the issue in return
for a fixed commission on each security that is actually sold. Unsold
securities are simply returned to the firm hoping to raise funds.
4. In a privileged subscription, the new issue is not offered to the
investing public. It is sold to a definite and limited group of investors.
Current stockholders are often the privileged group.
5. In a direct sale, the issuing firm sells the securities to the investing
public without involving an investment banker in the process. This is
not a typical procedure.
VI. More on Private placements: The Debt Side
A. Each year billions of dollars of new securities are privately (directly) placed
with final investors. In a private placement, a small number of investors
purchase the entire security offering. Most private placements involve debt
instruments.
B. Large financial institutions are the major investors in private placements.
These include (l) life insurance firms, (2) state and local retirement funds, and
(3) private pension funds.
C. The advantages and disadvantages of private placements as opposed to public
offerings must be carefully evaluated by management.
1. The advantages include (a) greater speed than a public offering in
actually obtaining the needed funds, (b) lower flotation costs than are
associated with a public issue, and (c) increased flexibility in the
financing contract.
348
2. The disadvantages include (a) higher interest costs than are ordinarily
associated with a comparable public issue, (b) the imposition of
restrictive covenants in the financing contract, and (c) the possibility
that the security may have to be registered some time in the future at
the lender's option.
VII. Flotation costs
A. The firm raising long-term capital typically incurs two types of flotation
costs: (l) the underwriter's spread and (2) issuing costs. The former is
typically the larger.
1. The underwriter's spread is the difference between the gross and net
proceeds from a specific security issue. This absolute dollar difference
is usually expressed as a percent of the gross proceeds.
2. Many components comprise issue costs. The two most significant are
(l) printing and engraving and (2) legal fees. For comparison
purposes, these are usually expressed as a percent of the issue's gross
proceeds.
B. SEC data reveal two relationships about flotation costs.
1. Issue costs (as a percent of gross proceeds) for common stock exceed
those of preferred stock, which exceed those of bonds.
2. Total flotation costs per dollar raised decrease as the dollar size of the
security issue increases.
VIII. Regulation
A. The primary market is governed by the Securities Act of 1933.
1. The intent of this federal regulation is to provide potential investors
with accurate and truthful disclosure about the firm and the new
securities being sold.
2. Unless exempted, the corporation selling securities to the public must
register the securities with the SEC.
3. Exemptions allow follow for a variety of conditions. For example, if
the size of the offering is small enough (less than $1.5 million), the
offering does not have to be registered. If the issue is already
regulated or controlled by some other federal agency, registration with
the SEC is not required. Railroad issues and public utility issues are
examples.
4. If not exempted, a registration statement is filed with the SEC
containing particulars about the security-issuing firm and the new
security.
5. A copy of the prospectus, a summary registration statement, is also
filed. It will not yet have the selling price of the security printed on it;
it is referred to as a red herring and called that until approved by the
SEC.
349
6. If the information in the registration statement and prospectus is
satisfactory to the SEC, the firm can proceed to sell the new issue. If
the information is not satisfactory, a stop order is issued which
prevents the immediate sale of the issue. Deficiencies have to be
corrected to the satisfaction of the SEC before the firm can sell the
securities.
7. The SEC does not evaluate the investment quality of any issue. It is
concerned instead with the presentation of complete and accurate
information upon which the potential investor can act.
B. The secondary market is regulated by the Securities Exchange Act of 1934.
This federal act created the SEC. It has many aspects.
1. Major security exchanges must register with the SEC.
2. Insider trading must be reported to the SEC.
3. Manipulative trading that affects security prices is prohibited.
4. Proxy procedures are controlled by the SEC.
5. The Federal Reserve Board has the responsibility of setting margin
requirements. This affects the proportion of a security purchase that
can be made via credit.
C. The Securities Acts Amendments of 1975 touched on three important issues.
1. Congress mandated the creation of a national market system (NMS).
Implementation details of the NMS were left to the SEC. Agreement
on the final form of the NMS is yet to come.
2. Fixed commissions (also called fixed brokerage rates) on public
transactions in securities were eliminated.
3. Financial institutions, like commercial banks and insurance firms,
were prohibited from acquiring membership on stock exchanges
where their purpose in so doing might be to reduce or save
commissions on their own trades.
D. In March 1982, the SEC adopted "Rule 415." This process is now known as a
shelf registration or a shelf offering.
1. This allows the firm to avoid the lengthy, full registration process
each time a public offering of securities is desired.
2. In effect, a master registration statement that covers the financing
plans of the firm over the coming two years is filed with the SEC.
After approval, the securities are sold to the investing public in a
piecemeal fashion or "off the shelf."
3. Prior to each specific offering, a short statement about the issue is
filed with the SEC.
350
E. Congress passed in July 2002 the Public Company Accounting Reform and
Investor Protection Act. The short name for the act became the Sarbanes-
Oxley Act of 2002.
1. The Sarbanes-Oxley Act was passed as the result of a large series of
corporate indiscretions.
2. The act contains 11 “titles” which tightened significantly the latitudes
given to corporate advisors (like accountants, lawyers, company
officers, and boards of directors) who have access to or influence
company decisions.
3. The initial title of the act created the Public Company Accounting
Oversight Board. This board’s purpose is to regulate the accounting
industry relative to public companies that they audit. Members are
appointed by the SEC.
4. As recently June of 2003, the oversight board itself published a set of
ethics rules to police its own set of activities.
IX. The Multinational Firm: Efficient Financial Markets and Intercountry Risk
A. The United States’ highly developed, complex and competitive financial
markets facilitate the transfer of savings from the saving-surplus sector to the
saving-deficit sector.
B. Multinational firms are reluctant to invest in countries with ineffective
financial systems.
1. Financial and political systems lacking integrity will often be rejected
for direct investment by multinational firms.
2. Countries that experience significant devaluation of its currency may
also be considered too risky for investment.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
14-1. Financial markets are institutions and procedures that facilitate transactions in all
types of financial claims. Financial markets perform the function of allocating
savings in the economy to the ultimate demander(s) of the savings. Without these
financial markets, the total wealth of the economy would be lessened. Financial
markets aid the rate of capital formation in the economy.
14-2. A financial intermediary issues its own type of security which is called an indirect
security. It does this to attract funds. Once the funds are attracted, the intermediary
purchases the financial claims of other economic units in order to generate a return
on the invested funds. A life insurance company, for example, issues life insurance
policies (its indirect security) and buys corporate bonds in large quantities.
351
14-3. The money market consists of all institutions and procedures that accomplish
transactions in short-term debt instruments issued by borrowers with (typically) high
credit ratings. Examples of securities traded in the money market include U.S.
Treasury Bills, bankers’ acceptances, and commercial paper. Notice that all of these
are debt instruments. Equity securities are not traded in the money market. It is
entirely an over-the-counter market. On the other hand, the capital market provides
for transactions in long-term financial claims (those claims with maturity periods
extending beyond one year). Trades in the capital market can take place on
organized security exchanges or over-the-counter markets.
14-4. Organized stock exchanges provide for:
(1) A continuous market. This means a series of continuous security prices is
generated. Price changes between trades are dampened, reducing price
volatility, and enhancing the liquidity of securities.
(2) Establishing and publicizing fair security prices. Prices on an organized
exchange are determined in the manner of an auction. Moreover, the prices
are published in widely available media like newspapers.
(3) An aftermarket to aid businesses in the flotation of new security issues. The
continuous pricing mechanism provided by the exchanges facilitates the
determination of offering prices in new flotations. The initial buyer of the
new issue has a ready market in which he can sell the security should he need
liquidity rather than a financial asset.
14-5. The criteria for listing can be labeled as follows: (1) profitability; (2) size; (3) market
value; (4) public ownership.
14-6. Most bonds are traded among very large financial institutions. Life insurance
companies and pension funds are typical examples. These institutions deal in large
quantities (blocks) of securities. An over-the-counter bond dealer can easily bring
together a few buyers and sellers of these large quantities of bonds. By comparison,
common stocks are owned by millions of investors. The organized exchanges are
necessary to accomplish the "fragmented" trading in equities.
14-7. The investment banker is a middleman involved in the channeling of savings into
long-term investment. He performs the functions of: (1) underwriting; (2)
distributing; (3) advising. By assuming underwriting risk, the investment banker and
his syndicate purchase the securities from the issuer and hope to sell them at a higher
price. Distributing the securities means getting those financial claims into the hands
of the ultimate investor. This is accomplished through the syndicate's selling group.
Finally, the investment banker can provide the corporate client with sound advice on
which type of security to issue, when to issue it, and how to price it.
14-8. In a negotiated purchase, the corporate security issuer and the managing investment
banker negotiate the price that the investment banker will pay the issuer for the new
offering of securities. In a competitive-bid situation, the price paid to the corporate
security issuer is determined by competitive (sealed) bids, which are submitted by
several investment banking syndicates hoping to win the right to underwrite the
offering.
352
14-9. Investment banking syndicates are established for three key reasons: (1) the
investment banker who originates the business probably cannot afford to purchase
the entire new issue himself; (2) to spread the risk of loss among several
underwriters; (3) to widen the distribution network.
14-10. Several positive benefits are associated with private placements. The first is speed.
Funds can be obtained quickly, primarily due to the absence of a required registration
with the SEC. Second, flotation costs are lower as compared to public offerings of
the same dollar size. Third, greater financing flexibility is associated with the private
placement. All of the funds, for example, need not be borrowed at once. They can
be taken over a period of time. Elements of the debt contract can also be
renegotiated during the life of the loan.
14-11. As a percent of gross proceeds, flotation costs are inversely related to the dollar size
of the new issue. Additionally, common stock is more expensive to issue than
preferred stock, which is more expensive to issue than debt.
14-12. The answer on this is clear. The corporate debt markets dominate the corporate
equity markets when new funds are raised. The tax system of the U.S. economy
favors debt financing by making interest expense deductible from income when
computing the firm's federal tax liability. Consider all corporate securities offered
for cash over the period 1999-2001. The percentage of the total represented by bonds
and notes was 76.9 percent compared to 23.1 percent equity.
14-13. The household sector is the largest net supplier of savings to the financial markets.
Foreign financial investors have recently been net suppliers of savings to the
financial markets. On the other hand, the nonfinancial corporate business sector is
most often a savings-deficit sector. The U.S. Government sector too is a deficit
sector in most years.
14-14. First, there may be a direct transfer of savings from the investor to the borrower.
Second, there may be an indirect transfer that used the services provided by an
investment banker. Third, there may be an indirect transfer that uses the services of a
financial intermediary. Private pension funds and life insurance companies are
prominent examples of the latter case.
353
