Raising Capital Through Debt and Equity

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					                               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.


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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.




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            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.



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           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.



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            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.


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               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.



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     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.




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       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.




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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.



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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.




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