19-2 After studying Chapter 19, you should be able to: u Understand the characteristics of the capital market and the difference between a primary and a secondary market. u Describe the three primary methods used by companies to raise external long-term funds -- public issue, privileged subscription, and private placement. u Explain the role of investment bankers in the process of issuing new securities, including traditional underwriting, best efforts offering, shelf registration, and standby arrangements. u 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. u Understand the Securities and Exchange Commission (SEC) registration process, including the role played by the registration statement, red herring, prospectus, and tombstone advertisement. u Understand the roles that venture capital and an initial public offering (IPO) play in financing the early stages of a companys growth. u Discuss the potential signaling effects that often accompany the issuance of new long-term securities.
19-3 The Capital Market u Public Issue u Privileged Subscription u Regulation of Security Offerings u Private Placement u Initial Financing u Signaling Effects u The Secondary Market
19-4 Deja Vu All Over Again Capital Market Capital Market -- The market for relatively long-term (greater than one year original maturity) financial instruments. Primary Market Primary Market -- A market where new securities are bought and sold for the first time (a new issues market). Secondary Market Secondary Market -- A market for existing (used) securities rather than new issues.
19-5 Deja Vu All Over Again INVESTMENT SECTOR FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET Public issue Privileged subscription Private placement Indicates the possible presence of a standby arrangement Indicates the financial intermediaries own securities flow to the savings sector
19-6 Public Issue u Securities are sold to hundreds, and often thousands, of investors under a formal contract overseen by federal and state regulatory authorities. investment banker u When a company issues securities to the general public, it is usually uses the services of an investment banker. Public Issue Public Issue -- Sale of bonds or stock to the general public.
19-7 Investment Banker underwriting spread u Investment banker receives an underwriting spread when acting as a middleman in bringing together providers and consumers of investment capital. u Underwriting spread u 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. Investment Banker Investment Banker -- A financial institution that underwrites (purchases at a fixed price on a fixed date) new securities for resale.
19-8 Investment Banker lower cost u Thus, the services can be provided at a lower cost to the firm than the firm can perform the same services internally. u Three primary means companies use to offer securities to the general public: u Traditional (firm commitment) underwriting u Best efforts offering u Shelf registration efficiently u Investment bankers have expertise, contacts, and the sales organization to efficiently market securities to investors.
19-9 Traditional Underwriting the underwriter u If the security issue does not sell well, either because of an adverse turn in the market or because it is overpriced, the underwriter, not the company, takes the loss. Underwriting firm commitment 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.
19-10 Traditional Underwriting A.Competitive-bid u The issuing company specifies the date that sealed bids will be received. u Competing syndicates submit bids. u The syndicate with the highest bid wins the security issue. Underwriting Syndicate Underwriting Syndicate -- A temporary combination of investment banking firms formed to sell a new security issue.
19-11 Traditional Underwriting u The issuing company selects an investment banking firm and works directly with the firm to determine the essential features of the issue. u Together they discuss and negotiate a price for the security and the timing of the issue. u Depending on the size of the issue, the investment banker may invite other firms to join in sharing the risk and selling the issue. u Generally used in corporate stock and most corporate bond issues. B.Negotiated Offering
19-12 Traditional Underwriting Best Efforts Offering Best Efforts Offering -- A security offering in which the investment bankers agree to use only their best efforts to sell the issuers securities. The investment bankers do not commit to purchase any unsold securities. Shelf Registration SEC Rule 415 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. These securities can then be sold piecemeal whenever the company chooses.
19-13 Shelf Registration: Flotation Costs and Other Advantages u This competition reduces underwriting spreads. u 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. u The amount of free advice available from underwriters is less than before shelf registration was an alternative to firms. u A firm with securities sitting on the shelf can require that investment banking firms competitively bid for its underwriting business.
19-14 Privileged Subscription Privileged Subscription rights offering 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. Preemptive Right 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.
19-15 Terms of Offering Terms specify: u the number of rights required to subscribe for an additional share of stock u the subscription price per share u the expiration date of the offering Right subscription right Right -- A short-term option to buy a certain number (or fraction) of securities from the issuing corporation; also called a subscription right.
19-16 Subscription Rights Generally, the subscription period is three weeks or less. Options available to the holder of rights: u Exercise the rights and subscribe for additional shares u Sell the rights (they are transferable) u Do nothing and let the rights expire
19-17 Subscription Rights Thus, the shareholder needs to purchase an additional 3 rights. 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. What action should the shareholder take? 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?
19-18 Value of Rights 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: u the market price of the stock u the subscription price u the number of rights required to purchase an additional share of stock What gives a right its value?
19-19 P 0 R 0 R 0 NS P 0 - R 0 = [ (R 0 )(N) + S ], therefore R 0 P 0 R 0 NS R 0 = P 0 - [ (R 0 )(N) + S ] R 0 R 0 = the market price of one right when the stock is selling rights-on P 0 P 0 = the market price of a share of stock selling rights-on S S = the subscription price per share N N = the number of rights required to purchase one share of stock How is the Value of a Right Determined?
19-20 R 0 Solving for R 0. How is the Value of a Right Determined? P 0 S P 0 - S N N + 1 R 0 R 0 = P X P 0 R 0 R 0 NS P X = P 0 - R 0 = [ (R 0 )(N) + S ] R 0 By substitution for R 0, we can solve the ex-rights value of one share of stock, P X ex-rights value of one share of stock, P X. P 0 NS (P 0 )(N) + S N N + 1 P X P X =
19-21 Example of the Valuation of a Right u Assume the following information u Assume the following information: current market price $50. u The current market price of a stock rights-on is $50. subscription price is $40. u The subscription price is $40. nine rights u It takes nine rights to buy an additional share of stock. 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?
19-22 R 0 Solving for R 0. P X Solving for P X. How is the Value of a Right Determined? $50$40 $50 - $40 9 9 + 1 R 0 R 0 = R 0 $1 R 0 = $1 $50 9$40 ($50 )(9) + $40 9 9 + 1 P X P X = P X $49 P X = $49
19-23 Theoretical versus Actual Value of Rights u Transaction costs u Speculation u 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. Why might the actual value of a right differ from its theoretical value?
19-24 Standby Arrangement u Fee often composed of a flat fee and an additional fee for each unsold share of stock. u The greater the risk of an unsuccessful rights offering, the more desirable a standby arrangement. 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.
19-25 Oversubscription Privilege u 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. u As a result, each shareholder oversubscribing receives 5/8ths (50,000 / 80,000) of a share for each share oversubscribed. Oversubscription Privilege Oversubscription Privilege -- The right to purchase, on a pro rata basis, any unsubscribed shares in a rights offering.
19-26 Privileged Subscription versus Underwritten Issue u Investors are familiar with the firms operations when using a rights offering. u The principal sales tool is a discounted price (rights offering) and the investment banking organization (underwriting). u A disadvantage of a rights offering is that the shares will be sold at a lower price. u There is greater dilution with a rights offering which many firms attempt to avoid. u There is a wider distribution of shares with a public offering.
19-27 Regulation of Security Offerings -- Federal Securities Exchange Act of 1934 Securities Exchange Act of 1934 -- Regulates the secondary market for long- term securities -- the securities exchanges and the over-the-counter market. Securities Act of 1933 Truth in Securities Act 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. Securities and Exchange Commission (SEC) enforces both of these acts.
19-28 Regulation of Security Offerings -- Federal Part 1: Prospectus Part 1: Prospectus -- Discloses information about the issuing company and its new offering and is distributed to investors. Part 2 Part 2:Additional information required by the SEC that is not part of the printed prospectus. Registration Statement Registration Statement -- The disclosure document filed with the SEC in order to register a new securities issue.
19-29 Red Herring u SEC reviews the registration statement to see that all the required information is presented and that it is not misleading. comment letter u Deficiencies are communicated in a comment letter. stop order u Once the SEC is satisfied, it approves the registration. If not, it issues a stop order. 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.
19-30 Regulation of Security Offerings -- Federal u Registration statements become effective on the 20th day after filing (or on the 20th day after filing the last amendment). u The SEC, at its discretion, can advance the date. Typical time from filing to approval is 40 days. Registration Statement Effective Date
19-31 Regulation of Security Offerings -- Federal u A shelf registration allows a company to register with the SEC in advance of a security offering. u 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. u Typically, the waiting period following this simple amendment is only a day or two. Impact with shelf registration:
19-32 Regulation of Security Offerings -- Federal u The term reflects the stark, black-bordered look of the ad. u Includes the companys name, a brief description of the security, the offering price, and the names of the investment bankers in the underwriting syndicate. Tombstone Advertisement Tombstone Advertisement -- An announcement placed in newspapers and magazines giving just the most basic details of a security offering.
19-33 Sarbanes-Oxley Act of 2002 u Most important security law reform since 1930s. u Establishes: u an oversight board to regulate public accounting firms that audit public companies u New audit and audit committee standards u Executive officers of public companies must certify the companys SEC reports u Increases liability for violations of federal security laws Sarbanes-Oxley Act of 2002 (SOX) Sarbanes-Oxley Act of 2002 (SOX) – Addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information.
19-34 Regulation of Security Offerings -- State u Individual states have security commissions that regulate securities in their states. u 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. u Important if the SEC provides only limited review. u States vary on the strictness of their regulation. Blue Sky Laws Blue Sky Laws -- State laws regulating the offering and sale of securities.
19-35 Private Placement u Eliminates the underwriting function of the investment banker. u The dominant private placement lender in this group is the life-insurance category (pension funds and bank trust departments are very active as well). Private (or Direct) 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).
19-36 Private Placement Features u Allows the firm to raise funds more quickly. u Eliminates risks with respect to timing. u Eliminates SEC regulation of the security. u Terms can be tailored to meet the needs of the borrower. u Flexibility in borrowing smaller amounts more frequently rather than a single large amount.
19-37 Private Placement and Other Developments u Qualified Institutional Buyers (QIBs) u 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. u Event Risk u 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.
19-38 Private Placement and Other Developments u Underwritten Rule 144a Private Placement u 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. u Private Placement with Registration Rights u 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.
19-39 Initial Financing -- Venture Capital u Wealthy investors and financial institutions are the primary providers of funds for a new enterprise (usually common stock). u 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. u Letter stock u 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.
19-40 Initial Public Offering (IPO) Initial Public Offering (IPO) -- A companys first offering of common stock to the general public. Initial Financing -- Initial Public Offerings u Often prompted by venture capitalists who wish to realize a cash return on their investment. u Founders of the firm may wish to go through an IPO to establish a value for their company. u There exists greater price uncertainty with an IPO than with other new public stock issues.
19-41 Signaling Effects u Negative stock price reaction to common stock or convertible issues. u Straight debt and preferred stock do not tend to show statistically significant effects. -10 -8 -6 -4 -2 0 2 4 6 8 0 -2 -3 -4 3 2 1 Cumulative Average Abnormal Return (%) Time Around Announcement (in days) Relative Abnormal Stock Returns for a New Equity Issue
19-42 Possible Explanations for Price Reactions Asymmetric (Unequal) Information u Potential investors have less information than management (particularly for common stock). u Exchanges of different types of securities show that increases (decreases) in financial leverage are associated with positive (negative) abnormal returns. Expectations of Future Cash Flows u 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.
19-43 The Secondary Market u Purchases and sales of existing stocks and bonds occur in the secondary market. u Transactions in the secondary market do not provide additional funds to the firm. u The secondary market increases the liquidity of securities outstanding and lowers the required returns of investors. u Composed of organized exchanges like the New York Stock Exchange and American Stock Exchange plus the over-the-counter (OTC) market.