2. Chapter Nine
The Capital Markets

3. Capital Markets
The market for securities with an original maturity greater than one year
Firms & investors use the capital markets for long-term investments
Firms typically try to match the term of financing with the expected economic life of the assets acquired – why? What is the cost of doing this?
Investors expect to earn higher rates of return on long term securities than on money market securities
Best known capital market securities:
Stocks and bonds

4. Capital Market Participants
Primary issuers of securities:
Federal and local governments
Federal government – fund the national debt
Provincial & local governments – to fund large infrastructure projects
Corporations
Acquire funds to invest in new capital equipment
The decision to issue debt or equity is the capital structure decision
Largest purchasers of securities:
Households - You and me (often in the form of mutual funds or pension funds)

5. Capital Market Trading
Primary market
Any new sale of securities by a firm is done in the primary market
If it is the first time a firm has issued securities in the public market, is referred to as an IPO (Initial Public Offer)
Secondary market
After securities have been sold by a firm in the primary market, future transactions between investors occurs in the secondary market
Secondary market trading can occur:
Over-the-counter (OTC)
On organized exchanges (i.e., TSX)

6. Some Stock Exchange History
Toronto Stock Exchange
Established in 1861
Membership cost $5.00
Eighteen securities listed for trading
Trading hours limited to daily half-hour sessions
1901
Price of a stock exchange seat now cost $12,000
Trading volume 1,000,000 shares per year
100 companies listed
Continuous auction trading introduced
1914
The fear of a financial panic following the declaration of WWI prompted the TSE to cease operations for three months, beginning July 28, Trading also halted on the NYSE

7. Some Stock Exchange History
1922 – 1926
Canadian firms issue over $700 million of new securities
From 1924 to 1929, annual trading volume rises from 1,000,000 shares per year to 10,000,000 shares per year
1933
The Great Depression exacts a toll. Over 2,000 investment & brokerage firms fail in the U.S. However, no TSE member firm defaults on obligations to clients
1937
The TSE moves to a new facility at 234 Bay Street, the first building in Toronto to have air conditioning
1955
The price of a TSE membership was $100,000 and 1 billion shares worth $2.6 billion traded

8. Some Stock Exchange History
1977
The TSE launches the world’s first Computer Assisted Trading System (CATS). The TSE 300 Composite Index is launched
1980
3.3 Billion shares worth $29.5 Billion are traded, accounting for 80% of all equity trading in Canada
1987
The TSE 35 Index is created
Annual trading value exceeds $100 Billion
1996
The TSE is the first exchange in North America to introduce decimal trading
All US exchanges forced to adopt decimal trading my April 9, 2001

9. Some Stock Exchange History
1997
The TSE is the largest stock exchange in North America to introduce a floorless, electronic trading environment. The trading floor is closed.
1999
Barbara Stymiest named President & CEO, the first female head of a North American exchange
The TSE becomes the sole exchange for the trading of senior equities
Vancouver Stock Exchange and Alberta Stock Exchange merge to form Canadian Venture Exchange (CDNX) for trading in junior equities
The Canadian Dealing Network, Winnipeg Stock Exchange and the equities portion of the Montreal Stock Exchange later merge with CDNX

10. Some Stock Exchange History
2000
The TSE becomes a for-profit company on April 3, 2000
Daily trading value tops $15 Billion in May, 2000
2001
TSE acquires the Canadian Venture Exchange. CDNX renamed TSX Venture Exchange
2002
The TSE 300 Composite Index renamed S&P/TSX Composite Index May 1, 2002
Iceberg Orders introduced (allows a large order to be broken into many small orders to hide trading information and prevent moving market prices)
TSX does an IPO

11. Some Stock Exchange History
2003
First quarterly dividend of $0.15 paid
2005
TSX splits stock 2:1
Dividend is increased to $0.25 per share (post split)
Launches S&P/TSX Canadian Bond Index
Annual trading value more than $1 Trillion, up 29% from 2004
Income Trusts added to the S&P/TSX Composite Index.

12. Rankings of Exchanges by Market Capitalization
1- New York Stock Exchange
2- Tokyo Stock Exchange
3- NASDAQ
4- London Stock Exchange
5- Euronext
6- Toronto Stock Exchange
7- Frankfurt Stock Exchange (Deutsche Börse)
8- Madrid Stock Exchange (BME Spanish Exchanges)
9- Hong Kong Stock Exchange
10-SWX Swiss Exchange
Source: World Federation of Exchanges, as of September 2005.

13. Total Value of Shares Traded, 2004
Source: World Federation of Exchanges Website

14. Average Daily Trading Value, 2004
Source: World Federation of Exchanges Website

15. Average Value of a Trade, 2004
Source: World Federation of Exchanges Website

16. Benefits of Going Public
Access to capital – expand investor base
Facilitates growth – use shares as currency
Maintain control
Enhance reputation – provides greater transparency
Create a market for existing shareholders
Reward for managers & employees

17. Three Ways to List On the TSX Venture Exchange
Initial Public Offer (IPO)
Capital Pool Company (CPC)
In stage one, a shell corporation is created whose business it is to locate a promising asset. Funds are raised for the search and due diligence process.
In stage two, the actual asset is acquired. Known as a Qualifying Transaction.
Reverse Takeover (RTO)
A private company “buys” a listed company that has no substantial business activity

18. What it Costs to Go Public on the TSX Venture Exchange
Initial Public Offer
Capital Pool Company
Reverse Takeover
TSX Venture Fees
$7,500 – 30,000
$12,500 – 40,000
Securities Commission Fees
$1,000 – 10,000
$1,000 – 3,000
N/A
Sponsor Fees
$30,000 – 50,000
$20,000 – 50,000
Legal Fees
$75,000 +
$100,000 +
Accounting & Auding Fees
$25,000 – 50,000
Source: TSX Website, “Your Guide to Public Venture Capital”

19. Costs Not Included on the Previous Page
Valuation reports
Geological or engineering reports
Expert reports
Investment dealer fees & commissions on financings
Printing costs
Transfer agency costs
Investor relations fees

20. Want to be listed on the TSX?
You will need:
At least 300 investors
A minimum of 1 million shares traded publicly, with a market value of $4 million
Any shareholder with more than 10% of the stock must provide information on their experience in business
A Participating Organization of the TSX must sponsor the company

21. Want to be listed on the NYSE?
You will need at least:
2000 stockholders, each owning at least 100 shares
A minimum of 1.1 million shares traded publicly
Pretax earnings of $2.5 million at the time of listing
$2 million in pretax earning in each of the two prior years
A total of $100 million in market value of publicly traded shares

22. Number of Listed Companies Yearly Comparison with NYSE, AMEX, Nasdaq and TSX

23. Canada Bonds

24. Canada Bonds Issued as No default risk Very low interest rates
Bearer Bonds
Registered Bonds
No default risk
Very low interest rates
Long bonds yields usually higher than short bond yields due to greater interest rate risk
Canada Savings Bonds
Redeemable at face value at any time
Canada Premium Bonds
Redeemable at face value yearly on anniversary date

25. Real Return Bonds First issued in Canada in 1991
Provide a hedge against inflation
Issued with a fixed coupon
Face value of the bond is grossed up by the change in the CPI
Coupon rate paid on the grossed up face value
At maturity, bonds are redeemed at the greater of face value or grossed-up value

26. Canada STRIPS
STRIPS – separate trading of registered interest and principal securities
Investment dealer strips the coupons from the face value. Each cash flow sold as a separate investment.
Issued in book entry form (no paper security is issued)
Collateralized by the underlying Canada bond and thus have no default risk

27. Canada Bond Interest Rates
Figure 2: Interest Rate on Long-Term Canada Bonds and the Inflation Rate, 1976–2001

28. Compare Long-Term Canada Bonds to 90-Day Treasury Bills

29. Municipal Bonds Issued by local governments
Used to finance public interest projects
Municipal bonds in the United States are tax-free. To compare a tax-free municipal interest rate with a fully taxable interest rate: Muni = taxable interest rate  (1  marginal tax rate)
Two types
General obligation bonds – no specific collateral
Revenue bonds – backed by cash flows of a specific asset
NOT default-free

30. Corporate Bonds Sold in increments of $1000 Pay interest semi-annually
Can be redeemed anytime the issuer wishes (Call feature)
Degree of risk varies with each bond
Interest rate varies with level of risk

31. Corporate Bond Interest Rates

32. Characteristics of Corporate Bonds
Today, usually sold in registered form. Issuers must report holders of bonds to CRA (Canada Revenue Agency)
Bond Indenture – contract between the issuer and the bond investors. Usually contains restrictive covenants designed to control the actions of management
Call Provisions
Higher yield – investors don’t like the call feature
Sinking fund – a portion of bond redeemed each year
Conversion into common
Value of the convertible the higher of the bond value or the conversion value

33. Types of Corporate Bonds
Secured Bonds
Mortgage bonds – secured against real estate
Equipment trust certificates – secured against other assets
Unsecured Bonds
Debentures
Subordinated debentures
Variable-rate bonds
Yield tied to some other market rate
Junk Bonds
Michael Milken, Drexel Burnham Lambert discovers an under-serviced niche in high yield bonds (fallen angels)
Milken’s personal income from > $1 Billion
Later fined for insider trading & went to jail for 3 years
Drexel files for bankruptcy in 1990 due to losses on junk bond portfolio

34. Debt Ratings

35. Stock Represents ownership in a firm Earn a return in two ways
Price of the stock rises over time
Dividends are paid to the stockholder
Stockholders have claim on all assets
Right to vote for directors and on certain issues
Two types
Common stock
Right to vote
Receive dividends
Preferred stock
Receive a fixed dividend
Do not usually vote

36. S&P/TSX Composite

37. 30 Stocks in the Dow Jones Industrial Average

38. Dow Jones Industrial Average, 1990-2002

39. Stock Market Indexes

40. Public Issues of Stocks and Bonds
Two principal ways to sell securities to the public
Investment bankers
Private placement