1. Chapter 2 Investment Banking

2. A.Primary Market 1. The initial sale of a security 2. Assistant of investment bankers 3. Initial sale only occurs once 4. Process by which securities come into existence B.Secondary Market 1. Buy and sell securities once they have been issued 2. NYSE 3. NASDAQ 4. American Stock Exchange

3. The Transfer of Funds to Business A. Indirect Transfer 1.Buying or selling securities through a financial intermediary a)Commercial bank B. Direct Transfer 1.Investing money directly in a firm or business 2.Firms raise money by selling securities directly to the general public

4. The Role of Investment Bankers A. Investment Bankers 1.Middleman who brings together investors and firms (and governments) issuing new securities 2.Channel money from investors to firms that need money 3.Often are not bankers 4.Generally do not invest 5.Division of a brokerage firm a) Goldman, Sacks & Co. b) Donaldson c) Montgomery Securities

5. The Role of Investment Bankers B. Initial Public Offering 1. First sale of common stock to the general public

7. The Role of Investment Bankers –Firm Commitment Investment bankers guarantee the sale and make a firm commitment to raise a specified amount of money –Underwriting Purchase of an issue of new securities for subsequent sale by investment bankers The guaranteeing of the sale of a new issue of securities

8. The Role of Investment Bankers –Underwriters Buy securities with the intention to sell them to the general public By agreeing to buy the securities, the underwriters guarantee the sale and bear all risk If the underwriters cannot sell the securities to the general public, they must still pay the agreed-on sum to the issuing firm

9. The Mechanics of Underwriting –Syndicate A group of brokerage houses that joins together to underwrite and market a specific sale of securities The firms that manage the sale are the lead underwriters Advantages –More potential buyers –Reduced amount of securities that each firm must sell –Increased probability that the entire issue will be sold

10. The Mechanics of Underwriting –Best Efforts Agreement The investment bankers that do not want to guarantee the sale or underwrite the sale Instead, the investment bankers agree to make their best efforts to sell the securities, but the risk of the sale is borne by the issuing firm Most Sales are through underwriting, small issues of risky securities are often best efforts sales

11. Pricing an IPO If the price is set too high… –The syndicate will be unable to sell the securities –The syndicate has two options: Maintain the offer price and hold the securities in inventory until they are sold Let the market find a lower price level that will induce investors to purchase NEITHER CHOICE IS GOOD! –If the securities are held in inventory, the investment bankers will be either tying up their own funds or pay interest on borrowed funds

12. Pricing and IPO  Overpricing inflicts losses on initial buyers and investment bankers.  Tendency to underprice to assure successful sale  Underpricing leads to windfall gains for initial buyers.

13. Marketing a New Security  Once the terms of sale have been agreed upon, the managing house may issue a preliminary prospectus –Often referred to as a “red herring” A term that means the document should be read with caution as it is not final or complete –Initial document detailing the financial condition of a firm that must be filed with the SEC to register a new issue of securities –Cost of printing this is the issuing firms responsibility

14. Marketing a New Security –The Preliminary Prospectus Includes: Description of company Securities to be issued Income statement Balance sheet Current activities Regulations Nature of competition –Does not include: Price of securities –That is determined on the day the securities are issued

15. Marketing a New Security  Securities and Exchange Commission –Government agency that enforces the federal security laws  Registration –The process of filing information with the SEC concerning a proposed sale of securities to the general public  Registration Acceptance –After the SEC accepts the registration, a final prospectus is published –Does not approve investment worth –Approves the completeness of the prospectus

16. Marketing a New Security  Cost of Underwriting –A.K.A. Flotation costs or Underwriting Discount –The difference between the price of securities to the public and the proceeds received by the firm

17. The Price Volatility of IPOs –Extremely volatile Because… –Number of securities that are offered –Price changes of new issues (Prices can rise dramatically) Many firms that go public will fail and will inflict losses on those investors who have accepted this risk by purchasing securities issued by small firms Few investors get to participate in IPOs.

18. Shelf Registration  Firms that have previously sold securities to the public and wish to sell more  Construct a prospectus and file with SEC  Same basic procedures apply  Differences –Price of securities There is no guessing on what the initial price should be The price is set by the securities current market Less need for a detailed prospectus (already done)  After shelf registration has been accepted, the firm can sell those securities any time funds are needed

19. Private Placement  Nonpublic sale of securities to a financial institution  Venture Capital Firms –Often sustain a large loss –But successes usually generate large returns –After a firm achieves success, the venture capital company may sell to the general public  Mutual Funds that specialize in emerging firms

20. Regulation  Federal Level A.Protect the investing public 1.Provide information to help prevent fraud 2.Notify investors so they can make informed decisions 3.Prevent employee’s from using privileged information for personal gain B.Will not assure you that profits will be made C.You must protect yourself from your own mistakes

21. Regulation D.Securities and Exchange Commission (SEC) Enforces Federal security laws –New issues –Trading in securities Can suspend trading

22. Regulation E.Full Disclosure Laws Law requires a timely disclosure of information that may affect the value of a firm’s securities Firm’s do not have to tell you everything –Trade secrets F.10-K Report Required annual report filed with the SEC by publically held firms G.Firm’s must issue new information throughout the year that may affect the value of a security

23. Regulation H.Firm’s must issue new information throughout the year that may affect the value of a security I.Insider Information Not limited to employees Applies to people who work elsewhere but have access to privileged information J.Securities Investor Protection Corporation (SIPC) Federal agency that insures investors against failure by brokerage firms (similar to FDIC) –$500,000 per customer of which only $100,000 can be cash Brokerage firms may carry additional insurance.

24. Sarbanes-Oxley Act of 2002  Intended to restore public confidence  Main provisions: –The independence of auditors and the creation on the Public Company Accounting Oversight Board Oversees the auditing of the financial statements of publically held companies –Corporate Responsibility and Financial Disclosure Require a publically held CEO and CFO to certify that the financial statements do not contain untrue statements or material omissions

25. Sarbanes-Oxley Act of 2002 –Conflicts of Interest and corporate fraud and accountability Usually securities analysts and investment bankers cannot work for the same firm –Must be independent  Penalties for Violation –Fines –Imprisonment for up to 20 years