Principles of Managerial Finance 9th Edition Chapter 2 Institutions, Securities, Markets and Rates

Learning Objectives Understand the relationship between financial institutions and markets, and the role of the money market. Describe the key characteristics and types of corporate bonds. Differentiate between debt and equity capital. Discuss the rights, characteristics, and features of both common and preferred stock.

Learning Objectives Review the operation of the capital market, particularly the securities exchanges and the role of the investment banker. Describe the interest rate fundamentals and the basic relationship between risk and rates of return.

Financial Institutions & Markets Firms that require funds from external sources can obtain them in three ways: through a bank or other financial institution through financial markets through private placements This chapter will focus on financial institutions and markets

Financial Institutions & Markets Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.

Financial Intermediaries in the U.S.

The Changing Role of Financial Institutions DIDMCA A revolution in the financial services industry began with the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980. This legislation was crafted and passed as a result of the tumultuous conditions in the financial markets during the late 1970s which resulted in rapid disintermediation.

The Changing Role of Financial Institutions DIDMCA DIDMCA (1980) actually consisted of two parts: Depository Institutions Deregulation and Monetary Control. DID was designed to do a number of things: curtail regulation Q (interest rate ceilings) increase various sources of funding available to banks expand the scope and activity of S&Ls by allowing them to invest in other than home mortgages

The Changing Role of Financial Institutions DIDMCA The monetary control (MC) portion of DIDMCA was designed to extend the Fed’s control to thrifts and nonmember banks by extending reserve requirements and other controls to them. This permitted both greater competition for deposits and more flexibility in terms of the types of investments various institutions could make.

Financial Markets Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and the capital market. Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.

Financial Markets Whether subsequently traded in the money or capital market, securities are first issued through the primary market. The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. Once issued, securities then trade on the secondary markets such as the New York Stock Exchange or NASDAQ.

Financial Markets

Claims to Wealth While real assets include the direct ownership of tangible assets such as land or buildings, financial assets represent claims against the income and assets of those who issued the claims. Types of financial assets include stocks, bonds, and bank deposits. Some financial assets, such as stocks and bonds, can be traded in the secondary markets while others, such as bank deposits, cannot.

The Relationship between Financial Institutions and Financial Markets

The Money Market The money market exists as a result of the interaction between the suppliers and demanders of short-term funds (those having a maturity of a year or less). Most money market transactions are made in marketable securities which are short-term debt instruments such as T-bills and commercial paper. Money market transactions can be executed directly or through an intermediary.

The Money Market The international equivalent of the domestic (U.S.) money market is the Eurocurrency market. The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or other marketable currencies. The Eurocurrency market has grown rapidly mainly because it is unregulated and because it meets the needs of international borrowers and lenders.

Corporate Bonds Bonds are long-term debt instruments issued by corporations. Corporate bonds typically pay interest semiannually, pay fixed coupon interest, have a par or face value of $1,000 and have an original maturity of 10 to 30 years. Furthermore, they have a prior claim on the firm’s assets (in from of stockholders) but do not represent ownership in the firm.

Corporate Bonds Legal Aspects The bond indenture specifies the conditions under which it has been issued. It outlines both the rights of bondholders and duties of the issuing corporation. It also specifies the timing of interest and principal payments, any restrictive covenants, and sinking fund requirements.

Corporate Bonds Legal Aspects Common standard debt provisions in the indenture typically include: the maintenance of satisfactory accounting records periodically furnishing audited financial statements the payment of taxes and other liabilities when due the maintenance of all facilities in good working order identification of any collateral pledged against the bond

Corporate Bonds Legal Aspects Common restrictive provisions (or covenants) in the indenture typically include: the maintenance of a minimum level of liquidity prohibiting the sale of accounts receivable the imposition of certain fixed asset investments constraints on subsequent borrowing limits on annual cash dividend payments

Corporate Bonds Legal Aspects An additional restrictive provision often included in the indenture is a sinking fund requirement, which specifies the manner in which a bond is systematically retired prior to maturity. Sinking funds typically dictate that the firm make semi- annual or annual payments to a trustee who then purchases the bonds in the market.

Corporate Bonds Cost of Bonds In general, the longer the bond’s maturity, the higher the interest rate (or cost) to the firm. In addition, the larger the size of the offering, the lower will be the cost (in % terms) of the bond. Finally, the greater the risk of the issuing firm, the higher the cost of the issue.

Corporate Bonds General Features The conversion feature of convertible bonds allows bondholders to exchange their bonds for a specified number of shares of common stock. Bondholders will exercise this option only when the market price of the stock is greater than the conversion price. A call feature, which is included in most corporate issues, gives the issuer the opportunity to repurchase the bond prior to maturity at the call price.

Corporate Bonds General Features In general, the call premium is equal to one year of coupon interest and compensates the holder for having it called prior to maturity. Furthermore, issuers will exercise the call feature when interest rates fall and the issuer can refund the issue at a lower cost. Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature.

Corporate Bonds General Features Bonds also are occasionally issued with stock purchase warrants attached to them to make them more attractive to investors. Warrants give the bondholder the right to purchase a certain number of shares of the same firm’s common stock at a specified price during a specified period of time. Including warrants typically allow the firm to raise debt capital at a lower cost than would be possible in their absence.

Variety of Corporate Debt Mortgage Bonds Mortgage bonds are backed by real estate and/or the physical assets of the corporation. The real assets pledged will have a market value greater than the bond issue. If the company defaults on the bonds, the real assets are sold off to pay off the mortgage bond holders.

Variety of Corporate Debt Equipment Trust Certificates Equipment trust certificates are very similar to automobile loans. When you borrow money for your new car, you make a down payment. Then you make your monthly installment payments. At no time throughout the life of the loan is your car worth less than the outstanding amount of the loan.

Variety of Corporate Debt Equipment Trust Certificates Many railroad and transportation companies use equipment trust certificates to meet their financing needs. Usually, 20% of the purchase price is put down by the company in the form of a down payment. Then the balance is paid off over 15 years.

Variety of Corporate Debt Equipment Trust Certificates When the company is finished paying off the loan, it receives clear title from the trustee. If the company defaults on its loan, the equipment is sold off and the bond holders are paid off.

Variety of Corporate Debt Equipment Trust Certificates Equipment Trust Certificates are serial bonds. That is, each time a payment is made, a portion of that payment is interest and a portion of that payment is principal. In this way, as previously stated, the loan amount never exceeds the collateral value.

Variety of Corporate Debt Debentures Debentures are unsecured promissory notes that are supported by the general creditworthiness of the issuing company. Because no assets are pledged, these bonds are riskier than collateralized bonds. As a result, they are often referred to as subordinate debt and carry higher interest rates and/or other features to make them more desirable to investors.

Variety of Corporate Debt Income Bonds Income bonds will only pay interest if income is earned by the issuing company and only to the extent that income is earned. Income bonds are the only bonds issued where failure to pay the interest in a timely fashion does not lead to immediate default. As a result, income bonds are considered to be extremely risky.

Variety of Corporate Debt Income Bonds In general, income bonds are issued by a company in bankruptcy. The company facing bankruptcy will meet with its creditors (usually bond holders) and agree to issue new income bonds in exchange for the old bonds. Because failure to pay interest would land the company back into bankruptcy court, the creditors agree that interest will only be paid to the extent earned.

Variety of Corporate Debt Convertible Bonds Convertible bonds are one type of hybrid security. They are like bonds in that they pay a fixed rate of interest and have a maturity date. They are also like stock because they give the investor an option to convert the bond into a specified number of shares of stock. The market price of a convertible bond therefore depends both on the firm’s stock price and prevailing interest rates.

Variety of Corporate Debt Variable Interest Rate Bonds Variable interest rate bonds are bonds with coupon rates that vary with changes in short-term interest rates (like adjustable rate mortgages). Usually, the interest rate is pegged to another rate such as U.S. Treasury bills. In general, the market price of a variable rate bond will be less volatile. On most bonds, an increase in interest rates will result in a decrease in market price.

Variety of Corporate Debt Discount and Zero Coupon Bonds A zero coupon bond pays no coupon interest from year to year the way most bonds do. Investors earn their returns by purchasing the bonds at deep discounts from the bond’s face value, and then receiving the full face value at maturity. Since the return on a zero depends strictly on the issuing firm’s ability to pay the face value at maturity, only the most creditworthy firms are able to issue them.

Variety of Corporate Debt High-Yield (Junk) Bonds High-yield bonds are not a different type of bond -- simply a bond of lower quality. Bonds rated BB (S&P) or Ba (Moodys) or lower are considered to be junk. Junk bonds are usually debentures and are subordinated to the firm’s other debt. In general, junk bonds pay around 3 to 4 percent higher yields to investors than higher-grade bonds.

Retiring Debt Serial-Bonds A serial bond is simply one in which some of the bonds in the issue mature or are retired each year rather than all at once. Serial bonds are usually used by companies to finance costly equipment, or by municipalities to finance capital improvements. Also, the assets financed are usually used as collateral to secure the bonds.

Retiring Debt Sinking Funds A sinking fund is simply a series of periodic payments to retire part of a debt issue. In most cases, the periodic payments plus the interest earned on those deposits retire the debt at maturity. In some cases, the firm sets aside funds and randomly selects bonds to be called. Strong sinking funds set aside a large amount to be retired (say 10% per year).

Retiring Debt Sinking Funds Weak sinking funds will leave most of the issue outstanding until maturity. This is sometimes referred to as a balloon payment. Bonds with strong sinking funds are generally considered to be less risky than those with weak sinking funds.

Retiring Debt Repurchasing Debt Firm’s that have outstanding bonds which have substantially declined in price and are selling at a discount are sometimes repurchased by the issuer in the open market. Thus, a firm with bonds selling at $500 with a face value of $1000 can cut their financing costs in half. However, this decision must be weighed against any alternative uses for the cash used to execute the repurchase.

Retiring Debt Callable Bonds A call feature gives the issuer the right (or option) to retire a debt issue prior to maturity. Issuer’s tend to call bonds that were issued during a period of high interest rates because it gives them the opportunity to refund the debt at a lower rate. To protect investors, callable bonds usually require the issuer to pay a call premium which amounts to one year of extra interest expense (but usually declines over time).

Bond Risk Sources of Risk Default Risk Risk that the interest will not be paid Risk that the principal will not be paid Risk that the price of the bond will decline due to poor company prospects Inflation Risk Call Risk Interest Rate Risk.

Corporate Bonds Bond Ratings

The Nature of Equity Capital Contrasting Debt & Equity

The Nature of Equity Capital Voice in Management Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. Common equity holders have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. Bondholders and preferred stockholders receive no such privileges.

The Nature of Equity Capital Claims on Income & Assets Equity holders are have a residual claim on the firm’s income and assets. Their claims can not be paid until the claims of all creditors, including both interest and principle payments on debt have been satisfied. Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear.

The Nature of Equity Capital Maturity Unlike debt, equity capital is a permanent form of financing. Equity has no maturity date and never has to be repaid by the firm.

The Nature of Equity Capital Tax Treatment While interest paid to bondholders is tax-deductible to the firm, dividends paid to preferred and common stock holders is not. In effect, this lowers the cost of debt relative to the cost of equity as a source of financing to the firm.

Common Stock Stockholder Rights Voting Rights In general, voting rights are relatively meaningless since share ownership is very widely dispersed among a large number of individual shareholders. As a result, directors and top management are relatively well-insulated. This has begun to diminish to some extent in recent years due to the rapid expansion of large institutional investors such as mutual funds and insurance companies.

Common Stock Stockholder Rights Voting Rights traditional voting Under traditional voting, each share owned gives the shareholder the right to vote for one individual for each set on the board of directors. Under this system, if the majority of shareholders vote as a block, the minority could never elect a director.

Common Stock Stockholder Rights Voting Rights traditional voting cumulative voting This system empowers minority stockholders by permitting each stockholder to cast all of his or her votes for one candidate for the firm’s board of directors.

Common Stock Stockholder Rights Voting Rights traditional voting cumulative voting Example: Under traditional voting, a shareholder with 100 shares can vote 100 shares for each of 5 members of the board of directors. Under cumulative voting, a shareholder with 100 shares can vote 500 shares for just one member running for the board of directors.

Common Stock Stockholder Rights Voting Rights Preemptive Rights A preemptive right gives a shareholder the right to maintain his or her proportionate share of the company by requiring that all new shares issued must be done so through a “rights offering.” Under a rights offering, a shareholder who owns 10% of the shares outstanding has the right to purchase 10% of any additional shares issued.

Common Stock Stockholder Rights Voting Rights Preemptive Rights Proxies Proxies are frequently used in the voting process since many smaller stockholders do not attend the annual meeting. Shareholders must sign a proxy statement giving their votes to another party who will then vote their shares.

Common Stock Dividends Payment of dividends is at the discretion of the Board of Directors. Dividends may be made in cash, additional shares of stock, and even merchandise. Stockholders are residual claimants -- they receive dividend payments only after all claims have been settled with the government, creditors, and preferred stockholders.

International Stock Issues Common Stock International Stock Issues The international market for common stock is not as large as that for international debt. However, cross-border trading and issuance of stock has increased dramatically during the past 20 years. Much of this increase has been driven by the desire of investors to diversify their portfolios internationally.

Common Stock International Stock Issues Stock Issued in Foreign Markets A growing number of firms are beginning to list their stocks on foreign markets. Issuing stock internationally both broadens the company’s ownership base and helps it to integrate itself in the local business scene.

Common Stock International Stock Issues Foreign Stocks in U.S. Markets Only the largest foreign firms choose to list their stocks in the U.S. because of the rigid reporting requirements of the U.S. markets. Most foreign firms instead choose to tap the U.S. markets using ADRs -- claims issued by U.S. banks representing ownership shares of foreign stock trading in U.S. markets.

Preferred Stock Preferred stock is an equity instrument that usually pays a fixed dividend and has a prior claim on the firm’s earnings and assets in case of liquidation. The dividend is expressed as either a dollar amount or as a percentage of its par value. Therefore, unlike common stock a preferred stock’s par value may have real significance. If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears.

Preferred Stock In general, and arrearage must be paid before common stockholders receive a dividend. Preferred stocks which possess this characteristic are called cumulative preferred stocks. Preferred stocks are also often referred to as hybrid securities because they possess the characteristics of both common stocks and bonds. Preferred stocks are like common stocks because they are perpetual securities with no maturity date.

Preferred Stock Preferred stocks are like bonds because they are fixed income securities. Dividends never change. Because preferred stocks are perpetual, many have call features which give the issuing firm the option to retire them should the need or advantage arise. In addition, some preferred stocks have mandatory sinking funds which allow the firm to retire the issue over time. Finally, participating preferred stock allows preferred stockholders to participate with common stockholders in the receipt of dividends beyond a specified amount.

Preferred Stock Two special types of preferred stock include adjustable (floating) rate preferred and payment-in-kind (PIK) preferred. The dividend on floating rate preferred is tied to the rate on specified government securities and and protects investors from variations in interest and inflation rates. PIK preferred pays dividends in the form of additional shares rather than in cash for a specified period after which investors are either paid in cash or are given the opportunity to swap these shares for more traditional securities.

Preferred Stocks & Bonds Contrasted Preferred stocks are riskier than bonds from the investor perspective because: Bond terms are legal obligations The investor cannot expect the firm to redeem preferred stock for a preset face value. It must be sold in the market at an uncertain price. Preferred stock prices are therefore more variable and thus riskier than bond prices.

Disadvantages of Preferred Stock Preferred stock offers no protection from inflation. Preferred stock tends to be less marketable than either bonds or common stock resulting in a large bid-ask spread. Inferior position to bondholders. Yields are insufficient for most (non-corporate) investors to justify risk.

Securities Exchanges Organized Exchanges Organized securities exchanges are tangible secondary markets where outstanding securities are bought and sold. They account for over 60% of the dollar volume of domestic shares traded. Only the largest and most profitable companies meet the requirements necessary to be listed on the New York Stock Exchange.

Securities Exchanges Organized Exchanges Only those that own a seat on the exchange can make transactions on the floor (there are currently 1,366 seats). Trading is conducted through an auction process where specialists “make a market” in selected securities. As compensation for executing orders, specialists make money on the spread (bid price - ask price).

Securities Exchanges Organized Exchanges Requirements NYSE AMEX shares held by public 1,100,000 400,000 stockholders with 100+ shares 2,000 1,200 pretax income (latest year) $2,500,000 $750,000 pretax income (prior 2 years) $2,000,000 N/A MV of public shares held $18,000,000 $300,000 tangible assets $16,000,000 $4,000,000

Over-the-Counter Exchange Securities Exchanges Over-the-Counter Exchange The over-the-counter (OTC) market is an intangible market for securities transactions. Unlike organized exchanges, the OTC is both a primary market and a secondary market. The OTC is a computer-based market where dealers make a market in selected securities and are linked to buyers and sellers through the NASDAQ System. Dealers also make money on the “spread”.

Securities Price Quotations Bond Quotations

Securities Price Quotations Stock Quotations

Functions of Investment Bankers Underwriting, Private Placement & Best Efforts Corporations typically raise debt and equity capital using the services of investment bankers through public offerings. When underwriting a security issue, an investment bankers guarantees the issuer will receive a specified amount of money from the issue. The investment banker purchases the securities from the firm at a lower price than the planned resale price.

Functions of Investment Bankers Underwriting, Private Placement & Best Efforts When underwriting an issue, the investment banker bears the risk of price changes between the time of purchase and the time of resale. With a private placement, the investment banker arranges for the direct sale of the issue to one or more individuals or firms and receives a commission for acting as the intermediary in the transaction. When a firm issues securities on a best efforts basis, compensation is based on the number of securities sold.

Functions of Investment Bankers Advising Underwriters also act as advisors and consultants for corporations. They can assist firms in planning both the timing of an issue and the amount and features of an issue. They also can assist in evaluating mergers and acquisitions.

Other Aspects of Investment Banking Selecting an Investment Banker An investment banker may be selected through competitive bidding, where the banker or group of bankers that bids the highest price for an issue is chosen for the underwriting. With a negotiated offering, the investment banker is merely hired rather than awarded the issue through a competitive bid.

Other Aspects of Investment Banking Syndicating the Underwriting Underwriting syndicates are typically formed when companies bring large issues to the market. Each investment banker in the syndicate normally underwrites a portion of the issue in order to reduce the risk of loss for any single firm and insure wider distribution of shares. The syndicate does so by creating a selling group which distributes the shares to the investing public.

Other Aspects of Investment Banking Syndicating the Underwriting

Other Aspects of Investment Banking Registration Requirements Before a new security can be issued, the firm must file a registration statement with the SEC at least 20 days before approval is granted. One part of the registration statement called the prospectus details the firm’s operating and financial position. However, a prospectus may be distributed to potential investors during the approval period as long as a red herring is printed on the front cover.

Other Aspects of Investment Banking Registration Requirements As an alternative to filing cumbersome registration statements, firms with more than $150 million in outstanding stock can use a procedure called shelf registration. This allows the firm to file a single document that covers all issues during the subsequent 2 year period. As a result, the approved securities are kept “on the shelf” until the need for or market conditions are appropriate for issue.

Other Aspects of Investment Banking Pricing & Distributing an Issue In general, underwriters wait until the end of the registration period to price securities to ensure marketability. If the issue is fully sold, it is considered an oversubscribed issue; if not fully sold, it is considered undersubscribed. In order to stabilize the issue at the initial offering price as it is being offered for sale, investment bankers often place orders to purchase the security themselves.

Other Aspects of Investment Banking Cost of Investment Banking Services Investment bankers earn their income by profiting on the spread. The spread is difference between the price paid for the securities by the investment banker and the eventual selling price in the marketplace. In general, costs for underwriting equity is highest, followed by preferred stock, and then bonds. In percentage terms, costs can be as high as 17% for small stock offerings to as low as 1.6% for large bond issues.

Other Aspects of Investment Banking Private Placements Although diminishing in frequency, firms can also negotiate private placements rather than public offerings. Private placements can reduce administrative and issuance costs for firms since registration and approval from the SEC is not required. However, they do pose problems for purchasers since the securities cannot not be resold via secondary markets.

Interest Rates & Required Returns Term Structure of Interest Rates The term structure of interest rates relates the interest rate to the time to maturity for securities with a common default risk profile. Typically, treasury securities are used to construct yield curves since all have zero risk of default. However, yield curves could also be constructed with AAA or BBB corporate bonds or other types of similar risk securities.

Interest Rates & Required Returns Term Structure of Interest Rates Impact of Inflation

Interest Rates & Required Returns Term Structure of Interest Rates Yield Curves

Theories of Term Structure Expectations Hypothesis This theory suggest that the shape of the yield curve reflects investors expectations about the future direction of inflation and interest rates. Therefore, an upward-sloping yield curve reflects expectations of higher future inflation and interest rates. In general, the very strong relationship between inflation and interest rates supports this theory.

Theories of Term Structure Liquidity Preference Theory This theory contends that long term interest rates tend to be higher than short term rates for two reasons: long-term securities are perceived to be riskier than short-term securities borrowers are generally willing to pay more for long-term funds because they can lock in at a rate for a longer period of time and avoid the need to roll over the debt.

Theories of Term Structure Market Segmentation Theory This theory suggests that the market for debt at any point in time is segmented on the basis of maturity. As a result, the shape of the yield curve will depend on the supply and demand for a given maturity at a given point in time.

Issue & Issuer Characteristics Risk Premiums Issue & Issuer Characteristics Default Risk Maturity Risk Liquidity Risk Contractual Provisions Tax Risk