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CHAPTER 19 INVESTMENT BANKING.

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Presentation on theme: "CHAPTER 19 INVESTMENT BANKING."— Presentation transcript:

1 CHAPTER 19 INVESTMENT BANKING

2 Primary Services of an Investment Bank
Bringing New Securities to Market. Trading and brokerage. Mergers and acquisitions. Other business activities. Copyright© 2006 John Wiley & Sons, Inc.

3 Bringing New Securities to Market
New issues are called primary offerings, first issued in the primary market. Unseasoned offering or Initial public offering (IPO) – first sale of securities to the public. One problem with IPO is how to price them, therefore, IPO suffers from underpricing. Seasoned offering - additional issue of securities already trading. Offering can be either: Public offering Private placement Copyright© 2008 John Wiley & Sons, Inc.

4 Bringing New Securities to Market
Public offering: Corporation wishing to make a public offering must decide whether to have: Underwriting: investment banker guarantees that the issuer will receive a fixed amount of money whether securities are sold or not. Best-efforts basis: investment banker makes no guarantee and instead promises only to make its best sales efforts. Copyright© 2006 John Wiley & Sons, Inc.

5 Bringing New Securities to Market
Corporation wishing to make an underwriting security can choose to solicit investment-banking services through: Competitive bidding: the issuer publicly announces a desire to sell securities and solicits offers from several investment-banking firms. Negotiated offering: direct negotiation with a single investment banker. Copyright© 2006 John Wiley & Sons, Inc.

6 Bringing New Securities to Market (continued)
Three steps of bringing a new issue to market: 1. Origination- During the origination process, investment bank helps the issuers to analyze the feasibility of the project, determine the amount of money and type of financing. design of a security contract that is acceptable to the market; Prepare SEC registration statements and a summary prospectus, obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee. Copyright© 2008 John Wiley & Sons, Inc.

7 Bringing New Securities to Market (concluded)
2.Underwriting (price risk bearing) - the IB buys the securities at a given price to resell them to the public at a higher price. 3.Sales and distribution - selling quickly reduces inventory risk. Syndicates are formed to reduce inventory risk. Market price declines cut the IB's margin. Copyright© 2008 John Wiley & Sons, Inc.

8 Underwriting Agreements
In an underwritten offer, IB guarantees the issuer a certain price The risk of not selling the issue at a price higher than that promised to the issuer is borne by the IB. The difference between the price at which the issue is sold and that promised to the issuer is the underwriting spread. This is the profit earned by the IB. Copyright© 2008 John Wiley & Sons, Inc.

9 Underwriting Agreements
In a best efforts offer, the investment bank does not guarantee a price or that the issue will be sold. The investment bank is compensated based on the number of securities sold. The risk of the securities not selling or not selling at a desired price is borne by the issuer, not the IB. Smaller and more risky issues resort to this type of offering. Copyright© 2008 John Wiley & Sons, Inc.

10 Copyright© 2008 John Wiley & Sons, Inc.
Trading and Brokerage Besides underwriting, investment banks provide services as brokers and dealers for existing securities. The brokerage function is to bring a buyer and seller together for a commission. Dealer (making market) function - buying (bid) and selling (ask) from an inventory of securities owned by the seller. Copyright© 2008 John Wiley & Sons, Inc.

11 Trading and Brokerage (continued)
Brokers and dealers can also provide security credits which represent loans to customers with margin account. Margin trading: means that the investor can buy securities partly with borrowed money. Example: if a customer uses a 40% margin, it means that 40% of the purchased securities is being financed with the investor’s own money and the remaining 60% is financed with money borrowed from the brokerage house. Dealer security credits are financed by bank call loans and repurchase agreements. Copyright© 2006 John Wiley & Sons, Inc.

12 Trading and Brokerage (continued)
Full service brokerage firms offer a wide range of services provided by licensed stockbrokers or account executives: Storage or safekeeping of securities. Execution of trades. Investment research and advice. Cash management service. Copyright© 2008John Wiley & Sons, Inc.

13 Trading and Brokerage (concluded)
Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions. Banks may act as a broker on behalf of its customers. Arbitrage activities involving the simultaneous buying/selling of a security to take advantage of a price that exists between two markets is another trading activity of IB. Example: if GMC stock is trading for $35/share on New York Stock Exchange (NYSE )and $34/share on the NASDAQ, an arbitrageur would buy GMC stock on NASDAQ and sell it on NYSE, so he will earn$1. this process will continue until the price differential is eliminated. Copyright© 2008 John Wiley & Sons, Inc.

14 Copyright© 2008 John Wiley & Sons, Inc.
Private Placements The sale of securities directly to the ultimate investor (no public offering). The underwriting function/cost is avoided. The investment banker’s role is to: Bring buyer and seller together. Help determine a fair price for the securities. Execute the transaction. Investment banks earn a fee. Copyright© 2008 John Wiley & Sons, Inc.

15 Copyright© 2006 John Wiley & Sons, Inc.
Private Placements Advantages of private placement: Less costly in terms of time and money (i.e. reduce the total flotation costs for a business or government). The extremes of high credit quality firms and low or unknown credit quality firms use private placements. The terms of private placement are easier to renegotiate. Disadvantages of private placement: Securities have no readily available market price, they are less liquid and there is a small group of investors. Copyright© 2006 John Wiley & Sons, Inc.

16 Mergers and Acquisitions
Investment banks provide four categories of M&A for which they can earn fees: Help firms indentify M&A candidates. Do the required analysis to price the deal. Provide advice and help the acquiring firm in negotiating. Help the acquiring firm in obtaining the funds to finance the purchase. Copyright© 2006 John Wiley & Sons, Inc.

17 Mergers and Acquisitions
Specialized IB departments provide the following services. Arrange mergers which would produce economic synergy or increase total value. Assist firms in fighting hostile takeovers. Help establish the value of target firms. Mergers and acquisitions have been a profitable aspect of the IB business. CB have expanded their M&A departments. Copyright© 2008 John Wiley & Sons, Inc.

18 Other business activities
Investment-banking firms are very flexible organizations and if they can earn a satisfactory return, they can perform many services: Financial consulting: e.g. assisting clients in financial planning, determining the firm’s optimal capital structure and dividend policy. Real estate investment and brokerage: purchasing real estate for investment purposes. Copyright© 2006 John Wiley & Sons, Inc.


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