CHAPTER 14

Raising Capital in the Financial Markets

CHAPTER ORIENTATION
This chapter considers the market environment in which long-term capital is raised. The underlying rationale for the existence of security markets is presented, investment banking services and procedures are detailed, private placements are discussed, and security market regulation is reviewed.

CHAPTER OUTLINE
I. The mix of corporate securities sold in the capital market. A. When corporations raise cash in the capital market, what type of financing vehicle is most favored The answer to this !uestion is corporate bonds. The corporate debt markets clearly dominate the corporate e!uity markets when new "external# funds are being raised. %rom our discussion on the cost of capital, we understand that the &.'. tax system inherently favors debt as a means of raising capital. (uring the )***+,,) period, bonds and notes accounted for about -..* percent of new corporate securities sold for cash. %inancial markets consist of institutions and procedures that facilitate transactions in all types of financial claims. 'ome economic units spend more than they earn during a given period of time. 'ome economic units spend less than they earn. Accordingly, a mechanism is needed to facilitate the transfer of savings from those economic units that have a savings surplus to those that have a savings deficit. %inancial markets provide such a mechanism. The function of financial markets then is to allocate savings in an economy to the ultimate demander "user# of the savings. If there were no financial markets, the wealth of an economy would be lessened. 'avings could not be transferred to economic units, such as business firms, which are most in need of those funds.

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II.

Why financial markets exist A. $.

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%inancing business0 The movement of funds through the economy.

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In a normal year the household sector is the largest net supplier of funds to the financial markets. We call the household sector then a savings-surplus sector. ). +. The household sector can also be a savings-deficit sector. %rom )**2 3 )***, the household sector was a net user of financial capital as a result of taking advantage of low interest rate mortgages.

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In contrast, the nonfinancial business sector is typically a savings-deficit sector. ). +. The nonfinancial business sector can also be a savings-surplus sector. 4conomic conditions and corporate profitability influence the ability of this sector to provide funds to the financial market.

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In recent years, the foreign sector has become a ma5or savings-surplus sector. Within the domestic economy, the nonfinancial business sector is dependent on the household sector to finance its investment needs. The movement of savings through the economy occurs in three distinct ways0 ). +. 6. The direct transfer of funds Indirect transfer using the investment banker Indirect transfer using the financial intermediary

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/omponents of the &.'. financial market system A. 8ublic offerings can be distinguished from private placements. ). The public "financial# market is an impersonal market in which both individual and institutional investors have the opportunity to ac!uire securities. a. b. +. A public offering takes place in the public market. The security-issuing firm does not meet "face-to-face# the actual investors in the securities.

In a private placement of securities, only a limited number of investors have the opportunity to purchase a portion of the issue. a. b. The market for private placements is more personal than its public counterpart. The specific details of the issue may actually be developed on a face-to-face basis among the potential investors and the issuer.

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7enture capital ")# 'tart-up firms often turn to venture capitalists to raise funds. "a# "b# $roader public markets find these firms too risky. 7enture capitalists are willing to accept the risks because of an expectation of higher returns.

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7enture capital firms that ac!uire e!uity in a start-up firm manage risk by sitting on the firm9s board of directors or actively monitoring management9s activities. 7enture capital is often provided by established nonventure-capitalist firms that take a minority investment position in an emerging firm or create a separate venture capital subsidiary. "a# The investment approach allows the established firm to gain access to new technology and to create strategic alliances. The subsidiary approach allows the established firm to retain human and intellectual capital.

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8rimary markets can be distinguished from secondary markets. ). 'ecurities are first offered for sale in a primary market. %or example, the sale of a new bond issue, preferred stock issue, or common stock issue takes place in the primary market. These transactions increase the total stock of financial assets in existence in the economy. Trading in currently existing securities takes place in the secondary market. The total stock of financial assets is unaffected by such transactions. The money market consists of the institutions and procedures that provide for transactions in short-term debt instruments which are generally issued by borrowers who have very high credit ratings. a. b. c. :'hort-term: means that the securities traded in the money market have maturity periods of not more than ) year. 4!uity instruments are not traded in the money market. Typical examples of money market instruments are "l# &.'. Treasury bills, "+# federal agency securities, "6# bankers; acceptances, "<# negotiable certificates of deposit, and "2# commercial paper.

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The money market can be distinguished from the capital market. ).

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The capital market consists of the institutions and procedures that provide for transactions in long-term financial instruments. This market encompasses those securities that have maturity periods extending beyond ) year.

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=rgani>ed security exchanges can be distinguished from over-the-counter markets. ). =rgani>ed security exchanges are tangible entities whose activities are governed by a set of bylaws. 'ecurity exchanges physically occupy space and financial instruments are traded on such premises. a. ?a5or stock exchanges must comply with a strict set of reporting re!uirements established by the 'ecurities and 4xchange /ommission "'4/#. These exchanges are said to be registered. =rgani>ed security exchanges provide several benefits to both corporations and investors. They "l# provide a continuous market, "+# establish and publici>e fair security prices, and "6# help businesses raise new financial capital. A corporation must take steps to have its securities listed on an exchange in order to directly receive the benefits noted above. @isting criteria differ from exchange to exchange.

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=ver-the-counter markets include all security markets except the organi>ed exchanges. The money market is a prominent example. ?ost corporate bonds are traded over-the-counter. a. AA'(AB, a telecommunication system providing an information link among brokers and dealers in the =T/ markets, accounted for <6C of the national exchange e!uity market trading in the &.'., measured in dollar volume for the year )**1. Aasda! 'tock ?arket, Inc. trades securities of over 6,.,, public companies as of +,,+.

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The Investment $anker A. The investment banker is a financial specialist who acts as an intermediary in the selling of securities. The investment banker works for an investment banking house "firm#. Three basic functions are provided by the investment banker0 ). The investment banker assumes the risk of selling a new security issue at a satisfactory "profitable# price. This is called underwriting. Typically, the investment banking house, along with the underwriting syndicate, actually buys the new issue from the corporation that is raising funds. The syndicate "group of investment banking firms# then sells the issue to the investing public at a higher "hopefully# price than it paid for it.

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The investment banker provides for the distribution of the securities to the investing public. The investment banker advises firms on the details of selling securities.

'everal distribution methods are available for placing new securities into the hands of final investors. The investment banker;s role is different in each case. ). In a negotiated purchase, the firm in need of funds contacts an investment banker and begins the se!uence of steps leading to the final distribution of the securities that will be offered. The price that the investment banker pays for the securities is :negotiated: with the issuing firm. In a competitive-bid purchase, the investment banker and underwriting syndicate are selected by an auction process. The syndicate willing to pay the greatest dollar amount per new security to the issuing firm wins the competitive bid. This means that it will underwrite and distribute the issue. In this situation, the price paid to the issuer is not negotiatedD instead, it is determined by a sealed-bid process much on the order of construction bids. In a commission "or best-efforts#, offering the investment banker does not act as an underwriter but rather attempts to sell the issue in return for a fixed commission on each security that is actually sold. &nsold securities are simply returned to the firm hoping to raise funds. In a privileged subscription, the new issue is not offered to the investing public. It is sold to a definite and limited group of investors. /urrent stockholders are often the privileged group. In a direct sale, the issuing firm sells the securities to the investing public without involving an investment banker in the process. This is not a typical procedure.

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?ore on 8rivate placements0 The (ebt 'ide A. 4ach year billions of dollars of new securities are privately "directly# placed with final investors. In a private placement, a small number of investors purchase the entire security offering. ?ost private placements involve debt instruments. @arge financial institutions are the ma5or investors in private placements. These include "l# life insurance firms, "+# state and local retirement funds, and "6# private pension funds. The advantages and disadvantages of private placements as opposed to public offerings must be carefully evaluated by management. ). The advantages include "a# greater speed than a public offering in actually obtaining the needed funds, "b# lower flotation costs than are associated with a public issue, and "c# increased flexibility in the financing contract.

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The disadvantages include "a# higher interest costs than are ordinarily associated with a comparable public issue, "b# the imposition of restrictive covenants in the financing contract, and "c# the possibility that the security may have to be registered some time in the future at the lender;s option.

7II.

%lotation costs A. The firm raising long-term capital typically incurs two types of flotation costs0 "l# the underwriter;s spread and "+# issuing costs. The former is typically the larger. ). The underwriter;s spread is the difference between the gross and net proceeds from a specific security issue. This absolute dollar difference is usually expressed as a percent of the gross proceeds. ?any components comprise issue costs. The two most significant are "l# printing and engraving and "+# legal fees. %or comparison purposes, these are usually expressed as a percent of the issue;s gross proceeds. Issue costs "as a percent of gross proceeds# for common stock exceed those of preferred stock, which exceed those of bonds. Total flotation costs per dollar raised decrease as the dollar si>e of the security issue increases.

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'4/ data reveal two relationships about flotation costs. ). +.

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Eegulation A. The primary market is governed by the 'ecurities Act of )*66. ). The intent of this federal regulation is to provide potential investors with accurate and truthful disclosure about the firm and the new securities being sold. &nless exempted, the corporation selling securities to the public must register the securities with the '4/. 4xemptions allow follow for a variety of conditions. %or example, if the si>e of the offering is small enough "less than F).2 million#, the offering does not have to be registered. If the issue is already regulated or controlled by some other federal agency, registration with the '4/ is not re!uired. Eailroad issues and public utility issues are examples. If not exempted, a registration statement is filed with the '4/ containing particulars about the security-issuing firm and the new security. A copy of the prospectus, a summary registration statement, is also filed. It will not yet have the selling price of the security printed on itD it is referred to as a red herring and called that until approved by the '4/.

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If the information in the registration statement and prospectus is satisfactory to the '4/, the firm can proceed to sell the new issue. If the information is not satisfactory, a stop order is issued which prevents the immediate sale of the issue. (eficiencies have to be corrected to the satisfaction of the '4/ before the firm can sell the securities. The '4/ does not evaluate the investment !uality of any issue. It is concerned instead with the presentation of complete and accurate information upon which the potential investor can act.

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The secondary market is regulated by the 'ecurities 4xchange Act of )*6<. This federal act created the '4/. It has many aspects. ). +. 6. <. 2. ?a5or security exchanges must register with the '4/. Insider trading must be reported to the '4/. ?anipulative trading that affects security prices is prohibited. 8roxy procedures are controlled by the '4/. The %ederal Eeserve $oard has the responsibility of setting margin re!uirements. This affects the proportion of a security purchase that can be made via credit. /ongress mandated the creation of a national market system "A?'#. Implementation details of the A?' were left to the '4/. Agreement on the final form of the A?' is yet to come. %ixed commissions "also called fixed brokerage rates# on public transactions in securities were eliminated. %inancial institutions, like commercial banks and insurance firms, were prohibited from ac!uiring membership on stock exchanges where their purpose in so doing might be to reduce or save commissions on their own trades.

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The 'ecurities Acts Amendments of )*-2 touched on three important issues. ).

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In ?arch )*1+, the '4/ adopted :Eule <)2.: This process is now known as a shelf registration or a shelf offering. ). +. This allows the firm to avoid the lengthy, full registration process each time a public offering of securities is desired. In effect, a master registration statement that covers the financing plans of the firm over the coming two years is filed with the '4/. After approval, the securities are sold to the investing public in a piecemeal fashion or :off the shelf.: 8rior to each specific offering, a short statement about the issue is filed with the '4/.

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/ongress passed in Guly +,,+ the 8ublic /ompany Accounting Eeform and Investor 8rotection Act. The short name for the act became the 'arbanes=xley Act of +,,+. ). +. The 'arbanes-=xley Act was passed as the result of a large series of corporate indiscretions. The act contains )) HtitlesI which tightened significantly the latitudes given to corporate advisors "like accountants, lawyers, company officers, and boards of directors# who have access to or influence company decisions. The initial title of the act created the 8ublic /ompany Accounting =versight $oard. This board9s purpose is to regulate the accounting industry relative to public companies that they audit. ?embers are appointed by the '4/. As recently Gune of +,,6, the oversight board itself published a set of ethics rules to police its own set of activities.

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The ?ultinational %irm0 4fficient %inancial ?arkets and Intercountry Eisk A. The &nited 'tates9 highly developed, complex and competitive financial markets facilitate the transfer of savings from the saving-surplus sector to the saving-deficit sector. ?ultinational firms are reluctant to invest in countries with ineffective financial systems. ). +. %inancial and political systems lacking integrity will often be re5ected for direct investment by multinational firms. /ountries that experience significant devaluation of its currency may also be considered too risky for investment.

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ANS ERS TO EN!"OF"CHAPTER #UESTIONS

)<-). %inancial markets are institutions and procedures that facilitate transactions in all types of financial claims. %inancial markets perform the function of allocating savings in the economy to the ultimate demander"s# of the savings. Without these financial markets, the total wealth of the economy would be lessened. %inancial markets aid the rate of capital formation in the economy. )<-+. A financial intermediary issues its own type of security which is called an indirect security. It does this to attract funds. =nce the funds are attracted, the intermediary purchases the financial claims of other economic units in order to generate a return on the invested funds. A life insurance company, for example, issues life insurance policies "its indirect security# and buys corporate bonds in large !uantities.

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)<-6. The money market consists of all institutions and procedures that accomplish transactions in short-term debt instruments issued by borrowers with "typically# high credit ratings. 4xamples of securities traded in the money market include &.'. Treasury $ills, bankers9 acceptances, and commercial paper. Aotice that all of these are debt instruments. 4!uity securities are not traded in the money market. It is entirely an over-the-counter market. =n the other hand, the capital market provides for transactions in long-term financial claims "those claims with maturity periods extending beyond one year#. Trades in the capital market can take place on organi>ed security exchanges or over-the-counter markets. )<-<. =rgani>ed stock exchanges provide for0 ")# A continuous market. This means a series of continuous security prices is generated. 8rice changes between trades are dampened, reducing price volatility, and enhancing the li!uidity of securities. 4stablishing and publici>ing fair security prices. 8rices on an organi>ed exchange are determined in the manner of an auction. ?oreover, the prices are published in widely available media like newspapers. An aftermarket to aid businesses in the flotation of new security issues. The continuous pricing mechanism provided by the exchanges facilitates the determination of offering prices in new flotations. The initial buyer of the new issue has a ready market in which he can sell the security should he need li!uidity rather than a financial asset.

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)<-2. The criteria for listing can be labeled as follows0 ")# profitabilityD "+# si>eD "6# market valueD "<# public ownership. )<-.. ?ost bonds are traded among very large financial institutions. @ife insurance companies and pension funds are typical examples. These institutions deal in large !uantities "blocks# of securities. An over-the-counter bond dealer can easily bring together a few buyers and sellers of these large !uantities of bonds. $y comparison, common stocks are owned by millions of investors. The organi>ed exchanges are necessary to accomplish the :fragmented: trading in e!uities. )<--. The investment banker is a middleman involved in the channeling of savings into long-term investment. Ke performs the functions of0 ")# underwritingD "+# distributingD "6# advising. $y assuming underwriting risk, the investment banker and his syndicate purchase the securities from the issuer and hope to sell them at a higher price. (istributing the securities means getting those financial claims into the hands of the ultimate investor. This is accomplished through the syndicate;s selling group. %inally, the investment banker can provide the corporate client with sound advice on which type of security to issue, when to issue it, and how to price it. )<-1. In a negotiated purchase, the corporate security issuer and the managing investment banker negotiate the price that the investment banker will pay the issuer for the new offering of securities. In a competitive-bid situation, the price paid to the corporate security issuer is determined by competitive "sealed# bids, which are submitted by several investment banking syndicates hoping to win the right to underwrite the offering.

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)<-*. Investment banking syndicates are established for three key reasons0 ")# the investment banker who originates the business probably cannot afford to purchase the entire new issue himselfD "+# to spread the risk of loss among several underwritersD "6# to widen the distribution network. )<-),. 'everal positive benefits are associated with private placements. The first is speed. %unds can be obtained !uickly, primarily due to the absence of a re!uired registration with the '4/. 'econd, flotation costs are lower as compared to public offerings of the same dollar si>e. Third, greater financing flexibility is associated with the private placement. All of the funds, for example, need not be borrowed at once. They can be taken over a period of time. 4lements of the debt contract can also be renegotiated during the life of the loan. )<-)). As a percent of gross proceeds, flotation costs are inversely related to the dollar si>e of the new issue. Additionally, common stock is more expensive to issue than preferred stock, which is more expensive to issue than debt. )<-)+. The answer on this is clear. The corporate debt markets dominate the corporate e!uity markets when new funds are raised. The tax system of the &.'. economy favors debt financing by making interest expense deductible from income when computing the firm;s federal tax liability. /onsider all corporate securities offered for cash over the period )***-+,,). The percentage of the total represented by bonds and notes was -..* percent compared to +6.) percent e!uity. )<-)6. The household sector is the largest net supplier of savings to the financial markets. %oreign financial investors have recently been net suppliers of savings to the financial markets. =n the other hand, the nonfinancial corporate business sector is most often a savings-deficit sector. The &.'. Lovernment sector too is a deficit sector in most years. )<-)<. %irst, there may be a direct transfer of savings from the investor to the borrower. 'econd, there may be an indirect transfer that used the services provided by an investment banker. Third, there may be an indirect transfer that uses the services of a financial intermediary. 8rivate pension funds and life insurance companies are prominent examples of the latter case.

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