Chapter 19 The Capital Market
After Studying Chapter 19, you should be able to: • Understand the characteristics of the capital market and the difference between a primary and a secondary market. • Describe the three primary methods used by companies to raise external long-term funds – public issue, privileged subscription, and private placement. • Explain the role of investment bankers in the process of issuing new securities, including traditional underwriting, best efforts offering, shelf registration, and standby arrangements. • Calculate the theoretical value of a (subscription) right, and describe the relationships among the market price of the stock, the subscription price, and the value of the right. • Understand the Securities and Exchange Commission (SEC) registration process, including the role played by the registration statement, red herring, prospectus, and tombstone advertisement. • Understand the roles that venture capital and an initial public offering (IPO) play in financing the early stages of a company’s growth. • Discuss the potential signaling effects that often accompany the issuance of new long-term securities.
The Capital Market • Public Issue • Privileged Subscription • Regulation of Security Offerings • Private Placement • Initial Financing • Signaling Effects • The Secondary Market
Déjà Vu All Over Again Capital Market– The market for relatively long-term (greater than one year original maturity) financial instruments. Primary Market– A market where new securities are bought and sold for the first time (a “new issues” market). Secondary Market– A market for existing (used) securities rather than new issues.
Déjà Vu All Over Again Public issue INVESTMENT SECTOR Privileged subscription Private placement FINANCIAL BROKERS FINANCIAL INTERMEDIARIES Indicates the possible presence of a “standby arrangement” SECONDARY MARKET Indicates the financial intermediaries’ own securities flow to the savings sector SAVINGS SECTOR
Public Issue Public Issue – Sale of bonds or stock to the general public. • Securities are sold to hundreds, and often thousands, of investors under a formal contract overseen by federal and state regulatory authorities. • When a company issues securities to the general public, it is usually uses the services of an investment banker.
Investment Banker Investment Banker – A financial institution that underwrites (purchases at a fixed price on a fixed date) new securities for resale. • Investment banker receives an underwriting spread when acting as a middleman in bringing together providers and consumers of investment capital. • Underwriting spread – the difference between the price the investment bankers pay for the security and the price at which the security is resold to the public.
Investment Banker • Thus, the services can be provided at a lower cost to the firm than the firm can perform the same services internally. • Three primary means companies use to offer securities to the general public: • Traditional (firm commitment) underwriting • Best efforts offering • Shelf registration • Investment bankers have expertise, contacts, and the sales organization to efficiently market securities to investors.
Traditional Underwriting • If the security issue does not sell well, either because of an adverse turn in the market or because it is overpriced, the underwriter, not the company, takes the loss. Underwriting – Bearing the risk of not being able to sell a security at the established price by virtue of purchasing the security for resale to the public; also known as firm commitment underwriting.
Traditional Underwriting Underwriting Syndicate – A temporary combination of investment banking firms formed to sell a new security issue. A. Competitive-bid • The issuing company specifies the date that sealed bids will be received. • Competing syndicates submit bids. • The syndicate with the highest bid wins the security issue.
Traditional Underwriting B. Negotiated Offering • The issuing company selects an investment banking firm and works directly with the firm to determine the essential features of the issue. • Together they discuss and negotiate a price for the security and the timing of the issue. • Depending on the size of the issue, the investment banker may invite other firms to join in sharing the risk and selling the issue. • Generally used in corporate stock and most corporate bond issues.
Traditional Underwriting Best Efforts Offering – A security offering in which the investment bankers agree to use only their best efforts to sell the issuer’s securities. The investment bankers do not commit to purchase any unsold securities. Shelf Registration – A procedure that allows a company to register securities in advance that it may want to sell and then put that registration ‘on the shelf’ until it makes a sales offering; also called SEC Rule 415. These securities can then be sold piecemeal whenever the company chooses.
Shelf Registration: Flotation Costs and Other Advantages • A firm with securities sitting “on the shelf” can require that investment banking firms competitively bid for its underwriting business. • This competition reduces underwriting spreads. • The total fixed costs (legal and administrative) of successive public debt issues are lower with a single shelf registration than with a series of traditional registrations. • The amount of “free” advice available from underwriters is less than before shelf registration was an alternative to firms.
Privileged Subscription Privileged Subscription – The sale of new securities in which existing shareholders are given a preference in purchasing these securities up to the proportion of common shares that they already own; also known as a rights offering. Preemptive Right – The privilege of shareholders to maintain their proportional company ownership by purchasing a proportionate share of any new issue of common stock, or securities convertible into common stock.
Terms of Offering Right – A short-term option to buy a certain number (or fraction) of securities from the issuing corporation; also called a subscription right. Terms specify: • the number of rights required to subscribe for an additional share of stock • the subscription price per share • the expiration date of the offering
Subscription Rights Generally, the subscription period is three weeks or less. • Options available to the holder of rights: • Exercise the rights and subscribe for additional shares • Sell the rights (they are transferable) • Do nothing and let the rights expire
Subscription Rights A shareholder who owns 77 shares and just received 77 rights would like to purchase 8 new shares. It takes 10 rights for each new share. What action should the shareholder take? The shareholder can then purchase 7 shares (use 70 rights) and still retain the 7 remaining rights. Thus, the shareholder needs to purchase an additional 3 rights.
Value of Rights What gives a right its value? A right allows you to buy new stock at a discount that typically ranges between 10 to 20 percent from the current market price. The market value of a right is a function of : • the market price of the stock • the subscription price • the number of rights required to purchase an additional share of stock
How is the Value of a Right Determined? P0 – R0 = [ (R0)(N) + S ], therefore R0 = P0 – [ (R0)(N) + S ] R0 = the market price of one right when the stock is selling “rights-on” P0 = the market price of a share of stock selling “rights-on” S = the subscription price per share N = the number of rights required to purchase one share of stock
How is the Value of a Right Determined? Solving for R0. P0 – S R0 = N + 1 PX = P0 – R0 = [ (R0)(N) + S ] By substitution for R0, we can solve the “ex-rights” value of one share of stock, PX. (P0 )(N) + S PX = N + 1
Example of the Valuation of a Right What is the value of a right when the stock is selling “rights-on”? What is the value of one share of stock when it goes “ex-rights”? • Assume the following information: • The current market price of astock “rights-on” is $50. • The subscription price is $40. • It takes nine rights to buy an additional share of stock.
How is the Value of a Right Determined? Solving for R0. Solving for PX. $50 – $40 R0 = 9 + 1 R0 = $1 ($50)(9) + $40 PX = 9 + 1 PX = $49
Theoretical Versus Actual Value of Rights Why might the actual value of a right differ from its theoretical value? • Transaction costs • Speculation • Irregular exercise and sale of rights over the subscription period Arbitrage acts to limit the deviation of the actual right value from the theoretical value.
Standby Arrangement • Fee often composed of a flat fee and an additional fee for each unsold share of stock. • The greater the risk of an unsuccessful rights offering, the more desirable a standby arrangement. Standby Arrangement – A measure taken to ensure the complete success of a rights offering in which an investment banker or group of investment bankers agrees to “stand by” to underwrite any unsubscribed (unsold) portion of the issue.
Oversubscription Privilege Oversubscription Privilege – The right to purchase, on a pro rata basis, any unsubscribed shares in a rights offering. • For example, shareholders subscribe for 450,000 shares of a 500,000-share rights offering. Let us assume that some shareholders would like more shares and oversubscribe by 80,000 shares. • As a result, each shareholder oversubscribing receives 5/8ths (50,000 / 80,000) of a share for each share oversubscribed.
Privileged Subscription versus Underwritten Issue • Investors are familiar with the firm’s operations when using a rights offering. • The principal sales tool is a discounted price (rights offering) and the investment banking organization (underwriting). • A disadvantage of a rights offering is that the shares will be sold at a lower price. • There is greater dilution with a rights offering which many firms attempt to avoid. • There is a wider distribution of shares with a public offering.
Regulation of Security Offerings – Federal Securities Act of 1933 – Generally requires that public offerings be registered with the federal government before they may be sold; also known as Truth in Securities Act. Securities Exchange Act of 1934 – Regulates the secondary market for long-term securities – the securities exchanges and the over-the-counter market. Securities and Exchange Commission (SEC) enforces both of these acts.
Regulation of Security Offerings – Federal Registration Statement – The disclosure document filed with the SEC in order to register a new securities issue. Part 1: Prospectus – Discloses information about the issuing company and its new offering and is distributed to investors. Part 2: Additional information required by the SEC that is not part of the printed prospectus.
Red Herring Red Herring – The preliminary prospectus. It includes a legend in red on the front page stating that the registration statement has not yet become effective. • SEC reviews the registration statement to see that all the required information is presented and that it is not misleading. • Deficiencies are communicated in a comment letter. • Once the SEC is satisfied, it approves the registration. If not, it issues a stop order.
Regulation of Security Offerings – Federal • Registration statements become effective on the 20th day after filing (or on the 20th day after filing the last amendment). • The SEC, at its discretion, can advance the date. Typical time from filing to approval is 40 days. Registration Statement Effective Date
Regulation of Security Offerings – Federal Impact with shelf registration: • A shelf registration allows a company to register with the SEC “in advance” of a security offering. • The company can sell “off the shelf” by filing a simple amendment and having the SEC accelerate the “normal” 20-day waiting period accorded amendments. • Typically, the waiting period following this simple amendment is only a day or two.
Regulation of Security Offerings – Federal Tombstone Advertisement – An announcement placed in newspapers and magazines giving just the most basic details of a security offering. • The term reflects the stark, black-bordered look of the ad. • Includes the company’s name, a brief description of the security, the offering price, and the names of the investment bankers in the underwriting syndicate.
Sarbanes-Oxley Act of 2002 Sarbanes-Oxley Act of 2002 (SOX) – Addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. • Most important security law reform since 1930s. • Establishes: • an oversight board to regulate public accounting firms that audit public companies • New audit and audit committee standards • Executive officers of public companies must certify the company’s SEC reports • Increases liability for violations of federal security laws
Regulation of Security Offerings – State • Individual states have security commissions that regulate securities in their states. • These laws are particularly important when a security issue is sold entirely to people within the state and may not be subject to SEC regulation. • Important if the SEC provides only limited review. • States vary on the strictness of their regulation. Blue Sky Laws – State laws regulating the offering and sale of securities.
Security Offerings Reform • SEC adopted new rules to improve registration, communications and the offering process. This is due, in large part, to technological advances. • Divided public companies into tiered groups of a) well-known seasoned issuers (WKSI), b) seasoned issuers, c) unseasoned issuers, d) non-reporting issuers and e) ineligible issuers. • WKSIs (approximately 30% of issuers) are most widely followed in capital markets WKSI – Well-known seasoned issuer. Essentially large, actively traded companies with established US public track records.
Security Offerings Reform Automatic shelf registration – A more flexible form of shelf registration only available to WKSIs that become automatically effective upon filing with the SEC. • WKSIs can shelf register an unlimited amount of securities • A “new” registration statement would be required every three years • No need to wait for the SEC to review and approve the shelf registrations for WKSIs. • Other tiers must wait for the SEC to declare the registration effective.
Security Offerings Reform Free-writing prospectus (FWPs) – Written or electronic communications, other than preliminary or final prospectuses, that constitutes an offer of securities related to a registered offering. • Ability to use FWPs depends on SEC tier classification of the company with WKSIs having the most flexibility • Additional information provided in tombstone ads will be allowed making them more marketing oriented than previously • Timely “access” to a final prospectus is now deemed equivalent to delivery thereby allowing EDGAR to be used and reducing traditional mailings
Private Placement Private (or Direct) Placement – The sale of an entire issue of unregistered securities (usually bonds) directly to one purchaser or a group of purchasers (usually financial intermediaries). • Eliminates the underwriting function of the investment banker. • The dominant private placement lender in this group is the life-insurance category (pension funds and bank trust departments are very active as well).
Private Placement Features • Allows the firm to raise funds more quickly. • Eliminates risks with respect to timing. • Eliminates SEC regulation of the security. • Terms can be tailored to meet the needs of the borrower. • Flexibility in borrowing smaller amounts more frequently rather than a single large amount.
Private Placement and Other Developments • Qualified Institutional Buyers (QIBs)– Eligible purchasers, by SEC Rule 144a, of previous securities from a private placement without having to go through a public market registration. • Event Risk– The risk that existing debt will suffer a decline in creditworthiness because of the issuance of additional debt securities, usually in connection with corporate restructuring.
Private Placement and Other Developments • Underwritten Rule 144a Private Placement– The issuer sells its securities initially to an investment bank that resells them to the same institutional buyers that are candidates for a regular private placement. Often includes registration rights. • Private Placement with Registration Rights– It combines a standard private placement with a contract requiring the issuer to register the securities with the SEC for possible resale in the public market.
Initial Financing – Venture Capital • Wealthy investors and financial institutions are the primary providers of funds for a new enterprise (usually common stock). • Rule 144 and the 1933 Act require privately placed securities to be held for at least two years or be registered before they can be resold. • Letter stock*– Privately placed common stock that cannot be immediately resold. * Note: Under SEC Rule 144a, however, letter stock could be sold to qualified institutional buyers (QIBs) without a waiting period.
Initial Financing – Initial Public Offerings • Often prompted by venture capitalists who wish to realize a cash return on their investment. • Founders of the firm may wish to go through an IPO to establish a value for their company. • There exists greater price uncertainty with an IPO than with other new public stock issues. Initial Public Offering (IPO) – A company’s first offering of common stock to the general public.
Signaling Effects • Negative stock price reaction to common stock or convertible issues. • Straight debt and preferred stock do not tend to show statistically significant effects. Relative Abnormal Stock Returns for a New Equity Issue 3 2 1 Cumulative Average Abnormal Return (%) 0 –1 –2 –3 –4 –10 –8 –6 –4 –2 0 2 4 6 8 Time Around Announcement (in days)
Possible Explanations for Price Reactions • Expectations of Future Cash Flows • The unexpected sale of securities may be associated with lower than expected operating cash flows and interpreted as bad news. Hence, the stock price might suffer accordingly. Asymmetric (Unequal) Information • Potential investors have less information than management (particularly for common stock). • Exchanges of different types of securities show that increases (decreases) in financial leverage are associated with positive (negative) abnormal returns.
The Secondary Market • Purchases and sales of existing stocks and bonds occur in the secondary market. • Transactions in the secondary market do not provide additional funds to the firm. • The secondary market increases the liquidity of securities outstanding and lowers the required returns of investors. • Composed of organized exchanges like the New York Stock Exchange and American Stock Exchange plus the over-the-counter (OTC) market.