Understanding Securities Regulation and Investment Valuation

1. Securities Regulation Introduction Info  Price (last updated 18 Jan 12)

3. Information  Price • Auction 1: no information • Information is critical to pricing • Discount for lack of info • Auction 2: inside information • Information through signaling • Efficient Capital Market Hypothesis • Auction 3: widespread information • Can you feel the fraud? • Consider effect on subsequent auctions

4. Securities industry demographics(Feb 2009) Mutual funds: • 950 complexes (such as Vanguard) • 4,600 registered funds (Vanguard 2050 Target Fund) Nationally recognized statistical rating organizations • Ten (S&P, etc) Stock exchanges • Eleven exchanges (NYSE) Clearing agencies • Five Public companies: • 12,000 (securities registered with SEC) • 7,500 operating companies Investment advisers: • 11,300 (includes hedge fund managers) • up from 7,546 in 2002 Broker-dealers: • 5,500 firms • 173,000 branch offices (up from 75,000 in 2001) • 665,000 registered reps

5. What are incentives to disclose? Nature of US securities regulation

6. Securities regulation Mandatory disclosure • Sales of securities to public • Public companies – periodic disclosure Antifraud liability • Private actions • SEC enforcement Regulate intermediaries (gatekeepers) • Self-regulation • SEC disciplinary oversight * * * Legislation • Securities Act of 1933 • Securities Exchange Act of 1934 • 5 Commissioners • 4 Divisions • various offices (inc OGC)

8. Securities fraud Elements • Material • Misrepresentation or omission • Scienter • Reliance • Causation • Damages Rule 10b-5 adds: • Jurisdictional nexus (federal court) • Transactional nexus (“in connection with purchase or sale of securities”)

9. How value an investment? What is a security?

10. Types of Securities

11. Valuation Which investment would you choose? (assuming 5% interest rate) • Put $10 million under mattress for two years • Annuity that pays $2.5 million every year for next four years • Preferred stock that pays $400,000 per year (in perpetuity) FV = PV * (1 + i) ^ n * * * PV = FV / (1 + i) ^ n Investment #1 PV = $10,000,000 / (1 +.05) 2 PV = $10,000,000 / (1.05) 2 PV = $10,000,000 / (1.1025) PV = $ 9,070,295 Investment #2 PV1 = $2,500,000/(1.05)1 = $ 2,380,952 PV2 = $2,500,000/(1.05)2 = $ 2,267,574 PV3 = $2,500,000/(1.05)3 = $ 2,159,594 PV4 = $2,500,000/(1.05)4 = $ 2,056,756 PV = $ 8,864,876 Investment #3 PV = FVpymt / i PV = $400,000 / .05 PV = $8,000,000 Investment #3 (assume 4% interest rate) PV = FVpymt / i PV = $400,000 / .04 PV = $10,000,000

12. End

13. #2 - $10 million in 2-year 10% bond FV = PV * (1 + i) ^ n PV = FV / (1 + i) ^ n

14. #5 - zero-coupon bond ($15 million – 3 years) FV = PV * (1 + i) ^ n PV = FV / (1 + i) ^ n

15. #5 - zero-coupon bond ($15 million – 3 years) FV = PV * (1 + i) ^ n PV = FV / (1 + i) ^ n