01 fm&i chap 11 mfs and ibfs

Chapter Objectives Review and evaluate the key functions of investment banking firms Evaluate the key functions of brokerage firms Explain the concept of mutual fund operation Explain

Chapter 11:

Mutual Funds and Investment Banking Firms

Chapter Objectives

Review and evaluate the key functions of

investment banking firms

Evaluate the key functions of brokerage firms

Explain the concept of mutual fund operation Explain various types of mutual funds

Describe the various types of stock and bond mutual funds

Describe the characteristics of money market funds

Investment Banking Services

Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal

governments

IBF’s serve both financing entities and investors: serve as an intermediary buying securities (promise to pay) from issuing companies and selling them

(securities) to investors

Generate fees for services rather than interest income

sell investing services to institutional and other investors Advise companies on mergers and acquisitions

Value companies for sale or purchase

In recent years, loaned funds for mergers and acquisitions

Investment Banking Services

How IBFs Facilitate New Stock

prospective investors

How IBFs Facilitate New Stock

Incentive to under-price IPO’s

The lead investment bank usually forms an

underwriting syndicate

Other IBFs underwrite a part of the security offering

How IBFs Facilitate New Stock

Issues

Distribution of stock

Full underwriting vs best efforts

IBFs in the syndicate have retail brokerage

operations

Other IBF added as part of selling group

Corporation incurs flotation costs

Underwriting spread Direct issuance costs—accounting, legal fees, etc.

How IBFs Facilitate New Stock

Private placement of stock

An entire stock offering may be placed with a

Small set of institutional Investors and not offered

to the general public

Without filing the extensive registration

Statement that is required for public placements Lower costs

There may not be be an established secondary

market for the stock => higher return

How IBFs Facilitate New Bond Issues

Origination

IBF may suggest a maximum amount of bonds that should be issued based on firm

characteristics

Decisions on coupon rate, maturity

Benchmark with market prices of bonds of similar risk Credit rating

Bond issuers must register with the SEC

Registration Statement

Prospectus

How IBFs Facilitate New Bond Issues

How IBFs Facilitate New Bond Issues

How IBFs Facilitate New Bond Issues

Private placement of bonds

Avoids underwriting and SEC registration

expenses

Potential purchaser may buy the entire issue

Insurance companies mutual funds

commercial banks pension funds

Demand may not be as strong, so price may be

less, resulting in a higher cost for issuing firm

Investment banks may be involved to provide advice and find potential purchasers

Exhibit 24.2 Participation of Securities Firms in an Acquisition

(6) (After Acquisition) Periodic Cash Flows Resulting from Target's Business

(5) Payment for Target's Shares

Target Firms Acquirer

Target's

Shares

(2) Bridge Loans Provided

(4) Repayment of Bridge Loans ¬

(4) Fees for Placing Securities 1S

(3) Funds Paid for Securities Issued Investors

(Such as Mutual Funds, Insurance Companies, Pension

How IBFs Facilitate Leveraged

Buyouts

IBFs facilitate LBOs in three ways:

They assess the market value of the LBO firm They arrange financing

Purchase outstanding stock held by public

Often invest in the deal themselves

Provide advice

Brokerage Services

Investor sells shares they do not own

Investor borrows the shares from their broker (who

borrows the shares from other accounts)

Later, the investor buys the stock and repays the shares to the broker

If the price has fallen the investor earns a profit Investor still seeks to buy low and sell high, but the order

is reversed

Brokerage Services

Full-service versus discount brokerage

services

well as executing transactions

Discount brokerage firms only execute security

Online brokerage firms

Exhibit 24.3 Sources of Income for a Securities Firm

INVESTMENT BANKING SERVICES

government agencies

« Identifying potential targets

¢ Valuing targets

¢ Identifying potential acquirers

« Protecting against takeovers

Risks of Securities Firms

Credit Risk

Risks of Securities Firms

Market risk

Securities firms’ activities are linked to stock

When stock prices are rising:

Greater volume of stock offerings Increased secondary market transactions More mutual fund activity

securities firms take equity positions which are bolstered when prices rise

Risks of Securities Firms

Interest rate risk

interest rate movements because:

Market values of bonds held as investments Increase as interest rates fall

Exchange rate risk

Operations in foreign countries

Investments in securities denominated in foreign

currency

Background on Mutual Funds

Mutual tunds offer a way for small investors to diversify when they could not do so on their

own with the purchases of individual stocks

Comparison to depository institutions

Like depository institutions, mutual funds

repackage proceeds from individuals to make

Background on Mutual Funds

Mutual funds adhere to a variety of federal and state regulations

securities and Exchange Commission (SEC) regulates

Funds must register and provide a prospectus

to investors

Background on Mutual Funds

Mutual fund prospectus information includes:

The minimum amount of investment required

The investment objective of the fund

The return on the fund over the past year, the past three years and the the past five years

The exposure of the fund to various types of risk services the fund offers

Check writing

Telephone or Internet funds transfer

Management fees incurred that investors pay

Background on Mutual Funds

Estimating the net asset value

Net asset value is the value per share

Background on Mutual Funds

Management of mutual funds

Cover management costs with fees which are

typically around one percent of total assets per

year

Managers adjust the composition of their

portfolios in response to market and economic conditions

Background on Mutual Funds

Expenses

Fees include management plus record-keeping

Expense ratio = annual expenses/fund NAV

Passed on to investors since NAV is reduced by

fees

Investor should compare expense ratios

Active marketing expenses and

compensation increases expenses

Background on Mutual Funds

Mutual fund classifications depend on the

type of securities the fund invests in and

can include

stock or equity mutual funds

Bond mutual funds

Money market mutual funds

Investor able to allocate then transfer funds

among funds

Growth and Size of Mutual Funds

Volume and mix in the kind of funds varies over time

Overall investment via mutual funds much

higher in recent years

New kinds of funds target customers with

different risk preferences

Exhibit 23.6 Composition of Mutual Funds

Hybrid Funds

$1,352 billion 9%

Taxable MM Funds Taxable Bond SH

Tax-free MM Funds 16% 18%

$261 billion Municipal 2% —_ Bond Funds

$566 billion

4%

Stock Funds

$8,314 billion 52%

Open-End versus Closed-End Funds

Closed-end funds

Mutual fund does not repurchase the shares they sell—

similar to direct common stock investment

Investors must sell shares on an exchange

Number of outstanding shares is constant

Value of shares related to expectations of portfolio and

determined in market, thus share price may be higher

or lower than NAV per share

Willing to repurchase investor shares at any time

Number of shares outstanding does not remain -

constant

NAV determined by fund daily

stock Mutual Fund Categories

Growth funds for investors who want high

returns with moderate risk

Mutual fund invests in companies that are

Generate an increase in investment value

rather than steady income

Capital appreciation or aggressive growth

funds

stock Mutual Fund Categories

Growth and income funds try to offer

International and global funds allow

investment in foreign securities without the

costs involved in purchasing and

monitoring individual stocks

Returns affected by stock prices

Returns also affected by foreign exchange rates

stock Mutual Fund Categories

Internet funds focus on investments in

Specialty funds focus on a group of

Background on Mutual Funds

Corporate control by mutual funds

Mutual funds are large shareholders in

companies whose stock they hold

Managers may serve on the board of directors

of companies in which the fund invests

Companies try to satisfy mutual fund managers

Bond Funds

Risks of bond funds

Interest rate risk

Credit risk

Tax implications of bond fund investments

Income bond funds vary in terms their

exposure to credit risk and focus on

investors who are

Interested in periodic income since prices are

volatile

Plan to hold the fund long term

Bond Funds

Tax-free funds for high tax bracket

investors

High-yield or junk bond funds invest in

bonds with a high risk of default

International and global bond funds

International bond funds contain bonds issued

by governments or corporations from other

countries

Global funds may contain both U.S and foreign bonds

Intermediate-term funds invest in bonds with 5 to 10

years remaining to maturity

Long-term funds invest in maturities of 15 to 30 years

Hybrid tunds

Asset allocation funds

Funds that contain a variety of investments

Composition among stocks, bonds and money

market securities is based on manager's

expectations

Money Market Funds

Money Market Funds

Asset composition of money market funds

Individual funds concentrate in assets that

reflect the fund’s objective

Money market securities of varying maturity

Maturity of money market funds

Varies over time with market conditons

Money Market Funds

Risk of money market funds

Credit risk minimized by the short-term nature

of maturities

Consistent positive returns over time

Lower credit risk Lower interest rate risk

Money Market Funds

Management of money market funds

Managers try to maintain the overall objective of the fund

Manage the composition of the assets

Investors have a variety of choices when it

comes to money market funds

Hedge Funds

Hedge funds sell shares to wealthy investors | and financial institutions (larger initial

investment)

Invest in derivatives, sell stock short, private |

investments with advance notice However

hedge funds may stipulate that they will not

allow withdrawals (redemptions) by investors for several years

Hedge Funds

Subject to minimal regulation

Although some hedge funds have

performed well, many have failed

between 1 and 2 percent of the investment |

per year In addition, they charge an

incentive fee that is based on the return of the fund

Real Estate Investment Trusts

Classifications

Equity REIT

Mortgage REIT

Hybrid of the two

Sometimes seen as an inflation hedge

Performance influenced by interest rates

and area real estate performance

Venture capital funds

Use money that they receive from wealthy

individuals and some institutional investors

to invest in companies

Invest in young, growing firms that need

equity funding but are not ready or willing

to go public

Tend to focus on technology firms, which

have the potential for high returns but also

exhibit a high level of risk

Private Equity Funds

Usually created as a limited liability —

General partners develop a business plan for investing in businesses and managing

the businesses that they acquire

Mutual Fund Distributions

Advantages of MF

Diversitication

Professional management Various portfolio choices Economics of scale

Performance of Stock Mutual Funds

Both investors and managers closely monitor performance as modeled by the equation below

A pere= f(A mkt, A sector, A MANAB)

Where:

PERF = Performance

MKT = General stock market conditions

SECTOR = Conditions in the fund’s sector

MANAB = The ability of the fund’s management

Performance of Stock Mutual Funds

Change in market conditions

Close relationship between performance and market conditions

Change in sector conditions

Depends on the focus of the fund

Change in management ability includes

both managers skills and operating

efficiency

Performance of Stock Mutual Funds

Performance of closed-end stock funds

Driven by the same factors that influence open- ended funds

Fixed supply of the fund’s shares

Additional issues

Performance is affected by changes in the premium

If the fund’s premium increases relative to NAV,

Performance of Bond Mutual Funds

Performance of bond mutual funds as

shown in the model below

A perF= f(A Rr, A rp, Actass, A MANAB)

Where:

PERF = Performance

R,= Risk free interest rates

RP =Risk premium

CLASS =the classification of the bond fund

MANAB = The ability of the bond fund’s management

Performance of Bond Mutual Funds

Change in the risk free rate

Bond prices are inversely related to the risk-

free rate

Change in the risk premium

Linked to economic condition:

Risk premiums increase in recessions Risk premiums decrease in boom times as investors buy riskier investments

Performance of Bond Mutual Funds

Impact of the bond fund's classification

Some funds target a specific risk or maturity Classification may have more impact than any other factor

Change in management abilities

affected by all of the other factors and -

changes in the premium or discount

Performance of Mutual Funds

Investors should diversify among different

kinds of funds to reduce volatility

Research on stock mutual fund

performance

Using return only is not valid

Evaluate mutual fund expenses

Mutual funds typically do not outperform the

market

Research on bond mutual funds

Bond mutual funds underperform bond indexes Investors should look for low expense bond funds