Solution manual financial management 10e by keown chapter 14

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 fo

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 question is corporate bonds The corporate debt markets clearly dominate the corporate equity markets when new (external) funds are being raised

B From our discussion on the cost of capital, we understand that the U.S tax

system inherently favors debt as a means of raising capital During the

1999-2001 period, bonds and notes accounted for about 76.9 percent of new corporate securities sold for cash

II Why financial markets exist

A Financial markets consist of institutions and procedures that facilitate

transactions in all types of financial claims

B Some economic units spend more than they earn during a given period of

time Some 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 Financial markets provide such a mechanism

C The function of financial markets then is to allocate savings in an economy

to the ultimate demander (user) of the savings

D If there were no financial markets, the wealth of an economy would be

lessened Savings could not be transferred to economic units, such as business firms, which are most in need of those funds

III Financing business: The movement of funds through the economy

A 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

1 The household sector can also be a savings-deficit sector

2 From 1995 – 1999, the household sector was a net user of financial

capital as a result of taking advantage of low interest rate mortgages

B In contrast, the nonfinancial business sector is typically a savings-deficit

sector

1 The nonfinancial business sector can also be a savings-surplus

sector

2 Economic conditions and corporate profitability influence the ability

of this sector to provide funds to the financial market

C. In recent years, the foreign sector has become a major savings-surplus

sector

D Within the domestic economy, the nonfinancial business sector is dependent

on the household sector to finance its investment needs

E The movement of savings through the economy occurs in three distinct

ways:

1 The direct transfer of funds

2 Indirect transfer using the investment banker

3 Indirect transfer using the financial intermediary

IV Components of the U.S financial market system

A Public offerings can be distinguished from private placements

1 The public (financial) market is an impersonal market in which both

individual and institutional investors have the opportunity to acquire securities

a A public offering takes place in the public market

b The security-issuing firm does not meet (face-to-face) the

actual investors in the securities

2 In a private placement of securities, only a limited number of

investors have the opportunity to purchase a portion of the issue

a The market for private placements is more personal than its

public counterpart

b The specific details of the issue may actually be developed on

a face-to-face basis among the potential investors and the issuer

c Venture capital

(1) Start-up firms often turn to venture capitalists to raise

funds

(a) Broader public markets find these firms too

risky

(b) Venture capitalists are willing to accept the

risks because of an expectation of higher returns

(1) Venture capital firms that acquire equity in a start-up

firm manage risk by sitting on the firm’s board of directors or actively monitoring management’s activities

(2) Venture capital is often provided by established

non-venture-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 (b) The subsidiary approach allows the established

firm to retain human and intellectual capital

B Primary markets can be distinguished from secondary markets

1 Securities are first offered for sale in a primary market For 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

2 Trading in currently existing securities takes place in the secondary

market The total stock of financial assets is unaffected by such transactions

C The money market can be distinguished from the capital market

1 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 "Short-term" means that the securities traded in the money

market have maturity periods of not more than 1 year

b Equity instruments are not traded in the money market

c Typical examples of money market instruments are (l) U.S

Treasury bills, (2) federal agency securities, (3) bankers' acceptances, (4) negotiable certificates of deposit, and (5) commercial paper

2 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 1 year

D Organized security exchanges can be distinguished from over-the-counter

markets

1 Organized security exchanges are tangible entities whose activities

are governed by a set of bylaws Security exchanges physically occupy space and financial instruments are traded on such premises

a Major stock exchanges must comply with a strict set of

reporting requirements established by the Securities and Exchange Commission (SEC) These exchanges are said to be registered

b Organized security exchanges provide several benefits to both

corporations and investors They (l) provide a continuous market, (2) establish and publicize fair security prices, and (3) help businesses raise new financial capital

c A corporation must take steps to have its securities listed on

an exchange in order to directly receive the benefits noted above Listing criteria differ from exchange to exchange

2 Over-the-counter markets include all security markets except the

organized exchanges The money market is a prominent example Most corporate bonds are traded over-the-counter

a NASDAQ, a telecommunication system providing an

information link among brokers and dealers in the OTC markets, accounted for 43% of the national exchange equity market trading in the U.S., measured in dollar volume for the year 1998

Nasdaq Stock Market, Inc trades securities of over 3,600 public companies as of 2002

V The Investment Banker

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)

B Three basic functions are provided by the investment banker:

1 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

2 The investment banker provides for the distribution of the securities

to the investing public

3 The investment banker advises firms on the details of selling

securities

C Several distribution methods are available for placing new securities into the

hands of final investors The investment banker's role is different in each case

1 In a negotiated purchase, the firm in need of funds contacts an

investment banker and begins the sequence 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

2 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 negotiated; instead, it is determined by a sealed-bid process much on the order of construction bids

3 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 Unsold securities are simply returned to the firm hoping to raise funds

4 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 Current stockholders are often the privileged group

5 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

VI More on Private placements: The Debt Side

A Each 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 Most private placements involve debt instruments

B Large financial institutions are the major investors in private placements

These include (l) life insurance firms, (2) state and local retirement funds, and (3) private pension funds

C The advantages and disadvantages of private placements as opposed to

public offerings must be carefully evaluated by management

1 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

2 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

VII Flotation costs

A The firm raising long-term capital typically incurs two types of flotation

costs: (l) the underwriter's spread and (2) issuing costs The former is typically the larger

1 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

2 Many components comprise issue costs The two most significant are

(l) printing and engraving and (2) legal fees For comparison purposes, these are usually expressed as a percent of the issue's gross proceeds

B SEC data reveal two relationships about flotation costs

1 Issue costs (as a percent of gross proceeds) for common stock exceed

those of preferred stock, which exceed those of bonds

2 Total flotation costs per dollar raised decrease as the dollar size of

the security issue increases

VIII Regulation

A The primary market is governed by the Securities Act of 1933

1 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

2 Unless exempted, the corporation selling securities to the public

must register the securities with the SEC

3 Exemptions allow follow for a variety of conditions For example, if

the size of the offering is small enough (less than $1.5 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 SEC is not required Railroad issues and public utility issues are examples

4 If not exempted, a registration statement is filed with the SEC

containing particulars about the security-issuing firm and the new security

5 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

it; it is referred to as a red herring and called that until approved by the SEC

6 If the information in the registration statement and prospectus is

satisfactory to the SEC, 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 Deficiencies have to be corrected to the satisfaction of the SEC before the firm can sell the securities

7 The SEC does not evaluate the investment quality of any issue It is

concerned instead with the presentation of complete and accurate information upon which the potential investor can act

B The secondary market is regulated by the Securities Exchange Act of 1934

This federal act created the SEC It has many aspects

1 Major security exchanges must register with the SEC

2 Insider trading must be reported to the SEC

3 Manipulative trading that affects security prices is prohibited

4 Proxy procedures are controlled by the SEC

5 The Federal Reserve Board has the responsibility of setting margin

requirements This affects the proportion of a security purchase that can be made via credit

C The Securities Acts Amendments of 1975 touched on three important issues

1 Congress mandated the creation of a national market system (NMS)

Implementation details of the NMS were left to the SEC Agreement

on the final form of the NMS is yet to come

2 Fixed commissions (also called fixed brokerage rates) on public

transactions in securities were eliminated

3 Financial institutions, like commercial banks and insurance firms,

were prohibited from acquiring membership on stock exchanges where their purpose in so doing might be to reduce or save commissions on their own trades

D In March 1982, the SEC adopted "Rule 415." This process is now known as

a shelf registration or a shelf offering

1 This allows the firm to avoid the lengthy, full registration process

each time a public offering of securities is desired

2 In effect, a master registration statement that covers the financing

plans of the firm over the coming two years is filed with the SEC After approval, the securities are sold to the investing public in a piecemeal fashion or "off the shelf."

3 Prior to each specific offering, a short statement about the issue is

filed with the SEC

E Congress passed in July 2002 the Public Company Accounting Reform and

Investor Protection Act The short name for the act became the Sarbanes-Oxley Act of 2002

1 The Sarbanes-Oxley Act was passed as the result of a large series of

corporate indiscretions

2 The act contains 11 “titles” 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

3 The initial title of the act created the Public Company Accounting

Oversight Board This board’s purpose is to regulate the accounting industry relative to public companies that they audit Members are appointed by the SEC

4 As recently June of 2003, the oversight board itself published a set of

ethics rules to police its own set of activities

IX The Multinational Firm: Efficient Financial Markets and Intercountry Risk

A The United States’ highly developed, complex and competitive financial

markets facilitate the transfer of savings from the saving-surplus sector to the saving-deficit sector

B Multinational firms are reluctant to invest in countries with ineffective

financial systems

1 Financial and political systems lacking integrity will often be

rejected for direct investment by multinational firms

2 Countries that experience significant devaluation of its currency may

also be considered too risky for investment

ANSWERS TO END-OF-CHAPTER QUESTIONS

14-1 Financial markets are institutions and procedures that facilitate transactions in all

types of financial claims Financial 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 Financial markets aid the rate of capital formation in the economy

14-2 A financial intermediary issues its own type of security which is called an indirect

security It does this to attract funds Once 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 quantities

14-3 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 Examples of securities traded in the money market include U.S Treasury Bills, bankers’ acceptances, and commercial paper Notice that all of these are debt instruments Equity securities are not traded in the money market It is entirely an over-the-counter market On 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 organized security exchanges or over-the-counter markets

14-4 Organized stock exchanges provide for:

(1) A continuous market This means a series of continuous security prices is

generated Price changes between trades are dampened, reducing price volatility, and enhancing the liquidity of securities

(2) Establishing and publicizing fair security prices Prices on an organized

exchange are determined in the manner of an auction Moreover, the prices are published in widely available media like newspapers

(3) 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 liquidity rather than a financial asset

14-5 The criteria for listing can be labeled as follows: (1) profitability; (2) size; (3)

market value; (4) public ownership

14-6 Most bonds are traded among very large financial institutions Life insurance

companies and pension funds are typical examples These institutions deal in large quantities (blocks) of securities An over-the-counter bond dealer can easily bring together a few buyers and sellers of these large quantities of bonds By comparison, common stocks are owned by millions of investors The organized exchanges are necessary to accomplish the "fragmented" trading in equities

14-7 The investment banker is a middleman involved in the channeling of savings into

long-term investment He performs the functions of: (1) underwriting; (2) distributing; (3) advising By assuming underwriting risk, the investment banker and his syndicate purchase the securities from the issuer and hope to sell them at a higher price Distributing the securities means getting those financial claims into the hands of the ultimate investor This is accomplished through the syndicate's selling group Finally, 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

14-8 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

14-9 Investment banking syndicates are established for three key reasons: (1) the

investment banker who originates the business probably cannot afford to purchase the entire new issue himself; (2) to spread the risk of loss among several underwriters; (3) to widen the distribution network

14-10 Several positive benefits are associated with private placements The first is speed

Funds can be obtained quickly, primarily due to the absence of a required registration with the SEC Second, flotation costs are lower as compared to public offerings of the same dollar size 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 Elements of the debt contract can also be renegotiated during the life of the loan

14-11 As a percent of gross proceeds, flotation costs are inversely related to the dollar size

of the new issue Additionally, common stock is more expensive to issue than preferred stock, which is more expensive to issue than debt

14-12 The answer on this is clear The corporate debt markets dominate the corporate

equity markets when new funds are raised The tax system of the U.S economy favors debt financing by making interest expense deductible from income when computing the firm's federal tax liability Consider all corporate securities offered for cash over the period 1999-2001 The percentage of the total represented by bonds and notes was 76.9 percent compared to 23.1 percent equity

14-13 The household sector is the largest net supplier of savings to the financial markets

Foreign financial investors have recently been net suppliers of savings to the financial markets On the other hand, the nonfinancial corporate business sector is most often a savings-deficit sector The U.S Government sector too is a deficit sector in most years

14-14 First, there may be a direct transfer of savings from the investor to the borrower

Second, 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 Private pension funds and life insurance companies are prominent examples of the latter case