1. Chapter Ten
THE CAPITAL MARKETS

2. Why Firms Borrow To acquire new assets or replace existing assets
These can be financed by
internal financing (from retained earnings)
external financing (debt or equity issue)

3. What affects firm borrowing?
Economic Conditions
Credit Availability and i-rates
Level and expected growth among internal fund sources
Economic Conditions
Business cycle and business optimism and pessimism
Credit Availability and i-rates
Rising I-rates
reduce NVP of projects
Make inventories more costly
Falling I-rates
increase NPV of projects
Lead to restocking of inventories
Level and expected growth among internal fund sources
Internal Fund sources such as firm earnings and CFs tend to be volatile so the use of external funding is also volatile. External funding is often viewed as supplemental to internal funding.

4. Capital Markets Original maturity is greater than one year.
Best known capital market securities:
Stocks and Bonds
Primary issuers of securities:
Federal and Local Governments
Corporations
Largest purchasers of securities:
Households
Primary use of K markets is for longer-term investments

5. Bonds
Debenture or debt
Issuer
Maturity
Coupon Rate
Face or Par Value

6. Principal Investors in Bonds
Investor Amount Percent of Total
Households $ %
ROW $ %
Commercial Banks $ %
Savings Institutions $ %
Life Insurance Companies $1, %
Property-Casualty Ins $ %
Private Pension Funds $ %
Gov’t Pension Funds $ %
Mutual Funds $ %
Security Dealers/Brokers $ %
Other $ %
TOTAL $3, %

7. Bonds Growth of Corporate Bonds and Notes Issued by US Companies
Year New Issues
$ 4,920
$ 8,801
$ 30,321
$ 53,199
$ 114,500
$ 428,100

8. Treasury Bonds Used to finance US Gov’t debt
Note the difference between a note and a bond – maturity

9. Treasury Bond Interest Rates
No default risk
Very low interest rates

10. Treasury Bond Interest Rates

11. Compare 20-Year Treasury Bonds to 90-Day Treasury Bills

12. STRIPS
Separate Trading of Registered Interest and Principal Securities or STRIPS
Separates out the CFs of the bond
Coupon Payments and Principal

13. Agency Bonds Quasi-private Government Entities
Low risk, backed by Federal Gov’t

14. Agency Bonds Gov’t National Mortgage Administration Ginnie Mae
Student Loan Marketing Association
Sallie Mae, SLMA
Federal Home Loan Mortgage Corp.
Freddie Mac, FHLMC
Postal Service PS
Tennessee Valley Authority
TVA
Federal Agricultural Mortgage Corporation
Farmer Mac, FAMC
Federal National Mortgage Association
Fannie Mae, FNMA
Federal Farm Credit Banks
FFCB

15. Agency Bond Growth Year-End Agency Debt Outstanding ($ billions) 1961
$ 8.6
1971
$ 50.7
1980
$ 193.2
1990
$ 434.7
1998
$ 1,296.5

16. Municipal Bonds Issued by local, county, and state governments
Used to finance “public interest” projects
Two types
General obligation bonds
Revenue bonds
NOT Default-Free
Defaults of $1.4 b in 1990
General obligation bonds are backed by “good will” or the :full faith and credit” if the issuing entity. No specific asset or CF is tied to the bond.
Revenue bonds are linked to a specific asset of stream of future CFs. As a result the ratio of revenue bond issues to general obligation bond issues is over 1.

17. “Tax-free Muni’s”
Legislation at the federal level subsidizes municipality bond issues through the tax code
Tax-free municipal interest rate = taxable interest rate x (1 - marginal tax rate)

18. Comparing Revenue and General Obligation Bonds

19. Use of Muni’s Use Percentage Total 100% Other 27% Education 25%
Social Welfare
22%
Transportation
11%
Utilities
10%
Industrial Aid 5%
Total
100%

20. Corporate Bonds Face value of $1,000 Most pay interest semi-annually
Most are callable – option to be redeemed when the issuer wishes
Degree of risk varies with each bond
Interest rate varies with level of risk

21. Corporate Bond Interest Rates, 1973-1996

22. Characteristics of Corporate Bonds
Registered Bonds vs. Bearer Bonds
Restrictive Covenants
Moral hazard, CEOs, and stockholders
Call Provisions
Higher yield
Sinking fund
Interests of stockholders
Convertible Bonds
Today most bonds are “registered” (electronic) rather than “bearer bonds” (paper)
Restrictions on the issuers activity to protect the investor. Clauses in the bond debenture to protect bond holders. Usually limit the debt ratio of the firm and payment level of dividends. These restrictions result from the fact that both stockholders and bond holders have the firm beholden to them for providing capital. Yet stockholders have the advantage because they hire and fire CEOs (ostensibly.) The closer relationship of stockholders to the CEO creates moral hazard problems.
Restrictive covenants reduce risk to bond holder, so their effect is to lower coupon rate.
Call Provisions allow issuer to buy back bonds at will – some restrictions on timing of the call often exist.
Higher yield because they put a limit on bond appreciation caused by interest rate risk.
Sinking fund requires issuer to pay of a portion of the issue periodically. They typically have lower rates because their risk is lower because exposure lowers each time a chunk is paid off,
Interests of stockholders. Stockholder interests may be best served if the firm can remove restrictive covenants by paying off the bonds with the restrictive covenants. Suppose a 30 yr. bond issued by an electric company states no nuclear, and the price of oil quadruples and environmentalists have frozen all hydro-electric generation. Suddenly, nuclear looks attractive.
Alter Capital Structure. Firm may want to reduce debt load when flush with cash.
Used to finance convertible cars.
Conversion – convert into shares of common stock. Written so that the price must rise substantially. Allows bond holders to share in capital appreciation. Conversion is interesting – the market looks at stock issue as a sign the stock is over-valued. Managers issue when they think they can get a high price relative to value per stock certificate. This occurs when the stock is over-valued. Issuing convertible bonds sends the signal that managers feel the stock is currently under-valued. These signals are strong due to asymmetric information.

23. Types of Corporate Bonds
Secured Bonds
Mortgage bonds
Equipment trust certificates
Unsecured Bonds
Debentures
Subordinated debentures
Variable-rate bonds
Junk Bonds
Secured Bonds - Secured bonds have collateral attached
Mortgage bonds - linked to real estate
Equipment trust certificates – linked to real assets. Economic capital, plant and equipment, other non-real estate assets
Unsecured Bonds
Debentures -
Subordinated debentures
Variable-rate bonds
Junk Bonds
Speculative-grade bonds with potential of default

24. Debt Ratings

25. Trends in the Bond Market

26. Stocks Represents ownership in a firm Earn a return in two ways
Appreciation/Depreciation – the price of the stock rises/falls over time
Cash Flows - dividends are paid to the stockholder periodically
Stockholders have claim on all assets
Right to vote for directors and on certain issues

27. Stock Common stock Preferred stock Right to vote Receive dividends
Receive a fixed dividend
Do not usually vote

28. Valuing a Stock The NPV of the expected cash flows
Current Price = NPV of E(Appreciation or Depreciation) + NPV of E(Dividend Cash Flows)
Gordon Growth Model
P = D1 / (i-g)
Gordonm Growth Model
D1 – current dividend
Assume constant growth rate in dividends
i – discount rate
g – constant dividend growth rate expected

29. Preferred Stock Versus Common Stock

30. Want to be listed on the NYSE?
You Will Need at least:
2000 stockholders, each owning at least 100 shares
a minimum of 1.1 million shares traded publicly
pretax earnings of $2.5 million at the time of listing
$1 million in pretax earning in each of the two prior years.
net assets of $18 million
a total of $18 million in market value of publicly traded shares.

32. Stock Prices

33. 30 Stocks in the Dow Jones Industrial Average

34. Stock Market Indexes

35. Stock Market Indexes Many Others S&P 500 NASDAQ Composite
NTSE Composite
Russell 3000 Growth Index
Lipper Growth Fund Index
Russell 3000 Index
S&P 500 is a benchmark against which managers are commonly judged

36. Public Issues of Stocks and Bonds
Two principal ways to sell securities to the public
Investment bankers
Private placement
Investment Bankers underwrite the issue and place the issue with the public through private placement. They price the initial issue, handle the SEC requirements, sell the issue, get the issue rated, etc. The top ten investment banks issue 90% of all stocks. Reputation is important for them to maintain. They also guide the entrepreneur through the process of issue. Sometimes the investment bank promises to buy the entire issue – so setting the correct price is crucial. This is called “firm-commitment under writing.” There is also “Best-efforts underwriting” where the issue is sold on a commission basis. This send a signal to the market though – if the investment bank isn’t willing to buy it why should an individual investor buy it?
In some cases the risk of issue is handled by diversifying the initial holdings among a group of investment bankers.
Private placement: Sell directly to a large investor at a negotiated price. Registration costs are reduced significantly under SEC rules for private placement. This is a particularly attractive option for large institutional investors.