1. 19.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 19 The Capital Market

2. 19.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. After Studying Chapter 19, you should be able to:

3. 19.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Public Issue Privileged Subscription Regulation of Security Offerings Private Placement Initial Financing Signaling Effects The Secondary Market The Capital Market

4. 19.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Capital Market Capital Market – The market for relatively long-term (greater than one year original maturity) financial instruments. Primary Market Primary Market – A market where new securities are bought and sold for the first time (a “new issues” market). Secondary Market Secondary Market – A market for existing (used) securities rather than new issues. Déjà Vu All Over Again

5. 19.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. INVESTMENT SECTOR FINANCIAL INTERMEDIARIES SAVINGS SECTOR FINANCIAL BROKERS SECONDARY MARKET Public issue Privileged subscription Private placement Indicates the possible presence of a “standby arrangement” Indicates the financial intermediaries’ own securities flow to the savings sector Déjà Vu All Over Again

6. 19.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Securities are sold to hundreds, and often thousands, of investors under a formal contract overseen by federal and state regulatory authorities. investment bankerWhen a company issues securities to the general public, it is usually uses the services of an investment banker. Public Issue Public Issue – Sale of bonds or stock to the general public. Public Issue

7. 19.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. underwriting spreadInvestment banker receives an underwriting spread when acting as a middleman in bringing together providers and consumers of investment capital. Underwriting spreadUnderwriting 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 Investment Banker – A financial institution that underwrites (purchases at a fixed price on a fixed date) new securities for resale. Investment Banker

8. 19.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. lower costThus, 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:Three primary means companies use to offer securities to the general public: Traditional (firm commitment) underwriting Best efforts offering Shelf registration efficientlyInvestment bankers have expertise, contacts, and the sales organization to efficiently market securities to investors. Investment Banker

9. 19.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. the underwriterIf 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 firm commitment underwriting 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

10. 19.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Underwriting Syndicate Underwriting Syndicate – A temporary combination of investment banking firms formed to sell a new security issue. Traditional Underwriting

11. 19.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. B.Negotiated Offering Traditional Underwriting

12. 19.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Best Efforts Offering 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 SEC Rule 415 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. Traditional Underwriting

13. 19.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. A firm with securities sitting “on the shelf” can require that investment banking firms competitively bid for its underwriting business. Shelf Registration: Flotation Costs and Other Advantages

14. 19.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Privileged Subscription rights offering 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 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. Privileged Subscription

15. 19.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 Right subscription right Right – A short-term option to buy a certain number (or fraction) of securities from the issuing corporation; also called a subscription right. Terms of Offering

16. 19.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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

17. 19.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Thus, the shareholder needs to purchase an additional 3 rights. 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. What action should the shareholder take? 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? Subscription Rights

18. 19.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 What gives a right its value? Value of Rights

19. 19.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. P 0 R 0 R 0 NS P 0 – R 0 = [ (R 0 )(N) + S ], therefore R 0 P 0 R 0 NS R 0 = P 0 – [ (R 0 )(N) + S ] R 0 R 0 = the market price of one right when the stock is selling “rights-on” P 0 P 0 = the market price of a share of stock selling “rights-on” S S = the subscription price per share N N = the number of rights required to purchase one share of stock How is the Value of a Right Determined?

20. 19.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. R 0 Solving for R 0. P 0 S P 0 – S N N + 1 R 0 R 0 = P X P 0 R 0 R 0 NS P X = P 0 – R 0 = [ (R 0 )(N) + S ] R 0 By substitution for R 0, we can solve the “ex-rights” value of one share of stock, P X “ex-rights” value of one share of stock, P X. P 0 NS (P 0 )(N) + S N N + 1 P X P X = How is the Value of a Right Determined?

21. 19.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Assume the following informationAssume the following information: current market price $50.The current market price of a stock “rights-on” is $50. subscription price is $40.The subscription price is $40. nine rightsIt takes nine rights to buy an additional share of stock. 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”? Example of the Valuation of a Right

22. 19.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. R 0 Solving for R 0. P X Solving for P X. $50$40 $50 – $40 9 9 + 1 R 0 R 0 = R 0 $1 R 0 = $1 $50 9$40 ($50 )(9) + $40 9 9 + 1 P X P X = P X $49 P X = $49 How is the Value of a Right Determined?

23. 19.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Why might the actual value of a right differ from its theoretical value? Theoretical Versus Actual Value of Rights

24. 19.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 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. Standby Arrangement

25. 19.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Oversubscription Privilege Oversubscription Privilege – The right to purchase, on a pro rata basis, any unsubscribed shares in a rights offering. Oversubscription Privilege

26. 19.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Privileged Subscription versus Underwritten Issue

27. 19.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Securities Exchange Act of 1934 Securities Exchange Act of 1934 – Regulates the secondary market for long- term securities – the securities exchanges and the over-the-counter market. Securities Act of 1933 Truth in Securities Act 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 and Exchange Commission (SEC) enforces both of these acts. Regulation of Security Offerings – Federal

28. 19.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Part 1: Prospectus Part 1: Prospectus – Discloses information about the issuing company and its new offering and is distributed to investors. Part 2 Part 2:Additional information required by the SEC that is not part of the printed prospectus. Registration Statement Registration Statement – The disclosure document filed with the SEC in order to register a new securities issue. Regulation of Security Offerings – Federal

29. 19.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. SEC reviews the registration statement to see that all the required information is presented and that it is not misleading. comment letterDeficiencies are communicated in a comment letter. stop orderOnce the SEC is satisfied, it approves the registration. If not, it issues a stop order. 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. Red Herring

30. 19.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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

31. 19.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Impact with shelf registration: Regulation of Security Offerings – Federal

32. 19.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Tombstone Advertisement Tombstone Advertisement – An announcement placed in newspapers and magazines giving just the most basic details of a security offering. Regulation of Security Offerings – Federal

33. 19.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 Sarbanes-Oxley Act of 2002 (SOX) 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. Sarbanes-Oxley Act of 2002

34. 19.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 Blue Sky Laws – State laws regulating the offering and sale of securities. Regulation of Security Offerings – State

35. 19.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 WKSI – Well-known seasoned issuer. Essentially large, actively traded companies with established US public track records. Security Offerings Reform

36. 19.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. Automatic shelf registration Automatic shelf registration – A more flexible form of shelf registration only available to WKSIs that become automatically effective upon filing with the SEC. Security Offerings Reform

37. 19.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 Free-writing prospectus (FWPs) 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. Security Offerings Reform

38. 19.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 (or Direct) 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). Private Placement

39. 19.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 Features

40. 19.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Qualified Institutional Buyers (QIBs)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 RiskEvent 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

41. 19.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Underwritten Rule 144a Private PlacementUnderwritten 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 RightsPrivate 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. Private Placement and Other Developments

42. 19.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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 stockLetter 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 – Venture Capital

43. 19.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Initial Public Offering (IPO) Initial Public Offering (IPO) – A company’s first offering of common stock to the general public. 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 Financing – Initial Public Offerings Initial Public Offerings

44. 19.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Negative stock price reaction to common stock or convertible issues. Straight debt and preferred stock do not tend to show statistically significant effects. –10 –8 –6 –4 –2 0 2 4 6 8 0 –1 –2 –3 –4 3 2 1 Cumulative Average Abnormal Return (%) Time Around Announcement (in days) Relative Abnormal Stock Returns for a New Equity Issue Signaling Effects

45. 19.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Asymmetric (Unequal) Information 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. Expectations of Future Cash Flows 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. Possible Explanations for Price Reactions

46. 19.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 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. The Secondary Market