1. 12 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity Financing, Investment Banking, and Market Efficiency Equity financing Key features/terminology Valuation methods The investment banking process Market equilibrium and efficiency

2. 12 - 2 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Outside of long-term debt, the other major source of long-term capital is equity financing. In for-profit (investor owned) businesses, equity is supplied by stockholders and retained earnings. In not-for-profit (NFP) businesses, there are no stockholders, but “equity” financing is obtained in other ways. Introduction

3. 12 - 3 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Preferred stock Similarities to long term debt Similarities to equity Advantages and disadvantages to issuers and investors Valuation of preferred stock -- long term debt approach (discount rate differences) Hybrid Equity/Debt Issues

4. 12 - 4 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Claim on residual earnings Net income “belongs” to shareholders Some portion may be paid out as dividends Control of the firm Preemptive right Common Stock and Shareholder Rights

5. 12 - 5 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Most firms issue only one type of common stock, but some firms use multiple types, or classified stock. Used to designate voting differences between shares (rationale?) Tracking stock -- definition, rationale for issuance Types of Common Stock

6. 12 - 6 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Privately held stock is not traded in an organized market. Publicly held stock is traded: In the over-the-counter (OTC) market (NASDAQ). On stock exchanges (listed stock). Regional exchanges American Stock Exchange (AMEX) New York Stock Exchange (NYSE) The Market for Common Stock

7. 12 - 7 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Initial public offerings (IPOs) occur when shares of a privately held company are sold to the public for the first time. (The company “goes public.”) The primary market is used when new (additional) shares are sold by publicly owned companies. Share sales between individuals take place in the secondary market. Stock Market Transactions

8. 12 - 8 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Rights offering Public offering Private placement Employee stock purchase plans Dividend reinvestment plan (DRIP) Direct purchase plan Methods Used By Corporations to Sell New (Non-IPO) Shares of Common Stock

9. 12 - 9 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Markets are regulated by the SEC and by state commissions. Key features of regulation: New issues must be registered Investors must be given a prospectus Goals of regulation: Ensure investors have accurate information Prevent market manipulation Reduce insiders’ advantage Regulation of Securities Markets

10. 12 - 10 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Investment banks (such as Merrill Lynch and Salomon Smith Barney) assist businesses in issuing securities. The procedures followed when businesses (including NFP) issue new securities is called the investment banking process.  What securities do NFPs issue? The Investment Banking Process

11. 12 - 11 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Size of issue Type (types) of security (securities) Selection of an investment banker Contractual basis with banker Best efforts Underwritten issue Investment banker’s compensation Offering price Key Decisions

12. 12 - 12 Copyright © 1999 by the Foundation of the American College of Healthcare Executives NFP businesses must have “equity” capital, but it is not supplied by stockholders. Start-up equity comes from: Religious organizations Governmental entities Ongoing equity comes from: Profits Contributions Grants Equity in Not-For-Profit Businesses

13. 12 - 13 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Like all assets, the financial value of a share of common stock is the present value of the expected cash flow stream. For stocks, the cash flow stream is dividends and a future selling price. But, regardless of the holding period, a share of stock can be valued solely on the basis of its future dividend stream.  Why? Common Stock Valuation

14. 12 - 14 Copyright © 1999 by the Foundation of the American College of Healthcare Executives General Stock Valuation Model 012  R(R) E(D 1 )E(D  )E(D 2 )... PV E(D 1 ) PV E(D 2 ) PV E(D  ) Value = E(P 0 )  What’s the problem?

15. 12 - 15 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Constant Growth Model If dividends are expected to grow at a constant rate forever, then the general stock valuation model can be simplified to this form: E(P 0 ) = D 0 x [1 + E(g)] R(R i ) - E(g) = E(D 1 ) R(R i ) - E(g).

16. 12 - 16 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Constant Growth Model (Cont.) Here, E(P 0 ) is the intrinsic value of the stock. E(g) is the expected constant dividend growth rate. R(R i ) is the stock’s required rate of return. D 0 is the last dividend paid (assumed to be paid yesterday). E(D 1 ) is the next expected dividend (assumed to be received in one year).  Which of the above input variables are most uncertain?

17. 12 - 17 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Constant Growth Model (Cont.) Four assumptions are necessary for the constant growth model: E(g 1 ) = E(g 2 ) = E(g N ) = E(g). R(R i )  E(g). The last dividend was just paid yesterday. Dividends are paid annually.  Are these assumptions realistic?

18. 12 - 18 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Assume b i = 1.5, RF = 7%, and R(R M ) = 13%. What is the required rate of return on the stock? R(R i ) = RF + [R(R M ) - RF] x b i = 7% + (13% - 7%) x 1.5 = 7% + (6% x 1.5) = 16.0%. Use the SML to calculate R(R i ):

19. 12 - 19 Copyright © 1999 by the Foundation of the American College of Healthcare Executives If D 0 = $1.82 and E(g) = 10%, what is the stock’s intrinsic value? E(P 0 ) = D 0 x [1 + E(g)] R(R i ) - E(g) = $1.82 x 1.10 0.16 - 0.10 = = $33.33. $2.00 0.06

20. 12 - 20 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Constant Growth Model (Cont.) Dividend growth is primarily caused by: Inflation. Earnings retention. Note that the model can be used when E(g)= 0 (zero growth) and even when growth is negative.

21. 12 - 21 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The Rate of Return Form of the Constant Growth Model The constant growth model can be rearranged as follows: E(R i ) = + E(g) D 0 x [1 + E(g)] P0P0 = + E(g). E(D 1 ) P0P0

22. 12 - 22 Copyright © 1999 by the Foundation of the American College of Healthcare Executives If P 0 = $33.33, E(D 1 ) = $2.00, and E(g) = 10%, what is the stock’s expected rate of return? E(R i ) = + E(g) E(D 1 ) P0P0 = + 10.0% $2.00 $33.33 = 6.0% + 10.0% = 16.0%.

23. 12 - 23 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What is the expected stock price (expected value) at the end of Year 1? E(P 1 ) = D 1 x [1 + E(g)] R(R i ) - E(g) = $2.00 x 1.10 0.16 - 0.10 = = $36.67. $2.20 0.06

24. 12 - 24 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Find the dividend yield, capital gains yield, and total return expected during the first year of stock ownership. DY = = = 6.0%. E(D 1 ) P0P0 $2.00 $33.33 CGY = = 10.0%. $36.67 - $33.33 $33.33 Total return = DY + CGY = 6.0% + 10.0% = 16.0%.

25. 12 - 25 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The following conditions hold for a constant growth stock: The dividend is expected to grow at a constant rate forever. The stock price is expected to grow at the same rate. The expected dividend yield is constant over time. The expected capital gains yield is a constant equal to the growth rate.

26. 12 - 26 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Nonconstant Growth Model Clearly, most “real world” stocks do not exhibit constant growth. A somewhat more complicated model is required to value such stocks. Determinants of stock valuation Non-constant dividend stream Non-constant stock price

27. 12 - 27 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Security Market Equilibrium Investors will buy a security when its: Expected rate of return exceeds the required rate of return. Intrinsic value exceeds the current price. In equilibrium: E(R i ) = R(R i ). P 0 = E(P 0 ). In efficient markets, buying and selling actions continuously move security prices towards equilibrium.

28. 12 - 28 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Informational Efficiency A securities market is informationally efficient if: Relevant information can be easily obtained at low cost. The market contains many buyers and sellers who act on the information. Many tests confirm that the major securities markets in the U.S. are informationally efficient.

29. 12 - 29 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Implications of Market Efficiency Securities prices reflect all publicly available information. Investors should not expect to “beat the market” or to consistently forecast interest rate changes. Managers, unless they hold private (inside) information, should not question the “correctness” of securities prices.

30. 12 - 30 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Why might the major stock and bond markets be efficient? Major financial firms, such as Merrill Lynch, Fidelity Investments, and Prudential Insurance have thousands of well qualified analysts with immediate access to information along with billions of dollars to invest. Thus, new information is almost instantaneously reflected in current prices.

31. 12 - 31 Copyright © 1999 by the Foundation of the American College of Healthcare Executives What markets are efficient? In general, the markets for the stocks and bonds of large companies and for Treasury securities are efficient. However, many people believe that “pockets of inefficiency” exist. The markets for real assets (real estate, buildings, and so on) are not efficient.