FM567 - Capital Markets Finals

• Equity


  • Represents ownership in a firm
  • Residual claim (priority: loans, bondholders)
  • From an investor's perspective: riskier than debt (chance of no return)
• Agency cost


  To ensure that management acts in the owners' best interest and not solely on its behalf
• Agency problem


  The ultimate goal of shareholder is to maximize shareholders wealth, while manager just wants salary. Salary is part of company's expense and it is calculated in net income
• To avoid agency problem

  Company offers discounted stock options to management
• Types of equity/stock

  • Preferred stock - Preferential in declaration
  • Common stock - residual
• Private Equity


  • Issued primarily to institutional investors via nonpublic offerings, such as private placements
  • No active secondary market since they are not listed on public exchanges
  • Private equity securities do not have market-determined quoted prices, are highly illiquid, and require negotiations between investors in order to be traded (limited, hard to find ready buyer/seller)
• Venture Capital (VC)


  • Provides "seed" capital, start-up capital, or early-stage financing to companies that are in the early stages of development and require additional capital for expansion
  • These funds finance the firm's product development and growth
  • Generally, requires a commitment of funds for a relatively long period
  • The opportunity to "exit" the investment is typically within 3 to 10 years from the initial start-up (not fixed, depends)
  • Exit return earned by these private equity investors is based on the price that the securities can be sold for if and when the start-up company first goes public either via Initial Public Offering (IPO) on the stock market or by being sold to other investors (see as opportunity to exit)
• Venture Capital (VC) example


  • 2002 $1B = 5m shares -> 2022 $3B IPO
  • If may willing bumili -> $5B you can exit by selling your shares even if it's not yet IPO
• Leveraged Buyout (LBO)


  • Occurs when a group of investors uses a large amount of debt to purchase all of the outstanding common shares of a publicly traded company
  • Companies that are candidates for these types of transactions generally have large amounts of undervalued assets and generate high levels of cash flows (used to pay off debt)
  • Objective of LBO: to restructure the acquired company and later take it "public" again by issuing new shares to the public in the primary market
• 2 types: General LBO and MBO


  • Management buyout (MBO) – refers to the transaction where the group of investors acquiring the company is primarily comprised of the company’s existing management.

  
  

  • After the shares are purchased, they cease to trade on an exchange, and the group of investors takes full control of the firm.
• Private Equity: Crowdfunding (small scale)


  • Companies also have the option of trying to raise funds from a large number of investors through a process called “crowdfunding” over the Internet.

  • To engage in crowdfunding, the founders of a company provide information about their business or project on an Internet platform.

  • Investors then can invest their funds in the projects of their choice.

  • Examples: Crowdfunder, Indiegogo, and Kickstarter
• • Investing through crowdfunding can be very risky


  ➔ Some companies fail to obtain the funding they seek

  ➔ Some investors have not received any returns at all or have found that it can be difficult to sell their shares

  ➔ Companies relying on crowdfunding may disclose very little information to the investors
• Public Equity

  • When a firm goes public, it issues stock in the primary market in exchange for cash. (IPO -first time to issue share, if succeeding then it is trading in secondary market)

  • Going public has two effects on the firm:

  ➔ Changes the firm’s ownership structure by increasing the number of owners

  ➔ Changes the firm’s capital structure by increasing the equity investment in the firm (debt and equity)

  • Owners of small companies also tend to be the managers. In publicly traded firms, most shareholders are not the managers.
• Stock markets are like other financial markets

  they link the surplus units (those who have excess funds) with deficit units (those who need funds).
• How Stock Markets Facilitate the Flow of Funds

  How Stock Markets Facilitate the Flow of Funds

  
• Public Equity: Common Stock


  • Represents partial ownership in a corporation and a predominant type of equity security
• Two ways for an investor to generate returns:

  • Dividends
  • Capital Appreciation
• Public Equity: Common Stock

  ➔ Investors share in the operating performance of the company and participate in the governance process through voting rights.

  ➔ Normally, only the owners of common stock are permitted to vote on certain key matters concerning the firm.

  ➔ Investors may assign their vote to management through the use of a proxy. (reassign someone else to vote for you)
• Two types of voting

  • Statutory voting
  • Cumulative voting
• Statutory voting

  regular shareholder voting, where each share represents one vote.

  Example: If 4 Board of Directors (BODs) are to be elected, a shareholder holding 100 shares could cast only a maximum of 100 votes for each one candidate. - 100 shares x 4 = 400 votes - 400 votes/ 4 = 100 votes per candidate
• Cumulative voting


  allow shareholders to direct their total voting rights to specific candidates instead of allocating their voting rights evenly among all candidates.

  o Example: A shareholder holding 100 shares is entitled to 400 votes and can either cast all 400 votes in favor of a single candidate or spread them across the candidates in any proportion.

  o Key Benefit of Cumulative Voting: Allows shareholders with a small number of shares to apply all of their votes to one candidate, which provides the opportunity for a higher level of representation on the board.
• Public Equity: Preferred Stock


  • Represents equity interest in a firm that usually does not allow for significant voting rights

  • Ranks above common shares to pay dividends and distribute the firm’s net assets upon liquidation
• Types of Dividends on Preferred Shares

  • Cumulative

  • Non-cumulative

  • Non-participating
• Types of Dividends on Preferred Shares - Cumulative


  dividends accrue so that if the firm decides not to pay a dividend in one or more periods, the unpaid dividends must be paid in full before common shares can be paid (entitle shareholders to receive unpaid dividends from past years)
• Types of Dividends on Preferred Shares - Non-cumulative


  any dividends not paid in the current or subsequent periods are forfeited permanently and are not accrued over time to be paid later (only entitle to receive the current years, unpaid dividends do not accumulate)
• Types of Dividends on Preferred Shares - Non-participating

  does not allow shareholders to share the profits of the company
• Convertible Preferred Shares

  • Entitle the shareholders to convert their shares into a specified number of common shares where the conversion ratio is determined at issuance

  • Advantages:

  ➔ Allow investors to earn a higher dividend

  ➔ Allow investors the opportunity to share in the profits of the firm

  ➔ Allow investors to benefit from a rise in the price of the common shares through a conversion option

  ➔ Prices are less volatile than the underlying common shares because the dividend payments are known and more stable
• Institutional Use of Stock Markets

  • Commercial banks
  • Stock-owned savings institutions
  • Savings banks
  • Finance companies
  • Stock mutual funds
  • Securities firms
  • Insurance companies
  • Pension funds
• Commercial banks

  • Issue stock to boost their capital base
  • Manage trust funds that usually contain stocks
• Stock-owned savings institutions

  • Issue stock to boost their capital base
• Savings banks

  • Invest in stocks for their investment portfolios
• Finance companies

  • Issue stock to boost their capital base
• Stock mutual funds


  • Use the proceeds from selling shares to individual investors to invest in stocks
• Securities firms

  • Issue stock to boost their capital base
  • Place new issues of stock
  • Offer advice to corporations that consider acquiring the stock of other companies
  • Execute buy and sell stock transactions of investors
• Insurance companies

  • Issue stock to boost their capital base
  • Invest a large proportion of their premiums in the stock market
• Pension funds

  • Invest a large proportion of pension fund contributions in the stock market
• Initial Public Offering

  ➔ A first-time offering of shares by a specific firm to the public
• Process of Going Public

  1. Developing a Prospectus

  2. Pricing and Bookbuilding

  3. Allocation of IPO Shares
• Developing a Prospectus

  A document containing detailed information about the firm, including financial statements and a discussion of risks, that is filed with the SEC
• Syndicate


  A group of other securities firms that participate in the underwriting process and share the fees to be received for the underwriting