Chapter 12: Capital Markets
Outline: Overview of Capital Markets Debt Financing Equity (Stock) Securities Managing Capital Market Investments Valuation of Long-Term Securities
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 1
Discussion Question
What are the distinctions between money and capital markets? Give examples of each.
Answer:Money markets Money market instruments generally have ≤ 1 year to
maturity. Examples: T-bills, CP, repos and Bas.
Capital markets Capital market instruments are debt with
1 to 30+ years to maturity and equity securities (no fixed maturity date but can cease to exist).
Longer-dated capital market instruments are usually marginally less liquid than money market instruments.
Examples: Bonds and common and preferred stock.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 2
Key Participants
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 3
Issuers of securities
Central banks (debt)
Corporations (debt and equity)
GSEs (debt)
Municipalities (debt)
Mutual fund companies (debt and equity)
Investors
Investment banking and brokerage firms
Regulators
Rating agencies (debt)
Transaction processors
Other parties
Capital Markets
Primary markets
Debt and equity offered to investors; stock issues:■ Initial public offering ■ Secondary issues
Secondary markets
Existing debt and equity traded by retail and institutional investors
Private markets
Securities offered and sold to limited number of investors
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 4
Discussion Question
Identify the following market characteristics as primary, secondary or private.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 5
1. Issues may be exempt from SEC registration.
2. Underwritten issues provide funds to the firm on the issue date; a syndicate markets the issue to the investing public.
3. Trades take place on stock exchanges or over-the-counter market.
4. Market price of existing shares guides price for new shares.
Answers:
Primary
Secondary
Primary
Private
Security Exchanges and Over-the-Counter (OTC) Markets
Principal benefits: Competitive forces of
supply and demand determine securities prices
Market where frequent trading minimizes price volatility between individual trades
Companies can raise large amounts of capital
Regulated environment to ensure fairness
OTC markets: More decentralized Rely on electronic
communication to conduct auction-style market trading
Unlike exchanges, may trade government, municipal and corporate debt, equity
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 6
Medium- and Long-Term Borrowing
Medium- or intermediate-term notes 2- to 10-year range Periodic interest Liquid
Long-term bonds 10 to 30 years Customizable Coupon
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 7
Term loan Fixed maturity
typically > 1 year Specific need
Discussion Question
Which of the following describes a bond issue, lists collateral, makes representations and warranties, specifies covenants, specifies terms by which a firm will provide funds for redemption and sets forth interest payment schedules or call provisions?a) Guaranteesb) Indenturesc) Put provisions
Answer: b
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 8
Long-Term Bonds
Mortgage bonds
Finance specific assets pledged as security; usually include substantial covenants: Assets involved Right to issue additional bonds Use of second mortgages Sinking-fund, reporting, ratio requirements Prepayment terms Restrictions on dividend policy
Unsecured bonds
General claims against assets or cash flows; may be issued on subordinated basis.
Convertible bonds
Corporate securities are convertible into common/preferred stocks at a fixed price.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 9
Long-Term Bonds
Stock purchase warrants
Options to buy stock for a stated price until a stated date.
Municipal bonds
General obligation bonds paid from general tax revenues.
Revenue bonds paid from specific public projects.
Zero-coupon bonds
Pay no interest but sell at a deep discount; no cash outflow until maturity and deducts interest.
High-yield bonds
Junk bonds; issued by less creditworthy entities; imply a high required yield.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 10
Other Bonds
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 11
Income bonds Pay interest only if company has profits, reducing risk for company
Collateral trust bonds Backed by securities of other companies that are owned by the issuing company
Equipment trust certificates
Bonds secured with movable equipment (e.g., trucks, trains)
Index bonds Interest rate tied to economic index; used in countries with high inflation
Economic development bonds
Issued by underdeveloped countries or by World Bank or International Monetary Fund
Tax increment financing (TIF) bonds
Used primarily for local financing; municipality uses all or a portion to finance project
Tender option bonds Allow the holder to sell them back to the issuer
Discussion Question
A bond that is denominated in U.S. dollars and issued in India by a U.K. company would be an example of aa) foreign bond.b) Eurobond.c) global bond.d) multicurrency bond.
Answer: b
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 12
Other Forms of Debt Capital
Floating- (adjustable-) rate debt
Project financing Securitization Off-balance-
sheet financing (leasing)
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 13
Debt Contract Provisions
Bond indentures and covenants
Representations and warranties
Events of default Cure periods Remedies Waivers of defaults
MAC clause Call provisions Sinking funds
Refinancing Defeasance of debt Promissory note Collateral Liens
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 14
Other Factors in Using Debt as a Source of Capital
Credit enhancements
Guarantees Bond ratings Capital structure
considerations Maturity
matching
Effects of interest rate levels and forecasts
Availability of collateral
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 15
Types of Guarantee of Principal
Full guarantee Specific project
guarantee Guarantee of payment
or collection Comfort letter Performance guarantee Personal guarantee
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 16
Equity (Stock) Securities
Common stock Preferred stock Hybrid securities
Convertibles Warrants
International equity market
Depository receipts (DRs)
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 17
Discussion Question
What are some of the benefits of using depository receipts (DRs), especially for companies in countries with limited financial markets?Answer: They help increase global trade, including transaction
volumes on both local and foreign markets. They offer greater exposure and the
opportunity to raise capital on a global basis to companies in smaller countries.
They help reduce market inefficiencies, especially in emerging markets, by allowing for easier global investment in those markets.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 18
Types of Common Stock
Most companies have only one class.
Different classes may limit voting privileges, dividends and/or resales.
Tracking stock. Institutional investors
own 70% of all common stock.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 19
Objectives of Capital Market Investments
Some mix between current income and capital appreciation
Investment policy
Return objective
Risk tolerance
Issues to consider: Risk preferences for
portfolio Return objectives Liquidity needs Time horizons or
future needs for funds
Tax issues Legal or regulatory
factorsv3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 20
Capital Asset Pricing Model (CAPM) Beta (ß) measures the risk of a particular stock relative to overall
market. The market has a beta of one, so stocks with a beta > one are more risky than the market; those with a beta < one are less risky than the market. Risk-free assets (T-bills) have a beta of 0. Assume that the T-bill rate is 2%, the expected rate of return on the market portfolio is 8%, and the beta for this stock is 1.5 (greater risk than average).
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 21
E
RF
M
i
r = Required rate of return on stockholder's equity
r = Expected rate of return on risk-free asset (T-bill rate)
r = Expected return on market portfolio (S&P 500 index)
ß = Beta value for stock i
E RF M RF ir = r + (r r )ß
= 0.02 + (0.08 0.02) 1.5 = 0.110 or 11.0%Where:
Preferred Stock Valuation
Preferred stock is viewed as an annuity that exists into perpetuity.
Example: $50 par value; pays a 6.60% annual dividend; market requires 8% return.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 22
Preferred Stock Dividend = Preferred Stock Dividend Rate Par Value= 6.6% $50= 0.066 $50.00 = $3.30
Preferred Stock Annual Dividend Price of Preferred Stock = Required Rate of Return
$3.30= = $41.250.08
Common Stock Valuation Both timing and amount of cash flows from common stock
can vary. Following equation assumes that dividends will grow at a
constant rate in the future. Required rate of return can be determined using CAPM.
Example: P0 = Current value of the stock
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 9: Module 5, Chapter 12 - 23
010
s s
D 1 gDP = =
k g k g
$2.00 1 0.06 $2.12= = = $30.290.070.13 0.06
D1 = Next expected dividend (calculated as D0[1+g])
Next dividend (D0): $2.00 Estimated dividend growth
rate (g): 6% Required rate of return for the
stock (ks): 13%