Raising Capital The Process and the Players The Finance nFinance is the study of trade-off between the present and the future qInvestor – giving up something today to gain something in the future nCapital market is an area in which firms and other individuals or institutions that require funds to finance their operations come together with individuals and institutions that have money to invest. n Financing the Firm nHouseholds, firms, financial intermediaries, and government all play a role in the financial system of every developed economy. nFinancial intermediaries are institutions – banks, that collect money - the savings of individuals and corporations and funnel them to firms that use the money to finance their investments. Financing the Firm nIndirect financing qThrough financial intermediaries nDirect financing qThrough individual buying and holding stocks of bonds Description of Financial Intermediaries nTabulka 1.1 strana 4 Decisions Facing the Firms nFirms can raise investment capital from many sources with a variety of financial instruments. qThe firm’s financial policy describes the mix of financial instruments used to finance the firms nInternal Capital qFirms raise capital internally by retaining the earnings that generate nExternal Capital: Debt vs. Equity qFirms must gain an access to the capital market and make a decision about a type of funds to raise. Sources of Capital n External Capital: Debt vs. Equity nThe main difference between debt and equity is that the debt holders have a contract specifying that their claims must be paid in full between the firm can make payments to its equity holders. qIn other words, debt claims are senior, it means have priority, over equity claims nSecond important difference between the debt and equity is that payments to debt holders are generally viewed as a tax deductive expense of the firm. qIn contrast, dividends on an equity instrument are viewed as a payout of profits and are not tax-deductible expanses nMajor corporations frequently raise outside capital by accessing the debt markets qEquity is less frequently used as a source for external financing Public and Private Source of Capital nFirms raise debt and equity capital from both public and private sources qCapital raised from public sources must be in the form of registered securities nSecurities are publicly traded financial instruments nPublic securities differ from private instruments because they can be traded in public secondary market like NYSE, PSE, FSE etc. nPrivate capital comes at most in the form of bank loans or in the form called as private placements qFinancial claims takes of the registration requirements that apply to securities qTo quality for this private placement exemption, the issue must be restricted to a small group of sophisticate investors – fewer than 35 in number – with minimum income or wealth requirements nThese sophisticate investor are very often represented by insurance companies of pension funds n Public and Private Source of Capital nPublic markets tend to be anonymous, that is, buyers and sellers can complete they transactions without knowing each others identities qUninformed investor run the risk of trading with other investors that are more informed because they have “inside” information about the particular company and can make a profit from it. nAlthough, insider trading is illegal and uninformed investors are at least partially protected by laws that prevent investors from buying and selling public securities based on insider information. nInsider information is an internal company information that has not been made public qIn contrast, investors of privately placed debt and equity are allowed to base their decision of information that is not publicly known. §Because traders in private market are assumed to be sophisticate investors who are aware of each other’s identities, inside information about privately placed securities in not as problematic nBecause private market are not anonymous, they generally are less liquid qTransaction costs associated with buying and selling private debt and equity are generally much higher than the costs of buying and selling public securities q Result nCorporation raise capital from both private and public sources. Some advantages associated with private sources are follows: qTerms of private bonds and stock can be customized for individual investors qNo costly registration with some security commission – SEC, CNB, etc. qNo need to reveal confidential information qEasier to renegotiate nPrivately placed financial instruments also can have some disadvantages qLimited investor base qLess liquid nDepending on the state of the market, about 70 percent of debt offerings are made to the pubic and about 30 percentage are private placement. n q The Environment for Raising Capital nA bulk of regulations govern public debt and equity issue. qThese regulations certainly increase the costs of issuing public securities, but also provide protection for investors which support the value of securities. nMarkets that are highly regulated are e.g. markets in Western Europe or in the US n less regulated are e.g. emerging market qMajor risk in emerging markets is that shareholder rights will not be respected and as a result and, many stocks traded in these markets sell for substantially less than the value of their asset The Environment for Raising Capital nFor example: qIn 1995 Lukoil, Russia’s biggest oil company with proven reserves of 16 billion barrels, was valued at 850 USD million, that implies that its oil was worth 5 cents a barrel qAt the same time Royal Dutch/Shell with about 17 billion barrels of reserves, had a market value 94 billion USD, making its oil worth more than 5 USD per barrel qLukoil is worth so substantially less because of uncertainty about shareholder’s rights in Russia. q Investment banks nThe most important subject in the process of issuing of securities nModern investment banks are made up of two parts qCorporate businesses qTrading businesses Investment banks nThe Corporate Business qThe corporate side of investment banking is a fee-for-service business nInvestment bank sells its expertise qThe main expertise banks have is in underwriting securities qBut they are also sell other services nMerge and acquisition advice qProspecting for takeover targets qAdvising clients about the price to be offered for these targets qFinding financing for the take over qPlanning takeover tactics or on the other side takeover defenses qMajor investment banking houses are also actively engaged in the process of new financial instruments design nETFs, investment certificates, etc. n Investment banks nThe Sale and Trading Business qInvestment banks that underwrite securities sell them to the bank’s institutional investors qThese investors include mutual funds, pension funds or insurance companies qSales and trading of these institutions also consists of public market making, trading for clients, etc. nMarket making requires that investment bank act as a dealer in securities. It means that is standing ready to buy and sell, respectively, announces its bid and ask prices. The bank makes money from the difference between the bid and ask price called bid-ask spread. n The Underwriting Process nThe underwriting of a security issue performs four functions qOrigination qDistribution qRisk bearing qcertification Origination nOrigination involves giving advice to the issuing forms about qthe type of security to issue qthe timing of the issue qand the pricing of the issue nOrigination also means working with the firm to develop the registration statement and forming a syndicate of investment bankers to market the issue Distribution nIt is the second function in underwriting process, distribution means selling of the issue nDistribution is generally carried out by a syndicate of banks formed by the lead underwriter nThe banks in the syndicate are listed in the prospectus along with how much of the issue each has aggregate to sell Risk Bearing nThe third function the underwriting process is risk bearing nIn most cases, the underwriter has agreed to buy the securities the firm is selling and to resell them to its clients nThe Rules of Fair Practices prevents the underwriter from selling securities at a price higher than that agreed on at the pricing meeting, so the underwriter’s upside is limited nIf the issue does poorly, the underwriter may be stuck with securities that must be sold at bargain prices n Certification nAn addition role of an investment bank is to certify the quality of an issue, which requires that the bank maintain a sound reputation in capital markets nAn investment banker’s reputation quickly decline if the certification task is not performed correctly nIf an underwriter substantially misprices an issue, in the future business is likely to be damaged qStudies suggested (Booth and Smith 1986) that underwrites require higher fees on issues that are harder to value Underwriting Agreement nThe underwriting agreement between the firm and the investment bank is the document that specifies what is being sold, the amount that being sold and the selling price. nThe agreement also specifies the underwriting spread, which is the difference between the total proceeds of the offering and the net proceeds that is accrue to the issuing firm nThe underwriting agreement also shows the amount of fixed fees the firm must pay like listing fees, taxes, etc. n Classifying Offering nIPO qInitial Public Offering nIssuing equity to the public for the first time nSEO qSeasoned Offering nIf a firm has already publicly traded and is simply selling more common stock nBoth IPO and SEO can include primary and secondary issues nIn a primary issue qA firm rises capital for itself by selling stock to the public nIn a secondary issue qIt is undertaken by existing shareholders who want to sell a number of shares they currently own The Costs of Debt and Equity Issues n The Costs of Debt and Equity Issues nDebt fees are lower than equity fees qEquities are related with higher risk qBonds are easier for pricing than stock nThere are economies of scale in issuing qFixed fees decline as issue size rises nIPO is much more expensive than SEO qIPOs are far riskier and much more difficult to price q Raising Capital in International Markets nEuromarkets nDirect Issuance n n Euromarkets nThe term Euromarkets is a bid misnomer because Euromarkets have no true physical location nEuromarkets are a collection of large international banks that helps firm issue bonds and make loans outside the country in which the firm is located nE.g. firms domiciled in the U.S. could, for instance, issue dollar denominated bonds known as a Eurodollar bonds outside the U.S. or yen-denominated bonds known as a Euroyen bonds outside Japan nOn the other hand qGerman company could borrow through the Euromarkets in e.g. British pounds or Swiss francs Direct Issuance nThe second way how to raise money internationally is to sell directly in the foreign markets, or what is called as direct issuance nE.g. a U.S. corporation could issue a yen-denominated bond in the Japanese bond market nOr a German firm might sell stock to U.S. investors and list its stock on one of the U.S. exchanges Trend in Raising Capital nGlobalization nDeregulation nInnovative Instruments nTechnology nSecuritization Globalization nCapital market are now global nLarge multinational firms routinely issue debt and equity outside their domestic country nBy taking advantages of the differences in taxes and regulations across countries, corporation can sometimes lower their cost of funds qAs firms are better able to shop globally for capital, we can expect regulation around the world to become similar and the taxes associated with raising capital to decline nAs a result, the costs of raising capital in different part of worlds are likely to equalized Deregulation nDeregulation and globalization go hand in hand nCapital will tend to go to countries where returns are large and restrictions on inflows and outflows are small Innovative Instruments nNew instruments qAllow firms to avoid the constraints and costs imposed by government qTailor securities to appeal to new sets of investors qAllow firms to diminish the effects of fluctuating interest and exchange rates nThe result of this process is a wide range of financial instruments available in the global amrket place Technology nTechnology allows many of these recent trends to take place qTechnology leads to continuous 24-hour trading around the world, thus producing a true world market in some securities Securitization nIt is the process of bundling qthat is, combining financial instruments that are not securities, registering the bundles as securities, and selling them directly to the public nE.g. CMOs – Collateralized Mortgage Obligations qDebt contracts based on the payoffs of bundles of publicly traded mortgages nMarket of asset-backed securities Thank you for you attention