chapter 12: capital markets outline: overview of capital markets debt financing equity (stock)...

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.


Key Participants


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


Discussion Question

Identify the following market characteristics as primary, secondary or private.


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


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


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


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.


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.


Other Bonds


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


Other Forms of Debt Capital

Floating- (adjustable-) rate debt

Project financing Securitization Off-balance-

sheet financing (leasing)


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


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


Types of Guarantee of Principal

Full guarantee Specific project

guarantee Guarantee of payment

or collection Comfort letter Performance guarantee Personal guarantee


Equity (Stock) Securities

Common stock Preferred stock Hybrid securities

Convertibles Warrants

International equity market

Depository receipts (DRs)


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.


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.


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).


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.


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


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%

chapter 12: capital markets outline: overview of capital markets debt financing equity (stock)...

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