chapter 25 securities operations. chapter objectives n review and evaluate the key functions of...
TRANSCRIPT
CHAPTER
2525Securities
Operations
© 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter Objectives
Review and evaluate the key functions of investment banking firms
Describe the services provided by investment banking firms when they assist in issuing new stock issues
Analyze the risks of securities firms Evaluate the key functions of brokerage firms Evaluate the key factors impacting the value
of securities firms
Investment Banking ServicesInvestment Banking Services
Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments
IBF’s serve both financing entities and investors: Serve as an intermediary buying securities (promise to pay)
from issuing companies and selling them (securities) to investors
Generate fees for services rather than interest income Sell investing services to institutional and other investors Advise companies on mergers and acquisitions
Value companies for sale or purchase In recent years, loaned funds for mergers and acquisitions
Investment Banking ServicesInvestment Banking Services
Investment BankingServices
Origination
Underwriting
Distribution
Advising
How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues
Origination Company wishes to issue additional stock or issue
stock for the first time contacts IBF Gets advice on the amount to issue Helps determine stock price for first-time issues
IBF assists with SEC filings Registration statement Prospectus—summary of registration statement given to
prospective investors
How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues
Underwriting stock Issuer and investment bank negotiate the
underwriting spread The difference between the net price given the company
and the selling price to investors Incentive to under-price IPO’s
The lead investment bank usually forms an underwriting syndicate Other IBFs underwrite a part of the security offering Helps spread the underwriting risk among IBFs
How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues
Distribution of stock Full underwriting vs. best efforts IBFs in the syndicate have retail brokerage
operations Other IBF added as part of selling group Corporation incurs flotation costs
Underwriting spread Direct issuance costs—accounting, legal fees, etc.
How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues
Advising The IBF acts as an advisor throughout the process
Corporations do not have the in-house expertise Includes advice on:
Timing Amount Terms Type of financing
How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues
Origination IBF may suggest a maximum amount of bonds
that should be issued based on firm characteristics Decisions on coupon rate, maturity
Benchmark with market prices of bonds of similar risk Credit rating
Bond issuers must register with the SEC Registration Statement Prospectus
How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues
Underwriting bonds Public utilities often use competitive bids to select
an IBF, versus….. Corporations typically select an IBF based on
reputation and prior working experience The underwriting spread on bonds is lower than
that for stocks Can place large blocks with institutional investors Less market risk
How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues
Distribution of bonds Prospectus Advertisements to public Flotation costs are typically in the range of 0.5
percent to 3 percent of face value
How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues
Private placement of bonds Avoids underwriting and SEC registration expenses Potential purchaser may buy the entire issue
Insurance companies mutual funds commercial banks pension funds
Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm
Investment banks may be involved to provide advice and find potential purchasers
How IBFs Facilitate Leveraged BuyoutsHow IBFs Facilitate Leveraged Buyouts
IBFs facilitate LBOs in three ways: They assess the market value of the LBO firm They arrange financing Purchase outstanding stock held by public Often invest in the deal themselves Provide advice
How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage
Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price
IBFs work with arbitrage firms to search for undervalued firms
Asset stripping A firm is acquired, and then its individual divisions
are sold off Sum of the parts is greater than the whole
Kohlberg, Kravis, and Roberts
How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage
IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity
IBFs also provide bridge loans When fund raising is not expected to be complete
when the acquisition is initiated IBFs provide advice on takeover defense
maneuvers
How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage
History of arbitrage activity Greenmail is when a target company buys back stock
from arbitrage firm at a premium over market price Arbitrage activity has been criticized
Results in excessive financial leverage and risk for corporations
Restructuring sometimes results in layoffs
Arbitrage helps remove managerial inefficiencies Target shareholders can benefit from higher share
prices
Brokerage ServicesBrokerage Services
Market orders Requests by customers to buy or sell at the
prevailing market price Executed quickly, usually within minutes
Limit orders Requests by customers to buy or sell securities at a
specified price or better Day orders Good-till-cancelled orders
Brokerage ServicesBrokerage Services
Short selling—gain from falling prices Investor sells shares they do not own Investor borrows the shares from their broker (who
borrows the shares from other accounts) Later, the investor buys the stock and repays the
shares to the broker If the price has fallen the investor earns a profit Investor still seeks to buy low and sell high, but the order is
reversed
Brokerage ServicesBrokerage Services
Full-service versus discount brokerage services Full-service firms provide investment advice as
well as executing transactions Discount brokerage firms only execute security
transactions upon request Online brokerage firms
Allocation of Revenue SourcesAllocation of Revenue Sources
Importance of brokerage commissions has declined in recent years
Largest source of revenue has been trading and investment profits
Underwriting and margin interest also make up a significant portion of revenue
Revenue from fees earned on advising and executing acquisitions has increased over time
Regulation of Securities FirmsRegulation of Securities Firms
Regulated by the National Association of Securities Dealers (NASD) and securities exchanges
The SEC regulates the issuance of securities and specifies disclosure rules for issuers Also regulates exchanges and brokerage firms
SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties
Regulation of Securities FirmsRegulation of Securities Firms
The Federal Reserve determines the credit limits (margin requirements) on securities purchased
The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts Insured up to $500,000 Brokers pay premiums to SIPC to maintain the fund Boosts investor confidence, increasing economic
efficiency
Regulation of Securities FirmsRegulation of Securities Firms
Financial Services Modernization Act of 1999 Permitted banking, securities activities, and
insurance to be offered by a single firm Varied financial services organized as subsidiaries
under special holding company Financial holding companies regulated by the
Federal Reserve
Risks of Securities FirmsRisks of Securities Firms
Exchange Rate Risk
Market Risk Interest Rate Risk
Credit Risk
Risks of Securities FirmsRisks of Securities Firms
Market risk Securities firms’ activities are linked to stock
market conditions When stock prices are rising:
Greater volume of stock offerings Increased secondary market transactions More mutual fund activity Securities firms take equity positions which are
bolstered when prices rise
Risks of Securities FirmsRisks of Securities Firms
Interest rate risk Performance of securities firms can be sensitive to
interest rate movements because: Market values of bonds held as investments increase as interest
rates fall Lower rates can encourage investors to withdraw money from
banks and invest in stocks
Exchange rate risk Operations in foreign countries Investments in securities denominated in foreign
currency
Valuation of Securities FirmsValuation of Securities Firms
Value of a securities firm depends on its expected cash flows and required rate of return
V = f [E(CF),k]
V = Change in value of the securities firm
k = Change in required rate or return
Where:
E(CF) = Change in expected cash flows
+
Valuation of Securities FirmsValuation of Securities Firms
Factors that affect cash flows
E(CF) = Expected cash flow
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
Where:
E(CF)= f (ECON, Rf , INDUS, MANAB)
ECON = Economic growth
MANAB = The ability of the security firm’s management
+ +?
Valuation of Securities FirmsValuation of Securities Firms
Investors required rate of return
k = f(Rf , RP)++
Rf = Risk free interest rate
Where:
RP = Risk premium
Interaction With Other Financial Interaction With Other Financial InstitutionsInstitutions Offer investment advice and execute security
transactions for financial institutions that maintain security portfolios
Compete against financial institutions that have brokerage subsidiaries
Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms
Financial Services Modernization Act of 1999 Effectively repealed Glass-Steagall Commercial banks, securities firms, and insurance
companies will increasingly offer similar services
Globalization of Securities FirmsGlobalization of Securities Firms
Securities firms have increased their presence in foreign countries Merrill Lynch has more than 500 offices spread
across the world Allows them to place securities in various markets for
corporations or governments International M&A Ability to handle transactions with foreign securities
Globalization of Securities FirmsGlobalization of Securities Firms
Growth in international securities transactions Created more business for large securities firms
International stock offerings Increased liquidity for issuing firm, avoiding downward
price pressure
Growth in Latin America Increased business due to NAFTA
Growth in Japan Some barriers to foreign securities firms still exist