Online Financial Courses - The Management of CapitalProvided by : Matt H. Evans
Adress: 6903 29th St N ; Arlington, VA 22213
Phone number : 1-877-689-4097
Course 3: The Management of Capital
Chapter 4: The Financial MarketplaceOnce a company has decided how much capital to raise and the best mix of capital, it must go to the marketplace to raise the capital. The Financial Marketplace is where investors and companies trying to raise capital come together. Capital markets trade long-term sources of funds, such as stocks and bonds. Capital markets can be broken down into primary markets and secondary markets. Primary markets are those markets where new issues of securities are sold. Secondary markets are where outstanding securities are traded (such as the New York Stock Exchange).
The trading of stocks and bonds will usually involve the use of financial intermediaries, such as banks, pension funds, mutual funds, finance companies, etc. Therefore, the actual source of capital comes from financial intermediaries that purchase the securities. One of the most important financial intermediaries is the Investment Banker.
Investment BankersInvestment Bankers provide critical services for raising capital. They help sell new securities by establishing the price of the security. Investment Bankers determine how the securities will be sold and they distribute the securities to investors. Investment Bankers also investigate the company prior to issuance of securities and certify the issue. This function is necessary in the United States since the sale of securities must be registered with the Securities and Exchange Commission (SEC).
The process for selling securities is called underwriting. Underwriting involves the purchase of securities by the Investment Banker and the resale of securities to investors. The difference between the two prices (purchase vs. sale) is called the spread. The spread represents compensation to the Investment Banker for services rendered.
The Investment Banker wants to set a low price for the sale of securities so that he can sell all of the securities. On the other hand, the company trying to raise capital wants a high price to raise as much capital as possible. Therefore, establishing the right price for securities can be very difficult. For seasoned issues of securities, the offering price can be linked to the price of existing securities. For example, the price for a common stock issue can be set at a certain percentage below the closing market price on the last day of the SEC Registration Period.
Initial Public Offerings (IPOs)Private and closely held companies become publicly traded companies by "going public." The process for going public is called an Initial Public Offering or IPO. An IPO is a major transformation for a company whereby the company raises capital by issuing stock for the first time. Going public also establishes a market price for the company. However, going public has several disadvantages:
1. IPOs require registration with the SEC.
2. The Company is now subject to increased scrutiny and review by investors and other outside interest.
3. The IPO process can be very difficult on those who are directly involved in making it happen.
4. New owners (shareholders) can be demanding, putting pressure on management for higher earnings and growth.
5. Stock prices may not accurately reflect the value of the company.
In order to go public, a company must apply for membership with an exchange where its stock will be traded. There are requirements for stock exchange membership, such as complete disclosure of financial information. Additionally, the company must register with the SEC since the sale of stock will take place in interstate commerce. The purpose of a registration statement is to inform investors on the merits of the new stock offering. Registration statements include the following:
- Description of company assets
- Complete set of audited financial statements
- Statement concerning how capital will be used
- Description of any provisions contained in the securities
1. Pre-Filing Period: Preliminary negotiations and conferences between the issuer of securities and the Investment Banker will take place during the Pre-Filing Period. During this period, basic issues such as how much capital can be raised and what type of securities should be issued are addressed. During the Pre-Filing Period, offers to buy or sell securities are prohibited.
2. Waiting Period: This period starts when the Registration Statement is filed with the SEC. The 20-day waiting period gives the SEC a chance to review the Registration Statement. If the Registration Statement is incomplete, the SEC will issue comments on how to correct the Registration Statement. Any amendments to the Registration Statement result in a new 20-day waiting period.
During the waiting period, the Investment Banker will publish a tombstone ad that describes the pending issue of securities. The tombstone ad must include:
- Name of Issuer
- Amount of securities being offered
- Approximate date of offering
- Price of securities if known
3. Post Effective Period: Once approved by the SEC, the Registration Statement becomes effective and the securities can be sold to investors. A final prospectus must be made available to investors. Prior to issuing the securities, the Master Registration Statement is updated by filing a short form with the SEC.
The final price for the securities is set at the closing day when the SEC clears the issue. Investment Bankers pay the issuer of securities by the fourth day after securities have been issued and investors are required to pay the Investment Banker by the tenth day. The process of raising capital is now complete.
Private PlacementsThe issuance of equity and debt securities will sometimes take place directly between the issuer and the investor. This is type of direct issue is referred to as a private placement. Usually a select group of investors is involved and most private placements are for the issuance of debt instruments, not stock. Additionally, direct business loans with a term more than 15 years are classified as private placements.
Private placements are not subject to formal registration with the SEC and thus, they are less expensive to issue. However, since securities are not sold in an established capital market, the placement of securities will often involve restrictive covenants imposed by the investors. Since there is a lack of market for the securities, investors will demand a higher rate of return.
Although private placements are exempt from SEC registration, certain rules (Regulation D) are imposed on private placements:
- No advertising of the securities is allowed
- The issuing company must exercise care to ensure that investors are buying for their own accounts and not engaged in underwriting services.
- The SEC must be notified within 15 days of the first offering.
Course SummaryThe cost associated with capital is rarely reflected on the Income Statement. Accordingly, many financial managers mistakenly think there is no cost of capital. Therefore, one of the first steps in managing capital is to calculate the cost of capital. The cost of capital is calculated as the weighted average of each capital component - long-term debt, common stock, preferred stock, and retained earnings.
The cost of capital serves as the benchmark for making investment decisions. If a project can earn a rate of return higher than the cost of capital, then the market value of the firm will increase.
Not only do we need to understand the cost of capital, but we need to find the right mix of capital components. To find the right mix, we need to consider several factors. Three important factors to consider are:
1. What are the returns (EPS) under each of the financing plans? We can compare EPS at different levels of EBIT and select the best plan to maximize returns.
2. What is the risk of each financing plan? We can use coverage ratios to assess risk.
3. Finally, we need to make sure that the financing plan does not limit our financing options in the future. We need to have flexibility year after year when it comes to financing.
Once we have determined the right mix of capital, we must raise the capital by having investors purchase the securities. The capital markets bring investors and companies trying to raise capital together. Investment Bankers often serve as the middleman in underwriting the issue of securities.
Chapter 4 pointsInvestment Bankers
Initial Public Offerings (IPOs)