SECURITIES FIRMS

1. SECURITIES FIRMS FINANCIAL INSTITUTIONS & SERVICES

2. How Investment Banking firms Facilitate New Stock Issues • Origination • Underwriting Stock • Distribution of stock • Advising

3. Origination: • When a corporation decides to publicly issue additional stock, it may contact an IBF. • The IBF can recommend the appropriate amount of stock to issue, since it can anticipate the amount of stock the market can likely absorb without causing a reduction in the stock price. • Whether the stock to be issued should be preferred or common. • The IBF will evaluate the corporation’s financial condition to determine the appropriate price for the newly issued stock. • The issuing corporation then registers with the SEC. all information relevant to the security, as well as the agreement between itself and the IBF must be provided within the registration statement, which is intended to assure that accurate information is disclosed by the issuing corporation. • SEC approval does not guarantee the quality or safety of the securities to be issued; it simply acknowledges that a firm is disclosing accurate information about itself.

4. Underwriting Stock: • As a result of negotiations between the IBF and an issuing corporation, an underwriting spread is determined, the difference between the price the IBF is willing to pay for stock and the price at which it expects to sell the securities. • The underwriting spread represents a commission to the IBF for selling the stock. • The original IBF may form an underwriting syndicate of IBF’s which are requested to underwrite a portion of the stock. • IBF’s may not be willing to act as underwriters for securities issued by relatively risky corporations. • Instead, they may offer their best efforts in selling the stock. This result is best-efforts agreement; Whereby the IBF does not guarantee a price to the issuing corporation.

5. Distribution of Stock • Once all agreements between the issuing firm, the originating IBF, and other participating IBF’s are complete and the registration is approved by the SEC, the stock may be sold. • The prospectus is distributed to all potential purchasers of the stock, and the issue is advertised to the public. • Some IBF’s participating in a syndicate has brokerage subsidiaries that can sell stock on a retail level. • When a corporation publicly places stock, it incurs to types of floatationcosts, or costs of placing the securities. • First, the underwriting spread is paid to the underwriters, who guarantee the issuing firm a set price for the stock. • Second, issue costs from issuing stock include printing, legal, registration and the accounting expenses.

6. Advising • The IBF acts as an advisor throughout the origination stage as to the various terms of the stock. • Even after the stock is issued, the IBF may continue to provide advice on the timing, amount and the terms of future financing.

7. How Investment Banking Firms Facilitate New Bond Issues • 1. Origination: • The IBF may suggest a maximum amount of bonds that should be issued, based on the issuer’s characteristics. • The bonds would need to offer a relatively high yield, which reflects a high cost of borrowing to the issuer. • Next, the coupon rate, the maturity, and other provisions are decided, based on the characteristics of the issuing firm. Issuers of bonds must register with the SEC.

8. How Investment Banking Firms Facilitate New Bond Issues • 2. Underwriting Bonds: • Underwriting spreads on newly issued bonds are normally lower than on newly issued stock, because bonds can often be placed in large blocks to financial institutions. • The IBF may organize an underwriting syndicate of IBFs to participate in the placement of the bonds. • 3. Distribution of Bonds: • Upon SEC approval of registration, a prospectus is distributed to all potential purchasers of the bonds, and the issue is advertised to the public. • 4. Advising

9. How Investment Banking Firms Facilitate Private Placements • If an issuing corporation knows of a potential purchaser for its entire issue, it might be able to sell its securities directly without offering the bonds to the general public. • This private placement avoids the underwriting fee. • The price paid for privately placed securities is determined by negotiations between the issuing corporation and the purchaser.

10. How Investment Banking Firms Facilitate Leveraged buyouts • Investment Banking Firms Facilitate Leveraged buyouts in three ways: • They assess the market value of the firm of concern so that the participants planning to purchase the firm do not pay more than the firms value. • They arrange financing, which involves raising funds and purchasing any common stock outstanding that is held by the public. • They may be retained in an advisory capacity. • A group may not be able to afford an LBO because of constraints on the amount of funds it can borrow.

11. How Investment Banking Firms Facilitate Leveraged buyouts • The IBF may therefore consider purchasing a portion of the firms assets, which provides the group with some financial support. • It will either search for an immediate buyer of these assets or maintain the assets over a period of time • If it chooses, the latter alternative, it may finance the purchase by issuing bonds. Its return on this deal is based on the difference between the net cash inflows generated by the assets and the cash outflows resulting from the bond issue. • IBF’s initially borrow short term until bonds are issued. If interest rates rise prior to the issue date, the cost of long-term financing may be much higher than the IBF’s had anticipated. • The investment in the mutual fund is used mostly to purchase junk bonds of firms that went private.

12. How Investment Banking Firms Facilitate Arbitrage • Some IBF’s also facilitate arbitrage activity, which in the securities industry refers to the purchasing of undervalued shares and the resale of these shares for a higher profit. • One common form of arbitrage would be acquiring a firm and then selling off individual divisions of the firm. This action is called asset stripping. • IBF’s would generate fee income from their advising arbitrage firms as well as receive a commission on the bonds issued to support the arbitrage activity.

13. How Investment Banking Firms Facilitate Arbitrage • They would also receive fees from divestiture divisions. When the raising of funds is not expected to be complete before the acquisition is initiated, the IBF’s provide bridge loans. • The IBF’s can help finance acquisitions by: • Providing loans to the acquirer • Underwriting bonds or stocks for the acquirer • Investing their own equity in the acquirer’s purchase of the target.

14. How Investment Banking Firms Facilitate Arbitrage • Some times, Arbitrage firms accumulate shares of targets with the expectation that target would be willing to purchase them back at a premium. This tactic is known as Green Mail. • Final result of Green Mail is that target is not acquired and incurs a large expense of buying back shares held by arbitrage firms.

15. Brokerage Services • Market orders • Limit orders • Short-Selling • 1. Market Orders • Requests by customers to purchase or sell securities at the market price existing when the order reaches the exchange floor are called market orders. • 2. Limit Orders • Requests by customers to purchase or sell securities at a specified price or better are called limit orders. • A more specific type of limit order is Stop-Loss order. An investor specifies a selling price below the current market price. When the price drops to specified level, stop-loss order becomes market order.

16. 3. Short Selling •  Investors can speculate on expectations of a decline in securities prices by short selling or selling securities that they do not own. • Short sellers are required to reimburse the owners of the stock for any missed dividends. • Another type of order used in short selling is Stop-Buy-Order. Investor specifies a purchase price above the current market price. When the price rises to specified level, stop-Buy-order becomes market order.

17. Sources of Income for Securities Firm

18. SECURITIES FIRM RISKS • Market risk • Securities firm offer many services linked to stock market conditions. • Rising stock prices generate high volume of business for securities firm. • They benefit from: • Greater volume of stock offerings • Taking equity positions in IPOs • Taking partial equity stake in target firms • Generate more advising and financing acquisitions business

19. SECURITIES FIRM RISKS 2. Interest rate Risk Performance is sensitive to interest rate movements: • Price of bonds held as investments increases when interest rates are low • Low rates can encourage investors to withdraw deposits from commercial banks and invest in stock transactions. 3. Credit Risk • Many Securities firms offer bridge loans and other credit services to firms. • Under unfavorable economic conditions, firms have higher probability of default on their loans.

20. SECURITIES FIRM RISKS • Exchange Rate Risk • Due to depreciation of foreign currency against home currency: • Earnings remitted by foreign subsidiaries reduce. • Market value of foreign securities held as investments decline.

21. Securities Firm Valuation • Value of a Securities Firm changes in response to change in expected cash flows in future and to changes in required rate of return: • ∆V = ƒ[∆E(CF), ∆ k] • Factors affecting cash Flows: • ∆E(CF) = ƒ[∆ECON, ∆ Rf, ∆INDUS, ∆ MANAB] • Factors affecting Required rate of return: • ∆ k = ƒ[∆ Rf, ∆ RP]