Common Stock and the Investment Banking Process

Common Stock and the Investment Banking Process Besley Chapter 16

Balance Sheet Accounts and Definitions • Common Equity • The sum of the firm’s common stock, paid in capital, and retained earnings, which equals the common stockholders’ total investment in the firm, stated at book value • Par Value • The nominal or face value of a stock or bond

Balance Sheet Accounts and Definitions • Retained Earnings • The balance sheet account that indicates the total amount of earnings the firm has not paid out as dividends throughout its history • Additional Paid-In Capital • Funds received in excess of par value when a firm issues new stock

Common Equity Accountsas of December 31 (in millions of dollars, except per share data) 2000 1999 Common Stock (40 million sh. authorized, 25 million sh. out, $1par) $25.0 $25.0 Additional paid-in Capital 105.0 105.0 Retained Earnings 285.0260.0 Total Common Stockholder Equity 415.0 390.0 Book Value per Share $16.60 $15.60

Common stock + Paid-in capital + Retained earnings • Number of shares outstanding = Balance Sheet Accounts and Definitions Book Value Per Share • The accounting value of a share of common stock Book Value is based on historic value and may differ greatly from market value.

Legal Rights and Privileges of Common Stockholders Control of the Firm • Stockholders elect the firm’s directors, who select the officers that manage the business. • Normally, each share entitles the owner to one vote. Proxy - A document giving one person the authority to act for another, typically the power to vote shares of common stock.

Legal Rights and Privileges of Common Stockholders Control of the Firm Proxy Fight -An attempt by a person or group to gain control of a firm by getting its stockholders to grant the person or group the authority to vote their shares in order to elect a new management team.

Legal Rights and Privileges of Common Stockholders Control of the Firm Takeover - An action whereby a person or group succeeds in ousting a firm’s management and taking control of the company. Management attempts to prevent takeovers include: • Stagger Director elections – elect 1/3 of the directors each year. • Shareholder approvals - Require 75% of the shareholders to approve a merger (rather than 50%). • “Poison Pills” – provision that allows shareholders, during a take over, to purchase additional shares at a discounted rate (which makes the take over undesirable).

Legal Rights and Privileges of Common Stockholders The Preemptive Right A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities).

Types of Common Stock Classified Stock - Common stock that is given a special designation, such as Class A, Class B, etc., to meet the special needs of the company Founder’s Shares - The class of stock owned by the firm’s founders who have sole voting rights

Advantages Common stock does not obligate the firm to make payment to shareholders. Carries no fixed maturity date. Generally increases a firm’s creditworthiness, raises bond rating, lowers cost of capital. When a firm’s future appears positive, common stock can be sold for on better terms. Disadvantages Gives voting rights and perhaps control to new shareholders. Dilution of Profits (especially when compared to debt financing) Higher issuance costs Where the firm has exceeded it optimal capital structure, the cost of capital will be higher than necessary. Non-deductability of dividends for tax purposes Evaluation of Common Stock as a Source of Funds From the Corporation’s Viewpoint

Evaluation of Common Stock as a Source of Funds From a Social Viewpoint Common stock does not require periodic fixed payments, which may add additional financial pressure during times of hardship.

The Market for Common Stock Corporations and Markets Closely Held Corporation - One that is owned by a few individuals who are typically associated with the firm’s management Publicly Owned Corporation - One that is owned by a relatively large number of individuals who are not involved in its management Over-The-Counter (OTC) Market - The network of dealers that provides for trading securities not listed on the organized exchanges (these stocks are generally said to be unlisted) Organized Security Exchange - A formal organization having a tangible physical location, that facilitates trading in “listed” securities: NYSE, AMEX

The Market for Common Stock Corporations and Markets Companies generally first list on a regional exchange (such as the Chicago, or Midwest Exchange) As the company grows it will move up to the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE) Most Companies are traded on the OTC market (5,000 to 8,000 actively traded stocks), however, the NYSE (which lists approximately 3,000 stocks) accounts for about 60% of the daily transactions. Institutional investors (which include pension trusts; insurance companies; and mutual funds) own approximately 45 – 50% of all common stock and account for more than 75% of the trading volume.

The Market for Common Stock Types of Stock Market Transactions Primary Markets: • New public offerings by privately held firms • Initial Public Offering (IPO) Market - The market consisting of stocks that have just gone public • Going Public - The act of selling stock to the public at large by a closely held corporation or its principal stockholders • Additional shares sold by established, publicly owned companies The Secondary Market - Trading in the outstanding shares of established, publicly owned companies

The Market for Common Stock Types of Stock Market Transactions The need for additional capital prompts companies to “go public.” A firm will look to the equity markets when its growth can no longer be financed by solely by additional debt and the existing stockholder base. The additional financing opportunities provided by the markets do require strict financial reporting and disclosure as well as adherence security regulations.

The Market for Common Stock The Decision to List the Stock To have its stock listed, a company must: • Apply to the exchange • Pay a relatively small fee • Meet the exchange’s minimum requirements • Net Income • # of shares outstanding and held by outsiders Benefits of listing: • Listed companies receive free advertising and publicity • Status as a listed company enhances their prestige

The Market for Common Stock The Decision to List the Stock

The Market for Common Stock Regulation of Securities Markets Securities Exchange Commission • The U.S. Government agency that regulates the issuance and trading of stocks and bonds Registration Statement • A statement of facts filed with the SEC about a company that plans to issue securities Prospectus • A document describing a new security issue and the issuing company SEC lawyers and accountants analyze both the registration statement and the prospectus; if the information is inadequate or misleading, the SEC will delay or stop the public offering.

The Market for Common Stock Regulation of Securities Markets Securities Exchange Commission Regulations: • Ensure investors receive fair financial disclosure from publicly traded companies • Discourage fraudulent and misleading behavior by the firm’s investors, owners, and employees with the intent of manipulating the stock’s price

The Market for Common Stock Regulation of Securities Markets Elements of SEC regulation: • Jurisdiction over all interstate offerings of new securities to the general public in amounts of $1.5 million or more. • Regulates all national securities exchanges, and companies whose securities are listed on an exchange must file annual reports similar to the registration statement with both the SEC and the exchange.

The Market for Common Stock Regulation of Securities Markets Elements of SEC regulation: • Reviews stock trades by corporate insiders. • Insiders must file monthly reports of changes in their holdings of the firm’s stock. Insiders: Officers, directors, major shareholders, or others who might have inside, or privileged information on a company’s operations. • Power to prohibit manipulation • Control over the form of the proxy and the way the company uses it to solicit votes.

The Market for Common Stock Regulation of Securities Markets The Board of Governors of the Federal Reserve System controls the flow of credit into securities transactions through: • Margin Requirements - The percentage of a security’s purchase price that must be deposited by investors (currently 50%) • Margin Call - a call from a broker asking for more money to support a stock purchase loan • Blue Sky Laws - State laws that prevent the sale of securities that have little or no asset backing

Financial Instruments in International Markets American Depository Receipts (ADRs) Certificates presenting ownership in stocks of foreign companies; held in trust by a bank in the country in which the stock is traded, and traded on U.S. markets Foreign Equity Instruments Euro Stock - a stock that is traded in countries other than the home country of the company Yankee Stock - stock issued by foreign companies that is traded in the United States

The Investment Banking Process Investment Banker • An organization that underwrites and distributes new issues of securities • Helps businesses and other entities obtain needed financing

The Investment Banking Process Raising Capital: Stage I Decisions • Dollars to be raised 2. Type of securities used 3. Competitive bid versus negotiated deal 4. Selection of an investment banker

The Investment Banking Process Raising Capital: Stage II Decisions • Reevaluating the initial decisions • Best efforts or underwritten issues • Underwritten Arrangement - agreement for the sale of securities in which the investment bank guarantees the sale by purchasing the securities from the issuer • Best Effort Arrangement - investment bank handling the transaction gives no guarantee that the securities will be sold • Issuance Costs • Underwriter’s Spread - The difference between the price at which the investment banking firm buys an issue from the company and the price at which the securities are sold in the primary market • Flotation Costs - The costs associated with issuing new stocks or bonds • Setting the offering price • Offering Price - The price at which common stock is sold to the public

The Investment Banking Process Selling Procedures • Underwriting Syndicate • A syndicate of investment firms formed to spread the risk associated with the purchase and distribution of a new issuance of securities • Lead or Managing Underwriter • The member of an underwriting syndicate who actually manages the distribution and sale of a new security offering • Selling Group • A group (network) of brokerage firms formed for the purpose of distributing a new issuance of securities

The Investment Banking Process Shelf Registrations • Securities are registered with the SEC for sale at a later date • They are held “on the shelf” until the sale

The Investment Banking Process Maintenance of the Secondary Market • When a company is going public for the first time the investment banker is obligated to maintain a market for the shares after the issue has been completed • The lead underwriter agrees to “make a market” in the stock and keep it reasonably liquid

Common Stock and the Investment Banking Process