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Chapter Nine

Chapter Nine. The Capital Markets. Capital Markets. The market for securities with an original maturity greater than one year Firms & investors use the capital markets for long-term investments

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Chapter Nine

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  1. Chapter Nine The Capital Markets

  2. Capital Markets • The market for securities with an original maturity greater than one year • Firms & investors use the capital markets for long-term investments • Firms typically try to match the term of financing with the expected economic life of the assets acquired – why? What is the cost of doing this? • Investors expect to earn higher rates of return on long term securities than on money market securities • Best known capital market securities: • Stocks and bonds

  3. Capital Market Participants • Primary issuers of securities: • Federal and local governments • Federal government – fund the national debt • Provincial & local governments – to fund large infrastructure projects • Corporations • Acquire funds to invest in new capital equipment • The decision to issue debt or equity is the capital structure decision • Largest purchasers of securities: • Households - You and me (often in the form of mutual funds or pension funds)

  4. Capital Market Trading • Primary market • Any new sale of securities by a firm is done in the primary market • If it is the first time a firm has issued securities in the public market, is referred to as an IPO (Initial Public Offer) • Secondary market • After securities have been sold by a firm in the primary market, future transactions between investors occurs in the secondary market • Secondary market trading can occur: • Over-the-counter (OTC) • On organized exchanges (i.e., TSX)

  5. Some Stock Exchange History • Toronto Stock Exchange • Established in 1861 • Membership cost $5.00 • Eighteen securities listed for trading • Trading hours limited to daily half-hour sessions • 1901 • Price of a stock exchange seat now cost $12,000 • Trading volume 1,000,000 shares per year • 100 companies listed • Continuous auction trading introduced • 1914 • The fear of a financial panic following the declaration of WWI prompted the TSE to cease operations for three months, beginning July 28, 1914 Trading also halted on the NYSE

  6. Some Stock Exchange History • 1922 – 1926 • Canadian firms issue over $700 million of new securities • From 1924 to 1929, annual trading volume rises from 1,000,000 shares per year to 10,000,000 shares per year • 1933 • The Great Depression exacts a toll. Over 2,000 investment & brokerage firms fail in the U.S. However, no TSE member firm defaults on obligations to clients • 1937 • The TSE moves to a new facility at 234 Bay Street, the first building in Toronto to have air conditioning • 1955 • The price of a TSE membership was $100,000 and 1 billion shares worth $2.6 billion traded

  7. Some Stock Exchange History • 1977 • The TSE launches the world’s first Computer Assisted Trading System (CATS). The TSE 300 Composite Index is launched • 1980 • 3.3 Billion shares worth $29.5 Billion are traded, accounting for 80% of all equity trading in Canada • 1987 • The TSE 35 Index is created • Annual trading value exceeds $100 Billion • 1996 • The TSE is the first exchange in North America to introduce decimal trading • All US exchanges forced to adopt decimal trading my April 9, 2001

  8. Some Stock Exchange History • 1997 • The TSE is the largest stock exchange in North America to introduce a floorless, electronic trading environment. The trading floor is closed. • 1999 • Barbara Stymiest named President & CEO, the first female head of a North American exchange • The TSE becomes the sole exchange for the trading of senior equities • Vancouver Stock Exchange and Alberta Stock Exchange merge to form Canadian Venture Exchange (CDNX) for trading in junior equities • The Canadian Dealing Network, Winnipeg Stock Exchange and the equities portion of the Montreal Stock Exchange later merge with CDNX

  9. Some Stock Exchange History • 2000 • The TSE becomes a for-profit company on April 3, 2000 • Daily trading value tops $15 Billion in May, 2000 • 2001 • TSE acquires the Canadian Venture Exchange. CDNX renamed TSX Venture Exchange • 2002 • The TSE 300 Composite Index renamed S&P/TSX Composite Index May 1, 2002 • Iceberg Orders introduced (allows a large order to be broken into many small orders to hide trading information and prevent moving market prices) • TSX does an IPO

  10. Some Stock Exchange History • 2003 • First quarterly dividend of $0.15 paid • 2005 • TSX splits stock 2:1 • Dividend is increased to $0.25 per share (post split) • Launches S&P/TSX Canadian Bond Index • Annual trading value more than $1 Trillion, up 29% from 2004 • Income Trusts added to the S&P/TSX Composite Index.

  11. Rankings of Exchanges by Market Capitalization 1- New York Stock Exchange 2- Tokyo Stock Exchange 3- NASDAQ 4- London Stock Exchange 5- Euronext 6- Toronto Stock Exchange 7- Frankfurt Stock Exchange (Deutsche Börse) 8- Madrid Stock Exchange (BME Spanish Exchanges) 9- Hong Kong Stock Exchange 10-SWX Swiss Exchange Source: World Federation of Exchanges, as of September 2005.

  12. Total Value of Shares Traded, 2004 Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp

  13. Average Daily Trading Value, 2004 Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp

  14. Average Value of a Trade, 2004 Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp

  15. Benefits of Going Public • Access to capital – expand investor base • Facilitates growth – use shares as currency • Maintain control • Enhance reputation – provides greater transparency • Create a market for existing shareholders • Reward for managers & employees

  16. Three Ways to List On the TSX Venture Exchange • Initial Public Offer (IPO) • Capital Pool Company (CPC) • In stage one, a shell corporation is created whose business it is to locate a promising asset. Funds are raised for the search and due diligence process. • In stage two, the actual asset is acquired. Known as a Qualifying Transaction. • Reverse Takeover (RTO) • A private company “buys” a listed company that has no substantial business activity

  17. What it Costs to Go Public on the TSX Venture Exchange Source: TSX Website, “Your Guide to Public Venture Capital”

  18. Costs Not Included on the Previous Page • Valuation reports • Geological or engineering reports • Expert reports • Investment dealer fees & commissions on financings • Printing costs • Transfer agency costs • Investor relations fees

  19. Want to be listed on the TSX? • You will need: • At least 300 investors • A minimum of 1 million shares traded publicly, with a market value of $4 million • Any shareholder with more than 10% of the stock must provide information on their experience in business • A Participating Organization of the TSX must sponsor the company

  20. Want to be listed on the NYSE? • You will need at least: • 2000 stockholders, each owning at least 100 shares • A minimum of 1.1 million shares traded publicly • Pretax earnings of $2.5 million at the time of listing • $2 million in pretax earning in each of the two prior years • A total of $100 million in market value of publicly traded shares

  21. Number of Listed Companies Yearly Comparison with NYSE, AMEX, Nasdaq and TSX

  22. Canada Bonds

  23. Canada Bonds • Issued as • Bearer Bonds • Registered Bonds • No default risk • Very low interest rates • Long bonds yields usually higher than short bond yields due to greater interest rate risk • Canada Savings Bonds • Redeemable at face value at any time • Canada Premium Bonds • Redeemable at face value yearly on anniversary date

  24. Real Return Bonds • First issued in Canada in 1991 • Provide a hedge against inflation • Issued with a fixed coupon • Face value of the bond is grossed up by the change in the CPI • Coupon rate paid on the grossed up face value • At maturity, bonds are redeemed at the greater of face value or grossed-up value

  25. Canada STRIPS • STRIPS – separate trading of registered interest and principal securities • Investment dealer strips the coupons from the face value. Each cash flow sold as a separate investment. • Issued in book entry form (no paper security is issued) • Collateralized by the underlying Canada bond and thus have no default risk

  26. Canada Bond Interest Rates Figure 2: Interest Rate on Long-Term Canada Bonds and the Inflation Rate, 1976–2001

  27. Compare Long-Term Canada Bonds to 90-Day Treasury Bills

  28. Municipal Bonds • Issued by local governments • Used to finance public interest projects • Municipal bonds in the United States are tax-free. To compare a tax-free municipal interest rate with a fully taxable interest rate: Muni = taxable interest rate  (1  marginal tax rate) • Two types • General obligation bonds – no specific collateral • Revenue bonds – backed by cash flows of a specific asset • NOT default-free

  29. Corporate Bonds • Sold in increments of $1000 • Pay interest semi-annually • Can be redeemed anytime the issuer wishes (Call feature) • Degree of risk varies with each bond • Interest rate varies with level of risk

  30. Corporate Bond Interest Rates

  31. Characteristics of Corporate Bonds • Today, usually sold in registered form. Issuers must report holders of bonds to CRA (Canada Revenue Agency) • Bond Indenture – contract between the issuer and the bond investors. Usually contains restrictive covenants designed to control the actions of management • Call Provisions • Higher yield – investors don’t like the call feature • Sinking fund – a portion of bond redeemed each year • Conversion into common • Value of the convertible the higher of the bond value or the conversion value

  32. Types of Corporate Bonds • Secured Bonds • Mortgage bonds – secured against real estate • Equipment trust certificates – secured against other assets • Unsecured Bonds • Debentures • Subordinated debentures • Variable-rate bonds • Yield tied to some other market rate • Junk Bonds • Michael Milken, Drexel Burnham Lambert discovers an under-serviced niche in high yield bonds (fallen angels) • Milken’s personal income from 1983-1987 > $1 Billion • Later fined for insider trading & went to jail for 3 years • Drexel files for bankruptcy in 1990 due to losses on junk bond portfolio

  33. Debt Ratings

  34. Represents ownership in a firm Earn a return in two ways Price of the stock rises over time Dividends are paid to the stockholder Stockholders have claim on all assets Right to vote for directors and on certain issues Two types Common stock Right to vote Receive dividends Preferred stock Receive a fixed dividend Do not usually vote Stock

  35. S&P/TSX Composite

  36. 30 Stocks in the Dow Jones Industrial Average

  37. Dow Jones Industrial Average, 1990-2002

  38. Stock Market Indexes

  39. Public Issues of Stocks and Bonds • Two principal ways to sell securities to the public • Investment bankers • Private placement

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