Equity Financing, Investment Banking, and Market Efficiency

1. Equity Financing, Investment Banking, and Market Efficiency • Equity financing • Key features/terminology • Valuation methods • The investment banking process • Market equilibrium and efficiency

2. Introduction • Outside of long-term debt, the other major source of long-term capital is equity financing. • In for-profit (investor owned) businesses, equity is supplied by stockholders and retained earnings. • In not-for-profit (NFP) businesses, there are no stockholders, but “equity” financing is obtained in other ways.

3. Hybrid Equity/Debt Issues • Preferred stock • Similarities to long term debt • Similarities to equity • Advantages and disadvantages to issuers and investors • Valuation of preferred stock -- long term debt approach (discount rate differences)

4. Common Stock and Shareholder Rights • Claim on residual earnings • Net income “belongs” to shareholders • Some portion may be paid out as dividends • Control of the firm • Preemptive right

5. Types of Common Stock • Most firms issue only one type of common stock, but some firms use multiple types, or classified stock. • Used to designate voting differences between shares (rationale?) • Tracking stock -- definition, rationale for issuance

6. The Market for Common Stock • Privately held stock is not traded in an organized market. • Publicly held stock is traded: • In the over-the-counter (OTC) market (NASDAQ). • On stock exchanges (listed stock). • Regional exchanges • American Stock Exchange (AMEX) • New York Stock Exchange (NYSE)

7. Stock Market Transactions • Initial public offerings (IPOs) occur when shares of a privately held company are sold to the public for the first time. (The company “goes public.”) • The primary market is used when new (additional) shares are sold by publicly owned companies. • Share sales between individuals take place in the secondary market.

8. Methods Used By Corporations toSell New (Non-IPO) Sharesof Common Stock • Rights offering • Public offering • Private placement • Employee stock purchase plans • Dividend reinvestment plan (DRIP) • Direct purchase plan

9. Regulation of Securities Markets • Markets are regulated by the SEC and by state commissions. • Key features of regulation: • New issues must be registered • Investors must be given a prospectus • Goals of regulation: • Ensure investors have accurate information • Prevent market manipulation • Reduce insiders’ advantage

10. The Investment Banking Process • Investment banks (such as Merrill Lynch and Salomon Smith Barney) assist businesses in issuing securities. • The procedures followed when businesses (including NFP) issue new securities is called the investment banking process. • What securities do NFPs issue?

11. Key Decisions • Size of issue • Type (types) of security (securities) • Selection of an investment banker • Contractual basis with banker • Best efforts • Underwritten issue • Investment banker’s compensation • Offering price

12. Equity in Not-For-Profit Businesses • NFP businesses must have “equity” capital, but it is not supplied by stockholders. • Start-up equity comes from: • Religious organizations • Governmental entities • Ongoing equity comes from: • Profits • Contributions • Grants

13. Common Stock Valuation • Like all assets, the financial value of a share of common stock is the present value of the expected cash flow stream. • For stocks, the cash flow stream is dividends and a future selling price. • But, regardless of the holding period, a share of stock can be valued solely on the basis of its future dividend stream. • Why?

14. 0 1 2  E(D1) E(D2) E(D) General Stock Valuation Model R(R) ... PV E(D1) PV E(D2) PV E(D) Value = E(P0) • What’s the problem?

15. Constant Growth Model If dividends are expected to grow at a constant rateforever, then the general stock valuation model can be simplified to this form: D0 x [1 + E(g)] E(P0) = R(Ri) - E(g) E(D1) . = R(Ri) - E(g)

16. Constant Growth Model (Cont.) Here, • E(P0) is the intrinsic value of the stock. • E(g) is the expected constant dividend growth rate. • R(Ri) is the stock’s required rate of return. • D0 is the last dividend paid (assumed to be paid yesterday). • E(D1) is the next expected dividend (assumed to be received in one year). • Which of the above input variables are most uncertain?

17. Constant Growth Model (Cont.) Four assumptions are necessary for the constant growth model: • E(g1) = E(g2) = E(gN) = E(g). • R(Ri)  E(g). • The last dividend was just paid yesterday. • Dividends are paid annually. • Are these assumptions realistic?

18. Assume bi =1.5, RF = 7%, andR(RM) = 13%. What is therequired rate of return on the stock? Use the SML to calculate R(Ri): R(Ri) = RF + [R(RM) - RF] x bi = 7% + (13% - 7%) x 1.5 = 7% + (6% x 1.5) = 16.0%.

19. If D0 = $1.82 and E(g) = 10%, what is the stock’s intrinsic value? D0 x [1 + E(g)] E(P0) = R(Ri) - E(g) $1.82 x 1.10 = 0.16 - 0.10 $2.00 = = $33.33. 0.06

20. Constant Growth Model (Cont.) • Dividend growth is primarily caused by: • Inflation. • Earnings retention. • Note that the model can be used when E(g)= 0 (zero growth) and even when growth is negative.

21. The Rate of Return Form of the Constant Growth Model The constant growth model can be rearranged as follows: D0 x [1 + E(g)] E(Ri) = + E(g) P0 E(D1) = + E(g) . P0

22. If P0 = $33.33, E(D1) = $2.00, and E(g) = 10%, what is the stock’s expected rate of return? E(D1) E(Ri) = + E(g) P0 $2.00 = + 10.0% $33.33 = 6.0% + 10.0% = 16.0%.

23. What is the expected stock price (expected value) at the end of Year 1? D1 x [1 + E(g)] E(P1) = R(Ri) - E(g) $2.00 x 1.10 = 0.16 - 0.10 $2.20 = = $36.67. 0.06

24. Find the dividend yield, capital gains yield, and total return expected during the first year of stock ownership. E(D1) $2.00 DY = = = 6.0% . $33.33 P0 $36.67 - $33.33 CGY = = 10.0% . $33.33 Total return = DY + CGY = 6.0% + 10.0% = 16.0%.

25. The following conditions hold for a constant growth stock: • The dividend is expected to grow at a constant rate forever. • The stock price is expected to grow at the same rate. • The expected dividend yield is constant over time. • The expected capital gains yield is a constant equal to the growth rate.

26. Nonconstant Growth Model • Clearly, most “real world” stocks do not exhibit constant growth. • A somewhat more complicated model is required to value such stocks. • Determinants of stock valuation • Non-constant dividend stream • Non-constant stock price

27. Security Market Equilibrium • Investors will buy a security when its: • Expected rate of return exceeds the required rate of return. • Intrinsic value exceeds the current price. • In equilibrium: • E(Ri) = R(Ri). • P0 = E(P0). • In efficient markets, buying and selling actions continuously move security prices towards equilibrium.

28. Informational Efficiency • A securities market is informationallyefficient if: • Relevant information can be easily obtained at low cost. • The market contains many buyers and sellers who act on the information. • Many tests confirm that the major securities markets in the U.S. are informationally efficient.

29. Implications of Market Efficiency • Securities prices reflect all publicly available information. • Investors should not expect to “beat the market” or to consistently forecast interest rate changes. • Managers, unless they hold private (inside) information, should not question the “correctness” of securities prices.

30. Why might the major stock and bond markets be efficient? • Major financial firms, such as Merrill Lynch, Fidelity Investments, and Prudential Insurance have thousands of well qualified analysts with immediate access to information along with billions of dollars to invest. • Thus, new information is almost instantaneously reflected in current prices.

31. What markets are efficient? • In general, the markets for the stocks and bonds of large companies and for Treasury securities are efficient. • However, many people believe that “pockets of inefficiency” exist. • The markets for real assets (real estate, buildings, and so on) are not efficient.