CHAPTER

2525Securities

Operations

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Review and evaluate the key functions of investment banking firms

Describe the services provided by investment banking firms when they assist in issuing new stock issues

Analyze the risks of securities firms Evaluate the key functions of brokerage firms Evaluate the key factors impacting the value

of securities firms

Investment Banking ServicesInvestment Banking Services

Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments

IBF’s serve both financing entities and investors: Serve as an intermediary buying securities (promise to pay)

from issuing companies and selling them (securities) to investors

Generate fees for services rather than interest income Sell investing services to institutional and other investors Advise companies on mergers and acquisitions

Value companies for sale or purchase In recent years, loaned funds for mergers and acquisitions

Investment Banking ServicesInvestment Banking Services

Investment BankingServices

Origination

Underwriting

Distribution

Advising

How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues

Origination Company wishes to issue additional stock or issue

stock for the first time contacts IBF Gets advice on the amount to issue Helps determine stock price for first-time issues

IBF assists with SEC filings Registration statement Prospectus—summary of registration statement given to

prospective investors

How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues

Underwriting stock Issuer and investment bank negotiate the

underwriting spread The difference between the net price given the company

and the selling price to investors Incentive to under-price IPO’s

The lead investment bank usually forms an underwriting syndicate Other IBFs underwrite a part of the security offering Helps spread the underwriting risk among IBFs

How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues

Distribution of stock Full underwriting vs. best efforts IBFs in the syndicate have retail brokerage

operations Other IBF added as part of selling group Corporation incurs flotation costs

Underwriting spread Direct issuance costs—accounting, legal fees, etc.

How IBFs Facilitate New Stock IssuesHow IBFs Facilitate New Stock Issues

Advising The IBF acts as an advisor throughout the process

Corporations do not have the in-house expertise Includes advice on:

Timing Amount Terms Type of financing

How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues

Origination IBF may suggest a maximum amount of bonds

that should be issued based on firm characteristics Decisions on coupon rate, maturity

Benchmark with market prices of bonds of similar risk Credit rating

Bond issuers must register with the SEC Registration Statement Prospectus

How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues

Underwriting bonds Public utilities often use competitive bids to select

an IBF, versus….. Corporations typically select an IBF based on

reputation and prior working experience The underwriting spread on bonds is lower than

that for stocks Can place large blocks with institutional investors Less market risk

How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues

Distribution of bonds Prospectus Advertisements to public Flotation costs are typically in the range of 0.5

percent to 3 percent of face value

How IBFs Facilitate New Bond IssuesHow IBFs Facilitate New Bond Issues

Private placement of bonds Avoids underwriting and SEC registration expenses Potential purchaser may buy the entire issue

Insurance companies mutual funds commercial banks pension funds

Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm

Investment banks may be involved to provide advice and find potential purchasers

How IBFs Facilitate Leveraged BuyoutsHow IBFs Facilitate Leveraged Buyouts

IBFs facilitate LBOs in three ways: They assess the market value of the LBO firm They arrange financing Purchase outstanding stock held by public Often invest in the deal themselves Provide advice

How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage

Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price

IBFs work with arbitrage firms to search for undervalued firms

Asset stripping A firm is acquired, and then its individual divisions

are sold off Sum of the parts is greater than the whole

Kohlberg, Kravis, and Roberts

How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage

IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity

IBFs also provide bridge loans When fund raising is not expected to be complete

when the acquisition is initiated IBFs provide advice on takeover defense

maneuvers

How IBFs Facilitate ArbitrageHow IBFs Facilitate Arbitrage

History of arbitrage activity Greenmail is when a target company buys back stock

from arbitrage firm at a premium over market price Arbitrage activity has been criticized

Results in excessive financial leverage and risk for corporations

Restructuring sometimes results in layoffs

Arbitrage helps remove managerial inefficiencies Target shareholders can benefit from higher share

prices

Brokerage ServicesBrokerage Services

Market orders Requests by customers to buy or sell at the

prevailing market price Executed quickly, usually within minutes

Limit orders Requests by customers to buy or sell securities at a

specified price or better Day orders Good-till-cancelled orders

Brokerage ServicesBrokerage Services

Short selling—gain from falling prices Investor sells shares they do not own Investor borrows the shares from their broker (who

borrows the shares from other accounts) Later, the investor buys the stock and repays the

shares to the broker If the price has fallen the investor earns a profit Investor still seeks to buy low and sell high, but the order is

reversed

Brokerage ServicesBrokerage Services

Full-service versus discount brokerage services Full-service firms provide investment advice as

well as executing transactions Discount brokerage firms only execute security

transactions upon request Online brokerage firms

Allocation of Revenue SourcesAllocation of Revenue Sources

Importance of brokerage commissions has declined in recent years

Largest source of revenue has been trading and investment profits

Underwriting and margin interest also make up a significant portion of revenue

Revenue from fees earned on advising and executing acquisitions has increased over time

Regulation of Securities FirmsRegulation of Securities Firms

Regulated by the National Association of Securities Dealers (NASD) and securities exchanges

The SEC regulates the issuance of securities and specifies disclosure rules for issuers Also regulates exchanges and brokerage firms

SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties

Regulation of Securities FirmsRegulation of Securities Firms

The Federal Reserve determines the credit limits (margin requirements) on securities purchased

The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts Insured up to $500,000 Brokers pay premiums to SIPC to maintain the fund Boosts investor confidence, increasing economic

efficiency

Regulation of Securities FirmsRegulation of Securities Firms

Financial Services Modernization Act of 1999 Permitted banking, securities activities, and

insurance to be offered by a single firm Varied financial services organized as subsidiaries

under special holding company Financial holding companies regulated by the

Federal Reserve

Risks of Securities FirmsRisks of Securities Firms

Exchange Rate Risk

Market Risk Interest Rate Risk

Credit Risk

Risks of Securities FirmsRisks of Securities Firms

Market risk Securities firms’ activities are linked to stock

market conditions When stock prices are rising:

Greater volume of stock offerings Increased secondary market transactions More mutual fund activity Securities firms take equity positions which are

bolstered when prices rise

Risks of Securities FirmsRisks of Securities Firms

Interest rate risk Performance of securities firms can be sensitive to

interest rate movements because: Market values of bonds held as investments increase as interest

rates fall Lower rates can encourage investors to withdraw money from

banks and invest in stocks

Exchange rate risk Operations in foreign countries Investments in securities denominated in foreign

currency

Valuation of Securities FirmsValuation of Securities Firms

Value of a securities firm depends on its expected cash flows and required rate of return

V = f [E(CF),k]

V = Change in value of the securities firm

k = Change in required rate or return

Where:

E(CF) = Change in expected cash flows

+

Valuation of Securities FirmsValuation of Securities Firms

Factors that affect cash flows

E(CF) = Expected cash flow

Rf = Risk free interest rate

INDUS = Prevailing industry conditions

Where:

E(CF)= f (ECON, Rf , INDUS, MANAB)

ECON = Economic growth

MANAB = The ability of the security firm’s management

+ +?

Valuation of Securities FirmsValuation of Securities Firms

Investors required rate of return

k = f(Rf , RP)++

Rf = Risk free interest rate

Where:

RP = Risk premium

Interaction With Other Financial Interaction With Other Financial InstitutionsInstitutions Offer investment advice and execute security

transactions for financial institutions that maintain security portfolios

Compete against financial institutions that have brokerage subsidiaries

Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms

Financial Services Modernization Act of 1999 Effectively repealed Glass-Steagall Commercial banks, securities firms, and insurance

companies will increasingly offer similar services

Globalization of Securities FirmsGlobalization of Securities Firms

Securities firms have increased their presence in foreign countries Merrill Lynch has more than 500 offices spread

across the world Allows them to place securities in various markets for

corporations or governments International M&A Ability to handle transactions with foreign securities

Globalization of Securities FirmsGlobalization of Securities Firms

Growth in international securities transactions Created more business for large securities firms

International stock offerings Increased liquidity for issuing firm, avoiding downward

price pressure

Growth in Latin America Increased business due to NAFTA

Growth in Japan Some barriers to foreign securities firms still exist