Equity Financing, Investment Banking, and Market Efficiency

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

Equity Financing, Investment Banking, and Market Efficiency

Equity financingKey features/terminologyValuation methods

The investment banking processMarket equilibrium and efficiency

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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.

Introduction

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Preferred stockSimilarities 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)

Hybrid Equity/Debt Issues

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Claim on residual earningsNet income “belongs” to shareholders

Some portion may be paid out as dividends

Control of the firm

Preemptive right

Common Stock and Shareholder Rights

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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

Types of Common Stock

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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)

The Market for Common Stock

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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.

Stock Market Transactions

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Rights offeringPublic offeringPrivate placementEmployee stock purchase plansDividend reinvestment plan (DRIP)Direct purchase plan

Methods Used By Corporations toSell New (Non-IPO) Shares

of Common Stock

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Markets are regulated by the SEC and by state commissions.

Key features of regulation:New issues must be registeredInvestors must be given a prospectus

Goals of regulation:Ensure investors have accurate informationPrevent market manipulationReduce insiders’ advantage

Regulation of Securities Markets

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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?

The Investment Banking Process

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Size of issueType (types) of security (securities)Selection of an investment bankerContractual basis with banker

Best effortsUnderwritten issue

Investment banker’s compensationOffering price

Key Decisions

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NFP businesses must have “equity” capital, but it is not supplied by stockholders.

Start-up equity comes from:Religious organizationsGovernmental entities

Ongoing equity comes from:ProfitsContributionsGrants

Equity in Not-For-Profit Businesses

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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?

Common Stock Valuation

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General Stock Valuation Model

0 1 2 R(R)

E(D1) E(D)E(D2)

...

PV E(D1)

PV E(D2)

PV E(D)

Value = E(P0) What’s the problem?

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Constant Growth Model

If dividends are expected to grow at a constant rate forever, then the general stock valuation model can be simplified to this form:

E(P0) = D0 x [1 + E(g)]

R(Ri) - E(g)

= E(D1)

R(Ri) - E(g).

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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?

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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?

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Assume bi = 1.5, RF = 7%, andR(RM) = 13%. What is the

required rate of return on the stock?

R(Ri) = RF + [R(RM) - RF] x bi

= 7% + (13% - 7%) x 1.5 = 7% + (6% x 1.5)

= 16.0%.

Use the SML to calculate R(Ri):

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If D0 = $1.82 and E(g) = 10%, what is the stock’s intrinsic value?

E(P0) = D0 x [1 + E(g)]

R(Ri) - E(g)

= $1.82 x 1.100.16 - 0.10

= = $33.33. $2.000.06

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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.

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The Rate of Return Form of the Constant Growth Model

The constant growth model can be rearranged as follows:

E(Ri) = + E(g)D0 x [1 + E(g)]

P0

= + E(g) . E(D1)

P0

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If P0 = $33.33, E(D1) = $2.00, and E(g) = 10%, what is the stock’s

expected rate of return?

E(Ri) = + E(g) E(D1)

P0

= + 10.0% $2.00

$33.33

= 6.0% + 10.0% = 16.0%.

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What is the expected stock price (expected value) at the end of Year 1?

E(P1) = D1 x [1 + E(g)]

R(Ri) - E(g)

= $2.00 x 1.100.16 - 0.10

= = $36.67. $2.200.06

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Find the dividend yield, capital gains yield, and total return expected during

the first year of stock ownership.

DY = = = 6.0% . E(D1)

P0

$2.00$33.33

CGY = = 10.0% . $36.67 - $33.33

$33.33

Total return = DY + CGY = 6.0% + 10.0% = 16.0%.

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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.

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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

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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.

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Informational Efficiency

A securities market is informationally efficient 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.

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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.

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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.

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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.

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Equity Financing, Investment Banking, and Market Efficiency

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