The Financial Marketplace

Once a company has decided how much capital to raise and best mix of capital, it must go to the marketplace to raisecapital. Financial Marketplace is where investors and companies trying to raise capital come together. Capital markets trade long-term sources of funds, such as stocks and bonds. Capital markets can be broken down into primary markets and secondary markets. Primary markets are those markets where new issues of securities are sold. Secondary markets are where outstanding securities are traded (such asNew York Stock Exchange).

trading of stocks and bonds will usually involveuse of financial intermediaries, such as banks, pension funds, mutual funds, finance companies, etc. Therefore, the actual source of capital comes from financial intermediaries that purchasesecurities. One of the most important financial intermediaries isInvestment Banker.

Investment Bankers

Investment Bankers provide critical services for raising capital. They help sell new securities by establishingprice of the security. Investment Bankers determine how the securities will be sold and they distributesecurities to investors. Investment Bankers also investigate the company prior to issuance of securities and certifyissue. This function is necessary in the United States since the sale of securities must be registered withSecurities and Exchange Commission (SEC).

process for selling securities is called underwriting. Underwriting involves the purchase of securities byInvestment Banker and the resale of securities to investors. difference between the two prices (purchase vs. sale) is calledspread. spread represents compensation to the Investment Banker for services rendered.

Investment Banker wants to set a low price forsale of securities so that he can sell all of the securities. On the other hand, the company trying to raise capital wants a high price to raise as much capital as possible. Therefore, establishingright price for securities can be very difficult. For seasoned issues of securities, offering price can be linked to the price of existing securities. For example, price for a common stock issue can be set at a certain percentage below the closing market price onlast day of the SEC Registration Period.

Initial Public Offerings (IPO’s)

Private and closely held companies become publicly traded companies by "going public." process for going public is called an Initial Public Offering or IPO. An IPO is a major transformation for a company wherebycompany raises capital by issuing stock for the first time. Going public also establishes a market price forcompany. However, going public has several disadvantages:

1. IPO’s require registration withSEC.
2. Company is now subject to increased scrutiny and review by investors and other outside interest.
3. IPO process can be very difficult on those who are directly involved in making it happen.
4. New owners (shareholders) can be demanding, putting pressure on management for higher earnings and growth.
5. Stock prices may not accurately reflectvalue of the company.

In order to go public, a company must apply for membership with an exchange where its stock will be traded. There are requirements for stock exchange membership, such as complete disclosure of financial information. Additionally, company must register with the SEC since the sale of stock will take place in interstate commerce. purpose of a registration statement is to inform investors onmerits of the new stock offering. Registration statements includefollowing:

• Description of company assets
• Complete set of audited financial statements
• Statement concerning how capital will be used
• Description of any provisions contained insecurities

Registration Process has three distinct periods:

1. Pre-Filing Period: Preliminary negotiations and conferences between the issuer of securities andInvestment Banker will take place during the Pre-Filing Period. During this period, basic issues such as how much capital can be raised and what type of securities should be issued are addressed. DuringPre-Filing Period, offers to buy or sell securities are prohibited.

2. Waiting Period: This period starts whenRegistration Statement is filed with the SEC. 20-day waiting period gives the SEC a chance to review the Registration Statement. If the Registration Statement is incomplete,SEC will issue comments on how to correct the Registration Statement. Any amendments toRegistration Statement result in a new 20-day waiting period.

During the waiting period, Investment Banker will publish a tombstone ad that describes the pending issue of securities. tombstone ad must include:

• Name of Issuer
• Amount of securities being offered
• Approximate date of offering
• Price of securities if known

Additionally, investors can obtain a prospectus that contains information similar to what is contained inRegistration Statement. outside cover of the prospectus will be stamped in red ink - "Preliminary Prospectus." Investors sometimes call this prospectus a "red herring." Similar topre-filing period, offers to sell or buysecurities are prohibited. However, oral offers can be accepted during the 20-day waiting period.

3. Post Effective Period: Once approved by the SEC, Registration Statement becomes effective and the securities can be sold to investors. A final prospectus must be made available to investors. Prior to issuingsecurities, the Master Registration Statement is updated by filing a short form with SEC.

final price for the securities is set atclosing day when the SEC clears the issue. Investment Bankers pay the issuer of securities by the fourth day after securities have been issued and investors are required to payInvestment Banker by the tenth day. process of raising capital is now complete.

Private Placements

issuance of equity and debt securities will sometimes take place directly between the issuer and investor. This is type of direct issue is referred to as a private placement. Usually a select group of investors is involved and most private placements are for the issuance of debt instruments, not stock. Additionally, direct business loans with a term more than 15 years are classified as private placements.

Private placements are not subject to formal registration withSEC and thus, they are less expensive to issue. However, since securities are not sold in an established capital market, the placement of securities will often involve restrictive covenants imposed byinvestors. Since there is a lack of market forsecurities, investors will demand a higher rate of return.

Although private placements are exempt from SEC registration, certain rules (Regulation D) are imposed on private placements:

• No advertising ofsecurities is allowed
• issuing company must exercise care to ensure that investors are buying for their own accounts and not engaged in underwriting services.
• SEC must be notified within 15 days offirst offering.

Course Summary

cost associated with capital is rarely reflected on the Income Statement. Accordingly, many financial managers mistakenly think there is no cost of capital. Therefore, one of the first steps in managing capital is to calculatecost of capital. cost of capital is calculated asweighted average of each capital component - long-term debt, common stock, preferred stock, and retained earnings.

cost of capital serves asbenchmark for making investment decisions. If a project can earn a rate of return higher than the cost of capital, then the market value offirm will increase.

Not only do we need to understandcost of capital, but we need to find the right mix of capital components. To findright mix, we need to consider several factors. Three important factors to consider are:

1. What are the returns (EPS) under each offinancing plans? We can compare EPS at different levels of EBIT and select the best plan to maximize returns.

2. What is risk of each financing plan? We can use coverage ratios to assess risk.

3. Finally, we need to make sure that financing plan does not limit our financing options in the future. We need to have flexibility year after year when it comes to financing.

Once we have determined right mix of capital, we must raise the capital by having investors purchase the securities. capital markets bring investors and companies trying to raise capital together. Investment Bankers often serve as the middleman in underwriting issue of securities.