Service
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Integrity
Windy City Summit
CTP Review
Chapter 12
Presented by: The Northern Trust Company
Fran Wawrzyniak, CTP
June 7, 2012
© 2012 Northern Trust Corporation
Chapter 12
Capital Markets
Fran Wawrzyniak, CTP
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Studying for this Chapter
 There
are 7-9 questions on the exam from this chapter
 Understand
 CAPM
calculation
 Valuation
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debt vs. equity financing and key components
of Long-Term Securities
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Overview of Capital Markets
 Two
Basic Segments:
 Debt
– bond securities and loans
 Equity
 Market

– common and preferred stock
Basics
Money Markets – maturities of 1 year or less
 Capital
Markets – maturities greater than 1 year
 Majority
 Long-term debt (bonds), equity securities (stock)
 Equity instruments have no fixed maturity date
 Equity instruments cease to exist when issuing firm does
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Overview of Capital Markets
 Key
Market Participants
 Issuers
of securities
 Central Banks (debt securities)
 Corporations (debt and equity securities)
 Government-Sponsored Enterprises – GSEs (debt securities)
 Municipalities (debt securities)
 Mutual Fund Cos. (debt and equity securities)
 Investors
 Represent the demand side of the markets
 Purchase and hold securities
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Overview of Capital Markets
 Investment
Banking and Brokerage Firms
 “Middlemen”
 Investment
to complete transactions
bankers – assist issuers in design and placement of
issuances
 Origination
desks – evaluate, price and manage placement
traders – maintain secondary markets for equity and debt
instruments
 Securities
 Regulators
 Other
Participants
 Rating
agencies (Chapter 13), attorneys, printing companies and data
service providers
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Overview of Capital Markets
Division of Capital Markets
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Primary
•Offer newly issued debt/equity
•New issues increase stock outstanding or
indebtedness
Secondary
•Trade existing debt/equity
•Established exchanges – physical location with
trading hours
•OTC markets – electronic interchange
•Once a security is issued in the primary market, any
subsequent trades happen in the secondary market
Private
•Direct placement sold to limited number of investors
•May be exempt from registration with SEC
•Lower cost, less restrictive, quicker
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Debt Financing
 Medium-
 Term
and Long-Term Borrowing
Loan
 Fixed maturity, term greater than 1 year
 Paid in single payment or installments
 Usually for a specific purpose
 Secured by asset being financed and term is tied to asset’s useful
life
 Illiquid
 Medium-
or Intermediate-Term Notes
 Terms from 2-10 years
 Payments are interest only
 Marketable securities
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Debt Financing
 Long-Term
 Terms
Bonds
of 10-30 years
 Most
are coupon bonds with regular interest payments at fixed
(coupon) rate
 Indenture
= contract
 Describes bond issue
 Lists collateral
 Specifies covenants
 States terms
 Sets schedule of payments, maturity and provisions
 Multiple types:
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Debt Financing
 Long-Term
 Mortgage
Bonds
Bonds
 Include substantial covenants
 Assets
 Right to issue additional bonds
 Use of junior mortgages
 Sinking-funds
 Reporting requirements
 Restrictions of key fin’l ratios
 Prepayment terms
 Dividend policy
 Unsecured
(Debenture) Bonds
 Claims against assets or cash flows
 Based on issuer reputation
 Treasury, corporate or municipal
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 Convertible
Bonds
 Debt securities that can be
converted into stock
 Stock
Purchase Warrants
 Options to buy stock at stated price
until stated date
 Can be traded in the market
 Municipal
Bonds
 General obligation paid from tax
revenue
 Revenue bonds paid from revenue
of public project (stadium)
 Zero-Coupon
Bonds
 No cash value until maturity
 High-Yield
Bonds
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Debt Financing
Other Bonds
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Income
•Pay interest only if company has profit
Collateral Trust
•Backed by securities of other companies owned by issuer
Equipment Trust
•Secured by movable equipment
Index
•Interest rate tied to an economic index
Economic
Development
•Issued by underdeveloped countries or organizations like
IMF (International Monetary Fund).
Tax Increment (TIF)
•Used for local financing
•All or portion of property taxes provide financing
Tender Option
•Bondholder can redeem bond once over term or on a
specific date
•Redemption at par value
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Debt Financing
 International
Bond Market
 Foreign
Bonds - Sold in a particular country by foreign borrower,
denominated in currency of country of issue and regulated by country of
issue
 Eurobonds
 Sold in many countries outside of country of borrower and issued by
international syndicate
 Bond denominated in USD $ issued in India by a UK company
 Issuers can choose country with preferred regulatory rules
 Global
Bonds - Sold in and out of borrowers country, typically offered in
major currency
 Multicurrency
Bonds
 Issued as currency options which allow investors to choose from select
currencies
 Currency cocktail bonds that are denominated in standard basket of
several currencies
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Debt Financing
 Other
Forms of Debt Capital
 Floating-
(Adjustable-) Rate Debit
 Stable market value, matches current rates
 Take advantage of falling rates, match debt maturity to asset maturity
 Project
Financing
 Large projects such as power plants, stadiums
 Complex structure
 Lenders paid from project cash flows
 Securitization
 Accounts receivable/inventory serve as collateral
 “Mortgage Backed Securities”
 Off-Balance
Sheet Financing
 Joint ventures, factoring, operating leases
 ASC Topic 840-10-15 (Chapter 13)
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Debt Financing
 Debt
Contract Provisions
 Bond
Indentures and Covenants
 Indenture = contract to protect bondholders from risk or increase
value of equity holders
 Violation can make debit immediately due
 Representations
and Warranties
 Existing conditions at the time the loan agreement is executed
 Events
of Default
 Caused by breach of terms or conditions of debit agreement
 MAC
Clause (Material Adverse Change)
 Lets lender refuse funding or declare default if a MAC has
occurred
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Debt Financing
 Debt
Contract Provisions
 Call
Provision
 Issuer has right to call issue for redemption prior to maturity
 Valuable since issue can be redeemed if interest rates fall or other
financing becomes attractive
 Sinking
Fund
 Bonds are not amortized and a lump sum is due at maturity
 Requires company to repurchase portion of outstanding issue
each year, effectually amortizing it
 Refinancing
 Defeasance
of Debt
 Removes debt from balance sheet without retiring the issue
 Borrower places funds in escrow guaranteeing debt
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Debt Financing
 Debt
Contract Provisions
 Promissory
Note
 Collateral
 Liens
 Lender has legal claim on assets used as collateral
 Lenders search liens of potential borrower to ensure collateral is
available to pledge
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Debt Financing
 Other
Factors
Enhancements – reduces credit/default risk of debit, improving credit
rating and lowering interest rates. Common form is Guarantee.
 Credit
 Guarantees
 Full – Party agrees to take over loan if borrower defaults
 Specific Project – Guarantee of loans related only to a specific project,
rather than all loans of borrower
 Guarantee of Payment or Collection - guarantee of payment on loan or
collection of payment if default
 Comfort Letter – not legally enforceable
 Performance
 Full – parent guarantees performance of sub
 Best Efforts – Parents agrees to use best effort to get sub to
perform
 Personal – owner will personally repay loan of company
 Bond
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Ratings – reflect default probability of bond issuer
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Debt Financing
 Other
Factors
Structure Considerations – Target capital structure = best mix
of L/T debt and equity to finance firm
 Capital
 Maturity
 Effects
Matching – match life of debt to life of asset financed
of Interest Rates and Forecasts –
 General level impacts use and cost of debt
 Forecast impacts type of capital and provisions
of Collateral – companies with large asset bases which
can be used as collateral typically borrow at lower rates than other
companies with same credit quality that do not.
 Availability
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Equity Securities

Common Stock - Balance Sheet Accounts
 Par
Value - arbitrary amount representing minimum shareholders would
need to put up in the event of bankruptcy. Usually $1 or $0
 Retained
Earnings
 Net earnings of a corporation since inception less dividends paid to
shareholders
 Accounting entry, not an available pool of funds
 Additional
Paid-in-Capital (APIC)
 Difference at issue of par value and issue price
 Book
Value per Share – common stockholder equity ÷ # shares outstanding
 Market
Value per Share – current trading price of stock
 Treasury
Stock
 Stock issued and later reacquired and can be held in treasury, reissued, or
retired
 No dividends, no votes. Issued , not outstanding
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Equity Securities
Types of Common Stock
 Class
A and B: Classes used to limit voting rights, dividends, resale,
differentiate returns.

Tracking Stock: separate stock created to “track” the finances of a piece of
business . Has a unique ticker symbol.
Preferred Stock
 Major
provisions
 Stockholders have priority claim to earnings and assets before common
 Always has par value
 Dividend is fixed and is accumulated in arrears
 Can be convertible
 Evaluation:
steadier income than common, 70% of dividend can be excluded
from Federal tax
 Particular
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uses
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Equity Securities

Hybrid Securities
 Convertibles:
Bonds or preferred stock that can be exchanged for common
stock
 Disadvantages:
 Stock price increases, then better off issuing regular debt
 Coupon rate lost if bonds converted to stock
 If stock price does not increase, then locked into debt issue
 Warrants:
 Company issued options that give owner right to buy stated number of
shares at a specific price for a period of time.
 Often listed on major exchanges.
 Represent additional equity for issuer
 Detachable – can be traded separate from bond
 Can dilute the stockholder’s equity and EPS
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Equity Securities
 International
Equity Market
 Represents
 Depository
ownership of public corporations traded globally
Receipts (DRs)
 Negotiable
instruments that trade on a local exchange that represent
stock ownership in a foreign company
 Benefits:
 Increase global trade
 More opportunity to raise global capital
 Reduce market inefficiencies
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Managing Capital Market Investments
 Objectives
 Risk
of Capital Market Investments
preference
 Return
objectives
 Liquidity
 Future
 Tax
needs
needs
Issues
 Legal/regulatory
 Asset
factors
Allocation Decision
 Mix
of fixed income and equity securities
 Depends
on objectives for portfolio
 The
longer the portfolio maturity, the higher tolerance of risk, the
more equity used
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Managing Capital Market Investments
 Long-Term,
Fixed Income Portfolio Management
 Duration
 Measure of risk
 Weighted average time to receipt al future cash flows for a bond
investment
 Can provide estimate of how a bond will respond to rate changes
 Example:
 If interest rates rise 100 bps or 1%, then the price of a bond with
a duration of 4.0 years will fall by 4%
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Managing Capital Market Investments
 Long-Term,
 Interest
Fixed Income Portfolio Management
Rate Risk
 Risk from changes in market value when general level of market
rates changes
 Higher duration = higher interest rate risk
 Fixed/Floating
Ratio
 Ratio of fixed rate debt to floating rate debt
 Too narrow of an indicator to be effective
 Foreign
Currency Denominated Investments
 Must consider the fluctuating F/X rats on the overall portfolio
 Use of derivatives can mitigate risk
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Managing Capital Market Investments
 Long-Term,
 Using
Fixed Income Portfolio Management
Derivatives – Chapter 9
 Asset-Liability
Management
 Issue for portfolio that uses borrowed funds in overall strategy
 Issue for banks that fund investments with deposits or borrowed
funds – may have a maturity mismatch
 Equity
Portfolio Management
 Define
and measure investment risk
 Benefits
 Capital
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of diversification
Asset Pricing Model (CAPM)
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Managing Capital Market Investments
CAPM (Capital Asset Pricing Model)
rE = rRF + (rM – rRF) βi
rE = Required rate of return on stockholder’s equity
rRF = Expected rate of return on the risk free asset (T-Bill)
rM = Expected rate of return on the market portfolio (S&P 500)
Βi = Beta value for stock i
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Managing Capital Market Investments
CAPM (Capital Asset Pricing Model)
Example 1:
Risk free rate of return is 2.0% and expected rate of return on the stock
market is 8.0%. Apple Computer has a beta of 1.5.
rE = Expected Rate of Return
rRF =.02
rM = .08
βi = 1.5
rE = rRF + (rM – rRF) βi
= .02 + (.08 - .02)(1.5) = .110 or 11.0%
11.0% is the required rate of return for Apple, which is greater than the
rate of return for the market, because Apple is more risky than the
market.
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Managing Capital Market Investments
CAPM (Capital Asset Pricing Model)
Example 2:
Risk free rate of return is 2.0% and expected rate of return on the stock
market is 8.0%. Beta for H.J. Heinz is 0.6
rE = Expected Rate of Return
rRF =.02
rM = .08
βi = .06
rE = rRF + (rM – rRF) βi
= .02 + (.08 - .02)(.06) = .056 or 5.6%
The rate of return on Heinz is less than the market since the risk is less
than the market.
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Managing Capital Market Investments
 Determining
 Use
Portfolio Risk and Return
weighted averages of returns and betas of individual stocks
Example: Portfolio contains 70% Apple stock and 30% Heinz stock.
Portfolio β = (% of Apple stock x Apple β) + (% of Heinz stock x Heinz β)
= (.70 x 1.5) = (.30 x .60) = 1.23
Portfolio Return = (% of Apple Stock x Apple Return) + (% of Heinz stock x
Heinz Return) - there was an error in the material
= (0.70 x 0.11) + (0.30 x 0.56) = .0938 or 9.38%
Note: The same return is achieved when using the CAPM of portfolio:
rE = rRF + (rM – rRF) βi
= .02 + (.08 - .02)(1.23) = .0938 or 9.38%
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Valuation of Long-Term Securities
 The
market value of an asset is the present value of the anticipated
future cash flows discounted using a rate equal to the risk. It is
calculated using the Present Value formula:
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Valuation of Long-Term Securities
 Bond
or Fixed Income Valuation
– Yield to Maturity – The interest rate the market demands over the
remaining life of the bond at a particular point in time
 YTM
– Yield to Call – the yield the bond would provide if the issuer called
it prior to maturity. Typically lower than YTM.
 YTC
– Yield to Worst – The worst case scenario of possible YTC values
calculated, or lowest possible yield without an actual default.
 YTW
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Valuation of Long-Term Securities
 Bond
or Fixed Income Valuation
 Preferred
Stock Valuation:
Assume a $50 par value stock pays a 6.6% annual dividend and the market
requires an 8.0% return on the stock.
Preferred Stock Dividend = Preferred Stock Dividend Rate x Par Value
= .066 x $50 = $3.30
Price of Preferred Stock = Preferred Stock Annual Dividend
Required Rate of Return
= $3.30 / .08 = $41.25
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Valuation of Long-Term Securities
Common
Stock Valuation
The price an investor will pay is the present value of the future
dividend stream discounted by the cost of equity:
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Valuation of Long-Term Securities
 Common
Stock Valuation (continued)
 Assumptions must be made about the dividend stream
 Assume the dividends will grow at a constant rate:
Substituting this into the Common Stock Valuation equation results in:
Substitute the next dividend as D1, results in the following reduced equation:
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Valuation of Long-Term Securities
 Common
Stock Valuation (continued)
Example:
Next Dividend (D0) = $2.00
Estimated growth rate (g) = 6%
Return on stock (ks) = 13%
=
= $2.00 (1 + .06) = $2.12 = $30.29
(0.13 – 0.06)
0.07
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Top 15 Stock Exchanges
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Rank
Exchange
Country
1
New York Stock Exchange
United States
2
Tokyo Stock Exchange
Japan
3
NASDAQ
United States
4
Euronext
Belgium, France, Netherlands, Portugal
5
London Stock Exchange
United Kingdom
6
Shanghai Stock Exchange
China
7
Hong Kong Stock Exchange
Hong Kong
8
Toronto Stock Exchange
Canada
9
BM&F Bovespa
Brazil
10
Bombay Stock Exchange
India
11
BME Spanish Exchange
Spain
12
Frankfurt Stock Exchange
Germany
13
Australian Securities Exchange
Australia
14
National Stock Exchange of India
India
15
SIX Swiss Exchange
Switzerland
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