Chapter Nine
The Capital Markets
Capital Markets
 The market for securities with an original maturity greater
than one year
 Firms & investors use the capital markets for long-term
investments
 Firms typically try to match the term of financing with the expected
economic life of the assets acquired – why? What is the cost of doing
this?
 Investors expect to earn higher rates of return on long term securities
than on money market securities
 Best known capital market securities:
 Stocks and bonds
Slide 9–3
Capital Market Participants
 Primary issuers of securities:

Federal and local governments



Federal government – fund the national debt
Provincial & local governments – to fund large
infrastructure projects
Corporations


Acquire funds to invest in new capital equipment
The decision to issue debt or equity is the capital structure
decision
 Largest purchasers of securities:

Households - You and me (often in the form of mutual funds or
pension funds)
Slide 9–4
Capital Market Trading
 Primary market
 Any new sale of securities by a firm is done in
the primary market
 If it is the first time a firm has issued securities in
the public market, is referred to as an IPO (Initial
Public Offer)
 Secondary market
 After securities have been sold by a firm in the
primary market, future transactions between
investors occurs in the secondary market
 Secondary market trading can occur:


Over-the-counter (OTC)
On organized exchanges (i.e., TSX)
Slide 9–5
Some Stock Exchange History
 Toronto Stock Exchange
 Established in 1861
 Membership cost $5.00
 Eighteen securities listed for trading
 Trading hours limited to daily half-hour sessions
 1901




Price of a stock exchange seat now cost $12,000
Trading volume 1,000,000 shares per year
100 companies listed
Continuous auction trading introduced
 1914
 The fear of a financial panic following the declaration of WWI
prompted the TSE to cease operations for three months, beginning July
28, 1914 Trading also halted on the NYSE
Slide 9–6
Some Stock Exchange History
 1922 – 1926
 Canadian firms issue over $700 million of new securities
 From 1924 to 1929, annual trading volume rises from 1,000,000 shares
per year to 10,000,000 shares per year
 1933
 The Great Depression exacts a toll. Over 2,000 investment &
brokerage firms fail in the U.S. However, no TSE member firm
defaults on obligations to clients
 1937
 The TSE moves to a new facility at 234 Bay Street, the first building in
Toronto to have air conditioning
 1955
 The price of a TSE membership was $100,000 and 1 billion shares
worth $2.6 billion traded
Slide 9–7
Some Stock Exchange History
 1977
 The TSE launches the world’s first Computer Assisted Trading System
(CATS). The TSE 300 Composite Index is launched
 1980
 3.3 Billion shares worth $29.5 Billion are traded, accounting for 80%
of all equity trading in Canada
 1987
 The TSE 35 Index is created
 Annual trading value exceeds $100 Billion
 1996
 The TSE is the first exchange in North America to introduce decimal
trading
 All US exchanges forced to adopt decimal trading my April 9, 2001
Slide 9–8
Some Stock Exchange History
 1997
 The TSE is the largest stock exchange in North America to introduce a
floorless, electronic trading environment. The trading floor is closed.
 1999
 Barbara Stymiest named President & CEO, the first female head of a
North American exchange
 The TSE becomes the sole exchange for the trading of senior equities
 Vancouver Stock Exchange and Alberta Stock Exchange merge to form
Canadian Venture Exchange (CDNX) for trading in junior equities
 The Canadian Dealing Network, Winnipeg Stock Exchange and the
equities portion of the Montreal Stock Exchange later merge with
CDNX
Slide 9–9
Some Stock Exchange History
 2000
 The TSE becomes a for-profit company on April 3, 2000
 Daily trading value tops $15 Billion in May, 2000
 2001
 TSE acquires the Canadian Venture Exchange. CDNX renamed TSX
Venture Exchange
 2002
 The TSE 300 Composite Index renamed S&P/TSX Composite Index
May 1, 2002
 Iceberg Orders introduced (allows a large order to be broken into many
small orders to hide trading information and prevent moving market
prices)
 TSX does an IPO
Slide 9–10
Some Stock Exchange History
 2003
 First quarterly dividend of $0.15 paid
 2005




TSX splits stock 2:1
Dividend is increased to $0.25 per share (post split)
Launches S&P/TSX Canadian Bond Index
Annual trading value more than $1 Trillion, up 29% from
2004
 Income Trusts added to the S&P/TSX Composite Index.
Slide 9–11
Rankings of Exchanges by Market
Capitalization
1- New York Stock Exchange
2- Tokyo Stock Exchange
3- NASDAQ
4- London Stock Exchange
5- Euronext
6- Toronto Stock Exchange
7- Frankfurt Stock Exchange (Deutsche Börse)
8- Madrid Stock Exchange (BME Spanish Exchanges)
9- Hong Kong Stock Exchange
10-SWX Swiss Exchange
Source: World Federation of Exchanges, as of September 2005.
Slide 9–12
Be
n
Bu rm SE
ud
en
a
os
SE
Ai
Co r es
SE
lo
m
bi
a
M
SE
ex
L
im
ica
a
n
Ex SE
ch
an
ge
Na
sd
aq
Sa NY
SE
nt
i
Sa ago
o
Pa SE
ul
o
TS SE
X
G
ro
up
14,000,000.0
12,000,000.0
10,000,000.0
8,000,000.0
6,000,000.0
4,000,000.0
2,000,000.0
0.0
Am
er
ica
USD Millions
Total Value of Shares Traded, 2004
Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp
Slide 9–13
Average Daily Trading Value, 2004
Average Daily Turnover (USD Millions)
Am
er
ica
n
Be
SE
r
m
Bu
ud
en
a
os
SE
Ai
re
s
Co
SE
lo
m
bi
a
SE
M
ex
Li
m
ica
a
n
Ex SE
ch
an
ge
Na
sd
aq
NY
Sa
SE
nt
ia
go
Sa
SE
o
Pa
ul
o
TS SE
X
G
ro
up
50,000.0
40,000.0
30,000.0
20,000.0
10,000.0
0.0
Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp
Slide 9–14
Am
NY
Sa
SE
nt
ia
go
Sa
SE
o
Pa
ul
o
TS SE
X
G
ro
up
n
Be
SE
r
m
Bu
ud
en
a
os
SE
Ai
re
s
Co
SE
lo
m
bi
a
SE
M
ex
Li
m
ica
a
n
Ex SE
ch
an
ge
Na
sd
aq
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
er
ica
USD Thousands
Average Value of a Trade, 2004
Source: World Federation of Exchanges Website http://www.world-exchanges.org/WFE/home.Asp
Slide 9–15
Benefits of Going Public






Access to capital – expand investor base
Facilitates growth – use shares as currency
Maintain control
Enhance reputation – provides greater transparency
Create a market for existing shareholders
Reward for managers & employees
Slide 9–16
Three Ways to List On the TSX Venture
Exchange
 Initial Public Offer (IPO)
 Capital Pool Company (CPC)
 In stage one, a shell corporation is created whose business
it is to locate a promising asset. Funds are raised for the
search and due diligence process.
 In stage two, the actual asset is acquired. Known as a
Qualifying Transaction.
 Reverse Takeover (RTO)
 A private company “buys” a listed company that has no
substantial business activity
Slide 9–17
What it Costs to Go Public on the TSX Venture
Exchange
Cost
Initial Public
Offer
Capital Pool
Company
Reverse
Takeover
TSX Venture Fees $7,500 – 30,000
$12,500 – 40,000
$7,500 – 30,000
Securities
$1,000 – 10,000
Commission Fees
$1,000 – 3,000
N/A
Sponsor Fees
$30,000 – 50,000
$20,000 – 50,000
$30,000 – 50,000
Legal Fees
$75,000 +
$75,000 +
$100,000 +
Accounting &
Auding Fees
$25,000 – 50,000
$25,000 – 50,000
$25,000 – 50,000
Source: TSX Website, “Your Guide to Public Venture Capital”
Slide 9–18
Costs Not Included on the Previous Page







Valuation reports
Geological or engineering reports
Expert reports
Investment dealer fees & commissions on financings
Printing costs
Transfer agency costs
Investor relations fees
Slide 9–19
Want to be listed on the TSX?
 You will need:
1. At least 300 investors
2. A minimum of 1 million shares traded publicly, with a
market value of $4 million
3. Any shareholder with more than 10% of the stock must
provide information on their experience in business
4. A Participating Organization of the TSX must sponsor
the company
Slide 9–20
Want to be listed on the NYSE?
 You will need at least:
1. 2000 stockholders, each owning at least 100 shares
2. A minimum of 1.1 million shares traded publicly
3. Pretax earnings of $2.5 million at the time of listing
4. $2 million in pretax earning in each of the two prior
years
5. A total of $100 million in market value of publicly traded
shares
Slide 9–21
Number of Listed Companies Yearly Comparison
with NYSE, AMEX, Nasdaq and TSX
Slide 9–22
Canada Bonds
Slide 9–23
Canada Bonds
 Issued as
 Bearer Bonds
 Registered Bonds
 No default risk
 Very low interest rates
 Long bonds yields usually higher than short bond yields
due to greater interest rate risk
 Canada Savings Bonds
 Redeemable at face value at any time
 Canada Premium Bonds
 Redeemable at face value yearly on anniversary date
Slide 9–24
Real Return Bonds




First issued in Canada in 1991
Provide a hedge against inflation
Issued with a fixed coupon
Face value of the bond is grossed up by the change in
the CPI
 Coupon rate paid on the grossed up face value
 At maturity, bonds are redeemed at the greater of face
value or grossed-up value
Slide 9–25
Canada STRIPS
 STRIPS – separate trading of registered interest and
principal securities
 Investment dealer strips the coupons from the face
value. Each cash flow sold as a separate investment.
 Issued in book entry form (no paper security is
issued)
 Collateralized by the underlying Canada bond and
thus have no default risk
Slide 9–26
Canada Bond Interest Rates
Figure 2: Interest Rate on Long-Term Canada Bonds and the Inflation Rate, 1976–2001
Slide 9–27
Compare Long-Term Canada Bonds
to 90-Day Treasury Bills
Slide 9–28
Municipal Bonds
1. Issued by local governments
2. Used to finance public interest projects
3. Municipal bonds in the United States are tax-free. To
compare a tax-free municipal interest rate with a fully taxable
interest rate:
Muni = taxable interest rate  (1  marginal tax
rate)
4. Two types


General obligation bonds – no specific collateral
Revenue bonds – backed by cash flows of a specific asset
5. NOT default-free
Slide 9–29
Corporate Bonds
 Sold in increments of $1000
 Pay interest semi-annually
 Can be redeemed anytime the issuer wishes (Call
feature)
 Degree of risk varies with each bond
 Interest rate varies with level of risk
Slide 9–30
Corporate Bond Interest Rates
Slide 9–31
Characteristics of Corporate Bonds
 Today, usually sold in registered form. Issuers must report
holders of bonds to CRA (Canada Revenue Agency)
 Bond Indenture – contract between the issuer and the bond
investors. Usually contains restrictive covenants designed to
control the actions of management
 Call Provisions
 Higher yield – investors don’t like the call feature
 Sinking fund – a portion of bond redeemed each year
 Conversion into common
 Value of the convertible the higher of the bond value or the conversion
value
Slide 9–32
Types of Corporate Bonds
 Secured Bonds
 Mortgage bonds – secured against real estate
 Equipment trust certificates – secured against other assets
 Unsecured Bonds
 Debentures
 Subordinated debentures
 Variable-rate bonds
 Yield tied to some other market rate
 Junk Bonds
 Michael Milken, Drexel Burnham Lambert discovers an under-serviced
niche in high yield bonds (fallen angels)
 Milken’s personal income from 1983-1987 > $1 Billion
 Later fined for insider trading & went to jail for 3 years
 Drexel files for bankruptcy in 1990 due to losses on junk bond portfolio
Slide 9–33
Debt Ratings
Slide 9–34
Stock
1. Represents ownership
in a firm
2. Earn a return in two ways


Price of the stock rises
over time
Dividends are paid to the
stockholder
5. Two types

Common stock



Right to vote
Receive dividends
Preferred stock


Receive a fixed dividend
Do not usually vote
3. Stockholders have claim
on all assets
4. Right to vote for directors
and on certain issues
Slide 9–35
S&P/TSX Composite
Slide 9–36
30 Stocks in the Dow Jones
Industrial Average
Slide 9–37
Dow Jones Industrial Average, 1990-2002
Slide 9–38
Stock Market Indexes
Slide 9–39
Public Issues of Stocks and Bonds
 Two principal ways to sell securities
to the public
 Investment bankers
 Private placement
Slide 9–40