Common Stock and the
Investment Banking Process
Besley Chapter 16
Balance Sheet Accounts
and Definitions
• Common Equity
–
The sum of the firm’s common stock, paid
in capital, and retained earnings, which
equals the common stockholders’ total
investment in the firm, stated at book
value
• Par Value
–
The nominal or face value of a stock or
bond
Balance Sheet Accounts
and Definitions
• Retained Earnings
–
The balance sheet account that indicates
the total amount of earnings the firm has
not paid out as dividends throughout its
history
• Additional Paid-In Capital
–
Funds received in excess of par value when
a firm issues new stock
Common Equity Accounts
as of December 31
(in millions of dollars, except per share data)
2000
1999
Common Stock (40 million sh.
Additional paid-in Capital
Retained Earnings
Total Common Stockholder Equity
$25.0
105.0
285.0
415.0
Book Value per Share
$16.60
authorized, 25 million sh. out, $1par)
$25.0
105.0
260.0
390.0
$15.60
Balance Sheet Accounts
and Definitions
Book Value Per Share
–
=
The accounting value of a share of
common stock
Common stock + Paid-in capital + Retained earnings
Number of shares outstanding
Book Value is based on historic value and may differ greatly from
market value.
Legal Rights and Privileges of Common
Stockholders
Control of the Firm
• Stockholders elect the firm’s directors,
who select the officers that manage the
business.
• Normally, each share entitles the owner
to one vote.
Proxy - A document giving one person the
authority to act for another, typically the
power to vote shares of common stock.
Legal Rights and Privileges of Common
Stockholders
Control of the Firm
Proxy Fight -
An attempt by a person or
group to gain control of a firm by getting its
stockholders to grant the person or group the
authority to vote their shares in order to elect
a new management team.
Legal Rights and Privileges of Common
Stockholders
Control of the Firm
Takeover - An action whereby a person or group
succeeds in ousting a firm’s management and taking
control of the company.
Management attempts to prevent takeovers include:
–
–
–
Stagger Director elections – elect 1/3 of the directors each year.
Shareholder approvals - Require 75% of the shareholders to
approve a merger (rather than 50%).
“Poison Pills” – provision that allows shareholders, during a take
over, to purchase additional shares at a discounted rate (which
makes the take over undesirable).
Legal Rights and Privileges of Common
Stockholders
The Preemptive Right
A provision in the corporate charter or bylaws
that gives common stockholders the right to
purchase on a pro rata basis new issues of
common stock (or convertible securities).
Types of Common Stock
Classified Stock - Common stock that is given a
special designation, such as Class A, Class B, etc., to
meet the special needs of the company
Founder’s Shares - The class of stock owned by the
firm’s founders who have sole voting rights
Evaluation of Common Stock as a Source of
Funds
From the Corporation’s Viewpoint
Advantages
 Common stock does not
obligate the firm to make
payment to shareholders.
 Carries no fixed maturity
date.
 Generally increases a firm’s
creditworthiness, raises bond
rating, lowers cost of capital.
 When a firm’s future appears
positive, common stock can
be sold for on better terms.
Disadvantages
 Gives voting rights and perhaps
control to new shareholders.
 Dilution of Profits (especially
when compared to debt financing)
 Higher issuance costs
 Where the firm has exceeded it
optimal capital structure, the
cost of capital will be higher
than necessary.
 Non-deductability of dividends
for tax purposes
Evaluation of Common Stock as a Source of
Funds
From a Social Viewpoint
Common stock does not require periodic fixed
payments, which may add additional financial pressure
during times of hardship.
The Market for Common Stock
Corporations and Markets
Closely Held Corporation - One that is owned by a few individuals who
are typically associated with the firm’s management
Publicly Owned Corporation - One that is owned by a relatively large
number of individuals who are not involved in its management
Over-The-Counter (OTC) Market - The network of dealers that provides
for trading securities not listed on the organized exchanges (these
stocks are generally said to be unlisted)
Organized Security Exchange - A formal organization having a tangible
physical location, that facilitates trading in “listed” securities: NYSE,
AMEX
The Market for Common Stock
Corporations and Markets
Companies generally first list on a regional exchange (such as the Chicago,
or Midwest Exchange)
As the company grows it will move up to the American Stock Exchange
(AMEX) or the New York Stock Exchange (NYSE)
Most Companies are traded on the OTC market (5,000 to 8,000 actively
traded stocks), however, the NYSE (which lists approximately 3,000 stocks)
accounts for about 60% of the daily transactions.
Institutional investors (which include pension trusts; insurance companies;
and mutual funds) own approximately 45 – 50% of all common stock and
account for more than 75% of the trading volume.
The Market for Common Stock
Types of Stock Market Transactions
Primary Markets:
• New public offerings by privately held firms
 Initial Public Offering (IPO) Market - The market consisting of
stocks that have just gone public
 Going Public - The act of selling stock to the public at large by a
closely held corporation or its principal stockholders
• Additional shares sold by established, publicly owned companies
The Secondary Market - Trading in the outstanding shares of
established, publicly owned companies
The Market for Common Stock
Types of Stock Market Transactions
The need for additional capital prompts companies to “go public.”
A firm will look to the equity markets when its growth can no
longer be financed by solely by additional debt and the existing
stockholder base.
The additional financing opportunities provided by the markets do
require strict financial reporting and disclosure as well as
adherence security regulations.
The Market for Common Stock
The Decision to List the Stock
To have its stock listed, a company must:
 Apply to the exchange
 Pay a relatively small fee
 Meet the exchange’s minimum requirements
Net Income
# of shares outstanding and held by outsiders
Benefits of listing:
 Listed companies receive free advertising and publicity
 Status as a listed company enhances their prestige
The Market for Common Stock
The Decision to List the Stock
Table 16-2 (page 645) Listing Requirements for Exchanges and NASDAQ
AMEX AND
REGIONAL
NYSE
EXCHANGESa
NASDAQ
Round lot (100 shares) shareholders
2,000
800
300
Number of public shares (millions)
1.1
0.5
0.5
Market Value of public shares ($ millions)
$40
$3
$1
Net tangible assets ($ million)
$4
$4
$2
Pre-tax income ($ million)
$2.50
$0.75
$0.50
a
These numbers are indicative of the listing requirements for larger regional stock exchanges, including
the Chicago Stock Exchange, the Pacific Exchange, and the Philadelphia Stock Exchange. The listing
requirements for smaller regional exchnages generally are not as restictive.
The Market for Common Stock
Regulation of Securities Markets
Securities Exchange Commission
• The U.S. Government agency that regulates the issuance and
trading of stocks and bonds
Registration Statement
• A statement of facts filed with the SEC about a company that
plans to issue securities
Prospectus
• A document describing a new security issue and the issuing
company
SEC lawyers and accountants analyze both the registration
statement and the prospectus; if the information is inadequate
or misleading, the SEC will delay or stop the public offering.
The Market for Common Stock
Regulation of Securities Markets
Securities Exchange Commission Regulations:
–
Ensure investors receive fair financial disclosure from
publicly traded companies
–
Discourage fraudulent and misleading behavior by the firm’s
investors, owners, and employees with the intent of
manipulating the stock’s price
The Market for Common Stock
Regulation of Securities Markets
Elements of SEC regulation:
• Jurisdiction over all interstate offerings of new
securities to the general public in amounts of $1.5
million or more.
• Regulates all national securities exchanges, and
companies whose securities are listed on an
exchange must file annual reports similar to the
registration statement with both the SEC and the
exchange.
The Market for Common Stock
Regulation of Securities Markets
Elements of SEC regulation:
• Reviews stock trades by corporate insiders.
–
Insiders must file monthly reports of changes in their
holdings of the firm’s stock.
Insiders: Officers, directors, major shareholders, or others
who might have inside, or privileged information on a
company’s operations.
• Power to prohibit manipulation
• Control over the form of the proxy and the way the
company uses it to solicit votes.
The Market for Common Stock
Regulation of Securities Markets
The Board of Governors of the Federal Reserve System
controls the flow of credit into securities transactions
through:
•
•
•
Margin Requirements - The percentage of a security’s purchase
price that must be deposited by investors (currently 50%)
Margin Call - a call from a broker asking for more money to
support a stock purchase loan
Blue Sky Laws - State laws that prevent the sale of securities
that have little or no asset backing
The Market for Common Stock
Regulation of Securities Markets
The Board of Governors of the Federal Reserve System
controls the flow of credit into securities transactions
through:
•
•
•
Margin Requirements - The percentage of a security’s purchase
price that must be deposited by investors (currently 50%)
Margin Call - a call from a broker asking for more money to
support a stock purchase loan
Blue Sky Laws - State laws that prevent the sale of securities
that have little or no asset backing
Financial Instruments in International
Markets
American Depository Receipts
(ADRs)
Certificates presenting ownership in stocks of foreign
companies; held in trust by a bank in the country in which the
stock is traded, and traded on U.S. markets
Foreign Equity Instruments
Euro Stock - a stock that is traded in countries other than the
home country of the company
Yankee Stock - stock issued by foreign companies that is
traded in the United States
The Investment Banking Process
Investment Banker
• An organization that underwrites and distributes new issues of
securities
• Helps businesses and other entities obtain needed financing
The Investment Banking Process
Raising Capital: Stage I Decisions
• Dollars to be raised
2. Type of securities used
3. Competitive bid versus negotiated deal
4. Selection of an investment banker
The Investment Banking Process
Raising Capital: Stage II Decisions
•
•
Reevaluating the initial decisions
Best efforts or underwritten issues
•
•
•
Issuance Costs
•
•
•
Underwritten Arrangement - agreement for the sale of securities in
which the investment bank guarantees the sale by purchasing the
securities from the issuer
Best Effort Arrangement - investment bank handling the transaction
gives no guarantee that the securities will be sold
Underwriter’s Spread - The difference between the price at which the
investment banking firm buys an issue from the company and the price
at which the securities are sold in the primary market
Flotation Costs - The costs associated with issuing new stocks or bonds
Setting the offering price
•
Offering Price - The price at which common stock is sold to the public
The Investment Banking Process
Selling Procedures
•
Underwriting Syndicate
•
•
Lead or Managing Underwriter
•
•
A syndicate of investment firms formed to spread the risk
associated with the purchase and distribution of a new
issuance of securities
The member of an underwriting syndicate who actually
manages the distribution and sale of a new security offering
Selling Group
•
A group (network) of brokerage firms formed for the purpose
of distributing a new issuance of securities
The Investment Banking Process
Shelf Registrations
•
•
Securities are registered with the SEC for sale at a later date
They are held “on the shelf” until the sale
The Investment Banking Process
Maintenance of the Secondary
Market
•
•
When a company is going public for the first time the
investment banker is obligated to maintain a market for the
shares after the issue has been completed
The lead underwriter agrees to “make a market” in the stock
and keep it reasonably liquid