25
Securities
Operations
© 2003 South-Western/Thomson Learning
Chapter Objectives
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Review and evaluate the key functions of
investment banking firms
Describe the services provided by investment
banking firms when they assist in issuing new
stock issues
Analyze the risks of securities firms
Evaluate the key functions of brokerage firms
Evaluate the key factors impacting the value
of securities firms
Investment Banking Services
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Investment banking firms (IBFs) assist in raising
capital for corporations and state and municipal
governments
IBF’s serve both financing entities and investors:
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Serve as an intermediary buying securities (promise to pay)
from issuing companies and selling them (securities) to
investors
Generate fees for services rather than interest income
Sell investing services to institutional and other investors
Advise companies on mergers and acquisitions


Value companies for sale or purchase
In recent years, loaned funds for mergers and acquisitions
Investment Banking Services
Origination
Underwriting
Distribution
Investment
Banking
Services
Advising
How IBFs Facilitate New Stock
Issues

Origination

Company wishes to issue additional stock or issue
stock for the first time contacts IBF
 Gets
advice on the amount to issue
 Helps determine stock price for first-time issues

IBF assists with SEC filings
 Registration
statement
 Prospectus—summary of registration statement given to
prospective investors
How IBFs Facilitate New Stock
Issues
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Underwriting stock

Issuer and investment bank negotiate the
underwriting spread
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The difference between the net price given the
company and the selling price to investors
Incentive to under-price IPO’s
The lead investment bank usually forms an
underwriting syndicate
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Other IBFs underwrite a part of the security offering
Helps spread the underwriting risk among IBFs
How IBFs Facilitate New Stock
Issues
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Distribution of stock
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Full underwriting vs. best efforts
IBFs in the syndicate have retail brokerage
operations
Other IBF added as part of selling group
Corporation incurs flotation costs
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Underwriting spread
Direct issuance costs—accounting, legal fees, etc.
How IBFs Facilitate New Stock
Issues
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Advising
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The IBF acts as an advisor throughout the process
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Corporations do not have the in-house expertise
Includes advice on:
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Timing
Amount
Terms
Type of financing
How IBFs Facilitate New Bond
Issues
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Origination
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IBF may suggest a maximum amount of bonds
that should be issued based on firm characteristics
Decisions on coupon rate, maturity
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Benchmark with market prices of bonds of similar risk
Credit rating
Bond issuers must register with the SEC
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Registration Statement
Prospectus
How IBFs Facilitate New Bond
Issues
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Underwriting bonds
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Public utilities often use competitive bids to
select an IBF, versus…..
Corporations typically select an IBF based on
reputation and prior working experience
The underwriting spread on bonds is lower than
that for stocks
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Can place large blocks with institutional investors
Less market risk
How IBFs Facilitate New Bond
Issues
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Distribution of bonds
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Prospectus
Advertisements to public
Flotation costs are typically in the range of 0.5
percent to 3 percent of face value
How IBFs Facilitate New Bond
Issues
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Private placement of bonds
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Avoids underwriting and SEC registration expenses
Potential purchaser may buy the entire issue
 Insurance
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companies
mutual funds
commercial banks
pension funds
Demand may not be as strong, so price may be less,
resulting in a higher cost for issuing firm
Investment banks may be involved to provide advice
and find potential purchasers
How IBFs Facilitate Leveraged
Buyouts
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IBFs facilitate LBOs in three ways:
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They assess the market value of the LBO firm
They arrange financing
Purchase outstanding stock held by public
Often invest in the deal themselves
Provide advice
How IBFs Facilitate Arbitrage
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Arbitrage = purchasing of undervalued shares
and reselling the shares at a higher price
IBFs work with arbitrage firms to search for
undervalued firms
Asset stripping
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A firm is acquired, and then its individual divisions
are sold off
Sum of the parts is greater than the whole

Kohlberg, Kravis, and Roberts
How IBFs Facilitate Arbitrage
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IBFs generate fee income from advising
arbitrage firms as well as a commission on the
bonds issued to support arbitrage activity
IBFs also provide bridge loans
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When fund raising is not expected to be complete
when the acquisition is initiated
IBFs provide advice on takeover defense
maneuvers
How IBFs Facilitate Arbitrage
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History of arbitrage activity
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Greenmail is when a target company buys back stock
from arbitrage firm at a premium over market price
Arbitrage activity has been criticized
 Results
in excessive financial leverage and risk for
corporations
 Restructuring sometimes results in layoffs
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Arbitrage helps remove managerial inefficiencies
Target shareholders can benefit from higher share
prices
Brokerage Services
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Full-service versus discount brokerage
services
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Full-service firms provide investment advice as
well as executing transactions
Discount brokerage firms only execute security
transactions upon request
Online brokerage firms
Allocation of Revenue Sources
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Importance of brokerage commissions has
declined in recent years
Largest source of revenue has been trading
and investment profits
Underwriting and margin interest also make
up a significant portion of revenue
Revenue from fees earned on advising and
executing acquisitions has increased over time
Regulation of Securities Firms
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Regulated by the National Association of
Securities Dealers (NASD) and securities
exchanges
The SEC regulates the issuance of securities
and specifies disclosure rules for issuers
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Also regulates exchanges and brokerage firms
SEC establishes general guidelines, while the
NASD provides day-to-day self-regulatory
duties
Regulation of Securities Firms
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The Federal Reserve determines the credit limits
(margin requirements) on securities purchased
The Securities Investor Protection Corporation
(SIPC) offers insurance on brokerage accounts
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Insured up to $500,000
Brokers pay premiums to SIPC to maintain the fund
Boosts investor confidence, increasing economic
efficiency
Regulation of Securities Firms
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Financial Services Modernization Act of 1999
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Permitted banking, securities activities, and
insurance to be offered by a single firm
Varied financial services organized as subsidiaries
under special holding company
Financial holding companies regulated by the
Federal Reserve
Risks of Securities Firms
Market Risk
Credit Risk
Interest Rate
Risk
Exchange Rate
Risk
Risks of Securities Firms
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Market risk
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Securities firms’ activities are linked to stock
market conditions
When stock prices are rising:
 Greater
volume of stock offerings
 Increased secondary market transactions
 More mutual fund activity
 Securities firms take equity positions which are
bolstered when prices rise
Risks of Securities Firms
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Interest rate risk
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Performance of securities firms can be sensitive to
interest rate movements because:
Market values of bonds held as investments increase as interest
rates fall
 Lower rates can encourage investors to withdraw money from
banks and invest in stocks
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Exchange rate risk
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Operations in foreign countries
Investments in securities denominated in foreign
currency
Valuation of Securities Firms
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Value of a securities firm depends on its
expected cash flows and required rate of
return
V = f [E(CF),
k]
+
Where:
V = Change in value of the securities firm
E(CF) = Change in expected cash flows
k = Change in required rate or return
Valuation of Securities Firms

Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
+
?
+
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
MANAB = The ability of the security firm’s management
Valuation of Securities Firms

Investors required rate of return
k = f(Rf , RP)
+
+
Where:
Rf = Risk free interest rate
RP = Risk premium
Interaction With Other Financial
Institutions
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Offer investment advice and execute security
transactions for financial institutions that maintain
security portfolios
Compete against financial institutions that have
brokerage subsidiaries
Glass-Steagall Act of 1933 separated the functions
of commercial banks and investment banking firms
Financial Services Modernization Act of 1999
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Effectively repealed Glass-Steagall
Commercial banks, securities firms, and insurance
companies will increasingly offer similar services
Globalization of Securities Firms
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Securities firms have increased their presence
in foreign countries
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Merrill Lynch has more than 500 offices spread
across the world
 Allows
them to place securities in various markets for
corporations or governments
 International M&A
 Ability to handle transactions with foreign securities
Globalization of Securities Firms
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Growth in international securities transactions
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Created more business for large securities firms
 International
stock offerings
 Increased liquidity for issuing firm, avoiding downward
price pressure
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Growth in Latin America
 Increased
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business due to NAFTA
Growth in Japan
 Some
barriers to foreign securities firms still exist