Ebook Financial management Concepts and applications Part 2

Find more at www.downloadslide.com

Part 3    Financing Long-Term Needs

Overview of Capital Markets:
Long-Term Financing
Instruments

9
Learning
Objectives

There are two times in a man’s life when he should not
speculate: when he can’t afford it and when he can.
– Mark Twain

obj 9.1

Assess the key features of
bonds and credit ratings.
obj 9.2

Earlier in this book, we focused on sizing up a firm’s prospects and understanding the short-term financial requirements of the firm. In particular,
Chapter 5 introduced short-term financing instruments with maturities less
than one year, traded in what are known as money markets. Then, Chapter
7 presented a bridge between short-term and long-term financing and introduced the underpinnings of the valuation of financial securities such as
bonds and stocks. Now, we’ll focus our attention on understanding the longterm financing instruments issued by firms and the markets in which they
trade.
This chapter is the first of four that examine various aspects of a firm’s
financial needs for more than one year, with securities such as bonds and
stocks traded in what are known as capital markets. If a firm is not able to

meet its financial requirements through internally generated funds and
some short-term borrowing, then it must seek external financing through
capital markets.
Later in the book, we’ll look at the cost of raising capital in Chapter 10,
financing and dividend decisions in Chapter 11, and how to determine an
appropriate mix of debt and equity in Chapter 12. But first, in this chapter, we
examine the distinctive features of three important types of financial instruments that were briefly introduced in Chapter 7: bonds, preferred shares, and
common shares. We then present an overview of capital markets, with a general focus on the stock market because it is more complex than the bond
market. Later, we focus on the efficiency of stock markets, or the extent to
which securities trade at fair prices, as this is an important consideration for
firms issuing stocks. Finally, in the Appendix to this chapter, we present additional details on understanding bond and stock information from an investor’s perspective.
Let’s see how financial instruments such as bonds and stocks fit in our
financial management framework, as depicted in Figure 9.1. As shown in the
figure, issuing financial instruments is part of a firm’s financing decisions, and
accessing external financing impacts a firm’s ability to grow, as well as its overall risk.

Assess the key features of
preferred shares.
obj 9.3

Assess the key features of
common shares, describe
historical returns of major
asset classes, and explain
the difference between
arithmetic and geometric
returns.
obj 9.4

Describe key elements of

capital markets.
obj 9.5

Explain the concept of
market efficiency and
describe the various forms
of the efficient market
hypothesis.
obj 9.6

Explain why understanding
capital markets and longterm financing instruments
is relevant for managers.

money market: A financial market
in which very liquid, safe, shortterm investments are traded
capital markets (securities
markets): Markets for long-term
financing such as issuing bonds or
equity

167


Find more at www.downloadslide.com
168

Part 3  Financing Long-Term Needs

Fig 9.1

Financial Management
Framework: Long-Term
Financing Decisions

the enterprise

financing

operating

• Debt financing
• New equality
• Dividend policy

investing

Growing profits,
dividends, cash flow

Managing the
risk profile

growth

risk

9.1 Bonds
Objective 9.1

Assess the key features of

bonds and credit ratings.

principal: The original or face
amount of a loan on which interest
is paid
bondholders: Owners of bonds.
securities markets: See capital
markets. Markets for long-term
financing such as issuing bonds or
equity

Let’s begin our exploration of capital markets by looking at bonds, which were briefly
introduced in Chapter 7. From a firm’s perspective, bonds are simply a form of borrowing. At the most basic level, bonds are loan contracts or promises made by a firm indicating scheduled repayment of the principal amount—or the amount of money being
lent—along with interest or coupon payments typically paid every six months. Bonds are
issued by a firm, and because they represent a major form of long-term financing, they
are a type of financial instrument.
Bond investors, also called bondholders, can be thought of as a type of lender. The
majority of these investors are commonly referred to as institutional investors, such as
pension funds, mutual funds, endowment funds, and insurance companies. However,
once a firm has issued a bond, the bondholder can choose to sell or trade that bond to
another party in exchange for money equal to the value of the bond. In fact, there are
usually active markets whereby corporate and government-issued bonds can be traded;
these are known generically as securities markets (or capital markets) or specifically as
bond markets.

9.1.1Changing Bond Yields
As we saw in Chapter 7, bond prices move inversely to changes in yields or interest
rates—or conversely, yields move inversely to bond price changes. Let’s briefly examine
the implications of this observation for firms that may be considering issuing bonds. As
we do so, it is important for us to recognize that both short-term and long-term interest

rates or yields change over time, sometimes substantially, usually in a similar direction


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



20
1-year
30-year
15

10

5

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1962

–5

1964

0

Source: Federal Reserve (accessed
March 1, 2012)

but not always in lockstep. As a result, firms may be facing different costs today if they
issue bonds with short maturities (such as one year) or long maturities (such as thirty
years) compared with, say, issuing such bonds next year.
Corporate bond yields often move in a similar direction to yields on governmentissued bonds, but of course, corporate bond yields are higher than similar time-to-­
maturity government bond yields because owning a corporate bond is riskier. Figure 9.2
shows the yield on U.S. treasuries (or government-issued bonds) with one-year and
thirty-year maturities, from 1962 to 2012. Notice that yields or interest rates peaked
around 1981, then steadily declined through 2012. As we will see in Chapter 10, this
decline in rates resulted in a dramatic decline in firms’ cost of capital, which in turn
impacted the attractiveness of projects in which firms considered investing. From the
figure, we can also determine periods during which the yield curve was inverted by looking for times when short-term rates exceeded long-term rates, such as around 1980, 1988,
2000, and 2006. Each of these periods occurred just prior to the last four U.S. recessions,
which started in 1981, 1990, 2001, and 2007. Key takeaways from this figure are (1) for
investors, bond yields and hence prices can change dramatically over time; (2) firms may
face different costs over time—as indicated by the varying yields—when issuing bonds;
and (3) the relative cost of issuing short-term bonds (such as those with a one-year maturity) versus long-term bonds (such as those with a thirty-year maturity) may change over

time, so firms need to carefully consider the length of the borrowing period.

9.1.2 Bond Features
Issuing bonds is attractive from a firm’s perspective because any interest payments are
deductible as expenses for tax purposes, making bonds a relatively low-cost alternative for
obtaining capital. Bonds are typically issued at face value with a particular maturity date.
Generally, maturity dates range from one year to thirty years. In rare cases, 100-year or
century bonds have been issued—for example, the Walt Disney Company issued century
bonds in 1993 that became known as Sleeping Beauty bonds. In an even more extreme
example, the Toronto Grey and Bruce Railway issued a 1,000-year bond in 1883. That

169

Fig 9.2
U.S. Treasury Yields Percent,
One-Year and Thirty-Year
Maturities, 1962–2012


Find more at www.downloadslide.com
170

Part 3  Financing Long-Term Needs

sinking fund: A cash fund set aside
by the firm in order to meet future
debt obligations
variable rate: A floating or nonfixed
loan rate, often tied to changes in
the prime rate or LIBOR

prime rate: The rate offered
by lending institutions, such as
banks, to their most creditworthy
customers
LIBOR (London Inter-Bank Offered
Rate): The rate at which banks offer
to lend in the London inter-bank
market; often used as the basis for
floating-rate loans

bond, which is due to mature in 2883, appears to have the longest term to maturity on
record, and it remains on the books of the Canadian Pacific Limited.
Bonds differ by the types of features they have. For example, some bonds include a
sinking fund feature, which requires the firm to repurchase a portion of its bonds on a
regular basis throughout the life of the bonds or set aside an equivalent amount. This
feature is intended to reassure bondholders that they won’t be left with losses if the firm
is unable to meet its principal repayment obligation at maturity. In some cases, the firm
may repurchase a portion of its bonds in the bond market, or it may buy back bonds
directly from the bondholders by paying the face value.
Although most bond contracts specify a fixed coupon rate—recall that the coupon
rate reflects the annual amount of interest payments and is expressed as a percentage of
the face value of the bond—other contracts indicate a variable rate. For example, the
contract might specify repayment at the prime rate plus a certain percent (often in the
1/2 to 3 percent range). The prime rate is a benchmark set by each financial institution
as the rate at which interest is charged to its most-favored (i.e., least risky) customers. An
alternative benchmark rate common in Europe (but used worldwide) is the London
Interbank Offered Rate, or Libor. Libor is the average rate at which major banks in
­London borrow among themselves and is a benchmark rate for trillions of dollars of
mortgages, loans, and payments to individuals and businesses.

In the News

The Libor Scandal

On June 27, 2012, British investment bank Barclays PLC agreed to pay a fine of $453 million
to U.S. and British authorities to settle allegations that the firm manipulated Libor over a
period of at least five years. Barclays’ CEO Robert Diamond was forced to resign. Suspicions
of manipulation were originally raised by the Wall Street Journal in a May 29, 2008, article.
Libor borrowing rates are set daily for ten currencies and 15 maturities. The most
popular rate is the three-month dollar rate. A panel of 18 London-based banks submits
estimates of their costs for borrowing at each rate. The actual rate is set as an average,
excluding the four highest and four lowest submissions.
Investigations into the Libor scandal revealed two types of manipulation used by
Barclays and other investment banks to influence Libor. In one type of manipulation,
which was used during the financial crisis of 2007–2009, Barclays submitted estimates
that were lower than their true costs because they did not want to reveal to the marketplace how costly borrowing had become for fear it might make the bank’s financial position appear weak. In the other type, Barclays’ traders colluded with traders from other
banks to influence certain Libor rates in order to increase profits or decrease losses on
their exposure to products tied to Libor rates.
The fallout from the Libor scandal continues. By early 2013, two other banks implicated in the rate manipulation scandal—the large Swiss investment bank UBS and the
Royal Bank of Scotland—agreed to large settlements with various regulatory authorities.
In mid-2013 it was announced that a subsidiary of NYSE Euronext was appointed as the
new administrator of Libor, taking over from a subsidiary of the British Bankers Association, with a transfer expected in 2014.
Sources: D. Enrich and M. Colchester, “Embattled FSA Is Under Fire for Libor Policing,” Wall Street
Journal, July 6, 2012 and “NYSE Euronext Subsidiary to Become New Administrator Of Libor” (Press
release). NYSE Euronext, July 9, 2013


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments

Issue size:

$3 billion

Face (par) value:

$1,000

Maturity date:

December 16, 2036

Coupon rate:

5.875%

Coupon frequency:

Semiannually

Sinking fund:

None

171

Fig 9.3
Home Depot Bond Features

Callable:Yes
Type of rate:

Fixed

Payment currency:

U.S. dollar

Day/count basis:

30/360*

*For the purposes of quoting yields, the U.S. convention is to assume each month has 30 days and a year
has 360 days. In some other countries, it is assumed that a year has 365 days for yield calculations.
Source: Morningstar Inc. = 09db65ea
9d26041b644453391d82de18&bname = Hm + Depot + 5.875%25 + %7c + Maturity%3a2036&ticker =
HD&country = USA&clientid = dotcom (accessed September 17, 2012)

Another common feature of some bonds is a call provision. With callable bonds
(also known as redeemable bonds), a firm can choose to pay back the investor at a prespecified date prior to the maturity date, usually at a prespecified price above the face
value, representing a premium to the bondholder. For example, when interest rates have
declined and it is cheaper for the company to reissue new bonds with lower coupon
rates, it may choose to call its outstanding bonds. This provision is beneficial to the firm
because it adds flexibility to its financial strategy and gives the firm the option of refinancing its debt obligations at a lower rate if interest rates decline.
Because bondholders do not have a direct say in how a firm is run, their interests
are protected to a degree through bond covenants. These covenants place some restrictions on the firm in such a way as to improve the odds that the bondholders will be
repaid. For example, covenants might specify a maximum allowable debt-to-equity ratio
for the firm, a minimum level of working capital, a maximum limit on annual capital

expenditures, or a limit on the amount of dividend payments.
Figure 9.3 summarizes these features and other issue details for the Home Depot
bond introduced earlier in “Time Value of Money Basics and Applications.”

9.1.3 Bond Ratings
When a company is planning to issue a bond, potential investors want a method of
assessing the perceived riskiness of the bond investment. In other words, they want to
assess the possibility of default, or the firm’s failure to meet its interest and principal
repayment obligations. Bond-rating agencies fulfill this need by providing an assessment
of the creditworthiness of the firm.
Major rating agencies include Moody’s, Standard & Poor’s (S&P), and Fitch. These
agencies assess the financial health of a firm by completing a process similar to the business size-up process described in Chapter 2. They then assign the firm’s bonds a rating
based on their findings. For long-term bonds (i.e., those with a maturity of more than one
year), these ratings are based on the likelihood of repayment of principal, the capacity and
willingness of the firm to meet its financial commitments, the nature of the financial obligation (such as the maturity and any special features of the bond), and any protection
afforded to bondholders by the firm in the event of bankruptcy or reorganization.

call provisions: A description of
terms under which a firm may
redeem all or part of a bond or
preferred share issue
callable (redeemable): A type
of bond whereby the firm can
choose to pay back the lender at
a prespecified date prior to the
maturity date
covenants: Provisions in a bond
or debt agreement specifying
restrictions or requirements on the
borrower

default: Failure to make debt
obligation payments


Find more at www.downloadslide.com
172

Part 3  Financing Long-Term Needs

In-depth

What Credit-Rating
Agencies Do

Credit-rating agencies such as Moody’s, S&P, and Fitch provide opinions about the creditworthiness of debt issues such as bonds issued by companies or governments. In short,
these agencies assess the probability that an issuer may default on its obligation.
Credit ratings are meant to be a forward-looking assessment that takes into account
historical and current information about a firm, its industry, and general economic conditions. These ratings focus strictly on credit quality, not on the suitability or merit of the
investment. The assignment of credit ratings is not an exact science, and much objective
judgment is involved. Credit ratings are useful because they facilitate the issuance and
purchase of debt. They also impact the cost of borrowing because an issuer with a higher
rating is able to have a lower interest rate on its debt.
Most ratings are determined by a team of analysts who obtain information from published sources (such as annual reports) and discussions with management. The process
starts with a request for a rating from an issuer, followed by an initial evaluation, a meeting
with management, and the analysis. Rating agencies typically have committees that
review the analysis and vote on the rating to be assigned. After the issuer is notified of the
rating, the agency’s opinion is published and made public.
A credit analysis usually involves assessment of both business risk and financial risk.
Business risk assessment examines country risk, industry characteristics, and a firm’s
position relative to its peers. In comparison, financial risk assessment examines a firm’s

accounting data and various ratios, liquidity, cash flows, capital structure, and overall
governance.
Rating agencies don’t offer their services for free; they have a financial incentive to
do so. There are a variety of possible business models whereby rating agencies earn profits. The most common payment structure is the issuer-pay model, whereby the firm
requesting the rating pays the credit-rating agency. This model has been criticized
because it creates a potential conflict of interest for the rating agencies, but the agencies
try to mitigate this effect by separating the parts of the business that negotiate business
terms from those that perform the analysis. Potential conflicts of interest are also reduced
by reputation effects. In other words, any incentive an agency has to issue a biased rating
is offset by the likelihood that investors will come to see the agency’s ratings as biased
and therefore no longer make decisions based on those ratings. This, in turn, makes firms
less likely to contract with the agency in the future.
Source: Much of this description is from Standard & Poor’s Guide to Credit Rating Essentials, 2010

Ratings range from Aaa—the highest rating—to Aa, A, Baa, Ba, B, and below. A
summary of the various ratings, as provided by Moody’s investor service is presented in
Figure 9.4.1 Bonds with ­ratings of Baa - and higher are known as investment grade
bonds. Most institutional investors are restricted to investment grade bonds. Investments
rated below Baa - are known as speculative, high-yield, or junk bonds. Prior to 1980,
most high-yield bonds were so-called fallen angels—bonds that initially received an
investment grade but had since become riskier. Since that time, due in part to financier
Michael Milken, a huge market for firms to initially issue risky bonds has developed.
1

Fitch uses the same scale as S&P. Moody’s uses a similar but slightly different ratings scale: Aaa, Aa, A,
Baa, Ba, B, and below. Also, instead of plus/minus notches, Moody’s uses numbers. So, within Baa, there
is Baa1 (similar to S&P’s BBB +), Baa2 (BBB), and Baa3 (BBB -).


Find more at www.downloadslide.com

Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



173

FIG 9.4
General Summary of the Opinions Reflected by Moody’s Credit Ratings

Global Long-Term Rating Scale
Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk.
Aa

Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

A

Obligations rated A are judged to be upper-medium grade and are subject to low credit risk.

Baa

Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as
such may possess certain speculative characteristics.

Ba

Obligations rated Ba are judged to be speculative and are subject to substantial credit risk.

B

Obligations rated B are considered speculative and are subject to high credit risk.

Caa Obligations rated Caa are judged to be speculative of poor standing and are subject to very high
credit risk.

Ca

Obligations rated Ca are highly speculative and are likely in, or very near, default, with some
prospect of recovery of principal and interest.

C

Obligations rated C are the lowest rated and are typically in default, with little prospect for
recovery of principal or interest.

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aaa through Caa. The
modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a
mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Additionally,
a “(hyb)” indicator is appended to all ratings of hybrid securities issued by banks, insurers, finance companies, and
securities firms.*
* By their terms, hybrid securities allow for the omission of scheduled dividends, interest, or principal payments, which can
potentially result in impairment if such an omission occurs. Hybrid securities may also be subject to contractually allowable
write-downs of principal that could result in impairment. Together with the hybrid indicator, the long-term obligation rating
assigned to a hybrid security is an expression of the relative credit risk associated with that security.

Source: Moody’s Standing Committee on Rating Systems & Practices

9.2  Preferred Shares
The second type of financial instrument we will look at—and the least frequently used of
the three—is preferred shares. Issuance of preferred shares is another long-term form of

financing available to firms. Preferred shares are often described as hybrid securities, or
a mix of bonds and stocks. They have some similarities to bonds, but they have some
major differences as well. Although categorized on the balance sheet as a form of equity
(because from the debt holders’ perspective, preferred equity provides a cushion in the
event of bankruptcy), preferred shares are also very different from common shares.
Like bonds, preferred shares are issued with a face value. Unlike bonds, most preferred shares (known as perpetual preferreds) carry no obligation on the part of the firm to

Objective 9.2

Assess the key features of
preferred shares.


Find more at www.downloadslide.com
174

Part 3  Financing Long-Term Needs

cumulative feature: A feature
of preferred shares whereby any
missed dividend payments by
the firm are cumulated and paid
to preferred shareholders before
common shareholders receive
dividends
dividend payout: The amount
of dividends distributed to
shareholders

repay the initial investment of the preferred shareholders. Instead, preferred shareholders

receive a steady stream of dividends. The dividend is specified at a predetermined rate, a
percentage of the face value. For example, if the preferred share is issued with a face value
of $40 and the dividend is specified as 6 percent of the face value, preferred shareholders
can expect to receive $2.40 per share in dividends each year (i.e., $40 * 0.06). As with
common shares, preferred share dividends are typically paid quarterly, so in this example
the preferred shareholder would receive $0.60 every three months for each share owned.
Preferred shareholders have different rights than common shareholders. For example,
a firm must make dividend payments to preferred shareholders before paying any dividends to common shareholders. Many preferred shares also have a cumulative ­feature.
Here, if a firm is low on cash and can’t afford to make regularly scheduled preferred dividend payments, the dividends owed to preferred shareholders cumulate and must be paid
before any further dividends can be paid to common shareholders. In addition, in the
event of bankruptcy and liquidation by a firm, all preferred shareholders receive any claims
before common shareholders but after both secured and unsecured creditors (although in
most bankruptcy-related liquidations, there is no money left for any equity holders).
From a firm’s perspective, preferred shares are not as desirable as bonds because the
firm is not able to deduct preferred dividend payments for tax purposes like it can for
bond interest expenses. As mentioned previously, preferred shares are generally the least
common form of financing relative to bonds and common equity. Preferred shares tend
to be issued by stable companies with expected steady cash flows, but they are also
­prevalent among private firms that have received funding from venture capitalists. Furthermore, due to regulatory capital requirements, there tends to be a concentration of
preferred shares in the banking industry.
From a preferred shareholder’s perspective, there tends to be an inverse relationship
between preferred share prices and interest rates, as we saw in Chapter 7. Just like bonds, as
interest rates increase, the price of preferred shares tends to decrease, and vice versa. However, the relationship between preferred share prices and interest rates can become uncoupled if a firm is experiencing financial distress and its long-term survivability is in question. In this situation, the firm may be viewed as a high credit risk, so its preferred shares
will decline in value regardless of the general level of interest rates in the overall economy.

9.3  Common Shares
Objective 9.3

Assess the key features of
common shares, describe

historical returns of major
asset classes, and explain
the difference between
arithmetic and geometric
returns.

The third type of financial instrument we’ll consider is common shares or stocks. The
issuance of common shares represents a very different form of financing than bonds.
Common shareholders (or common equity holders) are the ultimate owners of a firm.
They are often referred to as residual claimants because they have a claim on any of the
income earned by the firm only after other stakeholders—such as bondholders—have
been paid (for example, after bondholders have received their interest payments). Common shares are perpetual instruments, lasting as long as the firm itself lasts. As with
bonds, an active market has developed for trading common shares.
Common shareholders benefit directly or indirectly through the earnings of a firm.
If the firm has earnings available to common shareholders, it has two choices of what to
do with these earnings: It can either pay dividends to the common shareholders or retain
the earnings to finance future projects and investments. Typically, established firms have
dividend payout policies whereby a certain percentage of earnings, such as 30 percent,
is paid in dividends on average over a long period. This is not to imply that firms strictly


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



175

follow such a policy on a year-by-year basis, since earnings tend to fluctuate from year to
year. Rather, we tend to observe that in the short run, firms stick to a stable dollar dividend policy.

For example, let’s suppose a firm had a target payout of 40 percent. Let’s also suppose
that average earnings per share over the past three years were $5.00. The firm might initially pay out $2.00 per share per year for several years. Then, a few years later, when average earnings per share have grown to, say, $6.00, the firm might increase its dividend to
$2.40, again in line with the 40 percent payout target. Typically, dividends are paid on a
regular quarterly schedule. However, in some cases, growing firms with frequent needs for
additional investments might elect not to pay out any dividends. For instance, Microsoft
Corporation went public in 1986 but didn’t start paying dividends until 2003. Note that
although firms are obliged to make regular interest payments to bondholders, firms have
no contractual obligation to pay dividends to common shareholders on a regular basis.
Still, as the ultimate owners of the firm, common shareholders do have rights. One
of the major shareholder rights is the right to vote; this right highlights the collective
power that shareholders have over the firm. Voting enables shareholders to elect a board
of directors to act in their best interest. The mandate of the board of directors is to
ensure that management makes decisions that are consistent with maximizing the value
of common shares. Thus, any action taken by the firm’s management team, including the
chief executive officer, must be justified to the board.
It is also important to note that different countries engage in different practices
related to common shareholders and have different regulations governing shareholder
rights. For example, in some countries, firms have more than one class of shares. A superior class of shares is typically held by a founding individual or family, and multiple votes
may be associated with those shares. A multiple class share structure like this allows the
individual or family to maintain control while still being able to raise capital through the
issuance of inferior voting shares. This structure is not as common in the United States
as in other countries because some stock exchanges (including the New York Stock
Exchange) restrict dual class shares. However, there have been some high profile cases of
dual class shares listed on the NASDAQ exchange, including Google and Facebook.

9.3.1Historical Returns
The return to investors from buying stocks varies considerably depending on the time
frame associated with the purchase and sale. Figure 9.5 compares the average annual
return (including the reinvestment of dividends or interest payments) on a variety of

Compound ReturnsMean ReturnsVolatility

(geometric)
(arithmetic)
(standard deviation)
Small stocks

16.9%

25.6%

49.1%

9.6%

11.6%

20.3%

Large stocks

9.2%

11.0%

19.2%

30-year treasury bonds

5.6%

6.3%

12.3%

90-day T-bills

3.9%

4.0%

3.4%

Inflation

3.0%3.1% 4.1%

All stocks

Note: Thirty-year treasury bond returns are since 1942
Source: The Center for Research in Security Prices database (CRSP)

Fig 9.5
U.S. Stock Returns,
30-Year Treasury
­Returns, 90-day T-Bill
Returns, and Inflation,
1926–2012

Find more at www.downloadslide.com
176

Part 3  Financing Long-Term Needs

investments and the volatility (or standard deviation) of annual returns since 1926. Note
that the figure looks at stocks of various sizes, long-term treasury (government) bonds,
and short-term treasury bills (T-bills), as well as inflation.
As shown in Figure 9.5, returns may be measured either geometrically or arithmetically. Geometric returns compare the initial investment value with the final wealth
value in order to determine the rate of return over the intervening period. The geometric
return over n periods is calculated as follows:
1

final value 1n 2
b
- 1
Geometric returnn = a
initial value

For example, if a nondividend paying stock was selling for $10 per share and three years
later it was selling for $13, its geometric or average annual compound return is2:
1

a

$13 13 2
b - 1 = 0.0914 = 9.14 percent
$10

Arithmetic returns, on the other hand, are the mean (or average) return across

each period (often a year) over n periods. They are calculated using the following
equation:
Arithmetic returnn = a
n

returni
n
i=1

geometric returns: A return
measure comparing initial wealth
and ending wealth and the rate at
which it grows
arithmetic returns: A return
measure that takes a simple
average of returns, summing
returns and dividing by the number
of observations

Reusing our same example stock, suppose that after starting out selling for $10, a year
later the stock’s price is $9, after two years it is $11, and then finally, after three years, it is
$13. Here, the return in each of the three years was –10.00 percent, 22.22 percent, and
18.18 percent, which gives us an overall arithmetic average of 10.13 percent.
We can categorize stocks based on their size. Small stocks are defined by the Center
for Research in Security Prices (CRSP) as those in the smallest decile (or 10 percent) of
the entire U.S. stock sample as measured by market capitalization (the number of shares
multiplied by the stock price), whereas large stocks are those in the largest decile. In
­Figure 9.5, we see that over the long run, stocks have tended to yield higher returns than
bonds, but they have done so with greater volatility. Furthermore, both stocks and government bonds have provided returns greater than the rate of inflation, and small stocks
have provided greater returns than large stocks.

Figure 9.6 compares the extent to which a dollar invested on December 31, 1925,
has grown over time if invested strictly in small stocks, large stocks, treasury bonds, or
T-bills. As we look at the 87-year span, we see the dramatic impact on wealth from
investing in small stocks compared to other stock investments. (Of course, there is no
guarantee that that trend will continue in the future!) We also see the rather steady
increase in the value of stock investments between the early 1940s and the late 1990s (as
indicated on the chart by a fairly straight upward sloping line), but with flatter and
bumpier performance since then. We additionally see a clear superior performance of
stock versus bond investments during the period from the early 1940s to the late 1990s.
Finally, we see how bond and T-bill investments have done somewhat better than inflation and stocks have done considerably better.

2 An alternative method of calculation is to use a spreadsheet such as Excel and insert into the “rate”

function the following information: Nper = 3, PMT = 0, PV = −10, FY = 13, or putting it all together, =
rate(3, 0, - 10, 13).


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



1,000,000
100,000

Small stocks
All stocks
Large stocks

30-yr Treasury Bonds

90-day T-bills
Inflation

10,000
1,000

177

Fig 9.6
Relative Wealth of One Dollar
Invested on December 31,
1925; U.S. Stock Returns
(Small Stocks, Large Stocks,
and All Stocks), 30-Year
Treasury Returns, 90-Day
T-Bill Returns, and Inflation,
1925–2012

100
10
1

1925
1928
1931
1934
1937
1940
1943
1946

1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012

0

Note: Assumed initial investment is $1; 30-year treasury returns start in 1942 at 90-day T-bill wealth level
Source: The Center for Research in Security Prices database (CRSP)

9.4 Capital Markets Overview
Up to this point, we have examined the three major types of financial instruments or

securities: bonds, preferred shares, and common shares. Now, we step back and examine
the overall markets in which these securities are issued and traded. Most of our discussion focuses on the preferred and common equity markets because these markets tend to
be more complex and garner more attention, and also because bonds still tend to be
traded predominately through investment banks that each hold their own inventory,
rather than through large organized exchanges.
There are several reasons why a firm’s management needs to understand capital
markets. First, from the firm’s perspective, the issuance of financial instruments may
seem like a one-time event; however, issuing bonds and shares is usually not a one-time
occurrence. Most firms have ongoing financial needs, and even after a large bond issuance, a firm may be presented with a new opportunity—such as the acquisition of a
competitor’s company—that requires additional long-term financing. Second, because
active markets have developed for the trading of securities, management needs to understand how these markets impact the firm’s constantly changing shareholder base. Finally,
capital markets evolve over time, so management needs to be aware of any new methods
or new locations for issuing securities that may come available.
Given their complexities and nuances, capital markets—and equity markets in
particular—can be segmented and described in countless ways. Figure 9.7 presents
one such segmentation. In the following sections, we will consider this segmentation
scheme in depth, and we will also describe the role of financial intermediaries.

9.4.1 Private versus Public Markets
As mentioned earlier, capital markets can be segmented in a number of ways. One segmentation scheme is based on the method by which securities are issued. Suppose a firm

Objective 9.4

Describe key elements of
capital markets.


Find more at www.downloadslide.com
178

Part 3  Financing Long-Term Needs

Fig 9.7
Overview of Capital Markets

Capital Markets

Public

Private

Domestic

Cross-listing

Organized
exchanges

Over-thecounter

Initial public
offerings (IPOs)

Angel
investors

Venture
capital firms

Seasoned equity

offerings (SEOs)

Shelf
offering

Rights
offering

wishes to raise capital via a bond issue. In many cases, the easiest and quickest method
firms can use to raise such capital is the private placement process. A private placement
involves the purchase of a large block of securities by a large institutional investor such
as a pension fund, an endowment fund, or an insurance company. The process is very
common with the issuance of debt securities but not with the issuance of equities.
Because private placement investors are deemed more sophisticated than other investors, different regulations are involved in the security issuance process. From the firm’s
perspective, the private placement process is much quicker and less expensive than a
public offering in terms of administrative and selling costs. The private placement process does, however, place restrictions on institutional investors’ ability to resell the securities they have purchased unless they are reselling to other large institutional investors.
Consequently, investors often demand a higher interest rate on bonds than would otherwise be charged.
An alternative method for raising funds is a public offering. In this process, securities are offered to both large institutional investors and smaller “retail” investors. This is
the most common process by which equities are issued. This process often takes six
months or more and is more expensive than private placement. However, the result is
typically a wider range of bondholders or stockholders. In the case of stockholders, the
breadth of ownership is often important because it determines who ultimately controls
the firm.

9.4.2Venture Capital and Private Equity

private placement: The sale of
securities to a selected group of
well-informed investors
public offering (public issue): The

sale of newly issued securities to
the public

Capital markets can also be segmented by the life cycle stage of the firm. Initially, all
firms are private. At some point, firms may choose to become public companies
(described in Section 9.4.3). Prior to this point, however, private firms often need capital, just like public firms.
When a firm is a very small start-up in need of capital, its riskiness may make it
unable to borrow money. In this situation, the firm may need to rely on the friends and
family of the founding entrepreneur to provide much-needed cash. Later, when the firm
outgrows the ability of friends and family to supply capital, it may be able to secure


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



179

Case Study

Private Placement
Example—Sesac
Inc. and the Music of
Bob Dylan and Neil
Diamond

In August 2012, Sesac Inc., a privately held Nashville-based firm that acts as a middleman between music companies, songwriters, and music broadcasters, announced plans
for a unique private placement of $300 million of bonds. The firm had exclusive rights to
the public broadcast of the music of Bob Dylan, Neil Diamond, Canadian rock band Rush,

and others. The bonds were being issued as a Rule 144a private placement, a rule
administered by the SEC that allowed certain “qualified institutional buyers” deemed to
be large and sophisticated to trade with other such investors without having to register
with the SEC. Such issues were not offered to the general public. The collateral for the
five-year bond was the revenue that Sesac was to receive from the music rights.
Source: L. Moyer and A. Yoon, “The Bonds, They Are A-Changin’,” Wall Street Journal, August 6, 2012

financing from angel investors who buy stakes in small private firms. Angel investors
tend to invest locally and recognize the risk of investing in start-ups. They do not expect
all of their investments to succeed, but they recognize that those investments that do
succeed may offer payouts of five to ten times the invested capital.
When a firm reaches the next stage of growth or is unable to identify angel investors, it may turn to venture capitalists as a source of capital. A venture capital firm is
organized as a limited partnership with a venture capitalist as the general partner and
various institutional investors—such as pension and endowment funds, as well as high
net worth individual investors—as limited partners. The general partner runs the business and typically receives a fee of about 2 percent of the fund’s capital and 20 percent or
more of any gains. The general partner may also have expertise to offer to the firms in
which the partnership invests. Venture capital is a form of private equity financing. Private equity firms invest in venture capital, leveraged buyouts (which are discussed in
more detail in Chapter 11), and “distressed” firms that are experiencing financial difficulties and are in need of a turnaround.
Figure 9.8 shows the number of venture capital deals in the United States between
1995 and 2011, and Figure 9.9 indicates the dollar amount of these deals during the
same time period. As shown, there has been a general upward trend in both the number
and amount of these deals with two notable exceptions. First, venture capital deals and
funding peaked in 2000 at the height of the technology bubble. Second, after resuming
an upward trend between 2004 and 2007, funding declined again in 2009 during the
recession that accompanied the financial crisis.

9.4.3Initial Offerings versus Seasoned Issues
In addition to the previous two schemes, capital markets can be segmented based on
the timing of securities issues. For example, when a private firm makes its equity
available to the public in order to meet its need for equity capital, it undertakes a process known as an initial public offering (IPO). “Going public” in this way is a major

step in the life of a firm because the initial owners of the firm are now effectively
sharing the ownership with a much larger group of shareholders. Typically, IPOs
involve raising new capital by issuing new shares, but they may also involve selling
the shares of existing shareholders (in which case the money goes to the selling
shareholders).

angel investor: An investor who
buy stakes in small private firms
venture capital firm: An investment
firm that invests shareholders’
money in private start-up firms with
high growth potential
private equity firm: An investment
firm that invests shareholders’
money in private firms, including
those with high growth potential,
leveraged buyouts, and distressed
firms
initial public offering (IPO): The
initial sale of stock of a firm to the
public


Find more at www.downloadslide.com
180

Part 3  Financing Long-Term Needs

Fig 9.8
Number of Venture Capital

Deals in the United States,
1995–2011

9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

0

1995

1,000

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:
Thomson Reuters

($ in billions)
$120

$100

$80

$60

$40

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

$0

1996

$20

1995

Fig 9.9
Amount Invested in U.S.
Venture Capital, 1995–2011

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report based on data
from Thomson Reuters


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



181

In Depth

SOX and the Cost of

Being a Public Firm

The Sarbanes-Oxley Act (known as SOX) is a federal law passed in 2002 in the wake of
numerous corporate scandals, including those at Enron, WorldCom, and Tyco International.
The law set new standards of accountability for public companies. It included rules requiring more independent auditors, increased corporate responsibility, enhanced financial disclosures, and increased white-collar crime penalties. Senior management was also required
to certify the accuracy of a firm’s financial information. In addition, Section 404 of the act
mandated that firms establish internal controls and report on the scope and adequacy of
these controls, and it required senior managers and boards to be comfortable enough with
the firm’s processes and monitoring to attest to their effectiveness. This section received
considerable attention because of the cost associated with its implementation, which was
severely underestimated when the law was enacted. Prior to SOX, experts estimated that
audit fees for small firms (i.e., those with market capitalization less than $75 million) were
equal to 0.64 percent of revenues. After SOX became law, this figure jumped to
1.14 percent—or nearly double the previous level.3 Thus, many listed public firms chose to
“go dark” and become private companies rather than face the steep costs of compliance.

There are many advantages to going public. First, the firm is able to raise capital in
order to make investments that can help it grow, and it has the ability to make acquisitions using existing stock. In addition, the initial owners have a much more liquid market in which to sell their stake in the firm, usually at a much higher per-share price than
if the company were still private. Beyond that, management is able to improve recruiting
by offering stock options and stock-related incentives to key employees. Finally, there is
an overall increased public awareness of the firm.
There are also a number of disadvantages to going public. Because shares are more
dispersed, management must work with a more diverse group of stakeholders, including
institutional and retail investors. The firm is more accountable to this larger group of
stakeholders and faces more rigorous disclosure of its financial situation, and this disclosure requirement has both monetary and time costs. Finally, management needs to be
more active in managing shareholder expectations and dealing with some investors who
have a short-term focus on profitability rather than long-term growth.
The IPO process begins with approval by the firm’s board of directors, followed by
selection of a lead underwriter or investment bank to assist in structuring, pricing, and
distributing the IPO. The underwriter is involved in conducting due diligence to ensure

that everything indicated in the prospectus is accurate. The prospectus is a regulatory
document filed with the SEC that describes the details of the IPO and is meant to help
investors make informed decisions. Once a preliminary prospectus is drafted and filed,
the firm applies for a stock exchange listing. Then, the underwriter and senior management conduct a “road show” by meeting with potential investors, explaining the purpose
of the IPO, and outlining the potential benefits to investors. Throughout this process,
the underwriter “builds the book” that describes the number of shares potential investors desire and the price they are willing to pay. This process allows the underwriter to
recommend a price and offering size. Finally, just before the offering date, the IPO price
is determined and indicated in the final prospectus.

3

See (accessed February 4, 2013).

prospectus: A regulatory document
filed with authorities, such as the
SEC, that describes the details of
a security offering in order to help
investors make informed decisions


Find more at www.downloadslide.com
182

Part 3  Financing Long-Term Needs

Case Study

Google and
Facebook IPOs

Not every firm has the same IPO experience. Let’s look at two leading Internet firms:
Google and Facebook. Google, which started as a search-engine company, went public
in August 2004, raising $1.7 billion. Instead of following a traditional underwriting process,
Google chose an online auction process to sell roughly 20 million shares. Investors
opened brokerage accounts and submitted their bids for a certain number of shares at a
particular price. Google then identified the highest bid that would allow for the 20 million
shares to be sold—which turned out to be $85—in a variation of the process known as a
Dutch auction. Because Google was a well-known firm and had been profitable since
2001, its leadership felt there was no need for a traditional underwriter, which typically
costs 3 to 7 percent of the amount of funds raised. There was also concern that firms
tend to “leave money on the table” by underpricing IPOs, giving investors strong first-day
returns to the firms’ detriment (because if the IPO had been priced higher, it could have
raised the same amount of money with fewer shares issued and less loss of control).
Google thus felt the auction process would result in lower overall costs and less “underpricing” of the firm’s stock. Even with the auction process, however, Google’s stock price
rose 18 percent on its first day on the market, and by late 2007 Google was selling for
over $700 a share. By late 2008, its share price dropped below $300, but it later recovered to over $600 by early 2010, and by the spring of 2013 it was selling for over $800.
Unlike Google, Facebook chose to use the traditional underwriting process when it
went public in May 2012, raising $16 billion. During its road show, underwriters increased
the planned offer price range from $28 to $35 to a range of $34 to $38. Then, just prior to
the IPO issue, Facebook decided to offer 25 percent more shares than originally planned
at the high-end price of $38. On their first day on the market, the firm’s shares opened at
$42 but promptly fell, ending the day at $38.23. Technical glitches in the NASDAQ system
hampered trading, and the exchange apologized to customers who were not able to sell
shares at posted prices, offering $40 million in compensation. Shortly after the IPO, it was
also revealed that several investment banks had told their major clients that they were
reducing their forecasted earnings for Facebook. By early June, share prices had fallen
below $26 before recovering somewhat. In August 2013 shares finally traded above the
IPO price.
Sources: Benjamin Edelman and Thomas R. Eisenmann, “Google Inc.,” Harvard Business School
case study, 2010; Shayndi Raice, Anupreeta Das, and Gina Chon, “Inside Fumbled Facebook

Offering,” Wall Street Journal, May 23, 2012

The cost for issuing stock is not cheap. In the United States, for issues less than
$500 million, the typical fee paid to underwriters is 7 percent of the amount of stock
raised. As this amount gets larger, underwriting costs might decline to around 3 percent.
(Given its prestige at the time of its IPO, Facebook was a rare exception with even lower
fees—just over 1 percent.)
There are a number of methods by which shares may be distributed. The most common method is a “firm commitment,” whereby the underwriter guarantees the sale of all
stock at the offer price. Another method sometimes used in smaller IPOs is “best
efforts,” whereby the underwriter doesn’t guarantee a particular price but attempts to get
the highest price possible given current market conditions. A third method is the auction process, with Google as the best known example.


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



183

Fig 9.10
Number of U.S. IPOs,
1960–2010

800
700
600
500
400
300

200

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1960

0

1962

100

Source: Jay Ritter’s website (accessed July 28, 2011)

As we see in Figure 9.10, IPOs tend to occur in waves of hot and cold markets. Hot
markets with a high number of IPOs are often concentrated in certain industries. For
example, in the mid-1990s, a vast number of IPOs were in the technology industry.
Researchers have made several empirical observations—known as stylized facts—
related to investors’ IPO returns. First, investors who receive shares as part of an IPO
tend to experience high returns on the first day of ownership. Figure 9.11 shows firstday IPO returns over time. As you can see, negative average first-day returns have
occurred in only two of the past fifty years, and returns peaked at 70 percent during the

Fig 9.11
U.S. IPO First-Day Returns,
1960–2010

80%
70%
60%
50%
40%
30%
20%
10%
0%

Source: Jay Ritter’s website (accessed July 28, 2011)

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

–20%

1960

–10%


Find more at www.downloadslide.com
184

Part 3  Financing Long-Term Needs

Fig 9.12
International IPO First-Day
Returns

300%

250%

200%

150%

100%

0%

Russia
Argentina
Austria
Canada
Denmark
Chile
Egypt
Norway
Netherlands
France
Turkey
Spain
Portugal
Nigeria
Belgium
Israel
Hong Kong
Mexico

United Kingdom
Italy
United States
Finland
South Africa
New Zealand
Philippines
Iran
Australia
Poland
Cyprus
Ireland
Germany
Indonesia
Sweden
Singapore
Switzerland
Sri Lanka
Brazil
Bulgaria
Thailand
Taiwan
Japan
Greece
Korea
Malaysia
India
China
Jordan
Saudi Arabia

50%

Source: Jay Ritter’s website (accessed July 28, 2011)

seasoned equity offering (SEO):
The additional sale of equity
securities to the public by an
already-public firm
shelf offering: A regulatory
provision that allows a firm to issue
more shares at a future date without
issuing a new prospectus
rights offer: A type of seasoned
equity offering whereby shares are
offered only to existing shareholders

technology stock craze of the late 1990s. Second, as Figure 9.12 shows, large first-day
returns are a worldwide phenomenon, and U.S. first-day returns of just under 17 percent
fall in the middle of the pack. Finally, over the first three to five years following their
issuance, IPOs tend to underperform relative to the market.
In comparison, if a firm that is already public decides to issue additional common
shares, the process is known as a seasoned equity offering (SEO). The SEO process is
similar to the IPO process except there is already an established market price for the
shares. Unlike an IPO, a seasoned offering is a much less dramatic step for the firm. However, depending on its size relative to the number of existing shares, an SEO can affect the
existing common share price. Specifically, after the SEO, there will be more common
shares outstanding. If the firm is not able to utilize its new funds in a way that creates additional profits and sufficient value for its common shareholders, then existing shareholders
will find their claim on the firm’s profits has been diluted, and the share price will decline.
In fact, one stylized fact noted by researchers is that stock prices tend to decrease upon the
announcement of an SEO. Thus, a firm must clearly articulate its reasons for issuing additional shares and must indicate how the issuance will add value in the long term.

Seasoned offerings may be available to the general public or offered to institutional
investors through a private placement. To facilitate quicker and more cost-efficient issuance of shares, a firm may file in advance for a shelf offering that allows it to issue more
shares at a future date without issuing a new prospectus. Also, to help protect existing
shareholders against possible ownership dilution, a firm may issue a rights offer, which
is a new share offer only available to existing shareholders. Although not very common
in the United States, rights offerings are common in other countries, including the
United Kingdom.


Find more at www.downloadslide.com


Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments

185

Large firms, particularly multinationals, may raise capital outside of their domestic
markets by cross-listing their shares on other exchanges (although cross-listing may
also take place without raising capital). For example, non-U.S. firms may list on U.S.
exchanges through American Depositary Receipts (ADRs), which are negotiable certificates issued by certain U.S. commercial banks that represent an equivalent amount of
the foreign securities. These firms may also raise capital through an SEO at the time of
cross-listing, or the cross-listing might be part of an IPO. Firms tend to cross-list in
hopes of reducing their cost of capital or broadening their shareholder base, or as part of
planning for a merger or acquisition.

9.4.4 Organized Exchanges versus Over-the-Counter Markets
Traditionally, organized exchanges have played a dominant role in the trading of securities. However, organized equity or stock exchanges are much more prevalent than organized bond exchanges because bond trading tends to take place primarily among large
institutional investors. One of the largest organized equity exchange operators is NYSE
Euronext, a holding company that combined the NYSE Group, Inc. (including the New
York Stock Exchange) with the Dutch company Euronext N.V. in 2007. NYSE Euronext

securities represent about one-third of the world’s equity trading. Until the New York
Stock Exchange (NYSE) became a public company in 2006 and facilitated electronic
trading, NYSE membership was limited to those who purchased one of 1,366 “seats” on
the exchange. Trading included face-to-face interactions on the exchange floor, with
specialists making markets for particular securities by matching buy and sell orders to
determine prices and ensuring that an orderly market transpired.
The other large global equity exchange operator is NASDAQ OMX Group. In 2007,
the National Association of Security Dealers Automated Quotation (NASDAQ) acquired
OMX, which dated back to various mergers of European exchanges, primarily in Sweden, Denmark, and Finland. NASDAQ OMX has the most listed companies globally and
the most share value traded. In contrast to the NYSE’s origins, NASDAQ originated in
1971 as an over-the-counter (OTC) market. Instead of having one specialist in a particular location setting the price for a stock, an OTC market allows for greater participation
among a larger number of brokers who are prepared to make a market for a stock. Most
bond markets are OTC. From its beginnings as an OTC market, the NASDAQ system
grew to challenge the traditional dominance of the NYSE.
On organized exchanges such as the NYSE or NASDAQ, firms must first apply to
have their stock listed. There are strict listing requirements based on a firm’s size and
financial performance track record, including number of shares, market capitalization,
and earnings history. In years past, a NYSE listing meant prestige, and most firms strived
to meet the qualifications for such a listing; consequently, more U.S. trading volume
occurs on the NYSE than the NASDAQ. However, some of the best-known firms in the
world—particularly in the technology sector—have chosen to list on NASDAQ rather
than the NYSE, including Google, Facebook, and Microsoft, although part of their reason for doing so was probably that many other technology-related firms were already
listed on NASDAQ.

9.4.5 Role of Intermediaries
Traditionally, financial intermediaries have played an important role related to the issuance and trading of securities. Financial intermediaries include the exchanges discussed
in the previous section, as well as investment banks such as Bank of America, Citigroup,
Goldman Sachs, JPMorgan Chase, and Morgan Stanley. These intermediaries attempt to
facilitate the buying and selling process, first between corporations and investors, and

cross-listing: The process by which
a firm lists its shares on a foreign
stock exchange
over-the-counter: A market for
stocks that is decentralized and not
a formal exchange
American Depositary Receipt
(ADR): Negotiable certificates
issued by certain U.S. commercial
banks that represent an equivalent
amount of the foreign securities
financial intermediaries: Stock
exchanges, investment banks, or
investment dealers that attempt
to facilitate the buying and selling
of securities, first between firms
and investors and second among
investors


Find more at www.downloadslide.com
186

Part 3  Financing Long-Term Needs

second among investors. For example, investment bankers have traditionally played a
critical role in the IPO process. They provide advice related to the appropriateness and
timing of an IPO, and they determine an appropriate share price to be offered. Then,
they facilitate the issuing or underwriting process whereby the securities are actually
sold to the public, often assuming the risk in the offer by buying the securities from the

firm at a preset price and reselling them to the public at a (hopefully) higher price.
The role of intermediaries is rapidly changing as the Internet provides more direct
access to capital markets. Firms are increasingly considering initial public offerings and
seasoned equity offerings over the Internet. For example, in 1999, investment banking
firm W.R. Hambrecht and Company created OpenIPO as an online auction process for
IPOs and seasoned equity offerings. OpenIPO has facilitated numerous offerings, including those of notable firms such as Google and Morningstar. Trading by individuals—who
have access to more information and low-cost online trading options than ever before—
is rapidly changing the role of intermediaries who must constantly assess how they can
add value for their clients.

9.5  Market Efficiency
Objective 9.5

Explain the concept of
market efficiency and
describe the various forms
of the efficient market
hypothesis.

underwriting: The process, initiated
by investment banks, of marketing
new security issues to the public
market efficiency: The degree to
which a security market is deemed
to reflect all relevant information
efficient market hypothesis
(EMH), weak form, semistrong
form, strong form: An investment
theory that states that prices fully
and immediately reflect all relevant

information. The weak form defines
relevant information as all historical
price information; the semistrong
form defines relevant information
as all public information; and
the strong form defines relevant
information as all forms of
information including private
information

Market efficiency is an important way of thinking about and comparing the prices for
securities in various types of markets, such as the bond market or the stock market. According to the efficient market hypothesis (EMH)4, a market is said to be efficient if prices fully
and immediately reflect all relevant information. In other words, a market is efficient if the
price paid for a security is the true price reflecting the intrinsic value of that security.
The concept of market efficiency is critical to both firms and investors. In Chapter 1,
we said a key objective of any firm is to maximize shareholder value, using the current
stock price as a measure of shareholder wealth. If markets are efficient, this implies that the
stock price should rise if the firm makes good decisions and fall if the firm makes bad decisions. But if markets aren’t efficient and prices don’t reflect intrinsic values, then there
won’t be a relationship between stock prices and the objective of maximizing shareholder
value. In addition, from a firm’s perspective, market efficiency has implications related to
the timing of the issuance of securities. For example, if markets are not efficient and if
management deems that a firm’s stock is overvalued, then it might be a good time to issue
equity if the firm is in need of capital. From the investor’s perspective, efficiency has implications for overall investment strategies. For instance, it helps the investor determine
whether to be passive and buy an index fund or actively trade in individual securities.
Although the notion of market efficiency is fairly straightforward, it is important to
note that market efficiency is not a statement of fact but rather a hypothesis put forward
to describe a particular market, such as the U.S. stock market in general. Because we can
never know the true price or intrinsic value of a security, we can never know with certainty whether a market is efficient. The challenge faced by countless academic researchers has been to develop empirical tests that yield results consistent or inconsistent with
the notion of market efficiency without providing definitive proof.
Researchers have developed three categories of hypotheses and tests related to market efficiency: weak form, semistrong form, and strong form. The words weak, semistrong, and strong are not meant to imply that one category is better than another; rather,

each form relates to how we define relevant information.
4 In October 2013, University of Chicago finance professor Eugene Fama was announced as a co-recipient of the Nobel Prize in Economics for his work in defining and testing the concept of market efficiency.


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



187

9.5.1Weak Form
The weak form of the efficient market hypothesis (EMH) states that market prices fully
and immediately reflect all historical price (and trading volume) information. If the
weak form of the EMH is deemed to be true—or more precisely, if the hypothesis is not
rejected based on empirical tests—then this implies that the current price of a security
already incorporates information regarding historical prices and volume. Thus, knowing
the pattern of stock prices (for example, whether the current price is much lower or
higher than the price one year ago) does not provide any insight about the future stock
price. In other words, if the weak form is true, then technical analysis—or examining
patterns and trends in historical stock prices—is not a fruitful investment strategy.
Many tests that attempt to evaluate the weak form by replicating technical analysis
strategies have failed to uncover reliable methods for outperforming the market over a
long period of time. However, more recent studies have uncovered some viable strategies
related to momentum investing (i.e., buying stocks that have done particularly well over
the last six months or so and holding them for the next six months).

9.5.2Semistrong Form
The semistrong form of the EMH states that prices fully and immediately reflect all
public information. If the semistrong form is deemed to be true based on empirical tests,

then this implies that trading based on publicly available information in annual reports,
in the newspaper, or on the Internet—known as fundamental analysis of a company—is
not a viable investment strategy. (Fundamental analysis often refers to a top-down
approach of investigating the economic outlook, the industry prospects, and the firmlevel analysis of growth and risk in order to estimate an intrinsic value of a firm ­compared
to its actual selling price.) In other words, if the publically available information is relevant, then it should be incorporated into the stock price immediately, not through a
gradual process.
Semistrong form tests have focused on the immediacy of market reaction to events that
provide new public information. These event studies have examined good-news announcements, such as an increase in dividends, and have found support related to the quickness
with which this information is incorporated into the stock price. Figure 9.13 shows

Fig 9.13
Sample Event Study Result
Testing the Semistrong
Form of the Efficient Market
Hypothesis

1.40
1.35

Semistrong
Not semistrong

1.30
1.25
1.20
1.15
1.10
1.05
1.00
0.95

0.90
–20 –18 –16 –14 –12 –10 –8 –6 –4 –2

technical analysis: A method of
evaluating the worth of securities
based on examining patterns and
trends in historical prices
fundamental analysis: A method
of evaluating the worth of securities
based on publicly available
information such as news stories
and annual reports
event study: A research
methodology for analyzing the
impact of certain types of events,
such as the announcement of
dividend increases on security
prices

0

2

4

6

8

10 12 14 16 18 20

Find more at www.downloadslide.com
188

Part 3  Financing Long-Term Needs

hypothetical results for event studies. The vertical axis shows a price index. The horizontal
axis shows days relative to the event on day 0, such as an announcement of a proposed
acquisition. If the price index follows the solid line, with a spike in prices on the day of the
announcement, then the test result is consistent with semistrong market efficiency. In contrast, if the price index follows the dotted line with a more gradual price increase after the
announcement, then the result is not consistent with semistrong market efficiency.

9.5.3Strong Form
The strong form of the EMH states that prices fully and immediately reflect all information, both public and private. If the strong form is deemed to be true, then this implies
that insiders—senior management, the board of directors, and anyone with private
information about a firm—would not be able to benefit from their knowledge. In other
words, if a member of the board of a firm had private and nonpublic information about
the firm—say, some pending good news about a new product development—and bought
shares of stock before the information became public, the strong form of the efficient
market hypothesis suggests the individual would not be able to earn excess profits (compared to noninsiders) on the stock purchase.
Studies on the strong form have focused on the ability of insiders to capitalize on
their ability to buy shares in their company prior to a rise in the stock price and sell prior
to a decline. Not surprisingly, these studies have refuted the notion of strong form EMH.
In other words, insiders do appear to have the ability to develop superior investment
strategies and earn excess profits.

9.5.4 U.S. Stock Market Efficiency
Empirical tests have focused on U.S. stock markets in particular, and they have provided
mixed results. These studies appear to suggest that U.S. stock markets are generally

­efficient (but certainly not in the strong form); however, there may be pockets of inefficiency whereby investors may be able to profit. It should be emphasized that these studies are never free from controversy, given the challenges of empirical research and the
lack of one agreed-on model related to the determination of stock prices. If stock markets are truly efficient, then managers should be less concerned with the timing of the
issuance of securities, and investors should be less concerned with trying to pick one or
two winning stocks than simply investing in a passive index fund strategy. In other
words, investors should focus on buying a well-diversified portfolio of stocks and holding them for a long period of time.

9.6 Relevance for Managers
Objective 9.6

Explain why understanding
capital markets and longterm financing instruments
is relevant for managers.

Very few firms can exist in a vacuum without external sources of funds. As such, it is
critical for managers to understand the nuances associated with financial instruments
such as bonds, preferred shares, and common stocks, as well as the markets in which
they trade. In fact, most firms need to access capital markets on a regular basis, particularly if they are growing or if they wish to acquire other firms and need to finance these
purchases. Managers must appreciate the perspective of the firm’s lenders and investors
and understand the trading environment, recognizing that their shareholder base is constantly changing. In addition, managers need to keep abreast of the evolution of capital
markets, including new trading venues.


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



189

Managers should also appreciate the concept of market efficiency. For many of us,

when it comes to our own firm’s stock price, we often feel like comedian Rodney Dangerfield: “I don’t get no respect!” In other words, we often feel that the market doesn’t
appreciate the true value of our stock and that it is constantly undervalued. (After all,
how often do you hear of CEOs who are kept awake at night worrying about their overvalued stock?) Although it is true that on some occasions, stocks may be undervalued—
or in the case of technology stocks in the late 1990s, overvalued—it is generally reason­
able to assume that markets are somewhat efficient and stock is being fairly valued.

Summary

1. A firm raises long-term financing by issuing
securities such as bonds, common shares, or
preferred shares.
2. Bonds are usually issued at face value and pay
interest or coupons every six months. The principal
amount is also repaid on the maturity date. The type
of features associated with bonds often distinguishes
them from one another.
3. The credit risk of bonds is assessed by various
bond-rating agencies. Ratings typically range from
AAA (most creditworthy) to C (least creditworthy). Bonds rated BBB and above are said to be
investment grade, whereas bonds rated BB and
below are referred to as speculative, high-yield,
or junk bonds.
4. Common shareholders are the residual claimants of
any earnings after other stakeholders, such as
bondholders, have been satisfied. Common
shareholders are collectively the owners of the
firm. Any earnings available to common shareholders are either paid out as common dividends
or retained in the business in order to generate
future profits.

5. Preferred shares represent a hybrid security with some
features of both bonds and common stocks. Preferred
shares pay regular dividends, but the dividends are
not tax deductible from the firm’s perspective. Typical
preferred shares have no maturity and, consequently,
no principal repayment. Preferred shareholders must
typically receive their dividends before any dividends
are paid to common shareholders.
6. Historically, stocks have outperformed bonds but
have exhibited more volatility. Small stocks have
outperformed large stocks. Both stocks and bonds
have provided positive real returns over the long run.
7. Capital markets represent the markets in which
securities are issued and traded. Markets can be
distinguished by the method of issue, either to private
investors such as pension funds and insurance companies or to the public at large. Most stocks are traded on
organized exchanges and most bonds are not. Intermediaries such as investment banks play an important role
in facilitating the buying and selling process.
8. Markets are said to be efficient if the prices of
securities fully and immediately reflect all relevant
information.

Additional Readings and Information

A useful overall investments book is: Bodie, Zvi, Alex Kane, and Alan
Marcus. Essentials of Investments, 8th ed. New York: McGraw-Hill Ryerson,
2010.
An interesting book focusing on bonds and fixed income securities is: Fabozzi,
Frank. Bond Markets: Analysis and Strategies, 7th ed. Englewood Cliffs, NJ:
Prentice Hall, 2009.

A classic investment book with an efficient market perspective is: Malkiel, Burton.
A Random Walk Down Wall Street, 10th ed. New York: W. W. Norton, 2010.


Find more at www.downloadslide.com
190

Part 3  Financing Long-Term Needs

Some important studies of market efficiency can be found in: Fama, Eugene.
“Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of
Finance 25 (1970): 383–417.
Fama, Eugene. “Market Efficiency, Long-Term Returns, and Behavioral Finance.”
Journal of Financial Economics 49 (1998): 283–306.

Problems

1. All things being equal, would you expect to receive a
higher or lower interest payment if a bond had a
sinking fund?
2. All things being equal, would you expect to receive a
higher or lower interest payment if a bond had a call
provision?
3. Twice Lucky, Inc. was planning a 10-year bond issue
with a 6% coupon rate. Just prior to the issue, a
major credit rating agency announced a surprise
upgrade in its rating. How might this announcement
impact the planned bond issue? Explain.
4. What is the average annual compound (geometric)
return over two years for a stock that goes from $10

to $20, then back to $10?
5. What is the average arithmetic return over two years
for a stock that goes from $10 to $20, then back to $10?
6. Historical U.S. market returns tend to approximately
follow a normal distribution, which implies that
returns are plus or minus one standard deviation
from the mean (arithmetic return) two-thirds of the
time and are plus or minus two standard deviations
from the mean 95% of the time. Based on the
information in Figure 9.5 and focusing on the mean
returns for “all stocks,” what is the range of returns
that are one standard deviation from the mean?
7. Based on the information in Figure 9.5 and focusing on
mean returns for “all stocks,” what is the range of returns
that are two standard deviations from the mean?
8. What factors would impact the price of preferred
shares?

9. On the basis of the following bond information,
describe the features of the bond and explain the timing
of the expected cash flows (assuming today is January 1,
2014): coupon = 6.4 percent; maturity date = January
1, 2024; price = $103.42; yield = 5.94 percent.
10. On the basis of the following stock information,
describe the features of the stock and assess its
performance: dividends per share = $0.80, current
share price = $28.50, current dividend yield = 2.8
percent, current P/E multiple = 24.5, share price one
year ago = $24.00, and market total return over the
past year = 16.5 percent.

11. What type of investor is most likely to purchase a
private placement?
12. Given the “stylized facts” related to IPO performance,
if you were able to obtain IPO shares at the issue price,
when might be the best time to sell the shares: after
the first day of trading or three-to-five years later?
13. If research employs an event study, what form of the
efficient market hypothesis is it most likely testing?
14. Suppose an investor uncovers a strategy by which she
or he is able to predict future stock prices by observing trends in past prices. What form of the efficient
market hypothesis would this be evidence against?
15. Suppose a firm is involved in major litigation and is
expected to lose its case, which would cost the firm
millions of dollars. Surprisingly the firm wins the case
and immediately the stock price jumps. Is the observation of the price increase consistent with the semi­
strong form of the efficient market hypothesis? Explain.


Find more at www.downloadslide.com
Chapter 9  Overview of Capital Markets: Long-Term Financing Instruments



Appendix: Understanding Bond and Stock Investment Information

In order to assist you in understanding more about the workings of capital markets, let’s
examine bonds and stocks from the perspective of the investor rather than the firm.
Whereas the firm is concerned with raising a particular amount of capital at one particular time, the investor is concerned with the day-to-day value of the investment. Information regarding the value of securities is available from a variety of sources, as described
in the following sections.

Bond Information
Given the predominance of large institutional bondholders (versus smaller retail investors), much less financial information is readily available about corporate bonds than
stocks. Nevertheless, an example of corporate bond information is presented in
Figure A9.1. In this example, Home Depot issued $1 billion worth of these bonds in late
March 2011. The 30-year bond matures on April 1, 2041. Based on a face value of $100,
annual coupon payments are $5.95, or $2.975 every six months. The current price of this
bond is $131.50. Since most (but not all) bonds are issued at a price near the face or par
value, we can surmise that when the bond was initially issued, interest rates were at a
higher level than they are currently—because as rates have declined, the bond price has
increased. It may also have been the case that Home Depot was viewed as a higher credit
risk at issue compared to the current quote.
Note that the bond represents a promise of fixed payments. Because interest rates
have fallen, this bond with fixed annual coupon payments looks more attractive than a
similar (in terms of creditworthiness) bond issued today with lower annual coupon
payments. This is why the bond price is more than $100. The bond yield essentially
indicates the coupon rate that would be attached to a similar bond if it were issued at
par today. Given that the Home Depot bond is selling for $131.50, it turns out that
buying this bond for that price is just like paying $100 for a bond that pays a coupon
rate of 4.08 percent, which is also the yield to maturity of the bond, as discussed in
Chapter 7.

Stock Information
The most common source of stock information is the Internet. An example of Home
Depot stock information is presented in Figure A9.2. The figure examines information
from a variety of sources, including Yahoo!Finance, Morningstar, Bloomberg, and NYSE
(the stock exchange on which Home Depot is listed). Note that the different sources
include different types of information, and there may be some slight discrepancies in
terms of different measures (for example, trading volume).
As you can see in the figure, the first section of information focuses on price.
Price information is important because it is an indication of the market value of the

firm’s stock. (Valuation is discussed in more detail in Chapter 13.) While the stock

June 29, 2012
IssuerAmountCoupon %MaturityPrice

Yield

Home Depot

4.08

Source: Morningstar.com

$1,000 mil

5.95

April 1/41

131.50

Fig A9.1
Home Depot Bond
Information

191