Capital market – some aspects


When companies finance their long-term needs externally, they may use three primary methods: a public issue of securities placed through investment bankers; a privileged subscription to the company’s own shareholders; and a private placement to institutional investors.

When a company issues securities to the general public, it usually hires the services of an investment banker. The investment banker’s principal functions are risk bearing, or underwriting, and selling the securities. For performing these functions, investment bankers are compensated by the spread between the price they pay for the securities and the price at which they resell the securities to investors.

A public issue can be either a traditional (firm commitment) underwriting; a best efforts offering; or, in the case of a large corporation, a shelf registration. With a shelf registration, a company, a company sells securities “off the shelf� without the delays associated with a lengthy registration process. Instead, only an amendment to a pre-approved offering is filed with the SEC. Not only is the shelf registration faster, but the cost of the issue is a good deal less than otherwise.

A company may give its existing shareholders the first opportunity to purchase a new security issue on a privileged subscription basis. This type of issue is also known as a rights offering, because existing shareholders receive one (subscription) right for each share of stock that they hold. A right represents a short-term option to buy the new security at the subscription price. It takes a certain number of rights to purchase the security.

Security offerings to the general public and offerings on a privileged subscription basis must comply with federal and state regulations. The enforcement agency for the federal government is the Securities and Exchange Commission (SEC), whose authority encompasses both the sale of new securities and the trading of existing securities in the secondary market.

Rather than sell new securities to the general public or to existing shareholders, a corporation can place them privately with an institutional investor or a group of such investors. With a private placement, the company negotiates directly with the investor (s). There is no underwriting and no registration of the issue with the SEC. The private placement has the virtue of flexibility, and it affords the medium-sized and even the small company the opportunity to sell its securities As a result in part institutional investors being able to sell private placements to- one another in the secondary market, such offering have grown in importance in recent years.

In its early stages, a company needs financing. One source is the venture capitalist, which specializes in financing new enterprises. If the company is successful, it will “go public� with an initial public offering of common stock.

The announcement of a debt or stock issue may be accompanied by a stock market reaction. The announcement may connote information about the future cash flows of the company or information about whether management believes the common stock is under or overvalued. Empirical evidence is consistent with both of these ideas, so the financial manager must be aware of information effects when issuing securities.

Purchases and sales of existing stocks and bonds occur in the secondary market. The presence of a viable secondary market increases the liquidity of securities already outstanding. Without this liquidity, firms issuing new securities would have to pay higher returns because investors would have trouble finding a resale market for their stocks and bonds.