presented by: the northern trust company fran wawrzyniak, ctp june 7, 2012

© 2012 Northern Trust Corporation

Presented by: The Northern Trust CompanyFran Wawrzyniak, CTP June 7, 2012

Windy City Summit CTP Review

Chapter 12

Service Expertise Integrity

IntegrityExpertiseService2 Windy City Summit CTP Review

Chapter 12

Capital Markets

Fran Wawrzyniak, CTP


Studying for this Chapter

There are 7-9 questions on the exam from this chapterUnderstand debt vs. equity financing and key componentsCAPM calculationValuation of Long-Term Securities


Overview of Capital Markets

Two Basic Segments:Debt – bond securities and loansEquity – common and preferred stock

Market Basics Money Markets – maturities of 1 year or lessCapital Markets – maturities greater than 1 year

Majority Long-term debt (bonds), equity securities (stock) Equity instruments have no fixed maturity date Equity instruments cease to exist when issuing firm does



Key Market ParticipantsIssuers of securities

Central Banks (debt securities) Corporations (debt and equity securities) Government-Sponsored Enterprises – GSEs (debt securities) Municipalities (debt securities) Mutual Fund Cos. (debt and equity securities)

Investors Represent the demand side of the markets Purchase and hold securities



Investment Banking and Brokerage Firms“Middlemen” to complete transactionsInvestment bankers – assist issuers in design and placement of

issuancesOrigination desks – evaluate, price and manage placementSecurities traders – maintain secondary markets for equity and debt

instruments Regulators Other Participants

Rating agencies (Chapter 13), attorneys, printing companies and data service providers


Division of Capital Markets

Primary •Offer newly issued debt/equity•New issues increase stock outstanding or indebtedness

Secondary •Trade existing debt/equity •Established exchanges – physical location with trading hours•OTC markets – electronic interchange•Once a security is issued in the primary market, any subsequent trades happen in the secondary market

Private •Direct placement sold to limited number of investors•May be exempt from registration with SEC•Lower cost, less restrictive, quicker



Debt Financing

Medium- and Long-Term Borrowing Term Loan

Fixed maturity, term greater than 1 year Paid in single payment or installments Usually for a specific purpose Secured by asset being financed and term is tied to asset’s useful

life Illiquid

Medium- or Intermediate-Term Notes Terms from 2-10 years Payments are interest only Marketable securities


Long-Term BondsTerms of 10-30 yearsMost are coupon bonds with regular interest payments at fixed

(coupon) rate Indenture = contract

Describes bond issue Lists collateral Specifies covenants States terms Sets schedule of payments, maturity and provisions Multiple types:

Debt Financing


Debt Financing

Long-Term Bonds Mortgage Bonds

Include substantial covenants· Assets· Right to issue additional bonds· Use of junior mortgages· Sinking-funds· Reporting requirements· Restrictions of key fin’l ratios· Prepayment terms· Dividend policy

Unsecured (Debenture) Bonds Claims against assets or cash flows Based on issuer reputation Treasury, corporate or municipal

Convertible Bonds Debt securities that can be

converted into stock Stock Purchase Warrants

Options to buy stock at stated price until stated date

Can be traded in the market Municipal Bonds

General obligation paid from tax revenue

Revenue bonds paid from revenue of public project (stadium)

Zero-Coupon Bonds No cash value until maturity

High-Yield Bonds


Debt Financing

Other Bonds

Income •Pay interest only if company has profit

Collateral Trust •Backed by securities of other companies owned by issuer

Equipment Trust •Secured by movable equipment

Index •Interest rate tied to an economic index

Economic Development

•Issued by underdeveloped countries or organizations like IMF (International Monetary Fund).

Tax Increment (TIF) •Used for local financing•All or portion of property taxes provide financing

Tender Option •Bondholder can redeem bond once over term or on a specific date•Redemption at par value


Debt Financing International Bond Market

Foreign Bonds - Sold in a particular country by foreign borrower, denominated in currency of country of issue and regulated by country of issue

Eurobonds Sold in many countries outside of country of borrower and issued by

international syndicate Bond denominated in USD $ issued in India by a UK company Issuers can choose country with preferred regulatory rules

Global Bonds - Sold in and out of borrowers country, typically offered in major currency

Multicurrency Bonds Issued as currency options which allow investors to choose from select

currencies Currency cocktail bonds that are denominated in standard basket of

several currencies


Debt Financing Other Forms of Debt Capital

Floating- (Adjustable-) Rate Debit Stable market value, matches current rates Take advantage of falling rates, match debt maturity to asset maturity

Project Financing Large projects such as power plants, stadiums Complex structure Lenders paid from project cash flows

Securitization Accounts receivable/inventory serve as collateral “Mortgage Backed Securities”

Off-Balance Sheet Financing Joint ventures, factoring, operating leases ASC Topic 840-10-15 (Chapter 13)


Debt Financing Debt Contract Provisions

Bond Indentures and Covenants Indenture = contract to protect bondholders from risk or increase

value of equity holders Violation can make debit immediately due

Representations and Warranties Existing conditions at the time the loan agreement is executed

Events of Default Caused by breach of terms or conditions of debit agreement

MAC Clause (Material Adverse Change) Lets lender refuse funding or declare default if a MAC has

occurred


Debt Contract ProvisionsCall Provision

Issuer has right to call issue for redemption prior to maturity Valuable since issue can be redeemed if interest rates fall or other

financing becomes attractiveSinking Fund

Bonds are not amortized and a lump sum is due at maturity Requires company to repurchase portion of outstanding issue

each year, effectually amortizing itRefinancing Defeasance of Debt

Removes debt from balance sheet without retiring the issue Borrower places funds in escrow guaranteeing debt

Debt Financing


Debt Contract ProvisionsPromissory NoteCollateral Liens

Lender has legal claim on assets used as collateral Lenders search liens of potential borrower to ensure collateral is

available to pledge

Debt Financing


Debt Financing Other Factors

Credit Enhancements – reduces credit/default risk of debit, improving credit rating and lowering interest rates. Common form is Guarantee.

Guarantees Full – Party agrees to take over loan if borrower defaults Specific Project – Guarantee of loans related only to a specific project,

rather than all loans of borrower Guarantee of Payment or Collection - guarantee of payment on loan or

collection of payment if default Comfort Letter – not legally enforceable Performance

· Full – parent guarantees performance of sub· Best Efforts – Parents agrees to use best effort to get sub to

perform Personal – owner will personally repay loan of company

Bond Ratings – reflect default probability of bond issuer


Other Factors Capital Structure Considerations – Target capital structure = best mix

of L/T debt and equity to finance firmMaturity Matching – match life of debt to life of asset financedEffects of Interest Rates and Forecasts –

General level impacts use and cost of debt Forecast impacts type of capital and provisions

Availability of Collateral – companies with large asset bases which can be used as collateral typically borrow at lower rates than other companies with same credit quality that do not.

Debt Financing


Equity Securities Common Stock - Balance Sheet Accounts

Par Value - arbitrary amount representing minimum shareholders would need to put up in the event of bankruptcy. Usually $1 or $0

Retained Earnings Net earnings of a corporation since inception less dividends paid to

shareholders Accounting entry, not an available pool of funds

Additional Paid-in-Capital (APIC) Difference at issue of par value and issue price

Book Value per Share – common stockholder equity ÷ # shares outstanding Market Value per Share – current trading price of stock Treasury Stock

Stock issued and later reacquired and can be held in treasury, reissued, or retired

No dividends, no votes. Issued , not outstanding


Equity SecuritiesTypes of Common Stock

Class A and B: Classes used to limit voting rights, dividends, resale, differentiate returns.

Tracking Stock: separate stock created to “track” the finances of a piece of business . Has a unique ticker symbol.

Preferred Stock Major provisions

Stockholders have priority claim to earnings and assets before common Always has par value Dividend is fixed and is accumulated in arrears Can be convertible

Evaluation: steadier income than common, 70% of dividend can be excluded from Federal tax

Particular uses


Equity Securities Hybrid Securities

Convertibles: Bonds or preferred stock that can be exchanged for common stock

Disadvantages:· Stock price increases, then better off issuing regular debt· Coupon rate lost if bonds converted to stock· If stock price does not increase, then locked into debt issue

Warrants: Company issued options that give owner right to buy stated number of

shares at a specific price for a period of time. Often listed on major exchanges. Represent additional equity for issuer Detachable – can be traded separate from bond Can dilute the stockholder’s equity and EPS


Equity Securities International Equity Market

Represents ownership of public corporations traded globally Depository Receipts (DRs)

Negotiable instruments that trade on a local exchange that represent stock ownership in a foreign company

Benefits: Increase global trade More opportunity to raise global capital Reduce market inefficiencies


Managing Capital Market Investments Objectives of Capital Market Investments

Risk preferenceReturn objectives Liquidity needsFuture needs Tax IssuesLegal/regulatory factors

Asset Allocation DecisionMix of fixed income and equity securitiesDepends on objectives for portfolioThe longer the portfolio maturity, the higher tolerance of risk, the

more equity used


Managing Capital Market Investments Long-Term, Fixed Income Portfolio Management

Duration Measure of risk Weighted average time to receipt al future cash flows for a bond

investment Can provide estimate of how a bond will respond to rate changes Example: If interest rates rise 100 bps or 1%, then the price of a

bond with a duration of 4.0 years will fall by 4%


Long-Term, Fixed Income Portfolio ManagementInterest Rate Risk

Risk from changes in market value when general level of market rates changes

Higher duration = higher interest rate riskFixed/Floating Ratio

Ratio of fixed rate debt to floating rate debt Too narrow of an indicator to be effective

Foreign Currency Denominated Investments Must consider the fluctuating F/X rats on the overall portfolio Use of derivatives can mitigate risk

Managing Capital Market Investments


Long-Term, Fixed Income Portfolio ManagementUsing Derivatives – Chapter 9Asset-Liability Management

Issue for portfolio that uses borrowed funds in overall strategy Issue for banks that fund investments with deposits or borrowed

funds – may have a maturity mismatch Equity Portfolio Management

Define and measure investment riskBenefits of diversificationCapital Asset Pricing Model (CAPM)




CAPM (Capital Asset Pricing Model)

rE = rRF + (rM – rRF) βi

rE = Required rate of return on stockholder’s equity

rRF = Expected rate of return on the risk free asset (T-Bill)

rM = Expected rate of return on the market portfolio (S&P 500)

Βi = Beta value for stock i




Example 1:

Risk free rate of return is 2.0% and expected rate of return on the stock market is 8.0%. Apple Computer has a beta of 1.5.

rE = Expected Rate of Return

rRF =.02

rM = .08

βi = 1.5


= .02 + (.08 - .02)(1.5) = .110 or 11.0%

11.0% is the required rate of return for Apple, which is greater than the rate of return for the market, because Apple is more risky than the market.



Example 2:

Risk free rate of return is 2.0% and expected rate of return on the stock market is 8.0%. Beta for H.J. Heinz is 0.6

rE = Expected Rate of Return

rRF =.02

rM = .08

βi = .06


= .02 + (.08 - .02)(.06) = .056 or 5.6%

The rate of return on Heinz is less than the market since the risk is less than the market.



Managing Capital Market Investments Determining Portfolio Risk and Return

Use weighted averages of returns and betas of individual stocks

Example: Portfolio contains 70% Apple stock and 30% Heinz stock.

Portfolio β = (% of Apple stock x Apple β) + (% of Heinz stock x Heinz β)

= (.70 x 1.5) = (.30 x .60) = 1.23

Portfolio Return = (% of Apple Stock x Apple Return) + (% of Heinz stock x Heinz Return) - there was an error in the material

= (0.70 x 0.11) + (0.30 x 0.56) = .0938 or 9.38%

Note: The same return is achieved when using the CAPM of portfolio:


= .02 + (.08 - .02)(1.23) = .0938 or 9.38%


Valuation of Long-Term Securities The market value of an asset is the present value of the anticipated

future cash flows discounted using a rate equal to the risk. It is calculated using the Present Value formula:


Valuation of Long-Term Securities Bond or Fixed Income Valuation

YTM – Yield to Maturity – The interest rate the market demands over the remaining life of the bond at a particular point in time

YTC – Yield to Call – the yield the bond would provide if the issuer called it prior to maturity. Typically lower than YTM.

YTW – Yield to Worst – The worst case scenario of possible YTC values calculated, or lowest possible yield without an actual default.


Valuation of Long-Term Securities Bond or Fixed Income Valuation

Preferred Stock Valuation:

Assume a $50 par value stock pays a 6.6% annual dividend and the market requires an 8.0% return on the stock.

Preferred Stock Dividend = Preferred Stock Dividend Rate x Par Value

= .066 x $50 = $3.30

Price of Preferred Stock = Preferred Stock Annual Dividend Required Rate of Return

= $3.30 / .08 = $41.25


Valuation of Long-Term Securities

Common Stock ValuationThe price an investor will pay is the present value of the future

dividend stream discounted by the cost of equity:


Common Stock Valuation (continued) Assumptions must be made about the dividend stream Assume the dividends will grow at a constant rate:


Substituting this into the Common Stock Valuation equation results in:

Substitute the next dividend as D1, results in the following reduced equation:



Common Stock Valuation (continued)

Example:

Next Dividend (D0) = $2.00

Estimated growth rate (g) = 6%

Return on stock (ks) = 13%

= $2.00 (1 + .06) = $2.12 = $30.29 (0.13 – 0.06) 0.07

=


Top 15 Stock Exchanges

Rank Exchange Country1 New York Stock Exchange United States

2 Tokyo Stock Exchange Japan

3 NASDAQ United States

4 Euronext Belgium, France, Netherlands, Portugal

5 London Stock Exchange United Kingdom

6 Shanghai Stock Exchange China

7 Hong Kong Stock Exchange Hong Kong

8 Toronto Stock Exchange Canada

9 BM&F Bovespa Brazil

10 Bombay Stock Exchange India

11 BME Spanish Exchange Spain

12 Frankfurt Stock Exchange Germany

13 Australian Securities Exchange Australia

14 National Stock Exchange of India India

15 SIX Swiss Exchange Switzerland

presented by: the northern trust company fran wawrzyniak, ctp june 7, 2012

Documents

ctp integrityexpertiseservice

debt bond securities

chapterunderstand debt

term greater

secondary markets

equity financing

equity securitiesinvestors

intermediateterm notesterms