Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

MBA Week 1 Financial Instruments and Markets

Gavin Kretzschmar1,
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Business School2

Accounting and Finance Group

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University of Edinburgh
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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Sequence today

Course Booklet - accounting and nance Equity Debt Odd numbers for tutorials Introduction - Chapter 5, Higgins (2009).

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity, Debt and Efciency in Capital Markets

Introductions Equity Debt Odd Numbers for practice

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Key Differences between F &A

As Financiers - we are concerned with the market value of debt and equity The market cost of debt and equity The capital decision The investment decision The nancing decision Accountants are concerned with all of the above - but at Historic cost... Lets consider an asset base of 150 with 40 percent equity.....

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Outline

Equity Markets Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Equity Capital Markets

A key distinction is between: Primary Markets - where companies sell new shares to investors Secondary Markets - where investors trade already issued shares with other investors We can also make a distinction between listed and unlisted equity shares. The former are traded on a stock exchange, the latter are not

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Financing a business

A business can be nanced by: - Internal funds - Bank loans Bond issues - Equity issues The initial founders of a business may lack enough capital to develop the business to the point of protability With limited capacity to borrow, many new companies turn to venture capital rms for initial equity funding The VC rm takes a stake in the start-up business, helps manage it, and hopes to be able to sell out at a prot

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Outline

Equity Markets Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Private Equity

We can make a distinction between: - Private companies - whos shares are tightly held - Public companies - whos shares trade on public markets Private equity funds make equity investments in unquoted securities, ie those not traded on a public market Venture capital funds provide nance to start-up and early-stage businesses Buy-out funds take public business private again, seeking to improve management and nancing Buyout funds typically use a lot of leverage, ie they increase the debt held by the companies they buy

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Outline

Equity Markets Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Initial Public Offerings

When a company sells its shares to investors for the rst time, this is called an "initial public offering" or "IPO" The IPO can be used to: - Raise new money for the company Allow VC rms to realise their investment - Allow the founders to realise their investment - Or, some combination of these three The IPO is a costly and complex process involving a number of specialist advisers

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Listing Requirements

In most markets, companies have to meet certain criteria in order to have their shares traded on the market In the UK, the Financial Services Authority is responsible for setting these "listing requirements" The main requirements are: - A three year trading history - An expected market value of GBP 700,000+ - At least 25% of shares made available to the public A junior market exists for newer companies that dont meet these requirements - the "Alternative Investment Market" (AIM)

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Underwriters

An investment bank usually plays a key role in the IPO process as the "underwriter" or "sponsor" The bank will provide the company with procedural and nancial advice It will then take on the responsibility for distributing the shares to investors The bank may act as principal, buying the shares to resell to investors, or it may act as agent, selling to investors on behalf of the company

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

The IPO Process

The company applies to have its shares listed on the market The investment bank does due diligence and prepares a "prospectus" that outlines key facts about the company and the share issue The investment bank markets the shares to investors, then sets the price for the issue and distributes the shares to investors The shares are admitted to the market and trading begins

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Pricing an IPO

The investment bank will set the price with reference to the valuation of comparable shares, e.g. using P/E ratio The bank will also discuss the issue with investors in order to gauge the likely level of demand (book-building) There is substantial evidence that IPOs are, on average, underpriced - i.e. the issue price is below the price that holds on the rst day of trading (Ritter 1998)

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

Average Initial Return

US - Ibbotson et al 1960-96 15.8% UK - Dimson & Levis 1959-90 12.0% India- Krishnamurti & Kumar 1992-93 35.3% China - Datar & Mao 1990-96 388.0%

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Equity Markets Private Equity Initial Public Offerings

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Outline

Debt Markets Bond and Money Markets Government Bonds Corporate Bonds

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Bond and Money Markets Debt Markets

A bond is like a loan, where the borrower is committed to pay interest (coupons) and to return the principal at a set date in the future Unlike a traditional bank loan, a bond is tradable on the secondary market We will look at bonds issued by governments and bonds issued by companies We will take for granted that you know how to price a bond (PV of future cashows) and calculate the redemption yield (IRR)

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Outline

Debt Markets Bond and Money Markets Government Bonds Corporate Bonds

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Government Bonds

Gilts in the UK, or Treasury bonds in the US The government seeks to meet its borrowing requirements - e.g. to fund infrastructure investment - by selling bonds to investors Gilts typically have maturities from 1 year to 30 years. The money market deals with borrowing less than 1 yr Government bonds are usually regarded as being free from credit risk. This is because governments have the power of taxation

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Examples of Gilts Gilt Auctions

Since 1998 the Debt Management Ofce (DMO)has been responsible for gilt issues Its objective is "to minimise over the long term the cost of meeting the governments nancing needs, taking into account risk, while ensuring that the debt management policy is consistent with the objectives of monetary policy." Most gilts are sold by auction, typically 300m - 3bn. Bond dealers and large investors can make competitive bids (1m+) and, if successful, pay the price they bid Individuals can make non-competitive bids, and pay the average price from the auction

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Outline

Debt Markets Bond and Money Markets Government Bonds Corporate Bonds

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Gavin Kretzschmar Financial Instruments and Markets

Financial Instruments and Markets MBA, MSc slides Equity Markets Debt Markets

Bond and Money Markets Government Bonds Corporate Bonds

Corporate Bonds

Corporate bonds come in a variety of forms: - Secured bonds (debentures / mortgage bonds) - Unsecured loan stock Convertible bonds (convertible to equity shares) The key difference between corporate bonds and those issued by government is in the probability of default Credit rating agencies exist to provide investors with guidance on the probability an issuer will default Generally, you would expect corporate bonds to yield more than government bonds and this yield spread will be higher the lower the bonds credit rating

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Gavin Kretzschmar Financial Instruments and Markets