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Chapte th
Foundations of Financial
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Investment
Banking: Public and Private

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Chapter 15 - Outline
Foundations of Financial
Management

• What is Investment Banking?

• Functions of the Investment Banker
• Underwriting Spread
• Public vs. Private Companies
• Advantages and Disadvantages of a Public
Company
• Initial Public Offering and Leveraged Buyout

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Foundations of Financial

What is Investment Banking?

Management

• Investment Banking deals with

primary offerings of new securities
• The Investment Banker serves as the
intermediary or link between the
corporation and the investor
• Brings the two parties together by
channeling money from one to the
other
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The Role of
Investment
Banking
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Foundations of Financial
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The Investment
Banker is a link
between the
corporation in need of
funds and the investor.
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Foundations of Financial
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The Investment Banker

is responsible for
designing and packaging
a security offering and
selling the securities to
the public
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Competition in
the Investment
Banking
industry is very
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Raising capital has

become an
international
proposition—firms
need to be very large
to compete.
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Foundations of Financial
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Table 15-1, Page

425, lists the top
investment
bankers in 2000.
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The list has its

share of foreign
investment
bankers.
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Foundations of Financial
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Many investment
banks specialize
in specific types
of securities.
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Foundations of Financial
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Functions of
the Investment
Banker
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Underwriter:
Foundations of Financial
Management

• buying the security and reselling it

to the public
• the risk-taking function
– Large firms normally assume risk of
distribution.
– Small firms may work on a “best
efforts” or commission basis.
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9 Market Maker:
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• ensuring an available
market by buying
and selling the
security
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9 Advisor:
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•providing
advice on the
issue
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Foundations of Financial
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• Helping make a private

placement with an
insurance ocmpany,
wealthy individual, or
pension fund
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Foundations of Financial
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The Distribution
Process—Some
Terms
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9 Managing investment banker
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• The principal—calls on other

investment banking houses to
share the burden of risk and to
aid in distribution.

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9 Underwriting syndicate
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• Act as wholesalers in
distributing shares to
brokers and dealers.

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9 Brokers and dealers
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• Eventually sell shares

to the public.

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Figure 15-1 (next)

shows the
distribution
process.
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Figure 15-1
Foundations of Financial
Management

Distribution process in investment banking—Page 428

T 15-1

Issues 250,000 additional shares

MaxwellCorporation
Maxwell Corporation
of stock

Managinginvestment
Managing investmentbanker
banker Merrill Lynch

Underwritingsyndicate
syndicate 15 investment dealers
Underwriting
(including Merrill Lynch)

Selecteddealers
Selected dealersgroup
group

Brokers
Brokers

Public
Public
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Underwriting Spread
Foundations of Financial
Management

• Spread represents the compensation for

those participating in the distribution
Spread = Public Price - Issue Price
• It is shared by all the participants
• Spread on common stocks is greater than
spread on bonds

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Distribution Spread

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9 Table 15-2 shows SEC
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Foundations of Financial
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figures concerning spreads.

Note that whether the new
issue is debt or common
stock, the spread declines as
a percentage of the size of
the issue, as the size of the
issue increases.
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Figure 15-2
T 15-2

Allocation of Underwriting Spread—Page 429

Foundations of Financial
Management

Price paid ($) Price received

$20.00 Managinginvestment
Managing investmentbanker
banker
$20.75 if sold to dealers
$21.50 if sold to public
$20.25 Othersyndicate
Other syndicatemembers
members

Selecteddealers
dealersgroup
group $21.25 if sold through broker
$20.75 Selected
$21.50 if sold to public

$21.25 Broker
Broker $21.50 to public

$21.50 Public
Public

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9 In Figure 15-2, The
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Foundations of Financial
Management

managing banker pays

the firm $20 and the
public ultimately pays
$21.50, making the
spread $1.50. The spread
is actually distributed as
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9 To the managing investment
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Foundations of Financial
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banker
• $1.50 if sold to the public
• $.75 if sold to dealers

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9 To other syndicate members
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Foundations of Financial
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• $1.25 if sold to the public

• $.50 if sold to other dealers

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9 To “selected dealer group”
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Foundations of Financial
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• $.50 if sold through brokers

• $.75 if sold to the public

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Foundations of Financial
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Brokers--$.25 when
sold to public

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Foundations of Financial
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Table 15-3 (no slide) shows

that when the spread plus
“out-of-pocket” costs are
considered, the total cost of
a new issue is rather high,
depending on the size of the
issue.
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Foundations of Financial
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“Out-of-pocket” costs
include such items as
legal and accounting
fees, printing expenses,
etc.
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Foundations of Financial
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Because the costs are

high, it is desirable to
get as large a new issue
as possible for most
companies that go to
market.
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Foundations of Financial
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Pricing the
Security
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9 Primary offering
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Management

• Shares are sold to the

public for the first
time.

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9 Secondary offering
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• A large block of
already trading
securities is sold at
below current prices to
the public.
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9 Underpricing
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• When a company whose stock is

already trading issues
additional shares, the
investment banker will
generally set the price at
slightly below the current
market value.
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The investment banker must

perform a market analysis and
carefully price the stock, since
they will ultimately be
responsible for selling the issue
to the public and bear the risk
that the stock does not sell.
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Dilution
Foundations of Financial
Management

Suppose Maxwell Company currently has 2,500,000

shares outstanding and earnings of $5 million.
Then, EPS before any new issue will be $2 per share.
If Maxwell issues 250,000 new shares, its EPS will
temporarily drop to about $1.82 per share.
The market anticipates this dilution, and when a
company announces that it will sell new shares, its
stock price often drops.

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Market Stabilization
Foundations of Financial
Management

The managing investment banker is

generally responsible for stabilizing the
offering during the distribution period
and may accomplish this by
repurchasing securities if the market
price moves below the initial public
offering price.

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Aftermarket
Foundations of Financial
Management

• Studies provide evidence that initial

public offerings often do well following
the public issue.
• Because managing underwriters may
underprice the issue initially to ensure
a successful offering, often the value
jumps after the issue first goes public.

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Foundations of Financial
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Changes in the Investment Banking Industry

• Investment banking is becoming nationally
oriented
• There have recently been mergers between large
commercial banks and brokerage/investment
banking firms.
• Market share and concentration of power has
increased, with the top ten investment banking
firms controlling over 65 percent of the worldwide
underwriting market.
• The top 4 investment banking firms control 40%
of the market.
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Shelf Registration
Foundations of Financial
Management

• Under SEC Rule 415, Shelf registration

permits large companies, such as Exxon or
Citigroup, to file one comprehensive
registration statement that outlines the
firm’s financing plans for up to the next
two-and-one-half years.
• This allows the company to get to the
market quickly when conditions are right,
without SEC approval.
• Future issues are sitting on the shelf.
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Foundations of Financial

Public vs. Private Companies

Management

Public company:
– when shares of a company are offered to
the public
– anyone can buy shares of the stock
Private company:
– privately owned or held by an individual
or family
– not available to the general public
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Foundations of Financial

Advantages and Disadvantages

of a Public Company
Management

Advantages of being public:

– greater availability of funds (easier to
grow and raise money)
– prestige
Disadvantages of being public:
– company information must be made
available to the public (opening the
company up to public scrutiny and
criticism)
– high costs of going public (expensive)
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Public Offerings

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Your text has

examples of two
public offerings,
EDS (Page 434) and
Internet Capital
Block
Group (Page 435).
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Foundations of Financial
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Figure 15-3, page 437, is the “tombstone”

advertisement for the Internet Capital
Group offering and depicts many of the
characteristics of the distribution process.
• Lead underwriter is Merrill Lynch & Co.
• Offering is co-managed by Goldman, Sachs & Co.
• Syndicate members are listed by size of their
position
• Number of shares to be sold are shown, as is the
offering price

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Foundations of Financial
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Foundations of Financial
Management

Initial Public
Offering and
Leveraged
Buyout
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Foundations of Financial

Initial Public Offering (IPO):

Management

• when a company sells its stock

to the public for the first time
• company becomes publicly
traded

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Leveraged Buyout (LBO):

Management

• money is borrowed to
repurchase all the shares of the
company resulting in a great
deal of debt
• when a company “goes private”

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9 Privitization
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• A previously
government-owned
company is sold to and
becomes owned by the
private sector.
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Foundations of Financial
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THE END
Block
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