Capital Mobilization and Capital Asset Pricing Model - Term Paper Example

CAPITAL MOBILIZATION AND CAPITAL ASSET PRICING MODEL Capital Mobilization by Large Companies from Equity and Bond Markets: In case of large companies, raising capital from the equity and bond markets requires two stages of decision making. At stage 1, the firm has to take certain preliminary decisions such as quantum of money to be raised, type of securities, type of bid; competitive or negotiated and appointment of an appropriate investment banker. At stage 2, the firm and the merchant banker would reevaluate the firm’s decisions and terms of working for the investment banker and set the price. Stage 1 decisions determine the direction of fund raising, which gets ratified and implemented in stage 2. The firm has to decide whether to raise funds through common stock, preferred stock, bonds or hybrid securities or a combination. In the case of common stock, the firm has to decide whether it should it be rights issue or public issue. The company can put on offer its block of securities for sale to the highest bidder or negotiate a deal with the investment banker. Since in the latter, the investment bankers should carry out a substantial investigation, they would do it for best known companies. Otherwise, the prohibitive costs and uncertainty of clinching the deal would make the bidding for lesser known companies unattractive for the investment bankers. Therefore, only the very large companies, about 100 of the largest companies in New York stock exchange have a choice of seeking competitive bidding for their offering. Others have only an option of negotiated deal with an investment banker. In case of a negotiated deal, the firm has to select an investment banker. Most of the investment banks operate in niches. For instance, older and larger veteran merchant bankers such as Morgan Stanley deal mainly with IBM, AT&T and Exxon and such and Drexel Burnham Lambert deals with speculative issues. Some investment bankers have penchant for new issues, while some others with a conservative brokerage client base would not take up speculative and risky issues. In Stage 2, the firm’s initial decisions will be revisited by the merchant banker. For instance, the merchant banker, after studying the environmental trends, may recommend and convince the management to change their earlier plan of raising $200 million by selling common stock to raising $100 million by common stock and the rest by the issue of bonds. In this stage, the firm and investment banker will come to a conclusion as to whether the banker will work on the best efforts basis or will underwrite the issue. In the best efforts basis, the banker does not assume responsibility for the success of the issue. On the other hand, if the issue is underwritten by the investment banker, the banker will assume the risk and the responsibility for the success of the issue. For instance, in 1979, on IBM’s $1 billion sale of bond the interest rates rose sharply resulting in the fall of bond prices (Brigham & Gapenski, 1988). This inflicted a loss of $10 to $20 billion to the merchant bankers. If the bankers had concluded the deal on the best efforts basis, IBM would have lost that money instead of the investment banker. The investment banker’s fee and other expenses are also arrived at. The other expenses include the lawyer’s fee, accountant’s fee, printing and engraving fee etc. Often the merchant bankers seek a part of compensation as option to buy stock from the firm. For instance in the 1987 issue of 1 million Glasgow Technologies Inc. shares at a price of $10 per share, the investment bankers not only bought 1000000 company shares at $9.75, but were also offered 5 year option to buy 200000 company shares at $9.75. Therefore, the direct underwriting fee was only $250000, but the 5 year option would amount to additional underwriting fee, if the share price moved up in the stock market (Brigham & Gapenski, 1988). The issue’s offer price is also set at this stage. If the issuer is already a company with its common stock traded, the offer price will depend on the prevailing price in the market in case of shares and prevailing yield for bonds. Typically, in case of common stock, it is bought at predetermined points below the closing price on last day of registration. The price setting is often the bone of contention between the firm and its investment banker. While the investment bankers want the issue price to be as low as possible, the firm wants it to be as high as possible. Pricing low will reduce the risk of the underwriting investment banker but also reduces the money raised to the issuer firm. Normally, the stock market treats the fresh issue of common share by an existing listed company as bad news. This will have the effect of depressing the market price of the stock. The success of the issue depends on the investor’s perception of the firm’s plan to deploy the money raised and the efficacy of the brokers in marketing the issue. After the firm and its investment bankers decide on the amount of money to be raised, the type of securities to be issued and also arrive at the basis of pricing, they have to prepare and file an SEC registration statement and a “red herring” prospectus containing all the key information that will appear in the final prospectus except the price. The price however is generally set after the market closes the day before the new securities are actually offered to the public. SEC would normally take 20 days to approve the issue. The final price of the stock or the interest rate of bond is defined at the end of business on the day, SEC clears the issue. The securities are offered to the public the next day. In case of Initial Public Offering, the firm’s executives and the underwriting team will undertake a road show in all the financial centers explaining the potential investors about the purpose of the issue and the brighter prospects for the company. During these road shows, the team will not only feel the investor’s pulse but also have quantified assessment of the reception to the issue. As the offering date closes in, the underwriter crystallizes his idea of how many shares can be sold at different prices. This will enable him to set the highest price that can make the issue sail through. The day before the sale will actually take place, the number of shares offered and the price will be finalized and agreed to by the issuer and investment banker. While there is no need for the investors to pay for the stock until ten days after they place their buy orders, the investment bankers necessarily pay the issuing firm within four days of the opening of the offer. Generally, the bankers sell the stock within a day or two after the offering begins. Sometimes, they do not assess the market properly and set unrealistic offer price and fail to move the issue. There are also instances, when the market declined during the offer period compelling the investment bankers to slash the offer price. In both the cases, the underwriter must absorb losses, while the firm receives the price agreed upon. Most underwritten stock offerings include a Green Shoe provision. This Provision allows the issuance of additional shares in the event of buoyant demand from the investors (Financial Times Lexicon). This provision confers the investment bankers the right to purchase more stock than the planned offerings to an agreed extent. The purpose of a Green Shoe is to reduce the underwriter’s risk. With this provision in place, an investment banker has committed to the company to sell say 100,000 shares can have its sales reps promise their customers 120000 shares. Then if 20% of the customers back out of the deal, the banker will still sell the required 100000 shares. Sans this provision, the bankers would be exposed to more risk and consequently would have to charge higher underwriting fees. In view of the high risk inherent in the purchase and distribution of an issue, the merchant bankers do not generally handle it singlehandedly except for very small issues. They normally form underwriting syndicates to spread the risk among themselves. These syndicates are led by the banking house which sets up the deal, which is called the lead, or managing, underwriter. Larger offerings would need more investment bankers to be added in the sales team to give traction to the sales and distribution of securities to the individual investors. Thus the underwriters perform as wholesalers, with other members of the selling team as retailers. The number of houses in a selling team depends partly on the size of the issue. The selling is depicted in the figure-1 The selling procedures, which includes the20-day minimum waiting period between registration with the SEC and sale are to be adhered to in the sale of most securities. But, deviation is allowed for large, well-known public enterprises that issue securities frequently. Such firms can file a master registration statement with the SEC and then update it with a short-form statement just before each issue. Individual offering. In such a case, a company that decided at 10 a.m. to sell registered securities could have the sale completed before noon. This procedure is known as shelf registration, because in effect the company puts its new securities ‘on the shelf’ and then sells them to investors when it feels the market is ‘right”. Source: http://thismatter.com/money/stocks/investment-banking.htm Figure 1: The Selling of the Issue Relevance of CAPM for Cost of Capital Evaluation The Capital Asset Pricing Model is a model for analyzing the relationship between risk and rate of return. This model incorporates the fact that a stock held in isolation is more risky than a stock held in isolation. The cost of capital in the CAPM equals the risk free rate plus a risk premium. The CAPM states that the only appropriate measure of risk for security is its beta. The risk premium of the investment is the product of multiplication of beta factor times the excess return of the market over the risk free rate as shown in equation (1). A key input for the CAPM is the excess return of the market over the risk free rate, which is the market (equity) risk premium. The practice adopted commonly has been to apply the historical average return over a long period as a measure of what investors expect to earn. As a substitute for the market portfolio, a broad equity market index is applied. The cost of capital can be calculated as per Capital Asset Pricing Model (CAPM) as follows (3): Ke=Rf+i(Rm-Rf) (1) Where: Ke is the cost of equity capital Rf is the risk free rate of return usually measured by the rate of return on US treasury securities. Rm is the market return of a diversified portfolio I is the Beta co-efficient of the firm’s portfolio. The beta coefficient shows the volatility of the stock relative to that of an average stock. If it is 0.5, it is half as volatile as the market and hence less risky. If it is 2.0, it is twice as volatile as the market and hence more risky. Market risk premium is the additional return over the risk-free rate required to compensate investors for assuming an “average” amount of risk. Average risk meansI is 1.0. Financial services companies like Merrill Lynch regularly publish a forecast based on DCF methodology for the expected rate of return on the market. One can subtract the current T-bond rate from such a market forecast to obtain an estimate of the current market risk premium ((Brigham & Gapenski, 1988). For example, the Equity Cost of Capital for Microsoft: Beta = 1.49 Rf = 4.87% (20 year treasury bond) (Rm –Rf) = 7.95% E( R ) = Rf+ E*(Rm-Rf) = 4.87% + 1.49*(7.95%) =16.7% Source: Cost of Capital, Class #13 The Capital Asset Pricing Model has certain assumptions which are not practical. CAPM demands specification of ex ante data, while only ex post or past data is available. Therefore Beta calculated on past data indicates the volatility of the scrip in the past but not in the future. Though CAPM is a remarkable model but it does suffer from deficiencies and has been the focus of controversy. Banz in 1981 challenged the relevance of CAPM with empirical evidence showing stocks of smaller firms earning a higher return than forecast by the CAPM. This however was glossed over by the academia, which opined that CAPM was only an abstraction from reality and it was too much to expect it to be exact all the time. Since in the total market capitalization, small firms comprise less than 5%, Banz’s views were not considered economically significant. The Fama and French in 1992 later challenged CAPM on the basis of a study which found no systematic relation between return and risk as measured by beta. Lack of empirical support for the CAPM was emphasized in the words of Campbell, Lo, and MacKinlay "There is some statistical evidence against the CAPM in the past 30 years of US stock-market data. Despite this evidence, the CAPM remains a widely used tool in finance." (Jagannathan & Meier, 2002). Unfazed by controversy, CAPM continues to be an important tool for evaluation of the cost of capital. A recent study states that three out of four CFOs use the CAPM as the primary tool to assess cost of capital. References Brigham, Eugene F & Gapenski, Louis C, (1988). Financial Management, Theory and Practice, fifth edition, The Dryden Press. Cost of Capital, Class #13 http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-535Business-Analysis-Using-Financial-StatementsSpring2003/6158982A-5B15-421A-B01C-61BBE868C5A5/0/class13.pdf Financial Times Lexicon, http://lexicon.ft.com/term.asp?t=greenshoe-option Jagannathan, Ravi & Meier, Iwan (2002), Do We Need CAPM for Capital Budgeting ? , Financial Management (Financial Management Association), winter 2002 This Matter.com, http://thismatter.com/money/stocks/investment-banking.htm, Read More