In a private placement, a small number of investors purchase the entire security offering. Most private placements involve debt instruments. Large financial institutions are the major investors in private placements. These include l life insurance firms, 2 state and local retirement funds, and 3 private pension funds.
The advantages and disadvantages of private placements as opposed to public offerings must be carefully evaluated by management. The advantages include l greater speed than a public offering in actually obtaining the needed funds, 2 lower flotation costs than are associated with a public issue, and 3 increased flexibility in the financing contract.
Flotation Costs 1. The former is typically the larger. This absolute dollar difference is usually expressed as a percentage of the gross proceeds. Many components comprise issue costs. The two most significant are l printing and engraving and 2 legal fees. SEC data reveal two relationships about flotation costs. Issue costs as a percentage of gross proceeds for common stock exceed those of preferred stock, which in turn exceed those of bonds.
Total flotation costs per dollar raised decrease as the dollar size of the security issue increases. The short name for the act became the Sarbanes-Oxley Act of The Sarbanes-Oxley Act was passed as the result of a large series of corporate indiscretions. The act holds corporate advisors e. Rates of Return in the Financial Markets A. Rates of Return Over Long Periods Although interest rates are presently at historically low levels and stock prices have been extremely volatile since , the following relationships have been observed over the longer run 88 years from to : 1.
The default-risk premium for long-term corporate bonds over long-term government bonds has between about 0. Large common stocks earned 4. Interest Rate Levels in Recent Periods 1. The nominal or quoted rate of interest is the interest rate paid on debt securities without an adjustment for inflation. An inflation premium is the additional return required by investors to compensate for inflation expected to occur over the life of the investment.
The default-risk premium is the additional return required by investors to compensate for the risk of default. The maturity-risk premium is another factor that affects interest rate levels and arises even if a security possesses equal odds of default. It is the additional return required by investors in longer-term securities to compensate for a greater risk of price fluctuations on these securities due to changes in interest rates.
The liquidity-risk premium also determines interest rate levels. It is the additional return required by investors for securities that cannot be converted into cash quickly without a substantial loss in value. Interest Rate Determinants in a Nutshell A. The interest rate on a security is equal to the real risk-free interest rate plus compensation for taking on different types of risk measured by risk premiums.
The real risk-free interest rate is the required rate of return on a fixed-income security that has no risk in an economic environment of zero inflation. It is one component of the nominal interest rate. Thus, the real interest rate is an inflation-adjusted risk-free interest rate. Real and Nominal Rates of Interest 1. The real rate of interest is the difference in the nominal rate and the anticipated rate of inflation. It tells you how much more purchasing power you have.
Practicing analysts and executives employ an approximation method to estimate the real rate of interest over a selected past time frame. The Term Structure of Interest Rates 1. Shifts in the Term Structure of Interest Rates 1. The term structure of interest rates changes over time, depending on the environment.
The particular term structure observed today may be quite different from the term structure one month ago and different still from the term structure one month from now. The term structure reflects observed rates or yields on similar securities, except for the length of time until maturity, at a particular moment in time.
What Explains the Shape of the Term Structure? Three theories are commonly used to explain the term structure of interest rates.
The liquidity preference theory proposes that investors require liquidity premiums additional returns to compensate them for buying securities that expose them to a greater risk of changes in market value due to fluctuating interest rates. The market segmentation theory proposes that legal restrictions and personal preferences limit investment choices to certain ranges of maturities.
Thus, the interest rate observed is determined solely by supply and demand conditions for securities of a given maturity. The money market consists of all institutions and procedures that accomplish transactions in short-term debt instruments those claims with maturities up to one year that are issued by borrowers with typically high credit ratings.
Examples of securities traded in the money market include U. Notice that all of these are debt instruments. Equities are not traded in the money market. The money market is entirely an over-the-counter market. On the other hand, the capital market provides for transactions in long-term financial claims those claims with maturity periods extending beyond one year. The capital market includes both debt and equity securities. Trades in the capital market can take place on organized exchanges or over-the-counter.
Organized stock exchanges provide for the following: 1 A continuous market. This means a series of continuous security prices is generated. Price changes between trades are dampened, reducing price volatility, and enhancing the liquidity of securities.
Prices on an organized exchange are determined in the manner of an auction. Moreover, the prices are published in widely available media, like newspapers. The continuous pricing mechanism provided by the exchanges facilitates the determination of offering prices in new flotations. The initial buyer of the new issue has a ready market in which he can sell the security should he need liquidity rather than a financial asset.
Because most NYSE stocks trades take place electronically rather than on the floor of the exchange, the difference between an organized exchange and the over-the counter market has lost much of its meaning. The statement is correct. However, Listing requirements e. Most bonds are traded among very large financial institutions.
Life insurance companies and pension funds are typical examples. These institutions deal in large quantities blocks of securities. An over-the-counter bond dealer can easily bring together a few buyers and sellers of these large quantities of bonds.
By comparison, common stocks are owned by millions of investors. The investment banker is a middleman involved in the channeling of savings into long- term investment. He performs the functions of 1 underwriting, 2 distributing, and 3 advising. By assuming underwriting risk, the investment banker and his syndicate purchase the securities from the issuer and hope to sell them at a higher price.
Distributing the securities means getting those financial claims into the hands of the ultimate investor. In a negotiated purchase, the corporate security issuer and the managing investment banker negotiate the price that the investment banker will pay the issuer for the new offering of securities. In a competitive-bid situation, the price paid to the corporate security issuer is determined by competitive sealed bids, which are submitted by several investment banking syndicates, each hoping to win the right to underwrite the offering.
Investment banking syndicates are established for three key reasons: 1 the investment bank that originates the business probably cannot afford to purchase the entire new issue itself; 2 the risk of loss is spread among several underwriters; and 3 the distribution network is widened. Several positive benefits are associated with private placements. The first is speed. Funds can be obtained quickly, primarily due to the absence of a required registration with the SEC.
Second, flotation costs are lower compared to public offerings of the same dollar size. Third, greater financing flexibility is associated with the private placement. All of the funds, for example, need not be borrowed at once. They can be taken down over time.
Also, elements of the debt contract can be renegotiated during the life of the loan. As a percentage of gross proceeds, flotation costs are inversely related to the dollar size of the new issue. In addition, common stock is more expensive to issue than preferred stock, which is more expensive to issue than debt. First, savings may be directly transferred from the investor to the borrower. Second, an indirect transfer might use the services provided by an investment banker.
Third, an indirect transfer might use the services of a financial intermediary, such as private pension funds and life insurance companies. As a net user of funds, a firm must raise funds in the financial markets, either in the form of debt or of equity. We should never base our decisions on past or historical costs, even when they represent the actual out-of-pocket costs to the firm. Historically, returns of different types of securities have followed the risk-return relationship that securities with higher levels of risk produce: higher returns.
Short-term treasury bills typically have the lowest risk and lowest return, while bonds, on average, have an intermediate level of risk and an intermediate rate of return. Common stocks, on average, have higher levels of risk and higher rates of return.
For the relationship to be meaningful, all factors other than maturity, such as the chance of the bond defaulting, must be held constant. The chapter gives three theories for explaining the term structure of interest rates: 1 the unbiased expectations theory, 2 the liquidity preference theory, and 3 the market segmentation theory. If interest rates are expected to be higher in the future, securities with longer maturities will carry a higher interest rate and vice versa. Looking at the current term structure of interest rates, we can estimate what investors should expect future interest rates to be.
For instance, if we know the current interest rates for securities maturing in one and two years, we can estimate what rate investors expect on a similar security issued one year from now with a one-year maturity date. For example, commercial banks prefer short- to medium-term maturities as a result of their short-term deposit liabilities.
They simply do not like to invest in long-term securities. Life insurance companies, on the other hand, have longer-term liabilities, so they prefer longer maturities when they invest. The market segmentation theory implies that the rate of interest for a particular maturity is determined solely by demand and supply conditions for a given maturity and is independent of the demand and supply conditions for securities having different maturities.
The difference between the nominal yield and the inflation rate indicates the inferred real interest rate, which can serve as an approximation of the increase in real purchasing power over the study period.
Those calculations are shown below. Ignoring the cross-product involves using the simple arithmetic calculation for the real rate of interest, rather than the geometric calculation for the real rate of interest. In this problem, we are implicitly assuming the same inflation premium for each bond and that there are no tax differences between the bonds.
Thus, you would invest in the one-year security paying 6 percent only if you believed you could earn at least 10 percent in the second year on a security issued at the beginning of the second year. The forgoing logic is based on the unbiased expectations theory of term structure of interest rates. If you require an 11 percent rate on the second one-year investment, then the unbiased expectations theory is not fully explaining the term structure of interest rates.
The unbiased expectations theory suggests you should accept 10 percent in year two. Thus, you are requiring a liquidity premium on the second-year investment to compensate for the uncertainty of the future interest rates in year two. Unbiased expectation theory: — This theory proposes that the slope of the yield curve is based solely on expected future rates. The rise in the yield curve over the next five years is based on expectations by investors that prevailing interest rates in the market will rise.
Liquidity preference theory: — This theory proposes that investors have a preference toward more liquid investments. Lenders prefer shorter-term investments so that they do not suffer large capital losses on their investments if interest rates increase. Thus, we cannot say what the shape of the yield curve means.
Due to the liquidity premium, an upward-sloping yield curve is consistent with expectations for rising, falling, or unchanged future short-term rates. If you invest the money for two years at 3. Because 3. Information is given for the Mini Case.
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