Capital Markets PDF

I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 2 Basic Types...

I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 2 Basic Types of Market Procedures: 1. Physical Location Stock Exchanges - Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities. - Physical location exchanges are tangible entities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body – its board of governors. 2. Over-The-Counter (OTC) - A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities. - Although the stocks of most large companies trade on the NYSE, a larger number of stocks trade o_ the exchange in what was traditionally referred to as the over- the-counter (OTC) market. Dealer Markets – A dealer market includes all facilities needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of: 1. The relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities; 2. The thousands of brokers who act as agents in bringing the dealers together with investors; and 3. The computers, terminals, and electronic networks that provide a communication link between dealers and brokers. B. Equity Valuation The main purpose equity valuation is to estimate the value of a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day. There are a number of di_erent methods of valuing a company with one of the primary ways being the comparable (or comparables) approach. Comparables Approach. A company’s equity value should bear some resemblance to other equities in a similar class. This entails comparing a company’s equity to competitors or other firms in the same sector.  Discounted Cash Flow. A company’s equity value is determined by the future cash flow projections using net present value. This approach is most useful if the company has strong data to support future operating forecasts. Precedent Transactions. A company’s equity depends on historical prices for completed M&A transactions involving similar companies. This approach is only relevant if similar entities have been recently valued and/or sold. Asset-Based Valuation. A company’s equity value is determined based on the fair market value of net assets owned by the company. This method is most often used for entities with a going concern, as this approach emphasizes outstanding liabilities determining net asset value. Book-Value Approach. A company’s equity value is determined based on its previous acquisition cost. This method is only relevant for companies with minimal growth that might have undergone a recent acquisition. C. Capital Structure The term capital refers to investor-supplied funds—debt, preferred stock, common stock, and retained earnings. Accounts payable and accruals are not included in our definition of capital because they are not provided by investors—they come from suppliers, workers, and taxing authorities as a result of normal operations, not as investments by investors. A firm’s capital structure is typically defined as the percentage of each type of investor- supplied capital, with the total being 100%. The optimal capital structure is the mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic value. The capital structure that maximizes the intrinsic value also minimizes the weighted average cost of capital (WACC).