Securities and Markets

The objective of financial decision, whether it is a financing or

investment decisions, should be to maximize owners wealth.
If a firm needs funds,
should it issue stock or borrow?
If it issue new stock, will present investors lose?
If it borrows, what interest rate will its lenders require?
How should the loan be paid off?
If a firm has fund to invest
Invest in what kind of financial instruments?
What characteristic must the investment vehicle have?
What types of risk they must take on with their investment?
 Securities and Markets
The financial manager must understand the wide range of
securities available and the markets in which they are bought
and sold.
This chapter provides an overview of both.
 Securities
Security is a document that gives the owner a claim on future
cash flows. A security may represent an ownership claim on
an asset (such as a share of stock) or a claim on the repayment of
borrowed funds, with interest (such as bond).
The document may be a piece of paper (such as a stock certificate
or bond).
A Securities market is an arrangement for buying and selling
securities. It may be a physical location or simply a computer
or telephone network
 Securities
Securities are classified into three groups
1. Money market securities
2. Capital Market securities
3. Derivative securities
Based on their maturity and the source of their value.
The word maturity is the length of time before the
repayment of a debt. The maturity date of a security is
the pre set date on which the amount borrowed (called the
face value, the par value, the principal or the maturity value) is
repaid. The original maturity is the time between the
date a security is issued and its maturity date.
 1. Money Market Securities
Money market securities are short term indebtedness.
Original maturity of one year or less.
The most common money market securities are treasury bills,
commercial paper, negotiable certificate of deposits, and
bankers acceptance
Treasury bills (T-bills)
Short term securities issued by the U.S government.
The have original maturities of either four weeks, three months or six
months.
Carry no stated interest rate.
Sold on a discounted basis.
 1. Money Market Securities
Commercial Paper
A promissory note, a written promise to pay.
Issue by a large, credit worthy corporations.
Original maturities ranging from one day to 270 days and usually trade
in units of $100,000.
Most commercial paper is backed by bank lines of credit.
Commercial paper may be either interest-bearing or sold on a
discounted basis.
 1. Money Market Securities
Certificates of deposit (CD)
A written promise by a bank to pay a depositor.
Nowadays Original maturities from six months to three years.
Negotiable Certificates of deposit
Issued by large commercial banks that can be bought and sold among
investors.
Have original maturities between one month and one year and are
sold in denominations of $100,000 or more.
Sold to investors at their face value and carry a fixed interest rate.
The investor is repaid the amount borrowed plus interest.
 1. Money Market Securities
Bankers acceptances
Short term loans.
Usually to importers and exportes, made by bank to finance specific
transactions.
Draft (Promise to pay) Is written by a banks customer and the bank
accepts it, promising to pay.
The bankers acceptance of the draft is a promise to pay the face
amount of the draft to whomever represents for payment. The banks
customer then uses the draft to finance a transaction, giving this draft
to her supplier in exchange for goods.
Maturities have less than 180 days.
With money market securities there is no collateral.
 2. Capital Market Securities
Capital Market Securities are long term securities issued by
corporations and government.
Securities with maturities greater than 1 year and perpetual
securities (those with no maturity).
There are two types of capital market securities.
1. Equity
2. Indebtedness
 Equity
The equity of a corporation is referred to as stock;
ownership of stock is representing by shares. Investors who
own stock are referred to as shareholders.
Every corporation has common stock, and some corporations
have another type of stock, preferred stock as well.
Common Stock
The most basic ownership interest in corporation.
common shareholders are the residual owners of the firm.
Common stock is a perpetual security; it has no maturity.
Common stock holders may receive cash payment (Dividend).
They may also receive a return on their investment in the form of
increased value of their stock as the corporation prospers and grows.
 Equity
Preferred Stock
Receive fixed dividend that never changes.
Preferred stock price relatively stable.
Preffered stock do not usually vote.
Preferred stock holders hold a claim on assets that has priority over
the claims of common shareholders but after that of creditors such as
bond holders.
 Indebtedness
Debt securities include
a. Bonds
b. Notes
Note is a debt security with a maturity at issuance of 10
years or less.
Bond is a debt security with a maturity greater than 10
years.
Coupon bond: A debt security may provide a promise to
pay the investor a periodic interest.
Zero coupon bond: A debt security that does not include
a promise to pay interest.
 Indebtedness
A capital market debt obligation is a financial instrument
whereby the borrower promises to repay the face amount of
the obligation by the maturity date, in most cases, to make
periodic interest payments to the holder of the debt
obligation.
These debt obligation can be broken into two categories: bank loans
and debt securities.
Syndicated bank loans is a loan in which group of banks provides funds
to the borrower.
The need for a group of banks arises because the amount sought by a
borrower may be too large for any one bank to be exposed to the
credit risk of that borrower.
 Indebtedness
Bonds and notes are issued by corporations, government, and municipal
government.
Corporate debt securities backed by a specific assets as collateral are
referred to as secured notes.
If they are not backed by specific assets, they are referred to as
debentures.
Collateral therefore reduces the securitys riskiness and the level of return.
Bonds issued by state and local government are called municipal bonds.
They are either general obligation bonds which are backed by the general
taxing power of the issuing government.
Or revenue bonds which are issued to finance a specific project.
 Securities Markets
The primary function of a securities market whether or not it
has a physical location is to bring together buyers and sellers
of securities.

Securities markets can be classified by whether they are

involved in original sales or resale's of securities, and by

Whether or not they involve a physical trading location.

 Primary Market
When securities is first issued, it is sold in the primary market.
This is the market in which new issues are sold and new capital is
raised.
It is the market whose sales directly benefit the issuer of the securities.
There are three ways to raise the capital in primary market.
1. Direct sale; in which the purchases stock directly from the issuer.
Many venture capital firms invest in small, growing business in this
way.
Many corporations sell securities directly to large investors, such as
pension funds.
The issuer can tailor the features of the security (such as maturity) to
suit the desires of the organization.
This type of selling is referred to as private placement.
 Primary Market
2. Through Financial institutions.
Which are firms that obtain money from investors in return
for the institutions securities and then invest that money. For
example, a bank issues bank accounts in return for their
depositors and then loans that money to a firm.
Beside banks, firms such as mutual funds and pension funds
operate as financial institutions.
 Primary Market
3. Investment Bankers.
Third method for primary market transactions operates
through investment bankers, who buy the securities issued
by corporations and then sell those securities to investors for
a higher price.
This process of buying shares from the issuer and reselling
them to investors is called underwriting.
Investment Banks in Pakistan.
JS Investment Bank Limited
IGI Investment Bank Limited
First Dawood Investment Bank Limited
 Secondary Market
A secondary market is one in which securities are resold
among investors.
No new capital is raised and the issuer of the security does
not benefit directly from the sale.
Trading taking place among investors.
Investors who buy and sell securities on the secondary
markets may obtain the services of stock brokers, individuals
who buy or sell securities for their clients.
 Secondary Market
If a firm can raise new funds only through the primary market,
why should financial managers be concerned about the
secondary market on which the firms securities trade?
 Secondary Market
Because investors may not be interested in buying securities
that are not liquid, that they could not sell at a fair price at
any time. The secondary markets provide the liquidity.
For example, suppose XYZ company wants to issue new
common shares to pay for its expansion program; investors
would not be willing to buy such shares if they could not
expect to sell them on the secondary market.
 Exchanges and over the counter
Markets
There are two types of secondary securities markets;
1. Exchanges
2. Over-the-Counter Markets.
Stock Exchanges are formal organizations, approved and
regulated by the securities and exchange commission (SEC).
They are made of members who use the exchange system
and facilities to exchange or trade listed stocks.
These exchange are physical locations where members
assemble to trade.
Stocks that are traded on an exchange are said to be listed
stocks
 Stock Exchanges
To be listed, a company must apply and satisfy requirements
established by the exchange for minimum capitalization,
shareholder equity and other criteria. Even after being listed,
exchanges may delist a companys stock if it no longer meets
exchange requirements.
Role & Function of Stock Exchange
Established for the purpose of assisting, regulating and
controlling business of buying, selling and dealing in
securities
Provides a market for the trading of securities to individuals
and organizations seeking to invest their saving or excess
funds through the purchase of securities
Provides a physical location for buying and selling securities
that have been listed for trading on that exchange.
Establishes rules for fair trading practices and regulates the
trading activities of its members according to those rules
 Stock Exchanges
The exchange itself does not buy or sell the
securities, nor does it set prices for them.
 Market Trend
Bull Market.
The term Bull Market indicates the upward market
trend.
A bull market is associated with increasing investor
confidence, and increased investing in anticipation
of future price increases (capital gains).

Bear Market.
A bear market is a general decline in the stock
market over a period of time
 Pricing System
Pure Auction Process.
dealer Market.
 Stock Exchange in Pakistan
Karachi Stock Exchange.
1. KSE 100 Index
2. KSE-30 Index

Lahore Stock Exchange.

1. LSE 25 Index

Islamabad Stock Exchange.

1. ISE 10 Index
KSE Market Performance
KSE 100 Index
 Share holders Pay Off
Possible income:
dividends: payments made periodically, usually every
quarter, to stockholders. Shareholders are eligible for
dividends, but no guarantee.
capital gain: can sell stocks to earn price appreciation but
may also incur loss from price decline.

limited liability.
 Computing the Price of Common
Stock
The principle of finance is that the value of any
investment is found by computing the value today of
all cash flows the investment will generate over its
life.
Similarly, we value common stock as the value in
todays dollars of all future cash flows.
The cash flows a stockholder may earn from stock
are dividends, the sales price or both.
The One Period Valuation Model
Suppose that you have some extra money to invest
for one year. After a year you will need to sell your
investment. After watching the stock exchange on
TV you decide that you want to buy XYZ stock. You
call your broker and find that XYZ is currently selling
for $50 per share and pays $0.16 per year in
dividends. The analyst on Stock Exchange predicts
that the stock will be selling for $60 in one year.
Should you buy this stock?
The One Period Valuation Model
To answer this question you need to determine
whether the current price accurately reflects the
analysts forecast. To value the stock today, you
need to find the present discounted value of the
expected cash flows (future payments) using the
formula.
 The One Period Valuation Model

Current stock price = PV of all future cash flows

For a one-period stock, current price should be:

Div1 P1
P0
(1 ke ) (1 ke )
P0 = the current price of the stock
Div1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period
The One Period Valuation Model

P0 = 0.143.5 + 53.57 = 53.71

Based on your analysis, you find that the stock is

worth $53.71. Since the stock is currently available
for $ 50 per share, you would choose to buy it. Why
is the stock selling for less than $ 53.71?
The One Period Valuation Model

It may be because other investors place a different

risk on the cash flows or estimate the cash flows to
be less than you do.
 The One Period Valuation Model
People use expected return rates in the previous
formula to evaluate stocks.
The expected return rate of a stock should be
proportional to the risk associated with the stock.
Different people may have different expectation
because they have different taste for risk or they
have different information.
Since a stock is more risky than a bond, people
require a higher return than that offered in the bond
market.
 Generalized dividend valuation
model
for a n-period stock, current price should
be
D1 D2 Dn Pn
P0
(1 ke ) (1 ke )
1 2
(1 ke ) n
(1 ke ) n

Dt
P0
t 1 (1 k e ) t
 Gordon Growth Model
Assume dividend growth is a constant, denote
as g
D0 (1 g )1 D0 (1 g ) 2 D0 (1 g )
P0
(1 ke )1
(1 ke ) 2
(1 ke )

Assume the growth rate g is less than the

required return on equity Ke
D0 (1 g ) D1
P0
( ke g ) ( ke g )
 Growth Phases Model

The growth phases model assumes that

dividends for each share will grow at two or
more different growth rates.

n D0(1+g1)t Dn(1+g2)t
V =S + S t
t=1 (1 + ke)t t=n+1
(1 + ke)
 Exercise
Q #1
LaserAcer is selling at $22.00 per share. The most
recent annual dividend paid was $.80. using the
Gordon Growth model, if the market requires a
return of 11%, what is the expected dividend growth
rate for LaserAcer?

Answer : g = 7.1%
 Exercise
Q#2
Huskie Motors just paid an annual dividend of
$1.00 per share. Management has promised
shareholders to increase dividends a constant rate
of 5%. If the required return is 12%, what is the
current price per share?

Answer: P0 = 15
 Exercise
Q#3
Suppose Microsoft, Inc. is trading at $27.29 per
share. It pays an annual dividend of $0.32 per share,
which is double its last years dividend of $0.16 per
share. If this trend is expected to continue, what is
the required return on Microsoft?

Answer: ke = 102%
 Exercise
Q#4
Gordon & Cos stock has just paid its annual
dividend $1.10 per share. Analysts believe that
Gordon will maintain its historic dividend growth
rate of 3%. If the required return is 8%, what is the
expected price of the stock next year?

Answer: P1 = 23.34
 Exercise
Q#5
Macro systems just paid an annual dividend of $0.32
per share. Its dividend is expected to double for the
next four years (D1 through D4), after which it will
grow at a more modest pace of 1% per year. If the
required return is 13%, what is the current price?

Answer: P0 = 32.91
 Exercise
Q#6
Analysts are projecting that CB Railway will have
earnings per share $3.90. if the average industry
ratio is about 25, what is the current price of CB
Railways?

Answer: P0 = 97.50
 Exercise
Q# 7
Suppose Microsoft, Inc. reported earnings per share
around $0.75. If Microsoft is in an industry with a
ratio ranging from 30 to 40, what is a reasonable
price range for Microsoft?

Answer: 22.50 to & 30.00

 Exercise
Q#8
Compute the price of a share of stock that pays a $1
per year dividend and that you expect to be able to
sell in one year for $20, assuming you require a 15%
return.

Answer: 18.26
 Exercise
Q#9
Ebay, Inc. went public in September of 1998. the following
information on share outstanding was listed in the final
prospectus filed with the SEC.
In the IPO, the Ebay issued 3,500,000 new shares. The initial
price to the public was $18.00 per share. The final first-day
closing price was $44.88.
If the investment bankers retained $1.26 per share fees,
what was the net proceeds to Ebay?. What was the market
capitalization of new shares of Ebay?
Answer : $58,590,000.00, 157,080,000.00
 Exercise
Q # 10
Suppose soft people Inc, is selling at $19.00 and
currently pays an annual dividend of $0.65 per
share. Analysts project that the stock will be priced
around $23.00 in one year. What is the expected
rate ofreturn?

Answer: 24.47