Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

1 What are financial intermediaries, and what role do these firms play in providing long-term capital

to publicly traded corporations?

CONCEPT REVIEW QUESTIONS 12-1

12-2 INVESTMENT BANKING AND THE

PUBLIC SALE OF SECURITIES

Although corporations around the world rely on internal financing for most of their funding, companies

also raise large amounts of capital externally each year. Once corporate managers have decided to raise

external capital and to raise equity rather than debt, they usually enlist an investment bank to help sell the

firm’s securities. Issuing firm managers can either negotiate privately with individual banks regarding

the terms of the equity sale, or they can solicit competitive bids for the business. On behalf of firms,

investment banks can issue shares to a small group of sophisticated investors in a private placement,

they can issue new shares to existing shareholders through a rights offering or they can engage in a much

broader public share offering that reaches domestic as well as international investors.

The investment banks that are ranked highest each year in terms of the total amount of money raised

typically include the same group of firms. Among them are Bank of America Merrill Lynch, J. P. Morgan,

Barclays Capital, Citigroup, Deutsche Bank, Goldman Sachs, Morgan Stanley, Credit Suisse and UBS.

These firms are perennial members of investment banking’s prestigious bulge bracket, firms that generally

occupy the lead or co-lead manager’s position in large, new security offerings, meaning that they take

primary responsibility for the new offering (even though other banks participate as part of a syndicate).

As a result, they earn higher fees. Investment banks are compensated with an underwriting spread, the

difference between the price at which the banks sell shares to investors and the price at which they

purchase shares from firms. You can readily identify the lead investment bank in a security offering

by looking at the offering prospectus, the legal document that describes the terms of the offering. The

lead bank’s name appears on the front page, usually in larger, bolder print than the names of other

participating banks.

example

Figure 12.4 presents the prospectus title page for the

March 2010 initial public share offering by Financial

Engines, Inc., a leading US provider of independent,

technology-enabled portfolio management

services, investment advice and retirement help

to participants in employer-sponsored defined

contribution retirement plans. The lead underwriters

were Goldman Sachs and UBS Investment Bank.

Both firms are perennial members of investment

banking’s bulge bracket. Piper Jaffray and Cowen

and Company are also important underwriters for this

offering, though these companies are not routinely

members of investment banking’s bulge bracket. The

title page also shows an underwriting discount of

$0.84 per share and an offer price of US$12.00 per

share, for a percentage discount of 7.00% (US$0.84 ÷

US$12.00). The underwriters thus stood to receive

total compensation of US$8,904,000 for their efforts

in this underwriting. This represented a fairly normal

underwriting discount for an offering of this size.

LO 12.3

investment bank
A bank that helps firms
acquire external capital. In the
UK these are also known as
merchant banks

bulge bracket
Consists of firms that
generally occupy the lead or
co-lead manager’s position in
large, new security offerings

underwriting spread
The difference between the
price at which an investment
bank sells shares to investors
and the price at which the
bank purchases shares from
the issuing firm

prospectus
The principal disclosure
document for public security
offerings; it is distributed to
all prospective investors