Financial Markets in Their Seminal 1989 Work, Essay

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Financial Markets

In their seminal 1989 work, Kopcke and Rosengren posed the question "are the distinctions between debt and equity disappearing?" They noted several challenges to the historical distinction between the two, including new instruments that combined elements of each (e.g. preferred shares, warrants, mezzanine financing) and an increased use in derivative securities. They noted that debt instruments were beginning to incorporate equity-like features, in response to market demand for such innovative forms of financing. The authors also note that in the U.S. At least the tax code and regulatory environment was not keeping up with the changes, contributing to the proliferation of hybrid securities. On closer examination, however, none of these changes indicates a fundamental change in the nature of debt or the nature of equity, simply a change in market preferences. Hybrids have not eliminated or even materially altered debt or equity, they have simply offered the market alternatives.

Damodar (n.d.) notes that there has always been a continuum between debt and equity. While the two are clearly different at the ends of the continuum (common stock and bonds), securities that lie in the middle of the continuum have always contained elements of each. Preferred shares and convertible bonds, for example, have been around for decades. The basic differences between equity and debt are outlined as follows. If the payments from the security are contractual, this is closer to debt and if payments are residual this is closer to equity. Tax treatment is another way to differentiate, except as Kopcke and Rosengren (1989) note where the tax code has not kept up with market innovations and may therefore not be an accurate reflector of whether a security is debt or equity. However, by Damodar's theory, securities that lie along the continuum rather than at its ends will always be subject to such questions -- attempts to classify such securities as either debt or equity will inherently fail due to the application of false dichotomy to the question.

Even if there is a rise in the usage of hybrid financing instruments, this does not imply widespread blurring of the distinction between debt and equity. For one, Kopcke and Rosengren framed their discussion vs. The most traditional capital structure forms, which dominated business for the mid-part of the 20th century. Framing modern capital structure practices vs. ones that just happened to be exceptionally rigid says little. One must instead consider whether the traditional debt and equity distinctions have genuinely been eroded, and that is not the case. Common stock and conventional debt instruments remain the norm in capital markets, despite increased use of hybrid instruments. The market for hybrid instruments requires higher knowledge on the part of investors, so is inherently less liquid than the market for conventional instruments. This limits the use of hybrids; even academics who study capital structure have little trouble making a clear distinction between debt and equity on corporate balance sheets (Phillips & Sipahoglu, 2004; Myers, 2005).

While the topic is worthy of discussion, there is little evidence to support the contention that any change has occurred in the nature of debt or the nature of equity to declare that any line has blurred between the two. Hybrid instruments are just that -- instruments born of the combination of traits that derive from two distinct entities. It is easy to break down a hybrid instrument into its constituent debt and equity-derived components on the basis of Damodar's criteria. Conflating the rise of hybrid instruments with erosion in the definition of traditional debt and traditional equity is a logical fallacy. As traditional debt and traditional equity are alive in their pure forms, and remain the most popular forms of financing for public companies, the hypothesis that there has been erosion in their definition is demonstrably false. The question would be better framed as an issue of usage, such a question about the role of hybrid instruments in the optimal capital structure than arguing about whether two forms of capital that remain dominant in the market and unchanged no longer exist.

2.

Valuing assets that are not publicly-traded can be challenging. The UK government has come under fire for what is perceived to be undervaluing of assets that were privatised, for example British Gas, British Telecom, British Airlines, and more. There remain many assets that could be sold off in the future such as Channel 4, the Royal Bank of Scotland, the Royal Mint and BBC Worldwide, raising the issue of appropriate valuation and value for money for the British taxpayer (Hawkins, 2010).

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Oxlade (2011) notes that British Gas shares have increased 12 times in value in the 25 years since privatisation. While this is not evidence of undervaluation, the fact that the shares increased significantly in the first week is (Ibid). Indeed, the aggressive marketing campaign to get the public to invest in British Gas suggests that the government might have felt compelled to suppress the offering price either to ensure sellout or to make the shares more accessible to members of the public.

Grout, Jenkins and Zalewska (2001) posit that undervaluation and underpricing are chronic problems with public utilities. They find that regulators address the problem by using the market value technique of valuation. The market value technique is difficult to apply to public companies, because of the inherent difficulties in finding comparable private-sector firms on which to base the calculations. As Grout, Jenkins and Zalewska (2001) point out, utilities in particular have rate of return requirements set out by regulators, but also price cap regulations, and significant differences in the cost of capital compared with private-sector organizations (Lowe, 2008). These fundamental differences will necessarily affect the value of the discounted future cash flows. Attempting to value a public utility -- especially ones with a monopoly -- by finding a corollary on the London Stock Exchange is exceptionally challenging because there are no firms in the industry, and few firms that face a similar regulatory or financial environment.

Schofield (2002) notes that the government attempted to overcome some of these challenges by adapting from three different approaches. These were the "complete restructuring of industries to provide greater focus on core business activities," "devising and establishing regulatory arrangements for industries where a significant amount of monopoly power is unavoidable" and "creating and developing new sales techniques…innovative pricing and distribution techniques, including bookbuilding, which have now been adopted around the world." The latter point, it should be noted, is a logical fallacy. Whether the techniques have been widely adopted is not relevant to whether the techniques are sound, or whether they extracted appropriate value for the British taxpayer. With the other points, these changes, while well-meaning, do not replace actual market conditions and therefore cannot be expected to fully replicate the conditions of the comparison company. Utilities in particular pose problem because they often meet public goods criteria, and therefore ensuring anything resembling market competition is next to impossible.

In addition, the pricing policies have been at least somewhat political. The practice of bookbuilding, in particular by marketing issues to the public as was done under Thatcher, has been blamed for the undervaluation in the issue of some public entities (Schofield, 2002). Since 1991, there has been away from this type of bookbuilding and towards the use of banking syndicates to market issues, and bring them to float on the LSE. Such a move should in theory improve the valuation of privatisations, even where it does not address the other underlying problems contributing to undervaluation.

Instead of taking a market value approach to valuation, the characteristics of most privatisation issues are ideal for discounted cash flow valuation. Using the example of British Gas, the cash flows from this entity would have been well-known as demand is generally linear, elasticities well-known and substitutes few and far between. The future cash flows, then, could have been estimated. Beyond that, the government sought to create conditions that would mirror market competition, or at least constrict the ability of the privatised entity to abuse its monopoly position. The effects of these constraints on cash flow would also be known. This leaves the issue of the discount rate, which would change for the company under private ownership compared with government ownership. Perhaps this is the one area where comparables could be found among market firms.

This form of valuation works as a simple net present value calculation. The expected future cash flows are discounted back to present day pounds using the discount rate. The only major issue with using this methodology is that to float the issue, the deal must be profitable for the end buyers. Former privatisations may have been undervalued, but they also sold out. When the government sets a specific target for its float, it needs to price the issue at a point that all but ensures a sellout. Today, this would be done in conjunction with the City partners. All stocks are said to trade at fair value of the expected future cash flows under the efficient market….....

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