Chapter 10

Primary Market
&
The Underwriting of security
Introduction
Within the capital market there exist both a primary and a
secondary market. A primary market is a “new issues”
market. It is here that funds raised through the sale of new
securities flow from the buyers of securities (the savings
sector) to the issuers of securities (the investment sector).
In a secondary market, existing securities are bought and
sold. Transactions in these already existing securities do
not provide additional funds to finance capital investment.
In this chapter, we will focus chiefly on primary market
activities within the capital market.
Features of Primary Market
Primary market provide the channel for sale of new
securities and also for the new companies to enter
into the share market.
These shares are issued in both domestic and
international market and is a channel for the
companies to meet their financial requirements.

Features of primary markets include:

 The securities are issued by the company directly to
the investors
 This is the market for new long term
equity capital
 The primary market is the market where
the securities are sold for the first time.
 In a primary issue, the securities are
issued by the company directly to
investors
 Primary issues are used by companies
for the purpose of setting up new
business or for expanding or
modernizing the existing business.
 It comes before secondary market.
Various method of float capital in
primary market:

Following are the method of raising capital in the

primary market:
1) Public issue
2) Offer for sale
3) Private placement
4) Right issue
5) Electronic initial public offer
Function of primary market
The main function of a new issue market is to facilitate

transfer of resources from severs to the users. The savers are

individuals, commercial banks, insurance companies etc. the

users are public limited companies and the government. It is

not only a platform for raising finance to establish new

enterprises but also for expansion/ diversification/

modernization of existing units.

In this basis the new issue market can be classified as:-

 Initial public offering(for the first time)

 Seasonal equity offering (raise additional capital)

The primary market deals with the issue of new instruments by

the corporate sector such as equity shares, preference share and

debenture

Function of primary market –

Origination: is the work of investigation and analysis and

processing of new issue proposals

Underwriting: is a form of guarantee that the new issue

would be sold by eliminating the risk arising from uncertainty of

public response

Distribution: is the sale of the ultimate investor

Underwriting
The efficient functioning of financial markets requires a number of financial in

situations. One of these institutions, the investment banking firm, acts as

middleman in the distribution of new securities to the public. Its principal function

is to buy the securities from the company and the resell them to investors. For this

service, investment bankers receive the difference, or spread, between the price

they pay for the security and the price at which the securities are resold to the

public. Because most companies make only occasional trips to the capital market,

they are not specialists in the distribution of securities. On the other hand,

investment banking firms have the expertise, the contracts, and sales organization

necessary to do an efficient job of marketing securities to investors.

There are two means by which companies offer securities to the public:

 a traditional underwriting and

 a shelf registration.
 Underwriting
process

Traditional
Shelf registration
underwriting

Best Effort Market Making

Let us explore the two methods for offering bonds

and stocks to investors.
 Traditional Underwriting
The underwriting bearing the risk of not being able to
sell a security at the established price.

Also known as firm commitment underwriting.

If the security issue does not sell well, either because

of an adverse turn in the market or because it is
overpriced, the underwriter, not the company, takes
the loss.
 Best effort offering
Best effort offering – a security offering in which the
investment bankers agree to use only their best
effort to sell the issuer`s securities. The investment
bankers do not commit to purchase any unsold
securities
 Making a Market
At this system of underwriting the underwriter will make

or create a market for a security after it is issued.

In the first public offering of common stock, making a

market is important to investors. In making a market, the

underwriter maintains a position in the stock, quotes or

fix bid or buying price and asked or selling prices, and

stands ready to buy and sell it at those prices.

These quotations are based on underlying supply and

demand conditions.
 Shelf Registrations
A procedure whereby a company is permitted to register securities it plans to sell

over the next two years; also called SEC Rule 415.

These securities can then be sold step by step whenever the company chooses.

Self registration has following advantages:

1. Securities can be issued in dribs and drabs (in small amount) without

incurring excessive costs.

2. Securities can be issued on short notice.

3. Security issues can be timed to take advantage of “market conditions”

(although any financial manager who can reliably identify favorable market

conditions could make a lot more money by quitting and becoming a bond or

stock trader instead).

4. The issuing firm can make sure that underwriters compete for its business.
Category of the listed companies
A - category companies –
 Regular in holding the current AGM.
 Declared at least 10% dividend in the last calendar year.
 Newly listed company with at least 10% EPS.
 Debentures and Mutual Funds.

B – category companies –
 Regular in holding the current AGM.
 Declared less than 10% dividend in the last calendar year.
 Newly listed company with less than 10% EPS. 

Z – category companies –
 Failed to hold current AGM.
 Failed to declare dividend.
 Not in operation for more than six months.
 Accumulated loss exceeds paid-up capital, however, this condition shall not apply
if the company declares dividend out of current years profit and holds AGM.
G- category companies –
 Newly listed green field companies shall be grouped under this category.
N- category companies –
 Newly listed companies shall be grouped under this category for first year.
Method of Selling Share to Raise Capital
When a company
requires long-term
fund & it want to raise
the fund by issuing
common stock, the • Public
company can appoint a
number of methods to Placement
raise capital for sale of • Private
share to raise capital
from the market, In Placement
fact for initial public
offering there are
several methods of
selling share.
 IPO (Initial Public offering)
An initial public offering (IPO) is a type of public offering
where shares of stock in a company are sold to the
general public, on a securities exchange, for the first
time. Through this process, a private company
transforms into a public company.
A company selling shares is never required to repay the
capital to its public investors. After the IPO, when shares
trade freely in the open market, money passes between
public investors.
Procedures to go to public or Process
of IPO

I P O process
The listing
procedure is
Process before consent
divided into two or approval from SEC
Parts according
Process after consent
to their behavior or approval from SEC
 Process before consent or approval from SEC

A. Selection of Advisors A. Agreement with CDBL:

B. Completion of Valuation B. Approval from Sponsors:

and restructuring C. Refund warrant

C. Selection of Bankers to guarantee:

the Issue D. Draft Prospectus:

D. Selection of underwriters E. Application Submission:

E. Collection of NOC from F. Consent from SEC:

Lenders:

F. Audit of Accounts:
Process after consent or approval from SEC

A. Submission of prospectus:

B. Announcement for the investor:

C. Provide full prospectus:

D. Application for listing:

E. Subscription period:

F. Transaction rate:

G. In case of under subscription:

H. Application to Stock Exchanges for Listing:

I. Approval of listing:
Here are 8 important steps in the IPO
process:
1. Have a trusted and reliable management team
They must possess strong communication skills to handle investors or SEC queries and be able to clearly present
the company’s vision and plans.

2. Be ready with your financial reporting systems

Important financial reports required:
2.1. disclosure controls and procedures
2.2. internal controls over financial reporting

Once the company goes public it requires a thorough disclosure of the financial health of the company thereby
adopting more complex financial and accounting requirements. The company must have a credible system in place
to ensure all data are recorded in a timely and accurate manner.

3. Choose your investment bankers

Investment bankers or the “underwriters” play an important role in the IPO process. They look for and approach
potential investors. They act as the sales guy offering to buy shares for the company. Thus, characteristics of your
ideal investment banker include sales and distribution capabilities and strong analyst coverage.

4. Write your company’s story

Writing your company’s story or overview of the business enables your prospect investors to see the objectives of
the company. Your story must present your company’s goal, mission and vision – emphasizing its strengths,
greater market opportunity, and why your company will be a good investment in the long run.
5. Register with SEC
Next step would be to present the final company story as well as the prospectus to SEC for
registration and review process. Initial prospectus contains all information about the company
except for the offer price and date, which are not shown yet. Normally, the registration takes more
than a month.
6. Start your road show
Once your company has complied with SEC’s comments and recommendations, then you may now
proceed to meeting your prospective investors. You must travel and attend a lot of meetings, press
conferences (if your budget allows), city/area visits to introduce your company and the merits of
investing in it. This is also considered as your marketing venue to attract more investors.
7. Price your IPO
After completing the review process and generating a list for possible IPO investors, the company’s
board of directors and underwriters agree on a value to which the company sets a price per share
of stock.
8. Ready to be publicly-owned company
Issuer and selling stockholders will issue the shares to the underwriters, and the underwriters will
buy those shares at a 7 percent discount more or less. Issuers will still undergo SEC quiet period
for 25 days following the pricing. This period gives broker-dealers time to approach and deliver IPO
sales materials to investors.
Pricing Process
 Private placement
Whenever a company makes a public offering, it must register the

issue with the SEC. It could avoid this costly process by selling the

issue privately. The process of selling security privately or directly to

the investor is known as private placement. On the other way, Private

placement occurs when a company makes an offering of securities not

to the public, but directly to an individual or a small group of

investors. Such offerings do not need to be registered with the

Securities and Exchange Commission (SEC) and are exempt (free) from

the usual reporting requirements. Private placements are generally

considered a cost-effective way for small businesses to raise capital

without "going public" through an initial public offering (IPO).

 Public Vs Private Placement of Securities

Private placement has the following advantages, compared to

a public issuance:
i. The flotation cost is less. than for larger ones.

ii. It avoids SEC filing requirements.

iii. It avoids the disclosure of information to the public at large.

iv. There is less time involved in obtaining funds.

v. It may not be practical to issue securities in the public market when a

company is so small

vi. The company’s credit rating may be low, and as a consequence investors

may not be interested in buying securities when the money supply is

limited.
Private placement has the following disadvantages,
when compared to a public issuance

i. It is more difficult to obtain significant amounts of

money privately compared to publicly.

ii. Large investors usually employ stringent (rigid) credit

standards

iii. Large institutional investors may watch more closely

the company’s activities

iv. Large institutional investors are more capable of

obtaining voting control of the company.

 Right Issue
Right share are those share which are issued by a corporation in ratio

of equity share to existing shareholder to raise capital. According

to Weston and Brigham “ A right is an option to buy a security at a

specified price during a designated period.

Under a preemptive right, existing common stockholders have the

right to preserve their proportionate ownership in the corporation

If the corporation issues additional common stock, they must be

given the right to subscribe to the new stock so that they maintain

their pro rata interest in the company.

 Offering through rights:
When a company sells securities by privileged

subscription, it mails to its stockholders one right for

each share of stock held. With a common stock offering,

the rights give stockholders the option to purchase

additional share according to the terms of the offering.

The terms specify the number of rights required to

subscribe for an additional share of stock, the

subscription price per share, and the expiration date of

the offering.
The holder of rights has three choices:

(1) Exercise them and subscribe for additional shares

(2) Sell the right because they are transferable, or

(3) Do nothing and let them expire.

In a rights offering, the board of directors establishes a date of
record. Investors who buy the stock prior to that date, receive
the right to subscribe to the new issue. The stock is said to sell
with rights-on through the date of record.
After the date of record, the stock is said to sell ex-rights; that is
the stock is traded without the rights attached. An investor who
buys the stock after this date does not receive the right to
subscribe to additional stock.
 Value of Rights

Value of rights when the stock is selling Rights-On:

P0  S
R0 
N 1
Where,
R0 = Market value of one right when stock is selling rights-on.

P0 = Market value of a share of stock selling rights-on,

S = Subscription price per share, and

N = Number of rights required to purchase one share of stock.

 Market Value of stock when the stock is selling Ex-Right:

( P0  N )  S
Px 
N 1
Value of rights when the stock is selling ex-rights:

Px  S
R0 
Where,
N
Px = Market price of the stock (a share) when it goes ex-rights.
 Problem-1:

Branch Labs, Inc, has common stock selling for Tk20 per share. The company currently has 5

million shares outstanding and plans to issue 4 million new shares through a rights issue.

a. How many rights must be presented to buy one share of stock during the rights issue?

b. What is the cost of a new share if the subscription price is set at Tk18 per share?

Problem- 2:

The Sun Moon Limited has 10,00,000 shares outstanding at current market price of Tk 120 per

share. The company needs Tk 20 million to finance the proposed project. The board of the

company has decided to issue rights for raising the required money. The subscription (issue)

price (S) has been fixed at Tk100 per share. The subscription price has been set below the

market price to ensure that the rights issue is fully subscribed.

a. How many rights required purchasing a new share?

b. Calculate the price of share after rights issue.

c. What is the value of a right? (both ex-right and cum right).