The Finacnial Enviroment Ch 2

7/28/2019 The Finacnial Enviroment Ch 2

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The Financial Environment


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The Flow of Savings to Corporations

Small firms:

Money for corporate investments in realassets comes from Investors;

The firm can sell new shares

It can reinvest cash back in firms operations,

that could have been paid out to

shareholders. Bank loan (Investor money flows through bank

to the firms.


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The Flow of Savings to Corporations

Public corporations: can raise money

worldwide

Savings flow through financial markets,

financial intermediaries or both.

Financial Markets: Where securities are issued

and traded


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The Stock Market: (Equity market)

A financial market is a market where securities

are issued and trades

A security is just traded financial asset, e.g

share of stock

For a corporation is the most importantfinancial market


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Primary Market: Where new securities aresold.

Secondary Market: where already issued

securities are traded among investors.Over the counter market (OTC): OTC is not acentralized exchange but a net work of

securities dealers who use an electronicsystem known as NASDAQ to quote prices atwhich they buy and sell shares


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Organized stock Market:

New York Stock Exchange (NYSE)

Karachi Stock Exchange (KSE)

Initial Public Offer (IPO)


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Other Financial markets

Bond: more complex security that a share of

stock.

Can vary;

in maturity

Degree of protection or collateral offered by

the issuer Level of timing of interest payment


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Floating bonds make floating interest

payments tied to the future level of interest

rates.

Some can be called, repurchased, retired) by

the company before maturity.

Some bonds can be converted into stock of

the issuing company.


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Fixed income market; Market for debt

securities

Capital market; Market for long-term financing

Money market; Market for short-termfinancing (less than 1 year)


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Self Test

What is the difference between

a. Primary and secondary market?

b. Trading on the NYSE and Over the countertrading on NASDAQ?

c. Capital market and money market?

d. Stock market and Fixed income market?


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Other Financial Markets

Foreign-exchange markets;

Transferring money from dollars to othercurrencies or vice versa.

Foreign exchange is trade over-the-counterthrough a network of larges internationalbanks.

Commodities Market: Commodities like what,corn, oil, copper, silver, platinum can bebough or sold through organized exchanges


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Like New York Mercantile Exchange or ChicagoBoard of Trade.

Markets for Options and other derivatives:

Derivatives are securities whose payoffsdepend on the prices of other securities or

commodities, e.g buy an option to purchaseIBM shares at a fixed price at a fixed futuredate


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Future contract: Commodities can be traded by adifferent type of derivative security.

Commodities and derivatives markets not sources of financing,

use to adjust risk exposure to various business risks,

e.g an electric generating company may lock in thefuture price of natural gas by trading in commoditymarkets to eliminate the risk of price rise.


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Financial Intermediaries: raises money frominvestors and provided financing to users

Important source of financing

Classes of Financial Intermediaries:

1. Mutual fund: are investment companies pools

the savings of many investors and invests in aportfolio of securities, pay no taxes if all incomeand price appreciation passed to shareholders


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Mutual funds offer investors;

A. low-cost diversification

B. Professional management.

Open end mutual funds continuously buy and

sell securities Closed end mutual funds have a fixed number

of shares traded on an exchange.


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Pension fund: Investment plan set buy anemployer to provide for employeesretirement. In a defined contribution plan a

percentage of employee pay is contributed toa pension fund. Contribution from allparticipating employees are pooled andinvested in security or mutual fund, each

employee balance grow over the years, atretirement his balance can be used to payhim.


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Pension funds are designed for long-run

investment.

Provide professional management and

diversification.

Contributions are tax deductible


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Self Test

Individual investors can buy bonds and stocks

directly, or they can put their money in a

mutual fund or d defined-contribution

pension fund. What are the advantages of thesecond strategy


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Financial Institutions:

A financial intuitions is an intermediary thatdoes more than just pool and invest savings.

Institutions raises They accept deposits or sell insurance policies,

they also lend money directly to users.

In the US insurance companies are moreimportant than banks for the long termfinancing.


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Self Test

What are the key differences between mutual

fund and a bank or an insurance company?


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Functions of Financial Markets and

Intermediaries

Transporting cash across time: If you have

money today you wish to save for a rainy day.

If you need money today you can borrow

money and pay later.

Lenders transport money forward in time,

Borrowers transport it back


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Intermediaries

Liquidity: The ability to sell or exchange an

asset for cash on short notice.

Bank can make illiquid loans financed by liquid

deposits.

If you pay money to directly to the real estate

developer you will have hard time retrieving

it.


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Intermediaries

The shares of public companies are liquidbecause they are traded easily.

Mutual funds can redeem their shares for cashon short notice.

The Payment mechanism:

Easy, quick, safe over long distance payments.You can also write checks on mutual fundsinvestment, like bank deposits.


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Intermediaries

Reducing risk:

Insurance companies

Diversification

Index funds


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Intermediaries

Futures:

Forwards:


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Intermediaries

Information provided by Financial Markets:

Well functioning financial markets you can seethe value of securities and commodities

The rate of return that investor can expect. How information can be used?

A company uses platinum which is traded on theNew York Mercantile Exchange $ 517 (closingprice of August 1. 2002) per ounce for delivery inOctober. The CFO can lock in prices if she wishes


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Intermediaries

Interest Rates:

The CFO has to raise $ 400m in its new

financing. She considers an issue of 10-year

bond . What will the interest on bond be?

The CFO looks up interest rate for existing

bonds traded in financial markets.


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Intermediaries

Company values:

Stock price and company values summarizeinvestors collective assessment of how well a

company is doing, both its currentperformance and future prospects.

An increase in stock is a positive signal from

investors to managers. A private company can not use its stock price

as measure of its performance.


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Intermediaries

Calculating Market Value: (August 2, 2002)

Stock Price Numbers of shares Market Value

Alaska Air Group: $22.20 x 26.48 = $ 589 m


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Intermediaries

The Opportunity Cost of Capital:

Is Minimum acceptable rate of return on

capital investment.

Financial managers look to financial markets

to estimate the cost of capital

Investment projects offering rates of return

higher that the cost of capital add value to the

firm.


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Intermediaries

The cost of capital for corporate investment is

set by the rates of return on investment

opportunities in financial markets.

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The Finacnial Enviroment Ch 2

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