The Financial Environment

The Flow of Savings to Corporations

Small firms: Money for corporate investments in real assets 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.

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

 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 important financial market

 Primary Market: Where new securities are sold. Secondary Market: where already issued securities are traded among investors. Over the counter market (OTC): OTC is not a centralized exchange but a net work of securities dealers who use an electronic system known as NASDAQ to quote prices at which they buy and sell shares

 Organized stock Market: New York Stock Exchange (NYSE) Karachi Stock Exchange (KSE) Initial Public Offer (IPO)

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

Other Financial markets

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.

Other Financial markets

Fixed income market; Market for debt securities Capital market; Market for long-term financing Money market; Market for short-term financing (less than 1 year)

Self Test
What is the difference between a. Primary and secondary market? b. Trading on the NYSE and Over the counter trading on NASDAQ? c. Capital market and money market? d. Stock market and Fixed income market?

Other Financial Markets

Foreign-exchange markets; Transferring money from dollars to other currencies or vice versa. Foreign exchange is trade over-the-counter through a network of larges international banks. Commodities Market: Commodities like what, corn, oil, copper, silver, platinum can be bough or sold through organized exchanges

Other Financial Markets

Like New York Mercantile Exchange or Chicago Board of Trade. Markets for Options and other derivatives: Derivatives are securities whose payoffs depend on the prices of other securities or commodities, e.g buy an option to purchase IBM shares at a fixed price at a fixed future date

Other Financial Markets

Future contract: Commodities can be traded by a different 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 the future price of natural gas by trading in commodity markets to eliminate the risk of price rise.

Other Financial Markets

Financial Intermediaries: raises money from investors 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 a portfolio of securities, pay no taxes if all income and price appreciation passed to shareholders

 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.

 Pension fund: Investment plan set buy an employer to provide for employees retirement. In a defined contribution plan a percentage of employee pay is contributed to a pension fund. Contribution from all participating employees are pooled and invested in security or mutual fund, each employee balance grow over the years, at retirement his balance can be used to pay him.

 Pension funds are designed for long-run investment. Provide professional management and diversification. Contributions are tax deductible

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 the second strategy

 Financial Institutions: A financial intuitions is an intermediary that does 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 more important than banks for the long term financing.

Self Test
What are the key differences between mutual fund and a bank or an insurance company?

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

Functions of Financial Markets and 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.

Functions of Financial Markets and Intermediaries

The shares of public companies are liquid because they are traded easily. Mutual funds can redeem their shares for cash on short notice. The Payment mechanism: Easy, quick, safe over long distance payments. You can also write checks on mutual funds investment, like bank deposits.

Functions of Financial Markets and Intermediaries

Reducing risk: Insurance companies

Diversification
Index funds

Functions of Financial Markets and Intermediaries

Futures:

Forwards:

Functions of Financial Markets and Intermediaries

Information provided by Financial Markets: Well functioning financial markets you can see the 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 the New York Mercantile Exchange $ 517 (closing price of August 1. 2002) per ounce for delivery in October. The CFO can lock in prices if she wishes

Functions of Financial Markets and 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.

Functions of Financial Markets and Intermediaries

Company values: Stock price and company values summarize investors collective assessment of how well a company is doing, both its current performance 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.

Functions of Financial Markets and Intermediaries

Calculating Market Value: (August 2, 2002)
Stock Price Numbers of shares Market Value

Alaska Air Group:

$22.20 x 26.48 = $ 589 m

Functions of Financial Markets and 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.

Functions of Financial Markets and Intermediaries

The cost of capital for corporate investment is set by the rates of return on investment opportunities in financial markets.