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CH2 The Financial Environment

FINA3313 Business Finance

Spring 2006

Instructor: Bing Y. Du ©2006

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Topics covered

• How savings flow from investors through financial markets or financial intermediaries to the corporations;

• Financial markets: stock markets, debt markets, and other financial markets;

• Financial intermediaries: mutual funds, pension funds;• Financial institutions: banks, insurance companies,• Functions of financial markets and financial institutions;• Concept of cost of capital

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Introduction

• If GM plans to open a new assembly-line in Arlington, and needs new money to finance this project. The financial manager should have two considerations:

1) Where to get these money? 2) And what is the cost to raise the capital?

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Introduction

• Generally, two ways to raise money for a corporation: issuing new stocks, or borrowing debts.

• If we are going to issue new stocks, we can go to stock market; • If we plan to borrow debts, we can issue corporation bonds or we

can go to banks or insurance companies to apply for a loan. • As a financial manager, you should be very familiar with 1) How do financial markets, such as stock markets, bond markets

work? 2) How to maintain relationship with financial intermediaries or

financial institutions? 3) How to estimate the cost of capital from financial markets?

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The Flow of savings to corporations

• The capital that the a company raised to finance its real assets comes ultimately from the investors savings.

• But there can be many middle steps for the investors savings finally transformed into the corporations’ real asset investment (new plants, buildings or assembly-lines).

• The road for the money flowing from savings to real assets can pass through the financial markets, or financial intermediary , or both of them

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The Flow of savings to corporations-Small Company case

• A small corporation which owns timberland, harvests logs and runs a small sawmill. Its shares are closely held by the local investors.

• If this small company decides to expand, he has some choices to raise the money? (what options he can do to raise money),

1) First, paying for the expansion with the cash generated by its operations (using retained earnings);

2) Second, if the retained earning is not sufficient to pay the expansion, ask local investors to put more their savings in the firm;

3) Alternatively, it could borrow a loan from a local bank, while the bank raised the needed money from the depositor’s saving account. In this case, the depositors’ savings are the ultimate source of the timberland firm new capital. The depositors’ savings flow from the bank to the firm.

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Financial

Manager

Firm's

operations

Investors

(1) Investors buy shares with cash

(1)

(2)Cash is invested

(2)

(3) Timber harvest generates cash

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Flow of savings to corporations-Small Company case

Real assets(timberland)

(stockholders save and invest in closely held firm.)

Usually it is difficult for small companies to raise money from financial market or to borrow from financial intermediaries.

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The Flow of savings to corporations-Large company case

• How about a large, pubic forest-products firm, such as International paper or Weyerhaeuser?

• What is the difference for a big company to raise money from the small company? -SCALE

• For big companies, the financing requirements are very large, and the amounts of the money they needed for financing is huge.

• The process of capital flowing from investors to the corporations will not be as simple as the capital flowing process in small company. The linkages between the investors and the large corporation are much more diverse.

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The Flow of savings to corporations -Large company case

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The Flow of savings to corporations -Large company case

• First, the public corporations can drawing savings from investors world wide.

• Second, the savings flow through financial markets, financial intermediaries, or both.

• Here we can consider three scenarios:

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Investor savings flow through Financial Market:

• Scenario 1: Investor savings flow through financial market

-Investors directly own shares of International Paper, or

-Investors are directly the creditors of International Paper.

International Paper directly issue new stocks

Stock Market (Stock Exchanges)

Worldwide Investors

International Paper directly issue new bonds

Bond Markets Worldwide Investors

Financial Markets

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Investors saving flow from Financial Intermediaries (Financial Institutions)

International Paper applying for a loan

Bank of AmericaPension FundsInsurance company

Depositors Savings AccountInsurance policy,Investment account

•Scenario 2: Savings flow from financial intermediaries-BOA is the direct creditor of International Paper;-Depositors are not the direct creditors of International Paper, while they are the direct creditors of BOA;-Thus the depositors savings flow through the financial intermediaries

to the corporation;

Financial Intermediary

(Financial institutions)

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Investors saving flow both from Financial Markets and Financial intermediaries

International Paper applying for a loan

Bank of AmericaPension Funds

Bank of America issuing new stocks or bonds

Worldwide investors

• Scenario 3: Savings flow from both financial markets and intermediaries -Capital of the BOA loan not directly from the depositors savings account in BOA, but from the worldwide investors who buy the BOA stocks or bonds.

Financial IntermediaryFinancial Markets

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The Flow of savings to corporations

• Financial markets, financial intermediaries and financial institutions bridge the investors and the corporations.

• A Security is a traded financial asset, such as a share of stock, a bond;

• A Financial Market is a market where securities are issued and traded;

• A Financial intermediary is an organization that raises money from investors and provides financing for individuals, corporations, or other organizations;

• A Financial institution is an intermediary that pools and invests savings, and generally does more than that.

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Financial Market - Stock Markets

• When a corporation is in early stage, the resources of his financing requirement is limited.

• He can only be financed by several start-up investors’ stocks, or apply for a loan,

• At early stage, a company generally can not raise fund from stock markets, such as NYSE, or Nasdaq.

• If he plans to get money from stock markets, he must first satisfy the public listing requirements of SEC, NYSE or Nasdaq.

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• When a corporation grows and satisfies some financial conditions, such as good profits, asset/liability ratio, he can go public to expand the fund sources.

• The firm can go public by issuing new shares on an organized exchange, such as NYSE,

• The first issue is called INITIAL PULIC OFFERING or IPO. The buyers of the IPO are helping to finance the firm’s investment in real assets. And in return, the buyers become part-owners of the firm and share in its future success or failure. After the IPO, the firm also can again issue new shares second time or third time, or more, if he can satisfy the financial conditions for issuing new shares.

• Primary Market: the market for corporations issuing or selling new shares of stocks to investors,

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• If an investor wants to buy BOA’s stock, but he did not have the chance to buy the new shares of BOA at the time of IPO. Can he be a stockholder of BOA?

• The answer is absolutely yes. I have bought the new shares of BOA at its IPO. Now if I want to sell my shares of BOA and at the same time you want to buy BOA’s shares, I can sell my shares directly to you in a secondary market. The result is just a transfer of the ownership from me to you.

• Secondary Market, is a market in which previously issued securities are traded among investors;

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• Stock markets are also called Equity Markets since stockholders are said to own the common equity of the firm

• Two types of stock market: organized stock exchanges, which has a fixed physical place, like NYSE

• Over-the-Counter Market (OTC) market, is not a centralized exchange like the NYSE, but a network of security dealers who use electronic systems known as NASDAQ to quote prices at which they will buy and sell shares;

• Now with the trend of globalization, a corporations stocks can be traded in several different places over the world at the same time, such as Citibanks’ stocks are being listed in NYSE, and also in European stock exchanges.

• If a firm’s stocks are listed and traded in several different stock exchanges at the same time, This is called CROSSLISTING.

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Financial Market - Debt markets

• The bonds are securities representing promise to make regular interest payments and to repay investor’s money on a specified future date.

• Large companies, like GE,GM, issue both long term and short term bonds;

• Federal government and municipal government also issue bonds;• Debt securities are also traded in financial markets. • Some debt securities are traded on the NYSE and other exchanges,

but most corporate debt securities are traded on the OTC market, however, not on NASDAQ, but on a network of banks and security dealers.

• Government debt is also traded on over the counter market

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Financial Market - Debt markets

• There are various of bonds, the most common is the bonds which pay fixed interests semi-annually or yearly,

• Some bonds pay floating interests tied to future interest level;• Some bonds can be called (repurchased by the issuing company

before the bond’s stated maturity date);• Some bonds can be converted into other securities, such as the

stocks of the issuing company. • The Debt securities market is also called fixed-income market. • When a company is considering how to finance its new projects, it

must decide between the debt or equity finance. It also must consider the design of the debt, how much interests should be paid, how long is the debt, how often should the interest be paid, what are the other factors to be considered? Like, should the bond be callable, convertible?

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Capital market and Money market • We have classified the financial markets by the types of financing,

equity financing or debt financing.• Another way to categorize the financial markets is by the terms of

the financing.• The market for the long term debt and equity are called Capital

Market. Long term (in finance) usually refers to longer than 1 year.• Short term securities, usually referring to less than 1 year are

traded in the Money Market. • Creditworthy firms can raise short term financing by issuing

Commercial Paper, commercial paper are also a debt with the maturities no longer than 270 days, three quarters.

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Other forms of financial Markets

• In addition to the equity and debts market, there are other forms of financial markets.

• Foreign-Exchange Markets: markets for converting money from one currency to another currency; FX market is an OTC market through a network of the largest international banks;

• Commodities Market: Industrial materials and raw materials like, corn, wheat, cotton, fuel oil, natural gas are traded on organized exchanges, such as NYMEX, CBOT;

• Derivatives Markets: Derivatives, such as call options, put options, are securities whose payoffs depend on the prices of the other securities or commodities.

• Strictly speaking, commodity market and derivative markets are not sources of financing, but these markets can provide information to discover asset price, and financial manager can utilize these markets to adjust the firm’s exposure to various business risks (Risk management).

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Financial Intermediaries

• We now will take a look at how the financial intermediaries bridge the investors and corporations.

• A financial intermediaries is an organization that raises money from investors and provides financing for individuals, companies, and other organizations.

• Financial intermediaries play a role of the middleman between the savings and investment.

• We start with two important classes of intermediaries: Mutual Funds and Pension Funds

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Financial Intermediaries - Mutual Funds • Mutual Funds raise money by selling shares to the investors. It

pools the savings of many investors and invests in a portfolio of securities.

• The advantages of a mutual fund: Mutual funds offer investors low cost diversification and professional management. For most investors, it is more efficient to buy a mutual fund than to assemble a diversified portfolio of stocks and bonds;

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Financial Intermediaries - Mutual Funds

Mutual FundsInvestors

International Paper

Bank of America

IBM

Pooling

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Financial Intermediaries - Mutual Funds

Irwin/McGraw-Hill

Bank of AmericaBank of America

Windsor Fund

Windsor Fund

Investors

Investors

$ $

Sells shares

Issues shares

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Financial Intermediaries -Pension funds

• Another ways of pooling and investing savings: Pension Funds• Pension funds are investment plan set up by an employer to

provide for employee’s retirement. • Pension funds provide professional management and diversification,

and also tax advantages: Contributions are tax-deductible, and investment return inside the plan are also not taxed until cash is finally drawn out.

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Financial Institutions

• A financial institution is an financial intermediary that does more than just pool and invest savings.

• Banks and insurance companies are typical financial institutions.• Financial institutions raise financing in some special ways. - Banks raise money by accepting deposits; - Insurance companies issue insurance policies• Unlike a mutual fund, banks and insurance companies not only

invest in the securities but also loan money directly to individuals, businesses, or other organizations.

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Banks

BANKS Depositors (Investors)International Paper

depositsloans

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Insurance company

INSURANCECOMPANY

InvestorsInternational Paper

Insurance policies

loans

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Investor savings flow from Financial Institutions

Irwin/McGraw-Hill

Funds

Funds

Banks

Insurance Cos.

Brokerage Firms

Obligations

Depositors

Policyholders

Investors

Obligations

Company

Intermediary

Investor

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Irwin/McGraw-Hill

Funds

Funds

Banks

Insurance Cos.

Brokerage Firms

Obligations

Depositors

Policyholders

Investors

Obligations

Company

Intermediary

Investor

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Irwin/McGraw-Hill

Insurance Company

Policyholders

$250 mil

Cash

Loan

Sell policies Issue Stock

Company

Intermediary

Investor

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Total financing of US corporations (Qtr 1, 2002)

11.9

21.9

8.826.7

11.7

10.68.4 Households

Rest of worldBanksInsurance CosPension FundsMutual FundsOther

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% Holdings of Corporate Equities (Qtr 1, 2002)

37.7

11.51.77.3

20.7

19.71.4 Households

Rest of worldBanksInsurance CosPension FundsMutual FundsOther

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Functions of Financial Markets

• Transporting cash across time.

-Financial markets can bridge your savings and consumptions across the time. Modern Finance provides a kind of time machine. Lenders transport money forward in time, and borrowers transport it back. Both are happier than if they were forced to spend income as it arrives.

• Liquidity

-Financial markets and intermediaries can also provide liquidity. (The ability of turning an investment back into cash when needed)

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• The payment mechanism -Using checking accounts, credit cards, and electronic transfers

individuals and firms will easily send and receive payments quickly and safely over long distances.

-Banks are the providers of the payment services. They are like the clearing house of the whole society.

-Also mutual funds can provide the function of payment services. You can write checks on your mutual fund investment account, just as you had a bank deposit.

• Reducing Risks -Derivatives markets like futures, options and swaps market can

be used to hedge financial or price risks;

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• Information provided by financial markets

-Price discovery:

-Commodity price,

-Interest rate,

-and company values,

are provided by the financial markets;

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The opportunity cost of capital

• Financial managers can use the financial markets to measure and estimate the cost of capital.

• The cost of capital is the minimum acceptable rate of return for capital investment.

• Investment projects offering rates of return higher than the cost of capital add value to the firm; projects offering rates of return lower than the cost of capital will not be worthwhile financially.

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Example of cost of capital:

GM opened a new assembly line in Arlington, which costs 10 million; this investment will generate 1 million per year in additional income. A 10% percent return on the 10 million investment. Is the project worthwhile? Is the 1 million per year return enough to justify the investment?

• Two scenarios:

1. When the return is absolutely safe, you can compare the new investment’s return with the return rates of the comparable top quality corporate bonds;

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2. When the return is not safe, meaning a risky investment, the future returns on the project are just forecasts, not certainties. Suppose investing in the Assembly line is as risky as investing in the whole stock market. And you have estimated that the expected rate of return on the whole stock market is 10%, the investment in new assembly line is just a break even, the same as investing in stock markets.

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• In summarization, because of shareholders can also invest for themselves in financial market, the investments by the firm should therefore offer rates of return at least as high as those available in financial markets at the same level of riskThe cost of capital for corporate investment is set by the rate of return on investment opportunities in financial markets.

• Why call OPPORTUNITY COST OF CAPITAL? Because when the firm invests, shareholders lose the opportunity to invest in financial markets;

• Refer the cost of capital of your investment to the same risk category securities in the financial markets.

• For safe investments, you can observe opportunity cost of capital by looking up current interest rates on safe debt securities; for risky investment, the opportunity cost of capital has to be estimated.

• NOTE: the opportunity cost of capital is generally NOT the interest rate that the firm pays on a loan from a bank or insurance company.

Economy & Finance

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