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Chapter 1 Introduction to Finance. “ Remember that time is money. ” -Benjamin Franklin, “ Advice to a Young Tradesman, ” Poor Richards Almanac , 1738. Chapter 1 Outline. 1.1 What is Finance?.
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Chapter 1Introduction to Finance “Remember that time is money.” -Benjamin Franklin, “Advice to a Young Tradesman,”Poor Richards Almanac, 1738
1.1 What is Finance? • Finance is the allocation of funds between those with more funds than they need and those who need the funds. • More specifically, finance deals with the “how” and “under what terms” of this allocation. • You may recognize in this definition a similarity between finance and economics. • Economics deals with the allocation of scarce resources in an economy, whereas finance focuses on how resources are allocated and by what channels, as well as the terms of the allocation. • In many ways, we can view finance as applied economics.
Our focus in this book is business finance, which includes the following: • Financial statement analysis • The time value of money and other valuation financial mathematics • Portfolio theory and asset pricing
The Financial System & the Role of Financial Intermediaries The Financial System
The Financial System & the Role of Financial Intermediaries The financial system of any country provides an environment in which households provide funds to businesses and government. A financial intermediary transforms the nature of the securities they issue and invest in. Amarket intermediary simply makes the markets work better.
1.2 Financial Instruments and Markets A financial instrument is any legal agreement that represents an ownership interest, a debt obligation, or other claim on assets or income.
What is a Security? • A security is a negotiable financial instrument that is evidence of indebtedness or ownership. Securities include the following: • Debt obligations, such as a bond or a note with a fixed term for repayment and interest to compensate the lender for the use of the funds • Equity interests, such as common stock, which represent the ownership interest that the provider of funds has in the user of funds • Hybrid securities, such as convertible bonds, that have characteristics of both equity and debt
Types of Debt • Short term debt • Bank loan- a loan made by a financial institution • Commercial paper- a loan issued by a business or governmental entity • Bankers’ acceptance- a credit instrument that is issued by a business and guaranteed by a bank • U.S. Treasury bill- a short-term indebtedness of the U.S. government
Types of Debt • Long-term debt • Mortgage loan- a loan that is backed by specific collateral, such as a home in the case of a home mortgage • Municipal bond- an indebtedness issued by a state or local government • Corporate bond- an indebtedness issued by a corporation
Additional Financial Terms Bond- a debt instrument that takes the form of a security that investors can buy and sell. The owner of the bond is the creditor of the bond issuer. Note- similar to a bond, but with a maturity in the range of one to ten years. In common usage, however, the term “bond” is often used interchangeably with the term “note.” Collateral-the borrower’s pledge of specific property, which may be a building, aircraft, or any other identifiable, tangible asset. Debenture- debt not secured; backed by the “full faith and credit” of the issuer.
Additional Financial Terms • Types of municipal bonds: • General obligation bond- backed by the full faith and credit of the issuer, much like U.S. Treasury bonds. • Revenue bond- backed by a specific revenue stream of the issuing entity, such as the payments for electricity by customers of a city-owned electric utility. • Assessment bond- backed by the property taxes that are assessed by the local government. An advantage of investing in municipal debt is that the interest earned on this investment is exempt from federal income tax and, depending on the state, may be exempt from state income tax.
Additional Financial Terms • Equity instrument or equity security- represents an ownership stake in a company • Common stock- the most common form of equity • Represents the residual ownership of a corporation; the common stock owners are last in line, in terms of seniority of claims on the company, but they also reap the benefits from the company’s earnings and appreciation in value. • Common stock owners generally also have voting rights, with the ability to elect members of the company’s Board of Directors. • Preferred stock- usually entitles the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders.
Additional Financial Terms Money market security- a short-term (i.e., maturity of less than one year) security; examples include debt instruments such as T-bills, commercial paper, and bankers’ acceptances. Capital market security- a security with a maturity greater than one year; includes notes, bonds, and debentures, as well as equity securities, which represent ownership in a company and generally have no maturity date.
Financial Markets Initial public offerings by U.S. corporations, 1990-2012Source of data: SIFMA.org In a primary financial market, issuers issue new securities in return for cash from investors. In the case of a debt obligation, the issuer is the borrower and the investor is the lender. When a company goes public, selling equity interests to investors for the first time, we refer to the offering as an initial public offering (IPO).
Financial Markets Debt and equity issuance by Corporations, 1990-2012 Source of data: sifma.org
Financial Markets • A secondary financial market provides trading environments that permit investors to buy and sell existing securities. • Exchange markets- referred to as auction markets because they involve a bidding process that takes place in a specific location (i.e., similar to an auction). • Dealer market or over-the-counter (OTC) markets- do not have a physical location, but rather consist of a network of dealers who trade directly with one another. • The distinction between these two types of secondary markets has become blurred in recent years because trading on most of the major exchanges in the world has become fully computerized, making the physical location of the exchanges of little consequence.
Financial Markets • The third marketrefers to the trading of securities that are listed on organized exchanges in the OTC market. • Historically, this market has been particularly important for “block trades,” which are extremely large transactions involving at least 10,000 shares or $100,000. • The fourth marketrefers to trades that are made directly between investors (usually large institutions), without the involvement of brokers or dealers. • The fourth market operates through the use of privately owned automated systems, with one of the most widely recognized systems being Instinet.
Equity Securities Common shares represent the major financial security issued by corporations and comprise a proportionate ownership in a company. Common shares are generally issued once and then stay outstanding indefinitely. We often compare stocks by referring to their market capitalization. A company’s market capitalization is the product of the market price of a share and the number of shares outstanding.
Regulation • Most economies operate with a central bank that oversees financial institutions and the economy’s money supply. In the U.S., the central bank is the Federal Reserve System. • The Federal Reserve System (the Fed) has been given the power, among other things, to do the following: • Establish margin requirements, which affect the extent that stock is purchased with borrowed funds • Require disclosures regarding consumer lending • Assess reserve requirements of member banks and non-depository institutions
Regulation The Securities and Exchange Commission (SEC) bears the responsibility of ensuring that financial markets are fair, orderly, and efficient. The SEC is tasked with encouraging capital flows from investors to businesses, but also with protecting investors.
1.3 The Global Financial Crisis The financial crisis of 2007–2008 was a significant event that affected businesses and economies around the world. To understand the crisis, it is important to first appreciate the linkages that exist among the global economies.
The Global Financial Community U.S. Investors’ international investments, Second quarter 2010 and 2011
Equity or Stock Markets The United States possesses the largest equity markets in the world. The NYSE Euronext is the world’s largest stock market with a market capitalization at the end of January 2011 of $15.1 trillion. The NASDAQ is the second-largest stock market in the world, based on its market capitalization of $3.6 trillion.
The Financial Crisis 2007-2008 • There is no single cause of the crisis, but rather many that occurred to create the perfect storm. • One of the most visible causes of the crisis was the housing bubble. • Other causes included: • Lax lending standards • A push for the government-sponsored entities (GSEs) of Freddie Mac and Fannie Mae to purchase lower quality loans for resale as securities • The insatiable appetite of investors for high-return, high-risk securities that were backed by mortgages • Rampant fraud in mortgage origination
Securitization Mortgage backed security Securitization is the process of converting loans into securities. Example: creating a mortgage-backed security:
The Future of Regulation • The regulatory structure in the U.S. financial system is undergoing changes to address the problems that created significant systemic risk. • The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: • Created the Financial Stability Oversight Council, which provides a formal system ofcoordination among key regulators • Created criteria and standards for systemically important financial companies • Provides for the orderly liquidation of financial companies that are insolvent • Limits proprietary trading (Volcker Rule)
Lessons for Financial Managers • Financial risk management is important. • Financial managers need to identify, assess, and manage risks; • companies must develop an assessment of how much risk they are willing to take (that is, their risk appetite), and • risk management must be an essential part of a company’s strategy. • Companies that rely on securitizing their assets should be prepared for the associated risks. • Securitization of assets is performed by many companies, not just banks and, for example, has been a source of cash flow for companies that sell their receivables through these transactions. • For instance, Harley-Davidson Financial Services securitized the loans made on the purchases of Harley-Davidson motorcycles; when the securitization market dried up and the company could no longer securitize the loans, it could not turn the loans into cash, but rather had to retain and maintain them.
Lessons for Financial Managers • Reliance on bank financing for short-term needs is problematic during a credit crunch. • Many companies that relied on lines of credit from banks or issuing commercial paper to meet seasonal needs found that they could not get financing during severe times. • For example, the commercial paper market was disrupted in September 2008 with Lehman Brothers’ bankruptcy; in December 2008, the outstanding commercial paper was half of what is was at the end of 2007. • Executive compensation should be tied to some measure of risk, not just earnings. • Many financial institutions tied compensation to earnings, without regard to the risk associated with the expansion of the entity into other, riskier lines of business. The focus on earnings may have inadvertently encouraged excessive risk taking.
Summary Finance as a subject area is the study of the flow of funds from those with funds to those who need funds. Financial decision making encompasses investment and financing decisions, which may be short-term or long-term decisions.
Summary • A business may borrow funds, either through borrowing or selling equity interests in the business. • Borrowing includes loans from banks, issuing commercial paper, or issuing notes or bonds. • Borrowing requires repayment of the debt, as well as interest on the debt. • A company may sell ownership stakes in the company, which are represented by shares of stock. • These shares may be common stock or preferred.
Summary • The financial system is global, with parties crossing borders to raise and invest funds. • No better example of the globalization of the financial system is available than the 2007–2008 financial crisis, where linkages among the markets were evident as the U.S. economy faltered, along with economies around the world.
