M02 Titman 2544318 11 FinMgt C02

Chapter 2
Firms and the

Financial Market
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Slide Contents
• Learning Objectives
• Principles Used in this Chapter
1. The Basic Structure of the U.S. Financial
Markets
2. The Financial Marketplace – Financial
Institutions
3. The Financial Marketplace – Securities
Markets.

2-2
Learning Objectives
1. Describe the structure and functions of

financial markets.
2. Distinguish between commercial banks
and other financial institutions in the
financial marketplace.
3. Describe the different securities markets
for bonds and stock.

2-3
Principles Used in this Chapter
• Principle 2: There is a Risk-Return

Tradeoff.
– Financial markets are organized to offer

investors a wide range of investment
opportunities that have different risk and
different expected rates of return that reflect
those risks.

2-4
Principles Used in this Chapter
(cont.)
• Principle 4: Market Prices Reflect

Information.
– It is through the operations of the financial

markets that new information is efficiently
impounded in security prices.

2-5
2.1 THE BASIC
STRUCTURE OF
THE U.S.
FINANCIAL
MARKETS

Three Players in the Financial
Markets
• There are three principal sets of players that
interact within the financial markets:
1. Borrowers
2. Savers (or sometimes called lenders)
3. Financial Institutions (or sometimes called
Financial Intermediaries)

2-7
Three Players in the Financial
Markets (cont.)
1. Borrowers: Individuals and businesses that need
money to finance their purchases or
investments.
2. Savers (Investors): Those who have money to
invest. These are principally individuals although
firms also save when they have excess cash.
3. Financial Institutions (Intermediaries): The
financial institutions and markets help bring
borrowers and savers together.

2-8
2-9
2.2 THE FINANCIAL
MARKETPLACE –
FINANCIAL
INSTITUTIONS

Financial Intermediaries
SAVERS Financial BORROWERS

Intermediaries

2-11
Financial Intermediaries
• Example on Intermediaries
• John’s three sons are grown up and are
looking to buy their first home.
– There is no intermediation if John directly gives
them the funds they need
– There is intermediation where a bank doles out
the funds and John is free to place his monies
in any bank he chooses to do so.

2-12
Financial Intermediaries (cont.)
• Financial institutions like commercial

banks, finance companies, insurance
companies, investment banks, and
investment companies are called financial
intermediaries as they help bring
together those who have money (savers)
and those who need money (borrowers).

2-13
Money versus Capital Market
• The money market refers to debt

instruments with maturity of one year or
less.
– Examples: Treasury bills (T-bills), Commercial
paper (CP).
• The capital market refers to long-term
debt and equity instruments.
– Examples: Common stock, Preferred stock,
Corporate bond, Treasury bond, Municipal
bond.

2-14
Commercial Banks – Everyone’s
Financial Marketplace
• Commercial banks collect the savings of

individuals as well as businesses and then lend
those pooled savings to other individuals and
businesses.
• They make money by charging a rate of interest to

borrowers that exceeds the rate they pay to
savers.
• In the United States, banks cannot own industrial

corporations.

2-15
2-16
Non-Bank Financial Intermediaries
• These include:
– Financial services corporations, like GE Capital
Division;
– Insurance companies, like Prudential;
– Investment banks, like Goldman Sachs;
– Investment companies including mutual funds,
hedge funds and private equity firms.

2-17
Financial Services Corporations
• Financial services corporation are in the
lending or financing business, but they are not
commercial banks.
• One well known financial service corporation is GE

capital, the finance unit of the General Electric
Corporation.

2-18
Financial Services Corporations
(cont.)
• GE capital provides commercial loans, financing

programs, commercial insurance, equipment
leasing, and other services in over 35 countries
around the world.
• GE capital also provides credit services to more

than 130 million customers that range from
retailers, auto dealers, consumers offering
products and services from credit cards to debt
consolidation to home equity loans.

2-19
Insurance Companies
• Insurance companies sell insurance to individuals

and businesses to protect their investments.
• They collect premium and hold the premium in

reserves until there is an insured loss and then pay
out claims to the holders of the insurance
contracts. Later, these reserves are deployed in
various types of investments including loans to
individuals, businesses and the government.

2-20
Investment Banks
• Investment banks are specialized

financial intermediaries that:
– help companies and governments raise money
– provide advisory services to client firms on
major transactions such as mergers
• Firms that provide investment banking
services include Bank of America, Goldman
Sachs, Morgan Stanley and JP Morgan
Chase.

2-21
Investment Companies
• Investment companies are financial

institutions that pool the savings of
individual savers and invest the money in
the securities issued by other companies
purely for investment purposes.

2-22
Mutual Funds and Exchange Traded
Funds (ETFs)
• Mutual funds are professionally managed

according to a stated investment objective.
• Individuals can invest in mutual funds by
buying shares in the mutual fund at the
net asset value (NAV).
• NAV is calculated daily based on the total
value of the fund divided by the number of
mutual fund shares outstanding.

2-23
Funds (ETFs) (cont.)
• Mutual funds can either be load or no-load

funds. The term load refers to the sales
commission that you pay when acquiring
ownership shares in the fund. These
commissions typically range between 4.0
to 6.0%.
• A mutual fund that does not charge a
commission is referred to as a no-load
fund.

2-24
• An exchange-traded fund (ETF) is

similar to a mutual fund except that the
ownership shares in the ETF can be bought
and sold on the stock exchange.
• Most ETFs track an index, such as the Dow
Jones Industrial Average or the S&P 500,
and generally have relatively low
expenses.

2-25
• Mutual funds and ETFs provide a cost-effective
way to diversify and reduce risk.
• If you had only $10,000 to invest, it would be
difficult to diversify since you will have to pay
commission for each individual stock. However,
by buying a mutual fund that invests in S&P
500,you can indirectly purchase a portfolio that
tracks 500 stocks with just one transaction.
Alternatively, you might purchase an ETF, such as
SPDR S&P 500 (SPY), which tracks S&P 500.

2-26
Hedge Funds
• Hedge funds are similar to mutual funds

but they tend to take more risk and are
generally open only to high net worth
investors.
• Management fees also tends to be higher
for hedge funds and most funds include an
incentive fee based on the fund’s overall
performance, which typically runs at 20%
of profits.

2-27
Private Equity Firms
• Private equity firms include two major

groups: Venture capital (VC) firms and
Leveraged buyout firms (LBOs).

2-28
Private Equity Firms (cont.)
• Venture capital firms raise money from

investors (wealthy individuals and other
financial institutions) that they then use to
provide financing for private start-up
companies when they are first founded.
• For example, Venture capital firm, Kleiner
Perkins Caufield & Byers (KPCB) was
involved in the initial financing of Google.

2-29
Private Equity Firms (cont.)
• Leveraged buyout firms acquire established

firms that typically have not been performing very
well with the objective of making them profitable
again and selling them. An LBO typically uses debt
to fund the purchase of a firm. LBO transactions
grew from $7.5 billion in 1991 to $500 billion in
2006.
• Prominent LBO private equity firms include
Cerberus Capital Management, L.P., TPG (formerly
Texas Pacific Group), and KKR (Kohlberg, Kravis,
and Roberts).

2-30
2.3 THE
FINANCIAL
MARKETPLACE –
SECURITIES
MARKET

Security
• A security is a negotiable instrument that

represents a financial claim and can take
the form of ownership (such as stocks) or
debt agreement (such as bonds).
• The securities market allow businesses and

individual investors to trade the securities
issued by public corporations.

2-32
Primary versus Secondary Market
• A primary market is a market in which

securities are bought and sold for the first
time. In this market, the firm selling
securities actually receives the money
raised. For example, securities sold by a
corporation to investment bank.

2-33
Primary versus Secondary Market
(cont.)
• A secondary market is where all

subsequent trading of previously issued
securities takes place.
• In this market, the issuing firm does not
receive any new financing. The securities
are simply transferred from one investor to
another.
• The secondary markets (for example, the
New York Stock Exchange) provide
liquidity to the investor. .
2-34
2-35
Process of Raising Money in the
Securities Market (Figure 2-2)
1. The firms sells securities (debt or equity)

to investors in the primary market.
2. The firm invests the funds it raises in its
business.
3. The firm distributes the cash earned from
its investments.
4. Security continues to trade in the
secondary market.

2-36
Types of Securities
• Debt Securities: Firms borrow money by

selling debt securities in the debt market.
• If the debt has a maturity of less than one
year, it is typically called notes, and is
traded in the money market.
• If the debt has a maturity of more than
one year, it is called bond and is traded in
the capital market.

2-37
Types of Securities (cont.)
• Most bonds pay a fixed interest rate on the

face or par value of bond.
• For example, a bond with a face value of
$1,000 and semi-annual coupon rate of
9% will pay an interest of $45 every 6
months or $90 per year, which is 9% of
$1,000. When the bond matures, the
owner of the bond will receive $1,000.

2-38
• Equity securities represent ownership of

the corporation.
• There are two major types of equity

securities: common stock and preferred
stock.

2-39
• Common stock is a security that represents
equity ownership in a corporation, provides voting
rights, and entitles the holder to a share of the
company’s success in the form of dividends and
any capital appreciation in the value of the
security.
• Common stockholders are residual owners of the
firm i.e. they earn a return only after all other
security holder claims (debt and preferred equity)
have been satisfied in full.

2-40
• Dividend on common stock are neither

fixed nor guaranteed. Thus a company can
choose to reinvest all of the profits in a
new project and pay no dividends.

2-41
• Preferred stock is an equity security.

However, preferred stockholders have
preference with regard to:
– Dividends: They are paid before the common
stockholders.
– Claim on assets: They are paid before common
stockholders if the firm goes bankrupt and sells
or liquidates its assets.

2-42
• Preferred stock is similar to common stocks

in that:
– It has no fixed maturity date,
– The nonpayment of dividends does not result in
bankruptcy of the firm, and
– The dividends are not deductible for tax
purposes.
Preferred stock is also referred to as a hybrid
security as it has features of both common stock
and bonds.

2-43
Preferred stock is similar to corporate bonds

in that:
– The dividends are typically a fixed amount, and
– There are no voting rights.

2-44
Stock Markets
• A stock market is a public market in which

the stocks of companies is traded.
• Stock markets are classified as either

organized security exchanges or over-the-
counter (OTC) market.

2-45
Stock Markets (cont.)
• Organized security exchanges are

tangible entities; that is, they physically
occupy space and financial instruments are
traded on their premises.
• For example, the New York Stock
Exchange (NYSE) is located at 11 Wall
Street in Manhattan, NY.
• The total value of stocks listed on the
NYSE fell from $18 trillion in 2007 to just
over $10 trillion at the beginning of 2009.
2-46
Stock Markets (cont.)
• The over-the-counter markets include
all security market except the organized
exchanges.
• NASDAQ (National Association of Securities
Dealers Automated Quotations) is an over-
the-counter market and describes itself as
a “screen-based, floorless market”.
• In 2009, nearly 3,900 companies were
listed on NASDAQ, including Starbucks,
Google, Intel.

2-47
Reading Stock Price Quotes
• Figure 2-3 illustrates how to read stock

price quotes from
www.google.com/finance.
• Similar information is available at

http://finance.yahoo.com

2-48
2-49
Other Financial Instruments
• Table 2-2 provides a list of different

financial instruments used by firms to raise
money beginning with the shortest
maturity instruments.
• Instruments are traded in the money
market and moving through to the longest
maturity instruments that are traded in the
capital market.

2-50
2-51
Key Terms
• Accredited investor
• Bond
• Capital market
• Common stock
• Coupon rate
• Credit default swaps

2-52
Key Terms (cont.)
• Debt securities
• Equity securities
• Exchange-traded funds (ETFs)
• Face or par value
• Financial intermediaries
• Hedge fund
• Investment bank

2-53
Key Terms (cont.)
• Investment companies
• Leveraged buyout fund
• Load funds
• Maturity
• Money market
• Mutual fund
• Net asset value

2-54
Key Terms (cont.)
• Notes
• No-load fund
• Organized security exchanges
• Over-the-counter markets
• Preferred stock
• Primary market
• Secondary market
• Security
• Venture Capital firm

2-55

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Chapter 2

Firms and the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1. Describe the structure and functions of

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Principle 2: There is a Risk-Return

– Financial markets are organized to offer

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Principle 4: Market Prices Reflect

– It is through the operations of the financial

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

SAVERS Financial BORROWERS

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Financial institutions like commercial

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The money market refers to debt

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Commercial banks collect the savings of

• They make money by charging a rate of interest to

• In the United States, banks cannot own industrial

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• One well known financial service corporation is GE

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• GE capital provides commercial loans, financing

• GE capital also provides credit services to more

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Insurance companies sell insurance to individuals

• They collect premium and hold the premium in

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Investment banks are specialized

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Investment companies are financial

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Mutual funds are professionally managed

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Mutual funds can either be load or no-load

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• An exchange-traded fund (ETF) is

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Hedge funds are similar to mutual funds

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Private equity firms include two major

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Venture capital firms raise money from

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Leveraged buyout firms acquire established

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• A security is a negotiable instrument that

• The securities market allow businesses and

Copyright © 2011 Pearson Prentice Hall. All rights reserved.