Principles of Managerial Finance

Sixteenth Edition, Global Edition

Chapter 2
The Financial Market Environment

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Learning Goals (1 of 2)
LG 1 Understand the role that financial institutions play in
managerial finance.
LG 2 Understand the role that financial markets play in
managerial finance.
LG 3 Describe the differences between the money market
and the capital market.
LG 4 Understand the major regulations and regulatory
bodies that affect financial institutions and markets.

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Learning Goals (2 of 2)
LG 5 Describe the process of issuing common stock,
including venture capital, going public, and the role of
the investment bank.
LG 6 Understand what is meant by financial markets in
crisis, and describe some of the root causes of the
Great Recession.

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2.1 Financial Institutions (1 of 2)
• Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into
loans or investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

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2.1 Financial Institutions (2 of 2)
• Banking Industry
– Commercial Banks
 Institutions that provide savers with a secure place to
invest their funds and that offer loans to individual and
business borrowers
– Investment Banks
 Assist companies in raising capital, advise firms on major
transactions such as mergers or financial restructurings,
and engage in trading and market-making activities

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2.2 Financial Markets (1 of 14)
• The Relationship Between Institutions and Markets
– Financial markets are forums in which suppliers of
funds and demanders of funds can transact business
directly
– Transactions in short-term marketable securities take
place in the money market while transactions in long-
term securities take place in the capital market
– A private placement involves the sale of a new
security directly to an investor or group of investors
– Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds
or stocks to the general public

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2.2 Financial Markets (2 of 14)
• The Relationship Between Institutions and Markets
– The primary market is the financial market in which
securities are initially issued; the only market in which
the issuer is directly involved in the transaction
– Secondary markets are financial markets in which
preowned securities (those that are not new issues)
are traded

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2.2 Financial Markets (3 of 14)
• The Money Market
– A market where investors trade highly liquid securities
with maturities of one year or less
– Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
 U.S. Treasury bills issues by the federal government
 Commercial paper issued by businesses
 Negotiable certificates of deposit issued by financial
institutions
– Investors generally consider marketable securities to
be among the least risky investments available.

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2.2 Financial Markets (5 of 14)
• The Capital Market
– A market that enables suppliers and demanders of
long-term funds to make transactions
– Key Securities Traded: Bonds and Stocks
 Securities traded in the capital market fall into two
broad categories: debt and equity
 Bonds
– Long-term debt instruments used by business
and government to raise large sums of money,
generally from a diverse group of lenders

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2.2 Financial Markets (6 of 14)
• The Capital Market
– Key Securities Traded: Bonds and Stocks
 Common Stock
– Units of ownership interest, or equity, in a
corporation
 Preferred Stock
– A special form of ownership that has features of
both a bond and common stock

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2.2 Financial Markets (7 of 14)
• The Capital Market
– Broker Markets
 Securities Exchanges
– Organizations that provide the marketplace in which
firms can raise funds through the sale of new
securities and in which purchasers can resell
securities
 Broker Markets
– Securities exchanges in which the two sides of a
transaction, the buyer and the seller, are brought
together to trade securities
– Trading takes place on centralized trading floors of
national exchanges, such as N Y S E Euronext, as
well as regional exchanges
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 2.2 Financial Markets (8 of 14)
• The Capital Market
– Dealer Markets
 Markets, like the NASDA Q, in which the buyer and seller are not
brought together directly but instead have their orders executed
by securities dealers who “make markets” in the given security
 The dealer market has no centralized trading floors
• It is made up of a large number of market makers who
are linked together via a mass-telecommunications
network
• As compensation for executing orders, market
makers make money on the bid/ask spread (ask
price – bid price)
• Ask Price: The lowest price a seller is willing to
accept for a security
• Bid Price: The highest price a buyer is willing to pay
for a security
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Matter of Fact (2 of 2)
NYSE Is the World’s Largest Stock Exchange
According to The World Federation of Exchanges, in 2020
the world boasted 77 major stock exchanges with a
combined total market value of $88 trillion. The largest stock
market in the world, as measured by the total market value
of securities listed on that market, is the NYS E, with listed
securities worth more than $24 trillion, or about 27% of the
total market value for all major exchanges globally. The
NYS E’s total market capitalization is larger than the total
market capitalizations of the world’s 50 smallest major
exchanges combined. The next largest is the Nasdaq at $11
trillion, with exchanges in Tokyo and Shanghai not far behind
at $6 trillion and $4 trillion, respectively.

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2.2 Financial Markets (11 of 14)
• The Efficient Markets Hypothesis
– An efficient market establishes prices for securities by
rapidly incorporating all available information.
 A security’s price is an unbiased estimate of its true
or intrinsic value
– “correct on average”
– Information in Efficient Markets
 Prices respond to new information, and by definition,
new information is unpredictable
 New information refers to things that market
participants do not know today and cannot predict
based on other information that they possess.

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2.2 Financial Markets (12 of 14)
• The Efficient Markets Hypothesis
– Price Movements in Efficient Markets
 Random Walk Hypothesis is the idea that in an
efficient financial market, prices should be virtually
unpredictable because they move in response to
new information, which is itself unpredictable.
– Even if a company’s financial results follow a
highly predictable pattern, its stock price will not
follow the same pattern (or perhaps even any
pattern)
– If stock prices do exhibit predictable patterns, the
actions of investors will tend to eliminate those
patterns over time

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2.2 Financial Markets (13 of 14)
• The Efficient Markets Hypothesis
– Price Movements in Efficient Markets
 The price of an individual security is determined by the
interaction of buyers and sellers in the market.
– The stock price is the best available estimate of the stock’s
true value.
– Investors compete with each other for information about a
stock’s true value, so at any given time, a stock’s price
reflects all information known about the stock.
• The more efficient the markets is, the more rapidly this
whole process works.
• That relatively few professional managers outperform
the overall market consistently is exactly what the
efficient markets hypothesis predicts.

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2.2 Financial Markets (14 of 14)
• The Efficient Markets Hypothesis
– The Behavioral Finance Challenge to Efficient Markets
 Behavioral finance is an emerging field that blends
ideas from finance and psychology, arguing that
stock prices and prices of other securities can
deviate from their true values for extended periods
and that these deviations may lead to predictable
patterns in stock prices.

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2.4 The Securities Issuing Process
(1 of 12)

• Issuing Common Stock

– Private Equity
 External equity financing that is raised via a private
placement, typically by private early-stage firms with
attractive growth prospects
 Angel Investors (or Angels)
– Wealthy individual investors who make their own
investment decisions and are willing to invest in
promising startups in exchange for a portion of
the firm’s equity

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2.4 The Securities Issuing Process
(2 of 12)

• Issuing Common Stock

– Private Equity
 Venture Capitalists (VC s)
– Formal business entities that take in private
equity capital from many individual investors,
often institutional investors such as endowments
and pension funds or individuals of high net
worth, and make private equity investment
decisions on their behalf

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2.4 The Securities Issuing Process
(4 of 12)

• Issuing Common Stock

– Going Public
 Private Placement
– The firm sells new securities directly to an
investor or group of investors
 Rights Offering
– The firm sells new shares to existing
stockholders
 Public Offering
– The firm sells new shares to the general public

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2.4 The Securities Issuing Process
(5 of 12)

• Issuing Common Stock

– Going Public
 Initial Public Offering (IP O)
– The first public sale of a firm’s stock, typically made
by small, rapidly growing companies that either
require additional capital to continue growing or have
met a milestone for going public that was established
in an earlier agreement to obtain VC funding
 Prospectus
– A portion of a security registration statement that
describes the key aspects of the issue, the issuer,
and its management and financial position

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2.4 The Securities Issuing Process
(6 of 12)

• Issuing Common Stock

– Going Public
 Red Herring
– A preliminary prospectus made available to
prospective investors during the waiting period
between the registration statement’s filing with
the SE C and its approval
 Quiet Period
– Period during which the law places restrictions on
what company officials may say about the
company

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2.4 The Securities Issuing Process
(7 of 12)

• Issuing Common Stock

– Going Public
 Roadshow
– A series of presentations to potential investors
around the country and sometimes overseas,
providing investors with information about the
new issue
– Sessions help investment banks gauge demand
for the offering and set a preliminary offer price
range

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2.4 The Securities Issuing Process
(8 of 12)

• Issuing Common Stock

– The Investment Bank’s Role
 Investment Bank
– Financial intermediary that specializes in selling new
security issues and advising firms with regard to
major financial transactions
– Promotes the stock and facilitates the sale of the I P
O shares
 Underwriting
– The role of the investment bank in bearing the risk of
reselling, at a profit, the securities purchased from an
issuing corporation at an agreed-on price
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2.4 The Securities Issuing Process
(9 of 12)

• Issuing Common Stock

– The Investment Bank’s Role
 IP O Offer Price
– The price at which the issuing firm sells its securities
 Originating Investment Bank
– The investment bank initially hired by the issuing firm,
which brings other investment banks in as partners to
form an underwriting syndicate
 Underwriting Syndicate
– A group of other banks formed by the originating
investment bank to share the financial risk associated
with underwriting new securities
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Figure 2.4 Cover of a Final
Prospectus for a Stock Issue

Source: Pinterest.
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Figure 2.5 The Selling Process for a
Large Security Issue

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2.4 The Securities Issuing Process
(11 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
 Total Proceeds
– The total amount of proceeds for all shares sold in the I P
O
– Total Proceeds = (I P O Offer Price × # of I P O Shares
Issued)
 Market Price
– The price of the firm’s shares as determined by the
interaction of buyers and sellers in the secondary market
 Market Capitalization
– The total market value of a publicly traded firm’s
outstanding stock
– Market Capitalization = (Market Price × # of Shares
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2.4 The Securities Issuing Process
(12 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
 IP O Market Price
– The final trading price on the first day in the secondary
market
 I P O Underpricing
– The percentage change from the final I P O offer price to
the IP O market price, which is the final trading price on
the first day in the secondary market; this is also called the
IP O initial return
– IP O Underpricing = (Market Price − Offer Price) ÷ Offer
Price
– The term underpricing applies because the offer price is
usually set below what secondary market investors are
willing to pay.

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Example 2.3 (1 of 2)
Investors looking for a good night’s sleep might have been
interested in the February 2020 I P O of Casper Sleep, Inc.
Known for its inexpensive mattresses shipped in a box easy
enough for one person to handle, Casper offered its shares
to primary market investors at $12. After one day of trading
the stock closed at $13.50, which means that Casper
underpriced its shares by 12.5% as Equation 2.6 indicates.

I P O Underpricing = ($13.50 − $12) ÷ $12 = 0.125 = 12.5%

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Example 2.3 (2 of 2)
Casper Sleep’s I P O underpricing of 12.5% is considerably
less than the 28% underpricing for Pinterest. This
demonstrates another interesting fact about I PO s,
specifically, that the degree to which I PO s are underpriced
varies tremendously from one deal to another and one time
to another. Usually, smaller I PO s are underpriced more than
larger ones, but that was not the case here. Casper raised
about $100 million in its offering, which is a small fraction of
the $1.4 billion raised by Pinterest.

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2.5 Financial Markets in Crisis (1 of 6)
• Financial Institutions and Real Estate Finance
– Securitization
 The process of pooling mortgages or other types of
loans and then selling claims or securities against
that pool in the secondary market
– Mortgage-Backed Securities
 Securities that represent claims on the cash flows
generated by a pool of mortgages
 A primary risk associated with mortgage-backed
securities is that homeowners may not be able to, or
may choose not to, repay their loans

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2.5 Financial Markets in Crisis (2 of 6)
• Financial Institutions and Real Estate Finance
– Falling Home Prices and Delinquent Mortgages
 Rising home prices between 1987 and 2006 kept
mortgage default rates low
 Lenders relaxed standards for borrowers and created
subprime mortgages
 As housing prices fell from 2006 to 2009, many
borrowers had trouble making payments, but were
unable to refinance
 As a result, there was a sharp increase in the number of
delinquencies and foreclosures
 Subprime Mortgages
– Mortgage loans made to borrowers with lower
incomes and poorer credit histories as compared with
“prime” borrowers

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2.5 Financial Markets in Crisis (3 of 6)
• Financial Institutions and Real Estate Finance
– Crisis of Confidence in Banks
 With delinquency rates rising, the value of
mortgage-backed securities began to fall and so did
the fortunes of financial institutions that had invested
heavily in real estate assets
 Only 3 banks failed in 2007, but 25 failed in 2008,
140 failed in 2009, peaking at 157 bank failures in
2010
 It was not until 2015 that bank failures fell back into
the single digits

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2.5 Financial Markets in Crisis (4 of 6)
• Spillover Effects and Recovery from the Great Recession
– As banks came under intense financial pressure in
2008, they began to tighten their lending standards,
dramatically reduce the quantity of loans they made,
and increase the rates that they charged borrowers.
– Corporations found that they could no longer raise
money in the money market, or could only do so at
extraordinarily high rates
– As a consequence, businesses began to hoard cash
and cut back on expenditures, and economic activity
contracted

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2.5 Financial Markets in Crisis (5 of 6)
• Pandemic Effects on Financial Markets
– On January 11, 2020, Chinese state media reported
the death of a 61-year-old man who had died from an
unknown virus that had infected many others in
Wuhan.
– Just 10 days later, came the first confirmed case in the
United States and soon dozens of countries reported
outbreaks.
– By March 13, President Trump declared a national
emergency, and within days many states issued
“shelter-in-place” orders to residents and shuttered
nonessential businesses.

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2.5 Financial Markets in Crisis (6 of 6)
• Pandemic Effects on Financial Markets
– The effects on financial markets were immediate and
dramatic.
 S&P 500 Stock Index, which had peaked in
February, fell in 17 out of the next 23 trading
sessions, dropping by more than 30%, perhaps the
most rapid decline in stocks in U.S. history.
 Yields on investment-grade corporate bonds, a
measure of what it costs financially sound
companies to borrow money, rose from 2.36% to
4.12% in two weeks
 For companies with less than stellar finances,
borrowing costs soared from 6% to more than 11%.

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Review of Learning Goals (1 of 10)
• LG 1
– Understand the role that financial institutions play in
managerial finance.
 Financial institutions bring net suppliers of funds and net
demanders together to help translate the savings of
individuals, businesses, and governments into loans and
other types of investments
 The net suppliers of funds are generally individuals or
households who save more money than they borrow
 Businesses and governments are generally net
demanders of funds, meaning they borrow more money
than they save

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Review of Learning Goals (2 of 10)
• LG 2
– Understand the role that financial markets play in
managerial finance.
 Like financial institutions, financial markets help
businesses raise the external financing they need to
fund new investments for growth
 Financial markets provide a forum in which savers
and borrowers can transact business directly
 Businesses and governments issue debt and equity
securities directly to the public in the primary market
 Subsequent trading of these securities between
investors occurs in the secondary market

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Review of Learning Goals (3 of 10)
• LG 3
– Describe the differences between the money market and the
capital market.
 In the money market, savers who want a temporary
place to deposit funds where they can earn interest
interact with borrowers who have a short-term need for
funds
 Marketable securities, including Treasury bills,
commercial paper, and other instruments, are the main
securities traded in the money market
 The Eurocurrency market is the international equivalent
of the domestic money market.
 In contrast, the capital market is the forum in which
savers and borrowers interact on a long-term basis

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Review of Learning Goals (4 of 10)
• L G 3 (Cont.)
– Describe the differences between the money market and the
capital market.
 Firms issue either debt (bonds) or equity (stock)
securities in the capital market
 Once issued, these securities trade on secondary
markets that are either broker markets or dealer markets
 An important function of the capital market is to
determine the underlying value of the securities issued
by businesses
 In an efficient market, the price of a security is an
unbiased estimate of its true value

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Review of Learning Goals (5 of 10)
• LG 4
– Understand the major regulations and regulatory bodies that
affect financial institutions and markets.
 The Glass-Steagall Act created the FDIC and imposed a
separation between commercial and investment banks
 The act was designed to limit the risks that banks could
take and to protect depositors
 More recently, the Gramm-Leach-Bliley Act essentially
repealed the elements of Glass-Steagall pertaining to the
separation of commercial and investment banks.
 After the recent financial crisis, much debate has
occurred regarding the proper regulation of large
financial institutions

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Review of Learning Goals (6 of 10)
• L G 4 (Cont.)
– Understand the major regulations and regulatory
bodies that affect financial institutions and markets.
 The Dodd-Frank Act was passed in 2010 and
contained a host of new regulatory requirements,
the effects of which are yet to be determined
 The Securities Act of 1933 and the Securities
Exchange Act of 1934 are the major pieces of
legislation shaping the regulation of financial
markets

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Review of Learning Goals (7 of 10)
• L G 4 (Cont.)
– Understand the major regulations and regulatory
bodies that affect financial institutions and markets.
 The 1933 act focuses on regulating the sale of
securities in the primary market, whereas the 1934
act deals with regulations governing transactions in
the secondary market
 The 1934 act also created the Securities and
Exchange Commission, the primary body
responsible for enforcing federal securities laws

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Review of Learning Goals (8 of 10)
• LG 5
– Describe the process of issuing common stock,
including venture capital, going public, and the role of
the investment bank.
 The initial external financing for business startups
with attractive growth prospects typically comes in
the form of private equity raised via a private equity
placement
 These investors can be either angel investors or
venture capitalists (VCs). VCs usually invest in both
early-stage and later-stage companies that they
hope to take public to cash out their investments
 The first public issue of a firm’s stock is called an
initial public offering (IPO).
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Review of Learning Goals (9 of 10)
• L G 5 (Cont.)
– Describe the process of issuing common stock,
including venture capital, going public, and the
investment bank.
 The company selects an investment bank to advise
it and to sell the securities
 The lead investment bank may form a selling
syndicate with other investment banks
 The IPO process includes getting SEC approval,
promoting the offering to investors, and pricing the
issue

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Review of Learning Goals (10 of 10)
• LG 6
– Understand what is meant by financial markets in crisis, and
describe some of the root causes of the Great Recession.
 The financial crisis was caused by several factors related
to investments in real estate
 Financial institutions lowered their standards for lending
to prospective homeowners, and institutions also
invested heavily in mortgage-backed securities
 When home prices fell and mortgage delinquencies rose,
the value of the mortgage-backed securities held by
banks plummeted, causing some banks to fail and many
others to restrict the flow of credit to business
 That, in turn, contributed to a severe recession in the
United States that became known as the Great
Recession
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