Finance Week 2-3

Financial
Management
Week 2: Financial
Market Environment
What is Financial Management?
Macro Finance
ABC Company
Balance Sheet
As of December 31, 19xx
Assets: Liabilities & Equity:

Current Assets Current Liabilities
Working Cash & M.S. Accounts payable
Working
Capital Accounts receivable Notes Payable
Capital
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Investment Less: Accumulated dep. Common Stock Financing
Decisions Goodw ill Paid-in-capital
Decisions
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
Shift from an emphasis on
Investing capital to:
Attracting capital
Basic relationships in the financial reporting
process
Financial Institutions & Markets
Firms that require funds from external sources can obtain

them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements
2-5
Financial Institutions &
Markets: Financial Institutions
• 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.
2-6
Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that provide savers

with a secure place to invest their funds and that offer
loans to individual and business borrowers.
• Investment banks are institutions that 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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2-7
Financial Institutions &
Markets: Financial 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.
2-8
Financial Institutions & Markets:
Financial Markets (cont.)
• 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.
2-9
Figure 2.1
Flow of Funds
2-10
The Money Market
• The money market is created by a financial relationship

between suppliers and demanders of short-term funds.
• Most money market transactions are made in marketable
securities which are short-term debt instruments, such as
U.S. Treasury bills, commercial paper, and negotiable
certificates of deposit issued by government, business,
and financial institutions, respectively.
• Investors generally consider marketable securities to be
among the least risky investments available.
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2-11
The Capital Market
• The capital market is a market that enables suppliers and

demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity, or
ownership).
– Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a
diverse group of lenders.
– Common stock are units of ownership interest or equity in a
corporation.
– Preferred stock is a special form of ownership that has features
of both a bond and common stock.
2-12
The Capital Market
Lakeview Industries, a major microprocessor manufacturer,

has issued a 9 percent coupon interest rate, 20-year bond
with a $1,000 par value that pays interest semiannually.
– Investors who buy this bond receive the contractual right to $90
annual interest (9% coupon interest rate  $1,000 par value)
distributed as $45 at the end of each 6 months (1/2  $90) for
20 years.
– Investors are also entitled to the $1,000 par value at the end of
year 20.
2-13
International Capital Markets
• In the Eurobond market, corporations and governments

typically issue bonds denominated in dollars and sell
them to investors located outside the United States.
• The foreign bond market is a market for bonds issued by
a foreign corporation or government that is denominated
in the investor’s home currency and sold in the investor’s
home market.
• The international equity market allows corporations to
sell blocks of shares to investors in a number of different
countries simultaneously.
2-14
The Role of Capital Markets
• From a firm’s perspective, the role of capital markets is to be a

liquid market where firms can interact with investors in order to
obtain valuable external financing resources.
• From investors’ perspectives, the role of capital markets is to be an
efficient market that allocates funds to their most productive uses.
• An efficient market allocates funds to their most productive uses
as a result of competition among wealth-maximizing investors and
determines and publicizes prices that are believed to be close to
their true value.
2-15
The Financial Crisis: Financial
Institutions and Real Estate Finance
• Securitization is the process of pooling mortgages or
other types of loans and then selling claims or securities
against that pool in a secondary market.
• Mortgage-backed securities represent claims on the cash
flows generated by a pool of mortgages and can be
purchased by individual investors, pension funds, mutual
funds, or virtually any other investor.
• A primary risk associated with mortgage-back securities
is that homeowners may not be able to, or may choose not
to, repay their loans.
2-16
The Financial Crisis: Falling Home Prices
and Delinquent Mortgages (Figure 2.2)
2-17
The Financial Crisis: Crisis of
Confidence in Banks (Figure 2.3)
2-18
The Financial Crisis: Spillover
Effects and the Great Recession
• As banks came under intense financial pressure in 2008,
they tightened their lending standards and dramatically
reduced the quantity of loans they made.
• 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.
2-19

Finance Week 2-3

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Financial

Assets: Liabilities & Equity:

Firms that require funds from external sources can obtain

• Commercial banks are institutions that provide savers

• The money market is created by a financial relationship

• The capital market is a market that enables suppliers and

Lakeview Industries, a major microprocessor manufacturer,

• In the Eurobond market, corporations and governments

• From a firm’s perspective, the role of capital markets is to be a

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