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The Financing Process Source: Flow of Funds Accounts, First Quarter 2000 , Flow if Funds Section, Statistical Release Z.1 (Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000). 241.5 561.7 320.2 Foreign ( 8.0) 48.4 56.4 State and Local Gov’ts (11.0) 62.9 73.9 U.S. Gov’t (63.7) 383.8 447.5 Nonfinancial Corporate Business (50.3) 397.1 447.4 Households Net Funds Supplied ($) Funds Supplied ($) Funds Raised ($) Sector
From 1998-2000, over $1.1 trillion in external corporate financing was raised.
Debt (Corporate Bonds and Notes) … 73.6%
Equities (Preferred & Common Stock) … 26.4%
(Interest is tax deductible and dividends are not)
Components of U.S. Financial Market System Public Offering Versus Private Placement Primary Versus Secondary Market Money Versus Capital Market Organized Exchange Versus OTC market Spot Versus Futures Market
Public Offering – Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities
Private Placement (direct placement) – The securities are offered and sold to a limited number of investors
Exchanges are tangible entities and financial instruments are traded on the premises.
There are 7 organized exchanges in the United States (ex. NYSE). Firms listed on the exchanges must comply with the listing requirements of the exchange and SEC.
OTC (Over-the-Counter) market refers to all securities markets except organized exchanges. There is no specific geographic location for OTC market. Most transactions are done through a loose network of security dealers who are known as broker-dealers and brokers.
Most prominent for stocks is NASDAQ (“screen based, floorless market) that lists more securities than NYSE (including Google, Microsoft, Starbucks)
They are financial specialists involved as an intermediary in the sale of securities (stocks and bonds). They buy the entire issue of securities from the issuing firm and then resell it to the general public.
Prominent investment banks in the US include Goldman Sachs, Merrill Lynch, Lehman Brothers, Citigroup/Salomon Smith Barney (See table 2-2).
Investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the highest price at which the issuing company can sell all the available shares.
Example: Inflation rate is 1.5%, real risk free rate is 3%, AAA corporate bonds are 9%, 3 month treasury bills are 4.5% and 30 year treasury bonds are 7%. Given the LP is 3 basis points (.03%) What are the k*, IRP, DRP, liquidity premium, and the MP? What is the nominal rate of this bond for Company X?
Solution k = k* +IRP+DRP+MP+LP k* = 3% (4.5%-1.5%)(real risk free rate-diff to treasury bills) IRP = 1.5% (given) MRP = 2.5% (7.0%-4.5%) (diff to treasury notes) DRP = 2.0% (9%-7%) (diff to AAA bonds - LP) LP = .03% (given) (diff to a particular AAA bond) k=9.03% NOMINAL RATE OF INTEREST ON THIS BOND
Term Structure of Interest Rates or Yield-to-Maturity