Corporate governance ppt @ bec doms

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Financial background my ppt @ bec doms

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Corporate governance ppt @ bec doms

  1. 1. The Financial System, Corporate Governance, and Interest
  2. 2. The Financial System <ul><li>The economy is divided into sectors </li></ul><ul><ul><li>Consumption </li></ul></ul><ul><ul><li>Production (includes government) </li></ul></ul><ul><ul><li>Most people are in both sectors </li></ul></ul><ul><ul><ul><li>as workers in production and as consumers at home </li></ul></ul></ul><ul><li>Services, products, and money flow between the sectors every day </li></ul><ul><ul><li>Producers pay wages to workers for labor services </li></ul></ul><ul><ul><li>Workers spend incomes as consumers on production sector’s output </li></ul></ul><ul><ul><li>Producers spend revenues on materials and more labor to make more product </li></ul></ul><ul><ul><li>Creates a cyclical flow of money </li></ul></ul>2
  3. 3. BUT, Diagram Omits Two Things <ul><li>Consumption sector </li></ul><ul><ul><li>Most people do not consume all of their income—they save a portion </li></ul></ul><ul><ul><li>They deposit those savings and earn a return </li></ul></ul><ul><li>Production sector </li></ul><ul><ul><li>Companies need to raise money from time to time to finance large, infrequent projects </li></ul></ul><ul><ul><ul><li>New factories, additional equipment, new enterprises </li></ul></ul></ul><ul><li>Economy has a need for and a source of $ </li></ul>3
  4. 4. Savings and Investment <ul><li>Financial markets channel consumer savings to companies through the sale of financial assets </li></ul><ul><ul><li>Companies issue securities to raise money usually to spend on big assets or projects </li></ul></ul><ul><ul><li>Consumers purchase securities to earn a return on their savings </li></ul></ul>4
  5. 5. The Term Invest <ul><li>Using a resource to better one’s position in the future rather than for current consumption </li></ul><ul><ul><li>Individuals invest by putting savings into financial assets: stocks, bonds, etc. </li></ul></ul><ul><ul><li>Companies invest by buying assets used in production </li></ul></ul><ul><li>Funds available for business investment come from savings put into financial assets by individuals </li></ul><ul><li>Hence: SAVINGS EQUALS INVESTMENT </li></ul><ul><ul><li>More precisely : </li></ul></ul><ul><ul><li>(Consumer) Savings Equals (Business) Investment </li></ul></ul>5
  6. 6. Raising and Spending Money in Business <ul><li>Firms spend two kinds of money </li></ul><ul><ul><li>Day-to-day funds – come from normal profits, support routine activities </li></ul></ul><ul><ul><li>Large sums needed for major projects and to get businesses started - comes from selling financial assets </li></ul></ul><ul><ul><ul><ul><li>Borrowing money: Debt Financing </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Selling stock: Equity Financing </li></ul></ul></ul></ul>6
  7. 7. Term <ul><li>The length of time between now and the end (or term ination ) of something </li></ul><ul><ul><li>Long-term projects (lasting over 5-10 years) are financed with long-term funds </li></ul></ul><ul><ul><ul><li>Debt (bonds) </li></ul></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul><ul><ul><li>Short-term projects (lasting less than 1 year) are financed with short-term funds </li></ul></ul><ul><ul><ul><li>Bank loans </li></ul></ul></ul><ul><ul><li>Process is known as maturity matching </li></ul></ul>7
  8. 8. Financial Markets <ul><li>Capital Markets </li></ul><ul><ul><li>Trade in stocks and long-term debt </li></ul></ul><ul><li>Money Markets </li></ul><ul><ul><li>Trade in short term debt securities </li></ul></ul><ul><ul><ul><li>Federal government issues a great deal of short-term debt </li></ul></ul></ul>8
  9. 9. Financial Markets: Primary and Secondary Markets <ul><li>Primary Market: Initial sale of a security </li></ul><ul><ul><li>Proceeds go to the issuer </li></ul></ul><ul><li>Secondary Market: Subsequent sales of the security </li></ul><ul><ul><li>Between investors </li></ul></ul><ul><ul><li>Company not involved </li></ul></ul>9
  10. 10. Primary and Secondary Markets <ul><li>Corporations care about a stock’s price in the secondary market </li></ul><ul><ul><li>Influences how much money can be raised in future stock issues </li></ul></ul><ul><ul><li>Senior management’s compensation is usually tied to stock price </li></ul></ul>10
  11. 11. Direct and Indirect Transfers, Financial Intermediaries <ul><ul><li>Directly </li></ul></ul><ul><ul><li>Issuer sells directly to buyers or through an investment bank </li></ul></ul><ul><ul><li>Investment bank lines up investors and functions as a broker </li></ul></ul><ul><li>Indirectly </li></ul><ul><li>Financial intermediary sells shares in itself and invests the funds collectively on behalf of investors </li></ul><ul><li>Mutual fund is an example </li></ul><ul><li>Portfolio is collectively owned </li></ul>11 Primary market transactions can occur
  12. 12. Transfer of Funds From Investors to Businesses Figure 5.3 12
  13. 13. Direct and Indirect Transfers, Financial Intermediaries <ul><li>Institutional investors play a major role in today’s financial markets </li></ul><ul><ul><li>Own ¼ of all stocks, make over ¾ of all trades </li></ul></ul><ul><ul><li>Examples include: </li></ul></ul><ul><ul><ul><li>Mutual funds </li></ul></ul></ul><ul><ul><ul><li>Pension funds </li></ul></ul></ul><ul><ul><ul><li>Insurance companies </li></ul></ul></ul><ul><ul><ul><li>Banks </li></ul></ul></ul>13
  14. 14. The Stock Market and Stock Exchanges <ul><li>Stock market—a network of exchanges and brokers </li></ul><ul><ul><li>Exchange —a physical marketplace such as NYSE, AMEX, regional exchanges </li></ul></ul><ul><ul><li>Brokerage houses employ licensed brokers to assist individuals with securities transactions </li></ul></ul>14
  15. 15. Trading—The Role of Brokers <ul><li>What brokers do… </li></ul><ul><ul><li>An investor opens an account with a broker and place trades via phone or online </li></ul></ul><ul><ul><li>Local broker forwards order to floor broker on the exchange trading floor </li></ul></ul><ul><ul><ul><li>Each stock trades in a particular spot on the exchange floor in an auction-like process </li></ul></ul></ul><ul><ul><ul><li>Trading supervised by a specialist who makes markets in designated securities </li></ul></ul></ul><ul><ul><li>Trade confirmation is forwarded to local broker and investor </li></ul></ul>15
  16. 16. Exchanges <ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>Trades securities for  2800 US </li></ul></ul><ul><ul><li>issuers and  480 foreign companies </li></ul></ul><ul><li>American Stock Exchange (AMEX) </li></ul><ul><ul><li>Handles slightly smaller, younger firms than NYSE </li></ul></ul><ul><li>Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc .) </li></ul><ul><li>Exchanges are linked electronically </li></ul>16
  17. 17. Stock Market and Exchanges <ul><li>Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocks </li></ul><ul><li>Stock Exchanges are the administrative and trading centers of the stock market </li></ul><ul><li>Regulation </li></ul><ul><ul><li>Securities Act of 1933 </li></ul></ul><ul><ul><ul><li>Required companies to disclose certain information </li></ul></ul></ul><ul><ul><li>Securities Exchange Act of 1934 </li></ul></ul><ul><ul><ul><li>Set up Securities and Exchange Commission </li></ul></ul></ul><ul><ul><li>Securities law is primarily aimed at disclosure </li></ul></ul>17
  18. 18. Private, Public, and Listed Companies, and the NASDAQ Market <ul><li>Privately Held Companies </li></ul><ul><li>Can’t sell securities to the general public </li></ul><ul><ul><li>Sale of securities is severely restricted by regulation </li></ul></ul><ul><li>Publicly Traded Companies </li></ul><ul><li>Received approval from SEC to offer securities to the general public </li></ul><ul><li>Process of obtaining approval and registration is known as ‘going public’ </li></ul>18
  19. 19. Private, Public, and Listed Companies, and the OTC Market <ul><li>The IPO </li></ul><ul><ul><li>Once prospectus is approved by SEC securities can be sold to public </li></ul></ul><ul><ul><li>Initial public offering (IPO) is the initial sale </li></ul></ul><ul><ul><ul><li>Market for IPOs is very volatile and risky </li></ul></ul></ul><ul><ul><li>Investment banks usually line up institutional buyers prior to the actual securities sale </li></ul></ul><ul><ul><li>IPO occurs in primary market, then trading begins in the secondary market </li></ul></ul>19
  20. 20. The NASDAQ Market <ul><li>After a company goes public, its shares can trade in the over-the-counter (OTC) market </li></ul><ul><li>Eventually a firm may list on an exchange </li></ul><ul><li>Smaller, public companies can trade on the NASDAQ market </li></ul><ul><ul><li>National Association of Securities Dealers Automated Quotation System </li></ul></ul>20
  21. 21. The Governance Problem <ul><li>So top executives are personally motivated to hold financial performance up - often at any cost </li></ul><ul><li>Which in turn holds stock price up and makes them rich </li></ul>21
  22. 22. Compensation: Harry Johnson, CEO <ul><li>Salary $2,500,000 </li></ul><ul><li>Bonus 1,500,000 </li></ul><ul><li>$4,000,000 </li></ul><ul><li>Plus: Stock option: </li></ul><ul><li>200,000 shares @ $20, Market Price now $48.65 </li></ul><ul><ul><li>Option Value: </li></ul></ul><ul><ul><li>200,000 x ($48.65 - $20.00) = $5,730,000 </li></ul></ul><ul><li>Total comp = $9,730,000; 59% from options </li></ul>22
  23. 23. Moral Hazard of Stock Based Compensation <ul><li>BUT what if Harry can’t exercise his option for another six months </li></ul><ul><ul><li>AND some disturbing financial information has come up that will cause the stock’s price to drop by $10. </li></ul></ul><ul><ul><li>If released that info will cost Harry $2,000,000 </li></ul></ul><ul><li>Harry is motivated to hold stock price up at any cost until he can exercise his option. </li></ul><ul><li>Usually means suppressing the damaging information while ordinary investors buy in at inflated price </li></ul>23
  24. 24. Measures of Performance <ul><li>The market measures performance on three important financial results </li></ul><ul><ul><li>Revenue </li></ul></ul><ul><ul><li>Earnings per share </li></ul></ul><ul><ul><li>Debt </li></ul></ul><ul><li>Revenue and Earnings per share </li></ul><ul><ul><li>More is better </li></ul></ul><ul><ul><li>Rapid growth is great </li></ul></ul><ul><li>Debt </li></ul><ul><ul><li>Less is better </li></ul></ul>24
  25. 25. The Crime Against Investors <ul><li>Company executives with auditors help misstated financial statements </li></ul><ul><ul><li>Stocks became grossly overvalued </li></ul></ul><ul><li>When fraud discovered stock price crashes </li></ul><ul><ul><li>Small investors who bought at high prices lose their investments </li></ul></ul><ul><ul><li>Executives see crash coming and cash out early </li></ul></ul><ul><li>Some firms had forced employee retirement savings into their own stock </li></ul><ul><ul><li>Ordinary employees lost their entire retirements </li></ul></ul>25
  26. 26. Recognition <ul><li>In 2000 Enron, the seventh largest company in the country got caught. </li></ul><ul><ul><li>Fraudulent reporting was discovered </li></ul></ul><ul><ul><li>CPA’s complicity was revealed </li></ul></ul><ul><ul><li>The firm collapsed along with its pension assets </li></ul></ul><ul><ul><li>Arthur Anderson, one of the largest accounting firms failed and disappeared completely </li></ul></ul><ul><li>Resulting investigations revealed many companies had misstated financials </li></ul>26
  27. 27. Federal Government Moves to Fix the Problem <ul><li>Three major culpable groups were identified </li></ul><ul><ul><li>Top management </li></ul></ul><ul><ul><li>Auditors </li></ul></ul><ul><ul><li>Wall Street financial analysts </li></ul></ul><ul><li>Federal government creates legislation that in future will </li></ul><ul><ul><li>Regulate the Public Accounting profession </li></ul></ul><ul><ul><li>Enhance accounting/reporting controls </li></ul></ul><ul><ul><li>Punish guilty executives severely </li></ul></ul><ul><ul><li>Regulate Analyst reporting </li></ul></ul><ul><li>Sarbanes-Oxley Act (SOX) </li></ul>27
  28. 28. Stock Analyst Conflicts <ul><li>Investors buy and sell stocks based on Wall Street analysts’ recommendations </li></ul><ul><li>But many analysts worked for brokerage houses that had Investment Banking departments doing business with the firms being analyzed </li></ul><ul><ul><li>investment banks advise companies on selling securities </li></ul></ul><ul><li>Employers pressured analysts for favorable reports </li></ul><ul><ul><li>pressure = compensation, threat of firing </li></ul></ul><ul><ul><li>of 33,000 buy/sell/hold recommendations issued in 1999, only 125 were sells (.3%) </li></ul></ul><ul><ul><ul><li>While market was on the brink of collapse </li></ul></ul></ul>28
  29. 29. Interest <ul><li>Interest is the return on debt </li></ul><ul><ul><li>Primary vehicle is the bond </li></ul></ul><ul><li>Investor lends money to the bond’s issuer </li></ul><ul><li>There are MANY interest rates in debt markets </li></ul><ul><ul><li>Depend on term and risk </li></ul></ul><ul><ul><li>Rates tend to move </li></ul></ul><ul><ul><li>together </li></ul></ul>29
  30. 30. Interest and the Economy <ul><li>Interest rates have a significant effect on the economy </li></ul><ul><ul><li>Lower interest rates stimulate business and economic activity </li></ul></ul><ul><ul><ul><li>Debt financed projects cost less if rates are low </li></ul></ul></ul><ul><ul><ul><ul><li>More projects are undertaken </li></ul></ul></ul></ul><ul><ul><ul><li>Consumers purchase more houses, cars, etc. when rates are low </li></ul></ul></ul>30
  31. 31. Supply and Demand – A Brief Review <ul><li>Interest rates are set by supply and demand </li></ul><ul><li>Demand curve relates price and quantity of a product that consumers will buy </li></ul><ul><ul><li>Reflects desires and abilities of buyers at a particular time </li></ul></ul><ul><ul><li>Usually slopes downward to the right since people buy more when the price of a product is low </li></ul></ul>31
  32. 32. The Determinants of Supply and Demand <ul><li>Demand for borrowed funds depends on: </li></ul><ul><ul><li>Opportunities available to use the funds </li></ul></ul><ul><ul><li>Attitudes of people and businesses about using credit </li></ul></ul><ul><ul><ul><li>If people feel good about the economy they will spend with borrowed money and businesses will borrow for expansion and new projects </li></ul></ul></ul>32
  33. 33. The Components of an Interest Rate <ul><li>Interest rates include base rates rates and risk premiums </li></ul><ul><li>Interest rate represented by the letter k </li></ul><ul><ul><li>k = base rate + risk premium </li></ul></ul><ul><li>Components of the Base Rate </li></ul><ul><ul><li>Base rate = k PR + INFL </li></ul></ul><ul><ul><li>The pure interest rate plus expected inflation </li></ul></ul><ul><ul><ul><li>Rate people lend money when no risk is involved </li></ul></ul></ul><ul><ul><li>Pure interest rate (k PR ) = earning power of money </li></ul></ul><ul><ul><ul><li>Would exist in the real world if no inflation </li></ul></ul></ul><ul><ul><ul><li>Generally between 2% and 4% </li></ul></ul></ul>33
  34. 34. The Components of an Interest Rate <ul><li>The Inflation Adjustment (INFL) </li></ul><ul><ul><li>Inflation refers to a general increase in prices </li></ul></ul><ul><ul><li>If prices rise, $100 at the beginning of the year will not buy as much at the end of the year </li></ul></ul><ul><ul><li>If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year </li></ul></ul><ul><ul><ul><li>Interest rates include estimates of average annual inflation over loan periods </li></ul></ul></ul>34
  35. 35. Risk Premiums <ul><li>Risk in loans is the chance that the lender will not receive the full amount of principal and interest payments </li></ul><ul><ul><li>Some loans are more risky than others </li></ul></ul><ul><li>Lenders demand risk premiums of extra interest for risky loans </li></ul>35
  36. 36. Different Kinds of Lending Risk <ul><li>Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans </li></ul><ul><li>Three sources of risk, each with its own risk premium: </li></ul><ul><ul><li>Default risk </li></ul></ul><ul><ul><li>Liquidity risk </li></ul></ul><ul><ul><li>Maturity risk </li></ul></ul>36
  37. 37. Different Kinds of Lending Risk <ul><li>Maturity Risk (MR) </li></ul><ul><ul><li>Bond prices and interest rates move in opposite directions </li></ul></ul><ul><ul><li>Long-term bond prices change more with interest rate swings than short-term bond prices </li></ul></ul><ul><ul><ul><li>Larger loss possible on long term bond if rates change </li></ul></ul></ul><ul><ul><ul><li>Gives rise to maturity risk </li></ul></ul></ul><ul><ul><li>Investors demand a maturity risk premium on longer term bonds </li></ul></ul><ul><ul><ul><li>Generally ranges from 0% to 2% </li></ul></ul></ul>37
  38. 38. Federal Government Securities, the Risk Free Rate <ul><li>Federal Government Securities </li></ul><ul><ul><li>The Federal government issues long-term bonds as well as shorter-term securities </li></ul></ul><ul><ul><ul><li>Treasury bills - terms from 90 days to a year </li></ul></ul></ul><ul><ul><ul><li>Treasury notes - terms from 1 to 10 years </li></ul></ul></ul><ul><li>Risk in Federal Government Debt </li></ul><ul><ul><li>No default risk: Can print money to pay off its debt </li></ul></ul><ul><ul><li>No liquidity risk: It’s easy to sell federal securities </li></ul></ul><ul><ul><li>Federal debt does have maturity risk </li></ul></ul><ul><ul><ul><li>But not on very short-term debt </li></ul></ul></ul><ul><li>Hence very short term federal securities, Treasury Bills , pay the RISK FREE RATE </li></ul>38
  39. 39. The Risk-Free Rate <ul><li>The risk-free rate is approximately the yield on short-term Treasury bills </li></ul><ul><ul><li>Includes the pure rate and inflation the inflation adjustment </li></ul></ul><ul><li>Conceptual floor for interest rates </li></ul><ul><li>Denoted as k RF </li></ul>39
  40. 40. The Real Rate of Interest <ul><li>Real implies the effects of inflation removed </li></ul><ul><li>Tells investors whether or not they are getting ahead </li></ul><ul><ul><li>Loss in purchasing power - earn a real rate of 8% when inflation is 10% </li></ul></ul><ul><li>There are periods during which the real rate has been negative </li></ul><ul><li>The Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero </li></ul>40
  41. 41. Yield Curves—The Term Structure of Interest Rates <ul><li>The graphic relation between interest rates and the term of debt </li></ul><ul><li>The normal yield curve </li></ul><ul><ul><li>Short-term rates are usually lower than long-term rates – curve slopes up </li></ul></ul><ul><li>The inverted yield curve </li></ul><ul><ul><li>Long-term rates are lower than short-term rates – curve slopes down </li></ul></ul><ul><li>A sustained inverted curve usually signals an economic downturn is ahead </li></ul>41
  42. 42. Yield Curves Figure 5.10 42

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