topic1-introduction_to_finance-students (1).ppt

Yulia B. Ilina
Asc. Prof.,
Deputy Chair,
Department of Finance and Accounting
Introduction to BA:
Finance

Course objectives
 to give an introduction to corporate finance, providing
a pre-requisite for International Finance course
 to provide an understanding of the most important
concepts and principles of corporate finance at a level
that is approachable for a wide audience
 to study essentials of investments, assets valuation,
capital structure, specifics of financial markets
instruments
 to develop basic skills of valuing assets given
forecasts of future cash flows.

Course content
 Topic 1. Introduction to Finance. Overview of Сorporate
Financing Decisions. Capital Markets and Financial
Instruments.
 Topic 2. Discounted Cash Flow Analysis and Present Value
Concept.
 Topic 3. Fundamentals of Stocks Valuation.
 Topic 4. Valuing Debt Securities.
 Topic 5. Investment Evaluation. Capital Budgeting Decisions.
 Topic 6. Risk and Return. Introduction to Portfolio Theory.
 Topic 7. Long-term Financial Decisions: Capital Structure and
Cost of Capital.

Grading system
Element Weight
1. In-class tests (2) 40%
2. Final test 60%
TOTAL 100%

Required textbook
 S. A. Ross, R. W. Westerfield, B. D. Jordan.
Essentials of Corporate Finance. 6-th ed.
McGraw Hill, 2008.

Introduction to Finance.
Overview of Сorporate
Financing Decisions. Capital
Markets and Financial
Instruments
Topic 1

Contents
 Introduction.
 Corporation and financial manager. The goal of
financial management. Corporate financial decisions.
 Financial system and financial markets.
 Money and capital markets.
 Types of financial instruments.
 Financial instruments by issuer.
 Yields on debt securities. Yield curve.
 Key interest rates.
 Bonds and stocks.

 SAO PAULO, Sept 1 (Reuters) - Brazilian real
estate developer Rossi Residencial said on Tuesday
it would sell shares in an offering aimed at local and
foreign investors.
 HONG KONG (Reuters) - Japan's stocks slipped and
the yen hit a seven-week high on Thursday on
unease that Friday's U.S. employment picture may
reflect a slower recovery than investors have priced
into markets, raising uncertainty about riskier assets.
Latest news

Function of Financial Manager
Operations
(plant,
equipment,
projects)
Financial
Manager
Financial
Markets
(investors)
1a.Raising
funds
2.Investments
3.Cash from
operational
activities
4.Reinvesting
1b.Obligations
(stocks, debt
securities)
5.Dividends or
interest
payments
Finance function – managing the cash flow

Financial decisions
 Financing decision – where is money going to come from
 Investment decision – how much to invest and in what assets
Operations Financial
markets
Financial
Manager
Investments
Financing

Financial decisions
Operations Financial
markets
Financial
Manager
Investments
Financing
Capital structure and cost of
capital

Example.
When you start your own business, what financial
decisions do you have to take?
1.What long-term investments should we take on?
2.What are the sources of long-term financing?
(equity, loans)
3.How should we manage everyday financial
activities – managing working capital?
(collecting receivables, paying suppliers etc.)

The goal of financial management
Maximizing shareholder’s wealth
Maximizing stock prices

Objectives for financial manager
 Maximizing earnings and earnings growth
 Maximizing return on investments and return
on equity

Video: Chief Financial Officer
 What are main functions of CFO?
 How CFO is involved in everyday financial
activities and long-term financial decisions?
 What is a corporate governance and what is a
role of CFO?

Financial markets
 The main goal of financial markets:
Take savings from those who do not wish to
consume (savings surplus units) and to
channel them to those who wish to invest
more than they have presently (saving deficit
units)

Financial markets and financial system
Financial
markets
Ф
Saving surplus
units (savers)
Saving deficit
units (investors)
Financial
intermediaries
Financial system
money
Return on
investments
Return on
investments
money
money
Return on
investments
Return on
investments
money

Financing decisions
Financing
decisions
Internal corporate
financing
External sources
of funds
Retained earnings
Direct financing
(financial markets
Instruments)
Indirect financing
(financial
Intermediaries)
Stocks
Debt instruments
(bonds, CPs etc.)
Loans

Financial markets
Financial markets
Primary markets
Secondary markets
Money market
Capital market
Organized exchanges
Over-the-counter

Video: Financial Markets
 What is the goal of financial markets? How
participants are interrelated?
 What are conceptual differences between
types and sectors of financial markets?

Primary and secondary markets
 Primary market – primary issues of
securities are sold, allows governments,
banks, corporations to raise money by directly
selling financial instruments to the public.
 Secondary market – allows investors to trade
financial instruments between themselves.
Secondary transactions take place.
http://biz.yahoo.com/ipo/

Money and capital markets
Money markets – short-term assets (maturity less than
1 year) are traded:
Certificates of deposits (CDs)
Commercial papers (CPs)
Treasury bills
Capital markets – long-term assets (maturity longer
than 1 year) are traded:
Stocks
Corporate bonds
Long-term government bonds

Organized exchanges and over-the-
counter
 Organized exchange – most of stocks, bonds and
derivatives are traded. Has a trading floor where
floor traders execute transactions in the secondary
market for their clients.
 Stocks not listed on the organized exchanges are
traded in the over-the-counter (OTC) market.
Facilitates secondary market transactions. Unlike the
organized exchanges, the OTC market doesn’t have
a trading floor. The buy and sell orders are
completed through a telecommunications network.

 Prices of financial instruments are determined
in equilibrium by demand and supply forces
 They reflect market expectations regarding
the future as inferred from currently available
information
http://www.rts.ru/s797

Types of financial instruments
Type of issuer
Government, government
agencies
States (regions,
provinces), municipalities
Corporations
Financial
institutions
Others

Maturity
Short-term instruments
Long-term instruments

Type of yield
Dividend bearing
(stocks)
Discount debt
Instruments
(treasury bills)
Interest-bearing
income instruments
(bonds)

By level of risk
Risk-free instruments (treasury bills)
Low-risky securities (treasury notes and bonds),
investment grade corporate bonds,
blue-chip stocks)
High-risky securities (junk bonds,
stocks), derivatives

Financial instruments issued by
government: goals
 To finance any shortfall between expenditures
and taxes (deficit)
 To refinance maturing debt
 To finance investment projects, social
programs etc.

government
 Treasury bills (T-bills)
 T-Bills are the largest component of the money market
 Maturities: 4 weeks, 13 weeks, 26 weeks
 Sold at a discount from face value
 Considered as a risk-free investment
- No chance of default
- Very little interest rate risk
 Are actively traded
 Interest is subject to federal tax (but exempted from state and
local taxes)

government
 Treasury coupon issues:
- Treasury notes (T-notes): maturity of 1-10
years
- Treasury bonds (T-bonds): maturity of 10-30
years
 Considered free of default risk
 Subject to interest rate risk
 Interest is subject to federal tax (but exempted
from state and local taxes)

government
Treasury inflation-protected securities (TIPs):
 Treasury inflation-indexed securities
 Offer a fixed (real) coupon rate plus linkage to the
consumer price index (inflation)
 Interest is subject to federal tax (but exempted from
state and local taxes)
 TIPs are available in 5,10,30-year maturities

Financial instruments issued by U.S.
federal agencies
 Federal agencies (such as Ginnie Mae) and government-
sponsored enterprises (such as Federal Home Loan Bank and
Federal Farm Credit Bank) issue bonds to finance projects
consistent with their mission
 Most popular bonds: Fannie Mae (FNMA) and Freddie Mac
(FHLMC)
- No explicit government guarantee, not risk free
- Securitize some loans, and hold others on balance sheet
- Provide liquidity by pooling many specific loans, thereby
creating diversification and a more active secondary market

Yields on debt securities
Are affected by the following characteristics:
- Credit (default) risk
- Liquidity
- Tax status
- Term to maturity

Credit (default) risk
 Investors have to consider the
creditworthiness of the security issuer, as
most securities are subject to the risk of
default
 Securities with higher degree of risk would
have to offer higher yields
 Is especially relevant for longer-term
securities

Liquidity
 Liquid securities could be easily converted to
cash without a loss in value
 Securities with less liquidity will have to offer
a higher yield
 Securities with a short-term maturity or an
active secondary market have greater liquidity

Tax status
 Investors are concerned with after-tax income earned
on securities
 Taxable securities will have to offer a higher before-
tax yield to investors than tax-exempt securities
 Investors in high tax brackets benefit most from tax-
exempt securities
rate
tax
inal
m
s
investor
T
yield
tax
before
Y
yield
tax
after
Y
where
T
Y
Y
bt
at
bt
at
arg
'
,
)
1
(








Yield Curve
 Yield curve describes YTM (yield to maturity) for
different maturities of debt instruments. It reflects
risk and expectations regarding future interest rates.
 Also called “term structure of interest rates”
Bond price reaction to interest rate changes:
 As interest rates increase bond prices decrease
 As interest rates decrease bond prices increase

Yield curve
 http://www.bloomberg.com/markets/rates/ind
ex.html
 stockcharts.com/charts/yieldcurve.html
Yield curve could be inverted: short-term interest rates
are higher than long-term interest rates.
Long-term rates should raise because of expectations of
higher interest rates reflecting inflation and risk.
Inverted yield curve could be a signal of recession.

commercial banks
Banks raise funds by accepting deposits and selling securities.
These funds are used to fund various loans.
Certificates of Deposits (CDs):
Large fixed-maturity deposits.
Minimum deposit is $100 000, and typical deposit is $1 000
000.
Liquid secondary market
Upon maturity, the holder of the certificate receives the funds
from the issuing bank.
What could be the difference between yields of T-bills and CDs?

Bank rates
 Prime rate – base rate on corporate loans
posted by at least 75% of American 30 largest
banks
 Federal funds – reserves traded among
commercial banks in amounts of $1 mln or
more
 Discount rate (federal reserve target rate) –
the charge on loans to depository institutions
by the Federal Reserve banks

Prime rate
The Prime Interest Rate is the interest rate
charged by banks to their most creditworthy
customers (usually the most prominent and
stable business customers). The rate is almost
always the same among major banks.
Adjustments to the prime lending rate are
made by banks at the same time; although, the
prime rate does not adjust on any regular
basis.

Key interest rates for US money market
http://www.bloomberg.com/markets/rates/index.html
CURRENT
1 MONTH
PRIOR
3 MONTH
PRIOR
6 MONTH
PRIOR
1 YEAR
PRIOR
Federal Reserve Target Rate 3.00 3.00 4.50 5.25 5.25
1-Month Libor 2.94 3.15 5.23 5.81 5.32
3-Month Libor 2.90 3.09 5.13 5.70 5.34
Prime Rate 6.00 6.00 7.50 8.25 8.25
5-Year AAA Banking & Finance 4.07 4.05 4.74 4.93 5.07
10-Year AAA Banking & Finance 5.36 5.20 5.57 5.52 5.31

Prime rate in USA
http://www.bloomberg.com/markets/
rates/keyrates.html

http://www.reuters.com/news/video?videoId=11
0725&videoChannel=5&refresh=true
Latest news: rates stay low

corporations: goals
 To finance operations
 To invest in new projects
 To expand their business
 To repay debt or repurchase shares

Commercial paper – short-term debt with
maturity of not more than 270 days
 Issued by larger, known corporations (GE –
$80 bln)
 Issued at discount
 Higher rates than comparable Treasury bills
because of higher default risk and less
liquidity than government securities
corporations: CPs

Corporate bond – long-term debt security,
promising a bondholder interest payments on a
regular basis and payback of a par (face) value at
maturity.
Maturities
Short-term: 1-5 years
Intermediate-term: 5-10 years
Long-term: 10-20 years
Exceptions: Ford and Disney – 100 years
Interest is quoted as a percentage from face value
corporations: bonds

corporations: bonds ratings
Moody’s S&P Meaning Expected
return
Investment grade
Aaa AAA Best quality Lowest
Aa AA High quality Lower
A A Favorable Middle
Baa BBB Medium-
grad
Middle/Upp
er

return
Speculative grade
Ba BB Speculative
element
High
B B Not
desirable.Small
long-term
assurance of
payments
Higher

return
Speculative grade
Caa CCC Poor standing,
Default or danger of
default
Very high
Ca CC Highly speculative
standing
C C Very speculative.
Very poor prospects
of ever attaining
investment standing
D In default

 Junk bonds – bonds with below investment
grade rating
 High yield (high risk) bonds

Corporate bonds
 Debentures-unsecured debt. Backed only by the general
assets of the issuing corporation
 Secured debt (mortgage debt) – secured by specific assets
 Subordinated debt – in default, holders get payments only
after other debtholders get their full payment
 Senior debt – in default holders get payment before other
debtholders get.
http://www.reuters.com/article/marke
tsNews/idAFN0150108520090901?r
pc=44

Corporate bonds
Bonds that pay face value at maturity and no
payment until then
Sell today at a discount from face value
Taxed based on accrued interest
No reinvestment risk or reinvestment cost

corporations: common stocks
 The common stockholders are the owners of
the corporation’s equity
 Do not have a specified maturity date and the
firm is not obliged to pay dividends to
shareholders
 Returns come from dividends and capital
gains

 Common stockholders are called the residual
claimants of the firm
 Stockholders have only limited liabilities
corporations: common stocks

 Hybrid securities: has characteristics of debt
and equity
 Have face value, predetermined periodical
(dividend) payments with priority over
common stockholders
 If dividend payment is not paid, preferred
stockholders may get voting rights
corporations: preferred stocks

Summary of companies: stocks,
financials, ownership etc.
 http://finance.yahoo.com
General Electric
http://finance.yahoo.com/q?s=
GE

Derivative securities
 Securities whose value is derived from the
value of some underlying asset
 Most important derivatives are options and
futures
Stock options. Is not a tool of fundraising, it is a
method of compensation

International Financial Markets
Eurocurrency is a domestic currency of one country on deposit in
a second country – time deposit of money in an international
bank located in a country different from the country that
issued the currency.
The Eurocurrency market includes:
Eurosterling (British pounds deposited outside the UK)
Euroeuros (euros on deposit outside the euro zone)
Euroyen (Japanese yen deposited outside Japan)
Eurodollars (US dollars deposited outside USA)

The basic borrowing interest rate for Eurodollar
loans has long been tied to the
London Interbank Offered Rate (LIBOR) –
the average of Interbank offered rates for
Eurocurrency deposits in London market
International Financial Markets
http://www.bloomberg.com/markets/
rates/keyrates.html

Resources on the Web
 www.careers-in-business.com
 www.cfo.com
 www.nolo.combusiness-law.freeadvice.com/partnerships/
 www.corporateinformation.com/defext.asp
 www.llc.com
 www.businessfinancemag.com
 www.TheCRO.com
 finance.yahoo.com
 www.sec.gov
 www.nyse.com
 www.nasdaq.com
 www.tse.or.jp/english
 www.londonstockexchange.com
 www.bizfilings.com

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