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  1. 1. Principles of Managerial Finance Brief Edition Chapter 2 Institutions, Markets, and Interest Rates
  2. 2. Learning Objectives <ul><li>Identify key participants in financial transactions and the basic activities and changing role of financial institutions. </li></ul><ul><li>Understand the relationship between financial institutions and markets, and the basic function and operation of the money market. </li></ul><ul><li>Describe the capital market, the securities traded there, and the role of the securities exchanges in the capital market. </li></ul>
  3. 3. Learning Objectives <ul><li>Be able to interpret bond & stock quotations. </li></ul><ul><li>Understand the role of the investment banker in securities offerings. </li></ul><ul><li>Describe the fundamentals of interest rates and required returns: inflation, term structure, risk premiums, and the basic relationship between risk and rates of return. </li></ul><ul><li>Explain the fundamentals of business taxation, and the role of S corporations. </li></ul>
  4. 4. Effective Financial Systems <ul><li>An effective financial system must posses three characteristics: </li></ul><ul><ul><li>monetary systems that provide an efficient medium for exchanging goods and services, </li></ul></ul><ul><ul><li>facilitate capital formation whereby excess capital from savers is made available to borrowers (investors), and </li></ul></ul><ul><ul><li>efficient and complete financial markets which provide for the transfer of financial assets (such as stocks and bonds), and for the conversion of such assets into cash. </li></ul></ul>
  5. 5. Financial Intermediaries in the U.S.
  6. 6. <ul><li>Intermediation is the process by which savings are accumulated in depository institutions and then lent or invested. </li></ul><ul><li>During periods of disintermediation,such as during the late 1970s and early 1980s, funds actually flow out of depository institutions. </li></ul><ul><li>This impedes the flow of funds to demanders such as businesses or individuals wishing to finance homes or cars. </li></ul>Financial Intermediation
  7. 7. Banking Legislation <ul><li>DIDMCA (1980) actually consisted of two parts: Depository Institutions Deregulation and Monetary Control. </li></ul><ul><li>DID was designed to do a number of things: </li></ul><ul><ul><li>curtail regulation Q (interest rate ceilings) </li></ul></ul><ul><ul><li>increase various sources of funding available to banks </li></ul></ul><ul><ul><li>expand the scope and activity of S&Ls by allowing them to invest in other than home mortgages </li></ul></ul>Depository Institutions Deregulation and Monetary Control Act (DIDMCA)
  8. 8. Banking Legislation <ul><li>The monetary control (MC) portion of DIDMCA was designed to extend the Fed’s control to thrifts and nonmember banks by extending reserve requirements and other controls to them. </li></ul><ul><li>This permitted both greater competition for deposits and more flexibility in terms of the types of investments various institutions could make. </li></ul>Depository Institutions Deregulation and Monetary Control Act (DIDMCA)
  9. 9. Banking Legislation <ul><li>The principal focus of the Garn-St. Germain Act (1982) was to assist the ailing S&L industry. </li></ul><ul><li>This was in direct response to the dramatic increase in inflation and interest rates in 1980-81 which caused massive withdrawals from S&Ls to MMMFs which could pay market interest rates on short term deposits. </li></ul><ul><li>Specifically, it authorized S&Ls to issue MMDAs with no regulated interest rate ceiling, and allowed them to make non-residential real estate loans. </li></ul>Garn-St. Germain Depository Institutions Act
  10. 10. The S&L Crisis <ul><li>The extensive deregulation of the early 1980s allowed S&Ls to invest in assets in which they had little prior experience - particularly risky commercial real estate. </li></ul><ul><li>Because many of these investments were ill conceived resulting in large default rates, many S&Ls became insolvent. </li></ul><ul><li>Because depositors were insured by the FDIC, the federal government had an obligation to provide reimbursement to depositors to the tune of $500 billion. </li></ul>
  11. 11. Deposit Insurance <ul><li>Federal deposit insurance was first established during the Great Depression. </li></ul><ul><li>Three separate institutions provided insurance for the three main types of institutions: </li></ul><ul><ul><li>FDIC for Banks </li></ul></ul><ul><ul><li>FSLIC for S&Ls </li></ul></ul><ul><ul><li>NCUSIF for Credit Unions </li></ul></ul><ul><li>The level of insurance per account was increased over the years until it stood at $100,000 by 1980. </li></ul>
  12. 12. Deposit Insurance <ul><li>In 1989, the FSLIC was absorbed into the FDIC because the high S&L bankruptcy rate during the 1980s also resulted in the bankruptcy of the FSLIC. </li></ul><ul><li>One special problem with deposit insurance is the “too big to fail” assumption meaning that banks would always be bailed out in crisis due to the far reaching effects caused by failure. </li></ul><ul><li>This problem was addressed by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. </li></ul>
  13. 13. The Relationship between Financial Institutions and Financial Markets
  14. 14. <ul><li>While real assets include the direct ownership of tangible assets such as land or buildings, financial assets represent claims against the income and assets of those who issued the claims. </li></ul><ul><li>Types of financial assets include stocks, bonds, and bank deposits. </li></ul><ul><li>Some financial assets, such as stocks and bonds, can be traded in the secondary markets while others, such as bank deposits, cannot. </li></ul>Claims to Wealth
  15. 15. <ul><li>Marketable financial assets can be further categorized according to whether they trade in the primary market or the secondary market. </li></ul><ul><li>Primary markets are where new securities are issued. </li></ul><ul><li>Secondary markets are where securities are bought and sold after initially issued in the primary markets. </li></ul><ul><li>In addition, financial assets may be money market instruments or capital market instruments. </li></ul>Claims to Wealth
  16. 16. Claims to Wealth <ul><li>Examples of money market and capital market instruments include the following: </li></ul>
  17. 17. Capital Markets Bonds <ul><li>Bonds are long-term debt instruments issued by corporations and government. </li></ul><ul><li>Corporate bonds typically pay interest semiannually, pay fixed coupon interest, have a par or face value of $1,000 and have an original maturity of 10 to 30 years. </li></ul><ul><li>Furthermore, bonds have a prior claim on the firm’s assets but do not represent ownership in the firm. </li></ul>
  18. 18. Capital Markets Stocks <ul><li>Unlike bonds, common stock represents ownership in a business, expect to receive periodic dividends, and hope to profit through an increase in share price. </li></ul><ul><li>Preferred stock possesses features of both common stocks and bonds and are sometimes referred to as hybrid securities. </li></ul><ul><li>Like bonds, they provide fixed payments to holders. </li></ul><ul><li>Like common stock, they have no maturity date. </li></ul>
  19. 19. Securities Exchanges Organized Exchanges <ul><li>Organized securities exchanges are tangible secondary markets where outstanding securities are bought and sold. </li></ul><ul><li>They account for over 60% of the dollar volume of domestic shares traded. </li></ul><ul><li>Only the largest and most profitable companies meet the requirements necessary to be listed on the New York Stock Exchange. </li></ul>
  20. 20. Securities Exchanges Organized Exchanges <ul><li>Only those that own a seat on the exchange can make transactions on the floor (there are currently 1,366 seats). </li></ul><ul><li>Trading is conducted through an auction process where specialists “make a market” in selected securities. </li></ul><ul><li>As compensation for executing orders, specialists make money on the spread (bid price - ask price). </li></ul>
  21. 21. Securities Exchanges Organized Exchanges Requirements NYSE AMEX shares held by public 1,100,000 400,000 stockholders with 100+ shares 2,000 1,200 pretax income (latest year) $2,500,000 $750,000 pretax income (prior 2 years) $2,000,000 N/A MV of public shares held $18,000,000 $300,000 tangible assets $16,000,000 $4,000,000
  22. 22. Securities Exchanges Over-the-Counter Exchange <ul><li>The over-the-counter (OTC) market is an intangible market for securities transactions. </li></ul><ul><li>Unlike organized exchanges, the OTC is both a primary market and a secondary market. </li></ul><ul><li>The OTC is a computer-based market where dealers make a market in selected securities and are linked to buyers and sellers through the NASDAQ System. </li></ul><ul><li>Dealers also make money on the “spread”. </li></ul>
  23. 23. Securities Price Quotations Bond Quotations
  24. 24. Securities Price Quotations Stock Quotations
  25. 25. Functions of Investment Bankers Underwriting, Private Placement & Best Efforts <ul><li>Corporations typically raise debt and equity capital using the services of investment bankers through public offerings . </li></ul><ul><li>When underwriting a security issue, an investment bankers guarantees the issuer will receive a specified amount of money from the issue. </li></ul><ul><li>The investment banker purchases the securities from the firm at a lower price than the planned resale price. </li></ul>
  26. 26. Functions of Investment Bankers <ul><li>When underwriting an issue, the investment banker bears the risk of price changes between the time of purchase and the time of resale. </li></ul><ul><li>With a private placement , the investment banker arranges for the direct sale of the issue to one or more individuals or firms and receives a commission for acting as the intermediary in the transaction. </li></ul><ul><li>When a firm issues securities on a best efforts basis, compensation is based on the number of securities sold. </li></ul>Underwriting, Private Placement & Best Efforts
  27. 27. Functions of Investment Bankers <ul><li>Underwriters also act as advisors and consultants for corporations. </li></ul><ul><li>They can assist firms in planning both the timing of an issue and the amount and features of an issue. </li></ul><ul><li>They also can assist in evaluating mergers and acquisitions. </li></ul>Advising
  28. 28. Other Aspects of Investment Banking <ul><li>An investment banker may be selected through competitive bidding , where the banker or group of bankers that bids the highest price for an issue is chosen for the underwriting. </li></ul><ul><li>With a negotiated offering , the investment banker is merely hired rather than awarded the issue through a competitive bid. </li></ul>Selecting an Investment Banker
  29. 29. Other Aspects of Investment Banking <ul><li>Underwriting syndicates are typically formed when companies bring large issues to the market. </li></ul><ul><li>Each investment banker in the syndicate normally underwrites a portion of the issue in order to reduce the risk of loss for any single firm and insure wider distribution of shares. </li></ul><ul><li>The syndicate does so by creating a selling group which distributes the shares to the investing public. </li></ul>Syndicating the Underwriting
  30. 30. Other Aspects of Investment Banking Syndicating the Underwriting
  31. 31. Other Aspects of Investment Banking <ul><li>Before a new security can be issued, the firm must file a registration statement with the SEC at least 20 days before approval is granted. </li></ul><ul><li>One part of the registration statement called the prospectus details the firm’s operating and financial position. </li></ul><ul><li>However, a prospectus may be distributed to potential investors during the approval period as long as a red herring is printed on the front cover. </li></ul>Registration Requirements
  32. 32. Other Aspects of Investment Banking <ul><li>As an alternative to filing cumbersome registration statements, firms with more than $150 million in outstanding stock can use a procedure called shelf registration . </li></ul><ul><li>This allows the firm to file a single document that covers all issues during the subsequent 2 year period. </li></ul><ul><li>As a result, the approved securities are kept “on the shelf” until the need for or market conditions are appropriate for issue. </li></ul>Registration Requirements
  33. 33. Other Aspects of Investment Banking <ul><li>In general, underwriters wait until the end of the registration period to price securities to ensure marketability. </li></ul><ul><li>If the issue is fully sold, it is considered an oversubscribed issue; if not fully sold, it is considered undersubscribed . </li></ul><ul><li>In order to stabilize the issue at the initial offering price as it is being offered for sale, investment bankers often place orders to purchase the security themselves. </li></ul>Pricing & Distributing an Issue
  34. 34. Other Aspects of Investment Banking <ul><li>Investment bankers earn their income by profiting on the spread. </li></ul><ul><li>The spread is difference between the price paid for the securities by the investment banker and the eventual selling price in the marketplace. </li></ul><ul><li>In general, costs for underwriting equity is highest, followed by preferred stock, and then bonds. </li></ul><ul><li>In percentage terms, costs can be as high as 17% for small stock offerings to as low as 1.6% for large bond issues. </li></ul>Cost of Investment Banking Services
  35. 35. Other Aspects of Investment Banking <ul><li>Although diminishing in frequency, firms can also negotiate private placements rather than public offerings. </li></ul><ul><li>Private placements can reduce administrative and issuance costs for firms since registration and approval from the SEC is not required. </li></ul><ul><li>However, they do pose problems for purchasers since the securities cannot not be resold via secondary markets. </li></ul>Private Placements
  36. 36. Interest Rates & Required Returns <ul><li>The term structure of interest rates relates the interest rate to the time to maturity for securities with a common default risk profile. </li></ul><ul><li>Typically, treasury securities are used to construct yield curves since all have zero risk of default. </li></ul><ul><li>However, yield curves could also be constructed with AAA or BBB corporate bonds or other types of similar risk securities. </li></ul>Term Structure of Interest Rates
  37. 37. Interest Rates & Required Returns Term Structure of Interest Rates Impact of Inflation
  38. 38. Interest Rates & Required Returns Term Structure of Interest Rates Yield Curves
  39. 39. Theories of Term Structure <ul><li>This theory suggest that the shape of the yield curve reflects investors expectations about the future direction of inflation and interest rates. </li></ul><ul><li>Therefore, an upward-sloping yield curve reflects expectations of higher future inflation and interest rates. </li></ul><ul><li>In general, the very strong relationship between inflation and interest rates supports this theory. </li></ul>Expectations Hypothesis
  40. 40. Theories of Term Structure <ul><li>This theory contends that long term interest rates tend to be higher than short term rates for two reasons: </li></ul><ul><ul><li>long-term securities are perceived to be riskier than short-term securities </li></ul></ul><ul><ul><li>borrowers are generally willing to pay more for long-term funds because they can lock in at a rate for a longer period of time and avoid the need to roll over the debt. </li></ul></ul>Liquidity Preference Theory
  41. 41. Theories of Term Structure <ul><li>This theory suggests that the market for debt at any point in time is segmented on the basis of maturity. </li></ul><ul><li>As a result, the shape of the yield curve will depend on the supply and demand for a given maturity at a given point in time. </li></ul>Market Segmentation Theory
  42. 42. Risk Premiums <ul><li>Default Risk </li></ul><ul><li>Maturity Risk </li></ul><ul><li>Liquidity Risk </li></ul><ul><li>Contractual Provisions </li></ul><ul><li>Tax Risk </li></ul>Issue & Issuer Characteristics
  43. 43. Expected Risk & Required Return