The document provides an overview of corporate finance and discusses key concepts such as:
1) Corporate finance deals with sources of funding, capital structure, and tools to allocate financial resources to increase shareholder value.
2) The main forms of business organization are sole proprietorships, partnerships, and corporations. Most business is conducted through corporations.
3) Managers should pursue policies that maximize shareholder wealth and stock price through decisions impacting cash flows, timing of cash flows, and cash flow certainty.
Introduction to business finance by Ayesha Noor Ayesha Noor
Here is an introduction to what business finance is and what are the roles and responsibilities of financial manager. Includes various other business related terms.
1 the role of managerial finance(modified 4)Ahmed Elgazzar
1-The Role of Managerial Finance(Modified 4)
2-Time value of money(modified 1)
3-Capital Budgeting(Modified 1) [Repaired]
4-Stock Valuation(modified 1)
MBA Assignments
Introduction to business finance by Ayesha Noor Ayesha Noor
Here is an introduction to what business finance is and what are the roles and responsibilities of financial manager. Includes various other business related terms.
1 the role of managerial finance(modified 4)Ahmed Elgazzar
1-The Role of Managerial Finance(Modified 4)
2-Time value of money(modified 1)
3-Capital Budgeting(Modified 1) [Repaired]
4-Stock Valuation(modified 1)
MBA Assignments
Need help please writting this essay.The number one reason for a.pdfarihantelehyb
Need help please writting this essay.
\"The number one reason for a corporation to exist is to maximize shareholder value\"
In a minimum 600-word essay, explain this concept. Explain what determines value for a
shareholder. Identify short-term versus long-term result and balancing the interest of the
shareholders versus society as a whole. Conflicts between managers and shareholders can exist.
Debt holders have a different perspective from shareholders on what is important. Discuss what
is at stake for all three groups (management, shareholders, debt holders).
Solution
First we have to understand the meaning of shareholder,shareholder is an individual or institution
that legally owns one or more shares of stock in a public or private corporation. Shareholders
may be referred to as members of a corporation.Shareholders of a corporation are legally
separate from the corporation itself. They are generally not liable for the debts of the
corporation.Shareholders are granted special privileges depending on the class of stock. The
board of directors of a corporation generally governs a corporation for the benefit of
shareholders.In fact corporations are legal entities, with shareholders having a contract with the
corporation as owning share of the stock.
After understanding the meaning of Shareholder, Now let us discuss on what determines value
for a shareholder: Increasing shareholder value increases the total amount in the stockholders\'
equity section of the balance sheet. The balance sheet formula is assets less liabilities equals
stockholders\' equity, and stockholders\' equity includes retained earnings, or the sum of a
company\'s net income less cash dividends since inception.Companies raise capital to buy assets
and use those assets to generate sales. A well-managed company maximizes the use of its assets
so the firm can operate the business with a smaller investment in assets so that value for
shareholder can be maximized. Companies typically create most of their value through day-to-
day operations, but a major acquisition can create or destroy value faster than any other corporate
activity.
Short-term maximization is disastrous to shareholders. It’s true that maximizing shareholder
value in the short term leads to catastrophic results, since the firm starts to do things that hurt its
long term prosperity.Thus short termism harms shareholders!
Interest of shareholders as well as of the society are both important to the company. It is essential
to make money, the company has a higher purpose, and this purpose goes beyond profit. The
purpose could be creating value for society, and the company’s stakeholders. The corporation
must fulfill its higher value creating purpose. And for this they need a Conscious Culture that
fosters love and care and builds trust between a company’s team members and its other
stakeholders.when you ask whom does the company work for, one of the answers will be for
society (as tax payer), for customers who provides.
The first chapter introduces us to Corporate finance is essential .docxoreo10
The first chapter introduces us to Corporate finance is essential to all managers as it provides all the skills managers need to; Identify corporate strategies and individual projects that add value to the organization and come up with plans for acquiring the funds. The types of business forms are; sole proprietorship, corporation and partnerships. A sole proprietorship form of business possesses different advantages and disadvantages. A partnership maintains roughly similar pros and cons of a sole proprietorship. A corporation is a legal entity that is separate from its owners and managers. Advantages include a smooth transfer of ownership, limited liability, ease of raising capital. The disadvantages include; double taxation, and a high cost of set-up and report filing. The chapter then deals with Objective of the firm, which is to maximize wealth. The final topic is an in-depth look at Financial Securities, which are markets and institutions.
In the second chapter, we are introduced to financial statements, Cash flow and taxes. Financial statements include; the Income statement and the Balance sheet. An income statement is a financial statement that shows a company’s financial performance regarding revenues and expenses, over a particular period, mostly one year. A balance sheet, on the other hand, is a financial statement that states a company’s assets, liabilities and capital at a particular point in time. Under the cash flow, the chapter covers on the Statement of cash flows, indicates how various changes in balance sheet and income statement accounts affect cash and analyses financing, investing and operating activities. A free cash flow shows the cash that an organization is capable of generating after investment to either maintain or expand its database. Under taxes, Corporate and personal taxes are well explained and the scenarios under which they apply.
Chapter Three analyzes Financial Statements. This analysis is broken down into; Ratio Analysis, DuPont equation. The effects of improving ratios, the limitations of ratio analysis and the Qualitative factors. Ratios help in comparison of; one company over time and one company versus other companies. Ratios are used by; Stockholders to estimate future cash flows and risks, lenders to determine their creditworthiness and managers to identify areas of weaknesses and strengths. Liquidity ratios show whether a company can meet its short-term commitments using the resources it has at that particular time. Asset management ratios exemplify how well an organization utilize its assets. Debt management ratios, leverage ratios as well as profitability ratios are explained.
The DuPont equation focuses on several issues. These are; Debt Utilization, Asset utilization and the Expense Control. Consequently, Ratio analysis has various problems and limitations. These include; Distortion of ratios from seasonal factors, various operating and accounting practices can distort comparisons and also it i ...
An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.
,
introduction finance
,
what is finance
,
scope/major areas of finance
,
what is business finance
,
goal for the financial manager
,
principles of finance
,
fundamental financial management decisions…
,
special partnerships
,
the functions of financial manager
,
sole proprietorship
,
key decision of a financial manager
,
partnership
,
corporations
,
agency theory
,
agency cost
1.1. Nature and Definition of Auditing
Different scholars have defined auditing in different ways. For example, Auditing is a process of collection and evaluation of evidence for the purpose of reporting on economic transaction. The other definition of auditing given by the Institute of Chartered Accountants of India, in its publication titled, General Guidelines on Internal Auditing has defined auditing as ‘ a systematic and independent evaluation of data, statements, records, operations and performances ( financial or otherwise) of an enterprise for stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his/her judgment which is communicated through audit report.
As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing as the process by which a complete, independent person accumulates and evaluates evidence about quantifiable information related to specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. To sum up, Auditing is the process of verifying the assertions produced by accounting, as to whether they present a true and fair view of the entity's financial position in accordance with accounting standards and GAAP. In other words, auditing seeks to verify whether or not financial records have been properly prepared.
Study Note
The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them Auditing is as old as accounting.
It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.
The original objective of auditing was to detect and prevent errors and frauds and most recently objective of audit shifted to ascertain whether the accounts were true and fair rather than detection of errors and frauds.
Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the growth of the joint stock companies the ownership and management became separate.
The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees.
1.2. Historical Development of Auditing
The development of auditing is closely linked to the development of accounting. In the early stage of civilization, the number of transaction was usually so small that able to record the transactions himself. However, with the growth of civilization and consequential growth in volume and complexity of transactions, it becomes necessary to entrust the job of recording the transactions to other persons. The trend started with maintenance of accounts to empires by public officials
Need help please writting this essay.The number one reason for a.pdfarihantelehyb
Need help please writting this essay.
\"The number one reason for a corporation to exist is to maximize shareholder value\"
In a minimum 600-word essay, explain this concept. Explain what determines value for a
shareholder. Identify short-term versus long-term result and balancing the interest of the
shareholders versus society as a whole. Conflicts between managers and shareholders can exist.
Debt holders have a different perspective from shareholders on what is important. Discuss what
is at stake for all three groups (management, shareholders, debt holders).
Solution
First we have to understand the meaning of shareholder,shareholder is an individual or institution
that legally owns one or more shares of stock in a public or private corporation. Shareholders
may be referred to as members of a corporation.Shareholders of a corporation are legally
separate from the corporation itself. They are generally not liable for the debts of the
corporation.Shareholders are granted special privileges depending on the class of stock. The
board of directors of a corporation generally governs a corporation for the benefit of
shareholders.In fact corporations are legal entities, with shareholders having a contract with the
corporation as owning share of the stock.
After understanding the meaning of Shareholder, Now let us discuss on what determines value
for a shareholder: Increasing shareholder value increases the total amount in the stockholders\'
equity section of the balance sheet. The balance sheet formula is assets less liabilities equals
stockholders\' equity, and stockholders\' equity includes retained earnings, or the sum of a
company\'s net income less cash dividends since inception.Companies raise capital to buy assets
and use those assets to generate sales. A well-managed company maximizes the use of its assets
so the firm can operate the business with a smaller investment in assets so that value for
shareholder can be maximized. Companies typically create most of their value through day-to-
day operations, but a major acquisition can create or destroy value faster than any other corporate
activity.
Short-term maximization is disastrous to shareholders. It’s true that maximizing shareholder
value in the short term leads to catastrophic results, since the firm starts to do things that hurt its
long term prosperity.Thus short termism harms shareholders!
Interest of shareholders as well as of the society are both important to the company. It is essential
to make money, the company has a higher purpose, and this purpose goes beyond profit. The
purpose could be creating value for society, and the company’s stakeholders. The corporation
must fulfill its higher value creating purpose. And for this they need a Conscious Culture that
fosters love and care and builds trust between a company’s team members and its other
stakeholders.when you ask whom does the company work for, one of the answers will be for
society (as tax payer), for customers who provides.
The first chapter introduces us to Corporate finance is essential .docxoreo10
The first chapter introduces us to Corporate finance is essential to all managers as it provides all the skills managers need to; Identify corporate strategies and individual projects that add value to the organization and come up with plans for acquiring the funds. The types of business forms are; sole proprietorship, corporation and partnerships. A sole proprietorship form of business possesses different advantages and disadvantages. A partnership maintains roughly similar pros and cons of a sole proprietorship. A corporation is a legal entity that is separate from its owners and managers. Advantages include a smooth transfer of ownership, limited liability, ease of raising capital. The disadvantages include; double taxation, and a high cost of set-up and report filing. The chapter then deals with Objective of the firm, which is to maximize wealth. The final topic is an in-depth look at Financial Securities, which are markets and institutions.
In the second chapter, we are introduced to financial statements, Cash flow and taxes. Financial statements include; the Income statement and the Balance sheet. An income statement is a financial statement that shows a company’s financial performance regarding revenues and expenses, over a particular period, mostly one year. A balance sheet, on the other hand, is a financial statement that states a company’s assets, liabilities and capital at a particular point in time. Under the cash flow, the chapter covers on the Statement of cash flows, indicates how various changes in balance sheet and income statement accounts affect cash and analyses financing, investing and operating activities. A free cash flow shows the cash that an organization is capable of generating after investment to either maintain or expand its database. Under taxes, Corporate and personal taxes are well explained and the scenarios under which they apply.
Chapter Three analyzes Financial Statements. This analysis is broken down into; Ratio Analysis, DuPont equation. The effects of improving ratios, the limitations of ratio analysis and the Qualitative factors. Ratios help in comparison of; one company over time and one company versus other companies. Ratios are used by; Stockholders to estimate future cash flows and risks, lenders to determine their creditworthiness and managers to identify areas of weaknesses and strengths. Liquidity ratios show whether a company can meet its short-term commitments using the resources it has at that particular time. Asset management ratios exemplify how well an organization utilize its assets. Debt management ratios, leverage ratios as well as profitability ratios are explained.
The DuPont equation focuses on several issues. These are; Debt Utilization, Asset utilization and the Expense Control. Consequently, Ratio analysis has various problems and limitations. These include; Distortion of ratios from seasonal factors, various operating and accounting practices can distort comparisons and also it i ...
An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.
,
introduction finance
,
what is finance
,
scope/major areas of finance
,
what is business finance
,
goal for the financial manager
,
principles of finance
,
fundamental financial management decisions…
,
special partnerships
,
the functions of financial manager
,
sole proprietorship
,
key decision of a financial manager
,
partnership
,
corporations
,
agency theory
,
agency cost
1.1. Nature and Definition of Auditing
Different scholars have defined auditing in different ways. For example, Auditing is a process of collection and evaluation of evidence for the purpose of reporting on economic transaction. The other definition of auditing given by the Institute of Chartered Accountants of India, in its publication titled, General Guidelines on Internal Auditing has defined auditing as ‘ a systematic and independent evaluation of data, statements, records, operations and performances ( financial or otherwise) of an enterprise for stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his/her judgment which is communicated through audit report.
As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing as the process by which a complete, independent person accumulates and evaluates evidence about quantifiable information related to specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. To sum up, Auditing is the process of verifying the assertions produced by accounting, as to whether they present a true and fair view of the entity's financial position in accordance with accounting standards and GAAP. In other words, auditing seeks to verify whether or not financial records have been properly prepared.
Study Note
The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them Auditing is as old as accounting.
It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.
The original objective of auditing was to detect and prevent errors and frauds and most recently objective of audit shifted to ascertain whether the accounts were true and fair rather than detection of errors and frauds.
Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the growth of the joint stock companies the ownership and management became separate.
The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees.
1.2. Historical Development of Auditing
The development of auditing is closely linked to the development of accounting. In the early stage of civilization, the number of transaction was usually so small that able to record the transactions himself. However, with the growth of civilization and consequential growth in volume and complexity of transactions, it becomes necessary to entrust the job of recording the transactions to other persons. The trend started with maintenance of accounts to empires by public officials
India Orthopedic Devices Market: Unlocking Growth Secrets, Trends and Develop...Kumar Satyam
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3. Overview of Corporate Finance and the Financial
Environment
Corporate finance
Forms of business organization
Objective of the firm: Maximize wealth
Determinants of stock pricing
The financial environment
Financial instruments, markets and institutions
Interest rates and yield curves
4. Corporate Finance
Corporate finance is an area of finance that deals with sources of funding,
the capital structure of corporations, the actions that managers take to increase
the value of the firm to the shareholders, and the tools and analysis used to allocate
financial resources.
They want the financial manager to increase the value of the corporation and its
current stock price.
5. Why is corporate finance important to all
managers?
Corporate finance provides the skills managers need to:
Identify and select the corporate strategies and individual projects that add
value to their firm.
Forecast the funding requirements of their company, and devise strategies for
acquiring those funds.
6. Forms of Business Organizations
Sole proprietorship
Partnership
Corporation
7. Cont.….
There are three main forms of business organization: (1) sole proprietorships, (2)
partnerships, and (3) corporations. In terms of numbers, about 80 percent of busi-
nesses are operated as sole proprietorships, while most of the remainder are divided
equally between partnerships and corporations. Based on dollar value of sales, how-
ever, about 80 percent of all business is conducted by corporations, about 13 percent
by sole proprietorships, and about 7 percent by partnerships and hybrids. Because
most business is conducted by corporations, we will concentrate on them in this
book. However, it is important to understand the differences among the various
forms.
8. Sole Proprietorship
A sole proprietorship is an unincorporated business owned by one
individual.
Going into business as a sole proprietor is easy—one merely begins
business operations.
However, even the smallest business normally must be licensed by a
governmental unit.
9. Sole Proprietorship
Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:
Limited life
Unlimited liability
Difficult to raise large sum of capital
10. Partnership
A partnership exists whenever two or more persons associate to conduct a
non-corporate business.
Partnerships may operate under different degrees of formality, ranging from
informal, oral understandings to formal agreements filed with the secretary
of the state in which the partnership was formed.
11. Partnership
Advantages:
Low cost business organization
Ease of formation
Disadvantages:
Limited life
Unlimited liability
Difficulty transferring ownership
Difficult to raise large sum of capital
12. Corporation
A corporation is a legal entity created by a state, and it is separate and
distinct from its owners and managers.
This separateness gives the corporation some major advantages:
14. Unlimited and Limited Liability
Suppose you invested $10,000 in a partnership that then went bankrupt owing $1
million.
Because the owners are liable for the debts of a partnership, you could be assessed for
a share of the company’s debt, and you could be held liable for the entire $1 million if
your partners could not pay their shares. Thus, an investor in a partnership is exposed
to unlimited liability.
On the other hand, if you invested $10,000 in the stock of a corporation that then went
bankrupt, your potential loss on the investment would be limited to your $10,000
investment.
15. Hybrid Forms of Organization
Although the three basic types of organization-proprietorships, partnerships, and
corporations dominate the business scene, several hybrid forms are gaining
popularity.
It is possible to limit the liabilities of some of the partners by establishing a limited
partnership, where in certain partners are designated general partners and others
limited partners.
The limited liability partnership (LLP), sometimes called a limited liability company
(LLC).
There are also several different types of corporations. One that is common among
professionals such as doctors, lawyers, and accountants is the professional
corporation (PC), or in some states, the professional association (PA).
16. The Primary Objective of the Corporation
Shareholders are the owners of a corporation, and they purchase stocks
because they want to earn a good return on their investment without
undue risk exposure.
Shareholders elect directors, who then hire managers to run the
corporation on a day-to-day basis.
Managers are supposed to be working on behalf of shareholders, it
follows that they should pursue policies that enhance shareholder value.
17. Management’s Primary Objective
The primary objective should be shareholder wealth maximization, which translates
to maximizing stock price.
Maximize the sale of corporate business.
Minimize the cost of manufacturing and the cost of labor.
Maximize the profitability of the corporation.
18. What type of actions can managers take to
maximize a firm’s stock prices?
19. Managerial Actions to Maximize Shareholders
Wealth
Management’s decisions can significantly affect the firm’s value.
Managers can increase the value of a firm by making decision that :
Cash flow- will focus on the cash flows
1. Size or Level of the Cash Flows
Increase sale
Charge higher prices
To decrease direct expenses (labor/material cost)
20. 2. Timing of the Cash Flows
principle of finance is that individual prefer to receive cash flows earlier than
later. A dollar receive today is worth more than a dollar receive tomorrow.
3. Certainty of the Cash Flows
Investors fear from risk, so they will pay more for stocks, whose cash flows are
certain, than for stocks whose cash flows are risky
Managerial Actions to Maximize Shareholders
Wealth
21. Capital Allocation Process
One of the most important responsibilities of a company’s management team is
capital allocation. But what exactly is capital allocation?
Capital allocation is the process of distributing an organizations financial
resources.
The purpose of capital allocation in publicly traded corporations is to maximize
shareholder returns.
As shareholders, it is our job to ensure that management is making intelligent
decisions for capital allocation. We must therefore understand the impact of
various capital allocation techniques.
22. The 5 Methods of Capital Allocation are Listed
Below:
Invest in organic growth
Mergers and acquisitions
Repurchase shares
Pay down debt
Pay dividends
23. 1. Investing In Organic Growth
Expansion of a firms operations form its own resources. When investing for organic
growth managers prefer to reinvest excess capital into the operating business that
originally generated it instead of diverting funds away from a core business line to
make balance sheet improvements, perform acquisitions, or return capital to
shareholders.
Examples of organic growth investments include:
Research and development
Building out the supply chain
Launching a new product or service
Improving an existing product or service
24. 2. Mergers & Acquisitions
1. Horizontal integration: if merged firms were competitors.
2. Vertical integration: if the merged firms were suppliers and customers of one another.
Acquisition: taking control of a firm by purchasing 51% of its voting shares. Or
purchasing of another firm.
3. Paying Down Debt
Repurchasing the debt securities before its maturity from the market and decreasing the
level of debt of the firm.
4. Paying Dividends
Distributing the financial resources among the shareholders.
25. Share repurchases occur when a company buys back its own shares,
reducing the number of shares outstanding. This has the beneficial effect of
improving important per-share financial metrics such as earnings-per-share,
book-value-per-share, and free-cash-flow-per-share.
5. Share Repurchases
26. What is Financial System?
Financial system is a framework for describing set of markets,
organisations, and individuals that engage in the transaction of financial
instruments (securities), as well as regulatory institutions.
The basic role of financial system is essentially channelling of funds
within the different units of the economy from surplus units to deficit
units for productive purposes.
28. What are Financial Markets?
Financial markets are markets where funds are transferred from people who have an
excess of available funds to people who have shortage.
At any point in time in an economy, there are individuals or organizations with excess
amounts of funds, and others with a lack of funds they need for example to consume or
to invest.
30. Types of Exchanges in Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial markets by selling financial
instruments which are claims on the borrower’s future income or assets.
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial intermediaries
(established to source both loanable funds and loan opportunities) by issuing
financial instruments which are claims on the borrower’s future income or assets.
31. Structure or Types of Financial Markets
These are the types of financial markets in financial system.
Money Market
Capital Market
Primary Market
Secondary Market
Stock Exchange Market
32. Over the Counter Market
Debt Market
Equity Market
Derivative Markets
Spot versus future markets
Structure or Types of Financial Markets
33. Capital in a free economy is allocated through the price system. The interest rate is the
price paid to borrow debt capital. With equity capital, investors expect to receive
dividends and capital gains, whose sum is the cost of equity money.
The four most fundamental factors affecting the cost of money are (1) production
opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.
the higher the perceived risk, the higher the required rate of return.
When money is used, its value in the future, which is affected by inflation, comes into
play:
the higher the expected rate of inflation, the larger the required return.
35. How are secondary markets organized?
By “location”
Physical location exchanges
Computer/telephone networks
By the way that orders from buyers and sellers are matched
Open outcry auction
Dealers (i.e., market makers)
Electronic communications networks (ECNs)
36. Physical Location vs. Computer/telephone Networks
Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange
Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange
markets
37. Auction Markets
NYSE and AMEX are the two largest auction markets for stocks.
NYSE is a modified auction, with a “specialist.”
Participants have a seat on the exchange, meet face-to-face, and place orders for
themselves or for their clients; e.g., CBOT.
Market orders vs. limit orders
38. Dealer Markets
“Dealers” keep an inventory of the stock (or other financial asset) and place bid and
ask “advertisements,” which are prices at which they are willing to buy and sell.
Computerized quotation system keeps track of bid and ask prices, but does not
automatically match buyers and sellers.
Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ,
German Neuer Markt.
39. Electronic Communications Networks (ECNs)
ECNs:
Computerized system matches orders from buyers and sellers and
automatically executes transaction.
Examples: Instinet (US, stocks), Eurex (Swiss-German, futures contracts),
SETS (London, stocks).
40. Over the Counter (OTC) Markets
In the old days, securities were kept in a safe behind the counter, and passed “over
the counter” when they were sold.
Now the OTC market is the equivalent of a computer bulletin board, which allows
potential buyers and sellers to post an offer.
No dealers
Very poor liquidity
41. Financial Intermediaries
• A financial intermediary is an organization that raises money from
investors and provide financing for individuals, companies and other
organizations.
• For corporations, intermediaries are important source of financing.
43. 1. Mutual Funds
• Mutual fund is an investment company which raises money by selling
shares to investors, the investors money is pooled and invested in
portfolio of securities.
• Mutual Funds offers investors low cost diversification and
professional management for most investors, it is more efficient to buy
a mutual fund than to assemble a diversified portfolio of stocks and
bonds.
• In exchange of their services, the funds managers take out the
management fee.
44. 2. Pension Fund
• Pension Fund is an investment plan set up by an employer to provide
for employees’ retirement.
• It is set up on behalf of its employees.
• It is defined contribution plan, a percentage of the employees monthly
paycheck is contributed to pension fund.
• Contribution from all participating employees are pooled and invested
in securities or mutual fund.
45. Financial Institution
• A financial institution is an intermediary that does more than just pool
and invest savings. (by accepting deposits or selling insurance polices
and they provide additional financial services).
• They not only invest in securities but also loan money directly to
individuals, businesses and other organizations.
46. Banks
• Banks are financial intermediaries that does more than just pool and
invest money.
• They raise money by accepting deposits and provide loans.
• To cover the cost of services, it charges higher interest from borrowers
and pays lower interest to depositors.
47. Insurance Companies
• Insurance companies are more important for the long term financing of
business.
• The money to make loan comes mainly from the sale of insurance
policies.
48. Types of Market Transactions
1. Private Placement
2. Seasoned Issued
3. Initial Public Offerings
49. The Cost of Money
Capital in a free economy is allocated through the price system.
The interest rate is the price paid to borrow debt capital.
With equity capital, investors expect to receive dividends and capital
gains, whose sum is the cost of equity money.
50. What do we call the price, or cost, of debt capital?
The interest rate
What do we call the price, or cost, of equity capital?
Required Dividend Capital
return yield gain
51. What four factors affect the cost
of money?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
52. Real versus Nominal Rates
r* = Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
= Any nominal rate.
= Rate on Treasury securities.
r
rRF
53. r = r* + IP + DRP + LP + MRP.
Here:
r = Quoted interest rate or
Required rate of return on a
debt security.
r* = Real risk-free rate.
IP = Inflation premium. IP is equal to the
average expected inflation rate over the life of
the security.
54. Real versus Nominal Rates
DRP = Default risk premium.
This premium reflects the possibility that the issuer will not pay interest or
principal at the stated time and in the stated amount.
LP = Liquidity premium.
This is a premium charged by lenders to reflect the fact that some securities
cannot be converted to cash on short notice at a “reasonable” price.
MRP = Maturity risk premium.
Longer-term bonds, even Treasury bonds, are exposed to a significant risk
of price declines, and a maturity risk premium is charged by lenders to
reflect this risk.
55. Premiums Added to r* for Different Types of Debt
• ST Treasury: only IP for ST inflation
• LT Treasury: IP for LT inflation, MRP
• ST corporate: ST IP, DRP, LP
• LT corporate: IP, DRP, MRP, LP
56. What is the “term structure of interest rates”?
What is a “yield curve”?
• Term structure: the relationship between interest rates (or yields) and
maturities.
• A graph of the term structure is called the yield curve.
57. How can you construct a hypothetical
Treasury yield curve?
• Estimate the inflation premium (IP) for each future year. This is the
estimated average inflation over that time period.
• Step 2: Estimate the maturity risk premium (MRP) for each future
year.
58. Step 1: Find the average expected
inflation rate over years 1 to n:
n
INFLt
t = 1
n
IPn = .
Assume investors expect inflation to be 5% next year, 6% the
following year, and 8% per year thereafter.
59. IP1 = 5%/1.0 = 5.00%.
IP10 = [5 + 6 + 8(8)]/10 = 7.5%.
IP20 = [5 + 6 + 8(18)]/20 = 7.75%.
Must earn these IPs to break even versus inflation; that
is, these IPs would permit you to earn r* (before taxes).
60. Step 2: Find MRP based on this equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
Assume the MRP is zero for Year 1 and increases by 0.1% each
year.
62. Hypothetical Treasury Yield Curve
0
5
10
15
1 10 20
Years to Maturity
Interest
Rate (%) 1 yr 8.0%
10 yr 11.4%
20 yr 12.65%
Real risk-free rate
Inflation premium
Maturity risk premium
63. What factors can explain the shape of this yield
curve?
• This constructed yield curve is upward sloping.
• This is due to increasing expected inflation and
an increasing maturity risk premium.
64. What kind of relationship exists between the Treasury
yield curve and the yield curves for corporate issues?
• Corporate yield curves are higher than that of the Treasury bond.
However, corporate yield curves are not necessarily parallel to the
Treasury curve.
• The spread between a corporate yield curve and the Treasury curve
widens as the corporate bond rating decreases.
66. What is the Pure Expectations
Hypothesis (PEH)?
• Shape of the yield curve depends on the investors’ expectations about
future interest rates.
• If interest rates are expected to increase, L-T rates will be higher than S-
T rates and vice versa. Thus, the yield curve can slope up or down.
67. • PEH assumes that MRP = 0.
• Long-term rates are an average of current and future short-term rates.
• If PEH is correct, you can use the yield curve to “back out” expected
future interest rates.
68. Observed Treasury Rates
If PEH holds, what does the market expect will be the interest
rate on one-year securities, one year from now? Three-year
securities, two years from now?
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
69. 0 1 2 5
6.0%
3 4
x%
6.2%
PEH tells us that one-year securities will
yield 6.4%, one year from now (x%).
6.2% =
12.4% = 6.0 + x%
6.4% = x%.
(6.0% + x%)
2
70. 0 1 2 5
6.2%
3 4
x%
6.5%
[ 2(6.2%) + 3(x%) ]
5
PEH tells us that three-year securities
will yield 6.7%, two years from now (x%).
6.5% =
32.5% = 12.4% + 3(x%)
20.1% = 3(x%)
6.7% = x%.
71. Conclusions about PEH
• Some argue that the PEH isn’t correct, because securities of different
maturities have different risk.
• General view (supported by most evidence) is that lenders prefer S-T
securities, and view L-T securities as riskier.
• Thus, investors demand a MRP to get them to hold L-T securities (i.e.,
MRP > 0).
72. What various types of risks arise
when investing overseas?
Country risk: Arises from investing or doing business in a particular
country. It depends on the country’s economic, political, and social
environment.
Exchange rate risk: If investment is denominated in a currency other
than the dollar, the investment’s value will depend on what happens to
exchange rate.
73. What two factors lead to exchange rate fluctuations?
• Changes in relative inflation will lead to changes in exchange rates.
• An increase in country risk will also cause that country’s currency to
fall.