Principles of Managerial Finance Brief Edition

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Principles of Managerial FinanceBrief Edition

• Chapter 2

Institutions, Markets, and Interest Rates
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Learning Objectives

• Identify key participants in financial
  transactions and the basic activities and
  changing role of financial institutions.
• Understand the relationship between financial
  institutions and markets, and the basic function
  and operation of the money market.
• Describe the capital market, the securities
  traded there, and the role of the securities
  exchanges in the capital market.

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Learning Objectives

• Be able to interpret bond stock quotations.
• Understand the role of the investment banker in
  securities offerings.
• Describe the fundamentals of interest rates and
  required returns inflation, term structure, risk
  premiums, and the basic relationship between risk
  and rates of return.
• Explain the fundamentals of business taxation,
  and the role of S corporations.

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Effective Financial Systems

• An effective financial system must posses three
  characteristics
• monetary systems that provide an efficient medium
  for exchanging goods and services,
• facilitate capital formation whereby excess
  capital from savers is made available to
  borrowers (investors), and
• 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.

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Financial Intermediaries in the U.S.
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Financial Intermediation

• Intermediation is the process by which savings
  are accumulated in depository institutions and
  then lent or invested.
• During periods of disintermediation,such as
  during the late 1970s and early 1980s, funds
  actually flow out of depository institutions.
• This impedes the flow of funds to demanders such
  as businesses or individuals wishing to finance
  homes or cars.

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Banking Legislation
Depository Institutions Deregulation and Monetary
Control Act (DIDMCA)

• DIDMCA (1980) actually consisted of two parts
  Depository Institutions Deregulation and Monetary
  Control.
• DID was designed to do a number of things
• curtail regulation Q (interest rate ceilings)
• increase various sources of funding available to
  banks
• expand the scope and activity of SLs by allowing
  them to invest in other than home mortgages

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Banking Legislation
Depository Institutions Deregulation and Monetary
Control Act (DIDMCA)

• The monetary control (MC) portion of DIDMCA was
  designed to extend the Feds control to thrifts
  and nonmember banks by extending reserve
  requirements and other controls to them.
• This permitted both greater competition for
  deposits and more flexibility in terms of the
  types of investments various institutions could
  make.

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Banking Legislation
Garn-St. Germain Depository Institutions Act

• The principal focus of the Garn-St. Germain Act
  (1982) was to assist the ailing SL industry.
• This was in direct response to the dramatic
  increase in inflation and interest rates in
  1980-81 which caused massive withdrawals from
  SLs to MMMFs which could pay market interest
  rates on short term deposits.
• Specifically, it authorized SLs to issue MMDAs
  with no regulated interest rate ceiling, and
  allowed them to make non-residential real estate
  loans.

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The SL Crisis

• The extensive deregulation of the early 1980s
  allowed SLs to invest in assets in which they
  had little prior experience - particularly risky
  commercial real estate.
• Because many of these investments were ill
  conceived resulting in large default rates, many
  SLs became insolvent.
• Because depositors were insured by the FDIC, the
  federal government had an obligation to provide
  reimbursement to depositors to the tune of 500
  billion.

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Deposit Insurance

• Federal deposit insurance was first established
  during the Great Depression.
• Three separate institutions provided insurance
  for the three main types of institutions
• FDIC for Banks
• FSLIC for SLs
• NCUSIF for Credit Unions
• The level of insurance per account was increased
  over the years until it stood at 100,000 by
  1980.

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Deposit Insurance

• In 1989, the FSLIC was absorbed into the FDIC
  because the high SL bankruptcy rate during the
  1980s also resulted in the bankruptcy of the
  FSLIC.
• 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.
• This problem was addressed by the Federal Deposit
  Insurance Corporation Improvement Act (FDICIA) in
  1991.

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The Relationship between Financial Institutions
and Financial Markets
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Claims to Wealth

• 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.
• Types of financial assets include stocks, bonds,
  and bank deposits.
• Some financial assets, such as stocks and bonds,
  can be traded in the secondary markets while
  others, such as bank deposits, cannot.

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Claims to Wealth

• Marketable financial assets can be further
  categorized according to whether they trade in
  the primary market or the secondary market.
• Primary markets are where new securities are
  issued.
• Secondary markets are where securities are
  bought and sold after initially issued in the
  primary markets.
• In addition, financial assets may be money
  market instruments or capital market
  instruments.

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Claims to Wealth

• Examples of money market and capital market
  instruments include the following

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Capital Markets
Bonds

• Bonds are long-term debt instruments issued by
  corporations and government.
• 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.
• Furthermore, bonds have a prior claim on the
  firms assets but do not represent ownership in
  the firm.

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Capital Markets
Stocks

• Unlike bonds, common stock represents ownership
  in a business, expect to receive periodic
  dividends, and hope to profit through an
  increase in share price.
• Preferred stock possesses features of both
  common stocks and bonds and are sometimes
  referred to as hybrid securities.
• Like bonds, they provide fixed payments to
  holders.
• Like common stock, they have no maturity date.

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Securities Exchanges
Organized Exchanges

• Organized securities exchanges are tangible
  secondary markets where outstanding securities
  are bought and sold.
• They account for over 60 of the dollar volume
  of domestic shares traded.
• Only the largest and most profitable companies
  meet the requirements necessary to be listed on
  the New York Stock Exchange.

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Securities Exchanges
Organized Exchanges

• Only those that own a seat on the exchange can
  make transactions on the floor (there are
  currently 1,366 seats).
• Trading is conducted through an auction process
  where specialists make a market in
  selected securities.
• As compensation for executing orders,
  specialists make money on the spread (bid price
  - ask price).

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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
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Securities Exchanges
Over-the-Counter Exchange

• The over-the-counter (OTC) market is an
  intangible market for securities transactions.
• Unlike organized exchanges, the OTC is both a
  primary market and a secondary market.
• 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.
• Dealers also make money on the spread.

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Securities Price Quotations
Bond Quotations
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Securities Price Quotations
Stock Quotations
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Functions of Investment Bankers
Underwriting, Private Placement Best Efforts

• Corporations typically raise debt and equity
  capital using the services of investment bankers
  through public offerings.
• When underwriting a security issue, an
  investment bankers guarantees the issuer will
  receive a specified amount of money from the
  issue.
• The investment banker purchases the securities
  from the firm at a lower price than the planned
  resale price.

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Functions of Investment Bankers
Underwriting, Private Placement Best Efforts

• When underwriting an issue, the investment
  banker bears the risk of price changes between
  the time of purchase and the time of resale.
• 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.
• When a firm issues securities on a best efforts
  basis, compensation is based on the number of
  securities sold.

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Functions of Investment Bankers
Advising

• Underwriters also act as advisors and
  consultants for corporations.
• They can assist firms in planning both the
  timing of an issue and the amount and features
  of an issue.
• They also can assist in evaluating mergers and
  acquisitions.

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Other Aspects of Investment Banking
Selecting an Investment Banker

• 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.
• With a negotiated offering, the investment
  banker is merely hired rather than awarded the
  issue through a competitive bid.

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Other Aspects of Investment Banking
Syndicating the Underwriting

• Underwriting syndicates are typically formed
  when companies bring large issues to the market.
• 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.
• The syndicate does so by creating a selling
  group which distributes the shares to the
  investing public.

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Other Aspects of Investment Banking
Syndicating the Underwriting
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Other Aspects of Investment Banking
Registration Requirements

• 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.
• One part of the registration statement called
  the prospectus details the firms operating and
  financial position.
• 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.

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Other Aspects of Investment Banking
Registration Requirements

• As an alternative to filing cumbersome
  registration statements, firms with more than
  150 million in outstanding stock can use a
  procedure called shelf registration.
• This allows the firm to file a single document
  that covers all issues during the subsequent 2
  year period.
• As a result, the approved securities are kept
  on the shelf until the need for or market
  conditions are appropriate for issue.

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Other Aspects of Investment Banking
Pricing Distributing an Issue

• In general, underwriters wait until the end of
  the registration period to price securities to
  ensure marketability.
• If the issue is fully sold, it is considered an
  oversubscribed issue if not fully sold, it
  is considered undersubscribed.
• 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.

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Other Aspects of Investment Banking
Cost of Investment Banking Services

• Investment bankers earn their income by
  profiting on the spread.
• The spread is difference between the price paid
  for the securities by the investment banker and
  the eventual selling price in the marketplace.
• In general, costs for underwriting equity is
  highest, followed by preferred stock, and then
  bonds.
• In percentage terms, costs can be as high as 17
  for small stock offerings to as low as 1.6 for
  large bond issues.

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Other Aspects of Investment Banking
Private Placements

• Although diminishing in frequency, firms can
  also negotiate private placements rather than
  public offerings.
• Private placements can reduce administrative and
  issuance costs for firms since registration and
  approval from the SEC is not required.
• However, they do pose problems for purchasers
  since the securities cannot not be resold via
  secondary markets.

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Interest Rates Required Returns
Term Structure of Interest Rates

• The term structure of interest rates relates the
  interest rate to the time to maturity for
  securities with a common default risk profile.
• Typically, treasury securities are used to
  construct yield curves since all have zero risk
  of default.
• However, yield curves could also be constructed
  with AAA or BBB corporate bonds or other types
  of similar risk securities.

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Interest Rates Required Returns
Term Structure of Interest Rates
Impact of Inflation
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Interest Rates Required Returns
Term Structure of Interest Rates
Yield Curves
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Theories of Term Structure
Expectations Hypothesis

• This theory suggest that the shape of the yield
  curve reflects investors expectations about the
  future direction of inflation and interest
  rates.
• Therefore, an upward-sloping yield curve
  reflects expectations of higher future
  inflation and interest rates.
• In general, the very strong relationship between
  inflation and interest rates supports this
  theory.

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Theories of Term Structure
Liquidity Preference Theory

• This theory contends that long term interest
  rates tend to be higher than short term rates
  for two reasons
• long-term securities are perceived to be riskier
  than short-term securities
• 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.

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Theories of Term Structure
Market Segmentation Theory

• This theory suggests that the market for debt at
  any point in time is segmented on the basis of
  maturity.
• 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.

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Risk Premiums
Issue Issuer Characteristics

• Default Risk
• Maturity Risk
• Liquidity Risk
• Contractual Provisions
• Tax Risk

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Expected Risk Required Return