Chapter 1Introduction to Finance“Remember that time is money.”-Benjamin Franklin, “Advice to a Young Tradesman,” Poor Richards Almanac, 1738

Chapter 1 Outline1.1 What is Finance

• The three primary areas of finance

• The financial system &the role of financial intermediaries

1.2 Financial Instruments and

Markets• Securities• Types of debt• Financial

markets• Regulation

1.3 The Global Financial Crisis

• The global financial community

• The financial crisis 2007-2008

• The future of regulation

Finance is the allocation of funds between those with more funds than they need and those who need the funds. More specifically, finance deals with the “how” and “under

what terms” of this allocation. You may recognize in this definition a similarity

between finance and economics. Economics deals with the allocation of scarce resources in an

economy, whereas finance focuses on how resources are allocated and by what channels, as well as the terms of the allocation.

In many ways, we can view finance as applied economics.

1.1 What is Finance?

The Three Primary Areas of Finance

Our focus in this book is business finance, which includes the following:

Financial statement analysisThe time value of money and other

valuation financial mathematicsPortfolio theory and asset pricing

The Financial System & the Role of Financial Intermediaries

The Financial System

The Financial System & the Role of Financial Intermediaries The financial system of any country provides

an environment in which households provide funds to businesses and government.

A financial intermediary transforms the nature of the securities they issue and invest in.

A market intermediary simply makes the markets work better.

1.2 Financial Instruments and Markets

A financial instrument is any legal agreement that represents an ownership interest, a debt obligation, or other claim on assets or income.

What is a Security? A security is a negotiable financial instrument that is

evidence of indebtedness or ownership. Securities include the following: Debt obligations, such as a bond or a note with a fixed term for

repayment and interest to compensate the lender for the use of the funds

Equity interests, such as common stock, which represent the ownership interest that the provider of funds has in the user of funds

Hybrid securities, such as convertible bonds, that have characteristics of both equity and debt

Types of DebtShort term debt

Bank loan- a loan made by a financial institution

Commercial paper- a loan issued by a business or governmental entity

Bankers’ acceptance- a credit instrument that is issued by a business and guaranteed by a bank

U.S. Treasury bill- a short-term indebtedness of the U.S. government

Types of DebtLong-term debt

Mortgage loan- a loan that is backed by specific collateral, such as a home in the case of a home mortgage

Municipal bond- an indebtedness issued by a state or local government

Corporate bond- an indebtedness issued by a corporation

Additional Financial Terms Bond- a debt instrument that takes the form of a

security that investors can buy and sell. The owner of the bond is the creditor of the bond issuer.

Note- similar to a bond, but with a maturity in the range of one to ten years. In common usage, however, the term “bond” is often used interchangeably with the term “note.”

Collateral- the borrower’s pledge of specific property, which may be a building, aircraft, or any other identifiable, tangible asset.

Debenture- debt not secured; backed by the “full faith and credit” of the issuer.

Additional Financial Terms Types of municipal bonds:

General obligation bond- backed by the full faith and credit of the issuer, much like U.S. Treasury bonds.

Revenue bond- backed by a specific revenue stream of the issuing entity, such as the payments for electricity by customers of a city-owned electric utility.

Assessment bond- backed by the property taxes that are assessed by the local government. An advantage of investing in municipal debt is that the interest earned on this investment is exempt from federal income tax and, depending on the state, may be exempt from state income tax.

Additional Financial Terms Equity instrument or equity security- represents

an ownership stake in a company Common stock- the most common form of equity

Represents the residual ownership of a corporation; the common stock owners are last in line, in terms of seniority of claims on the company, but they also reap the benefits from the company’s earnings and appreciation in value.

Common stock owners generally also have voting rights, with the ability to elect members of the company’s Board of Directors.

Preferred stock- usually entitles the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders.

Additional Financial Terms Money market security- a short-term (i.e.,

maturity of less than one year) security; examples include debt instruments such as T-bills, commercial paper, and bankers’ acceptances.

Capital market security- a security with a maturity greater than one year; includes notes, bonds, and debentures, as well as equity securities, which represent ownership in a company and generally have no maturity date.

Financial Markets In a primary financial market, issuers issue new

securities in return for cash from investors. In the case of a debt obligation, the issuer is the borrower and the investor is the lender.

When a company goes public, selling equity interests to investors for the first time, we refer to the offering as an initial public offering (IPO).

Initial public offerings by U.S. corporations, 1990-2012Source of data: SIFMA.org

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

$0

$20

$40

$60

$80

Valu

e of

IPO

Financial Markets

Debt and equity issuance by Corporations, 1990-2012Source of data: sifma.org

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

$0$1,000$2,000$3,000$4,000$5,000$6,000$7,000$8,000

Municipal US Treasury Mortgage related Corporate debtSecurities Asset-Backed

Issu

ance

in b

illion

s

Summary of Financial MarketsPrimary market

• Initial public offerings

• EX: Facebook in May 2012

Secondary market

• Trading among investors

• EX: NYSE Euronext

Third market

• Over the counter

• EX: Nasdaq trading of NYSE-listed stocks

Fourth market

• Institution to institution trading

• EX: Instinet

• EX: Dark pools, such as GS’s Sigma X

Financial Markets A secondary financial market provides trading

environments that permit investors to buy and sell existing securities. Exchange markets- referred to as auction markets because they

involve a bidding process that takes place in a specific location (i.e., similar to an auction).

Dealer market or over-the-counter (OTC) markets- do not have a physical location, but rather consist of a network of dealers who trade directly with one another.

The distinction between these two types of secondary markets has become blurred in recent years because trading on most of the major exchanges in the world has become fully computerized, making the physical location of the exchanges of little consequence.

Financial Markets The third market refers to the trading of securities

that are listed on organized exchanges in the OTC market. Historically, this market has been particularly important

for “block trades,” which are extremely large transactions involving at least 10,000 shares or $100,000.

The fourth market refers to trades that are made directly between investors (usually large institutions), without the involvement of brokers or dealers. The fourth market operates through the use of privately

owned automated systems, with one of the most widely recognized systems being Instinet.

Equity Securities Common shares represent the major financial

security issued by corporations and comprise a proportionate ownership in a company. Common shares are generally issued once and then stay outstanding indefinitely.

We often compare stocks by referring to their market capitalization. A company’s market capitalization is the product of the market price of a share and the number of shares outstanding.

Market Capitalization Examples

Company Ticker Market Capitalization(Aug. 19, 2013)

General Electric GE $242.4 billion

Procter & Gamble Co. PG $218.0 billion

Google GOOG $289.4 billion

Facebook FB $92.2 billion

Yahoo! YHOO $27.7 billion

Regulation Most economies operate with a central bank that

oversees financial institutions and the economy’s money supply. In the U.S., the central bank is the Federal Reserve System.

The Federal Reserve System (the Fed) has been given the power, among other things, to do the following: Establish margin requirements, which affect the

extent that stock is purchased with borrowed funds

Require disclosures regarding consumer lending Assess reserve requirements of member banks

and non-depository institutions

RegulationThe Securities and Exchange Commission

(SEC) bears the responsibility of ensuring that financial markets are fair, orderly, and efficient.

The SEC is tasked with encouraging capital flows from investors to businesses, but also with protecting investors.

Highlights of Selected U.S. Securities Laws

Law PurposeSecurities Act of 1933

Requires disclosure of specific information about securities offered to the public, and prohibits misrepresentations and fraud in the sale of securities.

Securities Exchange Act of 1934

Created the Securities and Exchange Commission, giving the SEC the power and responsibility to regulate and oversee brokerage firms, agents, and self-regulatory organizations. Requires periodic reporting by companies with publicly traded securities.

Trust Indenture Act of 1939

Regulates the provisions of indentures for bonds, debentures, and notes sold to the public.

Investment Company Act of 1940

Regulates investment companies, such as mutual funds.

26

Investment Advisers Act of 1940

Regulates investment advisers, and specifies who must register with the SEC.

Sarbanes-Oxley Act of 2002

Increases disclosure requirements of publicly traded companies, creates oversight boards for independent public accountants, requires specific corporate governance provisions, and holds the chief executive officer and the chief financial officer accountable for a public company’s disclosures.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Increases oversight responsibility and regulation of hedge funds, credit-rating agencies, and brokers and dealers, among other things.

Highlights of Selected U.S. Securities Laws

1.3 The Global Financial CrisisThe financial crisis of 2007–2008 was a significant event that affected businesses and economies around the world. To understand the crisis, it is important to first appreciate the linkages that exist among the global economies.

The Global Financial CommunityU.S. Investors’ international investments, Second quarter 2010 and 2011

In billions 2nd Q 2010

2nd Q 2011

US owned assets abroad -$175.2 -$343.8

Foreign owned assets in the US 188.5 486.5

Net position $13.3 $142.6

Net derivatives $10.0 $3.2

Equity or Stock MarketsThe United States possesses the largest equity markets in the world. The NYSE Euronext is the world’s largest stock

market with a market capitalization at the end of January 2011 of $15.1 trillion.

The NASDAQ is the second-largest stock market in the world, based on its market capitalization of $3.6 trillion.

The Financial Crisis 2007-2008 There is no single cause of the crisis, but rather many

that occurred to create the perfect storm. One of the most visible causes of the crisis was the

housing bubble. Other causes included:

Lax lending standards A push for the government-sponsored entities (GSEs) of Freddie

Mac and Fannie Mae to purchase lower quality loans for resale as securities

The insatiable appetite of investors for high-return, high-risk securities that were backed by mortgages

Rampant fraud in mortgage origination

Securitization Securitization is the process of converting loans into securities. Example: creating a mortgage-backed security:

Mortgage originator lends the money for

the purchase of a home

The mortgage originator sells the

mortgage to a dealer

The dealer pools mortgages together

and sells investments that

represent claims on cash flows from the

mortgagesMortgage backed security

The Future of Regulation The regulatory structure in the U.S. financial system is

undergoing changes to address the problems that created significant systemic risk.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Created the Financial Stability Oversight Council, which

provides a formal system of coordination among key regulators Created criteria and standards for systemically important

financial companies Provides for the orderly liquidation of financial companies that

are insolvent Limits proprietary trading (Volcker Rule)

Lessons for Financial Managers Financial risk management is important.

Financial managers need to identify, assess, and manage risks; companies must develop an assessment of how much risk they are

willing to take (that is, their risk appetite), and risk management must be an essential part of a company’s strategy.

Companies that rely on securitizing their assets should be prepared for the associated risks. Securitization of assets is performed by many companies, not just

banks and, for example, has been a source of cash flow for companies that sell their receivables through these transactions.

For instance, Harley-Davidson Financial Services securitized the loans made on the purchases of Harley-Davidson motorcycles; when the securitization market dried up and the company could no longer securitize the loans, it could not turn the loans into cash, but rather had to retain and maintain them.

Lessons for Financial Managers Reliance on bank financing for short-term needs is

problematic during a credit crunch. Many companies that relied on lines of credit from banks or issuing

commercial paper to meet seasonal needs found that they could not get financing during severe times. For example, the commercial paper market was disrupted in

September 2008 with Lehman Brothers’ bankruptcy; in December 2008, the outstanding commercial paper was half of what is was at the end of 2007.

Executive compensation should be tied to some measure of risk, not just earnings. Many financial institutions tied compensation to earnings, without

regard to the risk associated with the expansion of the entity into other, riskier lines of business. The focus on earnings may have inadvertently encouraged excessive risk taking.

SummaryFinance as a subject area is the study of

the flow of funds from those with funds to those who need funds.

Financial decision making encompasses investment and financing decisions, which may be short-term or long-term decisions.

Summary A business may borrow funds, either through

borrowing or selling equity interests in the business. Borrowing includes loans from banks, issuing

commercial paper, or issuing notes or bonds. Borrowing requires repayment of the debt, as well as

interest on the debt. A company may sell ownership stakes in the

company, which are represented by shares of stock. These shares may be common stock or preferred.

SummaryThe financial system is global, with parties

crossing borders to raise and invest funds. No better example of the globalization of the

financial system is available than the 2007–2008 financial crisis, where linkages among the markets were evident as the U.S. economy faltered, along with economies around the world.