Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

CHAPTER 1CHAPTER 1 An Introduction to FinanceAn Introduction to Finance

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Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Finance DefinedFinance Defined• Real versus Financial AssetsReal versus Financial Assets• The Financial SystemThe Financial System• Financial Instruments and MarketsFinancial Instruments and Markets• The Global Financial CommunityThe Global Financial Community• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions

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Learning ObjectivesLearning Objectives

1.1. What finance is and what is involved in the study of What finance is and what is involved in the study of finance.finance.

2.2. How financial securities can be used to provide How financial securities can be used to provide financing for borrowers and simultaneously to provide financing for borrowers and simultaneously to provide investment opportunities for lenders.investment opportunities for lenders.

3.3. How financial systems work in general.How financial systems work in general.4.4. The channels of intermediation and the role played by The channels of intermediation and the role played by

market and financial intermediaries within this market and financial intermediaries within this system.system.

5.5. The basic types of financial instruments that are The basic types of financial instruments that are available and how they are traded.available and how they are traded.

6.6. The importance of the global financial system.The importance of the global financial system.

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Key TermsKey Terms

• Bourse de MontréalBourse de Montréal• brokersbrokers• Canadian Trading and Quotation System Inc. (CNQ)Canadian Trading and Quotation System Inc. (CNQ)• capital market securitiescapital market securities• common sharecommon share• corporate financecorporate finance• Crown corporationsCrown corporations• dealer or over-the-counter (OTC) marketsdealer or over-the-counter (OTC) markets• debt instrumentsdebt instruments• equity instrumentsequity instruments• exchanges or auction marketsexchanges or auction markets• financefinance• financial assetsfinancial assets• financial intermediariesfinancial intermediaries• fourth marketfourth market• intermediationintermediation• investmentsinvestments

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Key TermsKey Terms

• market capitalizationmarket capitalization• market intermediarymarket intermediary• marketable financial assetsmarketable financial assets• money market securitiesmoney market securities• New York Stock Exchange (NYSE)New York Stock Exchange (NYSE)• non-marketable financial assetsnon-marketable financial assets• Ontario Securities CommissionOntario Securities Commission• preferred sharespreferred shares• primary marketsprimary markets• real assetsreal assets• secondary marketssecondary markets• third marketthird market• Toronto Stock Exchange (TSX)Toronto Stock Exchange (TSX)• TSX Group Inc.TSX Group Inc.• TSX MarketsTSX Markets• TSX Venture ExchangeTSX Venture Exchange• Winnipeg Commodity ExchangeWinnipeg Commodity Exchange

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What Is Finance?What Is Finance?

• Finance is the study of how and under Finance is the study of how and under what terms savings (money) are allocated what terms savings (money) are allocated between lenders and borrowers.between lenders and borrowers.– Finance is distinct from economics in that it addresses Finance is distinct from economics in that it addresses

not only how resources are allocated but also under not only how resources are allocated but also under what termswhat terms and through and through what channelswhat channels

• Financial contracts or Financial contracts or securitiessecurities occur occur whenever funds are transferred from whenever funds are transferred from issuer to buyer.issuer to buyer.

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The Study of FinanceThe Study of Finance

• The study of finance requires a basic The study of finance requires a basic understanding of:understanding of:– SecuritiesSecurities– Corporate lawCorporate law– Financial institutions and marketsFinancial institutions and markets

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Real Versus Financial AssetsReal Versus Financial Assets

• Real assets are tangible things owned by Real assets are tangible things owned by persons and businessespersons and businesses– Residential structures and propertyResidential structures and property– Major appliances and automobilesMajor appliances and automobiles– Office towers, factories, minesOffice towers, factories, mines– Machinery and equipmentMachinery and equipment

• Financial assets are what one individual Financial assets are what one individual has lent to anotherhas lent to another– Consumer creditConsumer credit– LoansLoans– Mortgages Mortgages

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Assets and Liabilities of Households, Assets and Liabilities of Households, 20052005

Assets $ Billion Liabilities $ BillionHouses 1,086 Consumer credit 260Consumer Durables 435 Loans 131Land 827 Mortgages 588Real Assets 2,348 Total Liabilities 979Deposits 683Debt 114Pensions and insurance 1,200Shares 1,254Foreign and other 72Financial Assets 3323Total Assets 5,671

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005. Ottawa: M inister of Industry, 2006 (Catalogue No. 13-214-XIE).

Table 1-2 Assets and Liabilities of Households, 2005

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The Financial System The Financial System OverviewOverview

• The household is the primary provider of funds to The household is the primary provider of funds to businesses and government.businesses and government.

• Households must accumulate financial resources throughout their Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in working life times to have enough savings (pension) to live on in their retirement yearstheir retirement years

• Financial intermediaries transform the nature of Financial intermediaries transform the nature of the securities they issue and invest inthe securities they issue and invest in

• Banks, trust companies, credit unions, insurance firms, mutual fundsBanks, trust companies, credit unions, insurance firms, mutual funds

• Market intermediaries simply help make markets Market intermediaries simply help make markets workwork

• Investment dealersInvestment dealers• BrokersBrokers

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The Financial System The Financial System

FIGURE 1-2

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The Financial SystemThe Financial SystemChannels of IntermediationChannels of Intermediation

• Funds can be channeled from saver to Funds can be channeled from saver to borrower in three ways:borrower in three ways:– Direct intermediation (direct transfer from saver to Direct intermediation (direct transfer from saver to

borrower – a non-market transaction)borrower – a non-market transaction)– Direct intermediation (a market-based transaction Direct intermediation (a market-based transaction

usually through a market intermediary such as a usually through a market intermediary such as a broker)broker)

– Indirect claims through a financial intermediary (where Indirect claims through a financial intermediary (where the financial intermediary such as a bank offers the financial intermediary such as a bank offers deposit-taking services and ultimately lends those deposit-taking services and ultimately lends those deposits out as mortgages or loans)deposits out as mortgages or loans)

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Channels of IntermediationChannels of Intermediation

FIGURE 1-3

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The Financial SystemThe Financial SystemFinancial IntermediariesFinancial Intermediaries

• Banks and other deposit-taking institutionsBanks and other deposit-taking institutions• Insurance companiesInsurance companies• Pension FundsPension Funds• Mutual FundsMutual Funds

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Financial IntermediariesFinancial IntermediariesCanadian Chartered BanksCanadian Chartered Banks

• Banks take deposits from numerous depositors from across Banks take deposits from numerous depositors from across CanadaCanada

• The deposits are ‘pooled’ in the BankThe deposits are ‘pooled’ in the Bank• The bank takes these pooled funds and lends them out to The bank takes these pooled funds and lends them out to

households and businesses in the form of mortgages and loanshouseholds and businesses in the form of mortgages and loans• The bank transforms the original nature of the savers (depositors) The bank transforms the original nature of the savers (depositors)

money:money:– Deposits are usually small in amount…face little or no risk, and depositors Deposits are usually small in amount…face little or no risk, and depositors

expect to withdraw the amount at any timeexpect to withdraw the amount at any time– Loans and mortgages on the other hand usually have the following Loans and mortgages on the other hand usually have the following

characteristics:characteristics:• Large sumsLarge sums• Borrowed for long periods of timeBorrowed for long periods of time• Borrowed for risky purposes.Borrowed for risky purposes.

• Banks can perform this transformation function because they Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing become experts at risk assessment, financial contracting (pricing the risk) and monitoring the activities of borrowers.the risk) and monitoring the activities of borrowers.

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Financial IntermediariesFinancial IntermediariesCanadian Chartered BanksCanadian Chartered Banks

BankRevenue

($ million)Assets

($ million)Profits

($ million)Royal Bank of Canada 29,403 469,521 3,387Canadian Imperial Bank of Commerce (CIBC) 18,677 280,370 -32Bank of Nova Scotia 18,332 314,025 3,209TD Canada Trust 18,665 365,210 2,229Bank of Montreal 15,138 297,532 2,400National Bank 5,320 107,598 855

Source: BM O InvestorLine website: www.bmoinvestorline.com, October 31, 2006.

Table 1-3 Chartered Banks: Financial Statistics, 2005

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Financial IntermediariesFinancial IntermediariesInsurance CompaniesInsurance Companies

– Insurers sell policies and collect premiums from customers Insurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a based on the pricing of those policies given the probability of a claim and the size the policy and administrative fees. claim and the size the policy and administrative fees.

– They invest the premiums so that the accumulated value in the They invest the premiums so that the accumulated value in the future will grow to meet the anticipated claims of the future will grow to meet the anticipated claims of the policyholders.policyholders.

– In this way, unsupportable risks (such as the death of wage In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a earner or the burning down of a business) are shared among a large number of policyholders through the insurance company.large number of policyholders through the insurance company.

– Insurance allows households, business and government to Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of engage in risky activities without having to bear the entire risk of loss themselves.loss themselves.

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Financial IntermediariesFinancial IntermediariesInsurance CompaniesInsurance Companies

InsurerRevenue

($ million)Assets

($ million)Profits

($ million)Manulife Financial 32,187 322,171 3,294Sun Life Financial 21,871 171,850 1,867Great-West Lifeco 23,883 102,161 1,775ING Canada 4,446 9,926 782

Source: Data from BM O InvestorLine website: www.bmoinvestorline.com, October 31, 2006.

Table 1-4 Insurance Companies: Financial Statistics, 2005

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Financial IntermediariesFinancial IntermediariesPension Plan AssetsPension Plan Assets

– Individuals and employers make payments over the Individuals and employers make payments over the entire working life of a person with those funds entire working life of a person with those funds invested to grow over time.invested to grow over time.

– Ultimately, the accumulated value in the pension can Ultimately, the accumulated value in the pension can be used by the person in retirement.be used by the person in retirement.

– Pension plans accumulate considerable sums of Pension plans accumulate considerable sums of money, and their managers invest those funds with money, and their managers invest those funds with long-term investment time horizons in diversified long-term investment time horizons in diversified portfolios of investments. These investments are a portfolios of investments. These investments are a major source of capital, fuelling investment in major source of capital, fuelling investment in research and development, capital equipment, research and development, capital equipment, resource exploration and ultimately contributing in a resource exploration and ultimately contributing in a substantial way to growth in the economy.substantial way to growth in the economy.

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Financial IntermediariesFinancial IntermediariesPension Plan AssetsPension Plan Assets

Pension Plan ManagersNet Assets ($ billion)

Caisse de depot et placement du Quebec 216.1Canada Pension Plan (CPP) 98.0Ontario Teachers (Teachers) 96.1Ontario Municipal Employees (OMERS) 41.6

* The Caisse manages the investments of several pension plans.

Table 1-5 Pension Plan Assets, 2005

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Financial IntermediariesFinancial IntermediariesCanadian Mutual Fund AssetsCanadian Mutual Fund Assets

• Mutual funds give small investors access to Mutual funds give small investors access to diversified, professionally-managed portfolios of diversified, professionally-managed portfolios of securities.securities.

• Small investors often do not have the funds Small investors often do not have the funds necessary to invest directly into market-traded necessary to invest directly into market-traded stocks and bonds.stocks and bonds.

• This is called denomination intermediation because This is called denomination intermediation because the mutual fund makes investments available in the mutual fund makes investments available in smaller, more affordable amounts of money.smaller, more affordable amounts of money.

• Canadian indirect investment in the markets Canadian indirect investment in the markets through managed products such as mutual funds through managed products such as mutual funds and segregated funds has grown exponentially. and segregated funds has grown exponentially.

(see Figure 1-4 on the next slide)(see Figure 1-4 on the next slide)

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Financial IntermediariesFinancial IntermediariesCanadian Mutual Fund AssetsCanadian Mutual Fund Assets

FIGURE 1-4

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The Financial SystemThe Financial SystemThe Major BorrowersThe Major Borrowers

• Public DebtPublic Debt– GovernmentsGovernments

• FederalFederal• ProvincialProvincial• MunicipalMunicipal• Crown CorporationsCrown Corporations

• Private DebtPrivate Debt– HouseholdsHouseholds– Non-financial CorporationsNon-financial Corporations

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The Financial SystemThe Financial SystemLargest Non-financial CompaniesLargest Non-financial Companies

Non-financial CompaniesRevenue

($ million)Assets

($ million)General Motors of Canada Ltd. 34,991 n/aLoblaw Companies Ltd. 27,812 13,761Magna International Inc. 22,873 12,321Imperial Oil Ltd. 26,936 15,582Alcan Inc.* 20,408 26,638BCE Inc. 19,150 40,630Bombardier Inc.* 14,882 17,483Petro-Canada 17,673 20,655Onex Corp. 17,626 14,845EnCana Corp.* 14,322 34,148

Source: Data from "The Top 1000 in 2005." Globe and M ail Report on Business website: www.theglobeandmail.com.

Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005

*Company reports in U.S. dollars.

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Financial InstrumentsFinancial Instruments

• There are two major categories of There are two major categories of financial securities:financial securities:

1.1. Debt InstrumentsDebt Instruments– Commercial paperCommercial paper– Bankers’ acceptancesBankers’ acceptances– Treasury billsTreasury bills– Mortgage loansMortgage loans– BondsBonds– DebenturesDebentures

2.2. Equity InstrumentsEquity Instruments– Common stockCommon stock– Preferred stockPreferred stock

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Financial Instruments Financial Instruments Non-marketableNon-marketable

• Characteristics of non-marketable Characteristics of non-marketable securitiessecurities

– Cannot be traded between or among investorsCannot be traded between or among investors– May be redeemable (a reverse transaction May be redeemable (a reverse transaction

between the borrower and the lender)between the borrower and the lender)– Examples:Examples:

• Savings accountsSavings accounts• Term DepositsTerm Deposits• Guaranteed Investment CertificatesGuaranteed Investment Certificates• Canada Savings BondsCanada Savings Bonds

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Financial Instruments Financial Instruments MarketableMarketable

• Characteristics of Marketable securitiesCharacteristics of Marketable securities– Can be traded between or among investors after their original Can be traded between or among investors after their original

issue in public markets and before they mature or expireissue in public markets and before they mature or expire

• Market CapitalizationMarket Capitalization– Is an important term in financeIs an important term in finance– It is the total market value of a company It is the total market value of a company – It is found by multiplying the number of shares outstanding by It is found by multiplying the number of shares outstanding by

the market price per share.the market price per share.

shareper Price shares ofNumber tion CapitalizaMarket

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Financial Instruments Financial Instruments MarketableMarketable

Markets can be categorized by the time to maturity:Markets can be categorized by the time to maturity:• Money Market SecuritiesMoney Market Securities (for short-term debt securities that are (for short-term debt securities that are

pure discount notes)pure discount notes)– Bankers’ acceptancesBankers’ acceptances– Commercial PaperCommercial Paper– Treasury BillsTreasury Bills

• Capital Market SecuritiesCapital Market Securities (for long-term debt or equity (for long-term debt or equity securities with maturities greater than 1 year)securities with maturities greater than 1 year)– BondsBonds– DebenturesDebentures– Common StockCommon Stock– Preferred StockPreferred Stock

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Financial MarketsFinancial Markets

• Primary MarketPrimary Market– Markets that involve the issue of new securities by the Markets that involve the issue of new securities by the

borrower in return for cash from investors (Capital borrower in return for cash from investors (Capital formation occurs)formation occurs)

• Secondary MarketSecondary Market– Markets that involve buyers and sellers of existing Markets that involve buyers and sellers of existing

securities. Funds flow from buyer to seller. Seller securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital becomes the new owner of the security. (No capital formation occurs)formation occurs)

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Financial Markets Financial Markets Types of Secondary MarketsTypes of Secondary Markets

• Exchanges or Auction MarketsExchanges or Auction Markets• Secondary markets that involve a bidding process that takes Secondary markets that involve a bidding process that takes

place in specific locationplace in specific location• For example TSX, NYSEFor example TSX, NYSE

• Dealer or Over-the-counter (OTC) MarketsDealer or Over-the-counter (OTC) Markets• Secondary markets that do not have a physical location and Secondary markets that do not have a physical location and

consist of a network of dealers who trade directly with one consist of a network of dealers who trade directly with one another.another.

• For example the bond marketFor example the bond market

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Financial Markets Financial Markets Other MarketsOther Markets

• Third MarketThird Market• Trading of securities that are listed on organized exchanges Trading of securities that are listed on organized exchanges

in the Over-the-counter marketin the Over-the-counter market

• Fourth MarketFourth Market• Trading of securities directly between investors (usually Trading of securities directly between investors (usually

between two large institutions) without the involvement of between two large institutions) without the involvement of brokers or dealers.brokers or dealers.

• Operates through the use of privately owned automated Operates through the use of privately owned automated systems such as systems such as InstinetInstinet

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The Global Financial CommunityThe Global Financial Community

• Represents an important source of funds Represents an important source of funds for borrowersfor borrowers

• Provides investors with important Provides investors with important alternatives as they seek to build wealth alternatives as they seek to build wealth through diversified portfoliosthrough diversified portfolios

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The Global Financial CommunityThe Global Financial Community

Total Assets($ million) 1,016,031

Canadian direct investments abroad 465,058Canadian portfolio investments 284,604Portfolio foreign bonds 82,374Portfolio foreign stocks 189,175Other portfolio investments 13,055Other Canadian investments 266,369Loans 48,325AllowancesDeposits 120,694Official international reserves 38,030Other assets 59,319Total Liabilities 1,184,534Foreign direct investments in Canada 415,561Foreign portfolio investments 508,398Portfolio Canadian bonds 380,017Portfolio Canadian stocks 107,598Portfolio Canadian money market instruments 20,783Other foreign investments 260,575Loans 36,107Deposits 201,639Other liabilities 22,829Canada's Net International Investment Position -168,503Source: Statistics Canada.

Table 1-7 Canada's International Investments, 2005

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SummarySummary

• In this chapter you have learned about:In this chapter you have learned about:– Financial systems in general, and the Canadian Financial systems in general, and the Canadian

financial system in particularfinancial system in particular– Major participants in the Canadian financial system, Major participants in the Canadian financial system,

including the different types of financial securities and including the different types of financial securities and financial marketsfinancial markets

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Internet LinksInternet Links

• BMO InvestorLine: BMO InvestorLine: www.bmoinvestorline.comwww.bmoinvestorline.com• Investment Funds Institute of Canada: Investment Funds Institute of Canada: www.ific.cawww.ific.ca• Globe and MailGlobe and Mail Report on Business: Report on Business:

www.theglobeandmail.comwww.theglobeandmail.com• Toronto Stock Exchange (TSX): Toronto Stock Exchange (TSX): http://www.tsx.com/http://www.tsx.com/• Canadian Trading and Quotation System Inc.: Canadian Trading and Quotation System Inc.:

http://www.cnq.ca/http://www.cnq.ca/ • Ontario Securities Commission: Ontario Securities Commission:

http://www.osc.gov.on.ca/index.jsphttp://www.osc.gov.on.ca/index.jsp• Winnipeg Commodity Exchange: Winnipeg Commodity Exchange: http://www.wce.ca/http://www.wce.ca/• New York Stock Exchange (NYSE) Euronext: New York Stock Exchange (NYSE) Euronext:

http://www.nyse.com/http://www.nyse.com/

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CopyrightCopyright

Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons addressed to the Permissions Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may make back-up copies for his or The purchaser may make back-up copies for his or her own use only and not for distribution or resale.her own use only and not for distribution or resale. The author The author and the publisher assume no responsibility for errors, omissions, and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from or damages caused by the use of these files or programs or from the use of the information contained herein.the use of the information contained herein.