Chapter 2Fundamentals of

Corporate FinanceFourth Edition

The Financial Environment

PRESENTED BYD-R EVGENI ZOGRAFSKI

Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 2

Irwin/McGraw Hill

Topics Covered

The Flow of Savings to CorporationsFunctions of Financial MarketsFunctions of Financial Intermediaries

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 3

Irwin/McGraw Hill

The Flow of Savings to Corporations

The ultimate source of financing is individual’s savings

Two forms of financing: internal and externalInternal-retained cash and selling new sharesExternal-loans and bonds

Savings flow through financial markets (stock exchanges) and financial intermediaries (mutual funds, pension funds, insurance companies)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 4

Irwin/McGraw Hill

Financial

Manager

Firm's

operations

Investors

(1) Investors buy shares with cash

(1)

(2)Cash is invested

(2)

(3) Timber harvest generates cash

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Flow of Savings to Corporations

Real assets

(timberland)

(stockholders save and invest in closely held firm.)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 5

Irwin/McGraw Hill

Financial Markets

Financial market-a market where securities are issued and traded Securities – a traded financial assets (shares; bonds) Shares-a proportion of ownership claim on the firm, with no

maturity Bonds-debt securities issued by a company representing a

obligation to investors to make regular interest payments and principal on a specified date in the future

Stock market (stock exchange) is the most important financial market

Stock market or equity market – trading own common equity (ordinary shares) of the firm

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 6

Irwin/McGraw Hill

Financial Markets

Primary market- market for sale of new issue of securities (shares, bonds); its organized in banks, brokerage co. (outside the exchange)

Secondary market - market in which previously issued securities are traded among investors

Secondary market: Stock exchange and OTC Stock exchange-organized market for trading securities OTC-over the counter market

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 7

Irwin/McGraw Hill

Financial Markets

Primary

Markets

Secondary

Markets

OTC

Markets

Money

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 8

Irwin/McGraw Hill

Other Financial Markets

Fixed income market-market for debt securities (bonds)

Capital market- market for long-term financingMoney market- market for short-term financing

(less than 1 year)Foreign-exchange market- inter bank market for

trading foreign currenciesCommodities market- organized market for trading

commodities (corn, wheat, cotton, oil)Derivatives market- organized market for trading

derivatives (options, futures, warrants, forwards, swaps)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 9

Irwin/McGraw HillIrwin/McGraw-Hill

Financial Markets

Company

Issue Debt

CashInvestors

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 10

Irwin/McGraw Hill

Financial Intermediaries

Financial intermediaries- an organization that rises money from investors and provide financing for individuals, companies e t.c.mutual funds,pension funds,insurance co., banks

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 11

Irwin/McGraw Hill

Mutual Funds

Mutual funds- pools the savings of many investors and invests in a portfolio of securities; mutual funds offer investors low-cost

diversification and professional management;Two types: Open-end funds and Close-end fundsfunds pursue a wide variety of investment

strategies (only stocks, only bonds, only dot.com.co’s,high-tech growth stocks, mixture of stock and bonds “balanced” funds, funds of funds)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 12

Irwin/McGraw HillIrwin/McGraw-Hill

Mutual Funds

Bank of AmericaBank of America

Windsor Fund

Windsor Fund

Investors

Investors

$ $

Sells shares

Issues shares

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 13

Irwin/McGraw Hill

Pension Funds

Pension funds- investment plan set up by employer (companies) for providing employees retirementDefined contribution pension plan (a % of

monthly pay is contributed to a pension fund-partly by employer, partly by employee)

Defined benefit pension plan (the employer invest to the pension fund)

Tax advantagesMacedonian experience

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 14

Irwin/McGraw Hill

Other financial institutions

Insurance companies- sells insurance policies and with cash finance companies

Banks- collect deposits and lend money to individuals and companies (short term and long term loans)

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 15

Irwin/McGraw Hill

Functions of Financial Markets

Financial markets and intermediaries channel savings to real investment

Financial markets and intermediaries provide financing for business

Other functionsTransporting cash across time Provide liquidityReduce and reallocate risk

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 16

Irwin/McGraw HillIrwin/McGraw-Hill

Financial Markets

Funds

Funds

Banks

Insurance Cos.

Brokerage Firms

Obligations

Depositors

Policyholders

Investors

Obligations

Company

Intermediary

Investor

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 17

Irwin/McGraw HillIrwin/McGraw-Hill

Financial Markets

Banks

Depositors

$2.5 mil

Cash

Loan

Deposits

Company

Intermediary

Investor

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 18

Irwin/McGraw HillIrwin/McGraw-Hill

Financial Markets

Insurance Company

Policyholders

$250 mil

Cash

Loan

Sell policies Issue Stock

Company

Intermediary

Investor

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 19

Irwin/McGraw Hill

Information Provided by Financial Markets

Securities and commodity pricesInterest ratesCompany values

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 20

Irwin/McGraw Hill

Opportunity Cost of Capital

Cost of capital- minimum acceptable rate of return of invested capital;

The cost of capital for corporate investment is set by the rates of return on investment opportunities in financial market; it’s an opportunity cost-the safest form of investment (yield on treasury bills)

Investment projects offering higher return that the cost of capital are acceptable

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 21

Irwin/McGraw Hill

Key Words

Securities-hartii od vrednostShares(Stocks)-akciiBonds-obvrzniciDerivatives-derivati na hartii od

vrednost(opcii,fju~ersi)Stock market (stock exchange)-berzaMutual fund-investicionen fondOpportunity cost of capital-oportunitetna

stapka na povrat na kapitalot

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

2- 22

Irwin/McGraw Hill

Web Resources

www.nyse.com

www.nasdaq.com

www.federalreserve.gov/releases/h15/update

www.investorlinks.com

www.indexfunds.com

www.morningstar.com

Click to access web sitesClick to access web sites

Internet connection requiredInternet connection required