lecture financing decision
TRANSCRIPT
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FINANCING DECISION AND
FINANCIAL MARKETS
Conf. dr. Anamaria CIOBANU
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Goals of the Firm.
Explain why each of the following may not be appropriate corporate goals:
• a. Increase market share• b. Minimize costs• c. Underprice any competitors• d. Expand profits
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Agency Issues.Discuss which of the following forms of
compensation is most likely to align the interests of managers and shareholders:
• a. A fixed salary• b. A salary linked to company profits• c. A salary that is paid partly in the form of
the company’s shares• d. An option to buy the company’s shares
at an attractive price
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The Financing Decision of a Company
Financing Decision
Internal Resources
External Resources
Auto-financing:-Reinvesting the profits;- Reserves;- Depreciation and amortization of the assets;
- Credits;- Bond issuing;- Equity.
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Financial Institutions & Financial Markets
• Firms that require funds from external sources
can obtain them in three ways:
– through financial institutions : eg banks
– through financial markets : e.g BSE
– through private placements
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Financial Institutions
• Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments.
• In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.
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The Relationship between Financial Institutions and Financial Markets
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• Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly.
• The two key financial markets are:
– the money market: deals with short term
marketable securities
– the capital market: deals with long-term securities
Financial Markets
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Financial Markets
MONEY MARKET:The securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid.
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Financial MarketsCAPITAL MARKET:
-where different types of securities (e.g. stocks, bonds etc.) are traded through members of securities exchanges.
Eg. of securities exchanges:•NYSE - New York Stock Exchange•BSE – Bucharest Stock Exchange
Members of securities exchanges consist of mainly brokerage firms.
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FINANCIAL INSTRUMENTS
• Represent a contract between a lender and a borrower;
• This type of contract establish:the amount and the maturity;
the currency;
the financing cost (interest rate) and the payment method;
the risk allocation between the participants;
the payback of the loan;
other aspects (special clause).
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Financial Markets
Money Market Instruments Capital Market Instruments Treasury Bills Treasury Notes & BondsNegotiable CDs Government Agency Bonds
Bankers Acceptances State & Local Government BondsCommercial Paper Corporate Bonds
Credits Corporate Stocks
MONEY MARKET CAPITAL MARKET
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Treasury Bills
short term debt instruments
maturity of 3, 6 or 12 month;
have no interest payments (initially sold at a discount);
the most liquid financial instruments;
the safest financial instrument (no default risk)
can be issued in different currencies (usually are issued in local currency)
“risk free rate” instruments;
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Negotiable Bank Certificate of Deposits
• debt instrument sold by a bank to depositors (one of the most important capital source for banks);
• pays annual interest;• at maturity pays back the original purchase
price;
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Commercial Papers
• short term instruments issued by banks or well known companies;
• no interest payments (usually issued at a discount);
• interest rates are related to the issuer’s risk;
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Banker’s Acceptances
• were developed in accordance with international trade development
• represent banks drafts (a promise of payment similar to a check) issued by a company for a future date and guarantee for a fee by the bank
• the bank acceptance = the guarantee
• these instruments are often resold on secondary market at a discount
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Capital Market’s Financial Instruments
• BONDS (Debt Financing)- A debt instrument where a borrower
(issuer) pays interest and principal, on specific dates, to the lender (holder) of the bond.
Eg. Corporate bonds,government bonds, treasury notes
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• STOCKS (Equity Financing)- Corporation can raise capital by issuing
stocks - either common stocks or preferred stocks.
- Common stockholders are owners of the company and have a voting right.
- Preferred stockholders - have priority over dividends.
Capital Market’s Financial Instruments
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Capital Market’s Financial Instruments
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Organization of the Securities Market
• Primary market: market for trading newly issued securities. The financial market in which new issues of a security are sold to initial buyers.
• Secondary markets: markets where securities are bought and sold subsequent to original issuance. The financial markets in which security (previously issued) can be resold by the investors for cash.
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Primary Capital MarketsGovernment Bonds
• Sold regularly through auctions• Treasury bills: one year maturity or less• Treasury notes: maturities of two to ten
years• Treasury bonds: original maturities of
more than ten years
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Primary Capital MarketsCorporate Bonds
• Negotiated arrangement with an investment banking firm who maintains a relationship with the issuing firm;
• Underwriting firm often organizes a syndicate for distribution;
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Primary Capital Markets Common Stock
New issues are divided into two groups:Seasoned new issues– New shares offered by firms that already have
stock outstandingInitial public offerings (IPOs)– Firms selling their stock to the public for the
first time
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Secondary Markets
Involves the trading of issues that are already outstanding
• Provide a means obtaining cash for sellers
• Provide buyers with more investment choices
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Why Secondary Markets Are Important?
Provide liquidity to investors who acquire securities in the primary market;– Helps issuers raise needed funds in the
primary market since investors want liquidity
Help determine market pricing for new issues;
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Secondary Market Trading Systems
• Pure auction market– Buyers “bid” and sellers “ask”– Buy and sell orders are matched at a central location– Price driven market: trades are made by determining
the highest bid and the lowest ask
• Dealer market– Dealers buy shares (at the bid price) and sell shares
(at the ask price) from their own inventory– Dealers compete against each other
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Call Versus Continuous Markets
Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders;
Used for opening prices on BSE if orders build up overnight or after trading is suspended;
Continuous markets trade any time the market is open;
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National Stock Exchanges
• Large number of listed securities• Listing often seen as a sign of prestige• Wide geographic dispersion of listed firms• Diverse clientele of buyers and sellers• Firms wanting to list must meet listing
requirements
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Five common mistakes of beginning investors
• No clear compensation of return and risk;• Using a friend or relative as an investment
adviser;• Trading too frequently;• Not enough diversification;• No clearly formulated investment goals.
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No clear compensation of return and risk
• How much return can I expect?• Over what period of time?• Subject to what risk?
• You have to know the answers to these questions before you make an investment!
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Using a friend or relative as an investment adviser
• Select your broker or other advisor with the same care you exercise in finding a physician or an attorney.
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Trading too frequently
• Sell the losers and buy the winners strategy is wrong! Over the log run, this investment approach enriches the broker and impoverishes you!
• As a rule of thumb, allow about 2% for commissions on the value of securities purchased and sold.
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Not enough diversification
• Much investment risk can be eliminated without sacrificing return through proper diversification.
• Yet surveys tell us that most investors hold fewer than five securities, with many holding only one or two.
• To be adequately protected you need a well-diversified portfolio, balanced across a wide array of different investments.
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No clearly formulated investment goals
• If you know why you are investing, you will know better how to invest!
• I want to get rich by investing! Is a elusive goal!
• Your goals have to be SMART! (Specific; Measurable; Achievable; Realistic; Timely)– Get 20% return on my investment by the end of
the year!
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Opening an account and making transactions
• Cash account: account that requires payment within five working days for securities purchased;
• Margin account: allows an investor to borrow from his broker, pledging securities as collateral;
• Discretionary account: gives a broker power of attorney to trade securities on an investor’s behalf
• Wrap account: involves the services of a professional money manager with an investor’s broker.
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Margin account
• Initial margin requirement• Maintenance margin requirement
– when this figure is touched, the investor get a margin call, which means that he must either deposit additional funds to increase his equity or sell some of his shares.
• Margin accounts are risky (the loan increases the risk and the costs for the investor…but allows to magnify the amount of money invested. A greater investment means greater profits…or losses.)
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Initiating a Position• After an account is opened, the investor can
begin trading!
• When he buy securities, he take a long position
• When he sell securities that he do not already own, he take a short position
• When he sell securities he originally bought or buy securities he originally sold, he is reversing a position
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Initiating a Position
• When you’ll initiate a long position?– When you forecast an increase in securities
price!• When you’ll initiate a short position?
– When you believe that the securities’ price will decrease!
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Initiating a Position
• Suppose you think IBM is overvalued at 150$ a share and its likely to decrease in future!
• What you’ll do?• Short sell of IBM stocks hoping to reverse
your position in the future after the price has fallen!
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Major Types of Orders
• Market orders– Buy or sell at the best current price
• Limit orders– Order specifies the buy or sell price– Time specifications for order may vary
• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)
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Major Types of Orders
• Special Orders– Stop loss
• Conditional order to sell stock if it drops to a given price
• Does not guarantee price you will get upon sale
– Stop buy order• Investor who sold short may want to limit loss if
stock increases in price
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Major Types of Orders
• Short sales– Sell overpriced stock that you don’t own and
purchase it back later (at a lower price)– Borrow the stock from another investor
(through your broker)– Margin requirements apply
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Major Types of OrdersBuying on Margin:• On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock as collateral
• Interest rate is based on the call money rate from a bank
• Regulations limit proportion borrowed and the investor’s equity percentage (margin)– Margin requirements are from 50% up
• Changes in price affect investor’s equity
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Major Types of OrdersMargin Order Details• Initial margin requirement at least 50%
– Lower margin requirements allow you to buy more• Maintenance margin
– Required proportion of equity to stock value– Protects broker if stock price declines– Minimum requirement is at least 25%– Margin call on undermargined account to meet
margin requirement– If call not met, stock will be sold to pay off the loan
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Major Types of Orders
Margin Example:• Buy 100 shares at $60 = $6,000 position• Borrow 50%, investment of $3,000If price increases to $70, position
Value is $7,000Less - $3,000 borrowed Leaves $4,000 equity for a$4,000/$7,000 = 57% equity position
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Major Types of Orders
Margin Example:• Buy 100 shares at $60 = $6,000 position• Borrow 50%, investment of $3,000If price decreases to $50, position
Value is $5,000Less - $3,000 borrowed Leaves $2,000 equity for a$2,000/$5,000 = 40% equity position
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QUIZ
• Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets!
• Comment this statement!
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QUIZ
• If you suspect that a company will go bankrupt next year, which you rather hold, bonds or equity issued by the company? Why?
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QUIZ
• An investor deposit 2000 $ and borrows 2000$ to purchase 4000$ of securities. He owns 100 shares of KLM at 40 $ a share.
• KLM’s price falls. Which is the price from where the broker requires additional margin to restore the initial margin requirement?
• What price increase of KLM’ stocks the investor need in order to get an annual return of 20% (the interest rate of the broker loan is 10%)?
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Thank you for your attention!