An Introduction To Finance3256

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 1 An Introduction to Finance
Prepared by Ken Hartviksen
CHAPTER 1 An Introduction to Finance
Lecture Agenda
Learning Objectives Important Terms Finance Defined Real versus Financial Assets The Financial System Financial Instruments and Markets The Global Financial Community Summary and Conclusions
Concept Review Questions Practice Problems
CHAPTER 1 - An Introduction to Finance 1-3
Learning Objectives
1. 2. What finance is and what is involved in the study of finance. How financial securities can be used to provide financing for borrowers and simultaneously to provide investment opportunities for lenders. How financial systems work in general. The channels of intermediation and the role played by market and financial intermediaries within this system. The basic types of financial instruments that are available and how they are traded. The importance of the global financial system.
3. 4. 5. 6.
CHAPTER 1 - An Introduction to Finance
1-4
Important Chapter Terms

Bourse de Montreal Brokers Canadian Trading and Quotation System Inc (CNQ) Capital market securities Common share Corporate finance Crown corporations Over-the-counter markets (OTC) Debt instruments Equity instruments Exchanges or auction markets Finance Financial assets Financial intermediaries Fourth market Intermediation
1-5
Important Chapter Terms

Investments Market capitalization Market intermediary Marketable financial assets New York Stock Exchange Non-marketable financial assets Ontario Securities Commission Preferred shares Primary markets Real assets Secondary markets Toronto Stock Exchange (TSX) TSX Group Inc. TSX Markets TSX Venture Exchange Winnipeg Commodity Exchange
1-6
What is Finance?
Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.
Finance is distinct from economics in that it addresses not only how resources are allocated but also under what terms and through what channels
Financial contracts or securities occur whenever funds are transferred from issuer to buyer.
1-7
The Study of Finance

The study of finance requires a basic understanding of:
Securities Corporate law Financial institutions and markets
1-8
Real Versus Financial Assets

Real assets are tangible things owned by persons and businesses
Residential structures and property Major appliances and automobiles Office towers, factories, mines Machinery and equipment
Financial assets are what one individual has lent to another

Consumer credit Loans Mortgages
CHAPTER 1 - An Introduction to Finance 1-9
Real Versus Financial Assets

The Household Balance Sheet
Households hold both real and financial assets Households also acquire some of those assets through debt A Household with no financial assets often faces financial problems because real assets cant be used to pay off debt or to service debt (make loan and interest payments) Real assets are not liquid
(See Table 1-2 on the next slide)
1 - 10
Assets and Liabilities of Households, 2005

Table 1-2 Assets and Liabilities of Households, 2005 Assets $ Billion Houses 1,086 Consumer Durables 435 Land 827 Real Assets 2,348 Deposits 683 Debt 114 Pensions and insurance 1,200 Shares 1,254 Foreign and other 72 Financial Assets 3323 Total Assets 5,671 Liabilities $ Billion Consumer credit 260 Loans 131 Mortgages 588 Total Liabilities 979
So urce: Statistics Canada. Natio nal B alance Sheet A cco unts, Quarterly Estimates, Fo urth Quarter 2005. Ottawa: M inister o f Industry, 2006 (Catalo gue No . 1 3-21 4-XIE).
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The Financial System

An Introduction to Finance

Overview
The household is the primary provider of funds to businesses and government.
Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in their retirement years
Financial intermediaries transform the nature of the securities they issue and invest in
Banks, trust companies, credit unions, insurance firms, mutual funds
Market intermediaries simply help make markets work

Investment dealers Brokers
(See Figure 1-2 on the next slide)
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FIGURE 1-2
1 - 14

Channels of Intermediation
Funds can be channeled from saver to borrower in three ways:

Direct intermediation (direct transfer from saver to borrower a non-market transaction) Direct intermediation (a market-based transaction usually through a market intermediary such as a broker) Indirect claims through a financial intermediary (where the financial intermediary such as a bank offers deposit-taking services and ultimately lends those deposits out as mortgages or loans)
(See Figure 1-3 on the next slide)
CHAPTER 1 - An Introduction to Finance 1 - 15
Channels of Intermediation
FIGURE 1-3
1 - 16

Financial Intermediaries
Banks and other deposit-taking institutions Insurance companies Pension Funds Mutual Funds
1 - 17
Canadian Chartered Banks
Banks take deposits from numerous depositors from across Canada The deposits are pooled in the Bank The bank takes these pooled funds and lends them out to households and businesses in the form of mortgages and loans The bank transforms the original nature of the savers (depositors) money:
Deposits are usually small in amountface little or no risk, and depositors expect to withdraw the amount at any time Loans and mortgages on the other hand usually have the following characteristics:
Large sums Borrowed for long periods of time Borrowed for risky purposes.
Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing the risk) and monitoring the activities of borrowers.
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Canadian Chartered Banks
Table 1-3 Chartered Banks: Financial Statistics, 2005 Revenue Assets Profits ($ million) ($ million) ($ million) 29,403 469,521 3,387 18,677 18,332 18,665 15,138 5,320 280,370 314,025 365,210 297,532 107,598 -32 3,209 2,229 2,400 855
Bank Royal Bank of Canada Canadian Imperial Bank of Commerce (CIBC) Bank of Nova Scotia TD Canada Trust Bank of Montreal National Bank
So urce: B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31 2006. ,
1 - 19
Insurance Companies
Insurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a claim and the size the policy and administrative fees. They invest the premiums so that the accumulated value in the future will grow to meet the anticipated claims of the policyholders. In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a large number of policyholders through the insurance company. Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of loss themselves.
Insurance Companies
Table 1-4 Insurance Companies: Financial Statistics, 2005 Revenue Assets Profits ($ million) ($ million) ($ million) 32,187 322,171 3,294 21,871 171,850 1,867 23,883 102,161 1,775 4,446 9,926 782
Insurer Manulife Financial Sun Life Financial Great-West Lifeco ING Canada
So urce: Data fro m B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31 2006. ,
1 - 21
Pension Plan Assets
Individuals and employers make payments over the entire working life of a person with those funds invested to grow over time. Ultimately, the accumulated value in the pension can be used by the person in retirement. Pension plans accumulate considerable sums of money, and their managers invest those funds with long-term investment time horizons in diversified portfolios of investments. These investments are a major source of capital, fuelling investment in research and development, capital equipment, resource exploration and ultimately contributing in a substantial way to growth in the economy.
1 - 22
Pension Plan Assets
Table 1-5 Pension Plan Assets, 2005 Net Assets ($ billion) 216.1 98.0 96.1 41.6
Pension Plan Managers Caisse de depot et placement du Quebec Canada Pension Plan (CPP) Ontario Teachers (Teachers) Ontario Municipal Employees (OMERS)
* The Caisse manages the investments o f several pensio n plans.
1 - 23
Canadian Mutual Fund Assets
Mutual funds give small investors access to diversified, professionally-managed portfolios of securities. Small investors often do not have the funds necessary to invest directly into market-traded stocks and bonds. This is called denomination intermediation because the mutual fund makes investments available in smaller, more affordable amounts of money. Canadian indirect investment in the markets through managed products such as mutual funds and segregated funds has grown exponentially.
(see 1-4 Figure on the next slide)
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Canadian Mutual Fund Assets
FIGURE 1-4
1 - 25

The Major Borrowers
Public Debt
Governments
Federal Provincial Municipal Crown Corporations
Private Debt
Households Non-financial Corporations
1 - 26

Largest Non-financial Companies
Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005 Revenue Assets ($ million) ($ million) 34,991 n/a 27,812 13,761 22,873 12,321 26,936 15,582 20,408 26,638 19,150 40,630 14,882 17,483 17,673 20,655 17,626 14,845 14,322 34,148
Non-financial Companies General Motors of Canada Ltd. Loblaw Companies Ltd. Magna International Inc. Imperial Oil Ltd. Alcan Inc.* BCE Inc. Bombardier Inc.* Petro-Canada Onex Corp. EnCana Corp.*
*Co mpany repo rts in U.S. do llars.
So urce: Data fro m "The To p 1 000 in 2005." Glo be and M ail Repo rt o n B usiness website: www.theglo beandmail.co m.
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Financial Instruments
There are two major categories of financial securities:
1. Debt Instruments
Commercial paper Bankers acceptances Treasury bills Mortgage loans Bonds Debentures
2. Equity Instruments
Common stock Preferred stock
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Non-marketable
Characteristics of Non-marketable securities

Cannot be traded between or among investors May be redeemable (a reverse transaction between the borrower and the lender) Examples:
Savings accounts Term Deposits Guaranteed Investment Certificates Canada Savings Bonds
Marketable
Characteristics of Marketable securities
Can be traded between or among investors after their original issue in public markets and before they mature or expire The market value will change over time due to changes in the general economic environment (for example, interest rate increases or decreases) and/or changes in the issuer of the security.
Market Capitalization
Is an important term in finance It is the total market value of a company It is found by multiplying the number of shares outstanding by the market price per share.
Market Capitaliza tion Number of shares Price per share
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Marketable
Markets can be categorized by the time to maturity:
Money Market Securities (for short-term debt securities that are pure discount notes)
Bankers acceptances Commercial Paper Treasury Bills
Capital Market Securities (for long-term debt or equity securities with maturities greater than 1 year)
Bonds Debentures Common Stock Preferred Stock
1 - 32
Financial Markets
Financial Markets
Primary Market
Markets that involve the issue of new securities by the borrower in return for cash from investors (Capital formation occurs)
Secondary Market
Markets that involve buyers and sellers of existing securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital formation occurs)
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Financial Markets
Types of Secondary Markets
Exchanges or Auction Markets

Secondary markets that involve a bidding process that takes place in specific location For example TSX, NYSE
Dealer or Over-the-counter (OTC) Markets

Secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another. For example the bond market
1 - 35
Financial Markets
Other Markets
Third Market
Trading of securities that are listed on organized exchanges in the Over-the-counter market
Fourth Market
Trading of securities directly between investors (usually between two large institutions) without the involvement of brokers or dealers. Operates through the use of privately owned automated systems such as Instinet
1 - 36
The Global Financial Community

Represents an important source of funds for borrowers Provides investors with important alternatives as they seek to build wealth through diversified portfolios
1 - 37
The Global Financial Community

Table 1-7 Canada's International Investments, 2005 ($ million) 1,016,031 465,058 284,604
Total Assets Canadian direct investments abroad Canadian portfolio investments Portfolio foreign bonds 82,374 Portfolio foreign stocks 189,175 Other portfolio investments 13,055 Other Canadian investments Loans 48,325 Allowances Deposits 120,694 Official international reserves 38,030 Other assets 59,319 Total Liabilities Foreign direct investments in Canada Foreign portfolio investments Portfolio Canadian bonds 380,017 Portfolio Canadian stocks 107,598 Portfolio Canadian money market instruments 20,783 Other foreign investments Loans 36,107 Deposits 201,639 Other liabilities 22,829 Canada's Net International Investment Position
So urce: Statistics Canada.
266,369
1,184,534 415,561 508,398
260,575
-168,503
1 - 38
Summary and Conclusions

In this chapter you have learned about:
Financial systems in general, and the Canadian financial system in particular Major participants in the Canadian financial system, including the different types of financial securities and financial markets
1 - 39
Internet Links
BMO InvestorLine: www.bmoinvestorline.com Investment Funds Institute of Canada: www.ific.ca Globe and Mail Report on Business: www.theglobeandmail.com Toronto Stock Exchange (TSX): http://www.tsx.com/ Canadian Trading and Quotation System Inc.: http://www.cnq.ca/ Ontario Securities Commission: http://www.osc.gov.on.ca/index.jsp Winnipeg Commodity Exchange: http://www.wce.ca/ New York Stock Exchange (NYSE): http://www.nyse.com/
1 - 40
Concept Review Questions

Concept Review Question 1

Finance
What is finance? Finance is the study of how and under what terms savings are allocated between borrowers and lenders. It also examines under what terms and through what channels resources are allocated.
1 - 42

Real and Financial Assets
Distinguish between real and financial assets. Real assets are tangible property owned by people and businesses such as buildings, land, machinery and equipment Financial assets are paper claims that are evidence of contracts between people, or between people and businesses (government)
1 - 43

Net Providers and Users of Funds
Which sectors of the economy are net providers of financing and which are the net users of financing?
Households and the non-resident sector traditionally are the net provider of financing for businesses and government.
1 - 44

Channels of Savings
Identify and briefly describe the three main channels of savings. Direct claims through Non-market transactions
A daughter arranging a loan through her mother
Direct claims through market intermediaries

Purchase of a stock through a broker
Indirect claims through financial intermediaries

Deposit in a savings accountthe funds eventually find themselves lent by the bank to a business to finance purchase of equipment.
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Market and Financial Intermediaries
Distinguish between market and financial intermediaries. Market intermediaries help with the proper functioning of financial markets
Investment dealers
Financial intermediaries transform financial assets and meet the needs of both savers and borrowers simultaneously through the asset transformation function
Banks Insurance firms Mutual funds
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How financial intermediaries operate
Discuss how the three most important types of financial intermediaries operate. Banks
Deposit-taking and lending
Insurance Firms
Sale of policies, collecting of premiums, investing premiums and underwriting losses
Pension Plans
Long-term accumulation of savings and channeling them to productive long-term investments that will yield long-term positive returns and provide financial security in old age for beneficiaries.
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Types of financial assets
Distinguish among the various types of financial assets. Debt (represents a lending arrangement)
Short-term debt is traded in the money market
Commercial paper Bankers acceptances Treasury Bills
Long-term debt is traded in the OTC capital market

Bonds and debentures
Equity (represents an ownership claim)

Common Stock Preferred Stock
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Sources of financing used by governments and business
Identify the major sources of financing used by governments and businesses. (a) Governments
Tax revenue (income taxes, excise taxes, consumption taxes (PST and GST), property taxes Borrowing (short-term through Treasury bills, and long-term through Government bonds) Reinvested Profits Common Stock Bonds Short-term loans from banks
(b) Businesses


Primary and Secondary Markets
Distinguish between primary and secondary markets.

Primary market is where new securities are sold for the first time. This is where the corporate issuer raises capital. Secondary markets occur when existing securities are traded among and between investors without capital formation occurring.

Importance of global financial markets to Canadians
Explain why global financial markets are so important to Canadians. Canadians as savers need to diversify their investment portfolios, and access to global financial markets allows that diversification to be more complete. Having access to funds in global markets, Canadian companies can raise more capital more cheaply making them more competitive in their chosen industry.
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Major U.S. Stock Markets
Identify and briefly describe the two major stock markets in the United States.
1. New York Stock Exchange (NYSE)
Worlds largest Most famous Market capitalization US $21.2 trillion (2005) Second largest and most important in U.S. Third largest in the world More listed companies than the NYSE
2. Nasdaq
Practice Problems
Practice Problem 1
The Four Major Financial Sectors
State the four major financial sectors in the financial system and discuss how they relate to one another
1. Borrowers
Deficit spending economic units (households, businesses, government) require funds now for investment and are willing to pay investors a return for the use of these funds
2.
Lenders/investors
Surplus saving economic units (households, businesses, government) have a surplus of funds available that they want to earn a return on so they lend or invest these funds to net borrowers
Banks, trusts, credit unions, pension funds, mutual funds, channel surplus savings to deficit spending economic units Money, bond and equity markets bring buyers (lenders/investors) and sellers (borrowers) of financial assets together to trade in those assets and establish market prices for them.
3. 4.
Financial intermediaries

Financial markets
1 - 54
Practice Problem 2
The role of different financial intermediaries in the financial system.
Explain how banks, pension funds, insurance firms, and mutual funds work in the financial system.
1. Banks
Accept deposits, pool the funds and lend them out as mortgages and loans Professionally managed pools of funds that fuel current investment in Canadian business and government but at the same time provide for the long-term financial security of the plan beneficiaries
2.
Pension Funds
3.
Insurance Firms
Facilitate the pooling or sharing of risks among the many policyholders thereby underwriting economic activity and minimizing the negative impacts of unsupportable losses.
Permits small investors with access to direct claims that are market traded such as stocks and bonds.
4.
Mutual Funds
Practice Problem 3
Why financial intermediaries and markets exist.
Briefly describe why financial and market intermediaries exist in our financial system.
Financial and market intermediaries serve to channel scarce financial resources from economic units that have a surplus of savings to economic units that have a deficit of savings. Ideally, financial and market intermediaries will ensure that these scarce financial resources will be put to the greatest and best use (ie. Perform their functions with effectiveness) Ideally, financial and market intermediaries will perform the channeling function at a low net cost to both borrower and saver (ie. Perform their functions with efficiency).
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Practice Problem 4
Primary Market Transactions
List the two main types of primary market transactions and concisely explain them.
Debt Offerings
When governments or businesses sell bonds to investors in return for cash that the issuer needs When businesses sell shares to the investing public in return for cash that the issuer needs.
Equity Offerings
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Practice Problem 4
Secondary Market Transactions
What are secondary market transactions? How do secondary markets facilitate the primary markets?
Secondary market transactions occur between two parties that wish to trade in a financial asset.
Funds flow from the purchaser to the seller of the financial asset No funds flow to the issuer of the financial asset
Secondary markets provide liquidity in the market place and continuous pricing function.
The fact that securities with long terms to maturity (or nonmaturing securities such as stock) can be sold, allows investors with shorter investment time horizons to consider their purchase.
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Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
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INTRODUCTION TO

Prepared by Ken Hartviksen

CHAPTER 1 An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

Important Chapter Terms

CHAPTER 1 - An Introduction to Finance

Important Chapter Terms

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

The Study of Finance

CHAPTER 1 - An Introduction to Finance

Real Versus Financial Assets

Financial assets are what one individual has lent to another

Real Versus Financial Assets

CHAPTER 1 - An Introduction to Finance

Assets and Liabilities of Households, 2005

CHAPTER 1 - An Introduction to Finance

The Financial System

The Financial System

Market intermediaries simply help make markets work

CHAPTER 1 - An Introduction to Finance

The Financial System

CHAPTER 1 - An Introduction to Finance

The Financial System

Funds can be channeled from saver to borrower in three ways:

CHAPTER 1 - An Introduction to Finance

The Financial System

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

The Financial System

CHAPTER 1 - An Introduction to Finance

The Financial System

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

Characteristics of Non-marketable securities

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

Exchanges or Auction Markets

Dealer or Over-the-counter (OTC) Markets

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

The Global Financial Community

(See Table 1-7 on the next slide)

CHAPTER 1 - An Introduction to Finance

The Global Financial Community

1,184,534 415,561 508,398

CHAPTER 1 - An Introduction to Finance

Summary and Conclusions

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 - An Introduction to Finance

Concept Review Questions

Concept Review Question 1

CHAPTER 1 - An Introduction to Finance

Concept Review Question 2

CHAPTER 1 - An Introduction to Finance

Concept Review Question 3