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Corporate Finance, Chapter 3 notes

by: Rafael Galindez

Corporate Finance, Chapter 3 notes Finance 301

Marketplace > Pennsylvania State University > Finance > Finance 301 > Corporate Finance Chapter 3 notes
Rafael Galindez
Pennsylvania State University Altoona
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About this Document

Notes for what was covered in Chapter 3
Intro to Finance
Jack Collins
Class Notes
finance, Corporate Finance




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This 3 page Class Notes was uploaded by Rafael Galindez on Monday February 8, 2016. The Class Notes belongs to Finance 301 at Pennsylvania State University taught by Jack Collins in Winter 2016. Since its upload, it has received 29 views. For similar materials see Intro to Finance in Finance at Pennsylvania State University.

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Date Created: 02/08/16
Chapter 2 Finance 301 Financial Markets and Institutions The Flow of Savings to Corporations The money that corporations invest in real assets comes ultimately from savings by investors. But there can be many stops on the road between savings and corporate investment. The road can pass through financial markets, financial intermediaries, or both. There are two possible paths of the flow of savings from the shareholders. In the first path the firm can sell new shares, or it can reinvest cash back into the firm’s operation. Reinvestment means additional savings by existing shareholders. The reinvested cash could have been paid out to those shareholders and spent by them on personal consumption. By not taking and spending the cash, shareholders have reinvested their savings in the corporation. Cash retained and reinvested in the firm’s operations is cash saved and invested on behalf of the firm’s shareholders. The flow of saving to large public corporations differs from that of a closely held private corporation. Two key differences are: First, public corporations can draw savings from investors worldwide. Second, the savings flow through financial markets, financial intermediaries, or both. The Stock Market A financial market is a market where securities are issued and traded. A security is just a traded financial asset, such as a share of stock. For a corporation, the stock market is probably the most important financial market. As corporations grow, their requirements for outside capital can expand dramatically. At some point the firm will decide to “go public” by issuing shares on an organized exchange such as the New York Stock Exchange; that first issue is called an initial public offering (IPO). The buyers of the IPO are helping to finance the firm’s investment in real assets. In return, the buyers become part owners of the firm and share in its future success or failure. A new issue of shares increases both the amount of cash held by the company and the number of shares held by the public. Such an issue is known as primary issue and it is sold in the primary market. But in addition to helping companies raise new cash, financial markets also allow investors to trade securities among themselves. Purchases and sales of existing securities are known as secondary transactions, and they take place in the secondary market. Stock markets are also equity markets, since stockholders are said to own the common equity of the firm. Most trading in the shares of U.S. corporations takes place on the NYSE and on NASDAQ, which tends to attract listings from smaller, high-tech companies. A few corporate debt securities are traded on the NYSE and other exchanges, but most corporate debt securities are traded over the counter, through a network of banks and securities dealers. A bond is a more complex security than a share of stock. A share is just a proportional ownership claim on the firm, with no definite maturity. Bonds and other debt securities can vary in maturity, in the degree of protection or collateral offered by the issuer, and in the level and timing of interest payments. This all takes place in the fixed-income market. The markets for long-term debt and equity are called capital markets. A firm’s capital is its long run financing. Short-term securities are traded in the money markets. Financial Intermediaries A financial intermediary is an organization that raises money from investors and provides financing for individuals, companies, and other organizations. For corporations, intermediaries are important sources of financing. Intermediaries are a stop on the road between savings and real investment. There are two important classes of intermediaries: mutual funds and pension funds. Mutual funds raise money by selling shares to investors. The investors’ money is pooled and invested in a portfolio of securities. Investors can buy or sell shares in mutual funds as they please, and initial investments are often $3,000 or less. Mutual funds offer investors low-cost diversification and professional management. For most investors, it’s more efficient to buy a mutual fund than to assemble a diversified portfolio of stocks and bonds. Mutual fund managers also try their best to “beat the market” that is, to generate superior performance by finding the stocks with better-than-average returns. In exchange for their services, the fund’s managers take out a management fee. Like mutual funds, hedge funds also pool the savings of different investors and invest on their behalf. They differ from mutual funds in two ways: First, because hedge funds usually follow complex, high-risk investment strategies, access is restricted to knowledgeable investors such as pension funds, endowment funds, and wealthy individuals. Second, hedge funds try to attract the most talented managers by compensating them with potentially lucrative, performance-related fees. There are other ways of pooling and investing savings. Consider a pension plan set up by a corporation or other organization on behalf of its employees. There are several types of pension plan. The most common type of plan is the defined- contribution plan. In this case, a percentage of the employee’s monthly paycheck is contributed to a pension fund. Contributions from all participating employees are pooled and invested in securities or mutual funds. Each employee’s balance in the plan grows over the years as contributions continue and investment income accumulates. The balance in the plan can be used to finance living expenses after retirement. The amount available for retirement depends on the accumulated contributions and on the rate of return earned on the investments. They also have an important tax advantage: Contributions are tax-deductible, and investment returns inside the plan are not taxed until cash is finally withdrawn. Financial Institutions A financial institution is an intermediary that does more than just pool and invests savings. Institutions raise financing in special ways, for example, by accepting deposits or selling insurance policies, and they provide additional financial services. Some financial institutions are:  Commercial Banks: They are major sources of loan for corporations. The flow of savings is: The bank provides debt financing for the company and, at the same time, provides a place for depositors to park their money safely and withdraw it as needed.  Investment Banks: These banks do not take deposits, and they do not usually make loans to companies. Instead, they advise and assist companies in raising financing. They offer investment advice and manage investment portfolios for individual and institutional investors.  Insurance Companies: They are more important than banks for the long- term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans. The money to make the loan comes mainly from the sale of insurance policies. Functions of Financial Markets and Intermediaries  Transporting Cash Across Time: Individuals need to transport expenditures in time. If you have money now that you wish to save for a bad day, you can put the money in a savings account at a bank and withdraw it with interests later. If you don’t have money today, say to buy a car, you can borrow money from the bank and pay off the loan later.  Risk Transfer and Diversification: Financial markets and intermediaries allow investors and businesses to reduce and reallocate risk. Insurance companies are an obvious example. When you buy homeowner’s insurance, you greatly reduce the risk of loss from fire, theft, or accidents. But your policy is not a very risky bet for the insurance company. It diversifies by issuing thousands of policies, and it expects losses to average out over the policies.  Liquidity: Markets and intermediaries also provide liquidity, that is, the ability to turn an investment back into cash when needed. The shares of public companies are liquid because they are traded more or less continuously in the stock market.  The Payment Mechanism: Checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances.  Information Provided by Financial Markets: The information provided by financial markets is often essential to a financial manager’s job. Here are four examples of how information can be used:  Commodity Prices  Interest Rates  Company Values: Stock prices and company values summarize investors’ collective assessment of how well a company is doing, both its current performance and its future prospects. Thus an increase in stock price sends a positive signal from investors to managers.  Cost of Capital: Financial managers look to financial markets to measure, or at least estimate, the cost of capital for the firm’s investment projects.


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