Chapter 2 The Domestic and International Finance Marketplace © 2001 South-Western College Publishing

2 Finance Decisions Affecting SWM u Form of business organization u Types of financing u Investment projects All based on after-tax cash flow

3 Implication of Income Taxes for Financial Managers u Capital structure policy u Tax advantage of debt financing u Dividend policy u Capital gains Vs Dividend policy u Capital budgeting u After-tax CF’s Depreciation Net present value u Leasing ( NPV ) u Motivated by tax effects

4 Corporate Tax Rates u Progressive u The average tax rate increases for increasing levels of income u Marginal u The tax rate on the next $ of income u Marginal tax rate used in text 40% = State + Fed

5 Credit Unions Primary and Secondary Markets Sole Proprietorship Partnership Corporations Net Savers Become Investors Financial Markets Savings Institution Mutual Funds Pension Funds Insurance Companies Financial Institutions Financial Companies Banks Supply Funds Money Markets Capital Markets First Comes the National Financial System

6 Investment Banking u Help corporations sell new security issues u Underwrite u Guarantee sale at a fixed price u Best effort u No guarantee

7 Secondary Market u Listed exchanges u Designated place of business u Requirements of securities listed or traded u Over-the -counter ( OTC ) market u Networks connected by communications u Dealers post prices to buy and sell u Stock market indexes u DJIA DJTA S & P 500 NASDAQ

8 Regulations u State u Blue sky laws u Federal u Securities Act of 1933 &1934 u Securities & Exchange Commission (SEC) u Ethical issues u u Insider trading SEC attempts to prevent profiting from unpublished information

9 Global Financial Transactions Import Export Foreign Branch Licensing Arrangements Joint Ventures Multinational Corporations Manufacturing Distribution International Finance

10 Global Risks u Fluctuating Exchange Rates u Government Regulations u Tax Laws u Business Practices u Political Environment

11 Eurocurrency u Currency deposited outside of the country of origin u Eurodollars are dollars deposited outside of the US u A new currency called the Euro has been created by many European countries u The Euro is not the same as Eurocurrency

12 Some Important Terms u Exchange Rate u Direct Quote u Indirect Quote u Spot Rate u Forward Exchange Rate

13 Forward Exchange Rates u Exchange rates for currencies delivered at some future date, i.e., 30, 90, or 180 days u Premium: u where spot rate is expected to increase in the future u Discount: u where spot rate is expected to decrease in the future

14 Annualized Forward Premium or Discount 100% Forward Rate Spot Rate 12 # of months forward  - 

15 Standard amount of currency Standard future time ( maturity date) At a price set at the present time Foreign currency futures contrast Contracts traded on Chicago Mercantile Exchange ( CME ) Delivery

16 European and American Options u What is the difference between an American and European option? u The difference is that you can exercise an American option anytime until expiration, while the European option can be exercised only at expiration.

17 Remember A call is the right to buy a currency A put is the right to sell a currency

Market Efficiency “Glue” that bonds the PV of a firm’s net cash flow to shareholder’s wealth

19 Market Efficiency Capital markets are efficient if prices instantaneously and fully reflect all the risk and economically relevant information about a security’s prospective returns.

20 3 Degrees of Market Efficiency u Weak-form u Semistrong-form u Strong-form

21 Weak-form Security prices fully reflect all historical information No investor can earn excess returns using historical prices or returns

22 Semistrong-form Security prices fully reflect historical and publicly available information No investor can earn excess returns based on an investment strategy using public information

23 Strong-form Security prices fully reflect all historical, public and private information Markets are quite efficient!

24 Implications for Financial Managers u Timing or gambling u An expected NPV of zero u Corporate diversification u Security price adjustment

25 Barriers to Market Efficiency Outside the US u Foreign exchange risk u Legal restrictions on investments u Taxation policies discourage capital flows u High transactions cost u Political risks of expropriation

26 Holding Period Rate of Return HPR The return from holding an investment for one period

27 Equation HPR% = Ending - Beginning + Distribution Price Price Received  100% Price Price Received  100% Beginning Beginning Price Price

28 Returns Ex post = realized ( after the fact ) Ex ante = expected ( before the fact )