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Learning Objectives  Understand how financial markets and institutions channel savings to corporate investment.  Understand the basic structure of mutual funds, pension funds and banks.  Explain the functions of financial marketts and institutions. 2-2

2-3 Financial Markets Financing Decision Source of Funds (Capital) Financing Decision : The form and amount of financing of a firm’s investments. Capital Structure: The mix of long-term debt and equity financing.

2-4 The Flow of Capital: Closely Held Corporations

2-5 The Flow of Capital: Public Corporations

2-6 The Flow of Capital: Public Corporations Financial Market: Market where securities are issued and traded. A security is just a traded financial asset such as a share of stock. Primary Market: Market for the sale of new securities by corporations. Secondary Market: Market in which previously issued securities are traded among investors.

2-7 Financial Markets Initial Public Offering (IPO): First offering of stock to the general public. Fixed-Income Market: Market for debt securities

2-8 Financial Markets: Markets for Debt Capital Markets are used for long-term financing Example of long-term debt: Bonds Money Markets are used for short-term financing. (Less than 1 year) Example of short-term debt: Commercial Paper

2-9 Information Provided by Financial Markets: Commodity Prices Interest Rates Company Value Cost of Capital

2-10 Financial Intermediaries Mutual Fund An investment company that pools the savings of many investors and invests in a portfolio of securities. Mutual funds offer investors low cost diversification and professional management. Hedge Fund A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds Pension Fund Fund set up by an employer to provide for employees’ retirement

2-11 Flow of Cash Example: Mutual Fund $$ Sells shares Issues shares Bank of America Investors Explorer Fund

2-12

2-13 A Closer Look: Financial Institutions Commercial Bank Investment Bank Insurance Company

2-14 Company Intermediaries Banks Insurance Companies Brokerage Firms Obligations Funds Companies and Intermediaries

2-15 Intermediaries and Investors Intermediaries Investors Depositors Policyholders Investors Obligations Funds

2-16 Cash Flow Example: Banks Banks Depositors $2.5 mil Cash Loan Deposits Company Intermediary Investor

2-17 Cash Flow Example: Insurance Company Insurance Company Policyholders $2.5 mil Cash Issue Debt Sell Policies Company Intermediary Investor

2-18 Function of Financial Markets and Intermediaries  Transport cash across time  Risk transfer and diversification  Liquidity: The ability to sell an asset on short notice at close to the market price.

2-19 Function of Financial Markets and Intermediaries  Payment mechanism Electronic transfers make it easy to do business.  Provide information: interest rate, company value, commodity price.

2-20

Opportunity Cost of Capital Cost of capital: Minimum acceptable rate of return on capital investment. 2-21

2-22 Homebuyers overextended Financial Crisis : Causes Federal Reserve Easy-Money Policy The U.S. Government encouraged expansion of credit to low-income housing Bankers aggressively promoted subprime mortgages Credit Rating Agencies gave many AAA ratings to MBS that shortly went into default A Perfect Storm: Falling Housing Prices Bankruptcy Credit Freeze International Effect

2-23  Government Bailouts  Government Response: TARP Financial Crisis : The Response Government Bailout (or arranged acquisition) No Government Bailout Bear Stearns (JP Morgan Chase)Lehman Brothers Fannie Mae Freddie Mac Merrill Lynch (Bank of America) AIG Did this response effectively decrease the uncertainty in the market? What was the rationale behind TARP?

2-24 Appendix A: Total U.S. Equity Financing Holdings of Corporate Equities, 3 rd Quarter 2010

2-25 Appendix B: Total U.S. Debt Financing Holdings of Corporate & Foreign Bonds, 3 rd Quarter 2010