Chapter 2 Learning Objectives Understand how financial markets and institutions channel savings to corporate investment. Understand the basic structure of mutual funds, pension funds, banks, and insurance companies. Explain the functions of financial markets and institutions. Understand the main events behind the financial crisis of 2007–2009.

Financial Markets Financing Decision Source of Funds (Capital) Capital Structure Chapter 2 Outline The Financing Decision The Flow of Savings to Corporations Closely Held Corporations vs. Public Corporations Financial Markets Types Information Provided by Financial Markets Financial Intermediaries Financial Institutions Function of Financial Markets and Intermediaries The Financial Crisis of 2007-2009 Note: Contrast the Financing Decision with the Investment Decision presented in Chapter 1. Definitions Financing Decision – The form and amount of financing of a firm’s investments. Capital Structure – The mix of long-term debt and equity financing. 5 5 5 6 5 5

The Flow of Capital: Closely Held Corporations 7 7 7 7 12 11

The Flow of Capital: Public Corporations 7 7 7 7 12 11

The Flow of Capital: Public Corporations Financial Market: Market where securities are issued and traded. Primary Market: Market for the sale of new securities by corporations. Secondary Market: Market in which previously issued securities are traded among investors. Financial Market – Market where securities are issued and traded. Primary Market – Market for the sale of new securities by corporations. Secondary Market – Markets in which previously issued securities are traded among investors. 7 7 7 12 11 7

Financial Markets Initial Public Offering (IPO): Fixed-Income Market: First offering of stock to the general public. Fixed-Income Market: Market for debt securities Initial Public Offering – First offering of stock to the general public. Fixed-Income Market – Market for debt securities. 7 7 7 12 11 7

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. Example of short-term debt: Commercial Paper Capital Market– Market for long-term financing Money Market – Market for short-term financing (less than one year). Note: What is meant by over the counter? 7 7 7 12 11 7

Information Provided by Financial Markets: Commodity Prices Interest Rates Company Value Cost of Capital Cost of Capital – Minimum acceptable rate of return on capital investment Note: How is the value of a company measured by the market? 7 7 7 12 11 7

Financial Intermediaries Mutual Fund An investment company that pools the savings of many investors and invests in a portfolio of securities 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 Financial Intermediary – An organization that raises money from investors and provides financing for individuals, corporations, or other organizations Mutual Fund – An investment company that pools the savings of many investors and invests in a portfolio of securities 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 7 7 7 12 11 7

Flow of Cash Example: Mutual Fund $ $ Bank of America Explorer Fund Investors Sells shares Issues shares Mutual Fund – An investment company that pools the savings of many investors and invests in a portfolio of securities. 7 7 11 12 7 7

A Closer Look: Financial Institutions Commercial Bank Investment Bank Insurance Company Financial Institution – A bank, insurance company or similar financial intermediary 7 7 7 12 11 7

Companies and Intermediaries Company Obligations Funds Intermediaries Banks Insurance Companies Brokerage Firms

Intermediaries and Investors Obligations Funds Investors Depositors Policyholders

Cash Flow Example: Banks $2.5 mil Cash Loan Deposits Company Intermediary Investor Banks Depositors 8 8 8 15 16 8

Cash Flow Example: Insurance Company Issue Debt $2.5 mil Insurance Company Intermediary Sell Policies Cash Policyholders Investor 8 8 8 16 15 8

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

Function of Financial Markets and Intermediaries Payment mechanism Provide information 18

Financial Crisis 2007-2009: Causes Federal Reserve Easy-Money Policy Bankers aggressively promoted subprime mortgages The U.S. Government encouraged expansion of credit to low-income housing Credit Rating Agencies gave many AAA ratings to MBS that shortly went into default Homebuyers overextended A Perfect Storm: Falling Housing Prices Bankruptcy Credit Freeze International Effect Note: What does the Federal Reserve’s Easy-Money Policy imply out interest rates and the time value of money? Note: Bankers aggressively promoted subprime mortgages as well as bundled and resold these riskier securitized mortgages with others mortgages. The so-called mortgage backed securities were promoted as virtually risk-free. Note: Is the securitization of mortgages necessarily a bad thing? Why? Why not?

Financial Crisis 2007-2009: The Response Government Bailouts Government Response: TARP 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 TARP – Troubled Asset Relief Program, the Treasury’s program which spent $700 billion to purchase “toxic” mortgage-backed securities. Did this response effectively decrease the uncertainty in the market? What was the rationale behind TARP?

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

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