Corporate Finance CHAPTER TWO J.D. Han

Learning Objectives 1. What kind of choices is a corporate financial manager faced with in funding a project? 2. What financial market instruments would he/she choose? What are the advantages and disadvantages of different funding sources? 4.What kind of institutional structures is the financial manager faced with? - Why does each country exhibit different characteristics in financial market?

2.1 How to Fund a Corporate Project? 1) Where does the fund for a corporate project come from? internal financing vs external financing 2) How to do external financing? direct financing vs. indirect financing through Financial intermediaries 3) What kinds of financial instruments to issue? bonds; loans; and/or equities (stocks)

2.2 Financial Instruments or Assets: 2 classifications of financial assets(instruments): 1. Debt versus Equity Debt: Bank Loans and Bonds- Contractual claims Equity: Residual claims 2. Loans versus Marketable Securities Loans: personalized Marketable Securities: Bonds, Equities, Derivatives (options, swaps, futures, and forwards) - arm’s length deals through securities exchanges

*Sources of External Corporate Financing in U. S.: Choice of Capital Structure Two puzzling findings 1) “Equities are not a major instruments for corporate financing.” 2) “Marketable Securities are not so important as bank loans.”

** It is due to both (lack of) supply and demand: - (Fund) Supply Side Limitation: financial investors are concerned about “Information Asymmetry”, “Moral Hazard”, “Principal- Agent Problem”, and “Adverse Selection” - (Fund) Demand Side Limitation: firms may prefer bonds to equities under the current hostile M & A environment and tax laws. *** In the Canadian corporate financing, equities are somewhat more important than in the U.S. coroporate financing.

2.3 Financial Intermediaries The “four pillars” of Canada’s financial system include: 1. Chartered banks – for Self liquidating short- term investment in principle 2. Trust companies 3. Insurance companies and Pension Funds 4. Investment dealers –for Long term/large scale investment

** Investment Dealers: the Big Hands Securities Firms /Houses Banks’ M & A Division of Investment Banking Department For instance - Morgan Stanley Dean Witter - Goldman Sachs - Salomon Smith Barney - Merrill Lynch - Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium) - Dominion Securities; Mellon; McLeod; Waterhouse.

*Structure of Securities Firm

*Important Concepts in Investment Banking Issuing Securities: IPO versus Seasoned Issuing Underwriting: advice, issue, risk-sharing, and stabilization. Bought Deal vs Best Efforts Private Placement

Financial Market Definition: An organized institutional structure or mechanism for creating and exchanging financial assets.

Financial Assets/(Liabilities) =Financial Instruments = Loans + Bonds + Equities = Loans + Marketable Securities = Debts + Equities Market includes Stock Exchange and OTC, and Loan Market

2.4 Kinds of Financial Markets 1) Primary vs. Secondary Market by Newness: - Primary Market: new securities are issued, and it is Corporate financing source - Secondary Market(Aftermarkets): existing securities are traded or exchanged

2) short-term Money Market vs. long-term Capital Market by term periods of financial instruments

* Money Market Short-term financial assets –Highly Liquid Operates as a dealer or over-the-counter market (OTC) Sold in denominations > $100,000 Most recognized money market instrument are T- bills Other money market instruments include commercial paper, Banker Acceptances, and eurodollars

* Capital Market 1: Bond Market Intermediate and long term horizon finanical assets Bond markets: -represent the most important markets for intermediate and long-term debt - operates as OTC market - Government bonds are most important items - Coporate bonds accounts for 20% only - Asset-backed Securities (ABS): - - example Mortgage-backed securities (MBS) - - Securitization

* Capital Market II : Equity/stock Market Common stocks, preferred stock and warrants trade in equity markets Equity securities trade on stock exchanges Stock exchanges operate as: - Auction markets is called Stock Exchanges (TSE, CDNX, ME; and NYSE) or - Over-the-counter is a sales network (NASDAQ).

*Canadian Stock Markets Before 1999, there were 5 stock exchanges: TSE, ME, VSE. WSE, and ASE After March 1999, there are only TSE, ME, and Canadian Venture Exchange(CDNX) ** Global Equity Market *** Emerging Equity Market in newly developing economies

3) Domestic vs. Global Financial Markets 3) Domestic vs. Global Financial Markets Investment banks act as global coordinators through underwriting syndicates; it has FOREX market International Money Market eg )Eurocurrency Market (definition of Eurocurency Market ) a market for deposits and loans denomitated in a currency other than that of the country in which the bank is located International Capital Markets; International Bond Market and International Equity Market ; Emerging Markets

4) Derivatives Markets Derivative securities - derive the value from underlying assets such as common shares or bonds Options - a contract that grants the holder the right to buy or sell a security at a given price on or before a given date Future contracts - agreements to trade assets at a specific price and time in the future Two types of futures: - Real commodities  commodity futures contract - Financial obligations  financial future contract

* Derivative Markets in North America Options : - -Montreal exchange (ME) - Canada - -Chicago Board Options Exchange (CBOT) – US Futures: commodities, stocks, and foreign exchanges -Canada’s only commodity futures exchange is the Winnipeg commodity exchange (WCE) -Major US futures exchanges Chicago Board of Trade (CBOT) - Chicago Mercantile Exchange (CME)

Summary 1.Efficient financial markets are required to channel funds from surplus-spending units (savers) to deficit-spending units. Typically, such securities entitle the holder to a stream of periodic future cash payments. 2.Financial intermediaries allow economies of scale to be realized when matching surplus-spending units with deficit-spending units. Greater opportunities for portfolio diversification and money management can be gained.