© Prentice Hall, Chapter 12 Global Financial Markets and Long-Term Corporate Financing Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

© Prentice Hall, Learning Objectives è Identify the functions and consequences of well-functioning financial markets. è Describe how the financial markets are organized. è Define and explain the forces that underlie securitization and indicate how it has affected the financing policies of corporations. è Discuss the differences between financial systems and how they influence corporate governance.

© Prentice Hall, Learning Objectives (Cont.) è Explain the advantages and dis- advantages of various sources of corporate financing. è Describe the links between national and international financial markets. è Explain why firms choose to raise capital overseas. è Describe the Eurocurrency and Eurobond markets and explain why they exist.

© Prentice Hall, Flow of Funds in the Financial Markets Financial Markets Borrowers Parties Whose Spending Exceeds Their Income Savers Parties Whose Income Exceeds Their Spending Cash Financial Assets

© Prentice Hall, Functions of the Financial Markets è Mobilize savings and allocate these funds to borrowers è Facilitate risk transfer è Provide a source of liquidity è Provide a mechanism for valuing financial assets

© Prentice Hall, Flow of Funds Through Financial Intermediaries Financial Intermediaries l Banks l Insurance Companies l Mutual Funds l Finance Companies Borrowers Parties Whose Spending Exceeds Their Income Savers Parties Whose Income Exceeds Their Spending Cash Secondary Claims Primary Claims

© Prentice Hall, Functions of Financial Intermediaries è Reduce the cost of bringing borrower and saver together è Bridge borrower’s and lender’s maturity preferences è Reduce investment risk through diversification è Some services of intermediaries provide a payments mechanism

© Prentice Hall, Money Market Instruments è Treasury Bills è Tax-Exempt Paper è Negotiable Certificates of Deposit (CDs) è Bankers Acceptances è Commercial Paper

© Prentice Hall, Capital Market Instruments è Treasury Notes and Bonds è Mortgages è Municipal Bonds è Corporate Notes and Bonds è Preferred Stock è Common Stock

© Prentice Hall, Primary versus Secondary Markets è Primary Market: The market for new issues where funds flow to issuers from creditors and investors è Secondary Market: The market where already-issued financial assets are bought and sold

© Prentice Hall, Dealer versus Brokered Markets è Dealer Markets: Where individuals or firms facilitate trades by buying and selling financial assets out of their own account è Brokered Markets: Markets where individuals or firms simply serve as agents in bringing buyers and sellers together

© Prentice Hall, Organized versus Over-the-Counter (OTC) Markets è Organized Exchanges: An actual physical place for the exchange of securities è OTC Markets: The OTC market has no physical place; instead, it is a set of dealers tied together by a tele- communications network.

© Prentice Hall, Spot versus Derivatives Markets è Spot or Cash Market è Derivatives Market èForward Contracts (OTC Markets) èFutures Contracts (CBOT) èOption Contracts (CBOE and OTC Markets) èSwaps (OTC Markets)

© Prentice Hall, External Financing Patterns è Demand is greatest after economic peaks è Most external financing is in the form of debt è Need for external financing is lowest after a recession

© Prentice Hall, Securitization There is a growing tendency towards securitization - the process whereby corporate borrowing takes the form of issuing negotiable securities issued in the public capital markets rather than through nonmarketable loans through financial intermediaries.

© Prentice Hall, Financial Systems and Corporate Governance è Anglo-Saxon (AS) Model: Market-oriented financial system where the firm’s accepted objective is to maximize shareholder value è Continental European - Japanese Model: Bank-centered system in which banks not only provide financing but also have an ownership interest in their client firms

© Prentice Hall, The Japanese Keiretsu è Large industrial grouping - often with a major bank at the center. è Keiretsu ties involve a complex set of traditions, cross-shareholding, trading relationships, management and information swapping. The key mission of the keiretsu is to provide a safety net for its members.

© Prentice Hall, Universal Banking A system practiced in Germany, where banks perform not only “banking” activities but also take major equity positions in their client firms. As both stockholders and creditors, universal banks can reduce the conflicts between the two classes of investors. This leads to lower costs and a faster speed of “workouts” of financial problems.

© Prentice Hall, Sources of Corporate Financing è Retained Earnings è Common Stock è Corporate Debt è Preferred Stock è Convertible Securities

© Prentice Hall, Advantages of Financing With Retained Earnings è Does not involve bringing in “outsiders” è Relative to dividends, the capital gains associated with retentions has tax benefits è Avoids the cost of new security issues

© Prentice Hall, Disadvantages of Financing With Retained Earnings è May be a unreliable source of financing if earnings are unstable è Retentions come at the expense of dividends è Many firms treat retained earnings as free capital

© Prentice Hall, Advantage of Common Stock Financing è Requires no contractual payments; a firm is not required to pay dividends. è With no maturity date, common stock is a permanent source of funds. è Sales of common stock lowers the cost of debt or preferred stock.

© Prentice Hall, Disadvantages of Common Stock Financing è Sale of common stock brings in new owners. è Dividends are paid out of after-tax earnings. è Flotation costs are higher than raising the same amount of money using debt.

© Prentice Hall, Advantages of Debt Financing è Interest payments are tax deductible. è Debtholders receive a fixed return and do not share in the value created by growth opportunities. è Bondholders don’t have voting rights. è Issue costs on bonds are typically low.

© Prentice Hall, Disadvantages of Debt Financing è Greater use of debt increases financial risk. è Debt servicing payments are contractual; failure to meet them is an act of default. è Increasing leverage increases the cost of equity. è Bonds typically have restrictive covenants.

© Prentice Hall, Advantages of Preferred Stock Financing è Provides firm with financial leverage without increasing bankruptcy risk. è Lack of a set maturity date and ability to skip payments provides a firm with flexibility in managing its cash flows. è Under normal circumstances, preferred stockholders don’t have voting rights. è Corporate holders can exclude from taxes 70 percent of the dividends they receive.

© Prentice Hall, Disadvantages of Preferred Stock Financing è Preferred stock dividends are not tax-deductible. è The claims of preferred stockholders on earnings and assets take priority over common stockholders. è Fixed dividend payment can lead to unfavorable leverage if earnings decline. è Preferred stockholders may be granted voting rights if dividend payments are not made.

© Prentice Hall, Advantages and Disadvantages of Convertible Securities è Advantages èConvertible debt carries a lower interest rate than straight bonds èSince investors share in upside potential, convertible debt contains fewer covenants than straight debt èAllows for a deferred equity offering at a higher price è Disadvantages èGives the holder the right to participate in an unexpected increase in share price

© Prentice Hall, International Financial Markets è Foreign Bond Market: That portion of the domestic bond market that represents issues by foreign firms or governments è Foreign Bank Market: That portion of domestic bank loans supplied to foreigners for use abroad è Foreign Equity Market: That portion of the equity markets represented by equity issued by foreign firms

© Prentice Hall, The Eurocurrency Market A Eurocurrency is a dollar or any other freely-convertible currency in a bank deposit outside its country of origin. Eurocurrency loans are made on a floating-rate basis. Historically, these rates have been set in relation to the London interbank offer rate (LIBOR).