INTRODUCTION TO CORPORATE FINANCE SECOND EDITION Lawrence Booth & W. Sean Cleary Prepared by Ken Hartviksen & Jared Laneus

Chapter 1 An Introduction to Corporate Finance 1.1 Real versus Financial Assets 1.2 The Financial System 1.3 Financial Instruments and Markets 1.4 The Global Financial Community 2 Booth/Cleary Introduction to Corporate Finance, Second Edition

Learning Objectives 1.1 Define finance and explain what is involved in the study of finance. 1.2 List the major financial and real assets held by Canadians and the major sectors in the financial system. 1.3 Explain how is money transferred from lenders to borrowers and the role played by market and financial intermediaries. 1.4 Identify the basic types of financial instruments that are available and explain and how they are traded. 1.5 Explain the importance of the global financial system and how Canada is impacted by events in the U.S. mortgage market. 3 Booth/Cleary Introduction to Corporate Finance, Second Edition

What Is Finance? Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers. Finance is distinct from economics in that it addresses not only how resources are allocated, but also under what terms and through what channels resources are allocated. Financial contracts or securities occur whenever funds are transferred from issuer to buyer. 4 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Study of Finance The study of finance requires a basic understanding of: securities corporate Law financial institutions and markets 5 Booth/Cleary Introduction to Corporate Finance, Second Edition

Real versus Financial Assets Real assets are tangible items owned by persons and businesses; e.g.: Residential structures and property Major appliances and automobiles (consumer durables) Office towers, factories, and mines Machinery and equipment Financial assets are what one individual has lent to another, e.g.: Consumer credit Loans Mortgages 6 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Household Balance Sheet Households hold both real and financial assets Households also acquire some of those assets through debt A household with no financial assets often faces financial problems because real assets cannot be easily used to pay off or service debt (i.e., make loan payments) Real assets are not as liquid as most financial assets. 7 Booth/Cleary Introduction to Corporate Finance, Second Edition

Assets and Liabilities of Households 8 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Overview The household is the primary provider of funds to businesses and government. Households must accumulate financial resources throughout their careers to have enough savings (pension) to live during their retirement. 9 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Overview Financial intermediaries transform the nature of the securities they issue and invest in (e.g., banks, trust companies, credit unions, insurance firms, mutual funds) Market intermediaries, such as investment dealers and brokers (investment advisors), simply help to make markets work by adding liquidity. 10 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Channels of Intermediation Funds can be channeled from savers to borrowers in three ways: 1.Direct transfer from saver to borrower in a non-market transaction. 2.Direct intermediation through a market intermediary such as a broker in a market-based transaction. 3.Indirect claims through a financial intermediary where the financial intermediary, such as a bank, offers deposit-taking services and ultimately lends the deposited funds out as mortgages or loans. 11 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Canadian Chartered Banks Deposits from numerous depositors from across Canada are ‘pooled’ into banks Pooled funds are lent to households and businesses in the form of mortgages and loans 12 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Canadian Chartered Banks (continued) The bank transforms the original nature of the savers’ (depositors’) money: Individual depositors save in small amounts and want to face little or no risk, but expect to be able to withdraw their deposit at any time. Loans and mortgages are usually large in amount, borrowed for long periods of time and for risky purposes, and may not always be repaid in full. Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing the risk), and monitoring the activities of borrowers. 13 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Canadian Chartered Banks 14 Booth/Cleary Introduction to Corporate Finance, Second Edition

Insurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a claim and the size of the policy and administrative fees. Premiums are invested so that the accumulated value in the future will grow to meet the anticipated claims of the policyholders. Risks that would be unsupportable by an individual, such as the death of wage earners or the destruction of a business’s assets by fire, are therefore shared among a large number of policyholders through the insurance company. Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of loss themselves. The Financial System: Financial Intermediaries Insurance Companies 15 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Insurance Companies 16 Booth/Cleary Introduction to Corporate Finance, Second Edition

Individuals and employees make payments over their entire working lives to pension plans, which invest those funds to grow over time. The accumulated value of the pension can be used to fund retirement. Pension plans accumulate large sums of money; their managers invest those funds with long-term investment time horizons in diversified investment portfolios. These investments are a major source of capital, fuelling investment in research and development, capital equipment, and resource exploration, which ultimately contributes to the growth of the economy. The Financial System: Financial Intermediaries Pension Plan Assets 17 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Pension Plan Assets 18 Booth/Cleary Introduction to Corporate Finance, Second Edition

Mutual funds give small investors access to diversified, professionally-managed portfolios of securities. Small investors often do not have the funds necessary to invest directly into market-traded financial instruments (e.g., stocks and bonds). This process is called denomination intermediation because the mutual fund divides investments denominated in larger amount of fund into smaller, more affordable amounts. (e.g., a $1 million Treasury bill could be purchased in $10 units in a money-market fund.) Canadian indirect investment in the markets through managed products such as mutual funds and segregated funds has grown exponentially in recent years. The Financial System: Financial Intermediaries Canadian Mutual Fund Assets 19 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: Financial Intermediaries Canadian Mutual Fund Assets 20 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: The Major Borrowers Public Debt: Government of Canada (the federal government) Provincial and territorial Governments Municipalities Crown corporations Private Debt: Households Non-financial corporations 21 Booth/Cleary Introduction to Corporate Finance, Second Edition

The Financial System: The Major Borrowers 22 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Instruments: Overview There are two major categories of financial securities: 1. Debt instruments: Examples: commercial paper, bankers’ acceptances, Treasury bills (T-bills), mortgage loans, bonds, debentures 2. Equity instruments: Examples: common share, preferred share 23 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Instruments: Characteristics of Non-Marketable Assets Non-Marketable Assets: Cannot be traded between or among investors May be redeemable (a reverse transaction between the borrower and the lender): Examples: savings accounts, term deposits, guaranteed investment certificates (GICs), Canada Savings Bonds 24 Booth/Cleary Introduction to Corporate Finance, Second Edition

Marketable Assets: Can be traded between or among investors after their original issue in public markets and before they mature or expire The market value will change over time due to changes in the general economic environment (for example, interest rate increases or decreases) and/or changes in the financial condition or prospects of the issuer of the security. Financial Instruments: Characteristics of Marketable Assets 25 Booth/Cleary Introduction to Corporate Finance, Second Edition

Marketable securities can be categorized according to their time to maturity: Money market securities are short-term debt securities that are pure discount notes and usually have maturities less than one year. Examples: Bankers’ acceptances, commercial paper, Treasury bills. Capital market securities are long-term debt or equity securities with maturities greater than one year. Examples: bonds, debentures, common and preferred shares Financial Instruments: Characteristics of Marketable Assets 26 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Markets: Overview 1.Primary Markets: Markets that involve the issue of new securities by a company in exchange for cash from investors. 2.Secondary Markets: Markets that involve buyers and sellers of existing securities. Funds flow from the buyer to the seller of the securities, and the buyer becomes the new owner of the security. No new capital is formed; this is only the exchange of already existing securities representing already formed capital. 27 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Markets: Types of Secondary Markets Exchange or auction markets involve a bidding process that takes place in a specific location. Examples: Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE) Dealer or over-the-counter (OTC) markets do not have a physical location and consist of a network of dealers who trade directly with each other. Example: bond market 28 Booth/Cleary Introduction to Corporate Finance, Second Edition

Market capitalization is the total market value of a company. Calculated by multiplying the number of shares outstanding by the market price of each share. Market Cap = # of Shares × Share Price Financial Markets: Market Capitalization 29 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Markets: Other Markets Third Market The trading of securities that are listed on organized exchanges in the over-the-counter (OTC) market Fourth Market The trading of securities directly between investors (usually between two large institutions) without the involvement of brokers or dealers Operates through the use of privately owned automated systems such as Instinet 30 Booth/Cleary Introduction to Corporate Finance, Second Edition

Financial Markets: The Global Financial Community Represents an important source of funds for borrowers as seen in Table 1-7 Provides investors with important alternatives as they seek to build wealth through diversified portfolios Money markets and bond markets are global Domestic equity markets are increasingly linked because of globalization and consolidation The correlation between markets is high, especially during a systemic downturn as seen in Table Booth/Cleary Introduction to Corporate Finance, Second Edition

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The Financial System: The Global Financial Community 33 Booth/Cleary Introduction to Corporate Finance, Second Edition

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