1. 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.

2. 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
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

3. The Flow of Capital: Closely Held Corporations7 7 7 7 12 11

4. The Flow of Capital: Public Corporations7 7 7 7 12 11

5. 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

6. 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

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

8. 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

9. 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

10. 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

11. 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

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

13. Intermediaries and Investors
Obligations
Funds
Investors
Depositors
Policyholders

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

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

16. 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

17. Function of Financial Markets and Intermediaries
Payment mechanism
Provide information 18

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?

19. 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?

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

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