1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 2 The Financial Market Environment

2. © 2012 Pearson Prentice Hall. All rights reserved. 2-2 Learning Goals  Financial institutions and financial markets.  Capital markets and the money markets.  Root causes of the recent financial crisis  Major regulations and regulatory bodies that affect financial institutions and markets  Business taxes and their importance in financial decisions

3. © 2012 Pearson Prentice Hall. All rights reserved. 2-3 Financial Institutions & Markets Firms that require funds from external sources can obtain them in three ways: 1.through a financial institution 2.through financial markets 3.through private placements

4. © 2012 Pearson Prentice Hall. All rights reserved. 2-4 Financial Institutions Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.

5. © 2012 Pearson Prentice Hall. All rights reserved. 2-5 Financial Institutions (Contd.): Commercial banks are institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers. are the traditional “departmental store” of finance serving a variety of savers (deposits) and borrowers (loans). – Securitization: The process of pooling mortgages or other types of loans and then selling claims or securities against that pool in the secondary market. Example: mortgage-backed security-MBS – In every country there is a central bank who monitors and guides all the other commercial banks. Example: Bangladesh Bank, Federal Reserve of USA.

6. Financial Institutions (Contd.): Investment banks are institutions that assist companies in raising capital, advise firms on major transactions such as mergers or financial restructurings, and engage in trading and market making activities. Sometimes they also participate in investment with their own share of funds along with their client investors. They sometimes help the corporations to design the securities with features that are currently attractive to investors.. Some investment banks specialize in particular industry sectors. Many investment banks also have retail operations that serve small, individual customers. Ex- Barclays,Citibank, (BRAC EPL, IDLC) © 2012 Pearson Prentice Hall. All rights reserved. 2-6

7. © 2012 Pearson Prentice Hall. All rights reserved. 2-7 Financial Institutions (Contd.): The shadow banking system describes a group of institutions that engage in lending activities, much like traditional banks, but these institutions do not accept deposits and are therefore not subject to the same regulations as traditional banks. Examples of important components of the shadow banking system include securitization vehicles, investment banks, and mortgage companies." Shadow banking has grown in importance to rival traditional depository banking but was a primary factor in the subprime mortgage crisis of 2007-2008 and global recession that followed.securitization vehiclesinvestment bankssubprime mortgage crisis

8. © 2012 Pearson Prentice Hall. All rights reserved. 2-8 Financial Markets Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Transactions in short term marketable securities take place in the money market while transactions in long- term securities take place in the capital market. A private placement involves the sale of a new security directly to an investor or group of investors. Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public.

9. © 2012 Pearson Prentice Hall. All rights reserved. 2-9 Financial Markets Financial Markets(cont.) Primary market is the financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction. Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded.

10. Financial Markets Financial Markets(cont.) Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction? – Since new shares of stock are being issued, this is a primary market transaction. What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction? – Since no new shares are created, this is a secondary market transaction.

11. What is an IPO? An initial public offering (IPO) is where a company issues stock in the public market for the first time. “Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements.

12. © 2012 Pearson Prentice Hall. All rights reserved. 2-12 Figure 2.1 Flow of Funds

13. © 2012 Pearson Prentice Hall. All rights reserved. 2-13 Financial Markets Financial Markets(cont.): The Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds. Most money market transactions are made in marketable securities which are short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively. Investors generally consider marketable securities to be among the least risky investments available.

14. © 2012 Pearson Prentice Hall. All rights reserved. 2-14 The Money Market (cont.) The international equivalent of the domestic (U.S.) money market is the Eurocurrency market. The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or other marketable currencies. The Eurocurrency market has grown rapidly mainly because it is unregulated ( is not protected by domestic banking laws) and because it meets the needs of international borrowers and lenders.

15. © 2012 Pearson Prentice Hall. All rights reserved. 2-15 Financial Markets Financial Markets(cont.): The Capital Market The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership). –Bonds are long-term debt instruments used by businesses and government to raise large sums of money, generally from a diverse group of lenders. –Common stock are units of ownership interest or equity in a corporation. –Preferred stock is a special form of ownership that has features of both a bond and common stock.

16. The Capital Market (Cont.) The most active secondary market and most important to financial managers is the stock market. There are two basic types of Stock Markets: – Physical Location Stock Exchange/ Broker Market – Over-the-counter (OTC) Market/Dealer Market

17. © 2012 Pearson Prentice Hall. All rights reserved. 2-17 The Capital Market (Cont.): Broker Markets and Dealer Markets Broker markets are securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities. –Trading takes place on centralized trading floors. –Examples include: NYSE Euronext, American Stock Exchange, Dhaka Stock Exchange (DSE)

18. © 2012 Pearson Prentice Hall. All rights reserved. 2-18 The Capital Market (Cont.): Broker Markets and Dealer Markets Dealer markets are markets in which the buyer and seller are not brought together directly but instead have their orders executed by securities dealers that “make markets” in the given security. –The dealer market has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked together via a mass- telecommunications network. Example: National Association of Securities Dealers Automated Quotations (NASDAQ), Central Depository Bangladesh Limited (CDBL) transactions of government securities to commercial banks. –Dealers (market makers ) state the bid price (buying price) of the stocks and the ask price (selling price). The difference between the two is the dealer’s profit, known as bid-ask spread. In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes Read more: http://www.investopedia.com/terms/o/otc.asp

19. © 2012 Pearson Prentice Hall. All rights reserved. 2-19 Matter of Fact NYSE Euronext is the World ’ s Largest Stock Exchange –According to the World Federation of Exchanges, NYSE Euronext is the largest stock market in the world, as measured by the total market value of securities listed on that market. –NYSE Euronext has listed securities worth more than $11.8 trillion in the U.S. and $2.9 trillion in Europe. –Next largest is the London Stock Exchange with securities valued at £ 1.7 trillion, which is equivalent to $2.8 trillion given the exchange rate between pounds and dollars prevailing at the end of 2009.

20. © 2012 Pearson Prentice Hall. All rights reserved. 2-20 The Role of Capital Markets From a firm ’ s perspective, the role of capital markets is to be a liquid market where firms can interact with investors in order to obtain valuable external financing resources. From investors ’ perspectives, the role of capital markets is to be an efficient market that allocates funds to their most productive uses. efficient marketAn efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and determines and publicizes prices that are believed to be close to their true value.

21. © 2012 Pearson Prentice Hall. All rights reserved. 2-21 Focus on Ethics The Ethics of Insider Trading –Martha Stewart was convicted of conspiracy, obstruction, and making false statements to federal investigators and served 5 months in jail, 5 months of home confinement, 2 years of probation, and a $30,000 fine. –Laws prohibiting insider trading were established in the United States in the 1930s. These laws are designed to ensure that all investors have access to relevant information on the same terms. –However, many market participants believe that insider trading should be permitted. –If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical? –Does allowing insider trading create an ethical dilemma for insiders?

22. © 2012 Pearson Prentice Hall. All rights reserved. 2-22

23. © 2012 Pearson Prentice Hall. All rights reserved. 2-23 Business Taxes Both individuals and businesses must pay taxes on income. The income of sole proprietorships and partnerships is taxed as the income of the individual owners, whereas corporate income is subject to corporate taxes. Both individuals and businesses can earn two types of income — ordinary income and capital gains income. Under current law, tax treatment of ordinary income and capital gains income change frequently due frequently changing tax laws. The average tax rate paid by a corporation ranges from 15 to 35 percent.

24. © 2012 Pearson Prentice Hall. All rights reserved. 2-24 Business Taxation: Tax-Deductible Expenses In calculating taxes, corporations may deduct operating expenses and interest expense but not dividends paid. This creates a built-in tax advantage for using debt financing as the following example will demonstrate. Example Two companies, Debt Co. and No Debt Co., both expect in the coming year to have EBIT of $200,000. During the year, Debt Co. will have to pay $30,000 in interest expenses. No Debt Co. has no debt and will pay not interest expenses.

25. © 2012 Pearson Prentice Hall. All rights reserved. 2-25 Business Taxation: Tax-Deductible Expenses (cont.)

26. © 2012 Pearson Prentice Hall. All rights reserved. 2-26 Business Taxation: Tax-Deductible Expenses (cont.) As the example shows, the use of debt financing can increase cash flow and EPS, and decrease taxes paid. The tax deductibility of interest and other certain expenses reduces their actual (after-tax) cost to the profitable firm. It is the non-deductibility of dividends paid that results in double taxation under the corporate form of organization. This exclusion moderates the effect of double taxation, which occurs when after-tax corporate earnings are distributed as cash dividends to stockholders, who then must pay personal taxes on the dividend amount.

27. © 2012 Pearson Prentice Hall. All rights reserved. 2-27 Business Taxation: Capital Gains A capital gain is the amount by which the sale price of an asset exceeds the asset ’ s purchase price. For corporations, capital gains are added to ordinary income and taxed like ordinary income at the firm ’ s marginal tax rate. Example Ross Company has just sold for $150,000 and asset that was purchased 2 years ago for $125,000. Because the asset was sold for more than its initial purchase price, there is a capital gain of $25,000 ($150,000 - $125,000).

28. © 2012 Pearson Prentice Hall. All rights reserved. 2-28 Review of Learning Goals LG1Understand the role that financial institutions play in managerial finance. –Financial institutions bring net suppliers of funds and net demanders together to help translate the savings of individuals, businesses, and governments into loans and other types of investments. LG2Contrast the functions of financial institutions and financial markets. –Financial institutions collect the savings of individuals and channel those funds to borrowers such as businesses and governments. Financial markets provide a forum in which savers and borrowers can transact business directly.

29. © 2012 Pearson Prentice Hall. All rights reserved. 2-29 Review of Learning Goals (cont.) LG3Describe the differences between the capital markets and the money markets. –In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have a short-term need for funds. In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis. LG4Explain the root causes of the recent financial crisis and recession. –Financial institutions lowered their standards for lending to prospective homeowners, and institutions also invested heavily in mortgage-backed securities. When home prices fell and mortgage delinquencies rose, the value of the mortgage-backed securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business.