1. Principles of Financial Analysis Week 3: Lecture 3 1Lecturer: Chara Charalambous

2. Learning Goals Financial Managers must understand the environment and markets within which businesses operate : the markets where firms raise funds, securities are traded and stock prices are established as well as the institutions that operate in these markets. 2Lecturer: Chara Charalambous

3. The Financial Markets People, governments and organizations very often need to borrow money to fund investments: companies need to explore their activities built new factories, offices or produce innovated products. Individuals need to buy houses, cars, yachts e.t.c While other individuals or firms have surplus of funds. People and organisations needs to borrow money have to brought together with those having surplus funds in the financial markets. 3Lecturer: Chara Charalambous

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5. What is a market? A market is a place where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds. Physical asset markets (real markets): are those in which autos, real estate, computers and machineries are traded. Financial asset markets deal with stocks (shares), bonds, mortgages. 5Lecturer: Chara Charalambous Financial markets are mechanisms by which borrowers and lenders get together

6. Major Types of Markets Different markets serve different types of customers, or operate in different parts of the country. Major types of markets are: 1.Debt Markets. Loans are traded: contracts that specifies the amounts and the times a borrower must repay the funds given by the lender. Equity Markets are those where stock of corporations are traded. Stock gives ownership to shareholders and the right to have share on profits through dividends. 6Lecturer: Chara Charalambous

7. 2.Money Markets: are the markets providing debt securities with maturities of less than one year. The main function of this market is to give liquidity to businesses, individuals or governments to meet short-term needs for cash. Capital Markets are the markets for long-term debt and corporate stocks and their main function is to give the opportunity to transfer cash surpluses or deficits to future years. For example without the availability of mortgages most people could not afford to buy houses when they are young and just starting their careers. Lecturer: Chara Charalambous7

8. 3.Mortgage Markets: deal with loans on residential, commercial, and industrial real estate, and on farmland. Consumer Credit Markets involve loans on autos and machines, as well as loans for education, vacations, and so forth. 4.World, National, Regional and Local Markets also exist. Thus depending on an organization’s size and scope of operations, it may be able to borrow all around the world, or it may be limited to a strictly local, even neighbourhood market. 5.Primary Markets: are the markets in which corporations and governments raise new capital. For example they sell new issue of ordinary shares to raise capital. This is a primary market transaction 8Lecturer: Chara Charalambous

9. Secondary Markets are markets in which existing previously issued securities are traded between investors. The New York Stock Exchange is a secondary market because it deals with already issued-existing shares and bonds. The corporation or government whose securities are being traded is not involved in a secondary market transaction and thus does not receive any funds from such a sale. 6.Spot Markets and Future Markets: are terms that refer to whether the assets are being bought or sold for “on the spot” which means delivery immediately or for delivery at some later date, such as six months or a year into the future. Lecturer: Chara Charalambous9

10. Financial Institutions 10Lecturer: Chara Charalambous

11. Financial Institutions 1.Commercial banks which are the traditional “department stores of finance” serve a wide variety of savers and those with needs for funds. Note that commercial banking organizations are different from investment banks because commercial banks lend money, whereas investment banks help companies raise capital from other parties. 2.Savings and loan associations which have traditionally served individual savers and residential and commercial mortgage borrowers, take the funds of many small savers and then lend this money to home buyers and other types of borrowers. 3.Mutual Funds are investment companies that accept money from savers, and then use these funds to buy various types of financial assets like stocks, long – term bonds, short term debt issued by businesses or government units. They provide investment diversification. Lecturer: Chara Charalambous 11

12. 4.Credit unions are cooperate associations whose members have a common link, such as being employees of the same firm. Members savings are loaned only to other members generally for auto purchases, home improvements e.t.c. Credit unions are often the cheapest source of funds available to individual borrowers. 5.Pensions funds are retirement plans funded by corporations or government agencies for their workers and managed primarily by the trust departments of commercial banks or by life insurance companies. Pension funds invest mainly in long-term financial instruments like bonds, stocks, mortgages and real estate. 6.Life insurance companies take savings in the form of annual payments, then invest theses funds in stock, bonds, real estate, and mortgages and finally make payments to the beneficiaries of the insured parties. Also recently they offer tax savings plans which provides benefits to the participants when they retire. 12 Lecturer: Chara Charalambous

13. 13 Direct Transfer from saver-to-borrower Savers – Investors Borrowers Funds – Euros /Dollars Stocks or Bonds A business sells its stocks or bonds directly to savers – investors, without going through any financial institution

14. 14 Indirect Transfer through Investment Banking House Savers Borrowers Investment Banks Funds $/€ Securities Funds $/€ Securities The company sells its shares or bonds to the investment bank which in turn sells these same securities to the investors. The business’s securities and the savers money just ‘pass through’ the investment banking house.The investment bank buy and hold the securities for a period of time and so it is taking the risk not to be able to resell them to savers for as much as it paid.

15. 15 Indirect Transfer through Financial Intermediary(FI) Savers Borrowers Financial Intermediary: Banks & Pension Funds Insurance Co.’s Finance Co.’s Funds $ /€ securities Transfers can also be made through a financial intermediary: Bank, Pension Fund co or Insurance co. Here the intermediary gets funs from savers by issuing its own securities and then it uses the money to lend out or to purchase another business’s securities. For example a saver might gives dollars to a bank receiving from it a certificate of deposit and then the bank might lend the money to a small business in the form of a mortgage loan.

16. The Stock Exchanges Secondary markets: previously issued securities are traded. It is here that the prices of firms’ stocks are established and because the primary goal of managerial finance is to maximize the firm’s stock price is important area of study. There are two basic types of stock markets: (1) organized exchanges, which include the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and several regional exchanges and (2) the less formal over the counter market. 16Lecturer: Chara Charalambous

17. 1. Organized Security Exchanges Characteristics : The Organized Security Exchanges are tangible physical entities where auction markets are conducted in ‘listed’ securities. Each of the larger ones occupies its own building, has specifically designated members, and has an elected governing body – its board of governors. Members are said to have “seat” on the exchange, although everybody stands up. These seats, which are brought and sold, give the holder the right to trade on the exchange. Most of the larger investment banking houses operate brokerage departments, that own seats on the exchanges and designate one or more of their officers as member. 17Lecturer: Chara Charalambous

18. Exchange members meet in a large room equipped with telephones and other electronic equipment (faxes, computers e.t.c.) that enable each member to communicate with his/her company’s offices throughout the country. Like other markets, security exchanges facilitate communication between buyers and sellers. The exchange members with sell orders offer the shares for sale and they are bid for by the members with buy orders. Thus the exchanges are operate as auction markets. Lecturer: Chara Charalambous18

19. 2. The Over – the – Counter Market Over the counter means there is no location does not exist physically and consists of a network of brokers and dealers: financial instruments that are not listed or available on an officially recognized exchange (such as the NYSE – New York Stock Exchange), are traded in direct negotiation between buyers and sellers. Trading takes place telephonically or electronically. Participants banks, brokers and foreign exchange dealers are connected by computers, telephones and telex and operates in most financial centers globally. Because the over the counter market is so highly integrated globally, it can operate 24 hours a day – when one major market is closed, another major market is open to facilitate trade occurring 24 hours a day moving from one major market to another. 19Lecturer: Chara Charalambous

20. – Over-the-counter market=NASD National Association of Security Dealers Lecturer: Chara Charalambous20

21. The Over – the – Counter Market has been created because there are stocks that are not treated often, perhaps because they are stocks of new or small companies. And thus few buy and sell orders come in and is difficult to much them. For that reason these stocks are not conducted on the organized exchanges. To solve this problem some brokerage firms keep an inventory of such stocks (they ‘make market’) - they buy when individual investors want to sell and sell when investors want to buy. In contrast to the organized exchanges the OTC does not operate as an auction market. The dealers who make a market in a particular stock continuously quote a price at which they are willing to buy the stock (the bid price) and a price at which they will sell shares (the asked price). So prices are adjusted based on supply and demand and they can been read on computer screens all around the world. The spread between bid and asked prices is the dealer’s profit. Lecturer: Chara Charalambous21

22. The Cost of Money In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital : individuals and institutions with “excess funds”. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital : individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay an interest rate on the capital they borrow. Lecturer: Chara Charalambous22

23. The interest rate is the price paid to borrow debt capital, whereas in the case of equity capital, investors expect to receive dividends and capital gains. The four most fundamental factors affecting the demand and supply of investment capital and therefore the cost of money are: production opportunities, time preferences for consumption, risk and inflation. 23Lecturer: Chara Charalambous

24. The Determinants of Market Interest Rates Quoted Interest Rate n a debt security = k k = k*+IP+DRP+LP+MRP k= quoted or nominal rate of interest on a given security. There are many different securities, hence many different nominal interest rates k* (k star)= the real risk-free rate of interest IP=inflation premium DRP= default risk premium LP=liquidity or marketability premium MRP=maturity risk premium 24Lecturer: Chara Charalambous

25. The Determinants of Market Interest Rates K* = The real risk – free rate of interest is defined as the interest rate that would exist on a riskless security if no inflation were expected.The real risk free rate changes over time depending on economic conditions especially: (1) on the rate of return corporations and other borrowers are willing to pay to borrow funds and (2) on peoples’ time preferences for current versus future consumption (increase or decrease in the future?) IP = Inflation Premium: Inflation has a major impact on interest rates because it crush down the purchasing power of the euro or any other currency and lowers the real rate of return on investments. 25Lecturer: Chara Charalambous

26. The Determinants of Market Interest Rates DRP = Default Risk is the risk that a borrower will default (failure to pay) on a loan, which means not to pay the interest or the principal, also affects the market interest rate on a security: the greater the default risk, the higher the interest rate lenders charge. Default Risk Premium is the difference between the nominal interest rate on a government bond and that on a corporation bond with similar maturity. LP = Liquidity Premium generally is defined as the ability to convert an asset to cash and receive the amount initially invested on a reasonable level. Financial assets are considered more liquid than real assets – land, equipment- and short term financial assets are more liquid than long term. Because liquidity is important investors include LP when interest rates are established. MRP = The prices of bonds decline whenever interest rates rise and for this reason they have an element of risk called interest rate risk. The longer the maturity of the bond the greater the interest rate risk. Therefore a Maturity Risk Premium must be taken in account when interest rates are calculated. 26Lecturer: Chara Charalambous

27. Other factors that influence Interest Rate Levels 1.Central Bank Policy is the policy which controls the supply. If the CB wants to control growth in the economy it slows growth in the money supply. When money supply goes down interest rates goes up 2.Government Deficits. If the government spends more than it takes in from tax revenues, it runs a deficit, and that deficit must be covered either by borrowing or by printing money. If the government borrows, this added demand for funds pushes up interest rates. The larger the government deficit, other things held constant, the higher the level of interest rates. 27Lecturer: Chara Charalambous

28. 3.Foreign Trade Balance. Businesses and individuals around the world buy from and sell to people and firms in other countries. If we buy more than we sell, we are said to be running a foreign trade deficit. When trade deficits occur they must be financed and the main source of financing is debt. Therefore the larger our deficit the more we must borrow and as we increase our borrowing this drives up borrowing rates. Also foreigners are willing to hold a country’s debt only if the interest rate on this debt is competitive with interest rates in other countries. 28Lecturer: Chara Charalambous

29. Income Tax System The government places taxes to citizens and organizations of two categories: (1) tax laws that are applicable to individuals and (2) tax laws that are applicable to organizations. 29Lecturer: Chara Charalambous

30. 1. Individual Income Taxes Individuals pay taxes on wages and salaries, on investment income and on the profits of proprietorships and partnerships. Our tax rates are progressive – that is, the higher one’s income, the larger the percentage paid in taxes. 30Lecturer: Chara Charalambous

31. 2. Corporate income taxes Corporate tax or company tax refers to a tax imposed on entities not individuals. Such taxes may include income taxes, capital gains taxes(profit from selling an asset more than its purchase price), or other taxes for example on dividends received from other companies. The tax is generally calculated on net taxable income, which is generally in the financial statement income.The rate of tax varies by authority and is frequently progressive. Lecturer: Chara Charalambous31