an introduction to finance3256

7/29/2019 An Introduction to Finance3256

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Prepared byKen Hartviksen

INTRODUCTION TO

CORPORATE FINANCELaurence Booth W. Sean Cleary

Chapter 1 An Introduction to Finance


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CHAPTER 1

An Introduction to Finance


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CHAPTER 1 - An Introduction to Finance 1 - 3

Lecture Agenda

Learning Objectives

Important Terms

Finance Defined

Real versus Financial Assets The Financial System

Financial Instruments and Markets

The Global Financial Community

Summary and Conclusions Concept Review Questions

Practice Problems


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Learning Objectives

1. What finance is and what is involved in the study of finance.

2. How financial securities can be used to provide financing forborrowers and simultaneously to provide investmentopportunities for lenders.

3. How financial systems work in general.

4. The channels of intermediation and the role played bymarket and financial intermediaries within this system.

5. The basic types of financial instruments that are available

and how they are traded.

6. The importance of the global financial system.


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Important Chapter Terms

Bourse de Montreal

Brokers

Canadian Trading andQuotation System Inc (CNQ)

Capital market securities

Common share

Corporate finance

Crown corporations

Over-the-counter markets(OTC)

Debt instruments

Equity instruments

Exchanges or auction markets

Finance

Financial assets

Financial intermediaries

Fourth market

Intermediation


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Important Chapter Terms

Investments

Market capitalization

Market intermediary

Marketable financial assets

New York Stock Exchange Non-marketable financial

assets

Ontario Securities Commission

Preferred shares

Primary markets

Real assets

Secondary markets

Toronto Stock Exchange

(TSX) TSX Group Inc.

TSX Markets

TSX Venture Exchange

Winnipeg CommodityExchange


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What is Finance?

Finance is the study of how and under whatterms savings (money) are allocated betweenlenders and borrowers.

Finance is distinct from economics in that itaddresses not only how resources are allocated butalso underwhat terms and through what channels

Financial contracts orsecurities occur whenever

funds are transferred from issuer to buyer.


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The Study of Finance

The study of finance requires a basicunderstanding of:

Securities Corporate law

Financial institutions and markets


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Real Versus Financial Assets

Real assets are tangible things owned bypersons and businesses Residential structures and property

Major appliances and automobiles

Office towers, factories, mines

Machinery and equipment

Financial assets are what one individual has lent

to another Consumer credit Loans

Mortgages


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Real Versus Financial AssetsThe Household Balance Sheet

Households hold both real and financial assets

Households also acquire some of those assetsthrough debt

A Household with no financial assets often facesfinancial problems because real assets cant be

used to pay off debt or to service debt (make loan

and interest payments) Real assets are not liquid

(See Table 1-2 on the next slide)


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Assets and Liabilities of Households,2005

Assets $ Billion Liabilities $ Billion

Houses 1,086 Consumer credit 260

Consumer Durables 435 Loans 131

Land 827 Mortgages 588Real Assets 2,348 Total Liabilities 979

Deposits 683

Debt 114

Pensions and insurance 1,200

Shares 1,254

Foreign and other 72Financial Assets 3323

Total Assets 5,671

Source: Statistics Canada. National Balance Sheet Acco unts, Quarterly Estimates, Fourth

Quarter 2005. Ottawa: M inister of Industry, 2006 (Catalo gue No . 13-214-XIE).

Table 1-2 Assets and Liabilities of Households, 2005


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The Financial System



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The Financial SystemOverview

The household is the primary provider of funds tobusinesses and government.

Households must accumulate financial resources throughout theirworking life times to have enough savings (pension) to live on intheir retirement years

Financial intermediaries transform the nature of thesecurities they issue and invest in

Banks, trust companies, credit unions, insurance firms, mutualfunds

Market intermediaries simply help make markets work Investment dealers

Brokers(See Figure 1-2 on the next slide)


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The Financial System

FIGURE 1-2


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The Financial SystemChannels of Intermediation

Funds can be channeled from saver to borrowerin three ways: Direct intermediation (direct transfer from saver to

borrower a non-market transaction)

Direct intermediation (a market-based transactionusually through a market intermediary such as abroker)

Indirect claims through a financial intermediary

(where the financial intermediary such as a bankoffers deposit-taking services and ultimately lendsthose deposits out as mortgages or loans)

(See Figure 1-3 on the next slide)


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Channels of Intermediation

FIGURE 1-3


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The Financial SystemFinancial Intermediaries

Banks and other deposit-taking institutions

Insurance companies

Pension Funds

Mutual Funds


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Financial IntermediariesCanadian Chartered Banks

Banks take deposits from numerous depositors from across Canada The deposits are pooled in the Bank The bank takes these pooled funds and lends them out to households and

businesses in the form of mortgages and loans The bank transforms the original nature of the savers (depositors) money:

Deposits are usually small in amountface little or no risk, and depositorsexpect to withdraw the amount at any time Loans and mortgages on the other hand usually have the following

characteristics: Large sums Borrowed for long periods of time Borrowed for risky purposes.

Banks can perform this transformation function because they becomeexperts at risk assessment, financial contracting (pricing the risk) andmonitoring the activities of borrowers.



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Financial IntermediariesCanadian Chartered Banks

Bank

Revenue

($ million)

Assets

($ million)

Profits

($ million)

Royal Bank of Canada 29,403 469,521 3,387Canadian Imperial Bank of Commerce

(CIBC) 18,677 280,370 -32

Bank of Nova Scotia 18,332 314,025 3,209

TD Canada Trust 18,665 365,210 2,229

Bank of Montreal 15,138 297,532 2,400

National Bank 5,320 107,598 855

Source: B M O Investo rLine website: www.bmoinves to rline.com, October 31, 2006.

Table 1-3 Chartered Banks: Financial Statistics, 2005


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Financial IntermediariesInsurance Companies

Insurers sell policies and collect premiums from customersbased on the pricing of those policies given the probability of aclaim and the size the policy and administrative fees.

They invest the premiums so that the accumulated value in thefuture will grow to meet the anticipated claims of thepolicyholders.

In this way, unsupportable risks (such as the death of wageearner or the burning down of a business) are shared among alarge number of policyholders through the insurance company.

Insurance allows households, business and government toengage in risky activities without having to bear the entire risk ofloss themselves.



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Financial IntermediariesInsurance Companies

Insurer

Revenue

($ million)

Assets

($ million)

Profits

($ million)Manulife Financial 32,187 322,171 3,294

Sun Life Financial 21,871 171,850 1,867

Great-West Lifeco 23,883 102,161 1,775

ING Canada 4,446 9,926 782

Source: Data fro m BM O Investo rLine website: www.bmoinvesto rline.co m, October 31, 2006.

Table 1-4 Insurance Companies: Financial Statistics, 2005


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Financial IntermediariesPension Plan Assets

Individuals and employers make payments over the entireworking life of a person with those funds invested to grow overtime.

Ultimately, the accumulated value in the pension can be used bythe person in retirement.

Pension plans accumulate considerable sums of money, andtheir managers invest those funds with long-term investmenttime horizons in diversified portfolios of investments. Theseinvestments are a major source of capital, fuelling investment inresearch and development, capital equipment, resourceexploration and ultimately contributing in a substantial way togrowth in the economy.



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Financial IntermediariesPension Plan Assets

Pension Plan Managers Net Assets($ billion)Caisse de depot et placement du Quebec 216.1

Canada Pension Plan (CPP) 98.0

Ontario Teachers (Teachers) 96.1

Ontario Municipal Employees (OMERS) 41.6

* The Caisse manages the investments of several pension plans.

Table 1-5 Pension Plan Assets, 2005


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Financial IntermediariesCanadian Mutual Fund Assets

Mutual funds give small investors access to diversified,professionally-managed portfolios of securities.

Small investors often do not have the funds necessary toinvest directly into market-traded stocks and bonds.

This is called denomination intermediation because themutual fund makes investments available in smaller,more affordable amounts of money.

Canadian indirect investment in the markets throughmanaged products such as mutual funds and segregated

funds has grown exponentially.(see 1-4 Figure on the next slide)


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Financial IntermediariesCanadian Mutual Fund Assets

FIGURE 1-4


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The Financial SystemThe Major Borrowers

Public Debt

Governments Federal

Provincial

Municipal

Crown Corporations

Private Debt

Households Non-financial Corporations



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The Financial SystemLargest Non-financial Companies

Non-financial Companies

Revenue

($ million)

Assets

($ million)General Motors of Canada Ltd. 34,991 n/a

Loblaw Companies Ltd. 27,812 13,761Magna International Inc. 22,873 12,321

Imperial Oil Ltd. 26,936 15,582

Alcan Inc.* 20,408 26,638

BCE Inc. 19,150 40,630

Bombardier Inc.* 14,882 17,483

Petro-Canada 17,673 20,655

Onex Corp. 17,626 14,845

EnCana Corp.* 14,322 34,148

Source: Data f rom "The Top 1000 in 2005." Globe and M ail Report on B usiness website:

www.theglobeandmail.com.

Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005

*Company reports in U.S. dollars.


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Financial Instruments



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Financial Instruments

There are two major categories of financialsecurities:

1. Debt Instruments Commercial paper

Bankers acceptances

Treasury bills

Mortgage loans

Bonds

Debentures

2. Equity Instruments Common stock

Preferred stock


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Financial InstrumentsNon-marketable

Characteristics of Non-marketablesecurities

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

Canada Savings Bonds


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Financial InstrumentsMarketable

Characteristics of Marketable securities 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 thegeneral economic environment (for example, interest rate increases

or decreases) and/or changes in the issuer of the security.

Market Capitalization Is an important term in finance

It is the total market value of a company

It is found by multiplying the number of shares outstanding by themarket price per share.

shareperPricesharesofNumbertionCapitalizaMarket


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Financial InstrumentsMarketable

Markets can be categorized by the time to maturity: Money Market Securities (for short-term debt securities that are

pure discount notes)

Bankers acceptances

Commercial Paper

Treasury Bills

Capital Market Securities (for long-term debt or equitysecurities with maturities greater than 1 year)

Bonds

Debentures

Common Stock

Preferred Stock


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Financial Markets



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Financial Markets

Primary Market

Markets that involve the issue of new securities by theborrower in return for cash from investors (Capitalformation occurs)

Secondary Market

Markets that involve buyers and sellers of existingsecurities. Funds flow from buyer to seller. Seller

becomes the new owner of the security. (No capitalformation occurs)


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Financial MarketsTypes of Secondary Markets

Exchanges or Auction Markets Secondary markets that involve a bidding process that takes

place in specific location

For example TSX, NYSE

Dealer or Over-the-counter (OTC) Markets Secondary markets that do not have a physical location and

consist of a network of dealers who trade directly with one

another. For example the bond market


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Financial MarketsOther Markets

Third Market Trading of securities that are listed on organized exchanges

in the Over-the-counter market

Fourth Market Trading of securities directly between investors (usually

between two large institutions) without the involvement ofbrokers or dealers.

Operates through the use of privately owned automatedsystems such as Instinet


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Represents an important source of funds forborrowers

Provides investors with important alternatives asthey seek to build wealth through diversifiedportfolios



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Total Assets

($ million)

1,016,031Canadian direct investments abroad 465,058

Canadian portfolio investments 284,604

Portfolio foreign bonds 82,374

Portfolio foreign stocks 189,175

Other portfolio investments 13,055

Other Canadian investments 266,369

Loans 48,325

Allowances

Deposits 120,694

Official international reserves 38,030

Other assets 59,319

Total Liabilities 1,184,534

Foreign direct investments in Canada 415,561

Foreign portfolio investments 508,398

Portfolio Canadian bonds 380,017

Portfolio Canadian stocks 107,598

Portfolio Canadian money market instrume 20,783

Other foreign investments 260,575

Loans 36,107

Deposits 201,639

Other liabilities 22,829

Canada's Net International Investment Position -168,503

Source: Statistics Canada.

Table 1-7 Canada's Internationa l Investments, 2005


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Summary and Conclusions

In this chapter you have learned about:

Financial systems in general, and the Canadianfinancial system in particular

Major participants in the Canadian financial system,including the different types of financial securities andfinancial markets


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Internet Links

BMO InvestorLine: www.bmoinvestorline.com Investment Funds Institute of Canada: www.ific.ca Globe and MailReport on Business: www.theglobeandmail.com Toronto Stock Exchange (TSX): http://www.tsx.com/

Canadian Trading and Quotation System Inc.: http://www.cnq.ca/ Ontario Securities Commission: http://www.osc.gov.on.ca/index.jsp Winnipeg Commodity Exchange: http://www.wce.ca/ New York Stock Exchange (NYSE): http://www.nyse.com/
http://www.bmoinvestorline.com/http://www.ific.ca/http://www.theglobeandmail.com/http://www.tsx.com/http://www.cnq.ca/http://www.osc.gov.on.ca/index.jsphttp://www.wce.ca/http://www.nyse.com/http://www.nyse.com/http://www.wce.ca/http://www.osc.gov.on.ca/index.jsphttp://www.cnq.ca/http://www.tsx.com/http://www.theglobeandmail.com/http://www.ific.ca/http://www.bmoinvestorline.com/


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Concept Review Questions



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Concept Review Question 1Finance

What is finance?

Finance is the study of how and under what

terms savings are allocated between borrowersand lenders.

It also examines under what terms and throughwhat channels resources are allocated.


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Concept Review Question 2Real and Financial Assets

Distinguish between real and financial assets.

Real assets are tangible property owned by

people and businesses such as buildings, land,machinery and equipment

Financial assets are paper claims that areevidence of contracts between people, or

between people and businesses (government)


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Concept Review Question 3Net Providers and Users of Funds

Which sectors of the economy are net providersof financing and which are the net users offinancing?

Households and the non-resident sectortraditionally are the net provider of financing forbusinesses and government.


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Concept Review Question 4Channels of Savings

Identify and briefly describe the three main channels ofsavings.

Direct claims through Non-market transactions A daughter arranging a loan through her mother

Direct claims through market intermediaries Purchase of a stock through a broker

Indirect claims through financial intermediaries Deposit in a savings accountthe funds eventually find themselves

lent by the bank to a business to finance purchase of equipment.


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Concept Review Question 5Market and Financial Intermediaries

Distinguish between market and financial intermediaries.

Market intermediaries help with the proper functioning offinancial markets

Investment dealers Financial intermediaries transform financial assets and

meet the needs of both savers and borrowerssimultaneously through the asset transformation function

Banks

Insurance firms Mutual funds


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Concept Review Question 6How financial intermediaries operate

Discuss how the three most important types of financialintermediaries operate.

Banks Deposit-taking and lending

Insurance Firms Sale of policies, collecting of premiums, investing premiums and

underwriting losses

Pension Plans Long-term accumulation of savings and channeling them to

productive long-term investments that will yield long-termpositive returns and provide financial security in old age forbeneficiaries.


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Concept Review Question 7Types of financial assets

Distinguish among the various types of financial assets.

Debt (represents a lending arrangement) Short-term debt is traded in the money market

Commercial paper

Bankers acceptances

Treasury Bills

Long-term debt is traded in the OTC capital market Bonds and debentures

Equity (represents an ownership claim) Common Stock Preferred Stock


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Concept Review Question 8Sources of financing used by governments and business

Identify the major sources of financing used bygovernments and businesses.

(a) Governments

Tax revenue (income taxes, excise taxes, consumption taxes(PST and GST), property taxes

Borrowing (short-term through Treasury bills, and long-termthrough Government bonds)

(b) Businesses

Reinvested Profits Common Stock

Bonds

Short-term loans from banks


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Concept Review Question 9Primary and Secondary Markets

Distinguish between primary and secondarymarkets.

Primary market is where new securities are sold for thefirst time. This is where the corporate issuer raisescapital.

Secondary markets occur when existing securities aretraded among and between investors without capitalformation occurring.


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Concept Review Question 10Importance of global financial markets to Canadians

Explain why global financial markets are so importantto Canadians.

Canadians as savers need to diversify their investmentportfolios, and access to global financial markets allowsthat diversification to be more complete.

Having access to funds in global markets, Canadiancompanies can raise more capital more cheaply

making them more competitive in their chosen industry.


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Concept Review Question 11Major U.S. Stock Markets

Identify and briefly describe the two major stockmarkets in the United States.

1. New York Stock Exchange (NYSE) Worlds largest

Most famous

Market capitalization US $21.2 trillion (2005)

2. Nasdaq Second largest and most important in U.S.

Third largest in the world

More listed companies than the NYSE


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Practice Problems



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Practice Problem 1The Four Major Financial Sectors

State the four major financial sectors in the financial system anddiscuss how they relate to one another

1. Borrowers Deficit spending economic units (households, businesses, government)

require funds now for investment and are willing to pay investors a returnfor the use of these funds

2. Lenders/investors Surplus saving economic units (households, businesses, government)

have a surplus of funds available that they want to earn a return on sothey lend or invest these funds to net borrowers

3. Financial intermediaries Banks, trusts, credit unions, pension funds, mutual funds, channel surplus

savings to deficit spending economic units

4. Financial markets Money, bond and equity markets bring buyers (lenders/investors) and

sellers (borrowers) of financial assets together to trade in those assetsand establish market prices for them.


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Practice Problem 2The role of different financial intermediaries in the financial system.

Explain how banks, pension funds, insurance firms, and mutualfunds work in the financial system.

1. Banks

Accept deposits, pool the funds and lend them out as mortgages andloans

2. Pension Funds Professionally managed pools of funds that fuel current investment in

Canadian business and government but at the same time provide for thelong-term financial security of the plan beneficiaries

3. Insurance Firms

Facilitate the pooling or sharing of risks among the many policyholdersthereby underwriting economic activity and minimizing the negativeimpacts of unsupportable losses.

4. Mutual Funds

Permits small investors with access to direct claims that are market tradedsuch as stocks and bonds.


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Practice Problem 3Why financial intermediaries and markets exist.

Briefly describe why financial and marketintermediaries exist in our financial system.

Financial and market intermediaries serve to channel scarcefinancial resources from economic units that have a surplus of

savings to economic units that have a deficit of savings. Ideally, financial and market intermediaries will ensure thatthese scarce financial resources will be put to the greatest andbest use (ie. Perform their functions with effectiveness)

Ideally, financial and market intermediaries will perform thechanneling function at a low net cost to both borrower andsaver (ie. Perform their functions with efficiency).


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Practice Problem 4Primary Market Transactions

List the two main types of primary markettransactions and concisely explain them.

Debt Offerings When governments or businesses sell bonds to investors

in return for cash that the issuer needs

Equity Offerings When businesses sell shares to the investing public in

return for cash that the issuer needs.


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Practice Problem 4Secondary Market Transactions

What are secondary market transactions? How dosecondary markets facilitate the primary markets?

Secondary market transactions occur between two parties thatwish to trade in a financial asset.

Funds flow from the purchaser to the seller of the financial asset No funds flow to the issuer of the financial asset

Secondary markets provide liquidity in the market place andcontinuous pricing function. The fact that securities with long terms to maturity (or non-

maturing securities such as stock) can be sold, allows investorswith shorter investment time horizons to consider their purchase.


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an introduction to finance3256

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