Foundations of Finance

1. Foundations of Finance Week 1 – Overview of Financial Markets

2. Why do Financial Markets exist? People with excess capital ↵ ↵ Gains from trade ! People with Ideas/Opportunities Overview of Financial Markets

3. Most (all ?) transactions fit into this framework Demand for capital Supply of capital • Entrepreneurs • Students • Some countries • Firms • Households (bank accounts) • Pension plans • Some other countries Provides for 1.Consumption smoothing 2. Optimal use of capital Overview of Financial Markets

4. Core concepts TODAY: A bird’s eye perspective Overview of Financial Markets

5. FinancialMarkets The role of markets in our economy and how they function

6. A Closer Look • Question: How does a firm obtain financing? • Part of the answer: It must issue financial assets CAPITAL MARKETS CONSUMERS OF CAPITAL SUPPLIERS OF CAPITAL Overview of Financial Markets

7. What is a Financial Asset? Real Assets are used to produce goods and services: land, equipment, buildings, knowledge Financial Assets are claims on real assets or the income generated by them INVESTORS REAL ASSETS FINANCIAL ASSETS CLAIM Large Firm CLAIM Start-up Overview of Financial Markets

8. Financial and Real Assets • Financial Assets • One parties asset is another’s liability • Thus the value of all financial assets in the economy sums to zero • Real Assets • The value of all real assets determines the true value of the economy Overview of Financial Markets

9. Real and Financial Assets Households Firms Banks Overview of Financial Markets

10. Common Types of Financial Assets Features of Debt and Equity claims

11. Debt Bank Loan Corporate Bond Treasuries Pensions Equity (Ownership) Stocks Basic Financial Assets Overview of Financial Markets

12. A (hopefully) intuitive example • You want to start a lemonade stand • You anticipate that it will earn $20 • You have $10, but you need $15 • Your parents lend you $5 • How is this “firm” financed? • You make $12 in revenues • how do you split the proceeds? Overview of Financial Markets

13. Debt vs. Equity • Seniority • Debt holders paid first • Equity holders paid once debt holders have received all claims • Cash Flows • Debt holders receive a fixed amount • Equity holders have a claim on firm value which exceeds liabilities to debt holders What does this structure imply for the relative riskiness (variance) of these payoffs? Overview of Financial Markets

14. Debt vs. Equity - Graphically • What if the firm can’t pay back debt holders? • Renegotiation • Bankruptcy Overview of Financial Markets

15. Fixed Income Securities • Some examples: • Treasury Bills/Bonds • Municipal bonds • Mortgages • Credit card debt • Student loans • Two types of cash flows • Interest payments • Principal payments Overview of Financial Markets

16. Fixed Income Cash Flows: An Example • Loan with FV $ 20M, Semi-Annual Coupons & 5% Interest rate Initial Capital Injection Principal Payment   Semi-Annual Coupon Payments Overview of Financial Markets

17. Features of a Debt Contract • Maturity – length of loan term • Interest Rate – e.g. fixed or floating • Face value – The value of the principal owed at maturity • Payment Schedule • Frequency of coupon payments • (Potentially no coupon payments) • Optionality – e.g. prepayment options • If interest rates fall, borrowers may have the option of paying off their existing loans and issuing new debt at the lower interest rate • Covenants • Provisions which give the lender control rights in particular scenarios Overview of Financial Markets

18. Revisiting the lemonade stand • What were the features of the loan your parents made to you? • Interest rate? • Optionality? • Maturity? • Payment schedule? (e.g. coupons) Overview of Financial Markets

19. Market Value of Debt vs. Face Value • Firm has debt of face value 10M • Tomorrow the firm will either be worth • What is the market value of the firm’s debt? • Market value of debt: • Market value of equity: Overview of Financial Markets

20. Equity Financing • An equity claim contains • Cash-flow rights: the right to the firms cash flows once debt-holders are paid off • An infinite stream of dividends • Voting rights • Cash flows rights • Dividends • Should capital gains count? Overview of Financial Markets

21. Debt vs. Equity • SeatGeek.com is financed through debt and equity: • Current value of equity: 6M • Current value of debt: 9M, assume the face value of debt is also 9M • Presented with an investment opportunity which costs $11M and has payoffs given by: • Payoff = • What is the expected value of this project? • What is the firms value if it decides to undertake the project? Overview of Financial Markets

22. Debt vs. Equity • Goal: find the new value of debt and the new value of equity • Value of debt: • Value of equity: • Should management invest in the project? Overview of Financial Markets

23. Any questions on Debt and/or Equity? Overview of Financial Markets

24. Or what about a hybrid? – Preferred Equity • Attributes of both debt and equity • Bond-like • No voting power • Priority over common stock • Rated by credit-rating agencies • Stock-like • Subordinate to debt • Cash-flows are in the form of dividend payments Overview of Financial Markets

25. One clever type of preferred stock: Poison pills • (This is an example of a potential “current event” topic) - Financial Times Overview of Financial Markets

26. Some background: What is a Poison Pill? “In connection with the adoption of the Shareholder Rights Plan, the Board of Directors declared a dividend distribution of one preferred stock purchase right for each outstanding share of Tegal’s common stock to shareholders of record as of the close of business… Under the Plan, the rights generally will become exercisable if a person becomes an `acquiring person’ by acquiring 15% or more of the common stock of Tegal… If a person becomes an ‘acquiring person,’ each holder of a right (other than the acquiring person) would be entitled to purchase, at the then-current exercise price, such number of shares of preferred stock which are equivalent to shares of Tegal’s common stock having a value of twice the exercise price of the right.” Marty Lipton -Tegal press release – April 13, 2011 Overview of Financial Markets

27. Hostile take-over triggers the right to exercise the option 2-for-1 exchange means any shares not exercised have been diluted to half their value Acquirer cannot exercise Is this “rights plan” actually good for shareholders ? How does it work Overview of Financial Markets

28. Back go Airgas versus Air Products Overview of Financial Markets

29. How should a firm finance it’s investments? • Some possible considerations • Accessibility of debt versus equity • Management incentives • Asymmetric information • Bankruptcy costs • Tax advantages • Reporting costs • You can learn more about capital structure in corporate finance Overview of Financial Markets

30. Financing the Firm – The Role of Limited Liability • Limited Liability – The concept whereby a person’s financial liability is limited to a fixed sum (typically the value of the person’s financial investment) • Can you think of how this would be important in a firm’s ability to gain financing? • What are some costs? Overview of Financial Markets

31. Back to the (fictional) story of SeatGeek.com Expand operations by entering ticket brokering business Two college grads have a great business idea. Enter agreement with AMEX to purchase concierge services business Must hire employees to increase website functionality Personal loan from friends & family Issue corporate debt VC funding (equity) Issue public equity (IPO) 2000 2002 2003 2006 Overview of Financial Markets

32. How will SeatGeek.com do an IPO? • The role of investment banks • Determine size & features of offering • “Place shares” • Legal issues • Pricing issues Overview of Financial Markets

33. A Closer Look • How are these financial Assets traded? CAPITAL MARKETS CONSUMERS OF CAPTIAL SUPPLIERS OF CAPITAL Overview of Financial Markets

34. Market Mechanics The primary and secondary markets for financial assets

35. Primary Market • SeatGeek works with an investment bank to structure an IPO • The company is now owned by multiple classes of investors Debt Holders DEBT Equity Holders EQUITY Overview of Financial Markets

36. Primary and Secondary Market • After new issues occur through the primary market • Later some investors may want to change their holdings • Secondary market allows investors to trade securities Overview of Financial Markets

37. An Interesting Aside: Relative Sizes of Secondary Markets • Total value of US bond market – $31 trillion • Total value of US stock market - $22 trillion • Value of average daily dollar trade volume in some secondary markets? • US Stock Market ? • US Bond Market ? • Foreign Exchange ? Overview of Financial Markets

38. How are trades completed? Not this way • In a “direct search market” buyers and sellers transact without an intermediary Seller Buyer Overview of Financial Markets

39. Brokered Market • Sellers and buyers transact through brokers Seller Broker Broker Broker Broker Buyer Overview of Financial Markets

40. Dealer Market • Dealers specialize in particular securities • They absorb supply and demand shocks through their own books Seller Broker Broker Broker Broker Dealer Buyer Dealer Overview of Financial Markets

41. Auction Market • Transactions occur centralized through an auction Seller Broker Broker Broker Broker Broker Broker Broker Broker Exchange Buyer Overview of Financial Markets

42. Secondary Markets • Auction Market (NYSE, AMEX) • Call Auction • Continuous Auction: • Floor Trading (open outcry system) • Limit Order Book • Dealer (Market Maker) Market (NASDAQ) • Electronic Communication Network • What determines the price? Overview of Financial Markets

43. Call Auction • All orders are aggregated into demand and supply schedules • Transactions are conducted at aspecified time • A single price is determined such that supply equals demand Overview of Financial Markets

44. Call Auction – Building the Supply & Demand Curves Buy 1,000 shares at $101 Buy 1,000 shares at $101 Buy 1,000 shares at $101 Buy 1,000 shares at $101 Sell 2,000 shares at $104 Buy 500 shares at $103 Buy 500 shares at $103 Buy 500 shares at $103 Buy 500 shares at $103 $104 Sell 500 shares at $102 Buy 2,000 shares at $100 Buy 2,000 shares at $100 Buy 2,000 shares at $100 Sell 1,500 shares at $101 $103 Buy 1,500 shares at $102 Buy 1,500 shares at $102 $102 $101 $100 1,000 2,000 3,000 4,000 5,000 Overview of Financial Markets

45. Continuous Auction • Continuous Auction or Dealer Market: Bid and Ask Prices • Bid Price = Price at which a seller can sell an asset • Ask Price = Price at which a buyer can buy an asset • Which Price should be higher? Why? Overview of Financial Markets

46. Continuous Action – Limit Order Book - 11:05 11:00 11:05 Rob: BID 1500 @ 18 Bill: BID 500 @ 17 Jane: BID 2000 @ 21 Anne: ASK 2000 @ 18 Sue: ASK 500 @ 20 Jim: ASK 2000 @ 19 Overview of Financial Markets

47. The Role of the Dealer (a.k.a. Market Maker) • Dealer Holds inventory and quotes bid and ask prices • Provides a service of liquidity in exchange for the bid-ask spread • Bears risk of holding inventory • Bid-ask spread compensates dealer for risk and liquidity services Overview of Financial Markets

48. The Dealers Inventory: Some Thought Questions • What happens to the value of inventory if the stock price goes up? Down? • What happens to the size of the dealer’s inventory if bid-ask spread moves up? Down? • How does volume of trade affect inventory risk? • How does competition affect the spread? Overview of Financial Markets

49. US Equity Markets Today: Future of the NYSE Overview of Financial Markets

50. Types of Trading Orders • Market Order • Buy or sell orders to be executed immediately at the market price • Limit Order (Our dealer book example) • Order to sell (buy) shares at or above (below) a specified price • Stop Orders • Order to sell (buy) if prices falls below (rises above) a specified level Overview of Financial Markets