Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.

1. Foundations of FinanceArthur J. KeownJohn D. MartinJ. William Petty David F. Scott, Jr. Chapter 2 The Financial Market and Interest Rates

2. Chapter Objectives • Understanding the historical relationship between internally generated and externally generated sources of funds. • Understand the financing mix that tends to be used by the firms raising long-term capital. • Explain why the financial markets exist in a developed country. • Explain the financing process by which savings are supplied and raised by major sectors in the economy.

3. Chapter Objectives • Describe key components of the U.S. financial market system. • Understand the role of the investment-banking business in the context of raising corporate capital. • Distinguish between privately placed securities and publicly offered securities. • Be acquainted with securities floatation costs and securities markets regulations.

4. Chapter Objectives • Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets. • Be acquainted with recent interest rate levels and the fundamentals of interest rate determination. • Explain the popular theories of the term structure of interest rates. • Understand the relationships among the multinational firm, efficient financial markets, and the inter-country risk.

5. Principles Used in this Chapter Principle 1: The Risk-Return Tradeoff - We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. Principle 6: Efficient Capital Markets - The Markets are Quick and the Prices Are Right. Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance.

6. Federal Funds Rate • Short-term market rate of interest • Serves as a sensitivity indicator of the direction of future changes in interest rates

7. Federal Reserve System • Known as “The Fed” • Central Bank of the United States • Responsibilites: • Conducting Nation’s Monetary Policy • Supervise and Regulate Banking Institutions • Maintain Stability of Financial Systems • Provide Financial Services

8. Federal Reserve System • Independent Entity within the Federal Government • Derives Authority from Federal Government • How they get income • Accountable to Congress • Chairman is ______________

9. Objectives of the Fed • Maximum sustainable employment • Price stability

10. Federal Reserve System

11. Federal Reserve System

12. Federal Reserve System

13. Federal Reserve System Board of Governors • Seven members • Nominated by the President and confirmed by the Senate. • A full term is fourteen years. One term begins every two years, on February 1 of even-numbered years. • A member who serves a full term may not be reappointed but a member who completes an unexpired portion of a term may be reappointed. • All terms end on their statutory date regardless of the date on which the member is sworn into office. • The Chairman and the Vice Chairman of the Board are named by the President from among the members and are confirmed by the Senate. They serve a term of four years. A member's term on the Board is not affected by his or her status as Chairman or Vice Chairman.

14. Federal Reserve SystemBoard of Governors www.federalreserve.gov

15. Recent Interest Rate Cycles

16. Nonfinancial Corporate Business Sources of Funds, 1981-2000 • Changes in market conditions influence the way corporate funds are raised • Example: High interest costs discourage the use of debt.

17. Corporate Securities Offered for Cash • Nonfinancial Corporations- 3yr. Cash Weighted Average, 2001-2003 • Total Volume($M) • $1,288,515 Source:Statistical Supplement to the Federal Reserve Bulletin, Table 1.46, October 2004, A29.

18. Debt/Equity Mix • U.S. tax system favors debt as means of raising capital • Interest expense is deductible • Dividends paid are not deductible

19. Financial Markets • Financial markets are institutions and procedures that facilitate transactions in all types of financial claims • Financial markets exist in order to allocate the supply of savings in the economy to the demanders of those savings.

20. Financial Markets • Real assets are tangible assets such as houses, equipment, and inventories. • Financial assets represent claims for future payments in other economic units.

21. Financial Markets • Underwriting — the purchase of financial claims of borrowing units and reselling them at a higher price to other investors. • Secondary Markets — trading in already existing financial claims • Financial Intermediaries — major financial institutions, i.e. commercial banks, savings and loans, credit unions, life insurance companies, mutual funds etc.

22. Financial Markets • Indirect Securities – financial claims offered by financial intermediaries to economic units with excess savings • Direct Securities – financial claims purchased by financial intermediaries with proceeds from the sale of indirect securities

23. The Financing Process Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1 (Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000).

24. Movement of Savings • Direct Transfer of Funds • Indirect Transfer of Funds Using an Investment Banker • Indirect Transfer of Funds Using the Financial Intermediary

25. Three Ways to Transfer Financial Capital in the Economy Three Ways to Transfer Financial Capital in the Economy Foundations of Finance

26. Public Offerings and Private Placements • Public Offering – both individuals and institutional investors have the opportunity to purchase securities • Private Placement (direct placement) – the securities are offered and sold to a limited number of investors

27. Primary and Secondary Markets Primary Markets –Securities are offered for the first time to investors – a new issue of stock. Increases the total stock of financial assets outstanding in the economy. Secondary Markets – Transactions in currently outstanding securities. All transactions after the initial purchase. Sales do not affect the total stock of financial assets that exist in the economy.

28. Money Market and Capital Market Money Market:all institutions and procedures that provide for transactions in short-term debt instruments Capital Market:all institutions and procedures that provide for transactions in long-term financial instruments

29. Organized Security Exchanges and Over-the-Counter Markets Organized Security Exchanges — Tangible entities; physically operate space, where financial instruments are traded on the premises • National and regional exchanges Over-The-Counter Markets — All security markets except the organized exchanges • Money Market

30. Organized Security Exchanges and Over-the-Counter Markets • The business of an Exchange, including securities transactions, is conducted by Members. • Officer of the firm is designated to be the “Member” of the Exchange, which then permits the brokerage house to use the facilities to effect trades.

31. Stock Exchange Benefits • Provides a continuous market • Establishes and publicizes fair security prices • Helps businesses raise new capital

32. Listing Requirements • Listing criteria varies for each exchange. • General requirements include: • Profitability • Market Value • Public Ownership

33. New York Stock Exchange (NYSE) • “The Big Board” • Origins back to 1792. • Automated in 1995 using wireless hand held computers (HHC). • As of Jan. 24, 2007 all stocks can be traded using HHC. • 1366 seats on the exchange • In 2005, seat sold for $3.25 million. • Operated by NYSE Euronext • Acquired American Stock Exchange (AMEX) in Oct. 1, 2008

34. Over the Counter Market (OTC) • For firms who don’t meet listing requirements of major exchanges. • Avoids major exchange reporting requirements and fees. • More stocks and over 90% of corporate bonds traded on the OTC than on organized exchanges. • Trading done through brokers and broker - dealers. • National Association of Security Dealers Automated Quotation System. (NASDAQ) • “Screen Based – Floorless Market”

35. Original Dow Jones Companies American Cotton Oil Company – now part of Unilever. American Sugar Company–became Domino Sugar in 1900 - now Domino Foods, Inc. American Tobacco Company–broken up in a 1911 antitrust action. Chicago Gas Company–now an operating subsidiary of Integrys Energy Group. Distilling & Cattle Feeding Company– now Millennium Chemicals which is in Chapter 11 bankruptcy. General Electric Company – still in operation Laclede Gas Company–still in operation as the Laclede Group, Inc., removed from the DJIA in 1899. National Lead Company– now NL Industries, removed from the DJIA in 1916. North American Company–electric utility holding company broken up by the SEC in 1946. Tennessee Coal, Iron and Railroad Company–bought by U.S. Steel in 1907. U.S. Leather Company–dissolved in 1952. United States Rubber Company–changed its name to Uniroyal in 1961 - bought by Michelin in 1990

36. Current Dow Jones Companies

37. Investment Banker • A financial specialist involved as an intermediary in the merchandising of securities; facilitates flow of savings from economic units that want to invest in those units that want to raise funds.

38. Functions of an Investment Banker • Underwriting • Distributing • Advising

39. Distribution Methods • Negotiated Purchase • Competitive Bid Purchase • Commission or Best Efforts Basis • Privileged Subscription • Direct Sales

40. Private Placements • Advantages • Speed • Reduced Flotation Costs • Financing Flexibility • Disadvantages • Interest Costs • Restrictive Covenants • Possible Future SEC Registration

41. Flotation Costs • Incurred by the firm raising the capital • Sensitive to the risk involved with successfully distributing a security • Types • Underwriters Spread • Issue Costs • Printing and Engraving • Legal Fees • Accounting Fees • Trustee Fees • Other

42. Market Regulation • Securities Act of 1933 • Securities Exchange Act of 1934 • Securities Acts Amendments of 1975

43. Securities Exchange Act of 1933 • Securities Act of 1933 — Aims to provide potential investors with accurate, truthful disclosure about the firm and new securities being offered.

44. Securities Exchange Act of 1934 • Created SEC to enforce federal securities laws • Major security exchanges must register with the SEC • Insider trading is regulated • Prohibits manipulative trading • SEC control over proxy procedures • Gives Board of Governors of Federal Reserve System responsibility for setting margin requirements

45. Securities Acts Amendments of 1975 • Created a national market system (NMS)

46. SEC Rule 415 – Shelf Registration • Shelf Registration or Shelf Offering is a procedure for issuing new securities where the firm obtains a master registration statement approved by the SEC

47. Sarbanes-Oxley Act of 2002 • In July 2002, Congress passed the Public Accounting and Reform and Investor Protection Act • The Act contains 11 titles which tighten significantly the latitude given corporate advisors who have access to or influence company decisions.

48. Sarbanes-Oxley Act of 2002Key Elements • Public Company Accounting Oversight Board • Auditor Independence • Corporate Responsibility • Enhanced Financial Decisions • Analysts Conflicts of Interest • Commission Resources and Authority • Studies and Reports • Corporate and Criminal Fraud Accountability • White-Collar Crime Penalty Enhancements • Corporate Tax Returns • Corporate Fraud and Accountability

49. Rates of Return in Financial Markets • Opportunity Cost— Rate of return on next best investment alternative to the investor • Standard Deviation— Dispersion or variability around the mean, or average of the rate of return in the financial markets • Maturity Premium— Additional return required by investors in long-term securities to compensate them for greater risk of price fluctuations on those securities caused by interest rate changes

50. Rates of Return in Financial Markets • Liquidity Premium— Additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price. • Real Return— Return earned above the rate of increase in the general price level for goods and services in the economy (the inflation rate) • Real Rate of Interest— Rate of increase in actual purchasing power—after adjusting for inflation