CH 2 PPT

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Created by
Babu G. Baradwaj, Ph.D
Lawrence L. Licon, Ph.D
Chapter 2 The Financial Environment and Interest Rates
Copyright 2008 John Wiley & Sons
CHAPTER 2
The Financial Environment and the

Level of Interest Rates
Quick Links
The Financial System
Direct Financing
Types of Financial
Markets
The Stock Market
Financial Institutions and Their Services
The Determinants of Interest Rate
Levels
Exhibits

Financial System at Work
Competitive
Money is aggregated in small amounts and
loaned in large amounts.

Financial markets benefit consumers.

Moving Funds from Lenders to Borrowers
Budget positions
Balanced budget: income equals
expenditure
Deficit budget: expenditures exceed
income
Financial system most concerned with
funneling money from surplus spending units

(SSUs) to deficit spending units (DSUs)
Go to Exhibit 2.1
Direct Financing
Direct Financial Markets
Direct Financial Markets are wholesale markets

minimum transaction $1 million
Investment Banks help companies sell
new debt or equity issues in public or

private security markets
Money Center Banks are large
commercial banks in major U.S.

financial centers
Direct Financing
Direct Financial Markets
Underwriting is a basic investment banking
service is to assist firms in the sale of debt

or equity in the primary market.
Investment banker buys the entire
issue at a guaranteed price from the
issuing firm and resells the securities
to institutional investors and the
public.
Types of Financial Markets

Primary Market
Financial market selling new security issues
for first time
Secondary Market
Financial market where owners of outstanding
securities can resell

Marketability and Liquidity
Marketability: a security can be easily sold and
converted into cash
Liquidity: an asset can be easily converted into
cash without loss of value

Brokers versus Dealers
Brokers
Market specialists who bring buyers and
sellers together in secondary markets.
They bear no risk of securities ownership.
Dealers
They make markets for securities
They buy and sell from their own
securities inventory, so they do bear

some risk
10

Securities Exchanges
Organized Exchanges
NYSE, American, Pacific, Chicago, Philadelphia
Central trading location
Only members can use the exchange
Over-the-Counter (OTC) Markets

No central trading location
11

Money Markets
Collection of markets with no formal
organization or location, each trading different

financial instruments
Financial instruments sold have short
maturities; Highly marketable
Instruments include U.S. Treasury Bills,
negotiable CDs, commercial paper
Go to Exhibit 2.2
12

Capital Markets
Where capital goods are financed with equities
or long-term debt
Public and Private Markets

Public markets are where the general public
buy and sell securities through their broker
Private markets involve direct transactions
between two parties
13

Futures and Options Markets
Often called derivative securities, they derive
their value from some underlying asset

Futures Contracts - contracts for future
delivery of securities, foreign currencies,
interest rates, or commodities
Options Contracts - call for one party (option
writer) perform specific act at request of option
buyer or owner
14
The Stock Market

NYSE and NASDAQ
The New York Stock Exchange (1792) is the oldest
and largest securities exchange in the United States
NASDAQ (1971) is the worlds largest

electronic stock market, listing nearly
four thousand companies.
15
The Stock Market

Stock Market Indexes
Measure stock market performance - whether
stock prices on average move up or down
Dow Jones Average - comprised of 30 companies
representing 20% of market value of all U.S.

stocks.
16
The Stock Market

Stock Market Indexes
Standard and Poors 500 Index - considered
best for measuring performance of largest

companies in U.S. economy, represents 80%
of total market capitalization of all NYSE
stocks
NASDAQ Composite Index - comprised of all
common stocks listed on NASD Automatic
Quotation System (NASDAQ): >5,000 firms
17
Financial Institutions and

Their Services
Commercial Banks
Most prominent, largest financial intermediaries
in economy, offer widest range of financial

services to businesses
The major funding sources are checking and
savings accounts, time deposits. Banks

accumulate these funds, make a variety of
loans to consumers, businesses, governments.
Also, significant amount of equipment lease
financing
18

Their Services
Life Insurance Companies
Obtain funds by selling life insurance policies
that protect individuals against loss of income

from family members premature death
Funding to public corporations through
purchase of stocks, bonds in direct credit
markets
Fund closely held corporations through direct
placement financing
19

Their Services
Casualty Insurance Companies
Sell protection against property loss from fire,
theft, accidents, negligence, other predictable

causes
Pension Funds
Provide retirement programs for businesses as
part of employee benefit programs
Obtain money from employee and employer
contributions during employees working

years, then provide monthly retirement
payments
20

Their Services
Investment Funds
Sell shares to investors, use funds to purchase
wide range of direct and indirect financial

instruments
Business Finance Companies

Sell short-terms IOUs (commercial paper) to
investors in direct credit markets where funds
are used for short- and intermediate-term
loans, leases to small and large businesses.26
21
The Determinants of
Interest Rate Levels
The Real Rate of Interest
Long-term Interest Rate determined in the
absence of inflation
The determinants of the real rate are a firms
return on investment and the time preference
for consumption
Go to Exhibit 2.4
22
The Determinants of
Money, Inflation, and Purchasing Power
Value of money is its purchasing power

Inverse relationship between changes in price
level and value of money
23
The Determinants of
Inflation and Loan Contracts
Real rate of interest ignores inflation

Lenders must incorporate anticipated inflation
into lending contracts
24
The Determinants of
Inflation Premiums
Lenders can incorporate protection against
changes in buying power due to inflation in a

loan contract.
Nominal Rate = Real Rate of interest +
Expected Changes in Commodity Prices

Realized rate of return = Nominal Rate
Actual Rate of Inflation
25
The Determinants of
Interest Rates: The Business Cycle and Inflation
Interest rates tend to follow business cycle

During periods of economic expansion interest
rates tend to rise.

During a recession, opposite tends to occur
26
Exhibit 2.1: Flow of Funds Through

the Financial System
27
Exhibit 2.2: Selected Money Market

and Capital Market Instruments
28
Exhibit 2.3: Cash Flows between the

Firm and Financial System
29
Exhibit 2.4: The Determinants of the

Equilibrium Rate of Interest
30
Exhibit 2.5: Relation between Annual

Inflation Rate and LTIR
31

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Fundamentals of Corporate

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

The Financial Environment and the

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Copyright 2008 John Wiley & Sons

The Financial System

loaned in large amounts.

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

The Financial System

Deficit budget: expenditures exceed

Financial system most concerned with

funneling money from surplus spending units

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Direct Financial Markets are wholesale markets

new debt or equity issues in public or

Money Center Banks are large

commercial banks in major U.S.

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

service is to assist firms in the sale of debt

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Financial market selling new security issues

for first time

securities can resell

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Marketability: a security can be easily sold and

converted into cash

Liquidity: an asset can be easily converted into

cash without loss of value

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Types of Financial Markets

sellers together in secondary markets.

They bear no risk of securities ownership.

securities inventory, so they do bear

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Over-the-Counter (OTC) Markets

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Collection of markets with no formal

organization or location, each trading different

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Public and Private Markets

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

Types of Financial Markets

Often called derivative securities, they derive

their value from some underlying asset

Chapter 2 The Financial Environment and Interest Rates

Copyright 2008 John Wiley & Sons

The Stock Market

and largest securities exchange in the United States