CHAPTER 1: AN INTRODUCTION TO FINANCE PP Flashcards
what is Finance?
the study of how savings (money) are allocated between lenders and borrowers
the study of under what terms savings (money) are allocated between lenders and borrowers
how is finance distinct from economics?
it addresses more than how resources are allocated
addresses also under what terms and through what channels resources are allocated
when do Financial contracts or securities occur?
whenever funds are transferred from issuer to buyer
two main finance branches
asset pricing
corporate finance
asset pricing
Investor perspective
Price formation in capital markets
Investments
Portfolio management
CAPM (CapitalAsset
Pricing Model)
Corporate Finance
CEO perspective
Financial decisions of the corporation
Capital Budgeting
Capital Structure
Working Capital Management
Capital Budgeting
What assets to buy
involves real assets and financial assets
Capital Structure
how to pay for the assets you want
Mix of debt and equity
theory of value
Buy low, sell high
buy high sell low trust
Real assets
tangible items owned by persons and businesses
ex: Residential structures and property
Major appliances and automobiles (consumer durables)
Office towers, factories, and mines
Machinery and equipment
Financial assets
what one individual has lent to another
ex: Consumer credit
Loans
Mortgages
what type of assets do households own?
both real and financial assets
Why do households with no financial assets often face financial problems?
because real assets cannot be easily used to pay off or service debt
what is more liquid between real and financial assets?
financial assets
the primary provider of funds to businesses and government
households
what do financial intermediaries do?
transform the nature of the securities they issue and invest in
what type of intermediaries are the following:
banks
trust companies
credit unions
insurance firms
mutual funds
financial intermediaries
who are market intermediaries and what do they do?
investment dealers and brokers (investment advisors)
help to make markets work by adding liquidity
in which three ways can funds be channeled from savers to borrowers?
Direct transfer from saver to borrower in a non-market transaction
Direct intermediation through a market intermediary such as a broker in a market-based transaction
Indirect claims through a financial intermediary where the financial intermediary, such as a bank, offers deposit-taking services and ultimately lends the deposited funds out as mortgages or loans
Financial Intermediaries: Canadian Chartered Banks
how do they function?
Deposits from numerous depositors from across Canada are ‘pooled’ into banks
Pooled funds are lent to households and businesses in the form of mortgages and loans
The bank transforms the original nature of the savers’ (depositors’) money
what do banks do to transfer depositors’ money? how do they do it?
a bunch of depositors save in small amounts
Loans and mortgages are usually large in amount, pooling the many deposits
Banks can perform this transformation function because they become experts at risk assessment, financial contracting, and monitoring the activities of borrowers
financial contracting
pricing the risk
Financial Intermediaries: Insurance Companies
how do they work?
Insurers sell policies and collect premiums from customers based on the pricing of those policies
Premiums are invested so that the accumulated value in the future will grow to meet the anticipated claims of the policyholders
Risks that would be unsupportable by an individual are shared among a large number of policyholders through the insurance company
allow households, business and government to engage in risky activities without having to bear the entire risk of loss themselves
Financial Intermediaries:
Pension Plan Assets
how do they work?
Individuals and employees make payments over their entire working lives to pension plans
these invest those funds to grow over time and accumulate large sums of money
The accumulated value of the pension can be used to fund retirement
their managers invest those funds with long-term investment time horizons in diversified investment portfolios
These investments are a major source of capital, fueling investment in research and development, capital equipment, and resource exploration, which ultimately contributes to the growth of the economy
Financial Intermediaries:
Canadian Mutual Fund Assets
how do they work?
Mutual funds give small investors access to diversified, professionally-managed portfolios of securities
pool a bunch of little funds together to buy large financial instruments (denomination intermediation)
The Major Borrowers of Public Debt
the federal government
Provincial and territorial Governments
Municipalities
Crown corporations
The Major Borrowers of Private Debt
Households
Non-financial corporations
There are two major categories of financial securities
Debt instruments
Equity instruments
Debt instruments
commercial paper
bankers’ acceptances
Treasury bills (T-bills)
mortgage loans
bonds
debentures
etc
you lend your money basically and you expect to receive interest at the end of the maturity date
Equity instruments
common share
preferred share
you own the company or the organization that issued the equity instrument
no maturity date
as an important decision maker in a firm, how to get the money?
I can sell a part of my business (firm): e.g. Issue stocks
I can borrow money: e.g. get a loan from a bank, or Issue bonds
as an important decision maker in a firm, how to spend the money?
I can invest in a certain project (I have the money); should I invest in it or not?
I can invest in several projects; which one should I pick?
Non-Marketable Assets
Cannot be traded between or among investors
May be redeemable
ex: savings accounts
term deposits
guaranteed investment certificates (GICs)
Canada Savings Bonds
MarketableAssets
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 the general economic environment and/or changes in the financial condition or prospects of the issuer of the security
Money market securities
short-term debt securities
pure discount notes
usually have maturities less than one year
ex: Bankers’ acceptances
commercial paper
Treasury bills
Capital market securities
long-term debt or equity securities with maturities greater than one year
ex: bonds
debentures
common and preferred shares
Primary Markets
Markets that involve the issue of new securities by a company
issue IPOs
the money goes to the company
Secondary Markets
Markets that involve buyers and sellers of existing securities
Funds flow from the buyer to the seller of the securities, and the buyer becomes the new owner of the security
the money does not go to the company that has the share (no new capital is formed)
Types of Secondary Markets
Exchange or auction markets
Dealer or over-the-counter (OTC) markets
Exchange or auction markets
involve a bidding process that takes place in a specific location
ex: Toronto Stock Exchange (TSX)
New York Stock Exchange (NYSE)
Dealer or over-the-counter (OTC) markets
do not have a physical location
consist of a network of dealers who trade directly with each other
ex: bond market
Market capitalization
the total market value of a company
how to calculate the total market cap
multiplying the number of shares outstanding by the market price of each share
outstanding shares
company’s stock currently held by all its shareholders
Goals of a Financial Manager
maximize current value of existing stock (share price)
select investments and capital structure that maximize stock value
