FINANCING DECISION

AND
FINANCIAL MARKETS
Conf. dr.
Anamaria CIOBANU
Goals of the Firm.
Explain why each of the following may not
be appropriate corporate goals:
a. Increase market share
b. Minimize costs
c. Underprice any competitors
d. Expand profits
Agency Issues.
Discuss which of the following forms of
compensation is most likely to align the
interests of managers and shareholders:
a. A fixed salary
b. A salary linked to company profits
c. A salary that is paid partly in the form of
the companys shares
d. An option to buy the companys shares
at an attractive price
The Financing Decision of a Company
Financing
Decision
Internal
Resources
External
Resources
Auto-financing:
-Reinvesting the
profits;
- Reserves;
- Depreciation and
amortization of the
assets;
- Credits;
- Bond issuing;
- Equity.
Financial Institutions & Financial
Markets
Firms that require funds from external sources
can obtain them in three ways:
through financial institutions : eg banks
through financial markets : e.g BSE
through private placements
Financial Institutions
Financial institutions are intermediaries that
channel the savings of individuals, businesses,
and governments into loans or investments.
In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.
The Relationship between Financial
Institutions and Financial Markets
Financial markets provide a forum in which
suppliers of funds and demanders of funds can
transact business directly.
The two key financial markets are:
the money market: deals with short term
marketable securities
the capital market: deals with long-term securities
Financial Markets
Financial Markets
MONEY MARKET:
The securities market dealing in short-
term debt and monetary instruments.
Money market instruments are forms of
debt that mature in less than one year
and are very liquid.
Financial Markets
CAPITAL MARKET:
-where different types of securities (e.g. stocks,
bonds etc.) are traded through members of
securities exchanges.
Eg. of securities exchanges:
NYSE - New York Stock Exchange
BSE Bucharest Stock Exchange
Members of securities exchanges consist of
mainly brokerage firms.
FINANCIAL INSTRUMENTS
Represent a contract between a lender and a
borrower;
This type of contract establish:
the amount and the maturity;
the currency;
the financing cost (interest rate) and the payment
method;
the risk allocation between the participants;
the payback of the loan;
other aspects (special clause).
Financial Markets
Money Market Instruments Capi tal Market Instruments
Treasury Bills Treasury Notes & Bonds
Negotiable CDs Government Agency Bonds
Bankers Acceptances State & Local Government Bonds
Commercial Paper Corporate Bonds
Credits Corporate Stocks
MONEY MARKET
CAPITAL MARKET
Treasury Bills
short term debt instruments
maturity of 3, 6 or 12 month;
have no interest payments (initially sold at a
discount);
the most liquid financial instruments;
the safest financial instrument (no default risk)
can be issued in different currencies (usually are
issued in local currency)
risk free rateinstruments;
Negotiable Bank Certificate of
Deposits
debt instrument sold by a bank to depositors
(one of the most important capital source for
banks);
pays annual interest;
at maturity pays back the original purchase
price;
Commercial Papers
short term instruments issued by banks or well
known companies;
no interest payments (usually issued at a
discount);
interest rates are related to the issuers risk;
Bankers Acceptances
were developed in accordance with international
trade development
represent banks drafts (a promise of payment similar
to a check) issued by a company for a future date and
guarantee for a fee by the bank
the bank acceptance = the guarantee
these instruments are often resold on secondary
market at a discount
Capital Markets
Financial Instruments
BONDS (Debt Financing)
- A debt instrument where a borrower
(issuer) pays interest and principal, on
specific dates, to the lender (holder) of the
bond.
Eg. Corporate bonds,government bonds,
treasury notes
STOCKS (Equity Financing)
- Corporation can raise capital by issuing
stocks - either common stocks or
preferred stocks.
- Common stockholders are owners of the
company and have a voting right.
- Preferred stockholders - have priority
over dividends.
Capital Markets
Financial Instruments
Capital Markets
Financial Instruments
Organization of the Securities
Market
Primary market: market for trading newly
issued securities. The financial market in
which new issues of a security are sold to
initial buyers.
Secondary markets: markets where
securities are bought and sold subsequent
to original issuance. The financial markets
in which security (previously issued) can be
resold by the investors for cash.
Primary Capital Markets
Government Bonds
Sold regularly through auctions
Treasury bills: one year maturity or less
Treasury notes: maturities of two to ten
years
Treasury bonds: original maturities of
more than ten years
Primary Capital Markets
Corporate Bonds
Negotiated arrangement with an
investment banking firm who maintains a
relationship with the issuing firm;
Underwriting firm often organizes a
syndicate for distribution;
Primary Capital Markets
Common Stock
New issues are divided into two groups:
Seasoned new issues
New shares offered by firms that already have
stock outstanding
Initial public offerings (IPOs)
Firms selling their stock to the public for the
first time
Secondary Markets
Involves the trading of
issues that are
already outstanding
Provide a means
obtaining cash for
sellers
Provide buyers with
more investment
choices
Why Secondary Markets Are
Important?
Provide liquidity to investors who acquire
securities in the primary market;
Helps issuers raise needed funds in the
primary market since investors want liquidity
Help determine market pricing for new
issues;
Secondary Market Trading
Systems
Pure auction market
Buyers bidand sellers ask
Buy and sell orders are matched at a central location
Price driven market: trades are made by determining
the highest bid and the lowest ask
Dealer market
Dealers buy shares (at the bid price) and sell shares
(at the ask price) from their own inventory
Dealers compete against each other
Call Versus Continuous Markets
Call markets trade individual stocks at
specified times to gather all orders and
determine a single price to satisfy the most
orders;
Used for opening prices on BSE if orders
build up overnight or after trading is
suspended;
Continuous markets trade any time the
market is open;
National Stock Exchanges
Large number of listed securities
Listing often seen as a sign of prestige
Wide geographic dispersion of listed firms
Diverse clientele of buyers and sellers
Firms wanting to list must meet listing
requirements
Five common mistakes of
beginning investors
No clear compensation of return and risk;
Using a friend or relative as an investment
adviser;
Trading too frequently;
Not enough diversification;
No clearly formulated investment goals.
No clear compensation of return
and risk
How much return can I expect?
Over what period of time?
Subject to what risk?
You have to know the answers to these
questions before you make an investment!
Using a friend or relative as an
investment adviser
Select your broker or other advisor with
the same care you exercise in finding a
physician or an attorney.
Trading too frequently
Sell the losers and buy the winners
strategy is wrong! Over the log run, this
investment approach enriches the broker
and impoverishes you!
As a rule of thumb, allow about 2% for
commissions on the value of securities
purchased and sold.
Not enough diversification
Much investment risk can be eliminated
without sacrificing return through proper
diversification.
Yet surveys tell us that most investors hold
fewer than five securities, with many
holding only one or two.
To be adequately protected you need a
well-diversified portfolio, balanced across
a wide array of different investments.
No clearly formulated investment goals
If you know why you are investing, you will
know better how to invest!
I want to get rich by investing! Is a elusive
goal!
Your goals have to be SMART! (Specific;
Measurable; Achievable; Realistic; Timely)
Get 20% return on my investment by the end of
the year!
Opening an account and making
transactions
Cash account: account that requires payment within
five working days for securities purchased;
Margin account: allows an investor to borrow from his
broker, pledging securities as collateral;
Discretionary account: gives a broker power of
attorney to trade securities on an investors behalf
Wrap account: involves the services of a professional
money manager with an investors broker.
Margin account
Initial margin requirement
Maintenance margin requirement
when this figure is touched, the investor get a
margin call, which means that he must either
deposit additional funds to increase his equity or
sell some of his shares.
Margin accounts are risky (the loan increases
the risk and the costs for the investorbut
allows to magnify the amount of money
invested. A greater investment means greater
profitsor losses.)
Initiating a Position
After an account is opened, the investor can
begin trading!
When he buy securities, he take a long position
When he sell securities that he do not already
own, he take a short position
When he sell securities he originally bought or
buy securities he originally sold, he is reversing a
position
Initiating a Position
When youll initiate a long position?
When you forecast an increase in securities
price!
When youll initiate a short position?
When you believe that the securities price will
decrease!
Initiating a Position
Suppose you think IBM is overvalued at
150$ a share and its likely to decrease in
future!
What youll do?
Short sell of IBM stocks hoping to reverse
your position in the future after the price
has fallen!
Major Types of Orders
Market orders
Buy or sell at the best current price
Limit orders
Order specifies the buy or sell price
Time specifications for order may vary
Instantaneous - fill or kill, part of a day, a full day,
several days, a week, a month, or good until
canceled (GTC)
Major Types of Orders
Special Orders
Stop loss
Conditional order to sell stock if it drops to a given
price
Does not guarantee price you will get upon sale
Stop buy order
Investor who sold short may want to limit loss if
stock increases in price
Major Types of Orders
Short sales
Sell overpriced stock that you dont own and
purchase it back later (at a lower price)
Borrow the stock from another investor
(through your broker)
Margin requirements apply
Major Types of Orders
Buying on Margin:
On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the
stock as collateral
Interest rate is based on the call money rate
from a bank
Regulations limit proportion borrowed and the
investors equity percentage (margin)
Margin requirements are from 50% up
Changes in price affect investors equity
Major Types of Orders
Margin Order Details
Initial margin requirement at least 50%
Lower margin requirements allow you to buy more
Maintenance margin
Required proportion of equity to stock value
Protects broker if stock price declines
Minimum requirement is at least 25%
Margin call on undermargined account to meet
margin requirement
If call not met, stock will be sold to pay off the loan
Major Types of Orders
Margin Example:
Buy 100 shares at $60 = $6,000 position
Borrow 50%, investment of $3,000
If price increases to $70, position
Value is $7,000
Less - $3,000 borrowed
Leaves $4,000 equity for a
$4,000/$7,000 = 57% equity position
Major Types of Orders
Margin Example:
Buy 100 shares at $60 = $6,000 position
Borrow 50%, investment of $3,000
If price decreases to $50, position
Value is $5,000
Less - $3,000 borrowed
Leaves $2,000 equity for a
$2,000/$5,000 = 40% equity position
QUIZ
Because corporations do not actually raise
any funds in secondary markets, they are
less important to the economy than
primary markets!
Comment this statement!
QUIZ
If you suspect that a company will go
bankrupt next year, which you rather hold,
bonds or equity issued by the company?
Why?
QUIZ
An investor deposit 2000 $ and borrows
2000$ to purchase 4000$ of securities. He
owns 100 shares of KLM at 40 $ a share.
KLMs price falls. Which is the price from
where the broker requires additional margin to
restore the initial margin requirement?
What price increase of KLM stocks the
investor need in order to get an annual return
of 20% (the interest rate of the broker loan is
10%)?
Thank you for your attention!