INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Prepared by

Ken Hartviksen

CHAPTER 1 An Introduction to Finance

Lecture Agenda
Learning Objectives Important Terms Finance Defined Real versus Financial Assets The Financial System Financial Instruments and Markets The Global Financial Community Summary and Conclusions
Concept Review Questions
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Learning Objectives
1. 2. What finance is and what is involved in the study of finance. How financial securities can be used to provide financing for borrowers and simultaneously to provide investment opportunities for lenders. How financial systems work in general. The channels of intermediation and the role played by market and financial intermediaries within this system. The basic types of financial instruments that are available and how they are traded. The importance of the global financial system.

3. 4. 5. 6.

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Key Terms
Bourse de Montral brokers Canadian Trading and Quotation System Inc. (CNQ) capital market securities common share corporate finance Crown corporations dealer or over-the-counter (OTC) markets debt instruments equity instruments exchanges or auction markets finance financial assets financial intermediaries fourth market intermediation investments
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Key Terms
market capitalization market intermediary marketable financial assets money market securities New York Stock Exchange (NYSE) non-marketable financial assets Ontario Securities Commission preferred shares primary markets real assets secondary markets third market Toronto Stock Exchange (TSX) TSX Group Inc. TSX Markets TSX Venture Exchange Winnipeg Commodity Exchange
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What Is Finance?
Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.
Finance is distinct from economics in that it addresses not only how resources are allocated but also under what terms and through what channels

Financial contracts or securities occur whenever funds are transferred from issuer to buyer.

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The Study of Finance

The study of finance requires a basic understanding of:
Securities Corporate law Financial institutions and markets

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Real Versus Financial Assets

Real assets are tangible things owned by persons and businesses
Residential structures and property Major appliances and automobiles Office towers, factories, mines Machinery and equipment

Financial assets are what one individual has lent to another

Consumer credit Loans Mortgages
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Assets and Liabilities of Households, 2005

Table 1-2 Assets and Liabilities of Households, 2005 Assets $ Billion Houses 1,086 Consumer Durables 435 Land 827 Real Assets 2,348 Deposits 683 Debt 114 Pensions and insurance 1,200 Shares 1,254 Foreign and other 72 Financial Assets 3323 Total Assets 5,671 Liabilities $ Billion Consumer credit 260 Loans 131 Mortgages 588 Total Liabilities 979

So urce: Statistics Canada. Natio nal B alance Sheet A cco unts, Quarterly Estimates, Fo urth Quarter 2005. Ottawa: M inister o f Industry, 2006 (Catalo gue No . 1 3-21 4-XIE).

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The Financial System

Overview
The household is the primary provider of funds to businesses and government.
Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in their retirement years

Financial intermediaries transform the nature of the securities they issue and invest in
Banks, trust companies, credit unions, insurance firms, mutual funds

Market intermediaries simply help make markets work

Investment dealers Brokers

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The Financial System

FIGURE 1-2

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The Financial System

Channels of Intermediation

Funds can be channeled from saver to borrower in three ways:

Direct intermediation (direct transfer from saver to borrower a non-market transaction) Direct intermediation (a market-based transaction usually through a market intermediary such as a broker) Indirect claims through a financial intermediary (where the financial intermediary such as a bank offers deposit-taking services and ultimately lends those deposits out as mortgages or loans)
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Channels of Intermediation
FIGURE 1-3

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The Financial System

Financial Intermediaries

Banks and other deposit-taking institutions Insurance companies Pension Funds Mutual Funds

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Financial Intermediaries
Canadian Chartered Banks
Banks take deposits from numerous depositors from across Canada The deposits are pooled in the Bank The bank takes these pooled funds and lends them out to households and businesses in the form of mortgages and loans The bank transforms the original nature of the savers (depositors) money:
Deposits are usually small in amountface little or no risk, and depositors expect to withdraw the amount at any time Loans and mortgages on the other hand usually have the following characteristics:
Large sums Borrowed for long periods of time Borrowed for risky purposes.

Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing the risk) and monitoring the activities of borrowers.

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Financial Intermediaries
Canadian Chartered Banks

Table 1-3 Chartered Banks: Financial Statistics, 2005 Revenue Assets Profits ($ million) ($ million) ($ million) 29,403 469,521 3,387 18,677 18,332 18,665 15,138 5,320 280,370 314,025 365,210 297,532 107,598 -32 3,209 2,229 2,400 855

Bank Royal Bank of Canada Canadian Imperial Bank of Commerce (CIBC) Bank of Nova Scotia TD Canada Trust Bank of Montreal National Bank

So urce: B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31 2006. ,

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Financial Intermediaries
Insurance Companies
Insurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a claim and the size the policy and administrative fees. They invest the premiums so that the accumulated value in the future will grow to meet the anticipated claims of the policyholders. In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a large number of policyholders through the insurance company. Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of loss themselves.
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Financial Intermediaries
Insurance Companies

Table 1-4 Insurance Companies: Financial Statistics, 2005 Revenue Assets Profits ($ million) ($ million) ($ million) 32,187 322,171 3,294 21,871 171,850 1,867 23,883 102,161 1,775 4,446 9,926 782

Insurer Manulife Financial Sun Life Financial Great-West Lifeco ING Canada

So urce: Data fro m B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31 2006. ,

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Financial Intermediaries
Pension Plan Assets
Individuals and employers make payments over the entire working life of a person with those funds invested to grow over time. Ultimately, the accumulated value in the pension can be used by the person in retirement. Pension plans accumulate considerable sums of money, and their managers invest those funds with long-term investment time horizons in diversified portfolios of investments. These investments are a major source of capital, fuelling investment in research and development, capital equipment, resource exploration and ultimately contributing in a substantial way to growth in the economy.
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Financial Intermediaries
Pension Plan Assets

Table 1-5 Pension Plan Assets, 2005 Net Assets ($ billion) 216.1 98.0 96.1 41.6

Pension Plan Managers Caisse de depot et placement du Quebec Canada Pension Plan (CPP) Ontario Teachers (Teachers) Ontario Municipal Employees (OMERS)
* The Caisse manages the investments o f several pensio n plans.

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Financial Intermediaries
Canadian Mutual Fund Assets
Mutual funds give small investors access to diversified, professionally-managed portfolios of securities. Small investors often do not have the funds necessary to invest directly into market-traded stocks and bonds. This is called denomination intermediation because the mutual fund makes investments available in smaller, more affordable amounts of money. Canadian indirect investment in the markets through managed products such as mutual funds and segregated funds has grown exponentially.
(see Figure 1-4 on the next slide)

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Financial Intermediaries
Canadian Mutual Fund Assets
FIGURE 1-4

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The Financial System

The Major Borrowers

Public Debt
Governments
Federal Provincial Municipal Crown Corporations

Private Debt
Households Non-financial Corporations

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The Financial System

Largest Non-financial Companies
Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005 Revenue Assets ($ million) ($ million) 34,991 n/a 27,812 13,761 22,873 12,321 26,936 15,582 20,408 26,638 19,150 40,630 14,882 17,483 17,673 20,655 17,626 14,845 14,322 34,148

Non-financial Companies General Motors of Canada Ltd. Loblaw Companies Ltd. Magna International Inc. Imperial Oil Ltd. Alcan Inc.* BCE Inc. Bombardier Inc.* Petro-Canada Onex Corp. EnCana Corp.*
*Co mpany repo rts in U.S. do llars.

So urce: Data fro m "The To p 1 000 in 2005." Glo be and M ail Repo rt o n B usiness website: www.theglo beandmail.co m.

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Financial Instruments
There are two major categories of financial securities:
1. Debt Instruments
Commercial paper Bankers acceptances Treasury bills Mortgage loans Bonds Debentures

2. Equity Instruments
Common stock Preferred stock

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Financial Instruments
Non-marketable

Characteristics of non-marketable securities

Cannot be traded between or among investors May be redeemable (a reverse transaction between the borrower and the lender) Examples:
Savings accounts Term Deposits Guaranteed Investment Certificates Canada Savings Bonds

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Financial Instruments
Marketable
Characteristics of Marketable securities
Can be traded between or among investors after their original issue in public markets and before they mature or expire

Market Capitalization
Is an important term in finance It is the total market value of a company It is found by multiplying the number of shares outstanding by the market price per share.

Market Capitaliza tion Number of shares Price per share

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Financial Instruments
Marketable
Markets can be categorized by the time to maturity:
Money Market Securities (for short-term debt securities that are pure discount notes) Bankers acceptances Commercial Paper Treasury Bills

Capital Market Securities (for long-term debt or equity securities with maturities greater than 1 year)
Bonds Debentures Common Stock Preferred Stock

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Financial Markets
Primary Market
Markets that involve the issue of new securities by the borrower in return for cash from investors (Capital formation occurs)

Secondary Market
Markets that involve buyers and sellers of existing securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital formation occurs)

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Financial Markets
Types of Secondary Markets

Exchanges or Auction Markets

Secondary markets that involve a bidding process that takes place in specific location For example TSX, NYSE

Dealer or Over-the-counter (OTC) Markets

Secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another. For example the bond market

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Financial Markets
Other Markets

Third Market
Trading of securities that are listed on organized exchanges in the Over-the-counter market

Fourth Market
Trading of securities directly between investors (usually between two large institutions) without the involvement of brokers or dealers. Operates through the use of privately owned automated systems such as Instinet

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The Global Financial Community

Represents an important source of funds for borrowers Provides investors with important alternatives as they seek to build wealth through diversified portfolios

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The Global Financial Community

Table 1-7 Canada's International Investments, 2005 ($ million) 1,016,031 465,058 284,604

Total Assets Canadian direct investments abroad Canadian portfolio investments Portfolio foreign bonds 82,374 Portfolio foreign stocks 189,175 Other portfolio investments 13,055 Other Canadian investments Loans 48,325 Allowances Deposits 120,694 Official international reserves 38,030 Other assets 59,319 Total Liabilities Foreign direct investments in Canada Foreign portfolio investments Portfolio Canadian bonds 380,017 Portfolio Canadian stocks 107,598 Portfolio Canadian money market instruments 20,783 Other foreign investments Loans 36,107 Deposits 201,639 Other liabilities 22,829 Canada's Net International Investment Position
So urce: Statistics Canada.

266,369

1,184,534 415,561 508,398

260,575

-168,503

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Summary
In this chapter you have learned about:
Financial systems in general, and the Canadian financial system in particular Major participants in the Canadian financial system, including the different types of financial securities and financial markets

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Internet Links
BMO InvestorLine: www.bmoinvestorline.com Investment Funds Institute of Canada: www.ific.ca Globe and Mail Report on Business: www.theglobeandmail.com Toronto Stock Exchange (TSX): http://www.tsx.com/ Canadian Trading and Quotation System Inc.: http://www.cnq.ca/ Ontario Securities Commission: http://www.osc.gov.on.ca/index.jsp Winnipeg Commodity Exchange: http://www.wce.ca/ New York Stock Exchange (NYSE) Euronext: http://www.nyse.com/

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Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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