Corporate Finance

CHAPTER TWO

J.D. Han

Learning ObjectivesLearning Objectives

1. What kind of choices is a corporate financial manager faced with in funding a project?

2. What financial market instruments would he/she choose? What are the advantages and disadvantages of different funding sources?

4.What kind of institutional structures is the financial manager faced with? - Why does each country exhibit different characteristics in financial market?

2.1 How to Fund a Corporate Project?2.1 How to Fund a Corporate Project?

1) Where does the fund for a corporate project come from? internal financing vs

external financing

2) How to do external financing?direct financing vs. indirect financing through Financial intermediaries

3) What kinds of financial instruments to issue?bonds; loans; and/or equities (stocks)

2.2 Financial Instruments or Assets:2.2 Financial Instruments or Assets:

2 classifications of financial assets(instruments):1. Debt versus EquityDebt: Bank Loans and Bonds- Contractual claimsEquity: Residual claims2. Loans versus Marketable Securities2. Loans versus Marketable SecuritiesLoans: personalizedMarketable Securities: Bonds, Equities, Derivatives (options, swaps, futures, and forwards)- arm’s length deals through securities exchanges

**Sources of External Corporate Financing in U. S.: Choice of Sources of External Corporate Financing in U. S.: Choice of Capital StructureCapital Structure

Two puzzling findingsTwo puzzling findings1) “Equities are not a major instruments for corporate financing.”1) “Equities are not a major instruments for corporate financing.”2) “Marketable Securities are not so important as bank loans.”2) “Marketable Securities are not so important as bank loans.”

equities2%

bonds32%

loans66%

** It is due to both (lack of) supply and demand:

- (Fund) Supply Side Limitation: financial investors are concerned about “Information Asymmetry”, “Moral Hazard”, “Principal-Agent Problem”, and “Adverse Selection”

- (Fund) Demand Side Limitation: firms may prefer bonds to equities under the current hostile M & A environment and tax laws.

*** In the Canadian corporate financing, equities are somewhat more important than in the U.S. coroporate financing.

2.3 Financial Intermediaries2.3 Financial Intermediaries

The “four pillars” of Canada’s financial system include:

1. Chartered banks – for Self liquidating short-term investment in principle

2. Trust companies

3. Insurance companies and Pension Funds

4. Investment dealers –for Long term/large scale investment

** ** Investment Dealers: the Big HandsInvestment Dealers: the Big Hands

Securities Firms /Houses Banks’ M & A Division of Investment Banking

Department For instance- Morgan Stanley Dean Witter- Goldman Sachs- Salomon Smith Barney- Merrill Lynch- Donald Trump; Drexel Burnham, Campeu Co., T. Boone

Pickens (Mesa Petrolium)- Dominion Securities; Mellon; McLeod; Waterhouse.

**Structure of Securities FirmStructure of Securities Firm

M erg ers an d A q u is it ion s

B ou g h t D ea lU n d erw rit in g

M arke ted D ea l

In it ia l P u b lic O ffe rin g P riva te Is su e

In ves tm en t B an k in g secu rit ies d ea lin g an d b rockerag e

S ecu rit ies F irm

*Important Concepts in *Important Concepts in Investment BankingInvestment Banking

Issuing Securities: IPO versus Seasoned Issuing

Underwriting: advice, issue, risk-sharing, and stabilization.

Bought Deal vs Best Efforts Private Placement

Financial MarketFinancial Market

Definition: An organized institutional structure or mechanism for creating and exchanging financial assets.

Financial Assets/(Liabilities)

=Financial Instruments

= Loans + Bonds + Equities

= Loans + Marketable Securities

= Debts + Equities

Market includes

Stock Exchange and OTC, and Loan Market

2.4 Kinds of Financial Markets2.4 Kinds of Financial Markets

1) Primary vs. Secondary Market by Newness:- Primary Market: new securities are issued, and it

is Corporate financing source

- Secondary Market(Aftermarkets): existing securities are traded or exchanged

2) 2) short-termshort-term Money Market vs. Money Market vs. long-termlong-term Capital Market Capital Market

by term periods of financial instruments

* Money Market* Money Market

Short-term financial assets –Highly Liquid Operates as a dealer or over-the-counter market

(OTC) Sold in denominations > $100,000 Most recognized money market instrument are T-

bills Other money market instruments include

commercial paper, Banker Acceptances, and eurodollars

* Capital Market 1: Bond Market* Capital Market 1: Bond Market

Intermediate and long term horizon finanical assets Bond markets: -represent the most important markets for

intermediate and long-term debt - operates as OTC market - Government bonds are most important items- Coporate bonds accounts for 20% only

- Asset-backed Securities (ABS):- - example Mortgage-backed securities (MBS)- - Securitization

* Capital Market II : * Capital Market II : Equity/stock MarketEquity/stock Market

Common stocks, preferred stock and warrants trade in equity markets

Equity securities trade on stock exchangesStock exchanges operate as:- Auction markets is called Stock Exchanges (TSE,

CDNX, ME; and NYSE)

or- Over-the-counter is a sales network (NASDAQ).

*Canadian Stock Markets Before 1999, there were 5 stock exchanges: TSE,

ME, VSE. WSE, and ASE

After March 1999, there are only TSE, ME, and Canadian Venture Exchange(CDNX)

** Global Equity Market

*** Emerging Equity Market in newly developing economies

3) Domestic vs. 3) Domestic vs. Global Financial MarketsGlobal Financial Markets

Investment banks act as global coordinators through underwriting syndicates; it has

FOREX market International Money Market eg )Eurocurrency Market

(definition of Eurocurency Market ) a market for deposits and loans denomitated in a currency other than that of the country in which the bank is located

International Capital Markets; International Bond Market and International Equity Market ; Emerging Markets

4) Derivatives Markets4) Derivatives Markets

Derivative securities - derive the value from underlying assets such as common shares or bonds

Options - a contract that grants the holder the right to buy or sell a security at a given price on or before a given date

Future contracts - agreements to trade assets at a specific price and time in the future

Two types of futures:- Real commodities commodity futures contract- Financial obligations financial future contract

* * Derivative Markets in North AmericaDerivative Markets in North America Options :- -Montreal exchange (ME) - Canada- -Chicago Board Options Exchange (CBOT) – US

Futures: commodities, stocks, and foreign exchanges -Canada’s only commodity futures exchange is the

Winnipeg commodity exchange (WCE) -Major US futures exchanges Chicago Board of Trade

(CBOT)- Chicago Mercantile Exchange (CME)

SummarySummary

1. Efficient financial markets are required to channel funds from surplus-spending units (savers) to deficit-spending units. Typically, such securities entitle the holder to a stream of periodic future cash payments.

2. Financial intermediaries allow economies of scale to be realized when matching surplus-spending units with deficit-spending units. Greater opportunities for portfolio diversification and money management can be gained.