Practical financial manaegment lasher 7th ed chapter 05

Chapter 5 – The Financial System, Corporate Governance, and
Interest


The Financial System
The economy is divided into sectors
– Consumption
– Production (includes government)

Services, products, and money flow between
the sectors every day
– Producers pay wages
– Workers spend incomes
– Producers spend revenues
– Creates a cyclical flow of money
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Figure 5-1 Cash Flows Between Sectors

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Diagram Omits Two Things
Consumption sector
– Most people do not consume all of their income—they
deposit savings and earn a return

Production sector
– Companies need to raise money to finance large,
infrequent projects

Economy has a need for and a source of $

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Savings and Investment
Financial markets channel consumer
savings to companies through the sale of
financial assets
– Companies issue securities
– Consumers purchase securities

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Figure 5- 2 Flows Between Sectors

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The Term “Invest”
Individuals invest by putting savings into
financial assets: stocks, bonds, etc.
This makes funds available for business
investment
Hence: SAVINGS = INVESTMENT
(Consumer) Savings = (Business) Investment

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Raising and Spending Money
in Business
Firms spend two kinds of money
– Day-to-day funds
– Large sums needed for major projects

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Raising and Spending Money
in Business

Firms to raise money by:
Borrowing money: Debt Financing
Selling stock: Equity Financing


Term
The length of time between now and the end (or
termination) of something

– Long-term projects
last over 5-10 years
financed with debt (bonds) and equity (earnings/stocks)

– Short-term projects
last less than 1 year
financed with short-term funds (bank loans)

– Process is known as maturity matching

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Financial Markets
Capital Markets
– Trade in stocks and long-term debt

Money Markets
– Trade in short term debt securities
Federal government issues a great deal of
short-term debt

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Financial Markets:
Primary and Secondary Markets
Primary Market: Initial sale of a security
– Proceeds go to the issuer

Secondary Market: Subsequent sales of
the security
– Between investors
– Company not involved
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Primary and Secondary Markets
Corporations care about a stock’s
price in the secondary market
– Influences how much money can be
raised in future stock issues
– Senior management’s compensation
is usually tied to stock price

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Direct and Indirect Transfers, Financial
Intermediaries
Primary market transactions can occur
Directly

Indirectly

– Issuer sells
directly to buyers
or through an
investment bank

– Financial intermediary sells
shares in itself and invests
the funds collectively on
behalf of investors

– Investment bank
lines up investors

and functions as
a broker

– Mutual fund is an example
– Portfolio is collectively
owned

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Figure 5-3 Transfer of Funds

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Direct and Indirect Transfers, Financial
Intermediaries
Institutional investors play a major role in
today’s financial markets
– Own ¼ of all stocks, make over ¾ of all trades
– Examples include:
Mutual funds
Pension funds
Insurance companies
Banks
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The Stock Market and
Stock Exchanges

Stock market—a network of exchanges
and brokers
Exchange—a marketplace such as NYSE,
AMEX, NASDAQ, & regional exchanges
• Brokerage houses employ licensed brokers
to make securities transactions for investors

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Trading—The Role of Brokers
What brokers do…
– An investor opens an account with a
broker and place trades via phone or
online
– Local broker forwards order to floor
broker on the exchange trading floor
– Trade confirmation is forwarded to local
broker and investor
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Figure 5-4 Schematic Representation of a
Stock Market Transaction

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Exchanges
New York Stock Exchange (NYSE)

NYSE MKT (Previously AMEX)
(NASDAQ)
Regional stock exchanges (Philadelphia,
Chicago, San Francisco, etc.)
Exchanges are linked electronically

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Stock Market and Exchanges
Stock Market refers to the entire interconnected set of
places, organizations and processes involved in trading
stocks
Regulation
– Securities Act of 1933
Required companies to disclose certain information

– Securities Exchange Act of 1934
Set up Securities and Exchange Commission (SEC)

– Securities law is primarily aimed at disclosure

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Private, Public, and Listed Companies,
and the OTCBB Market
Privately Held Companies

Publicly Traded Companies

Can’t sell securities to
the general public

Received approval from
SEC to offer securities to
the general public

– Sale of securities is
strictly regulated

– Process of obtaining
approval and
registration is known
as ‘going public’


Private, Public, and Listed Companies,
and the NASDAQ Market
– Public Companies
Use an investment banking firm to “go public”
Prospectus—provides detailed information
about company
SEC reviews prospectus
– Red Herring - an unapproved, or preliminary,
prospectus

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Private, Public, and Listed Companies,
and the OTC Market
The IPO
– Initial public offering (IPO) is the initial sale
– Investment banks usually line up institutional
buyers prior to the actual securities sale
– IPO occurs in primary market, then trading begins in
the secondary market

– IPOs are discussed in detail in
Chapter 8
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The OTCBB Market
After a company goes public, its shares can
trade in the over-the-counter (OTC) market
Firms not listed on an exchange trade
through the OTCBB overseen by the NASD
Eventually a firm may list on an exchange

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