Chapter 1
Introduction to
Finance
“Remember that time is money.”
-Benjamin Franklin, “Advice to a Young
Tradesman,” Poor Richards Almanac, 1738
Chapter 1 Outline
1.1 What is Finance
• The three
primary areas of
finance
• The financial
system &the role
of financial
intermediaries
1.2 Financial Instruments
and Markets
1.3 The Global Financial
Crisis
• Securities
• Types of debt
• Financial markets
• Regulation
• The global
financial
community
• The financial
crisis 2007-2008
• The future of
regulation
1.1 What is Finance?

Finance is the allocation of funds between those with
more funds than they need and those who need the
funds.


More specifically, finance deals with the “how” and “under
what terms” of this allocation.
You may recognize in this definition a similarity
between finance and economics.


Economics deals with the allocation of scarce resources in an
economy, whereas finance focuses on how resources are
allocated and by what channels, as well as the terms of the
allocation.
In many ways, we can view finance as applied economics.
The Three Primary Areas of Finance
Our focus in this book is business
finance, which includes the following:
 Financial statement analysis
 The time value of money
and other
valuation financial mathematics
 Portfolio theory and asset pricing
The Financial System & the Role of
Financial Intermediaries
The Financial System
The Financial System & the Role of
Financial Intermediaries
 The financial
system of any country provides
an environment in which households provide
funds to businesses and government.
 A financial intermediary transforms the
nature of the securities they issue and invest
in.
 A market intermediary simply makes the
markets work better.
1.2 Financial Instruments and
Markets
A financial instrument is any legal agreement
that represents an ownership interest, a debt
obligation, or other claim on assets or income.
What is a Security?
 A security is a negotiable financial instrument
that is evidence of indebtedness or
ownership. Securities include the following:



Debt obligations, such as a bond or a note with a
fixed term for repayment and interest to
compensate the lender for the use of the funds
Equity interests, such as common stock, which
represent the ownership interest that the provider
of funds has in the user of funds
Hybrid securities, such as convertible bonds, that
have characteristics of both equity and debt
Types of Debt
 Short
term debt
 Bank loan- a loan
made by a financial
institution
 Commercial paper- a loan issued by a business
or governmental entity
 Bankers’ acceptance- a credit instrument that is
issued by a business and guaranteed by a bank
 U.S. Treasury bill- a short-term indebtedness of
the U.S. government
Types of Debt
 Long-term
debt
 Mortgage loan- a loan that is backed by specific
collateral, such as a home in the case of a home
mortgage
 Municipal bond- an indebtedness issued by a
state or local government
 Corporate bond- an indebtedness issued by a
corporation
Additional Financial Terms
 Bond-
a debt instrument that takes the form of a
security that investors can buy and sell. The owner
of the bond is the creditor of the bond issuer.
 Note- similar to a bond, but with a maturity in the
range of one to ten years. In common usage,
however, the term “bond” is often used
interchangeably with the term “note.”
 Collateral- the borrower’s pledge of specific
property, which may be a building, aircraft, or any
other identifiable, tangible asset.
 Debenture- debt not secured; backed by the “full
faith and credit” of the issuer.
Additional Financial Terms
 Types



of municipal bonds:
General obligation bond- backed by the full faith
and credit of the issuer, much like U.S. Treasury
bonds.
Revenue bond- backed by a specific revenue stream
of the issuing entity, such as the payments for
electricity by customers of a city-owned electric
utility.
Assessment bond- backed by the property taxes
that are assessed by the local government. An
advantage of investing in municipal debt is that the
interest earned on this investment is exempt from
federal income tax and, depending on the state,
may be exempt from state income tax.
Additional Financial Terms
 Equity
instrument or equity security- represents
an ownership stake in a company


Common stock- the most common form of equity
 Represents the residual ownership of a corporation;
the common stock owners are last in line, in terms of
seniority of claims on the company, but they also reap
the benefits from the company’s earnings and
appreciation in value.
 Common stock owners generally also have voting
rights, with the ability to elect members of the
company’s Board of Directors.
Preferred stock- usually entitles the owner to fixed
dividend payments that must be made before any
dividends are paid to common shareholders.
Additional Financial Terms
 Money market security-
a short-term (i.e.,
maturity of less than one year) security; examples
include debt instruments such as T-bills,
commercial paper, and bankers’ acceptances.
 Capital market security- a security with a maturity
greater than one year; includes notes, bonds, and
debentures, as well as equity securities, which
represent ownership in a company and generally
have no maturity date.
Financial Markets


In a primary financial market, issuers issue new
securities in return for cash from investors. In the case of a
debt obligation, the issuer is the borrower and the investor
is the lender.
When a company goes public, selling equity interests to
investors for the first time, we refer to the offering as an
initial public offering (IPO).
Value of IPO
$80
$60
$40
$20
Initial public offerings by U.S. corporations, 1990-2012
Source of data: SIFMA.org
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
$0
Financial Markets
Municipal
Corporate debt
US Treasury
Securities
Mortgage related
Asset-Backed
$8,000
Issuance in billions
$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
Debt and equity issuance by Corporations, 1990-2012
Source of data: sifma.org
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
$0
Summary of Financial Markets
Primary
market
• Initial
public
offerings
• EX:
Facebook
in May
2012
Secondary
market
• Trading
among
investors
• EX: NYSE
Euronext
Third market
• Over the
counter
• EX:
Nasdaq
trading of
NYSE-listed
stocks
Fourth
market
• Institution
to
institution
trading
• EX: Instinet
• EX: Dark
pools, such
as GS’s
Sigma X
Financial Markets
 A secondary financial market provides
trading
environments that permit investors to buy and sell
existing securities.



Exchange markets- referred to as auction markets because they
involve a bidding process that takes place in a specific location
(i.e., similar to an auction).
Dealer market or over-the-counter (OTC) markets- do not have a
physical location, but rather consist of a network of dealers who
trade directly with one another.
The distinction between these two types of secondary markets
has become blurred in recent years because trading on most of
the major exchanges in the world has become fully computerized,
making the physical location of the exchanges of little
consequence.
Financial Markets
 The third market refers to the trading of securities
that are listed on organized exchanges in the OTC
market.

Historically, this market has been particularly important
for “block trades,” which are extremely large transactions
involving at least 10,000 shares or $100,000.
 The fourth market refers to trades that are made
directly between investors (usually large
institutions), without the involvement of brokers
or dealers.

The fourth market operates through the use of privately
owned automated systems, with one of the most widely
recognized systems being Instinet.
Equity Securities
 Common shares represent the major financial
security issued by corporations and comprise
a proportionate ownership in a company.
Common shares are generally issued once and
then stay outstanding indefinitely.
 We often compare stocks by referring to their
market capitalization. A company’s market
capitalization is the product of the market
price of a share and the number of shares
outstanding.
Market Capitalization Examples
Market Capitalization
(Aug. 19, 2013)
Company
Ticker
General Electric
GE
$242.4 billion
Procter & Gamble Co. PG
$218.0 billion
Google
GOOG
$289.4 billion
Facebook
FB
$92.2 billion
Yahoo!
YHOO
$27.7 billion
Regulation

Most economies operate with a central bank that
oversees financial institutions and the economy’s
money supply. In the U.S., the central bank is the
Federal Reserve System.
 The Federal Reserve System (the Fed) has been
given the power, among other things, to do the
following:
 Establish margin requirements, which affect the
extent that stock is purchased with borrowed
funds
 Require disclosures regarding consumer lending
 Assess reserve requirements of member banks
and non-depository institutions
Regulation
 The Securities
and Exchange Commission
(SEC) bears the responsibility of ensuring
that financial markets are fair, orderly, and
efficient.
 The SEC is tasked with encouraging capital
flows from investors to businesses, but also
with protecting investors.
Highlights of Selected U.S. Securities Laws
Law
Purpose
Securities Act
of 1933
Requires disclosure of specific information about securities
offered to the public, and prohibits misrepresentations and
fraud in the sale of securities.
Securities
Exchange Act
of 1934
Created the Securities and Exchange Commission, giving the
SEC the power and responsibility to regulate and oversee
brokerage firms, agents, and self-regulatory organizations.
Requires periodic reporting by companies with publicly
traded securities.
Trust
Indenture Act
of 1939
Regulates the provisions of indentures for bonds, debentures,
and notes sold to the public.
Investment
Company Act
of 1940
Regulates investment companies, such as mutual funds.
Highlights of Selected U.S. Securities Laws
Investment
Advisers Act of
1940
Regulates investment advisers, and specifies who must
register with the SEC.
Sarbanes-Oxley
Act of 2002
Increases disclosure requirements of publicly traded
companies, creates oversight boards for independent public
accountants, requires specific corporate governance
provisions, and holds the chief executive officer and the
chief financial officer accountable for a public company’s
disclosures.
Dodd-Frank Wall Increases oversight responsibility and regulation of hedge
Street Reform
funds, credit-rating agencies, and brokers and dealers,
and Consumer
among other things.
Protection Act
of 2010
26
1.3 The Global Financial Crisis
The financial crisis of 2007–2008 was a
significant event that affected businesses
and economies around the world. To
understand the crisis, it is important to first
appreciate the linkages that exist among the
global economies.
The Global Financial Community
U.S. Investors’ international investments, Second quarter 2010 and 2011
2nd Q 2010
2nd Q 2011
-$175.2
-$343.8
Foreign owned assets in the US
188.5
486.5
Net position
$13.3
$142.6
Net derivatives
$10.0
$3.2
In billions
US owned assets abroad
Equity or Stock Markets
The United States possesses the largest equity
markets in the world.
 The NYSE Euronext is the world’s largest stock
market with a market capitalization at the end of
January 2011 of $15.1 trillion.
 The NASDAQ is the second-largest stock market in
the world, based on its market capitalization of
$3.6 trillion.
The Financial Crisis 2007-2008
 There
is no single cause of the crisis, but rather many
that occurred to create the perfect storm.
 One of the most visible causes of the crisis was the
housing bubble.
 Other causes included:




Lax lending standards
A push for the government-sponsored entities (GSEs) of Freddie
Mac and Fannie Mae to purchase lower quality loans for resale as
securities
The insatiable appetite of investors for high-return, high-risk
securities that were backed by mortgages
Rampant fraud in mortgage origination
Securitization


Securitization is the process of converting loans into securities.
Example: creating a mortgage-backed security:
The dealer pools
mortgages together
and sells investments
that represent claims
on cash flows from
the mortgages
Mortgage originator
lends the money for
the purchase of a
home
Mortgage
backed
security
The mortgage
originator sells the
mortgage to a
dealer
The Future of Regulation
 The
regulatory structure in the U.S. financial
system is undergoing changes to address the
problems that created significant systemic risk.
 The Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010:




Created the Financial Stability Oversight Council, which
provides a formal system of coordination among key
regulators
Created criteria and standards for systemically important
financial companies
Provides for the orderly liquidation of financial
companies that are insolvent
Limits proprietary trading (Volcker Rule)
Lessons for Financial Managers

Financial risk management is important.




Financial managers need to identify, assess, and manage risks;
companies must develop an assessment of how much risk they are
willing to take (that is, their risk appetite), and
risk management must be an essential part of a company’s strategy.
Companies that rely on securitizing their assets should
be prepared for the associated risks.


Securitization of assets is performed by many companies, not just
banks and, for example, has been a source of cash flow for companies
that sell their receivables through these transactions.
For instance, Harley-Davidson Financial Services securitized the loans
made on the purchases of Harley-Davidson motorcycles; when the
securitization market dried up and the company could no longer
securitize the loans, it could not turn the loans into cash, but rather
had to retain and maintain them.
Lessons for Financial Managers

Reliance on bank financing for short-term needs is
problematic during a credit crunch.


Many companies that relied on lines of credit from banks or issuing
commercial paper to meet seasonal needs found that they could not
get financing during severe times.
 For example, the commercial paper market was disrupted in
September 2008 with Lehman Brothers’ bankruptcy; in December
2008, the outstanding commercial paper was half of what is was
at the end of 2007.
Executive compensation should be tied to some
measure of risk, not just earnings.

Many financial institutions tied compensation to earnings, without
regard to the risk associated with the expansion of the entity into
other, riskier lines of business. The focus on earnings may have
inadvertently encouraged excessive risk taking.
Summary
 Finance
as a subject area is the study of
the flow of funds from those with funds to
those who need funds.
 Financial decision making encompasses
investment and financing decisions, which
may be short-term or long-term decisions.
Summary
 A business may borrow
funds, either through
borrowing or selling equity interests in the
business.


Borrowing includes loans from banks, issuing
commercial paper, or issuing notes or bonds.
Borrowing requires repayment of the debt, as well
as interest on the debt.
 A company may sell ownership stakes in the
company, which are represented by shares of
stock.

These shares may be common stock or preferred.
Summary
 The financial
system is global, with parties
crossing borders to raise and invest funds.

No better example of the globalization of the
financial system is available than the 2007–
2008 financial crisis, where linkages among the
markets were evident as the U.S. economy
faltered, along with economies around the
world.