The Flow of Capital

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Markets

Financing Decision

Source of Funds (Capital)

Capital Structure

2-2

The Flow of Capital:

Closely Held Corporations

2-3

The Flow of Capital:

Public Corporations

2-4

The Flow of Capital:

Public Corporations

Financial Market:

Market where securities are issued and traded.

Primary Market:

Market for the sale of new securities by corporations.

Secondary Market:

Market in which previously issued securities are traded among investors.

2-5

Financial Markets

Initial Public Offering (IPO):

First offering of stock to the general public.

Fixed-Income Market:

Market for debt securities

2-6

Financial Markets:

Markets for Debt

Capital Markets are used for long-term financing

Example of long-term debt: Bonds

Money Markets are used for short-term financing.

Example of short-term debt: Commercial Paper

2-7

Information Provided by

Financial Markets:

Commodity Prices

Interest Rates

Company Value

Cost of Capital

2-8

Financial Intermediaries

Mutual Fund

An investment company that pools the savings of many investors and invests in a portfolio of securities

• Hedge Fund

A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds

• Pension Fund

• Fund set up by an employer to provide for employees’ retirement

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Flow of Cash Example:

Mutual Fund

$ $

Bank of

America

Explorer

Fund

Investors

Sells shares

Issues shares

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A Closer Look:

Financial Institutions

Commercial Bank

Investment Bank

Insurance Company

2-11

Companies and Intermediaries

Company

Obligations

Funds

Intermediaries

Banks

Insurance Companies

Brokerage Firms

2-12

Intermediaries and Investors

Intermediaries

Obligations

Funds

Investors

Depositors

Policyholders

Investors

2-13

Cash Flow Example:

Banks

Company

Loan $2.5 mil

Banks Intermediary

Deposits

Cash

Investor

Depositors

2-14

Cash Flow Example:

Insurance Company

Company

Issue Debt $2.5 mil

Insurance

Company

Intermediary

Sell Policies

Cash

Investor

Policyholders

2-15

Function of Financial Markets and Intermediaries

Transport cash across time

Risk transfer and diversification

Liquidity

2-16

Function of Financial Markets and Intermediaries

Payment mechanism

Provide information

2-17

Financial Crisis 2007-2009:

Federal Reserve

Easy-Money

Policy

Credit Rating

Agencies gave many

AAA ratings to MBS that shortly went into default

Causes

The U.S.

Government encouraged expansion of credit to low-income housing

Bankers aggressively promoted subprime mortgages

Homebuyers overextended

A Perfect Storm:

Falling Housing Prices

Bankruptcy

Credit Freeze

International Effect

2-18

Financial Crisis 2007-2009:

The Response

Government Bailouts

Government Bailout

(or arranged acquisition)

Bear Stearns (JP Morgan Chase)

Fannie Mae

Freddie Mac

Merrill Lynch (Bank of America)

No Government Bailout

Lehman Brothers

AIG

Did this response effectively decrease the uncertainty in the market?

Government Response: TARP

What was the rationale behind TARP?

2-19

Appendix A:

Total U.S. Equity Financing

Holdings of Corporate Equities, 3 rd Quarter 2010

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Appendix B:

Total U.S. Debt Financing

Holdings of Corporate & Foreign Bonds, 3 rd Quarter 2010

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