Managerial Finance: Financial Environment

• Chapter 2 discusses the financial market environment

Practice 1: XYZ Co. Example

• XYZ Co. imported $2.5 million worth of carpets and resold them for $3 million.
• XYZ Co. collected 85% of its outstanding accounts receivable.
• The accounting profit is $500,000 ($3,000,000 sales - $2,500,000 costs)
• From an accounting perceptive the year was successful
• XYZ Co.'s cash inflow was $2,550,000
• XYZ Co.'s cash outflow was $2,500,000.
• The net cash flow is $50,000.
• From a financial perspective the year was not successful

IT System Upgrade Decision

• A decision needs to be made about whether to upgrade the current IT system.
• The upgrade requires an initial cash outlay of $300,000.
• The current system could be sold for $125,000.
• The new system's monetary benefit over five years is $625,000.
• The current system's monetary benefit over the same period is $510,000.

Learning Goals

• Understand the role of financial institutions in managerial finance.
• Contrast the functions of financial institutions and financial markets.
• Describe the differences between capital and money markets.

Financial Institutions & Markets

• Firms can obtain funds from external sources in three ways.
• Financial Institutions accept savings and transfer them to those that need funds
• Financial Markets provide organized forums for suppliers and demanders to make transactions.
• Private Placement is where a new security is sold directly to an investor or group of investors.

Financial Institutions

• They channel savings into investments.
• Key suppliers and demanders of funds are individuals, businesses, and the government
• In general, individuals are net suppliers of funds.
• In general, businesses and governments are net demanders of funds.

Major Financial Institutions in Egypt:

• Commercial Banks
• Insurance companies
• Mutual funds
• Securities Brokerage
• Investment Banks
• Finance company
• Payment processors

Commercial Banks

• Institutions that provide savers a secure place to invest their funds.
• They offer loans to both individual consumers and business borrowers

Investment Banks

• Institutions that assist companies in raising capital
• They Advise firms on major transactions like mergers
• Investment Banks engage in trading and market making activities

Shadow Banking System

• A group of institutions that engage in lending activities, similar to traditional banks.
• Key difference, they don't accept deposits.
• These institutions are not subject to the same regulations as traditional banks.

Financial Markets

• Forums where suppliers and demanders of funds can transact directly.

Primary Market

• Securities are initially issued.
• The issuer is directly involved in the transaction.

Secondary Markets

• Financial markets where preowned or not new securities are traded.

Private Placements

• A new security is sold directly to an investor or group of investors.

Public Offering

• Raising money through the sale of either bonds or stocks to the general public.

Money Market

• Transactions in short-term marketable securities take place here.

Capital Market

• Transactions in long-term securities take place here.

Money Market Details

• Created by the relationship between suppliers and demanders of short-term finds
• Transactions are made via marketable securities, eg treasury bills, commercial paper, negotiable certificates of deposit
• These are considered low-risk investments.

Eurocurrency Market

• The international equivalent of the domestic money market.
• Short-term bank deposits are denominated in U.S. dollars or other major currencies.
• Eurocurrency deposits arise when a bank deposit in a currency other than the local currency of the country where the bank is located.

Capital Market Details

• Enables suppliers and demanders of long-term funds to make transactions.
• The key securities: bonds (long-term debt) and both common and preferred stock (equity, or ownership).

Bonds

• Long-term debt instruments.
• Used by businesses and governments to raise large sums of money.

Common Stock

• Represent units of ownership interest or equity in a corporation.

Preferred Stock

• A special form of ownership with features of both a bond and common stock.
• Holders are promised a fixed periodic dividend, paid before common stockholders.

XYZ Industries Bond Example

• XYZ Industries issued a 9% coupon interest rate, 20-year bond with a $1,000 par value, paying interest semiannually.
• Investors receive $90 annually, distributed as $45 every six months for 20 years.
• Investors are also entitled to the $1,000 par value at the end of year 20.

XYZ Industries Preferred Stock Example

• XYZ issues a 9% preferred stock with a $100 par value.
• Investors have a contractual right to a $9 annual dividend.

Broker Markets

• Securities exchanges where buyers and sellers are brought together to trade securities.
• Trading occurs on centralized trading floors, such as the Egyptian Exchange.

Dealer Markets

• Markets, such as Nasdaq, where buyers and sellers are not directly brought together.
• Securities dealers execute orders and "make markets" in a security.
• The dealer market has no centralized trading floors.
• A large number of market makers are linked via a mass-telecommunications network.
• Market makers earn money on the spread of executing orders (bid-ask price difference)

Facebook Stock Order Example

• Mark instructs his broker to buy 100 shares of Facebook common stock with a market order.
• The ask price is $168.79, and the bid price is $168.71.
• To buy, Mark will pay $168.79 plus broker commissions.
• To sell owned stock, Mark would sell for $168.71 less commissions.

Merck & Co. Stock Example

• The current bid price is $83.55, and the ask price is $83.99, with a $25 commission.
• The bid/ask spread is $0.44 ($83.99 - $83.55).

Merck & Co.Stock Transaction Costs

• Total costs equal the Brokerage Commission, which is $25.

Merck Transaction Costs in a Dealer Market

• Total Transaction Costs = (Number of shares × ½ × Bid / Ask Spread) + Brokerage Commission
• Calculated to be $47

NYSE Stock Exchange

• The World Federation of Exchanges stated that in 2020 the world had 77 exchanges with a combined total market value of $88 Trillion
• The NYSE has listed securities of more than $24 Trillion
• Making up 27% of total market values globally
• The next largest is the Nasdaq at $11 trillion and Tokyo at $6T and Shanghai at $4T.

Eurobond Market

• Corporations and governments issue bonds denominated in dollars.
• They sell them to investors outside the United States.

Foreign Bond Market

• Bonds issued by a foreign corporation or government.
• Denominated in the investor's home currency and sold in their home market.

International Equity Market

• Allows corporations to sell blocks of shares to investors in multiple countries simultaneously.

Role of Capital Markets for Firms

• To be a liquid market.
• This is where firms interact with investors to obtain external financing.

Role of Capital Markets for Investors

• Be an efficient market that allocates funds to their most productive uses.

Efficient Market

• Allocates funds productively through competition among wealth-maximizing investors.
• Market prices are believed to be close to their true value.

Behavioral Finance

• Argues that security prices can deviate from their true values for extended periods.
• Is a field blends ideas from finance and psychology

Securitization

• Process of pooling mortgages or other loans.
• It then sells claims or securities against that pool in a secondary market.

Explore managerial finance, focusing on the financial market environment. Review the XYZ Co. example and IT system upgrade decision. Understand financial institutions' role and contrast accounting and financial perspectives.