Chapter 2: The Financial Market Environment PDF

Chapter 2 The Financial Market Environment Learning Goals LG1 Understand the role that financial institutions play in managerial finance. LG2 Contrast the functions of financial institutions and financial markets. LG3 Describe the differences between the capital markets and the mon...

Chapter 2 The Financial Market Environment Learning Goals LG1 Understand the role that financial institutions play in managerial finance. LG2 Contrast the functions of financial institutions and financial markets. LG3 Describe the differences between the capital markets and the money markets. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-2 Learning Goals (cont.) LG4 Explain the root causes and subsequent effects of the 2008 financial crisis and recession. LG5 Understand the major regulations and regulatory bodies that affect financial institutions and markets. LG6 Discuss business taxes and their importance in financial decisions. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-3 Financial Institutions and Markets Firms that require funds from external sources can obtain them in three ways: 1. through a financial institution 2. through financial markets 3. through private placements Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-4 Financial Institutions & Markets: Financial Institutions Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. Major financial institutions: commercial banks , saving and loans , credit unions , saving banks , insurance companies , mutual funds and pension funds. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-5 Financial Institutions & Markets: Financial Institutions The key customers of financial institutions are A- individuals B- businesses C- governments. In general, individuals are net suppliers of funds, they save more money than they borrow. while businesses and governments are net demanders of funds, they borrow more money than they save. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-6 Figure 2.1 Flow of Funds Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-7 Financial Institutions & Markets: Financial Markets Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market. A private placement involves the sale of a new security directly to an investor or group of investors. Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-8 Financial Markets (cont.) Primary Vs Secondary Markets The primary market is the financial market in which securities are initially issued (new issues of securities) ; the only market in which the issuer is directly involved in the transaction. Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-9 The Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds. Most money market transactions are made in marketable securities which are short-term debt instruments, such as: U.S. Treasury bills issues by the federal government commercial paper issued by businesses negotiable certificates of deposit issued by financial institutions certificates of deposits (CDS) Investors generally consider marketable securities to be among the least risky investments available. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-10 The Capital Market The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership). – Bonds are long-term debt instruments used by businesses and government to raise large sums of money, generally from a diverse group of lenders. – Common stock are units of ownership interest or equity in a corporation. – Preferred stock is a special form of ownership that has features of both a bond and common stock. Preferred stockholders do not have the "voting rights" Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-11  The Difference between Stocks and Bonds: Stocks Bonds Equity instrument Debt instrument Pay dividends Interest payments capital gain Has no maturity date Has a maturity date Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-12 Review of Learning Goals LG1 Understand the role that financial institutions play in managerial finance. Financial institutions bring net suppliers of funds and net demanders together to help translate the savings of individuals, businesses, and governments into loans and other types of investments. LG2 Contrast the functions of financial institutions and financial markets. Financial institutions collect the savings of individuals and channel those funds to borrowers such as businesses and governments. Financial markets provide a forum in which savers and borrowers can transact business directly. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-13 Review of Learning Goals (cont.) LG3 Describe the differences between the capital markets and the money markets. In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have a short-term need for funds. In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis. LG4 Explain the root causes and subsequent effects of the 2008 financial crisis and recession. Financial institutions lowered their standards for lending to prospective homeowners and invested heavily in mortgage-backed securities. When home prices fell and mortgage delinquencies rose, the value of the mortgage- backed securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business. That contributed to a severe recession in the United States and abroad. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-14 Review of Learning Goals (cont.) LG5 Understand the major regulations and regulatory bodies that affect financial institutions and markets. The Glass-Steagall Act created the FDIC and imposed a separation between commercial and investment banks. The Act was designed to limit the risks that banks could take and to protect depositors. Recently, the Gramm-Leach-Bliley Act essentially repealed the elements of Glass-Steagall pertaining to the separation of commercial and investment banks. After the recent financial crisis, much debate has occurred regarding the proper regulation of large financial institutions. The Securities Act of 1933 focuses on regulating the sale of securities in the primary market, whereas the Securities Exchange Act of 1934 deals with regulations governing transactions in the secondary market. The 1934 Act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-15 Review of Learning Goals (cont.) LG6 Discuss business taxes and their importance in financial decisions. Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capital gains. The average tax rate paid by a corporation ranges from 15 to 35 percent. Corporate taxpayers can reduce their taxes through certain provisions in the tax code: dividend income exclusions and tax-deductible expenses. A capital gain occurs when an asset is sold for more than its initial purchase price; they are added to ordinary corporate income and taxed at regular corporate tax rates. Copyright ©2015 Pearson Education, Inc. All rights reserved. 2-16