Lecture Financing Decision

FINANCING DECISION AND

FINANCIAL MARKETS

Conf. dr. Anamaria CIOBANU

Goals of the Firm.

Explain why each of the following may not be appropriate corporate goals:

• a. Increase market share• b. Minimize costs• c. Underprice any competitors• d. Expand profits

Agency Issues.Discuss which of the following forms of

compensation is most likely to align the interests of managers and shareholders:

• a. A fixed salary• b. A salary linked to company profits• c. A salary that is paid partly in the form of

the company’s shares• d. An option to buy the company’s shares

at an attractive price

The Financing Decision of a Company

Financing Decision

Internal Resources

External Resources

Auto-financing:-Reinvesting the profits;- Reserves;- Depreciation and amortization of the assets;

- Credits;- Bond issuing;- Equity.

Financial Institutions & Financial Markets

• Firms that require funds from external sources

can obtain them in three ways:

– through financial institutions : eg banks

– through financial markets : e.g BSE

– through private placements

Financial Institutions

• Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments.

• In general, individuals are net suppliers of

funds, while businesses and governments are

net demanders of funds.

The Relationship between Financial Institutions and Financial Markets

• Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly.

• The two key financial markets are:

– the money market: deals with short term

marketable securities

– the capital market: deals with long-term securities

Financial Markets

Financial Markets

MONEY MARKET:The securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid.

Financial MarketsCAPITAL MARKET:

-where different types of securities (e.g. stocks, bonds etc.) are traded through members of securities exchanges.

Eg. of securities exchanges:•NYSE - New York Stock Exchange•BSE – Bucharest Stock Exchange

Members of securities exchanges consist of mainly brokerage firms.

FINANCIAL INSTRUMENTS

• Represent a contract between a lender and a borrower;

• This type of contract establish:the amount and the maturity;

the currency;

the financing cost (interest rate) and the payment method;

the risk allocation between the participants;

the payback of the loan;

other aspects (special clause).

Financial Markets

Money Market Instruments Capital Market Instruments Treasury Bills Treasury Notes & BondsNegotiable CDs Government Agency Bonds

Bankers Acceptances State & Local Government BondsCommercial Paper Corporate Bonds

Credits Corporate Stocks

MONEY MARKET CAPITAL MARKET

Treasury Bills

short term debt instruments

maturity of 3, 6 or 12 month;

have no interest payments (initially sold at a discount);

the most liquid financial instruments;

the safest financial instrument (no default risk)

can be issued in different currencies (usually are issued in local currency)

“risk free rate” instruments;

Negotiable Bank Certificate of Deposits

• debt instrument sold by a bank to depositors (one of the most important capital source for banks);

• pays annual interest;• at maturity pays back the original purchase

price;

Commercial Papers

• short term instruments issued by banks or well known companies;

• no interest payments (usually issued at a discount);

• interest rates are related to the issuer’s risk;

Banker’s Acceptances

• were developed in accordance with international trade development

• represent banks drafts (a promise of payment similar to a check) issued by a company for a future date and guarantee for a fee by the bank

• the bank acceptance = the guarantee

• these instruments are often resold on secondary market at a discount

Capital Market’s Financial Instruments

• BONDS (Debt Financing)- A debt instrument where a borrower

(issuer) pays interest and principal, on specific dates, to the lender (holder) of the bond.

Eg. Corporate bonds,government bonds, treasury notes

• STOCKS (Equity Financing)- Corporation can raise capital by issuing

stocks - either common stocks or preferred stocks.

- Common stockholders are owners of the company and have a voting right.

- Preferred stockholders - have priority over dividends.



Organization of the Securities Market

• Primary market: market for trading newly issued securities. The financial market in which new issues of a security are sold to initial buyers.

• Secondary markets: markets where securities are bought and sold subsequent to original issuance. The financial markets in which security (previously issued) can be resold by the investors for cash.

Primary Capital MarketsGovernment Bonds

• Sold regularly through auctions• Treasury bills: one year maturity or less• Treasury notes: maturities of two to ten

years• Treasury bonds: original maturities of

more than ten years

Primary Capital MarketsCorporate Bonds

• Negotiated arrangement with an investment banking firm who maintains a relationship with the issuing firm;

• Underwriting firm often organizes a syndicate for distribution;

Primary Capital Markets Common Stock

New issues are divided into two groups:Seasoned new issues– New shares offered by firms that already have

stock outstandingInitial public offerings (IPOs)– Firms selling their stock to the public for the

first time

Secondary Markets

Involves the trading of issues that are already outstanding

• Provide a means obtaining cash for sellers

• Provide buyers with more investment choices

Why Secondary Markets Are Important?

Provide liquidity to investors who acquire securities in the primary market;– Helps issuers raise needed funds in the

primary market since investors want liquidity

Help determine market pricing for new issues;

Secondary Market Trading Systems

• Pure auction market– Buyers “bid” and sellers “ask”– Buy and sell orders are matched at a central location– Price driven market: trades are made by determining

the highest bid and the lowest ask

• Dealer market– Dealers buy shares (at the bid price) and sell shares

(at the ask price) from their own inventory– Dealers compete against each other

Call Versus Continuous Markets

Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders;

Used for opening prices on BSE if orders build up overnight or after trading is suspended;

Continuous markets trade any time the market is open;

National Stock Exchanges

• Large number of listed securities• Listing often seen as a sign of prestige• Wide geographic dispersion of listed firms• Diverse clientele of buyers and sellers• Firms wanting to list must meet listing

requirements

Five common mistakes of beginning investors

• No clear compensation of return and risk;• Using a friend or relative as an investment

adviser;• Trading too frequently;• Not enough diversification;• No clearly formulated investment goals.

No clear compensation of return and risk

• How much return can I expect?• Over what period of time?• Subject to what risk?

• You have to know the answers to these questions before you make an investment!

Using a friend or relative as an investment adviser

• Select your broker or other advisor with the same care you exercise in finding a physician or an attorney.

Trading too frequently

• Sell the losers and buy the winners strategy is wrong! Over the log run, this investment approach enriches the broker and impoverishes you!

• As a rule of thumb, allow about 2% for commissions on the value of securities purchased and sold.

Not enough diversification

• Much investment risk can be eliminated without sacrificing return through proper diversification.

• Yet surveys tell us that most investors hold fewer than five securities, with many holding only one or two.

• To be adequately protected you need a well-diversified portfolio, balanced across a wide array of different investments.

No clearly formulated investment goals

• If you know why you are investing, you will know better how to invest!

• I want to get rich by investing! Is a elusive goal!

• Your goals have to be SMART! (Specific; Measurable; Achievable; Realistic; Timely)– Get 20% return on my investment by the end of

the year!

Opening an account and making transactions

• Cash account: account that requires payment within five working days for securities purchased;

• Margin account: allows an investor to borrow from his broker, pledging securities as collateral;

• Discretionary account: gives a broker power of attorney to trade securities on an investor’s behalf

• Wrap account: involves the services of a professional money manager with an investor’s broker.

Margin account

• Initial margin requirement• Maintenance margin requirement

– when this figure is touched, the investor get a margin call, which means that he must either deposit additional funds to increase his equity or sell some of his shares.

• Margin accounts are risky (the loan increases the risk and the costs for the investor…but allows to magnify the amount of money invested. A greater investment means greater profits…or losses.)

Initiating a Position• After an account is opened, the investor can

begin trading!

• When he buy securities, he take a long position

• When he sell securities that he do not already own, he take a short position

• When he sell securities he originally bought or buy securities he originally sold, he is reversing a position

Initiating a Position

• When you’ll initiate a long position?– When you forecast an increase in securities

price!• When you’ll initiate a short position?

– When you believe that the securities’ price will decrease!

Initiating a Position

• Suppose you think IBM is overvalued at 150$ a share and its likely to decrease in future!

• What you’ll do?• Short sell of IBM stocks hoping to reverse

your position in the future after the price has fallen!

Major Types of Orders

• Market orders– Buy or sell at the best current price

• Limit orders– Order specifies the buy or sell price– Time specifications for order may vary

• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)


• Special Orders– Stop loss

• Conditional order to sell stock if it drops to a given price

• Does not guarantee price you will get upon sale

– Stop buy order• Investor who sold short may want to limit loss if

stock increases in price


• Short sales– Sell overpriced stock that you don’t own and

purchase it back later (at a lower price)– Borrow the stock from another investor

(through your broker)– Margin requirements apply

Major Types of OrdersBuying on Margin:• On any type order, instead of paying 100% cash,

borrow a portion of the transaction, using the stock as collateral

• Interest rate is based on the call money rate from a bank

• Regulations limit proportion borrowed and the investor’s equity percentage (margin)– Margin requirements are from 50% up

• Changes in price affect investor’s equity

Major Types of OrdersMargin Order Details• Initial margin requirement at least 50%

– Lower margin requirements allow you to buy more• Maintenance margin

– Required proportion of equity to stock value– Protects broker if stock price declines– Minimum requirement is at least 25%– Margin call on undermargined account to meet

margin requirement– If call not met, stock will be sold to pay off the loan


Margin Example:• Buy 100 shares at $60 = $6,000 position• Borrow 50%, investment of $3,000If price increases to $70, position

Value is $7,000Less - $3,000 borrowed Leaves $4,000 equity for a$4,000/$7,000 = 57% equity position


Margin Example:• Buy 100 shares at $60 = $6,000 position• Borrow 50%, investment of $3,000If price decreases to $50, position

Value is $5,000Less - $3,000 borrowed Leaves $2,000 equity for a$2,000/$5,000 = 40% equity position

QUIZ

• Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets!

• Comment this statement!

QUIZ

• If you suspect that a company will go bankrupt next year, which you rather hold, bonds or equity issued by the company? Why?

QUIZ

• An investor deposit 2000 $ and borrows 2000$ to purchase 4000$ of securities. He owns 100 shares of KLM at 40 $ a share.

• KLM’s price falls. Which is the price from where the broker requires additional margin to restore the initial margin requirement?

• What price increase of KLM’ stocks the investor need in order to get an annual return of 20% (the interest rate of the broker loan is 10%)?

Thank you for your attention!