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Copyright © 2011 Pearson Prentice Hall. All rights reserved. Firms and the Financial Market Chapter 2.

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1 Copyright © 2011 Pearson Prentice Hall. All rights reserved. Firms and the Financial Market Chapter 2

2 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-2 Three Players in the Financial Markets (cont.) 1.Borrowers: Individuals and businesses that need money to finance their purchases or investments. 2.Savers (Investors): Those who have money to invest. These are principally individuals although firms also save when they have excess cash. 3.Financial Institutions (Intermediaries): The financial institutions and markets help bring borrowers and savers together.

3 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-3 Financial Intermediaries SAVERS Financial Intermediaries BORROWERS

4 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-4 Financial Intermediaries (examples) Commercial Banks Finance Companies Insurance Companies Investment Banks Help bring together those who have money (savers) and those who need money (borrowers).

5 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-5 Commercial Banks – Everyone’s Financial Marketplace Commercial banks collect the savings of individuals as well as businesses and then lend those pooled savings to other individuals and businesses. They make money by charging a rate of interest to borrowers that exceeds the rate they pay to savers. In the United States, commercial banks cannot own industrial corporations.

6 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-6

7 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-7 Investment Banks Investment banks are specialized financial intermediaries that: – help companies and governments raise money –provide advisory services to client firms on major transactions such as mergers Firms that provide investment banking services include Bank of America, Goldman Sachs, Morgan Stanley and JP Morgan Chase.

8 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-8 Security A security is a negotiable instrument that represents a financial claim and can take the form of ownership (such as stocks) or debt agreement (such as bonds). The securities market allow businesses and individual investors to trade the securities issued by public corporations.

9 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-9 Primary versus Secondary Market A primary market is a market in which securities are bought and sold for the first time. In this market, the firm selling securities actually receives the money raised. For example, securities sold by a corporation to an investment bank.

10 Copyright © 2011 Pearson Prentice Hall. All rights reserved Primary versus Secondary Market (cont.) A secondary market is where all subsequent trading of previously issued securities takes place. In this market, the issuing firm does not receive any new financing. The securities are simply transferred from one investor to another. Provide liquidity to the investor. Examples: New York Stock Exchange; NASDAQ

11 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities Debt Securities: Firms borrow money by selling debt securities in the debt market. If the debt has a maturity of less than one year, it is typically called notes, and is traded in the money market. If the debt has a maturity of more than one year, it is called bond and is traded in the capital market.

12 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Equity securities represent ownership of the corporation. There are two major types of equity securities: common stock and preferred stock.

13 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Common stock is a security that represents equity ownership in a corporation, provides voting rights, and entitles the holder to a share of the company’s success in the form of dividends and any capital appreciation in the value of the security. Common stockholders are residual owners of the firm i.e. they earn a return only after all other security holder claims (debt and preferred equity) have been satisfied in full.

14 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Dividends on common stock are neither fixed nor guaranteed. Thus a company can choose to reinvest all of the profits in a new project or re-purchase its own stock and pay no dividends to common shareholders.

15 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Preferred stock is also an equity security. Preferred stockholders have preference with regard to: –Dividends: They are paid before the common stockholders are. –Claim on assets: They are paid before common stockholders if the firm goes bankrupt and sells or liquidates its assets.

16 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Preferred stock is also referred to as a hybrid security as it has features of both common stock and bonds.

17 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Preferred stock is similar to common stocks in that: –It has no fixed maturity date, –The nonpayment of dividends does not result in bankruptcy of the firm, and –The dividends are not deductible for tax purposes.

18 Copyright © 2011 Pearson Prentice Hall. All rights reserved Types of Securities (cont.) Preferred stock is similar to corporate bonds in that: –The dividends are typically a fixed amount, and –There are no voting rights.

19 Copyright © 2011 Pearson Prentice Hall. All rights reserved Stock Markets A stock market is a public market in which the stocks of companies are traded. Stock markets are classified as either organized security exchanges or an over- the-counter (OTC) market.

20 Copyright © 2011 Pearson Prentice Hall. All rights reserved Stock Markets (cont.) Organized security exchanges are tangible entities; that is, they physically occupy space and financial instruments are traded on their premises. For example, the New York Stock Exchange (NYSE) is located at 11 Wall Street in Manhattan, NY.

21 Copyright © 2011 Pearson Prentice Hall. All rights reserved Stock Markets (cont.) The over-the-counter markets include all security markets except the organized exchanges. NASDAQ (National Association of Securities Dealers Automated Quotations) is an over-the- counter market and describes itself as a “screen- based, floorless market”. In 2009, nearly 3,900 companies were listed on NASDAQ, including Starbucks, Google, and Intel.

22 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-22

23 Copyright © 2011 Pearson Prentice Hall. All rights reserved Other Financial Instruments Table 2-2 in your text provides a list of different financial instruments used by firms to raise money beginning with the shortest maturity instruments that are traded in the money market and moving through to the longest maturity instruments that are traded in the capital market.

24 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 2-24


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