1. Chapter 32: Financial Markets Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13e

2. 32-2 Financial Markets Financial markets exist to facilitate economic activities by managing the risks of failure.

3. 32-3 Learning Outcomes 32-01. Know how present discounted values are computed. 32-02. Know the difference between stocks and bonds. 32-03. Know key financial parameters for stocks and bonds. 32-04. Know how risks and rewards are reflected in current values.

4. 32-4 The Role of Financial Markets An entrepreneur needs start-up funds to launch a business. Sources: – Personal wealth. – Borrowed funds. – Inviting other investors to join the venture. Financial intermediaries make raising start- up funds easier.

5. 32-5 The Role of Financial Markets Financial intermediaries: institutions that steer funds from savers to entrepreneurs and other investors. – Business, household, and government savers put unspent income into banks, pension funds, bond markets, and stock markets. – This pool of national savings is passed on to firms to start or expand a business. – Search and information costs to access funds are reduced.

6. 32-6 The Supply of Loanable Funds The factors that influence saving decisions are – Time preferences (put off spending until later). – Interest rates (high rates spur more saving). – Risk (savers do not want to put “all their eggs in one basket”; they want to reduce the risk of losing their money). Risk premium: the difference in the rate of return on risky and safe investments. – The interest rate will be increased to cover this risk premium.

7. 32-7 Present Value of Future Profits A dollar today is worth more than a dollar received two years from today. – You can earn interest on today’s dollar for the next two years. – As long as interest-earning opportunities exist, present dollars are worth more than future dollars. To decide whether or not taking the risk of investing is worth doing, we must assess the potential rewards – that is, future profits.

8. 32-8 Present Value of Future Profits Time value of money: to calculate the present discounted value (PDV) of future earnings, the opportunity cost of money (the forgone interest) must be taken into account. Present discounted value (PDV): the value today of future payments, adjusted for interest accrual. – The longer one has to wait for a future payment, the less present value it has.

9. 32-9 Present Value of Future Profits A payment of $1,000 in one year (N = 1) has a present discounted value of $909.09 in a 10 percent interest rate world. PDV = $1,000 / (1.10) = $909.09 If N = 2 (2 years), PDV = $1,000 / (1.10) 2 = $826.45 Future payment N PDV = (1 + Interest rate ) N N is the number of years in the future when the payment is made.

10. 32-10 Present Value of Future Profits The present discounted value (PDV) of a future payment declines with – Higher interest rates. – Longer delays in future payment. Uncertainty must be taken into account. What if the payment does not happen? – Add a risk factor to calculate the expected value: – Expected value = (1 – Risk factor) X PDV – A 50 - 50 chance of failure cuts PDV in half.

11. 32-11 The Stock Market Stocks are part ownership in a corporation. – As an owner, you have limited liability; all you can lose is the cost of buying the stock. You are not liable for the firm’s taxes, debt, or lawsuit damages. – You buy stocks to receive future payments as an owner. There are two kinds: Dividends Capital gains.

12. 32-12 The Stock Market Dividends. – Earnings can be either retained for future investment in the firm or paid out to stockholders as a dividend. – Dividends = Corporate profits – Retained earnings. As a rule, corporations in mature (slowly expanding) industries pay out dividends. Corporations in growth (rapidly expanding) industries keep profits for future internal investment and pay no dividends.

13. 32-13 The Stock Market Capital gains. Why buy stock in growth industries? Their growth may trigger bigger profits in the future, and the price of the stock may soar in the stock market. – Stockholders will reap a capital gain when they sell the stock at a price higher than they paid. – Even if they keep the stock, capital gains increase shareholder wealth.

14. 32-14 The Stock Market Stock trading. – There are two kinds of stock trading: The initial public offering (IPO), which is the first sale of stock to the public by the corporation. Secondary trading, which is the everyday buying and selling of previously issued stock in the stock market. – The corporation receives the funds from an IPO. – The stock seller receives the funds from a secondary sale.

15. 32-15 The Stock Market Market fluctuations. – Secondary trading is subject to stock market supply and demand: Buyers will buy more shares if the price of a stock falls. Sellers may be induced to sell shares if the price of a stock rises. – Prices also fluctuate as expectations of potential buyers and sellers change. The future looks bad? Sellers want to sell more and buyers want to buy less, so the price drops. The future looks rosy? Sellers hold their stock but buyers want to buy more, so the price soars.

16. 32-16 The Stock Market Market fluctuations. – Booms and busts. Broad changes in the economic outlook tend to change expectations for all stocks, not just one or two. Expect a boom, and all prices get pushed up. Expect a bust, and all prices start to plunge. – Wild swings in stock prices are usually due to sudden, widespread changes in people’s expectations.

17. 32-17 The Economic Role of Financial Markets Financial markets facilitate resource reallocations. – Finding a source of funds allows a new venture to start up and expand. Resources can be acquired that would most likely have gone to another venture. The mix of output will be changed. – Resource reallocation follows the decision to fund a venture more likely to be successful in providing a desired return on investment.

18. 32-18 The Bond Market In the bond market people buy and sell promissory notes (IOUs) – that is, corporate and government bonds. – Bonds are issued in order to borrow funds. – There are two types of bond sales: Initial sale: the purchaser is lending funds directly to the bond issuer. The issuer gets the funds. Secondary sale: this is the interaction between owner-sellers and buyers of previously issued bonds. The seller gets the funds.

19. 32-19 The Bond Market The math of a bond. – Face value: the amount being borrowed by the issuer, the amount that will be repaid at maturity. – Coupon rate: the rate of interest the borrower will pay the bondholder each year until maturity. – Bond price: the current price one could get in the bond market by selling the bond. – Yield: the interest payment divided by the bond price.

20. 32-20 The Bond Market Bond trading. – A bond has liquidity: the ability to be easily turned into cash by offering it for sale in the bond market. – These resales increase the availability of funds. – Bond prices fluctuate because of Changes in expectations. Changes in alternative uses of funds. Changes in prevailing interest rates.

21. 32-21 The Bond Market Bond trading. – A $1,000 face value bond with a 10% coupon rate pays out $100 a year in interest. – If the prevailing interest rate falls to 9%, any new bond would pay out only $90 a year, so the 10% bond’s value would rise and its market price would rise also. – If the prevailing interest rate rises to 11%, any new bond would pay out $110 a year, so the 10% bond’s value would fall and its market price would fall also. – Bond prices move in the opposite direction as interest rates.