King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA Dr Abdeldjelil Ferhat BOUDAH 1

King Faisal University [ ] Chapter 2 The Operating environment of the Firm 2 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Introduction 2-1 Financial Institutions 2-2 Financial Markets 2-3 The relationship between institutions and markets 3 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-4 The Capital Market 2-5 Interest Rates and required Returns 2-6 Business Taxation Conclusion 4 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Introduction Financial managers must understand the environment and markets within which businesses operate. Therefore, in this chapter, we shall examine briefly the markets where firms raise funds, securities are traded, and stock prices are established, as well as the institutions that operate in these markets. 5 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-1 Financial Institutions Financial institutions are intermediaries that channel the savings of individuals, businesses, and government into loans or investment. See Table Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Many financial institutions directly or indirectly pay savers interest on deposited funds; others provide services for which they charge depositors(for example the service charges levied on checking accounts) 7 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Certain financial institutions accept customers’ savings deposits and lend this money to other customers; others invest customers’ savings in earning assets such as real estate or stocks and bonds; and still others both lend money and invest savings. 8 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Financial institutions are required by the government to operate within established regulatory guidelines. 9 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-2 Financial Markets The term of financial markets refers to as a conceptual “mechanism” rather than a physical location or a specific type organization or structure. 10 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Financial markets provide a forum in which suppliers of funds and demanders of loans and investments can transact business directly. 11 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Whereas the loans and investments of institutions are made without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested. (See figure 2.1) 12 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The two key financial markets the money markets and the capital markets. Transactions in short-term debt instruments, or marketable securities, take place in the money market. Long-term securities (bonds and stocks) are traded in the capital market. 13 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm All securities, whether in the money markets or capital markets, are initially issued in the primary markets. Once the securities begin to trade among individual, business, government, or financial institutions savers and investors, they become part of the secondary market. 14 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-3 The relationship between institutions and markets Financial institutions actively participate in the money market and the capital market as both suppliers and demanders of funds. Figure 2.1 depicts the general flow of funds through and between financial institutions and financial markets; private placements are also clarified. 15 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm T o understand what’s going on in figure 2.1, we shall start from left-hand side; that is suppliers of funds. Suppliers can use their funds either in financial markets or in financial institutions. In case of using financial markets, suppliers pump funds and get securities. Doing the same thing with financial institutions means pumping funds in the form of deposits and shares. 16 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Suppliers of funds can be considered as investors when they approach financial markets in terms of trading. However, suppliers are savers when they use their funds in financial institutions in the form of deposits. 17 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm On the right hand side of the figure 2.1, we can observe something different. Besides Suppliers of funds, there are demanders of funds. These are called primarily investors and they use both channels to get the necessary funds for their investments. 18 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm A direct channel can be used through financial markets by selling securities, however, the indirect channel is exercised via financial institutions in the form of loans. 19 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Finally, private placement, as it is shown in the same figure, points out, clearly, the relationship between institutions and markets. Financial institutions can supply financial markets with funds in the form of securities investment. The trade can be done on behalf the financial institutions themselves or for their customers. 20 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-4 The Capital Market The capital market is a financial relationship created by a number of institutions and arrangements that allow suppliers and demanders of long-term funds - funds with maturities of more than one year - to make transactions. Included among long-term funds are securities issues of business and government. 21 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The backbone of the capital market is formed by the various securities exchanges that provide a forum for debt and equity transactions. Mechanisms for efficiently offering and trading securities contribute to the smooth functioning of capital markets, which is important to the long-run growth of business. 22 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Key securities: A- Bonds B- Stocks - Common stock - preferred stock 23 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm A- Bonds Bonds are long-term instruments used by business and government to raise large sums of money, generally from a diverse group of lenders. 24 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Corporate bonds typically pay interest semiannually (every six months) at a state coupon interest rate, have initial maturity, and a par, or face value; which must be repaid at maturity. 25 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm B- Stocks - Common stock Shares or common stocks are units of ownership interest, or equity, in a corporation. Common stockholders (shareholders) expect to earn a return by receiving dividends (periodic distribution of earnings), or by realizing gains through increases in share price. 26 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm - Preferred stock Preferred stock is a special form of ownership that has features of both a bond and common stock. Preferred stockholders are promised a fixed period dividend that must be paid prior to payment of any dividends to the owners of common stock. 27 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The role of securities exchanges The securities exchanges create efficient markets that allocate funds to their most productive uses. This is especially true for securities that are actively traded on major exchanges where the competition among wealth maximizing investors determines and publicize prices that are believed to be close to their true value. 28 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The price of an individual security is determined by what is bought and sold, or the demand for and supply for the security. The figure 2.2 depicts the interaction of the forces of demand (represented by D 0 ). And supply (represented by line S). For a given security currently selling at an equilibrium price P 0. At that price, Q 0 shares of the stock are traded. 29 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Offering and trading securities To raise money in the capital market, firms can use either private placement or public offering. Private placement involves the sale of a new security issue, typically debt or preferred stock, directly to investor or group of investors. 30 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm However, most firms raise money through a public offering of securities, which is the nonexclusive sale of either bonds or stocks to the general public. 31 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-5 Interest Rates and required Returns Financial institutions and markets creates the mechanism through which funds flow between savers (funds suppliers) and investors (funds demanders). The level of funds flow between suppliers and demanders can significantly affect economic growth. 32 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Growth results from the interaction of a variety of economic factors, such as the money supply, trade balances, and economic policies, that affect the cost of money; that is the interest rate or required rate of return. The level of this rate acts as a regulating device that controls the flow of funds between suppliers and demanders. 33 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The interest rate or required rate of return represents the cost of money. It is the rent or level of compensation that a demander of funds must pay a supplier. When funds are lent, the cost of borrowing the funds is the interest rate. 34 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm When funds are obtained by selling an ownership (equity) interest-as in the sale of stock- the cost of the issuer (demander) is commonly called required return, which reflects the funds supplier’s level of expected return. In both cases, the supplier is compensated for providing either debt or equity funds. 35 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm 2-6 Business Taxation Business, like individuals, must pay taxes on their income. The actual rates of taxations differ depending upon the form of business organization. Income can be subject to either individual or corporate income taxes. 36 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The income of sole proprietorship and partnership is taxed as the income of the individual owners, whereas corporate income is subject to corporate taxes. Regardless of their legal form, all businesses can earn two types of income; ordinary and capital gains. 37 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Ordinary income: The ordinary income of a corporation is income earned through the sales of a firm’s goods or services. 38 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Capital gains: The capital gain is the amount by which the sale price of an asset exceeds the asset’s initial purchase price. If a firm sells a capital assets such as stock held as investment for more than its initial purchase price, the difference between the sale price and the purchase price is called a capital gain. 39 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm Conclusion To sum up, it can be said that the environment in which financial manager operates his transactions is so crucial and complex. 40 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] Chapter 2: The Operating Environment of the Firm The thing that might be so important for the financial manager is to have a knowledge about all the different instruments of financing that are available in the market place, in order to make the appropriate decisions that are oriented towards the use of convenient sources for financing the firm’s needs or the way how to use funds for different kinds of investments’ purposes. 41 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] 42 بحمد الله