Copyright ©2003 South-Western/Thomson Learning Chapter 2 The Domestic and International Financial Marketplace

Introduction This chapter looks at the domestic and international financial marketplaces that allocate scarce resources.

Finance Decisions Affecting SWM Form of business organization Types of financing Investment projects All based on after-tax cash flow

Implication of Income Taxes for Financial Managers Capital structure policy –Tax advantage of debt financing Dividend policy –Capital gains vs. Dividend policy Capital budgeting –After-tax CFs, Depreciation, Net present value (NPV) Leasing –Motivated by tax effects

Corporate Tax Rates Progressive –The average tax rate increases for increasing levels of income. Marginal –The tax rate on the next dollar of income –Marginal tax rate used in text 40% = State + Fed

Net Savers Become Investors Credit Unions Primary and Secondary Markets Sole Proprietorship Partnership Corporations Financial Markets Savings Institution Mutual Funds Pension Funds Insurance Companies Financial Institutions Financial Companies Banks Supply Funds Money Markets Capital Markets First Comes the National Financial System

Investment Banking Helps corporations sell new security issues Underwrite –Guarantee sale at a fixed price Best effort –No guarantee

Secondary Market Listed exchanges –Designated place of business –Requirements of securities listed or traded Over-the-counter (OTC) market –Networks connected by communications –Dealers post prices to buy and sell Stock market indexes –DJIA, DJTA, S&P 500, NASDAQ

Regulations State –Blue sky laws Federal –Securities Act of 1933 & 1934 –Securities & Exchange Commission (SEC) –Ethical issues Insider trading –SEC attempts to prevent profiting from unpublished information.

Global Financial Transactions Import Export Foreign Branch Licensing Arrangements Joint Ventures Multinational Corporations ManufacturingDistribution International Finance

Global Risks Fluctuating exchange rates Government regulations Tax laws Business practices Political environment

Eurocurrency Market Eurocurrency –Currency deposited outside of the country of origin Eurodollars –Dollars deposited outside of the United States Euro –A new currency created by many European countries –The euro is not the same as Eurocurrency.

Some Important Terms Exchange rate Direct quote Indirect quote Spot rate Forward exchange rate

Forward Exchange Rates Exchange rates for currencies delivered at some future date, i.e., 30, 90, or 180 days Premium –Where spot rate is expected to increase in the future Discount –Where spot rate is expected to decrease in the future

Annualized Forward Premium or Discount 100% # of months forward 12 Spot rate Forward rate – Spot rate  

Delivery Foreign currency futures contract Standard amount of currency Standard future time At a price set at the present time Contracts traded on Chicago Mercantile Exchange (CME)

European and American Options What is the difference between an American and European option? –You can exercise an American option anytime until expiration. –The European option can be exercised only at expiration.

Remember A call is the right to buy a currency. A put is the right to sell a currency.

Market Efficiency “Glue” that bonds the PV of a firm’s net cash flow to shareholders’ wealth

Market Efficiency Capital markets are efficient if prices instantaneously and fully reflect all the risk and economically relevant information about a security’s prospective returns.

Three Degrees of Market Efficiency Weak form Semi-strong form Strong form

Weak form Security prices fully reflect all historical information. No investor can earn excess returns using historical prices or returns.

Semi-strong form Security prices fully reflect historical and publicly available information. No investor can earn excess returns based on an investment strategy using public information.

Strong form Security prices fully reflect all historical, public, and private information. Markets are quite efficient!

Implications for Financial Managers Timing or gambling An expected NPV of zero Corporate diversification Security price adjustment Behavioral finance perspective

Barriers to Market Efficiency Outside the United States Foreign exchange risk Legal restrictions on investments Taxation policies discourage capital flows. High transaction costs Political risks of expropriation

Holding Period Rate of Return HPR The return from holding an investment for one period

Equation 100%  Beginning price Ending price – Beginning price + Distributions HPR% =

Returns Ex post = realized (after the fact) Ex ante = expected (before the fact)