1. Financial Management –Spring 2013 Chapter 2: Financial Markets And Institutions 1.The Importance of Financial Institutions 2.The Flow of Savings to Corporations 3.Functions of Financial Markets and Intermediaries 4.Value Maximization and the Cost of Capital

2. © Mehmet Cihan The Flow of Savings to Corporations A.B. Freeman School of BusinessFINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital 2 of 14

3. © Mehmet Cihan The Financial Market Financial Market: Market where equity securities are issued and traded. 1.Primary Market: Market for the sale of new securities by corporations. 2.Secondary Market: Market in which previously issued securities are traded among investors. A.B. Freeman School of BusinessFINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital 3 of 14

4. © Mehmet Cihan Miscellaneous Financial Markets Bond or Fixed-Income Market: Debt securities Money Market: Short-term, high quality, and liquid debt financing: Commercial Papers Capital Market: Long-term debt financing: Bonds Other Markets: Foreign exchange, futures, options Commodity markets A.B. Freeman School of BusinessFINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital 4 of 14

5. © Mehmet Cihan Financial Intermediaries: Funds Mutual Fund An investment company that pools the savings of many investors and invests in a portfolio of securities Hedge Fund A private investment pool, open to wealthy or institutional investors, that is only lightly regulated and therefore can pursue more speculative policies than mutual funds Pension Fund Fund set up by an employer to provide for employees retirement A.B. Freeman School of BusinessFINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital 5 of 14

6. © Mehmet Cihan Intermediaries and Investors FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital Intermediaries Investors Depositors Policyholders Investors Obligations Funds Company Intermediaries Banks Insurance Companies Brokerage Firms Obligations Funds A.B. Freeman School of Business6 of 14

7. © Mehmet Cihan Financial Institutions Commercial Banks Intermediate from savings to investments Checking services Money transfers etc. Investment Banks Help raising capital by selling stocks/bonds in fin markets Provide advice on mergers and acquisitions of companies Insurance Companies Protect individuals/corporations Invest in corporation securities FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business7 of 14

8. © Mehmet Cihan Flow of Funds Banks Insurance companies FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business8 of 14

9. © Mehmet Cihan Functions of Financial Markets and Intermediaries 1.Transport cash across time Savers transport purchasing power from current period to future Borrowers transport funds from future to current period 2.Risk transfer and diversification Reduction and reallocation of risk Risk may be hedged via futures, options, and swap contracts Pure insurance benefit, i.e. against casualty risks Advantage of holding assets in portfolio: diversification benefit FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business9 of 14

10. © Mehmet Cihan Functions of Financial Markets and Intermediaries 1.Transport cash across time Savers transport purchasing power from current period to future Borrowers transport funds from future to current period 2.Risk transfer and diversification Reduction and reallocation of risk Risk may be hedged via futures, options, and swap contracts Pure insurance benefit, i.e. against casualty risks Advantage of holding assets in portfolio: diversification benefit FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business10 of 14

11. © Mehmet Cihan Functions of Financial Markets and Intermediaries 3.Liquidity Liquidity: the ability to get cash, is a function of time and transaction cost Some liquidity channels: commercial paper, bank CD, or line of credit 4.Payment mechanism The efficiency of payment mechanism Send/receive payments readily 5.Provide information on Security Prices, Commodity Prices, Interest Rates, Company Value, Cost of Capital Information to financial markets Information to managers FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business11 of 14

12. © Mehmet Cihan Value Maximization FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital A.B. Freeman School of Business12 of 14

13. © Mehmet Cihan The Opportunity Cost of Capital FINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital Minimum acceptable rate of return Set by rates of return on investment opportunities in financial markets Investment projects with rate of returns > opp. cost of capital Investment projects with rate of returns < opp. cost of capital A.B. Freeman School of Business13 of 14

14. © Mehmet Cihan Assignments 1.Read Chapter 3 2.Problems (Chapter 2 – Brealy, Myers, and Marcus 6 th Edition) 4, 7, 9,12, 15, 17, 20, 22 Note: The slides are based on Brealy, Myers, and Marcus 6 th Edition A.B. Freeman School of BusinessFINANCIAL MARKETS AND INSTITUTIONS 2.2 The Flow of Savings to Corporations 2.3 Functions of Financial Markets and Intermediaries 2.4 Value Maximization and the Cost of Capital 14 of 14