1. Corporate Finance CHAPTER TWO J.D. Han

2. Learning Objectives 1. What kind of choices is a corporate financial manager faced with in funding a project? 2. What financial market instruments would he/she choose? What are the advantages and disadvantages of different funding sources? 4.What kind of institutional structures is the financial manager faced with? - Why does each country exhibit different characteristics in financial market?

3. 2.1 How to Fund a Corporate Project? 1) How to fund a corporate project? internal financing vs external financing 2) How to raise funds outside of the firm? direct financing vs. indirect financing - Direct financing may not work -Financial intermediaries create a system of indirect financing. 3) What kinds of finanical instruments to issue?

4. 2.2 Financial Instruments or Assets: 2 classifications of financial assets(instruments): 1. Debt versus Equity Debt: Bank Loans and Bonds- Contractual claims Equity: Residual claims 2. Loans versus Marketable Securities Loans: personalized Marketable Securities: Bonds, Equities, Derivatives (options, swaps, futures, and forwards) - arm’s length deals through securities exchanges

5. *Sources of External Corporate Financing in U. S.: Choice of Capital Structure Two puzzling findings 1) “Equities are not a major instruments for corporate financing.” 2) “Marketable Securities are not so important as bank loans.”

6. ** It is due to the limited demand for marketable securities by financial investors, and the limited supply of marketable securities: - (Fund) Supply Side: financial investors are concerned about which is a good financial asset and which is not - “Information Asymmetry”, “Moral Hazard”, “Principal-Agent Problem”, and “Adverse Selection” - (Fund) Demand Side: firms may prefer bonds to equities under the current hostile M & A environment. *** In the Canadian corporate financing, equities are somewhat more important than in the U.S. coroporate financing.

7. 2.3 Financial Intermediaries The “four pillars” of Canada’s financial system include: 1. Chartered banks – Self liquidating short-term investment in principle 2. Trust companies 3. Insurance companies and Pension Funds 4. Investment dealers –For Long term/large scale investment

8. ** Investment Dealers: the Big Hands Securities Firms /Houses Banks’ M & A Division of Investment Banking Department For instance - Morgan Stanley Dean Witter - Goldman Sachs - Salomon Smith Barney - Merrill Lynch - Donald Trump; Drexel Burnham, Campeu Co., T. Boone Pickens (Mesa Petrolium) - Dominion Securities; Mellon; McLeod; Waterhouse.

9. *Structure of Securities Firm

10. Important Concepts in Investment Banking Issuing Securities: IPO versus Seasoned Issuing Underwriting: advice, issue, risk-sharing, and stabilization. Bought Deal vs Best Efforts Private Placement

11. 2.4 Financial Markets 1. Primary vs. Secondary Market by Newness: - Primary Market: new securities are issued. Corporate financing source - Secondary Market: existing securities are traded 2. short-term Money Market vs. long-term Capital Market by term periods of financial instruments 3. Domestic vs. Glabal Market by Location Investment banks act as global coordinators through underwriting syndicates

12. 2.5 Classification of Money Markets by Assets’ Time Horizons 1. Money Market Short-term financial assets –Highly Liquid Operates as a dealer or over-the-counter market (OTC) Sold in denominations > $100,000 Most recognized money market instrument are T- bills Other money market instruments include commercial paper, Banker Acceptances, and eurodollars

13. 2. Debt Market: Capital Market 1 Intermediate and long term horizon finanical assets Bond markets: -represent the most important markets for intermediate and long-term debt - operates as OTC market - Government bonds are most important items - Coporate bonds accounts for 20% only - Asset-backed Securities (ABS): - - example Mortgage-backed securities (MBS) - - Securitization

14. 3. Equity/stock Market: Capital Market 2 Common stocks, preferred stock and warrants trade in equity markets Equity securities trade on stock exchanges Stock exchanges operate as: - Auction markets is called Stock Exchanges (TSE, CDNX, ME; and NYSE) or - Over-the-counter is a sales network (NASDAQ).

15. *Canadian Stock Markets Before 1999, there were 5 stock exchanges: TSE, ME, VSE. WSE, and ASE After March 1999, there are only TSE, ME, and Canadian Venture Exchange(CDNX) ** Global Equity Market *** Emgerging Equity Market in newly developing economies

16. 4. Derivatives Markets Derivative securities - derive the value from underlying assets such as common shares or bonds Options - a contract that grants the holder the right to buy or sell a security at a given price on or before a given date Future contracts - agreements to trade assets at a specific price and time in the future Two types of futures: - Real commodities  commodity futures contract - Financial obligations  financial future contract

17. * Derivative Markets in North America Options : - -Montreal exchange (ME) - Canada - -Chicago Board Options Exchange (CBOT) – US Futures: commodities, stocks, and foreign exchanges -Canada’s only commodity futures exchange is the Winnipeg commodity exchange (WCE) -Major US futures exchanges Chicago Board of Trade (CBOT) - Chicago Mercantile Exchange (CME)

18. 2.6 Stock Market Indicators Canadian indicators include: - TSE 300 Composite Index - S & P /TSE 60 Index - Four CDNX Indexes International indicators include - Dow Jones Industrial Average (US) - S & P 500 Index (US) - Nasdaq Composite Index (US) - Nikkei 225 Average (Japan) - FT-SE 100 Index (UK) - MSCI (International/Global) - EAFE Index

19. Summary 1.Efficient financial markets are required to channel funds from surplus-spending units (savers) to deficit-spending units. Typically, such securities entitle the holder to a stream of periodic future cash payments. 2.Financial intermediaries allow economies of scale to be realized when matching surplus-spending units with deficit-spending units. Greater opportunities for portfolio diversification and money management can be gained.