CHAPTER 2: THE FINANCIAL MARKET ENVIRONMENT

Financial Institutions & Markets

Firms that require funds from external sources can obtain them in three ways:
 through a financial institution
 through financial markets
 through private placements

Financial Institutions & Markets: Financial Institutions

 Financial institutions are intermediaries that channel the savings of individuals,
businesses, and governments into loans or investments.
 The key suppliers and demanders of funds are individuals, businesses, and
governments.
 In general, individuals are net suppliers of funds, while businesses and
governments are net demanders of funds.

Commercial Banks, Investment Banks, and the Shadow Banking System

 Commercial banks are institutions that:
- provide savers with a secure place to invest their funds
- offer loans to individual and business borrowers
 Investment banks are institutions that:
- assist companies in raising capital
- advise firms on major transactions such as mergers or financial restructurings
- engage in trading and market making activities
 The Glass-Steagall Act was an act of Congress in 1933 that created the federal
deposit insurance program and separated the activities of commercial and
investment banks. It was repealed it 1999 by Congress.
 The shadow banking system describes a group of institutions that:
- engage in lending activities, much like traditional banks
- but do not accept deposits
- are not subject to the same regulations as traditional banks

Matter of Fact
 Consolidation in the U.S. Banking Industry:
- The U.S. banking industry has been going through a long period of consolidation.
- According to the FDIC, the number of commercial banks in the United States
declined from 11,463 in 1992 to 6,048 in 2013, a decline of 47%.
- The decline is concentrated among small, community banks, which larger
institutions have been acquiring at a rapid pace.

Financial Institutions & Markets: Financial Markets

 Financial markets are forums in which suppliers of funds and demanders of funds
can transact business directly.
 Transactions in short term marketable securities take place in the money market
while transactions in long-term securities take place in the capital market.
 A private placement involves the sale of a new security directly to an investor or
group of investors.
 Most firms, however, raise money through a public offering of securities, which is
the sale of either bonds or stocks to the general public.
 The primary market is the financial market in which securities are initially issued;
the only market in which the issuer is directly involved in the transaction.
  Secondary markets are financial markets in which preowned securities (those that
are not new issues) are traded.

Figure 2.1. Flow of Funds

The Money Market

 The money market is created by a financial relationship between suppliers and
demanders of short-term funds.
 Most money market transactions are made in marketable securities which are
short-term debt instruments, such as:
 U.S. Treasury bills issues by the federal government
 commercial paper issued by businesses
 negotiable certificates of deposit issued by financial institutions
 Investors generally consider marketable securities to be among the least risky
investments available.
 The international equivalent of the domestic (U.S.) money market is the
Eurocurrency market.
 The Eurocurrency market is a market for short-term bank deposits denominated in
U.S. dollars or other marketable currencies.
 The Eurocurrency market has grown rapidly mainly because it is unregulated and
because it meets the needs of international borrowers and lenders.
 Nearly all Eurodollar deposits are time deposits.

The Capital Market

 The capital market is a market that enables suppliers and demanders of long-term
funds to make transactions.
 The key capital market securities are bonds (long-term debt) and both common
and preferred stock (equity, or ownership).
 Bonds are long-term debt instruments used by businesses and government to
raise large sums of money, generally from a diverse group of lenders.
 Common stock are units of ownership interest or equity in a corporation.
 Preferred stock is a special form of ownership that has features of both a
bond and common stock.
 Lakeview Industries, a major microprocessor manufacturer, has issued a 9 percent
coupon interest rate, 20-year bond with a $1,000 par value that pays interest
semiannually.
 Investors who buy this bond receive the contractual right to $90 annual interest
(9% coupon interest rate x $1,000 par value) distributed as $45 at the end of each 6
months (1/2 x $90) for 20 years.
 Investors are also entitled to the $1,000 par value at the end of year 20.
Focus on Practice
 Berkshire Hathaway – Can Buffett Be Replaced?
 Since the early 1980s, Berkshire Hathaway’s Class A common stock price has
climbed from $285/share to $114,000/share.
 The company is led by Chairman Warren Buffett (83) and Vice-Chairman
Charlie Munger (89).
 The share price of BRKA has never been split. Why might the company refuse
to split its shares to make them more affordable to average investors?

Broker Markets and Dealer Markets

 Broker markets are securities exchanges on which the two sides of a transaction,
the buyer and seller, are brought together to trade securities.
 Trading takes place on centralized trading floors of national exchanges, such as
NYSE Euronext, as well as regional exchanges.
 Dealer markets, such as Nasdaq, are markets in which the buyer and seller are not
brought together directly but instead have their orders executed by securities
dealers that “make markets” in the given security.
 The dealer market has no centralized trading floors. Instead, it is made up of a
large number of market makers who are linked together via a mass-
telecommunications network.
 As compensation for executing orders, market makers make money on the spread
(bid price – ask price).

Matter of Fact
According to the World Federation of Exchanges, in 2012:
1. NYSE Euronext is the largest stock market in the world, as measured by the total
market value of securities listed on that market. NYSE Euronext has listed securities
worth more than $14.1 trillion in the U.S. and $2.1 trillion in Europe.
2. The second largest exchange is Nasdaq, with listed securities valued at $4.6 trillion.
3. The Tokyo Stock Exchange has securities valued at $3.5 trillion.
4. The fourth largest exchange, the London Stock Exchange, has securities valued at
$3.3 trillion.

International Capital Markets

 In the Eurobond market, corporations and governments typically issue bonds
denominated in dollars and sell them to investors located outside the United
States.
 The foreign bond market is a market for bonds issued by a foreign corporation or
government that is denominated in the investor’s home currency and sold in the
investor’s home market.
 The international equity market allows corporations to sell blocks of shares to
investors in a number of different countries simultaneously.

The Role of Capital Markets

 From a firm’s perspective, the role of capital markets is to be a liquid market where
firms can interact with investors in order to obtain valuable external financing
resources.
 From investors’ perspectives, the role of capital markets is to be an efficient market
that allocates funds to their most productive uses.
  An efficient market allocates funds to their most productive uses as a result of
competition among wealth-maximizing investors and determines and publicizes
prices that are believed to be close to their true value.
 Advocates of behavioral finance, an emerging field that blends ideas from finance
and psychology, argue that stock prices and prices of other securities can deviate
from their true values for extended periods.
 Examples of the principle that stock prices sometimes can be wildly inaccurate
measures of value include:
 the huge run up and subsequent collapse of the prices of Internet stocks in the
late 1990s
 the failure of markets to accurately assess the risk of mortgage-backed
securities in the more recent financial crisis

Focus on Ethics
 The Ethics of Insider Trading
 Bryan Shaw received inside information on Herbalife and Skechers from Scott
London, a KPMG auditor. Using this information, Shaw made $1.3 million in
trading profits. He pleaded guilty to insider trading charges in 2013.
 Laws prohibiting insider trading were established in the United States in the
1930s. These laws are designed to ensure that all investors have access to
relevant information on the same terms.
 Some market participants believe that insider trading should be permitted,
arguing that information about the trades of insiders would be useful
information to the market.
 If efficiency is the goal of financial markets, is allowing or disallowing insider
trading more unethical?
 Does allowing insider trading create an ethical dilemma for insiders?

The Financial Crisis: Financial Institutions and Real Estate Finance

 Securitization is the process of pooling mortgages or other types of loans and then
selling claims or securities against that pool in a secondary market.
 Mortgage-backed securities represent claims on the cash flows generated by a
pool of mortgages and can be purchased by individual investors, pension funds,
mutual funds, or virtually any other investor.
 A primary risk associated with mortgage-back securities is that homeowners may
not be able to, or may choose not to, repay their loans.

The Financial Crisis: Falling Home Prices and Delinquent Mortgages

 Rising home prices between 1987 and 2006 kept mortgage default rate low.
 Lenders relaxed standards for borrowers and created subprime mortgages.
 As housing prices fell from 2006 to 2009, many borrowers had trouble making
payments, but were unable to refinance.
 As a result, there was a sharp increase in the number of delinquencies and
foreclosures.
Figure 2.2. House Prices Soar and then Crash
 The Financial Crisis: Crisis of Confidence in Banks
The price of bank stocks fell 81% between January 2008 and March 2009.

180
160
140
120
100
80
60
40
20 Figure 2.3 Bank Stocks Plummet During
0 Financial Crisis
2007 2008 2009 2010 2011

The Financial Crisis: Spillover Effects and the Great Recession

 As banks came under intense financial pressure in 2008, they tightened their
lending standards and dramatically reduced the quantity of loans they made.
 Corporations found that they could no longer raise money in the money market, or
could only do so at extraordinarily high rates.
 As a consequence, businesses began to hoard cash and cut back on expenditures,
and economic activity contracted.

Regulation of Financial Institutions and Markets: Regulations Governing Financial

Institutions
 The Glass-Steagall Act (1933) established the Federal Deposit Insurance
Corporation (FDIC) which provides insurance for deposits at banks and monitors
banks to ensure their safety and soundness.
 The Glass-Steagall Act also prohibited institutions that took deposits from engaging
in activities such as securities underwriting and trading, thereby effectively
separating commercial banks from investment banks.

 The Gramm-Leach-Bliley Act (1999) allows business combinations (e.g. mergers)

between commercial banks, investment banks, and insurance companies, and thus
permits these institutions to compete in markets that prior regulations prohibited
them from entering.
 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act
in 2010, but it has not been fully implemented.

 The Securities Act of 1933 regulates the sale of securities to the public via the
primary market.
 Requires sellers of new securities to provide extensive disclosures to the potential
buyers of those securities.
 The Securities Exchange Act of 1934 regulates the trading of securities such as
stocks and bonds in the secondary market.
 Created the Securities Exchange Commission, which is the primary
government agency responsible for enforcing federal securities laws.
  Requires ongoing disclosure by companies whose securities trade in secondary
markets (e.g., 10-Q, 10-K).
 Imposes limits on the extent to which “insiders” can trade in their firm’s
securities.
Business Taxes
 Both individuals and businesses must pay taxes on income.
 The income of sole proprietorships and partnerships is taxed as the income of the
individual owners, whereas corporate income is subject to corporate taxes.
 Both individuals and businesses can earn two types of income—ordinary income
and capital gains income.
 Under current law, tax treatment of ordinary income and capital gains income
change frequently due frequently changing tax laws.

Table 2.1 Corporate Tax Rate Schedule

Business Taxes: Ordinary Income

 Ordinary income is earned through the sale of a firm’s goods or services and is
taxed at the rates depicted in Table 2.1 on the previous slide.

Business Taxation: Marginal versus Average Tax Rates

 A firm’s marginal tax rate represents the rate at which additional income is taxed.
 The average tax rate is the firm’s taxes divided by taxable income.

Business Taxation: Interest and Dividend Income

 For corporations only, 70% of all dividend income received from an investment in
the stock of another corporation in which the firm has less than 20% ownership is
excluded from taxation.
 This exclusion moderates the effect of double taxation, which occurs when after-
tax corporate earnings are distributed as cash dividends to stockholders, who then
must pay personal taxes on the dividend amount.
  Unlike dividend income, all interest income received is fully taxed.

Business Taxation: Tax-Deductible Expenses

 In calculating taxes, corporations may deduct operating expenses and interest
expense but not dividends paid.
 This creates a built-in tax advantage for using debt financing as the following
example will demonstrate.

 As the example shows, the use of debt financing can increase cash flow and EPS,
and decrease taxes paid.
 The tax deductibility of interest and other certain expenses reduces their actual
(after-tax) cost to the profitable firm.
 It is the non-deductibility of dividends paid that results in double taxation under
the corporate form of organization.

Business Taxation: Capital Gains

 A capital gain is the amount by which the sale price of an asset exceeds the asset’s
purchase price.
 For corporations, capital gains are added to ordinary income and taxed like

ordinary income at the firm’s marginal tax rate.

Integrative Case: Merit Enterprise Corp.

Merit Enterprise Corporation’s CEO would like to dramatically expand the company’s
production capacity. This would require the company to raise up to $4 billion in addition to
the $2 billion of excess cash that they have accumulated. Merit is currently a private
company and is considering two options for raising the much needed capital.

 Option 1 – Merit could approach JPMorgan Chase, a bank that had served Merit
well for many years with seasonal credit lines as well as medium-term loans. Lehn
believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,
but it could probably gather a group of banks together to make a loan of this
magnitude. However, the banks would undoubtedly demand that Merit limit
further borrowing and provide JPMorgan with periodic financial disclosures so that
they could monitor Merit’s financial condition as it expanded its operations.
 Option 2 – Merit could convert to public ownership, issuing stock to the public in
the primary market. With Merit’s excellent financial performance in recent years,
Sara thought that its stock could command a high price in the market and that
many investors would want to participate in any stock offering that Merit
conducted.

a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the most
positive aspects of this option, and what are the biggest drawbacks?
b. Do the same for option 2.
c. Which option do you think Sara should recommend to the board and why?