Practical financial managment 7e LASHER chapter 5

Chapter – The Financial System, Corporate Governance, and Interest The Financial System The economy is divided into sectors – – Consumption Production (includes government) Services, products, and money flow between the sectors every day – – – – Producers pay wages Workers spend incomes Producers spend revenues Creates a cyclical flow of money Figure 5-1 Cash Flows Between Sectors Diagram Omits Two Things Consumption sector – Most people not consume all of their income—they deposit savings and earn a return Production sector – Companies need to raise money to finance large, infrequent projects Economy has a need for and a source of $ Savings and Investment Financial markets channel consumer savings to companies through the sale of financial assets – Companies issue securities – Consumers purchase securities Figure 5- Flows Between Sectors The Term “Invest” Individuals invest by putting savings into financial assets: stocks, bonds, etc This makes funds available for business investment Hence: SAVINGS = INVESTMENT (Consumer) Savings = (Business) Investment Raising and Spending Money in Business Firms spend two kinds of money – Day-to-day funds – Large sums needed for major projects Raising and Spending Money in Business Firms to raise money by: Borrowing money: Debt Financing Selling stock: Equity Financing Term The length of time between now and the end (or termination) of something – Long-term projects last over 5-10 years financed with debt (bonds) and equity (earnings/stocks) – Short-term projects last less than year financed with short-term funds (bank loans) – Process is known as maturity matching 10 Different Kinds of Lending Risk Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans Three sources of risk, each with its own risk premium: – – – Default risk Liquidity risk Maturity risk 65 Different Kinds of Lending Risk Default Risk (DR) – The chance the lender won't pay principal or interest – Investors demand a default risk premium based on the their perception of the borrower’s creditworthiness Losses can be as much as the entire amount Considers firm's financial condition and credit record 66 Different Kinds of Lending Risk Liquidity Risk (LR) – – – Associated with being unable to sell the bond of an little known issuer Debt of small, hard to market firms is “illiquid” Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk 67 Different Kinds of Lending Risk Maturity Risk (MR) – – Bond prices and interest rates move in opposite directions Long-term bond prices change more with interest rate swings than shortterm bond prices 68 Putting the Pieces Together: The Interest Rate Model k = kPR + INFL + DR + LR + MR k is the nominal or quoted interest rate Model tells what theoretically should be in an interest rate Setting Interest Rates – set by supply and demand – No one uses the model to set rates 69 Federal Government Securities, the Risk Free Rate Federal Government Securities – The Federal government issues long-term bonds as well as shorter-term securities Risk in Federal Government Debt – No default risk: Can print money to pay off its debt – No liquidity risk: It’s easy to sell federal securities – Federal debt does have maturity risk 70 The Risk-Free Rate Very short term federal securities, Treasury Bills, pay the risk free rate The risk-free rate is approximately the yield on short-term Treasury bills Denoted as kRF Conceptual floor for interest rates 71 The Real Rate of Interest The Real Rate of Interest implies the effects of inflation removed – Tells investors whether or not they are getting ahead – There are periods during which the real rate has been negative The Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero 72 Concept Connection Example 5-3 Using the Interest Rate Model Using the Interest Rate Model, Sunshine Inc is planning to borrow by issuing three year bonds (notes) The following information is available The pure interest rate is 2.0% Inflation will be 3% next year and 4% thereafter Sunshine’s debt carries a default risk premium of 1.5% The firm carries a liquidity risk premium of 5% Maturity risk premiums on three-year debt are 1.0% a Estimate the interest rate Sunshine will have to offer b Moonlight Ltd recently issued three-year debt paying 11% What does the interest rate model imply about Moonlight’s risk relative to Sunshine’s? Concept Connection Example 5-3 Using the Interest Rate Model SOLUTION: To estimate the interest rate Sunshine will have to offer to sell the bonds (k s) a Calculate INFL, the average inflation rate over the life of the loan INFL = (3 + + 4)/3 = 11/3 = 3.67 = 3.7 + +4 are the inflation rates for the three years, or the life of this project Add them together The is the number of years, or life of the project Then write the interest rate model and substitute for k S kS = kPR + INFL + DR + LR + MR = 2.0 + 3.7 + 1.5 + + 1.0 = 8.7% Concept Connection Example 5-3 Using the Interest Rate Model b Write the interest rate model for Moonlight treating DR as an unknown, then substitute, and solve for DR kM = kPR + INFL + DR + LR + MR Sunshine’s risk premium from assumptions 11.0 = 2.0 + 3.7 + DR + + 1.0 DR = 3.8 The debt market seems to be assigning Moonlight a default risk premium of 3.8%, which is (3.8/1.5 ) = 2.5 times as large as Sunshine’s This implies more risk Yield Curves—The Term Structure of Interest Rates A graphic relation between interest rates term The normal yield curve – Short-term rates are usually lower than long-term rates – curve slopes up The inverted yield curve – Long-term rates are lower than short-term rates – curve slopes down A sustained inverted curve usually signals an economic downturn is ahead 76 Inverted Yield Curve- An Economic Predictor Inversion Period Recession Date July 2000 - January 2001 March 2001 May 1989 - August 1989 July 1990 October 1980 - September 1981 July 1981 November 1978 - May 1980 January 1980 June 1973 - November 1974 November 1973 December 1968 - February 1970 December 1969 Figure 5-10 Yield Curves 78 Yield Curves—The Term Structure of Interest Rates Theories attempt to explain the term structure of interest rates – Expectations Theory Today's rates rise or fall with term as future rates are expected to rise or fall – Liquidity Preference Theory Investors prefer shorter term securities and must be induced to make longer loans – Market Segmentation Theory Loan terms define independent segments of the debt market which set separate rates 79 [...]... market bids prices up and down Current financial performance is the best indication of future performance 28 Concept Connection Example 5- 1 Executive Stock Options Harry Johnson, CEO Salary Bonus $2 ,50 0,000 1 ,50 0,000 $4,000,000 Plus: Stock option: 200,000 shares @ $20, Market Price now $48. 65 Option Value: 200,000 x ($48. 65 - $20.00) = $5, 730,000 Total comp = $9,730,000; 59 % from options – – 29 Moral Hazard... run – Focused on ethics and legality of financial relationships between top managers and the corporations they serve – The idea is connected to the agency problem, which refers to a conflict of interest between executives and stockholders Two major financial crises thus far in the 21st century – – Stock market crash of 2000 caused by financial reporting fraud Financial crisis of 2008 caused by the subprime... price 31 Holding Performance Up Company financial statements - Income Statement and Balance Sheet are actually easy to manipulate by “bending” accounting rules 32 Responsibility for Financial Statements Responsibility for the contents of financial statements primarily falls to top management Top execs have the power to enhance their own wealth by cheating on financial reporting 33 Events of the 1990s... Transfers, Financial Intermediaries Primary market transactions can occur Directly – Issuer sells directly to buyers or through an investment bank – Indirectly Financial intermediary sells shares in itself and invests the funds collectively on behalf of investors Mutual fund is an example Portfolio is collectively owned – – – Investment bank lines up investors and functions as a broker 14 Figure 5- 3 Transfer... is an example Portfolio is collectively owned – – – Investment bank lines up investors and functions as a broker 14 Figure 5- 3 Transfer of Funds 15 Direct and Indirect Transfers, Financial Intermediaries Institutional investors play a major role in today’s financial markets – Own ¼ of all stocks, make over ¾ of all trades – Examples include: Mutual funds Pension funds Insurance companies Banks 16 The... then trading begins in the secondary market – IPOs are discussed in detail in Chapter 8 24 The OTCBB Market After a company goes public, its shares can trade in the over-the-counter (OTC) market Firms not listed on an exchange trade through the OTCBB overseen by the NASD Eventually a firm may list on an exchange 25 Figure 5- 7 Stock Market Quotation for Microsoft Corp 26 Corporate Governance Corporate... $9,730,000; 59 % from options – – 29 Moral Hazard A situation that tempts people to act in immoral or unethical ways Concept Connection Example 5- 1 Moral Hazard of Stock Based Compensation What if Harry can’t exercise his option for another six months? – – AND some disturbing financial information comes up that will cause the stock’s price to drop by $10 If released, that info will cost Harry $2,000,000 Harry.. .Financial Markets Capital Markets – Trade in stocks and long-term debt Money Markets – Trade in short term debt securities Federal government issues a great deal of short-term debt 11 Financial Markets: Primary and Secondary Markets Primary Market: Initial sale of a security – Proceeds go to... register – Sets standards of performance & compliance – Inspections and disciplinary procedures 35 Events of the 1990s Resulted in the Sarbanes-Oxley (SOX)Act: – Title I: Oversight of the Public Accounting Industry – Title II: Auditor Independence – Title III: Corporate Responsibility – Title IV: Enhanced Financial Disclosure – Title V: Wall Street Reforms—Securities Analyst Conflicts of Interest 36... with a broker and place trades via phone or online – Local broker forwards order to floor broker on the exchange trading floor – Trade confirmation is forwarded to local broker and investor 18 Figure 5- 4 Schematic Representation of a Stock Market Transaction 19 Exchanges New York Stock Exchange (NYSE) NYSE MKT (Previously AMEX) (NASDAQ) Regional stock exchanges (Philadelphia, Chicago, San Francisco, ... functions as a broker 14 Figure 5- 3 Transfer of Funds 15 Direct and Indirect Transfers, Financial Intermediaries Institutional investors play a major role in today’s financial markets – Own ¼ of... down Current financial performance is the best indication of future performance 28 Concept Connection Example 5- 1 Executive Stock Options Harry Johnson, CEO Salary Bonus $2 ,50 0,000 1 ,50 0,000 $4,000,000... Stock option: 200,000 shares @ $20, Market Price now $48. 65 Option Value: 200,000 x ($48. 65 - $20.00) = $5, 730,000 Total comp = $9,730,000; 59 % from options – – 29 Moral Hazard A situation that tempts