Finance Markets, Institutions, and Management

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FinanceMarkets, Institutions, and Management

• Prof. Miles Cahill
• College of the Holy Cross

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Outline

• Financial Markets and Institutions
• Overview of financial system
• The role of interest rates
• Financial markets
• Financial instruments debt, equity, and
  derivatives
• Financial institutions
• Term structure of interest rates
• Corporation Finance
• Understanding cash flows
• Ways to raise various kinds of capital
• Measuring the cost of capital

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What is finance?

• Channeling funds to more productive resources

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What do financial institutions do?

• Allow lenders to
• Decrease risk
• Increase liquidity
• Lower transactions costs
• Lower information costs
• Lend at higher return (after costs)
• Allow borrowers to
• Access more funds
• Lower transactions and regulatory costs
• Structure liabilities/equity
• Borrow at lower rates

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What are interest rates?

• What is interest?
• Funds paid back above initial loan
• Compensate for time value of money, risk, costs,
  etc.
• Opportunity cost of holding asset
• Interest rate concepts
• Annual
• As percentage of original loan / investment
• Can be used to compare any two loans /
  investments

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Review Interest rate building

• Nominal real inflation rate
• Inflation rate compensate for higher prices when
  funds paid back
• Real compensate for time value of money, risk,
  costs, etc.
• Benchmark
• U.S. govt bond with same term (due date)
• Take into account expected rate changes
• Add premiums
• Risk, liquidity, costs, etc.
• The appropriate interest is called the cost of
  capital, required return, or discount rate.

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Key definitions

• Asset Anything of value (usually can be sold)
• Tangible, financial or intellectual property
• Maturity Date which a security expires
• date which funds must be fully repaid
• Face value, or par value Amount paid by issuer
  of security at maturity
• Coupon, or interest payments Fixed periodic
  dollar payments
• Dividends Periodic payments made to stock
  shareholders

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Key characteristics

• Term Length of time until maturity
• Risk The probability and magnitude of changes
  in value
• Liquidity How much of an assets value can be
  obtained if asset sold quickly
• Marketability Ability to sell asset
• How many trades are there in a day?
• Transactions costs Cost of buying/selling asset
• Fees, opportunity cost

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Defining financial markets

• Are securities newly issued or established?
• Primary markets Markets where securities are
  sold by original issuer (primary securities)
• Secondary markets Markets where securities are
  sold by owners other than original issuer
• No finance is done in secondary markets
  secondary markets only give securities liquidity
• Secondary market prices are used for primary
  market pricing (for additional securities)

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Defining financial markets

• What are ownership rights?
• Equity markets Securities are shares of
  ownership
• Debt markets Securities are claims to promised
  stream of payments
• Derivatives markets Securities are claims to
  future assets or claims to payments tied to other
  securities

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Defining financial markets

• How does trading operate?
• Auction markets
• Prices are set by competitive bidding by a large
  number of traders at a central location.
• Over-the-counter (OTC) markets
• Prices are posted electronically by dealers
• Electronic Communication Networks (ECNs)
• Exchanges are made between individuals over
  network rather than organized market
• NYSE merged with an ECN (to form NYSE Arca)

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Defining financial markets

• What is term to maturity of assets?
• Money markets
• Short-term (lt1 yr.) securities
• Capital markets
• Intermediate (1-10 yr.), long (10 yr.), infinite
  term securities

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Defining financial markets

• When will the securities (or goods) be delivered?
• Spot (cash) markets
• Sale and immediate delivery of security
• Futures (derivatives) markets
• Agreements are made for delivery of security at
  some future specified date.
• Option gives holder right to purchase a
  security during a period of time (or good or
  service), but holder is not obligated to do so.

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Financial intermediaries

• Depository institutions
• Accept deposits and make loans
• Non-depository lending/equity institutions
• Do not accept deposits
• Sell securities and make loans or buy securities
• Securities market institutions
• Not really intermediaries
• Assist lending, borrowing and liquidity on markets

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Depository institutions

• Commercial banks
• Business and commercial loans
• Lines of credit
• Mortgages, household loans
• Thrifts
• Savings and loan institutions, mutual savings
  banks, credit unions

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Venture capital

• Sells securities, shares or or partnerships to
  raise funds
• Buys ownership in young or struggling firms
• Time is usually limited to a few years
• Takes active role in running company
• Uses management expertise
• Often gives advice, makes key decisions
• Goals
• (1) go public, (2) find private partners,(3)
  find merger/buyer, (4) cash out/liquidate

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Finance companies

• Issue loans
• Fund loans by selling debt or equity securities
• May be owned by a large consumer products
  corporation or an independent business
• Lend to higher-risk borrowers

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Private equity capital

• Buys ownership shares in privately-held companies
• Sometimes does not take as active a role in
  running firm
• Often holds ownership for longer than VC
• Usually sells limited partnership shares to
  individuals and institutions
• Not subject to same regulatory scrutiny as
  publicly-held companies

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Real estate investment trusts (REITs)

• Buys real estate properties
• May build/improve/operate diverse real estate
  holdings
• May obtain funds through selling mutual fund
  shares, limited partnerships, or other
  arrangements

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Mutual funds and investment companies

• Issue shares in a portfolio of securities
• Pool investors funds into a portfolio
• Shares pay a return based on return on portfolio
  (less fees)
• Money market mutual funds
• Short-term securities, very safe
• Shares can be withdrawn by check
• Considered cash
• Many varieties
• Types of securities, firms, risk, etc.
• Closed-end vs. Open-end

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Hedge funds

• Umbrella term for large variety of funds
• May buy any asset
• Stocks, bonds, derivatives, short positions,
  violins
• May be highly speculative
• May take active management role
• Very limited regulatory scrutiny
• Very limited disclosure rules, asset holdings
• Number, net worth of investors limited, min.
  investment high
• Often set up as limited partnerships
• Very high fees

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Contractual savings

• Issue contracts for future payments under
  specified conditions
• Pension funds
• Life insurance companies
• Casualty insurance companies
• May buy other investments
• Mutual funds, VC, PE, hedge funds, etc.

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Investment banks

• Assist business in raising new funds through
  markets
• Type of securities, prices
• Legal and regulatory hurdles
• Find buyers
• May underwrite a new security issue
• Guarantee price for all new securities

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Investment bank underwriting
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Securities market institutions

• Brokers
• Bring together buyers and sellers on secondary
  market, but do not own securities
• Dealers
• Own securities and buy and sell securities
  directly on secondary market using own accounts
• Other specialists financial advisors, etc.

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Types of securities

• Equity
• Shares of common stock
• Preferred stock
• Non-marketable shares
• Partnerships (e.g. LLP)

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Types of securities

• Debt
• Bonds
• Treasury
• Bill (lt 1 yr.), Note (gt1 - 10 yrs.), Bond ( gt 10
  yrs.)
• Corporate
• Paper (lt 1 yr.), notes bonds (gt 1 yr.)
• Rated by agencies for default risk level
• Other money market
• CDs, Bankers acceptances, RPs
• Securitized
• Backed by other loans
• Loans

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Types of securities

• Derivatives
• Value based on another assets value
• Specify when payments/exchanges made
• Usually settled with cash
• Forwards, Futures
• Options
• Swaps

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Summary where to get funds?

• Venture capital
• Finance companies
• Banks
• Private equity
• Going public formal markets
• Stocks, bonds
• More access to funds from more individuals,
  institutions
• At mercy of shareholders and markets?
• Loss of control?

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Application of markets

• The yield curve / term structure of interest
  rates
• Plot / table of Treasury interest rates for bonds
  with different maturity dates
• Reflect
• Risk (volatility, events)
• Expectations (inflation, growth, policy)

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Term structure

• Normal upward sloping
• Interest rates expected to stay same
• Upward slope is compensation for risk

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Term structure

• Steep steeper than normal
• Reflects higher expectations for
• Inflation
• Real interest rates (growth, debt, policy, or
  risk)

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Term structure

• Inverted/flat downward sloping/flat
• Reflects lower expectations for
• Inflation
• Real interest rates (growth, policy, or risk)
• A recession is likely expected!

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Current term structure

• What is prediction?
• Short near upward-slope expect temp. rate hike?
• Flat/inverted
• Slow growth or recession
• Low inflation

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Corporation finance

• What is the right way to value a project?
• What is the right way to fund a project?
• Key terms
• Present value
• Cash flows
• Net present value
• Internal rate of return
• Cost of capital

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Review Interest rates and PV

• PV principles review
• PV(1i)nFV
• PV FV/(1i)n
• PV of stream of cash flows (FVs) is sum of PV of
  each cash flow
• This is the fundamental way all loans, stocks,
  bonds, etc. are valued
• i is the discount rate, the required rate of
  return, or the cost of capital

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PV review examples

• FV 105 in 1 year, i5
• FV 121 in 2 years, i10
• FV 5 in 1 yr, 105.25 in 2 yrs, i5
• FV 100 for 3 yrs, 1000 in 3 yrs, i8

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PV review examples

• FV 105 in 1 year, i5
• 100
• FV 121 in 2 years, i10
• 100
• FV 5 in 1 yr, 105 in 2 yrs, i5
• 100
• FV 10 for 3 yrs, 80.91 in 3 yrs, i8
• 100

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Cash flows

• Funds paid or received at different times
• Timing is critical to keeping track of true value
• Use a timeline to keep track

0
1
2
3
Time
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Valuing cash flows PV FV

• Use concept of PV and FV to value cash flows at
  points in time
• Example put 100 in bank today, and after 1 and
  2 years at i 8. What is value of account
  after 3 years?

0
1
2
3
Time
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FV cash flow example

• Answers

0
1
2
3
Time
CF
100
100
100
FV
100
208
324.64
350.61
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PV cash flow example

• What is the PV of the account?

0
1
2
3
Time
CF
100
100
100
FV
100
208
324.64
350.61
PV
100
192.59
278.33
278.33
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Annuity formula

• Annuity formula PV of a fixed stream of
  payments

• Can solve for CF
• Can use annuity tables
• Can use financial calculator/Excel
• Perpetuity PV CF/i

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Solving for the interest rate

• If have PV and FV, can solve for i?
• Yes, by hand for one period
• PV(1i)nFV ? i (FV/PV)1/n - 1
• Example PV 100, FV 140.50, n 3
• i (FV/PV)1/n - 1 (140.49/100)1/3 - 1
• 1.12 - 1 12
• This is actual rate of return for investment
• Need financial calculator/Excel for multiple
  periods

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Net present value

• Investment market value - cost
• PV of net cash flow cost of investment
• Fundamental method to evaluate investment
• Do investment if NPV gt 0

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Net present value

• Procedure
• Estimate cash flow revenues, costs
• Do sensitivity analysis look at different
  scenarios for i, cash flows
• Determine initial investment
• Find appropriate i (discount rate)
• Use i for similar investments
• Cost of borrowing or opportunity cost of funds
• NPV PV (net cash flows) - cost

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Net present value

• Team examples

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Net present value

• Summary
• As i?, NPV ?
• If project delayed, NPV ? and vice versa
• Faster payback not necessarily desirable
• Smooth returns not appreciated
• If all terms double, NPV doubles
• Need to be careful to take size of investment
  into account when selecting

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Payback

• The time to recover initial investment
• Break-even date
• Use raw cash flows
• Calculate years (or fraction)
• Use a payback rule
• Select payback date cutoff criteria to guide
  investment

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Payback

• Problems
• Not useful for erratic investments (Team 5)
• No PV
• No risk criteria
• No objective criteria for cutoff period
• Advantages
• Easy
• Useful for relatively small decisions
• May approximate NPV
• Stresses earlier cash flows
• Bias towards liquid, more certain cash flows

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Discounted Payback

• Use PV of cash flows for payback
• Additional advantages
• Uses PV
• If there is payback, NPVgt0
• Disadvantages
• No easier than NPV
• Still requires arbitrary cutoff
• Ignores cash flows beyond cutoff (Team 5)
• Biased against long-term projects

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Internal rate of return (IRR)

• Calculate implied interest rate (return) of
  project
• Use financial calculator or spreadsheet to find
  IRR where
• Use initial investment as PV
• Use estimated cash flows as FV
• Solve for interest rate this interest rate is
  the IRR
• Alt solve for return where NPV 0
• Select projects whose IRR gt base interest rate
  (required return)
• Selects projects with NPV gt 0

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Internal rate of return (IRR)

• Simple example
• 2 year investment costs 100
• Has single cash flow of 121 in two years
• Required return (cost of borrowing/interest rate
  on similar investments) is 8.
• NPV -100 121/1.082 3.73
• IRR 100 121/(1IRR)2
• IRR 10

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Internal rate of return (IRR)

• Comparison to NPV rule
• Identical for conventional investments
• Initial investment followed by positive cash
  flows
• Advantages
• Uses standard rate of return as measure
• Useful for comparing investments of different
  sizes
• Simpler to communicate
• Doesnt require discount rate (interest rate for
  PV)
• Disadvantages
• Nonconventional cash flows give absurd answers
• Highest NPV project may not have highest IRR

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Cost of capital

• What is right interest rate to use in NPV
  analysis?
• Use interest rate building
• Start with benchmark
• Add premia for risk, liquidity, etc.
• Weighted Average Cost of Capital (WACC)
• Weighted average of rates for entire firm
• Includes different assets (stocks, bonds, etc.)

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Summary

• The financial industry is complex
• There are many sources to raise funds
• The interest rate is a fundamental measure to
  evaluate investments
• The term structure of interest rates is a useful
  forecasting tool
• Timing of cash flows, interest rate very
  important
• NPV is probably best criteria for making
  investment choices, but be careful of size, risk