chapter 1

Prepared byKen Hartviksen

INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary

CHAPTER 1 - An Introduction to Finance

CHAPTER 1 An Introduction to Finance


CHAPTER 1 - An Introduction to Finance1 - *Lecture AgendaLearning ObjectivesImportant TermsFinance DefinedReal versus Financial AssetsThe Financial SystemFinancial Instruments and MarketsThe Global Financial CommunitySummary and ConclusionsConcept Review Questions


CHAPTER 1 - An Introduction to Finance1 - *Learning ObjectivesWhat finance is and what is involved in the study of finance.How financial securities can be used to provide financing for borrowers and simultaneously to provide investment opportunities for lenders.How financial systems work in general.The channels of intermediation and the role played by market and financial intermediaries within this system.The basic types of financial instruments that are available and how they are traded.The importance of the global financial system.


CHAPTER 1 - An Introduction to Finance1 - *Key TermsBourse de MontralbrokersCanadian Trading and Quotation System Inc. (CNQ)capital market securitiescommon sharecorporate financeCrown corporationsdealer or over-the-counter (OTC) marketsdebt instrumentsequity instrumentsexchanges or auction marketsfinancefinancial assetsfinancial intermediariesfourth marketintermediationinvestments


CHAPTER 1 - An Introduction to Finance1 - *Key Termsmarket capitalizationmarket intermediarymarketable financial assetsmoney market securitiesNew York Stock Exchange (NYSE)non-marketable financial assetsOntario Securities Commissionpreferred sharesprimary marketsreal assetssecondary marketsthird marketToronto Stock Exchange (TSX)TSX Group Inc.TSX MarketsTSX Venture ExchangeWinnipeg Commodity Exchange


CHAPTER 1 - An Introduction to Finance1 - *What Is Finance?Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.Finance is distinct from economics in that it addresses not only how resources are allocated but also under what terms and through what channelsFinancial contracts or securities occur whenever funds are transferred from issuer to buyer.


CHAPTER 1 - An Introduction to Finance1 - *The Study of FinanceThe study of finance requires a basic understanding of:SecuritiesCorporate lawFinancial institutions and markets


CHAPTER 1 - An Introduction to Finance1 - *Real Versus Financial AssetsReal assets are tangible things owned by persons and businessesResidential structures and propertyMajor appliances and automobilesOffice towers, factories, minesMachinery and equipmentFinancial assets are what one individual has lent to anotherConsumer creditLoansMortgages


CHAPTER 1 - An Introduction to Finance1 - *Assets and Liabilities of Households, 2005


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Table 1-2 Assets and Liabilities of Households, 2005

Assets$ BillionLiabilities$ Billion

Houses1,086Consumer credit260

Consumer Durables435Loans131

Land827Mortgages588

Real Assets2,348Total Liabilities979

Deposits683

Debt114

Pensions and insurance1,200

Shares1,254

Foreign and other72

Financial Assets3323

Total Assets5,671

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005. Ottawa: Minister of Industry, 2006 (Catalogue No. 13-214-XIE).

CHAPTER 1 - An Introduction to Finance1 - *The Financial System OverviewThe household is the primary provider of funds to businesses and government.Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in their retirement yearsFinancial intermediaries transform the nature of the securities they issue and invest inBanks, trust companies, credit unions, insurance firms, mutual fundsMarket intermediaries simply help make markets workInvestment dealersBrokers


CHAPTER 1 - An Introduction to Finance1 - *The Financial System FIGURE 1-2


CHAPTER 1 - An Introduction to Finance1 - *The Financial SystemChannels of IntermediationFunds can be channeled from saver to borrower in three ways:Direct intermediation (direct transfer from saver to borrower a non-market transaction)Direct intermediation (a market-based transaction usually through a market intermediary such as a broker)Indirect claims through a financial intermediary (where the financial intermediary such as a bank offers deposit-taking services and ultimately lends those deposits out as mortgages or loans)


CHAPTER 1 - An Introduction to Finance1 - *Channels of IntermediationFIGURE 1-3


CHAPTER 1 - An Introduction to Finance1 - *The Financial SystemFinancial IntermediariesBanks and other deposit-taking institutionsInsurance companiesPension FundsMutual Funds


CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesCanadian Chartered BanksBanks take deposits from numerous depositors from across CanadaThe deposits are pooled in the BankThe bank takes these pooled funds and lends them out to households and businesses in the form of mortgages and loansThe bank transforms the original nature of the savers (depositors) money:Deposits are usually small in amountface little or no risk, and depositors expect to withdraw the amount at any timeLoans and mortgages on the other hand usually have the following characteristics:Large sumsBorrowed for long periods of timeBorrowed for risky purposes.Banks can perform this transformation function because they become experts at risk assessment, financial contracting (pricing the risk) and monitoring the activities of borrowers.


CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesCanadian Chartered Banks


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Table 1-3 Chartered Banks: Financial Statistics, 2005

BankRevenue ($ million)Assets ($ million)Profits ($ million)

Royal Bank of Canada29,403469,5213,387

Canadian Imperial Bank of Commerce (CIBC)18,677280,370-32

Bank of Nova Scotia18,332314,0253,209

TD Canada Trust18,665365,2102,229

Bank of Montreal15,138297,5322,400

National Bank5,320107,598855

Source: BMO InvestorLine website: www.bmoinvestorline.com, October 31, 2006.

CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesInsurance CompaniesInsurers sell policies and collect premiums from customers based on the pricing of those policies given the probability of a claim and the size the policy and administrative fees. They invest the premiums so that the accumulated value in the future will grow to meet the anticipated claims of the policyholders.In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a large number of policyholders through the insurance company.Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of loss themselves.


CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesInsurance Companies


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Table 1-4 Insurance Companies: Financial Statistics, 2005

InsurerRevenue ($ million)Assets ($ million)Profits ($ million)

Manulife Financial32,187322,1713,294

Sun Life Financial21,871171,8501,867

Great-West Lifeco23,883102,1611,775

ING Canada4,4469,926782

Source: Data from BMO InvestorLine website: www.bmoinvestorline.com, October 31, 2006.

CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesPension Plan AssetsIndividuals and employers make payments over the entire working life of a person with those funds invested to grow over time.Ultimately, the accumulated value in the pension can be used by the person in retirement.Pension plans accumulate considerable sums of money, and their managers invest those funds with long-term investment time horizons in diversified portfolios of investments. These investments are a major source of capital, fuelling investment in research and development, capital equipment, resource exploration and ultimately contributing in a substantial way to growth in the economy.


CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesPension Plan Assets


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Table 1-5 Pension Plan Assets, 2005

Pension Plan ManagersNet Assets ($ billion)

Caisse de depot et placement du Quebec216.1

Canada Pension Plan (CPP)98.0

Ontario Teachers (Teachers)96.1

Ontario Municipal Employees (OMERS)41.6

* The Caisse manages the investments of several pension plans.

CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesCanadian Mutual Fund AssetsMutual funds give small investors access to diversified, professionally-managed portfolios of securities.Small investors often do not have the funds necessary to invest directly into market-traded stocks and bonds.This is called denomination intermediation because the mutual fund makes investments available in smaller, more affordable amounts of money.Canadian indirect investment in the markets through managed products such as mutual funds and segregated funds has grown exponentially.

(see Figure 1-4 on the next slide)


CHAPTER 1 - An Introduction to Finance1 - *Financial IntermediariesCanadian Mutual Fund AssetsFIGURE 1-4


CHAPTER 1 - An Introduction to Finance1 - *The Financial SystemThe Major BorrowersPublic DebtGovernmentsFederalProvincialMunicipalCrown CorporationsPrivate DebtHouseholdsNon-financial Corporations


CHAPTER 1 - An Introduction to Finance1 - *The Financial SystemLargest Non-financial Companies


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Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005

Non-financial CompaniesRevenue ($ million)Assets ($ million)

General Motors of Canada Ltd.34,991n/a

Loblaw Companies Ltd.27,81213,761

Magna International Inc.22,87312,321

Imperial Oil Ltd.26,93615,582

Alcan Inc.*20,40826,638

BCE Inc.19,15040,630

Bombardier Inc.*14,88217,483

Petro-Canada17,67320,655

Onex Corp.17,62614,845

EnCana Corp.*14,32234,148

*Company reports in U.S. dollars.

Source: Data from "The Top 1000 in 2005." Globe and Mail Report on Business website: www.theglobeandmail.com.

CHAPTER 1 - An Introduction to Finance1 - *Financial InstrumentsThere are two major categories of financial securities:Debt InstrumentsCommercial paperBankers acceptancesTreasury billsMortgage loansBondsDebenturesEquity InstrumentsCommon stockPreferred stock


CHAPTER 1 - An Introduction to Finance1 - *Financial Instruments Non-marketableCharacteristics of non-marketable securitiesCannot be traded between or among investorsMay be redeemable (a reverse transaction between the borrower and the lender)Examples:Savings accountsTerm DepositsGuaranteed Investment CertificatesCanada Savings Bonds


CHAPTER 1 - An Introduction to Finance1 - *Financial Instruments MarketableCharacteristics of Marketable securitiesCan be traded between or among investors after their original issue in public markets and before they mature or expire

Market CapitalizationIs an important term in financeIt is the total market value of a company It is found by multiplying the number of shares outstanding by the market price per share.


CHAPTER 1 - An Introduction to Finance1 - *Financial Instruments MarketableMarkets can be categorized by the time to maturity:Money Market Securities (for short-term debt securities that are pure discount notes)Bankers acceptancesCommercial PaperTreasury BillsCapital Market Securities (for long-term debt or equity securities with maturities greater than 1 year)BondsDebenturesCommon StockPreferred Stock


CHAPTER 1 - An Introduction to Finance1 - *Financial MarketsPrimary MarketMarkets that involve the issue of new securities by the borrower in return for cash from investors (Capital formation occurs)Secondary MarketMarkets that involve buyers and sellers of existing securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital formation occurs)


CHAPTER 1 - An Introduction to Finance1 - *Financial Markets Types of Secondary MarketsExchanges or Auction MarketsSecondary markets that involve a bidding process that takes place in specific locationFor example TSX, NYSEDealer or Over-the-counter (OTC) MarketsSecondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another.For example the bond market


CHAPTER 1 - An Introduction to Finance1 - *Financial Markets Other MarketsThird MarketTrading of securities that are listed on organized exchanges in the Over-the-counter marketFourth MarketTrading of securities directly between investors (usually between two large institutions) without the involvement of brokers or dealers.Operates through the use of privately owned automated systems such as Instinet


CHAPTER 1 - An Introduction to Finance1 - *The Global Financial CommunityRepresents an important source of funds for borrowersProvides investors with important alternatives as they seek to build wealth through diversified portfolios


CHAPTER 1 - An Introduction to Finance1 - *The Global Financial Community


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Table 1-7 Canada's International Investments, 2005

Total Assets($ million) 1,016,031

Canadian direct investments abroad465,058

Canadian portfolio investments284,604

Portfolio foreign bonds82,374

Portfolio foreign stocks189,175

Other portfolio investments13,055

Other Canadian investments266,369

Loans48,325

Allowances

Deposits120,694

Official international reserves38,030

Other assets59,319

Total Liabilities1,184,534

Foreign direct investments in Canada415,561

Foreign portfolio investments508,398

Portfolio Canadian bonds380,017

Portfolio Canadian stocks107,598

Portfolio Canadian money market instruments20,783

Other foreign investments260,575

Loans36,107

Deposits201,639

Other liabilities22,829

Canada's Net International Investment Position-168,503

Source: Statistics Canada.

CHAPTER 1 - An Introduction to Finance1 - *SummaryIn this chapter you have learned about:Financial systems in general, and the Canadian financial system in particularMajor participants in the Canadian financial system, including the different types of financial securities and financial markets


CHAPTER 1 - An Introduction to Finance1 - *Internet LinksBMO InvestorLine: www.bmoinvestorline.comInvestment Funds Institute of Canada: www.ific.caGlobe and Mail Report on Business: www.theglobeandmail.comToronto Stock Exchange (TSX): http://www.tsx.com/Canadian Trading and Quotation System Inc.: http://www.cnq.ca/ Ontario Securities Commission: http://www.osc.gov.on.ca/index.jspWinnipeg Commodity Exchange: http://www.wce.ca/New York Stock Exchange (NYSE) Euronext: http://www.nyse.com/


CHAPTER 1 - An Introduction to Finance1 - *CopyrightCopyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.


chapter 1

Documents

financial securities

financial systems

financial assetsreal

global financial system

equipmentfinancial assets

quotation system

liabilities of households

key termsbourse