MOS 1023 Finance Notes PDF

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MOS - Intro to finance...

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Lesson 6: Pages 185-205: An Introduction to Finance: - Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers. - Finance is not just about how resources are allocated; it also examines under what terms and through what channels the allocations are made. - When funds are transferred a financial contract comes into existence which are called financial securities. Real Versus Financial Assets: - The difference between what is owned (assets) and what is owed (liabilities) is “net worth” or equity. - Three major domestic groups in the economy are individuals, referred to as the household sector, businesses and the government. When everything is added up the debts to ourselves net out to zero because one person’s debt is another person’s asset. - Balance sheet shows all real assets according to six major classifications. - Real assets represent the tangible things that compose personal and business assets. o Personal assets are the value of houses, the land the houses are on, the major appliances in the houses and the cars.  Major appliances and cars are referred to as consumer durables because they last many years. o For businesses, the major assets are the office buildings, factories, mines and so no (non-residential cultures); the machinery and equipment in those structures; the land they are on and the stock or inventories of things waiting to be used or sold. - Although balance sheets are useful for understanding wealth and the different types of real assets it removes most of the things that are of interest to students of finance. This is because it nets out all the debts we Canadians owe to other Canadians, which is almost all of our debts. - Basic idea behind NBSA is to collect financial data on the major agents in the financial system and then track the borrowing and lending between these agents. - Four major areas of finance: personal finance, government finance, corporate finance and international finance. All areas are connected and if one is affected it affects the other areas too. - The two major financial assets of the household sectors are: the market value of investments in shares and the market value of investments in insurance and pensions. - Basic problem in retirement planning is determining how to finance our non-working or retirement years when we will be consuming but not earning. - Within the household sector, we see older individuals lending and younger ones borrowing. By aggregating across everyone within the household sector this dynamic is lost. - Large part of household wealth consists of life insurance and pension claims, with the latter being promises made by a government or private company to pay money to individuals after they retire.

The financial system: - In Canada, the household sector is the primary provider of funds to business and government. - Basic financial flow is “intermediated” through the financial system, which compromises of the financial intermediaries that transform the nature of the securities they issue and invest in, and market intermediaries that simply make the markets work better. - Channels of intermediation: o The financial system transfers money from those with a surplus (lenders) to those who need it (borrowers). o Transfer occurs through intermediation, which is the process of bringing these parties together. o Ways for this intermediation can occur are to borrow directly from friends, relatives, and acquaintances or from specialized financial institutions. o In the first case, borrowers obtain funds directly from individuals; in the second, they borrow indirectly from individuals who have first loaned their savings to (deposited them into) a financial institution, which in turn lends to the ultimate borrowers. o Three basic channels of intermediation:  Direct intermediation – The lender provides money directly to the ultimate borrower without any help from a specialist. This is a nonmarket transaction because the exchange is negotiated directly between the borrower and the lender.  Direct intermediation with assistance – Either because no one individual can lend the full amount needed or because the borrower is not aware of the available lenders. As a result, the borrower needs help to find suitable leaders, which is what market intermediaries do.  Market intermediary is simply an entity that facilitates the working of markets and helps the direct intermediation process. Typically called brokers whose responsibilities are to assist with the transaction and bring borrowers and lenders together however do not affect the transaction itself.  Financial intermediation – Where the financial institution or financial intermediary lends the money to the ultimate borrowers but raises the money itself by borrowing directly from other individuals. The ultimate lenders have only an indirect claim on the ultimate borrowers; their direct claim is on the financial institution. o Credit Crunch – When people are not willing to lend to financial intermediaries, and those intermediaries, in turn, have to restrict whom they can lend to. - Intermediaries: o Chartered Banks – Most familiar and important category.  Banks are involved in almost all areas of the financial system; their core activity is to act as deposit takers and lenders.  They take in deposits from individuals and institutions and then lend the money to others as loans.

Banking is a low-margin, high turnover business, which means a bank makes lots of “sales” – that is, loans – but each one in and of itself is not highly profitable. After a couple years of losses, investors may start to worry about whether the bank can survive, and a full-scale credit crunch will erupt. o Insurance Companies:  Banks are the most important financial intermediaries; the major insurance companies are also very large.  Life insurance is not insurance – we are all going to die, so we can’t insure against it – but it is often a form of savings.  Insurance is insurance in the sense that it pays off only if you die during the life of the policy.  Insurance companies are classified as contractual savers, because the premiums on a policy are paid every month, so the insurers receive a steady flow of money: you buy life insurance and pay premiums; then you die and the policy pays off to your survivors.  The companies have all the premiums to invest, which is why many view selling insurance as simply a way of getting “free” money to invest. o Pension Funds:  The two largest components of the major financial assets of the household sector were insurance and pension assets, and direct investments in shares.  Funds in pension plans are held directly for their pensioners, and they substitute for having individuals save for themselves for their retirement.  Chartered Banks take in deposits and make loans; insurance companies take in insurance premiums and pay off when an incident, such as a death or fire a fire, occurs; pension funds take in contributions and provide pension payments after plan members retire. o Mutual Funds:  Simply act as a “pass-through” for individuals, providing them with a convenient way to invest in the equity and debt markets.  Mutual funds do not transform the nature of the underlying financial security.  They perform two major functions:  The pool small sums of money so they can make investments that would not be possible for smaller investors.  They offer professional expertise in the management of those funds. The Major borrowers: o In addition to the governments themselves, government-owned Crown corporations, government owned companies that provide goods and services needed by Canadians. 

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o Both publicly owned corporations and many other Crown corporations issue debt to finance company growth and expenditures, and hence represent important borrowers in the financial system. o In terms of assessing how much debt this is, we normally divide the amount of debt by a country’s gross domestic product (GDP). This standardizes the amount of debt by a country’s income in the same way that we assess the burden of an individual’s debt by dividing the amount of debt by their income. o Although government debt is very important as a benchmark, and personal debt is important for financing houses and consumer credit, arguably the most important borrowing sector is business. The business sector makes the goods and services we consume, and it borrows to finance growth in this capacity. o Typically, the profits of non-financial corporations are significantly less than those of the 5 chartered banks, which reiterates the important role played by the banks in our financial system. Financial Instruments and Markets: o Financial assets are formal legal documents that set out the rights and obligations of all the parties involved. o There are two major categories of financial securities:  Debt instruments – Represent legal obligations to repay borrowed funds at a specified maturity date and provide interim interest payments as specified in the agreement. Some of the most common examples are bank loans, commercial paper, bankers’ acceptances (BAs), treasury bills (T-bills), mortgage loans, bonds, and debentures.  Equity instruments – These represent an ownership stake in a company. The most common form of equity is common share, an equity instrument that represents part ownership and usually gives voting rights on major decisions affecting the company. Companies may also issue preferred shares, which usually entitle the owner to dividend payments that must be made before any dividends are paid to common shareholders. o Aside from the debt-versus-equity distinction, financial instruments can be categorized in several additional ways. One way is to distinguish between non-marketable financial assets, invested funds that are available on demand in instruments that are not tradable and marketable financial assets, those assets that can be traded among market participants.  Non-marketable assets – Savings accounts or demand deposits with financial institutions. Funds invested here are available on demand, which guarantees the liquidity of these investments, but you can’t sell them to someone else: first you have to withdraw the funds and then transfer the cash.  Another type is CSB (Canada Savings Bond) and its provincial counterparts, which are non-marketable, unlike traditional bonds, because they are not tradable.  Marketable securities are those that can be traded among market participants. Typically categorized not only according to

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whether they are debt or equity securities but also by their “term to maturity”, or time until the obligation must be repaid. Money market securities include short-term debt instruments, such as T-bills, commercial paper, and BAs. Capital market securities include debt securities with maturities greater than one year, such as bonds, debentures, equity securities, which represent ownership in a company and generally have no maturity date.

Financial Markets: o They play a critical role in any open economy by facilitating the transfer of funds from lenders to borrowers. If markets are efficient these funds will be allocated to those who have the most productive use for them.  Primary and Secondary Markets:  Primary markets involve the issue of new securities by the borrower in return for cash from investors (or lenders). o Key to the wealth creation process, since they enable money to be transferred to those who can make best use of it in terms of developing new real assets, such as houses or factories.  Secondary markets are trading environments that permit investors to buy and sell existing securities. o Service is critical to the functioning of the primary markets because governments and companies would not be able to raise financing if investors were unable to sell their investments if necessary. o Two types of secondary markets; exchanges or auction markets and dealer or over the counter (OTC) markets.  Exchanges have been referred to as auction markets because they involve a bidding process that takes place in a specific location.  Investors can be represented at these markets by brokers.  OTC markets do not have a physical location, but rather consist of a network of dealers who trade directly with one another.  OTC markets have become increasingly automated, reducing the amount of direct haggling between dealers.  Money market trading is dominated by governments, financial institutions, and large corporations. Long-term debt instruments such as bonds are also traded primarily through dealer markets, although some are traded on exchanges.  Stock Exchanges:  Toronto stock exchange (TSX) – The major stock exchange in Canada, where most equity security transactions take place; it is the official exchange for trading Canadian senior securities.

TSX Venture Exchange – The stock exchange for trading the securities of emerging companies not listed on the TSX.  TMX group limited – The company that owns the TSX, the TSXV, the ME, CDS and Alpha, as well as several other related subsidiaries.  Montréal Exchange (ME) – The exchange that acts as the Canadian national derivatives market and carries on all trading in financial futures and options.  Traditionally stock exchanges were not-for-profit organizations. Membership in a stock exchange (form of a ‘seat’) was sold to individuals to allow them to trade on the exchange. o When it was converted into a regular corporation, seats were exchanged for shares so the new TMX group is for-profit institution owned by the shareholders.  Market capitalization – The total market value of the common equity of an entity.  Other Markets:  Trades in unlisted securities do not need to be reported except in Canada where the Ontario Securities Commission (OSC) requires that they be reported. o OSC – An agency created by the Ontario government to protect investors in securities transactions.  The first Canadian quotation and reporting system, trading and Quotation system Inc. was renamed to CNSX Markets Inc., an alternative market for small emerging companies.  The third market refers to the trading of securities that are listed on organized exchanges on the OTC market.  The fourth market refers to the trades that are made directly between investors (usually large institutions) without the involvement of brokers and dealers. o Operates through privately owned automated systems. The Global Financial Community: o Global financial markets represent important sources of funds for borrowers and provide investors with important alternatives.  Canadian debt and equity markets represent only a small proportion of the total market global place, thus making sense for Canadians borrow and invest abroad. o Global Financial Markets:  The New York Stock Exchange market (NYSE) – The world’s largest stock market.  As trading becomes computerized, the barriers between markets get smaller.  Main constraint becomes the capacity and sophistication of the computer program that manages the trading.  Business and Investors are currently living the significant uncertainty not from the business sector (highest risk in the financial market) but 

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from the household mortgages and government debt (normally regarded as the lowest risk in the financial market). Lesson 7: Pages 206-245: How firms raise capital: - Bootstrapping: o New start-ups are an important factor in determining and sustaining longterm economic growth. o How new businesses get started:  Started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concept’s viability.  Entrepreneur throws ideas and makes them operational through informal discussions with friends and early investors.  Discussions may involve issues related to technology, manufacturing, personnel, finance and marketing. o Initial Funding of the firm:  Bootstrapping – The process by which many entrepreneurs raise seed money and obtain other resources necessary to start their business.  Initial funding usually comes from the entrepreneurs or other founders.  Entrepreneurs work full time jobs helping to provide the cash flow needed and other cash may come from personal savings, sale of assets, borrowing against the family home, loans from family members and loans obtained through credit cards.  Money is spent on developing prototype of the product or service and a business plan. - Venture Capital: o Bootstrapping period usually lasts no more than one or two years, during this period founders will have developed a prototype of the product and a business plan. o Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing.  Individual venture capitalists are called angel investors. They are usually wealthy individuals who invest their own money in emerging businesses at the very early stages.  Venture capital firms typically pool money from various sources to invest in businesses.  Primary sources include financial and insurance firms, private and public pension funds, wealthy individuals and families, corporate investments, and endowments and foundations. o Why Venture Capital funding is different?  It is important because entrepreneurs have only limited access to traditional sources of funding. In general, three reasons, why traditional sources of funding do not work:  High degree of risk involved: o Starting a new business is a risky proposition.

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o Most new businesses fail, difficult to identify which firms will be successful.  Types of productive assets: o Most commercial loans are made to firms that have tangible assets. o Lenders understand that these operations of these firms and their inherent risks thus, they are comfortable making loans to them o New businesses have intangibles as primary assets find it difficult to secure financing from traditional lending sources.  Informational asymmetry problems: o Information asymmetry – When one party to a transaction has knowledge that the other party does not. o Entrepreneur knows more about his company than the lender.  Due to these reasons investors find it difficult to participate directly in the venture capital market. Instead they invest in venture capital funds that specialize in identifying attractive investments in new businesses. Venture Capital funding Cycle: o Starting a new business:  Bootstrap financing: entrepreneur supplies funds, prepares business plan and searches for initial outside funding.  Seed stage financing: venture capitalists provide funds to finish development of the concept.  Early stage financing: Venture capitalists provide financing to get the business up and running.  Latter Stage financing – typically includes one to five additional stages.  How venture capitalists reduce the risk: o Staged funding – Each stage gives the venture capitalist an opportunity to reassess the management team and the firm’s financial performance. If performance does not meet expectations then they can bail out and cut their losses or if they still have confidence then they can help management make some corrections so that the project can proceed. Venture capitalists’ investments give them an equity interest in the company, usually in the form of preferred stock, so that they have the most senior claim among the stockholders if the firm fails, while enabling them to share in the gains if the business is successful. o Personal Investment – Venture capitalists often require the entrepreneur to make a substantial personal investment in the business. Unlikely that venture capitalists allow you to pay yourself a large salary as

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manager of the business, they believe financial rewards should come from successful business not salary. o Syndication – Common practice to syndicate seed and early stage venture capital investments. Syndication occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists. It reduces risks in two ways:  Increases the diversification of the originating venture capitalist’s investment portfolio.  Second, willingness of other venture capitalists to share in the investment provides i...