Investment Investment AnalysisAnalysis

Class 1: Class 1: Market SecuritiesMarket Securities

Why to invest?Why to invest? When current income exceeds current consumption desires, When current income exceeds current consumption desires,

people can do many things with their savings.people can do many things with their savings. One possibility is to put the money under a mattress.One possibility is to put the money under a mattress. However, it is important to invest.However, it is important to invest.

Defining InvestmentDefining Investment: A current commitment of $ for a period of : A current commitment of $ for a period of time in order to derive future payments.time in order to derive future payments.

Reasons for investing:Reasons for investing: By investing (saving money now instead of spending it), individuals By investing (saving money now instead of spending it), individuals

can tradeoff present consumption for a larger future consumption.can tradeoff present consumption for a larger future consumption.Money is more valuable now than later. The rate of exchange between Money is more valuable now than later. The rate of exchange between future consumption and current consumption is the pure rate of future consumption and current consumption is the pure rate of interest. Both people’s willingness to pay this difference for borrowed interest. Both people’s willingness to pay this difference for borrowed funds and their desire to receive a surplus on their savings give rise to funds and their desire to receive a surplus on their savings give rise to an interest rate referred as the pure time value of money.an interest rate referred as the pure time value of money. Example: If you can exchange $100 today for $104 next year, Example: If you can exchange $100 today for $104 next year, this rate is 4% (104/100-1).this rate is 4% (104/100-1).

The problem of inflation, or more exactly the increase of the price of The problem of inflation, or more exactly the increase of the price of goods and services.goods and services.This rate of increase was on average 5.0 percent a year from 1970 to This rate of increase was on average 5.0 percent a year from 1970 to 2007. It totally diminishes your purchasing power over time. 2007. It totally diminishes your purchasing power over time.

Required Rate of ReturnRequired Rate of Return Now that you are convinced to invest, you will earn a return from Now that you are convinced to invest, you will earn a return from

your investment.your investment.As we have seen previously, you want to be compensated for:As we have seen previously, you want to be compensated for: Time value of money.Time value of money. Inflation, or increase of price of goods and services.Inflation, or increase of price of goods and services.

However, there is a third factor that you have consider when However, there is a third factor that you have consider when investing: Risk to compensated for uncertainty.investing: Risk to compensated for uncertainty. If it is a “risk free” investment (usually US Treasuries are considered If it is a “risk free” investment (usually US Treasuries are considered

risk free), then you don’t have to be compensated for any risk.risk free), then you don’t have to be compensated for any risk. However, for private equity or securities such as stocks, bonds, However, for private equity or securities such as stocks, bonds,

etc… , or actually any other financial instrument, you need to etc… , or actually any other financial instrument, you need to evaluate the risk of the investment and to be compensated for the evaluate the risk of the investment and to be compensated for the risk you take.risk you take.

Then, the investor evaluates the Then, the investor evaluates the Required Rate of ReturnRequired Rate of Return, which , which is the rate of return which compensate for the time, the rate of is the rate of return which compensate for the time, the rate of inflation, and the uncertainty of the return.inflation, and the uncertainty of the return.

What are the risks What are the risks associated with an associated with an

investment?investment? Business Risk Business Risk

Uncertainty of income flows caused by the nature of a firm’s business Uncertainty of income flows caused by the nature of a firm’s business Sales volatility and operating leverage determine the level of business riskSales volatility and operating leverage determine the level of business risk ..

Financial RiskFinancial Risk Uncertainty caused by the use of debt financingUncertainty caused by the use of debt financing.. Borrowing requires fixed payments which must be paid ahead of payments to stockholders.Borrowing requires fixed payments which must be paid ahead of payments to stockholders. The use of debt increases uncertainty of stockholder income and causes an increase in the The use of debt increases uncertainty of stockholder income and causes an increase in the

stock’s risk premium.stock’s risk premium. Liquidity Risk Liquidity Risk

How long will it take to convert an investment into cash?How long will it take to convert an investment into cash? How certain is the price that will be received?How certain is the price that will be received?

Exchange Rate RiskExchange Rate Risk Uncertainty of return is introduced by acquiring securities denominated in a currency Uncertainty of return is introduced by acquiring securities denominated in a currency

different from that of the investor.different from that of the investor. Changes in exchange rates affect the investors return when converting an investment back Changes in exchange rates affect the investors return when converting an investment back

into the “home” currency.into the “home” currency. Country RiskCountry Risk

Political risk is the uncertainty of returns caused by the possibility of a major change in the Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country.political or economic environment in a country.

Individuals who invest in countries that have unstable political-economic systems must Individuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return.include a country risk-premium when determining their required rate of return.

Macro PerspectiveMacro Perspective In a general perspective, finance is the science of funds management. In a general perspective, finance is the science of funds management.

Financial managers have to deal with the choice of allocation of funds to Financial managers have to deal with the choice of allocation of funds to improve the wealth of the player they are dealing with.improve the wealth of the player they are dealing with.

Here are the different parties in the financial world:Here are the different parties in the financial world:

Firms Consumers

Banking System

Government

Central Bank

Structure of ProductionStructure of Production However, there are also relationship between firms, so there is a structure of However, there are also relationship between firms, so there is a structure of

production.production.There are different firms in different industries, so they buy and sell products or There are different firms in different industries, so they buy and sell products or services between themselves.services between themselves.

We are going to represent the structure of production in a “vertical way”.We are going to represent the structure of production in a “vertical way”.Let’s consider a car. The way it is produced is that some firms extracted minerals Let’s consider a car. The way it is produced is that some firms extracted minerals from the ground, then following that action, some other firms transformed those from the ground, then following that action, some other firms transformed those minerals in useful metals or other products, then other firms build equipment from minerals in useful metals or other products, then other firms build equipment from those materials such as computers, robots, tires, brakes, etc…, then other firms those materials such as computers, robots, tires, brakes, etc…, then other firms such as Chrysler assemble all this equipment and fabric the car, then you have such as Chrysler assemble all this equipment and fabric the car, then you have following industries such as marketing, lawyers, and finally dealers that intervene following industries such as marketing, lawyers, and finally dealers that intervene for us to have finally the car.for us to have finally the car.It is a simplified version in the sense that you have multiples industries all the way It is a simplified version in the sense that you have multiples industries all the way one after another, from early stages to late stages, and you have loop patterns.one after another, from early stages to late stages, and you have loop patterns.We are going to represent that structure of production in a simple way with the We are going to represent that structure of production in a simple way with the following graph:following graph:

Stages of ProductionStages of Production Price Price

Macro RelationshipsMacro Relationships We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.LaborLabor

WagesWages

Consume Consume Taxes Taxes

Consume Consume Save Lend Save Lend

Issue Bonds Issue Bonds

InvestmentInvestment

FIRMS HOUSEHOLDS

BANKING SYSTEM -FINANCIALMARKET

GOVERNMENT

CENTRAL BANK

Macro RelationshipsMacro Relationships Let’s examine now the different parties that play a role in this system:Let’s examine now the different parties that play a role in this system:

The firmThe firm The householdsThe households The governmentThe government The banking systemThe banking system The central bankThe central bank

Financing CycleFinancing Cycle We can then see the overall evolution of financing of a start-up.We can then see the overall evolution of financing of a start-up.

RevenueRevenue Strategic AlliancesStrategic Alliances Acquisition/Mergers IPOAcquisition/Mergers IPO

Seed Capital Venture Capital Secondary MarketSeed Capital Venture Capital Secondary Market

TimeTime

Private Equity Public Private Equity Public MarketMarket

Sole ProprietorSole Proprietor A sole proprietor company is owned and run by only one person.A sole proprietor company is owned and run by only one person. They are obviously small firms, but they are numerous.They are obviously small firms, but they are numerous.

In the US, sole proprietorship represented 71% of the businesses in 2007 but In the US, sole proprietorship represented 71% of the businesses in 2007 but generated only 5% of the revenues.generated only 5% of the revenues.

CharacteristicsCharacteristics:: They are easy to set upThey are easy to set up There is no separation between the owner and the firm; there cannot be There is no separation between the owner and the firm; there cannot be

other investors with ownership.other investors with ownership. The owner has unlimited personal liability, so they are responsible for the The owner has unlimited personal liability, so they are responsible for the

debt of the firm. It limits the desire to be the sole owner in the sense that debt of the firm. It limits the desire to be the sole owner in the sense that as soon as debt becomes too big, owners don’t want to be personally liable.as soon as debt becomes too big, owners don’t want to be personally liable.

The life of the firm is limited to the life of the owner. The life of the firm is limited to the life of the owner. BusinessBusiness: it is the kind of small business that relies relationships developed : it is the kind of small business that relies relationships developed

through reputation. It is the case of small law firms, medical practice, through reputation. It is the case of small law firms, medical practice, accounting firms, small entrepreneurs, etc…accounting firms, small entrepreneurs, etc…

They are They are financedfinanced with the money of the owner, and/or money that the owner with the money of the owner, and/or money that the owner borrowed from other people or banks.borrowed from other people or banks.

PartnershipPartnership A partnership, contrary to sole proprietorship, is owned by more than one A partnership, contrary to sole proprietorship, is owned by more than one

owner.owner. CharacteristicsCharacteristics::

All partners are liable, so there are all responsible for the debt of the firm. All partners are liable, so there are all responsible for the debt of the firm. It reduces the risk for each individual partner because there are a few of It reduces the risk for each individual partner because there are a few of them, but there are still personally responsible.them, but there are still personally responsible.However, the firm can create a However, the firm can create a limited partnershiplimited partnership::

The general partners are personally liable for the debt of the firmThe general partners are personally liable for the debt of the firm The limited partners have limited liability in the sense that they are The limited partners have limited liability in the sense that they are

liable only for their investment.liable only for their investment. The partnership is terminated in the case of death or withdrawal of any The partnership is terminated in the case of death or withdrawal of any

single partner.single partner. To prevent liquidation in case of death or withdrawal, partners can have an To prevent liquidation in case of death or withdrawal, partners can have an

agreement that provides alternative solutions such as buyout of a decease agreement that provides alternative solutions such as buyout of a decease or withdrawn partner.or withdrawn partner.

BusinessBusiness: as for sole proprietorship, partnership is the kind of small business : as for sole proprietorship, partnership is the kind of small business that relies relationships developed through reputation. It is the case of small that relies relationships developed through reputation. It is the case of small law firms, medical practice, accounting firms, small entrepreneurs, etc…law firms, medical practice, accounting firms, small entrepreneurs, etc…

Limited Liability Limited Liability CompaniesCompanies

A limited liability company (LLC) is a partnership but all partners have A limited liability company (LLC) is a partnership but all partners have only limited liability.only limited liability.It means that they are personally responsible for their investment, not for It means that they are personally responsible for their investment, not for the all debt of the firm.the all debt of the firm.

This form of organization appeared in the US relatively late, while it is This form of organization appeared in the US relatively late, while it is common in Europe for a long time.common in Europe for a long time.The first state to pass a statue allowing the creation of an LLC was The first state to pass a statue allowing the creation of an LLC was Wyoming in 1977.Wyoming in 1977.

Financing of Financing of Partnerships and LLCsPartnerships and LLCs

As with the sole proprietorship, those firms can finance themselves in the sense As with the sole proprietorship, those firms can finance themselves in the sense that:that:

partners provide moneypartners provide money, so invest into the firm, so invest into the firm they can they can borrow money borrow money from others or banks.from others or banks.

There is always another distinct way:There is always another distinct way: Money from enterprises specialized in financing start-up:Money from enterprises specialized in financing start-up:

It starts usually with It starts usually with seed fundingseed funding: it is used for low scale operations that : it is used for low scale operations that are considered to be in preliminary stages of evolution: a product or service are considered to be in preliminary stages of evolution: a product or service is in an early development.is in an early development.Investments are usually low and really risky.Investments are usually low and really risky.

Then, at the next stage, when the product or service shows more promising Then, at the next stage, when the product or service shows more promising results, results, venture capitaventure capital firms start to finance those kind of firms.l firms start to finance those kind of firms.They are specialized in providing money for growth starting company with They are specialized in providing money for growth starting company with high risk.high risk.In exchange for the risk, venture capital firms get significant control over In exchange for the risk, venture capital firms get significant control over company decisions, and get a significant portion of the company’s company decisions, and get a significant portion of the company’s ownership. ownership. Venture capital firms are part of a larger sort of firms: Venture capital firms are part of a larger sort of firms: private equity firmsprivate equity firms..

CorporationsCorporations A corporation distinguishes itself from the previous form of organization by being A corporation distinguishes itself from the previous form of organization by being

a legal entity on itself and separated from the owners.a legal entity on itself and separated from the owners. CharacteristicsCharacteristics::

It has then as many legal powers that people have.It has then as many legal powers that people have.In that sense it can enter into contracts, acquire assets, and incur obligations.In that sense it can enter into contracts, acquire assets, and incur obligations.It is the solely responsible for its own obligations. Then, owners, employees, It is the solely responsible for its own obligations. Then, owners, employees, contractors and any other entity in contact with the firm are not liable.contractors and any other entity in contact with the firm are not liable.

The property of a corporation is private and entitle to protection under the US The property of a corporation is private and entitle to protection under the US Constitution.Constitution.

A corporation must be legally formed in the sense that the state in which the A corporation must be legally formed in the sense that the state in which the firm is incorporated must provide its consent for the formation of that firm is incorporated must provide its consent for the formation of that corporation.corporation.It is then more costly to set up than a sole proprietorship.It is then more costly to set up than a sole proprietorship.

The The ownershipownership of the firm is divided into shares, or known as stocks. of the firm is divided into shares, or known as stocks.The collection of those outstanding shares is called the equity of the The collection of those outstanding shares is called the equity of the corporation.corporation.An owner of a share is a shareholder, or stockholder, or equity holder.An owner of a share is a shareholder, or stockholder, or equity holder.There is no limit on the number of shareholders.There is no limit on the number of shareholders.There is no limitation on who can own a stock.There is no limitation on who can own a stock.

Corporate TaxesCorporate Taxes There are some implication on taxes for corporate entities.There are some implication on taxes for corporate entities. A corporation is a legal entity, so it is subject to taxation, and after the A corporation is a legal entity, so it is subject to taxation, and after the

firm gave back some profits to the owner, or shareholder through the firm gave back some profits to the owner, or shareholder through the form of dividend, then those shareholder are subject to taxes again: it is form of dividend, then those shareholder are subject to taxes again: it is double taxation.double taxation.However, we distinguish two kind of corporation in that regard:However, we distinguish two kind of corporation in that regard:

S corporations S corporations are firms that are exempt of double taxation.are firms that are exempt of double taxation.Firm’s profit are not subject of taxes, but are directly considered to be Firm’s profit are not subject of taxes, but are directly considered to be owned by shareholders, and those are of course taxes, even if they owned by shareholders, and those are of course taxes, even if they didn’t receive any dividends.didn’t receive any dividends.This is possible only for corporations with less than 100 shareholders.This is possible only for corporations with less than 100 shareholders.

C corporation C corporation are firm that have more than 100 shareholders, then are firm that have more than 100 shareholders, then then shareholders are subject to double taxation.then shareholders are subject to double taxation.

Financing or Raising Financing or Raising MoneyMoney

A firm wants to engage into projects but it needs to raise money to be able A firm wants to engage into projects but it needs to raise money to be able to invest into those.to invest into those.They are three ways to They are three ways to raise capitalraise capital: :

StocksStocks Preferred stocksPreferred stocks BondsBonds

Stocks

Preferred Stocks

Bonds

Financing or Raising Financing or Raising MoneyMoney

Firms that want to issue stocks, preferred stocks or bonds don’t do it by Firms that want to issue stocks, preferred stocks or bonds don’t do it by themselves.themselves.They use investment banks to do the work for them.They use investment banks to do the work for them.

They value the firmThey value the firm They organize the advertisement of the selling of the securitiesThey organize the advertisement of the selling of the securities They organize the selling of securities on secondary markets such as They organize the selling of securities on secondary markets such as

the stock market or bond market.the stock market or bond market.If it is the first time the firm issues stock, this operation is called an If it is the first time the firm issues stock, this operation is called an IPO, or initial public offering.IPO, or initial public offering.The investment banker could:The investment banker could:

Either buy all the stocks, it is the primary market, and sell them on Either buy all the stocks, it is the primary market, and sell them on the secondary market: so it guarantees that all the stocks will be the secondary market: so it guarantees that all the stocks will be bought at the agreed price: it is a firm commitment contract bought at the agreed price: it is a firm commitment contract

Or sell as much as possible the stocks: it is the best effort contract.Or sell as much as possible the stocks: it is the best effort contract. The company becomes then public: the stocks are sold on exchange The company becomes then public: the stocks are sold on exchange

markets or what we call over-the-counter and can be traded.markets or what we call over-the-counter and can be traded.

Financing or Raising Financing or Raising MoneyMoney

We can see that there are two steps when a firm issues stock:We can see that there are two steps when a firm issues stock: First, there is an initial transaction. First, there is an initial transaction.

The firm issues shares and sell them to investors through investment The firm issues shares and sell them to investors through investment bankers.bankers.It is the It is the primary marketprimary market..

Then, after that first step, those shares are sold again in the Then, after that first step, those shares are sold again in the secondary marketsecondary market, in which is exchange over and over., in which is exchange over and over.

Activities include also:Activities include also: Mergers and acquisitionsMergers and acquisitions Research Research Money managementMoney management

Financial MarketsFinancial Markets We can also make a distinction between the type of securities that are We can also make a distinction between the type of securities that are

traded depending on the maturity of the securities.traded depending on the maturity of the securities. If the maturity of the security is less than one year, then it is in the If the maturity of the security is less than one year, then it is in the

money marketmoney market..It includes mainly debt securities such as Treasury bills, commercial It includes mainly debt securities such as Treasury bills, commercial papers, banker’s acceptances, etc…papers, banker’s acceptances, etc…

The other securities are in the The other securities are in the capital marketcapital market..It includes notes, bonds, equities, etc… It includes notes, bonds, equities, etc…

Raising Money for the Raising Money for the FirmFirm

We can then represent the way finance works in the overall economic system: We can then represent the way finance works in the overall economic system: it is the financial cycle.it is the financial cycle.

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

Primary Secondary Primary SecondaryMarketMarket Market Market

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Bank

Corporate FinanceCorporate Finance Financial managers have to deal with the following situation:Financial managers have to deal with the following situation: They will have to deal mainly with selecting projects to invest in, make They will have to deal mainly with selecting projects to invest in, make

decisions about the capital structure and dividend policy, and how to decisions about the capital structure and dividend policy, and how to finance the firm.finance the firm.They will have also to manage short term cash needs.They will have also to manage short term cash needs.

Projects Futures/Swaps/Options

Financing-Capital Structure Capital BudgetingRisk Management

Earnings

Stockholders Bondholders

Dividend Policy

Investors

Managers

GovernmentTaxes

Goals of ManagersGoals of Managers As we saw, there is a separation between the firms and the owners.As we saw, there is a separation between the firms and the owners.

The shareholders own the firm, but managers are the ones who manage the firm The shareholders own the firm, but managers are the ones who manage the firm and make decisions.and make decisions.

There may be here a conflict of interest: managers may be tempted to engage There may be here a conflict of interest: managers may be tempted to engage into projects or make decisions that benefit them but not the shareholder.into projects or make decisions that benefit them but not the shareholder.The problem is that managers know better about the firms than the shareholders The problem is that managers know better about the firms than the shareholders in the sense that the latter have less information or precise knowledge of what is in the sense that the latter have less information or precise knowledge of what is going on.going on.This is the This is the agency problemagency problem..

However, it must be clear that the primary goal of managers is to However, it must be clear that the primary goal of managers is to maximize the maximize the wealth of the shareholders. wealth of the shareholders.

Here are the main task of the financial managers:Here are the main task of the financial managers: To choose projectsTo choose projects To choose finance or raise money and establish capital structureTo choose finance or raise money and establish capital structure To manage risksTo manage risks To set up dividend policyTo set up dividend policy To manage short-term cash needsTo manage short-term cash needs

Choosing Projects or Choosing Projects or Capital BudgetingCapital Budgeting

The first task of the firm is to select projects: it is The first task of the firm is to select projects: it is capital budgetingcapital budgeting.. Firms requires to engage in new project or make sure that current Firms requires to engage in new project or make sure that current

projects continue, so they need to develop new products, build factories, projects continue, so they need to develop new products, build factories, create distribution centers, install information technology, expand to new create distribution centers, install information technology, expand to new markets, and acquire other companies.markets, and acquire other companies.However, firms have to decide whether or not they should embark into However, firms have to decide whether or not they should embark into specific projects.specific projects.

It is the role of the financial managers to help to estimate the cost and It is the role of the financial managers to help to estimate the cost and benefits of different projects.benefits of different projects.They have to make sure that money is used in the best interest of the They have to make sure that money is used in the best interest of the shareholders.shareholders.

Capital StructureCapital Structure When choosing the quantity of stocks, preferred stocks, and bonds to When choosing the quantity of stocks, preferred stocks, and bonds to

raise money, financial managers have to make sure that they behave in raise money, financial managers have to make sure that they behave in the best interest of the shareholders.the best interest of the shareholders.

Indeed, there have to optimize the proportion of stocks, preferred stocks Indeed, there have to optimize the proportion of stocks, preferred stocks and bonds to obtain the maximum value for the price of the stock: it is and bonds to obtain the maximum value for the price of the stock: it is what we call what we call capital structurecapital structure..

Dividend PolicyDividend Policy When profits become positive, then the ways the company can distribute When profits become positive, then the ways the company can distribute

it are:it are: Pay interest expensesPay interest expenses Pay down the principal on debtPay down the principal on debt Pay dividendsPay dividends Repurchase stocksRepurchase stocks Buy non operating assets such as Treasury Bills or other marketable Buy non operating assets such as Treasury Bills or other marketable

securities. securities. It would reduce the risk of financial distress in case of an economic It would reduce the risk of financial distress in case of an economic downturn. downturn. It could also provide funding with no flotation cost and no signaling It could also provide funding with no flotation cost and no signaling effects.effects.However, there may be an agency cost: managers might be tempted However, there may be an agency cost: managers might be tempted to spend the money on perks or high-priced acquisition.to spend the money on perks or high-priced acquisition.

The objective for the financial manager is to find the optimal policy in The objective for the financial manager is to find the optimal policy in terms of redistribution to optimize the value of the stock.terms of redistribution to optimize the value of the stock.

Short-term Cash Short-term Cash ManagementManagement

Another objective of financial managers is to deal with short-term Another objective of financial managers is to deal with short-term management of cash.management of cash.

As we will see later, the firm has to make sure that even if they have As we will see later, the firm has to make sure that even if they have multiple years plans, they can have enough cash on the short term to multiple years plans, they can have enough cash on the short term to continue the functioning of the firm.continue the functioning of the firm.

It is made through what we call the management of working capital, or It is made through what we call the management of working capital, or current assets minus current liabilities.current assets minus current liabilities.

Management of RiskManagement of Risk By investing in projects, a firm is subject to some risk.By investing in projects, a firm is subject to some risk.

Indeed, most of the time, the projects have inputs and outputs that can Indeed, most of the time, the projects have inputs and outputs that can have their prices affected significantly by changes in commodity prices or have their prices affected significantly by changes in commodity prices or currencies fluctuations. As a consequence, the firm has to find a way to currencies fluctuations. As a consequence, the firm has to find a way to protect itself and hedge the riskprotect itself and hedge the risk

It is mainly made through the use of derivatives:It is mainly made through the use of derivatives: Forward and futuresForward and futures SwapsSwaps optionsoptions

HouseholdsHouseholds Households provide labor to and receive wages from firms. Households provide labor to and receive wages from firms.

From the wages they receive, household can use money in two ways:From the wages they receive, household can use money in two ways: They consumeThey consume They saveThey save

We include in saving the amount of money they deposit at banks, but we may also We include in saving the amount of money they deposit at banks, but we may also consider the amount of money they invest directly in different financial instruments.consider the amount of money they invest directly in different financial instruments.As an investor, they may put their money in:As an investor, they may put their money in:

StocksStocks BondsBonds Commodities,Commodities, CurrenciesCurrencies Real EstateReal Estate ArtArt Private equityPrivate equity Funds such as mutual funds, hedge funds, etc…Funds such as mutual funds, hedge funds, etc…

The study of finance for household is called The study of finance for household is called personal financepersonal finance, and includes the choice of , and includes the choice of investment considering the needs, the financial situation, and objectives of the investment considering the needs, the financial situation, and objectives of the household.household.

HouseholdHousehold We can then represent the way finance works in the overall economic system: We can then represent the way finance works in the overall economic system:

it is the financial cycle.it is the financial cycle.

Wages Wages

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

Primary Secondary Primary SecondaryMarketMarket Market Market

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Bank

Financial MarketsFinancial Markets As we can see on the graph previously designed, the banking system and As we can see on the graph previously designed, the banking system and

more generally financial markets play a role of intermediary between more generally financial markets play a role of intermediary between household and government in one hand and firms in the other hand.household and government in one hand and firms in the other hand.Financial markets are markets in which assets are exchanged, and in Financial markets are markets in which assets are exchanged, and in developed countries, they are structured and organized.developed countries, they are structured and organized.

We start with the We start with the depositary institutionsdepositary institutions: they accept deposits.: they accept deposits. Commercial banksCommercial banks Savings and loans (S&L)Savings and loans (S&L) Savings banksSavings banks Credit unionsCredit unions

They are highly regulated.They are highly regulated.Banks use those deposit and lend to firms for investing in projects.Banks use those deposit and lend to firms for investing in projects.

Depositary InstitutionsDepositary Institutions We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

LendLend

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Depositary

Institutions

IntermediariesIntermediaries We have also non-depository institutions:We have also non-depository institutions:

Insurance companiesInsurance companies Pension fundsPension funds Investment companies such as mutual funds, close-end funds, unit Investment companies such as mutual funds, close-end funds, unit

trust.trust.This part is This part is investment analysis investment analysis and also and also portfolio managementportfolio management..

However, there are other type of firms that also play a role of However, there are other type of firms that also play a role of intermediary, such as:intermediary, such as:

Hedge fundsHedge funds Private equity firmsPrivate equity firms Asset management firmsAsset management firms Etc..Etc..

Intermediary InstitutionsIntermediary Institutions We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.

Wages Wages

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

LendLend

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Depositary

Institutions

Intermediaries

Derivatives Others

GovernmentGovernment The government has regulatory activities and also consumes by engaging The government has regulatory activities and also consumes by engaging

in projects.in projects. To get funded, then it can:To get funded, then it can:

Use taxesUse taxes Raise money through debt.Raise money through debt.

It issues what we call Treasuries:It issues what we call Treasuries: Treasury bills (maturity less than 1 year)Treasury bills (maturity less than 1 year) Treasury notes (maturity more than 1 year and less than 10 years)Treasury notes (maturity more than 1 year and less than 10 years) Treasury bonds (maturities more than 10 years)Treasury bonds (maturities more than 10 years)

This part is This part is public financepublic finance..It is the study of the role of government. It assesses the government It is the study of the role of government. It assesses the government revenue and cost.revenue and cost.

GovernmentGovernment We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.

TaxesTaxes

Wages Wages

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

LendLend

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Depositary

Institutions

Intermediaries

Derivatives Others

Central BankCentral Bank In the US, the central bank was created in 1913 to manage the banking In the US, the central bank was created in 1913 to manage the banking

system.system.It supervises banks and was created to deal with specific issues:It supervises banks and was created to deal with specific issues:

The original idea was to manage the supply of currency by expanding The original idea was to manage the supply of currency by expanding or contracting it with changes in the quantity of currency demanded.or contracting it with changes in the quantity of currency demanded.This role was to prevent a panic when a lot of depositors were rushing This role was to prevent a panic when a lot of depositors were rushing to banks at the same time and the bank was not able to provide the to banks at the same time and the bank was not able to provide the corresponding cash. corresponding cash.

It plays a role of last resort when panic is installed and severe crisis It plays a role of last resort when panic is installed and severe crisis affect the good functioning of the banking system.affect the good functioning of the banking system.

It establishes the monetary policy with the objective to stabilize the It establishes the monetary policy with the objective to stabilize the economy and prevent disruptive and aggravated business cycles.economy and prevent disruptive and aggravated business cycles.The goal is to achieve full employment and stability of prices.The goal is to achieve full employment and stability of prices.

It plays a huge role because it establishes interest rates, plays a role of It plays a huge role because it establishes interest rates, plays a role of last resort to avoid crisis and so intervene in some operations that will last resort to avoid crisis and so intervene in some operations that will described later and affect banks, so the whole economy.described later and affect banks, so the whole economy.

Central BankCentral Bank There are 3 ways a central bank can intervene into the economy:There are 3 ways a central bank can intervene into the economy:

The central bank can buy or sell treasury bonds through what is called open The central bank can buy or sell treasury bonds through what is called open market operations.market operations.If it buys treasury bonds, it increases the amount of money into the financial If it buys treasury bonds, it increases the amount of money into the financial system, so it lowers the federal fund rate which is the rate at which borrow system, so it lowers the federal fund rate which is the rate at which borrow and lend to each others, and it supposes to stimulate the economy. and lend to each others, and it supposes to stimulate the economy. If it sells treasury bonds, it retracts the amount of money into the financial If it sells treasury bonds, it retracts the amount of money into the financial system, so it increases the federal fund rate, and it supposes to slow down the system, so it increases the federal fund rate, and it supposes to slow down the economy.economy.

The central bank can change the discount rate, which is the rate at which the The central bank can change the discount rate, which is the rate at which the central bank lends money to banks.central bank lends money to banks.By increasing the discount rate, it diminishes the capability for banks to lend By increasing the discount rate, it diminishes the capability for banks to lend and vice versa.and vice versa.

The central bank can change the level of reserve required in banks.The central bank can change the level of reserve required in banks.By increasing the level of reserve, it diminishes the capability for banks to By increasing the level of reserve, it diminishes the capability for banks to lend, and vice versa.lend, and vice versa.

This part is monetary policy.This part is monetary policy. Of course, we shouldn’t forget also the role it plays when exercising the role of Of course, we shouldn’t forget also the role it plays when exercising the role of

last resort.last resort.

Central BankCentral Bank We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.

Wages Wages

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

LendLend

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Depositary

Institutions

Intermediaries

Derivatives Others

Central BankCentral Bank There are three ways central banks can influence the economy. It is done There are three ways central banks can influence the economy. It is done

through manipulation of interest rate.through manipulation of interest rate.

Open MarketOpen Market Operation Operation

Discount Rate Discount Rate

ReserveReserve Fed Fund RateFed Fund Rate LevelLevel

Central Bank

Bank Bank Bank Bank Bank

Bond Market

Foreign InvestmentForeign Investment To have a complete picture of how different markets may move, it is To have a complete picture of how different markets may move, it is

essential to evaluate the level of foreign investment and the motive of essential to evaluate the level of foreign investment and the motive of foreigners to invest or not into the country.foreigners to invest or not into the country.Investment could come in two forms:Investment could come in two forms:

Private foreign investorsPrivate foreign investors Sovereign Wealth FundsSovereign Wealth Funds: they are state own investment funds.: they are state own investment funds.

They are vehicules that allow foreign states to invest in real assets They are vehicules that allow foreign states to invest in real assets and financial assets such as bonds, stocks, real estate, derivatives, and financial assets such as bonds, stocks, real estate, derivatives, etc… and even in private equity firms or hedge funds.etc… and even in private equity firms or hedge funds.Their money, for examples US dollars may come from:Their money, for examples US dollars may come from:

commodity export (such as for Norway, Saoudi Arabia…)commodity export (such as for Norway, Saoudi Arabia…) Trade surplus (such as China…)Trade surplus (such as China…)

Central BankCentral Bank We can then represent the way finance works in the overall economic We can then represent the way finance works in the overall economic

system: it is the financial cycle.system: it is the financial cycle.

Wages Wages

Consume Consume Money Money

Security Security Invest Invest Lend Lend Save Save

LendLend

FIRMS HOUSEHOLDS

Brokers

GOVERNMENT

CENTRAL BANK

Investment Bank

Stock market

Bond market Depositary

Institutions

Intermediaries

Derivatives Others

Foreign Investment

ReferenceReference ““Principle of Corporate Finance” Berk, DeMarzo, and Hartford, Custom Principle of Corporate Finance” Berk, DeMarzo, and Hartford, Custom

Edition, Pearson Edition, Pearson Chapter 1Chapter 1

““Essentials of Investment” Bodie, Kane, Marcus, McGraw Hill, 9Essentials of Investment” Bodie, Kane, Marcus, McGraw Hill, 9 thth Edition Edition Chapter 1,2,3,4Chapter 1,2,3,4

““Fundamentals of Corporate Finance” 7Fundamentals of Corporate Finance” 7thth Edition, Brealey, Myers and Edition, Brealey, Myers and MarcusMarcus

Chapter 1Chapter 1 ““Financial Management Theory & Practice” Brigham and EhrhardtFinancial Management Theory & Practice” Brigham and Ehrhardt

Chapter 1Chapter 1