2 The Domestic and International Financial Marketplace ©2006 Thomson/South-Western

2

The Domestic and International Financial Marketplace

©2006 Thomson/South-Western

2

Introduction

This chapter looks at the domestic and international financial marketplaces that allocate scarce resources.

3

Finance Decisions Affecting SWM Form of business organization

Types of financing

Investment projects

All based on after-tax cash flow

4

Implication Of Income Taxes For Financial Managers Capital structure policy

Tax advantage of debt financing Dividend policy

Capital gains vs. Dividend policy Capital budgeting

After-tax CFs, Depreciation, Net present value (NPV)

Leasing Motivated by tax effects

5

Corporate Tax Rates

Progressive The average tax rate increases for increasing

levels of income. Marginal

The tax rate on the next dollar of income Marginal tax rate used in text

40% = State + Fed

http://www.tax.org/

6

Corporate Tax Rates

7

Net Savers Become Investors

Credit Unions

Primary and Secondary

Markets

Sole Proprietorship Partnership Corporations

Financial Markets

Savings Institution Mutual FundsPension FundsInsurance Companies

Financial Institutions

Financial Companies

Banks

Supply Funds Supply Funds

Money Markets

Capital Markets

The National Financial System

8

Saving and Investment

http://www.bea.doc.gov/bea/pubs.htm

9

Flow of Funds

10

Primary Market

Investment banks help corporations sell new security issues

Underwrite Guarantee sale at a fixed price

Best effort No guarantee of sale

11

Secondary Market

Listed exchanges Designated place of business Requirements of securities listed or traded

Over-the-counter (OTC) market Networks connected by communications Dealers post prices to buy and sell

Stock market indexes DJIA, DJTA, S&P 500, NASDAQ

12

Financial Intermediaries

Commercial Banks Thrift Institutions Investment Companies Pension Funds Insurance Companies Finance Companies

13

Security Exchanges

Listed exchanges New York Stock Exchange American Stock Exchange Chicago, Pacific, Philadelphia, Boston,

Cincinnati exchanges

Over the counter markets

14

Regulations

State Blue sky laws

Federal Securities Act of 1933 & 1934 Securities & Exchange Commission (SEC) Ethical issues

Insider trading SEC attempts to prevent profiting from

unpublished information. http://www.uncle-sam.com/

15

Global Financial

Transactions

Import

Export

Foreign Branch

Licensing Arrangements

Joint Ventures

Multinational Corporations

Manufacturing Distribution

International Finance

16

Global Risks

Fluctuating exchange rates

Government regulations

Tax laws

Business practices

Political environment

17

Eurocurrency Market

Eurocurrency Currency deposited outside of the country of origin

Eurodollars Dollars deposited outside of the United States

Euro A new currency created by many European

countries

The euro is not the same as Eurocurrency.

http://www.xe.com/euro.htm

18

Some Important Terms

Exchange rate

Direct quote

Indirect quote

Spot rate

Forward exchange rate

http://www.futuresmag.com/

19

Forward Exchange Rates

Exchange rates for currencies delivered at some future date, i.e., 30, 90, or 180 days

Premium Where spot rate is expected to increase in the

future Discount

Where spot rate is expected to decrease in the future

20

Annualized Forward Premium Or Discount

100%

# of months forward

12Spot rate

Forward rate – Spot rate

21

Foreign Currency Futures

Foreign currency futures contract

Standard amount of currency

Standard future time

At a price set at the present time

Contracts traded on Chicago Mercantile Exchange (CME)

22

Foreign Currency Options

A call is the right to buy a currency.

A put is the right to sell a currency.

23

European and American Options

What is the difference between an American and European option? You can exercise an American option

anytime until expiration. The European option can be exercised

only at expiration.

24

Market Efficiency

“Glue” that bonds the PV of a firm’s net cash flow to shareholders’ wealth

Capital markets are efficient if prices instantaneously and fully reflect all the risk and economically relevant information about a security’s prospective returns.

25

Stock Prices

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Three Degrees Of Market Efficiency Weak form

Semi-strong form

Strong form

27

Weak Form

Security prices fully reflect all historical information.

No investor can earn excess returns using historical prices or returns.

28

Semi-Strong Form

Security prices fully reflect historical and publicly available information.

No investor can earn excess returns based on an investment strategy

using public information.

29

Strong Form

Security prices fully reflect all historical, public, and private information.

Markets are quite efficient!

30

Implications For Financial Managers

Timing or gambling An expected NPV of zero Corporate diversification expensive Security price adjustment Behavioral finance perspective

31

New Thinking About Behavioral Finance

Evidence of irrational behavior exists

Explanation? Self-delusion Herding

32

Barriers To Market Efficiency Outside The United States Foreign exchange risk

Legal restrictions on investments

Taxation policies discourage capital

flows.

High transaction costs

Political risks of expropriation

33

Holding Period Rate Of Return

HPR

The return from holding an investment for one period

34

Equation

100%

Beginning price

Ending price – Beginning price + Distributions

% HPR =

35

Returns

Ex post = realized (after the fact)

Ex ante = expected (before the fact)