Lecture Notes Finance 335
Financial Management
Chapter 4:
The Financial Environment: Markets, Institutions, and Interest Rates
  1. Governments and Corporations
    1. All too often we ignore the influence of government in business and yet government provides the greatest obstacles/opportunities for business through its power to tax and legislate.
      2. Example: On August 12, 1996 the Wall Street Journal reported that Microsoft Corporation is helping rival Apple Computer write Internet programs. The headline reads: Citing Antitrust Fears, Microsoft Boosts Apple's Internet Efforts Microsoft is afraid that if Apple goes out of business, it will be faced with Federal antitrust suits.
    2. We must not forget, however, the positive aspects of Government such as its ability to develop infrastructures (the highway system, the Internet) which are useful to business and its power to encourage development in certain industries.
  2. Markets and Exchange
    1. Markets exist primarily to facilitate the transfer of funds from those individuals or institutions with excess funds to those who need funds for investment.
    2. Active financial markets also provide information to investors. Information can be found in the prices and price changes of assets. For example, if you are perusing the classified adds in a newspaper you might come across an ad that reads like this: "Buick, runs good, new paint job, $200 obo" The price in this add tells you a great deal about the vehicle for sale.
    3. Allocative Efficiency
    4. Informational Efficiency (Efficient Financial Markets)
     
  3. Financial Markets can generally be broken down as follows:
    4.   Money Markets Capital Markets
    Primary Markets Short-term securities,
    Funds raised go to the issuer
    • Treasury Bills
    • Commercial Paper
    		Long-term securities,
    Funds raised go to the issuer
    • Corporate stocks
    • Corporate bonds
    • Treasury Notes and Bonds
    Secondary Markets Trading occurs among investors.
    These are typically institutional investors.    		 Trading occurs among investors on the exchanges
    (NYSE, ASE, NASDAQ)
    1. Money Markets
      1. Treasury bills are short term IOUs (13, 26 or 52 weeks) issued by the Federal Government.
      2. Commercial paper is issued by large corporations with good credit. It is also short term in nature as it matures in 270 days or less.
    2. Capital Markets
      3. The market for long-term (usually more than one year) debt and equity issues - common stock, bonds, preferred stock.
      1. Primary Markets
        2. - new issues of securities, bought and sold for the 1st time
        1. Initial Public Offering (IPO)

          2. Consider the following announcement (06/13/05):

          PREMIUM STANDARD FARMS, INC., ANNOUNCES INITIAL PUBLIC OFFERING

          For more information, contact Steve Lightstone at (816) 472-7675.

          KANSAS CITY, MO, June 13, 2005 -- Premium Standard Farms, Inc. (NASDAQ: PORK) announced the pricing of its initial public offering of 9,842,460 shares at an initial price to the public of $12.50 per share. All of the shares are being sold by existing shareholders of the company. Morgan Stanley & Co. Incorporated is serving as the lead underwriter and the sole bookrunning manager with Credit Suisse First Boston, JP Morgan, and Piper Jaffray serving as the co-managers.

          Premium Standard Farms, Inc. (PSF) is one of the largest vertically integrated providers of pork products in the United States, producing consistent, high quality pork products for the retail, wholesale, foodservice, further processor, and export markets. It has approximately 4,100 employees working at farms and processing facilities in Missouri, North Carolina, and Texas.

          Premium Standard Farms' Prospectus from the Securities and Exchange Commission

        2. Seasoned Offering

          3. Here's a seasoned offering announced June 9th:

          XM Satellite Radio Announces $300 Million Common Stock Financing

          WASHINGTON, June 9 /PRNewswire-FirstCall/ -- XM Satellite Radio Holdings Inc. (Nasdaq: XMSR) today announced that it has placed approximately 9.7 million shares of its Class A common stock in a public offering underwritten by UBS Securities LLC resulting in gross proceeds of approximately $300 million to the Company.

          The Company plans to use the proceeds for working capital and general corporate purposes, which may include launch payments for XM-4in mid to late 2006, construction payments for XM-5, payments for third-party programming, repayment of debt and other strategic initiatives.

          The closing is expected to occur on Tuesday, June 14, subject to customary closing conditions.

          All of the securities are being offered by the Company.

          XM Satellite Radio from the Securities and Exchange Commission

      2. Secondary Markets
        3. - Markets involving the sale of old (existing) securities from current owners to new investors - NYSE, ASE
    3. Investment Banks
      1. An investment bank originates, purchases, and distributes (sells) new securities. Examples of Investment Banks include Morgan Stanley Dean Witter, Merrill Lynch, UBS Warburg, etc.
      2. Tombstones:
        3. Here's an example of a current tombstone from Wall Street Net. They can also be found in section C of the Wall Street Journal print edition.

        CME Tombstone

        The The Chicago Mercantile Exchange Prospectus can be viewed at the Securities and Exchange Commission's EDGAR site.

        An Historical Aside: Vernon Walston of Walston & Co. killed himself on May 14, 1964 when his firm was to listed farther down in the tombstone for the Communications Satellite (Comsat)IPO than he had expected. This was bad news to Walston because it meant Walston & Co. would get less of the issue to sell. In the high pressure world of finance this news was the proverbial 'straw that broke the camel's back' for Mr. Walston. It also gave an eerie meaning to the term 'tombstone'.
         
      3. Flotation Costs

        4. Total Flotation Costs = Underwriting Spread + Issuing Expenses of the Company
        Underwriting Spread = Market Value of Security - Proceeds to Company
    4. THE STOCK MARKET
      1. The Organized Exchanges
        1. Regional or national in scope
        2. Central location (NYSE is located at 11 Wall Street but there has been talk of moving or expanding it.)
        3. Auction market
          1. Buyers & sellers not actually present on floor
          2. Represented by brokers
          3. Act as agents
          4. Registered members of the Exchange
        4. Since 1953
          1. Members of NYSE fixed at 1,366
          2. 650 members (AMEX)
      2. National Exchanges
        1. The New York Stock Exchange (NYSE), The American Stock Exchange (AMEX)

          2. Each exchange is governed by an elected board of directors.
          • half are public directors
          • half industry industry reps
      3. Securities are listed only by the approval of the board
      4. As of October 1976, securities can be listed on both exchanges simultaneously.
      5. NYSE MarkeTrac virtual trading floor.
    5. Regional Exchanges: The Pacific Exchange, The Philadelphia Stock Exchange
    6. The Over-the-Counter Market
      1. no central location
        1. network of dealers all over country
        2. linked by computer, telephone, teletype
      2. OTC dealers
        1. own securities they trade
        2. Exchange brokers - agents for buyers & sellers
      3. Thousands of stocks actively trade OTC
      4. The bulk of Bond Trading occurs on the OTC
      5. The National Association of Securities Dealers Automated Quotation system (NASDAQ) is probably the best known OTC market.
    7. Market Indexes
      1. The Dow Jones Industrial Average
        1. Began in 1884 (1886?) with 11 stocks
        2. Today, 30 stocks comprise the average
          3. Alcoa Altria Group American Express American International Group (AIG) Boeing Caterpillar
          Citigroup Coca-Cola Walt Disney DuPont Exxon Mobil General Electric
          General Motors Hewlett-Packard Home Depot Honeywell IBM Intel Corp.
          Johnson & Johnson J.P. Morgan Chase McDonald's Merck Microsoft Corp. Pfizer
          Procter & Gamble SBC Communications 3M United Technologies Verizon Wal-Mart Stores

        3. Calculating The DJIA:

          4. Stock Price
          Stock A $50.00
          Stock B $20.00
          Stock C $30.00
            $33.33 Average

          Now suppose Stock A splits 2-for-1. The average shouldn't change but:

          Stock Price
          Stock A $25.00
          Stock B $20.00
          Stock C $30.00
            $25.00 Average
          Must adjust the divisor: 33.33 = 75/x ⇒ x = 2.25
          Now 75/2.25 = 33.33 points (no longer expressed in dollars)
          The DJIA divisor currently stands at 0.13561241. The divisor can be found every day in the Wall Street Journal in Section C (Money and Investing) on page C2 or C3.
      2. The S&P 500 Index
        1. 500 common stocks
          1. 400 industrial
          2. 40 public utilities
          3. 20 transportation companies
          4. 40 financial firms
        2. Consists of NYSE and NASDAQ stocks
        3. Calculation

          4.  

  4. The Determinants of Market Interest Rates
    1. The nominal or quoted rate of interest (k) can be broken down into several components:

      k = k* + IP + DRP + LP + MRP

    2. Real Risk-Free Rate (k*) - the rate of interest on a default-free security assuming expected inflation is zero.
    3. Inflation Premium (IP) - the average expected inflation rate over the life of the security in question
    4. Default Risk Premium (DRP) - the risk that the borrower will not be able to pay interest or principal on a loan. Generally determined by credit rating agencies such as Moodys, Standard and Poors, or Fitches
    5. Liquidity Premium (LP) - A premium added to financial assets that cannot be quickly converted to cash at a fair market value.
    6. Maturity Risk Premium (MRP) - reflects interest rate risk. Interest rate risk is encountered when there is the possibility of changes in interest rates. Long-term debt is more sensitive to interest rate changes than short-term debt.
  5. The Term Structure of Interest Rates
    1. Definition: (See text p. 144) The term structure of interest rates describes the relationship between long- and short-term rates.
    2. Yield curve - A graph of bond yields for similar risk securities (e.g. Treasuries, AAA rated corporate bonds)
    3. The Treasury Yield Curve from Bloomberg

      Bloomberg Yield Curve

    4. The Living Yield Curve from Smartmoney.com (WSJ subscription required)
      The Treasury Yield curve can be also be found every day in Section C of the print Wall Street Journal
    5. Theories of the term structure of interest rates:
      1. Liquidity Preference Theory: Lenders, other things held constant, want to lend-short term, but borrowers want to borrow long-term. In order to induce lenders to lend for the long-term, a premium must be added to the interest rate.
      2. Market Segmentation Theory: Each borrower and each lender has a preferred maturity. The slope of the yield curve depends on the supply of and the demand for funds in the long-term market relative to the short-term market.
      3. Expectations Theory: The shape of the yield curve depends on investors' expectations about short-term interest rates.