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INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 1
An Introduction to Finance
Lecture Agenda
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Learning Objectives
Important Terms
Finance Defined
Real versus Financial Assets
The Financial System
Financial Instruments and Markets
The Global Financial Community
Summary and Conclusions
– Concept Review Questions
CHAPTER 1 - An Introduction to Finance
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Learning Objectives
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What 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 Finance
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Key Terms
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Bourse de Montréal
brokers
Canadian Trading and Quotation System Inc. (CNQ)
capital market securities
common share
corporate finance
Crown corporations
dealer or over-the-counter (OTC) markets
debt instruments
equity instruments
exchanges or auction markets
finance
financial assets
financial intermediaries
fourth market
intermediation
investments
CHAPTER 1 - An Introduction to Finance
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Key Terms
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market capitalization
market intermediary
marketable financial assets
money market securities
New York Stock Exchange (NYSE)
non-marketable financial assets
Ontario Securities Commission
preferred shares
primary markets
real assets
secondary markets
third market
Toronto Stock Exchange (TSX)
TSX Group Inc.
TSX Markets
TSX Venture Exchange
Winnipeg Commodity Exchange
CHAPTER 1 - An Introduction to Finance
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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 channels
• Financial contracts or securities occur
whenever funds are transferred from issuer
to buyer.
CHAPTER 1 - An Introduction to Finance
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The Study of Finance
• The study of finance requires a basic
understanding of:
– Securities
– Corporate law
– Financial institutions and markets
CHAPTER 1 - An Introduction to Finance
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Real Versus Financial Assets
• Real assets are tangible things owned by
persons and businesses
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Residential structures and property
Major appliances and automobiles
Office towers, factories, mines
Machinery and equipment
• Financial assets are what one individual has
lent to another
– Consumer credit
– Loans
– Mortgages
CHAPTER 1 - An Introduction to Finance
1-9
Assets and Liabilities of Households,
2005
Table 1-2 Assets and Liabilities of Households, 2005
Assets
$ Billion
Houses
1,086
Consumer Durables
435
Land
827
Real Assets
2,348
Deposits
683
Debt
114
Pensions and insurance
1,200
Shares
1,254
Foreign and other
72
Financial Assets
3323
Total Assets
5,671
Liabilities
$ Billion
Consumer credit
260
Loans
131
Mortgages
588
Total Liabilities
979
So urce: Statistics Canada. Natio nal B alance Sheet A cco unts, Quarterly Estimates, Fo urth
Quarter 2005. Ottawa: M inister o f Industry, 2006 (Catalo gue No . 13-214-XIE).
CHAPTER 1 - An Introduction to Finance
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The Financial System
Overview
• The 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 years
• Financial intermediaries transform the nature of the
securities they issue and invest in
• Banks, trust companies, credit unions, insurance firms, mutual
funds
• Market intermediaries simply help make markets
work
• Investment dealers
• Brokers
CHAPTER 1 - An Introduction to Finance
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The Financial System
FIGURE 1-2
CHAPTER 1 - An Introduction to Finance
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The Financial System
Channels of Intermediation
• Funds 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 Finance
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Channels of Intermediation
FIGURE 1-3
CHAPTER 1 - An Introduction to Finance
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The Financial System
Financial Intermediaries
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Banks and other deposit-taking institutions
Insurance companies
Pension Funds
Mutual Funds
CHAPTER 1 - An Introduction to Finance
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Financial Intermediaries
Canadian Chartered Banks
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Banks take deposits from numerous depositors from across Canada
The deposits are ‘pooled’ in the Bank
The bank takes these pooled funds and lends them out to households
and businesses in the form of mortgages and loans
The bank transforms the original nature of the savers (depositors)
money:
– Deposits are usually small in amount…face little or no risk, and depositors
expect to withdraw the amount at any time
– Loans and mortgages on the other hand usually have the following
characteristics:
• Large sums
• Borrowed for long periods of time
• Borrowed for risky purposes.
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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 Finance
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Financial Intermediaries
Canadian Chartered Banks
Table 1-3 Chartered Banks: Financial Statistics, 2005
Bank
Royal Bank of Canada
Canadian Imperial Bank of Commerce
(CIBC)
Bank of Nova Scotia
TD Canada Trust
Bank of Montreal
National Bank
Revenue
Assets
Profits
($ million) ($ million) ($ million)
29,403
469,521
3,387
18,677
18,332
18,665
15,138
5,320
280,370
314,025
365,210
297,532
107,598
-32
3,209
2,229
2,400
855
So urce: B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31, 2006.
CHAPTER 1 - An Introduction to Finance
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Financial Intermediaries
Insurance Companies
– Insurers 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 Finance
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Financial Intermediaries
Insurance Companies
Table 1-4 Insurance Companies: Financial Statistics, 2005
Insurer
Manulife Financial
Sun Life Financial
Great-West Lifeco
ING Canada
Revenue
Assets
Profits
($ million) ($ million) ($ million)
32,187
322,171
3,294
21,871
171,850
1,867
23,883
102,161
1,775
4,446
9,926
782
So urce: Data fro m B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31, 2006.
CHAPTER 1 - An Introduction to Finance
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Financial Intermediaries
Pension Plan Assets
– Individuals 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 Finance
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Financial Intermediaries
Pension Plan Assets
Table 1-5 Pension Plan Assets, 2005
Pension Plan Managers
Caisse de depot et placement du Quebec
Canada Pension Plan (CPP)
Ontario Teachers (Teachers)
Ontario Municipal Employees (OMERS)
Net Assets
($ billion)
216.1
98.0
96.1
41.6
* The Caisse manages the investments o f several pensio n plans.
CHAPTER 1 - An Introduction to Finance
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Financial Intermediaries
Canadian Mutual Fund Assets
• Mutual 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 Finance
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Financial Intermediaries
Canadian Mutual Fund Assets
FIGURE 1-4
CHAPTER 1 - An Introduction to Finance
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The Financial System
The Major Borrowers
• Public Debt
– Governments
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Federal
Provincial
Municipal
Crown Corporations
• Private Debt
– Households
– Non-financial Corporations
CHAPTER 1 - An Introduction to Finance
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The Financial System
Largest Non-financial Companies
Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005
Non-financial Companies
General Motors of Canada Ltd.
Loblaw Companies Ltd.
Magna International Inc.
Imperial Oil Ltd.
Alcan Inc.*
BCE Inc.
Bombardier Inc.*
Petro-Canada
Onex Corp.
EnCana Corp.*
Revenue
Assets
($ million) ($ million)
34,991
n/a
27,812
13,761
22,873
12,321
26,936
15,582
20,408
26,638
19,150
40,630
14,882
17,483
17,673
20,655
17,626
14,845
14,322
34,148
*Co mpany repo rts in U.S. do llars.
So urce: Data fro m "The To p 1000 in 2005." Glo be and M ail Repo rt o n B usiness website:
www.theglo beandmail.co m.
CHAPTER 1 - An Introduction to Finance
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Financial Instruments
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There are two major categories of financial
securities:
1. Debt Instruments
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Commercial paper
Bankers’ acceptances
Treasury bills
Mortgage loans
Bonds
Debentures
2. Equity Instruments
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Common stock
Preferred stock
CHAPTER 1 - An Introduction to Finance
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Financial Instruments
Non-marketable
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Characteristics of non-marketable
securities
– Cannot be traded between or among investors
– May be redeemable (a reverse transaction
between the borrower and the lender)
– Examples:
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Savings accounts
Term Deposits
Guaranteed Investment Certificates
Canada Savings Bonds
CHAPTER 1 - An Introduction to Finance
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Financial Instruments
Marketable
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Characteristics of Marketable securities
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Can be traded between or among investors after their original
issue in public markets and before they mature or expire
Market Capitalization
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Is an important term in finance
It is the total market value of a company
It is found by multiplying the number of shares outstanding by
the market price per share.
Market Capitaliza tion  Number of shares  Price per share
CHAPTER 1 - An Introduction to Finance
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Financial Instruments
Marketable
Markets can be categorized by the time to maturity:
•
Money Market Securities (for short-term debt securities that are
pure discount notes)
– Bankers’ acceptances
– Commercial Paper
– Treasury Bills
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Capital Market Securities (for long-term debt or equity
securities with maturities greater than 1 year)
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Bonds
Debentures
Common Stock
Preferred Stock
CHAPTER 1 - An Introduction to Finance
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Financial Markets
• Primary Market
– Markets that involve the issue of new securities by the
borrower in return for cash from investors (Capital
formation occurs)
• Secondary Market
– Markets 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 Finance
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Financial Markets
Types of Secondary Markets
• Exchanges or Auction Markets
• Secondary markets that involve a bidding process that takes
place in specific location
• For example TSX, NYSE
• Dealer or Over-the-counter (OTC) Markets
• Secondary 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 Finance
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Financial Markets
Other Markets
• Third Market
• Trading of securities that are listed on organized exchanges
in the Over-the-counter market
• Fourth Market
• Trading 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 Finance
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The Global Financial Community
• Represents an important source of funds for
borrowers
• Provides investors with important
alternatives as they seek to build wealth
through diversified portfolios
CHAPTER 1 - An Introduction to Finance
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The Global Financial Community
Table 1-7 Canada's International Investments, 2005
Total Assets
Canadian direct investments abroad
Canadian portfolio investments
Portfolio foreign bonds
82,374
Portfolio foreign stocks
189,175
Other portfolio investments
13,055
Other Canadian investments
Loans
48,325
Allowances
Deposits
120,694
Official international reserves
38,030
Other assets
59,319
Total Liabilities
Foreign direct investments in Canada
Foreign portfolio investments
Portfolio Canadian bonds
380,017
Portfolio Canadian stocks
107,598
Portfolio Canadian money market instruments 20,783
Other foreign investments
Loans
36,107
Deposits
201,639
Other liabilities
22,829
Canada's Net International Investment Position
($ million)
1,016,031
465,058
284,604
266,369
1,184,534
415,561
508,398
260,575
-168,503
So urce: Statistics Canada.
CHAPTER 1 - An Introduction to Finance
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Summary
• In this chapter you have learned about:
– Financial systems in general, and the Canadian
financial system in particular
– Major participants in the Canadian financial system,
including the different types of financial securities and
financial markets
CHAPTER 1 - An Introduction to Finance
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Internet Links
• BMO InvestorLine: www.bmoinvestorline.com
• Investment Funds Institute of Canada: www.ific.ca
• Globe and Mail Report on Business:
www.theglobeandmail.com
• Toronto 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.jsp
• Winnipeg Commodity Exchange: http://www.wce.ca/
• New York Stock Exchange (NYSE) Euronext:
http://www.nyse.com/
CHAPTER 1 - An Introduction to Finance
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Copyright
Copyright © 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 - An Introduction to Finance
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