Econ B252: Ch.8: Firms, The Stock Market, and Corporate Governance

the financial system: obtaining funds

firms utilize financial markets to raise funds needed to produce their goods and services

methods:

• If you are profitable, reinvest the profits back into your firm (may use existing profits and reinvest them back into the firm, retained earnings)

• Take on a partner (allow investors partial ownership)

• Borrow from a bank, government or friends/family

indirect finance

A flow of funds from savers to borrowers through financial intermediaries such as banks

direct finance

A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange

• borrowing funds directly from lenders through financial markets

• increases planned investment —> increases actual and potential real GDP

financial system

The system of financial markets and financial intermediaries through which firms acquire funds from households

• includes financial markets and intermediaries

• borrowers and lender interact through these markets

financial markets

Markets where financial securities, such as stocks and bonds, are bought and sold

financial intermediaries

Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borrowers

bond market: bond

a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.

• Term: The length of time until the bond matures.

• Credit Risk: The probability that the borrower will fail to pay some of the interest or principal.

• Tax Treatment: The way in which the tax laws treat the interest on the bond

• not the owners of the firm issuing the bond, but are one of the first creditors in line to be paid if the firm declares bankruptcy

elements of a bond

• Bond: A financial security that represents a promise to

repay a fixed amount of funds.

• Coupon payment: A payment on a bond.

• Interest rate: The cost of borrowing funds, usually

expressed as a percentage of the amount borrowed

risks of bonds

there is a risk that the bond issuer may fail to repay the principal or face value of the bond

• the greater the risk of default or the borrower not paying the lender back, the greater the return or interest rate

• the bond’s market price may change due to changes in supply and demand

  • as a result, the bond’s interest rate inversely relates to the price of the bond

stock market: stock

represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes.

• Dividends: Payments by a corporation to its shareholders.

• The sale of stock to raise money is called equity financing.

• Compared to bonds, stocks offer both higher risk and potentially higher returns.

• Changes in the value of a firm’s stocks and bonds offer important information for a firm’s managers, as well as for investors.

• A higher bond price indicates a lower cost of new external funds, while a lower bond price indicates a higher cost of new external funds.

mutual funds

An institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both.

• Mutual funds allow people with small amounts of money to easily diversify.

banks

Take deposits from people who want to save and use the deposits to make loans to people who want to borrow.

• Pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans

saving and investment relationship

Recall that GDP is both total income (Y) in an economy and total expenditure on the economy’s output of goods and services:

• Y = C + I + G + NX

Assume a closed economy – one that does not engage in international trade:

• Y = C + I + G

Now, subtract C and G from both sides of the equation:

• Y – C – G = I

The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Substituting S for Y – C – G, the equation can be written as:

• S = I

National saving, or saving, is equal to:

• S = I

• S = Y – C – G

• S = (Y + TR – T – C) + (T – G - TR)

national saving

the total income in the economy that remains after paying for consumption and government purchases

= private saving + public saving

private saving

The amount of income that households have left after paying their taxes and paying for their consumption.

• Private saving = (Y + TR – C – T)

public saving

The amount of tax revenue that the government has left after paying for its spending.

• Public saving = (T – G -TR)

loanable funds market

Financial markets coordinate the economy’s saving and investment

• The market in which those who want to save supply funds and those who want to borrow to invest demand funds.

• The supply of loanable funds comes from people who have extra income they want to save and lend out.

• The demand for loanable funds comes from households and firms that wish to borrow to make investments or spend

firms’ willingness to pay depends on the cost of borrowing money (real interest rate)

loanable funds market: real interest rate

The price of the loan

• The amount that borrowers pay for loans and the amount that lenders receive on their saving

• The equilibrium of the supply and demand for loanable funds determines the real interest rate

• demand for loanable funds is inversely related (downward sloping curve)

• supply curve is upward b/c households are more willing to save at higher interest rates

loanable funds: determinants of supply

• Wealth (Income)

• Taxes

• Government Spending

• Expectations of future income and price levels

factors affecting national, public, or private saving affect the supply of loanable funds

loanable funds: determinants of demand

• Expectations of future profitability

• Productive technology

• Business taxes

• Cash flow

graph: increase in demand

real interest rate: increases

quantity of loanable funds: increases

graph: decrease in demand

real interest rate: decrease

quantity of loanable funds: decrease

graph: increase in supply

real interest rate: decreases

quantity of loanable funds: increases

graph: decrease in supply

real interest rate: increases

quantity of loanable funds: decreases

graph: both demand and supply increase

real interest rate: indeterminate

quantity of loanable funds: increases

graph: both demand and supply decrease

real interest rate: indeterminate

quantity of loanable funds: decreases

graph: demand increases, supply decreasea

real interest rate: increases

quantity of loanable funds: indeterminate

graph: demand decreases, supply increases

real interest rate: decreases

quantity of loanable funds: indeterminate

real-world phenomena

• Investment tax credit

• Crowding out: A decline in private expenditures as a result of an increase in government purchases via deficits.

• Consumption tax

annuity

a sequence of regular payments over a specified time period

present value

The amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money.

• The concept of present value demonstrates the following

  • Receiving a given sum of money in the present is preferred to receiving the same sum in the future

  • In order to compare values at different points in time, compare their present values

  • Firms undertake investment projects if the present value of the project exceeds the cost

PV = FV / (1+r)^N

discounting

the process of finding a present value of a future sum of money

discontinuous present value formula

PV = FV1/(1 + r)1 + FV2/(1 + r)2 + FV3/(1 + r)3 + … +FVN/(1 + r)N

• typically used to calculate bond and stock prices since payments, coupons, and dividends occur in the future

  • a bond or stock price should equal the PV of the future payments received from these securities

how to receive your winnings

• The longer the time or lower expected rate of return (r): take the structured payment.

• The shorter the time or higher expected rate of return (r): take the lump sum now