NOTES LESSON 1-4 FINANCIAL MARKETS AE4 and number of securities to issue) and attracts the

initial public purchasers of the securities for the funds

LESSON 1: user. By issuing primary market securities with the
Economics – study of allocating scarce resources help of an investment bank, the funds user saves the
Financial Economics – we study the financial system risk and cost of creating a market for its securities on
its own (see discussion below).
3 Elements • Rather than a public offering (i.e., an offer of sale to
1. Financial Instruments – “What” – investors buy and the investing public at large), a primary market sale
sell or TRADE in the financial markets can take the form of a private placement. With a
o Financial Instruments – Financial private placement, the securities issuer (user of
Claim/Financial Asset – claim in entity’s funds) seeks to find an institutional buyer—such as a
future earnings and assets (stocks/bonds) pension fund—or group of buyers (suppliers of
2. Financial Markets – “Where” – marketplace where funds) to purchase the whole issue.
investors trade financial instruments Secondary Markets.
3. Financial Institutions – “Who” – financial • Once financial instruments such as stocks are issued
intermediary which invests in financial instruments in primary markets, they are then traded—that is,
and issues financial instruments on its own rebought and resold—in secondary markets .
o Financial Intermediary – intermediation – • When an economic agent buys a financial instrument
channelling funds (financial resource) from in a secondary market, funds are exchanged, usually
savers to users with the help of a securities broker such as Schwab
FINANCIAL INTERMEDIARIES are institutions that borrow acting as an intermediary between the buyer and the
funds from savers and then lends these funds to others seller of the instrument (see Chapter 8 ). The original
FINANCIAL INTERMEDIATION is the process of indirect issuer of the instrument (user of funds) is not
finance whereby financial intermediaries link savers and involved in this transfer.
borrowers Benefits
• Investors - Secondary markets provide the
Financial intermediaries are important because: opportunity to trade securities at their market values
They can reduce transaction costs quickly as well as to purchase securities with varying
They can provide customers with liquidity risk-return characteristics.
services • Corporates – accumulate inforrmation about the
Primary Markets current market value of their securities. This price
• A place where investors can directly buy securities information allows issuers to evaluate how well they
from a company, when it floats new stocks or bonds are using the funds generated from the financial
in the market. instruments they have already issued and provides
• Are markets in which users of funds (e.g., information on how well any subsequent offerings of
corporations) raise funds through new issues of debt or equity might do in terms of raising additional
financial instruments, such as stocks and bonds. money (and at what cost).
• The fund users have new projects or expanded Main diff
production needs, but do not have sufficient • Intermediaries – investment banks: stock exchange
internally generated funds (such as retained earnings) • Sale of securities – company: between investors
to support these needs. Thus, the fund users issue traders
securities in the external primary markets to raise • Price – fixed: influenced by supply/demand of the
additional funds. securites
• New issues of financial instruments are sold to the Money Markets.
initial suppliers of funds (e.g., households) in • are markets that trade debt securities or instruments
exchange for funds (money) that the issuer or user of with maturities of one year or less (see Figure 1–2 ).
funds needs. • In the money markets, economic agents with short-
• Most primary market transactions in the United term excess supplies of funds can lend funds (i.e.,
States are arranged through financial institutions buy money market instruments) to economic agents
called investment banks—for example, Morgan who have short-term needs or shortages of funds (i.e.,
Stanley or Bank of America Merril Lynch—that serve they sell money market instruments).
as intermediaries between the issuing corporations • The short-term nature of these instruments means that
(fund users) and investors (fund suppliers). fluctuations in their prices in the secondary markets
• For these public offerings, the investment bank in which they trade are usually quite small (see
provides the securities issuer (the funds user) with Chapters 3 and 19 on interest rate risk).
advice on the securities issue (such as the offer price
Capital Markets. The market where investment instruments like bonds, equities
• are markets that trade equity (stocks) and debt and mortgages are traded is known as the capital market.
(bonds) instruments with maturities of more than one The primal role of this market is to make investment from
year. investors who have surplus funds to the ones who are running
• The major suppliers of capital market securities (or a deficit.
users of funds) are corporations and governments.
• Households are the major suppliers of funds for these Investment in long term financial instruments is accompanied
securities. by high capital market risks. Since there are two types of
• Given their longer maturity, these instruments capital markets- the stock market and the bond market.
experience wider price fluctuations in the secondary ============================================
markets in which they trade than do money market  The Efficient Market Hypothesis shows that all price
instruments. movements are random whereas there are plenty of
Characteristics of Money Market Instruments studies that reflect the fact that there is a specific
• First, Sold in large dominations, money market trend in the stock market prices over a period of time.
instruments are generally sold in large denominations  Research has shown that there are certain
(often in units of $1 million to $10 million). Most psychological factors that shape the stock market
money market participants want or need to borrow prices.
large amounts of cash, so that transactions costs are  Sometimes the market behaves illogically to any
low relative to the interest paid. The size of these economic news.
initial transactions prohibits most individual investors  The stock market prices can be diverted in any
from investing directly in money market securities. direction in response to press releases, rumors and
Rather, individuals generally invest in money market mass panic.
securities indirectly, with the help of financial  The stock market prices are also subject to
institutions such as money market mutual funds or speculation. In the short run the stock market prices
short-term funds. may be very volatile due to the occurrences of the
• Second, low default risk, money market instruments fast market changing events.
have low default risk ; the risk of late or ============================================
nonpayment of principal and/or interest is generally  There is an inverse relationship existing between the
small. Since cash lent in the money markets must be interest rate and the price of the bond. Hence the
available for a quick return to the lender, money bond prices are sensitive to the monetary policy of
market instruments can generally be issued only by the country as well as economic changes.
high-quality borrowers with little risk of default.
• Finally, maturity of less than one year, money market Debt securities are issued by borrowers to obtain liquidity
securities must have an original maturity of one year (cash) or capital for either short-term or long-term needs.
or less. Given that adverse price movements resulting Such securities are contractual obligations of the issuers
from interest rate changes are smaller for short-term (borrowers) to make certain promised stream-of-cash fl
securities, the short-term maturity of money market ows in future. Promises made by borrowers may be
instruments helps lower the risk that interest rate secured by specifi c assets of the borrowers, or they can
changes will significantly affect the security’s market be unsecured.
value and price.
Criticisms in Bond Equivalent Yield In this market the investors receive regular income
• The bond equivalent yield simply annualizes with whether it is on a monthly, quarterly, half-yearly or yearly
simple interest – which ignores the opportunity to basis as well as repayment of principle amount on
earn interest on interest maturity.
Criticisms in Discount Yield
• The yield is based on the FV of the bond – not the Why is Unlevered Free Cash Flow Used? Unlevered free
purchase price. Investment returns should be cash flow is used to remove the impact of capital
evaluated relative to the amount of the investment. structure on a firm's value and to make companies
• The yield is based on a 360-day instead of 365-day. more comparable. Its principal application is in
The discount yield simply annualizes with simple interest – valuation, where a discounted cash flow (DCF) model.
which ignores the opportunity to earn interest on inter Free Cash Flow (FCF)

LESSON 2:
A capital market is market for securities (Debt or Equity),
where business enterprises (Companies) and government can
raise long term funds.
 In projecting Free Cash Flow for a business, • Ownership dilution
remember “C.V.S.”, and that Garbage In = Garbage Out: • Signal that managers feel stock is overvalued
Confirm historical financials for accuracy. • Dividend payments are not tax-deductible
Validate key assumptions for projections. Stock Issuance Types and Process
Sensitize variables driving projections to build a • Public Equity Issuance
valuation range. • Private Equity
In order to calculate Free Cash Flow projections, you • Venture Capital
must first collect historical financial results. • Private Equity Purchase and Resell
• Leveraged Buy Out
Terminal Value represents the value of the cash flows • Hybrid Securities
after the projection period. Projections only go out so far Debt (Bond/Loan Financing)
in the DCF (i.e. 5 or 10 years), so this is a mechanism for Advantages
estimating the future value of the business’s cash flows • Interest tax shield
after that projection period. • Encourage discipline by management
• Does not dilute ownership
The Terminal Value is based on the cash flows of the Disadvantage
business in a normalized environment. What this means is • Lower net income
that the business should be assumed, after the projection • Loss of future debt capacity and financing flexibility
period, to grow at a rate that is appropriate for a business • Risk of bankruptcy or financial distress
of its type at the end of the projection period, and/or to be Typical Bond Loan Covenant
valued at multiples consistent with those of its peers (see More often than not, bank loans restrict firm operations with
the chapter on Comparable Companies Analysis earlier in loan covenants. Business must assess their ability to meet the
this training course). covenant requirements
CALCULATING TERMINAL VALUE Affirmative
• Must maintain insurance policies on property, general
There are two primary methods to compute a company’s liability or key person life insurance
terminal value: • Audited/Reviewed FS/Tax Returns submitted to bank
o Terminal Multiple Method: Also referred • Maintain liquidity or performance ratios
to as the Exit Multiple Method, this • Maintain collateral/compensating balances
technique uses a multiple of a financial • Shareholder loans must be subordinated to bank loan
metric (such as EBITDA) to drive a Negative
business’s valuation. These multiples can be • No change in management or merges without
derived using multiples prevalent among approval
comparable companies. • No further loans or leases without approval
o Perpetuity Method: Assumes that the Free • No distribution of profits without approval
Cash Flows of the business grow in • No sale or purchase of equipment without approval
perpetuity at a given rate. The Perpetuity A breach of covenant may result in caution letters, penalties or
Method uses the Gordon Formula: Terminal accelerated payment/maturity.
Value = FCFn × (1 + g) ÷ (r – g), where r is Special Bond terms
the discount rate (discussed in the next Seniority
section on WACC) and g is the assumed • Senior Secured
annual growth rate for the company’s FCF. • Senior Unsecured
This will be demonstrated with an example • Subordinated/Junior Subordinate
LESSON 4: • Third Party Guaranteed/Insured Bonds
Amortizing Bonds
Why hold Cash? Puttable/Callable bonds
1. Transactional Cash Balance
2. Required Compensating Balance This proposition states that in perfect markets, the capital
3. Precautionary balance structure a company uses doesn't matter because the market
value of a firm is determined by its earning power and the risk
Equity Financing of its underlying assets.
Advantage The Modigliani-Miller theorem (M&M) states that the market
• Lower financial risk value of a company is correctly calculated as the present value
• Higher net income because no interest expense of its future earnings and its underlying assets, and is
Disadvantages independent of its capital structure.
 gain from these profit enhancement activities. Managers,
Many researchers, including M and M, have examined the therefore, can transfer the firm's resources to their own
effects of less restrictive assumptions on the relationship interests by consuming perquisites. As a result they may over-
between capital structure and the firm’s value. indulge in these sort of activities rather than those winch
The result is a theoretical optimal capital structure based on would maximize the value of the firm. it Is arued b" Jensen
balancing the benefits and costs of debt financing. and Meckling (1976) that if the manager's investment in the
The major benefit of debt financing is the tax shield, which firm is held constant, a rise in the fraction of the firm financed
allows interest payments to be deducted in calculating taxable by debt raises the manager's share of equity and hence reduces
income. the loss from conflicts between equityholders and managers.
The cost of debt financing results from Moreover, as a result of debt which firm is committed to pay
(1) the increased probability of bankruptcy caused by debt managers have less cash to spend on pursuits, which
obligations, constitutes the benefit of debt.
(2) the agency costs of the lender’s constraining the firm’s
actions, and The second type of conflict arises between shareholders and
(3) the costs associated with managers having more debtholders because debt contract gives equityholders an
information about the firm’s prospects than do investors incentive to invest suboptimally. To put it differently, the
structure of debt contract is such that if an investment yields
Bankruptcy Costs large returns this gain is captured by equityholders. If,
however, the investment fails, because of limited liability of
Higher costs of capital and an elevated degree of risk may, in equityholders, only debtholders bear the consequences. While
turn, increase the risk of bankruptcy. As the company adds owners benefit from the upside gains from high risk
more debt to its capital structure, the company's WACC investments they do not bear the costs of downside losses. As
increases beyond the optimal level, further increasing a result equityholders can invest in very risk projects, even if
bankruptcy costs. they have negative net present value. Then such investments
result in a decrease in the value of the debt. This may mean
Put simply, bankruptcy costs arise when there is a greater that prospective lenders insist on (expensive) legal safeguards
likelihood a company will default on its financial obligations to protect them. One way in which this can be done is to use
because it has decided to increase its debt financing rather protective covenants to monitor the action of stockholders.
than use equity. Costs involved in monitoring are one type of agency costs.
These costs are likely to be born by equityholders in terms of
In order to avoid financial devastation, companies should take higher interest rates asked by creditors. That is, the higher the
into account the cost of bankruptcy when determining how anticipation of monitoring costs by creditors, the higher the
much debt to take on, or even whether they should add to their interest rate, and, ceteris paribus, the lower the value of the
debt levels at all. The cost of bankruptcy can be calculated by firm to shareholders. Therefore, shareholders will have an
multiplying the probability of bankruptcy by its expected incentive to minimise monitoring costs which are likely to
overall cost. increase as leverage increases.

Bankruptcy costs vary depending on the structure and size of Pecking Order Theory
the company. They generally include filing fees, legal and The pecking order theory focuses on asymmetrical
accounting fees, the loss of human capital, and losses from information costs. This approach assumes that companies
selling distressed assets. prioritize their financing strategy based on the path of least
resistance. Internal financing is the first preferred method,
2.5 Agency Costs A followed by debt and external equity financing as a last resort.
Agency costs were introduced into the corporate finance Ihat if finance is required firms prefer internal finance
theory by the seminal paper of Jensen and Meckling (1976). (retention finance) to external finance. This is because firms
Since then researchers have paid a considerable attention to try to avoid facing the dilemma of either passing valuable
agency costs which arise as a result of the conflicts of interest investment opportunities or issuing equity at a price they think
between different agents of the finn. The main approach is too low. If external finance is required, however, firms issue
introduced by Jensen and Meckling (1976) is that of the safest security first. That is, debt comes first as the safest
explaining behaviour of firms with regard to financial policies security, then hybrid securities such as convertible bonds, and
which minimise agency costs. They point out two types of then equity as a last resort.
conflicts.
The first type of conflicts arises between managers and Signalling Theory
equityholders because managers hold less than 100 percent of Under the assumption that market prices do not really reflect
the residual claim. Consequently, while managers bear the full information, changes in capital structure of firms can be
entire cost of the firm's activities they do not have the entire
used as a signalling device to convey information to the
market (investors)