THE INVESTMENT

ENVIRONMENT

TOPIC 1
The Firm and the Financial Markets

Firm Firm issues securities (A) Financial

markets
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

The cash flows from

Ultimately, the firm
must be a cash
generating activity.
the firm must exceed
Government
the cash flows from
the financial markets.2
DIRECT AND INDIRECT FINANCING
Direct Finance
In direct finance, borrowers borrow funds
directly from lenders in financial markets by
selling them securities (financial instruments)
which are claims on the borrowers future
income or assets
E.g. A firm may borrow from savers by selling
the saver a bond

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Indirect Finance
Involves a financial intermediary that stands
between the lender-savers and the borrower-
spenders and helps transfer funds from one to the
other
A financial intermediary does this by borrowing
funds from the lender-savers and then using these
funds to make loans to borrower-spenders
This is called financial intermediation

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 Investment Defined
A current commitment of funds for a period of
time in order to derive future payments that
will compensate the investor for:
the time the funds are committed
the expected rate of inflation
uncertainty of future payments.

This is the required rate of return

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 Investment Defined
The investor can be
an individual
a government
a pension fund
or a corporation
Definition includes investment by
Corporations in plant and equipment
individuals in stocks, bonds, commodities, or real
estate

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Real Assets Versus Financial Assets
Real Assets
Determine the productive capacity and net
income of the economy
Examples: Land, buildings, machines,
knowledge used to produce goods and
services

Financial Assets
Claims on real assets

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 Financial Assets

Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

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 Fixed Income
Payments fixed or determined by a
formula

Money market debt: short term, highly

marketable, usually low credit risk

Capital market debt: long term bonds, can

be safe or risky

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Common Stock and Derivatives
Common Stock is equity or ownership in a
corporation.
Payments to stockholders are not fixed, but
depend on the success of the firm
Derivatives
Value derives from prices of other securities,
such as stocks and bonds
Used to transfer risk

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Financial Markets and the Economy

Information Role: Capital flows to

companies with best prospects

Consumption Timing: Use securities to

store wealth and transfer consumption to
the future

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 Financial Markets and the
Economy (Ctd.)

Allocation of Risk: Investors can select

securities consistent with their tastes for
risk

Separation of Ownership and

Management: With stability comes agency
problems

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 Financial Markets and the
Economy (Ctd.)
Corporate Governance and Corporate Ethics
Accounting Scandals
Examples Enron, Rite Aid, HealthSouth
Auditors watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate governance

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 The Investment Process

Asset allocation
Choice among broad asset classes
Security selection
Choice of which securities to hold within
asset class
Security analysis to value securities and
determine investment attractiveness

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 Markets are Competitive

Risk-Return Trade-Off

Efficient Markets
Active Management
Finding mispriced securities
Timing the market

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Markets are Competitive (Ctd.)
Passive Management
No attempt to find undervalued
securities
No attempt to time the market
Holding a highly diversified portfolio

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 The Players

Business Firms net borrowers

Households net savers

Governments can be both borrowers and

savers

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 The Players (Ctd.)
Financial Intermediaries: Pool and invest funds
Investment Companies
Banks
Insurance companies
Credit unions

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 Universal Bank Activities
Investment Banking Commercial Banking
Underwrite new stock
and bond issues Take deposits and make
Sell newly issued loans
securities to public in the
primary market
Investors trade previously
issued securities among
themselves in the
secondary markets

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