Chapter 6 Section 3 and Appendix Pg 195 198 How firms raise funds Owners and mangers of firms try to earn a profit o To earn a profit a firm must raise funds to pay for its operations including paying its employees and buying or renting computers and other machinery and equipment Challenge raising the funds needed to operate and expand the business Raise funds in 3 ways o If you are making a profit you could reinvest the profits back into your firm Profits that are reinvested in a firm rather than taken out of a firm and paid to the firm s owners are retained earnings o You could raise funds by recruiting additional owners to invest in the firm This arrangement would increase the firm s financial capital o You could borrow the funds from relatives friends or a bank Sources of External Funds Role of economy s financial system is to transfer funds from savers to borrowers Most firms raise external funds in 2 ways o Relies on financial intermediaries such as banks o Indirect finance a flow of funds from savers to borrowers through financial intermediaries such as banks Intermediaries raise funds from savers to lend to firms and other borrowers o Financial markets o Direct finance a flow of funds from savers to firms through financial markets such as New York Stock Exchange Investors are generally unwilling to buy securities issued by small and medium sized firms because the investors lack sufficient information on the financial health of smaller firms o Financial security is a document that states the terms under which the funds have passed from the buyer of the security to the borrower Bond a financial security that represents a promise to repay a fixed amount of funds o Each individual bond has a principal or face value which is the amount each bond purchaser is lending o Coupon payment an interest payment on a bond o Interest rate the cost of borrowing funds usually expressed as a percentage of the amount borrowed o Many bonds that corporations issue have terms or maturities o The interest rate that borrower selling a bond has to pay depends on how likely bond buyers investors think that the bond seller is to default Higher the default risk on a bond the higher the interest rate Stocks a financial security that represents partial ownership of a firm o When a corporation sells stock it is doing the same thing the owner of a small business does when she takes on a partner The firm is increasing its financial capital by bringing additional owners into the firm o Corporations keep some of their profits retained earning to finance future expansion Remaining profits are paid to shareholders as dividends Dividends payments by a corporation to its shareholders Investors hope that a firm will earn economic profits by using retained earnings to grow Cause the firm s share price to rise and providing a capital gain for investors o Corporations must make promised payments to bondholders before it can make any dividend payments to shareholders o When firms sells tock they acquire from investors an open ended commitment of funds to the firm o Do not have a maturity date Firm is not obliged to return the investor s funds at any particular date Stock and bond markets provide capital and information The original purchasers of stocks and bonds may resell them to other investors markets Common that investors resell existing stocks and bonds to each other rather than corporations selling new stocks and bonds to investors Buyers and sellers of stocks and bonds together make up the stock and bond Trading of stocks and bonds take place in buildings called exchanges Security dealers comprise the over the counter market o Trading of stocks and bonds outside exchanges to people linked by computer o NASDAQ Shares of stock represent claims on the profits of the firms that issue them o Fortunes of firms can change and they can earn more or less profit the prices of the stock the firms have issued should also change o Bonds represent claims to receive coupon payments and one final payment of principal down A bond that was issued in the past may have its price go up or Depending on whether the coupon payments being offered on newly issued bonds are higher or lower than existing bonds If price increases from the coupon you hold the price of your bond will fall because it is less attractive to investors o Changes in the value of a firm s stocks and bonds offer important information for a firm s managers and investors Increase in stock price means investors are more optimistic about the firm s profit prospects and the firm s managers might want to expand the firm s operations Decrease in stock price indicates that investors are less optimistic about the firm s profit prospects so mangers may want to shrink operations o Changes in the value of the firm s bonds imply changes in the cost of external funds to finance firms investments Higher bond price indicates a lower cost of new external funds Lower bond price indicates a higher cost of new external funds Why do stock prices fluctuate so much Performance of the Us stock market is measured using stock market indexes o Stock market indexes are averages of stock prices with value of the index set equal to 100 in a particular year base year o Stock indexes are intended to show movements in prices from one year to the next 3 most widely followed stock indexes o Dow Jones Industrial Average o The S P 500 o The NASDAQ Composite Index Ownership of firm s stock represent a claim on the firm s profits o The larger the firm s profits are the higher the stock price will be o When economy is expanding incomes employment and spending will increase and corporate profits will increase o When economy is in recession incomes employment and spending will fall and corporate profits will decrease o Expect stock prices will rise when economy is expanding o Expect stock prices to fall when the economy is in a recession Appendix Using Present Value to Make Investment Decision Firms raise funds by selling equity stock and debt bonds and loans to investors and lenders Present value the value in today s dollars of funds to be paid or received in the future o Present value Future value1 1 i Using Present Value to Calculate Bond Prices The price of a financial asset should be equal to the present value of the payments to be received from owning that asset Bond price Coupon1 1 i Coupon2 1 i 2 CouponN 1 Present value Future value1 1 i Future value2 1 i 2 Stock price Dividend1 1 i Divident2 1