INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Prepared by

Ken Hartviksen

CHAPTER 1
An Introduction to Finance

Lecture Agenda

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
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Learning Objectives
1. What finance is and what is involved in the study of
finance.
2. How financial securities can be used to provide
financing for borrowers and simultaneously to provide
investment opportunities for lenders.
3. How financial systems work in general.
4. The channels of intermediation and the role played by
market and financial intermediaries within this system.
5. The basic types of financial instruments that are
available and how they are traded.
6. The importance of the global financial system.
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Key Terms

Bourse de Montral
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
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Key Terms

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
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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.
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The Study of Finance

The study of finance requires a basic
understanding of:

Securities
Corporate law
Financial institutions and markets

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Real Versus Financial Assets

Real assets are tangible things owned by
persons and businesses

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
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Assets and Liabilities of Households,

2005

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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

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The Financial System

FIGURE 1-2

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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)
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Channels of Intermediation
FIGURE 1-3

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The Financial System

Financial Intermediaries

Banks and other deposit-taking institutions

Insurance companies
Pension Funds
Mutual Funds

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Financial Intermediaries
Canadian Chartered Banks
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 amountface 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.

Banks can perform this transformation function because they

become experts at risk assessment, financial contracting (pricing
the risk) and monitoring the activities of borrowers.
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Financial Intermediaries
Canadian Chartered Banks

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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.
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Financial Intermediaries
Insurance Companies

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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.
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Financial Intermediaries
Pension Plan Assets

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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)
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Financial Intermediaries
Canadian Mutual Fund Assets
FIGURE 1-4

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The Financial System

The Major Borrowers

Public Debt
Governments

Federal
Provincial
Municipal
Crown Corporations

Private Debt
Households
Non-financial Corporations

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The Financial System

Largest Non-financial Companies

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Financial Instruments
There are two major categories of
financial securities:
1. Debt Instruments

Commercial paper
Bankers acceptances
Treasury bills
Mortgage loans
Bonds
Debentures

2. Equity Instruments

Common stock
Preferred stock

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Financial Instruments
Non-marketable

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:

Savings accounts
Term Deposits
Guaranteed Investment Certificates
Canada Savings Bonds
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Financial Instruments
Marketable

Characteristics of Marketable securities

Can be traded between or among investors after their original

issue in public markets and before they mature or expire

Market Capitalization

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 Capitalization Number of shares Price per share

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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

Capital Market Securities (for long-term debt or equity

securities with maturities greater than 1 year)

Bonds
Debentures
Common Stock
Preferred Stock

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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)

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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

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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

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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

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The Global Financial Community

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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

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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/

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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
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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.

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