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

CHAPTER 1 - An Introduction to Finance 1-3

 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 Montréal
• 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
CHAPTER 1 - An Introduction to Finance 1-5
 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.

CHAPTER 1 - An Introduction to Finance 1-7

 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
CHAPTER 1 - An Introduction to Finance 1-9
Assets and Liabilities of Households,
2005
Table 1-2 Assets and Liabilities of Households, 2005

Assets $ Billion Liabilities $ Billion

Houses 1,086 Consumer credit 260
Consumer Durables 435 Loans 131
Land 827 Mortgages 588
Real Assets 2,348 Total Liabilities 979
Deposits 683
Debt 114
Pensions and insurance 1,200
Shares 1,254
Foreign and other 72
Financial Assets 3323
Total Assets 5,671

So urce: Statistics Canada. Natio nal B alance Sheet A cco unts, Quarterly Estimates, Fo urth
Quarter 2005. Ottawa: M inister o f Industry, 2006 (Catalo gue No . 13-214-XIE).

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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

CHAPTER 1 - An Introduction to Finance 1 - 11

The Financial System
FIGURE 1-2

CHAPTER 1 - An Introduction to Finance 1 - 12

 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)

CHAPTER 1 - An Introduction to Finance 1 - 13

Channels of Intermediation

FIGURE 1-3

CHAPTER 1 - An Introduction to Finance 1 - 14

 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 amount…face 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.

CHAPTER 1 - An Introduction to Finance 1 - 16

 Financial Intermediaries
Canadian Chartered Banks

Table 1-3 Chartered Banks: Financial Statistics, 2005

Revenue Assets Profits

Bank ($ million) ($ million) ($ million)
Royal Bank of Canada 29,403 469,521 3,387
Canadian Imperial Bank of Commerce
(CIBC) 18,677 280,370 -32
Bank of Nova Scotia 18,332 314,025 3,209
TD Canada Trust 18,665 365,210 2,229
Bank of Montreal 15,138 297,532 2,400
National Bank 5,320 107,598 855

So urce: B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31, 2006.

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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.

CHAPTER 1 - An Introduction to Finance 1 - 18

 Financial Intermediaries
Insurance Companies

Table 1-4 Insurance Companies: Financial Statistics, 2005

Revenue Assets Profits

Insurer ($ million) ($ million) ($ million)
Manulife Financial 32,187 322,171 3,294
Sun Life Financial 21,871 171,850 1,867
Great-West Lifeco 23,883 102,161 1,775
ING Canada 4,446 9,926 782

So urce: Data fro m B M O Investo rLine website: www.bmo investo rline.co m, Octo ber 31, 2006.

CHAPTER 1 - An Introduction to Finance 1 - 19

 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.
CHAPTER 1 - An Introduction to Finance 1 - 20
 Financial Intermediaries
Pension Plan Assets

Table 1-5 Pension Plan Assets, 2005

Net Assets
Pension Plan Managers ($ billion)
Caisse de depot et placement du Quebec 216.1
Canada Pension Plan (CPP) 98.0
Ontario Teachers (Teachers) 96.1
Ontario Municipal Employees (OMERS) 41.6

* The Caisse manages the investments o f several pensio n plans.

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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)

CHAPTER 1 - An Introduction to Finance 1 - 22

Financial Intermediaries
Canadian Mutual Fund Assets
FIGURE 1-4

CHAPTER 1 - An Introduction to Finance 1 - 23

 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

Table 1-6 Non-Financial Canadian Companies: Financial Statistics, 2005

Revenue Assets
Non-financial Companies ($ million) ($ million)
General Motors of Canada Ltd. 34,991 n/a
Loblaw Companies Ltd. 27,812 13,761
Magna International Inc. 22,873 12,321
Imperial Oil Ltd. 26,936 15,582
Alcan Inc.* 20,408 26,638
BCE Inc. 19,150 40,630
Bombardier Inc.* 14,882 17,483
Petro-Canada 17,673 20,655
Onex Corp. 17,626 14,845
EnCana Corp.* 14,322 34,148
*Co mpany repo rts in U.S. do llars.
So urce: Data fro m "The To p 1000 in 2005." Glo be and M ail Repo rt o n B usiness website:
www.theglo beandmail.co m.

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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

CHAPTER 1 - An Introduction to Finance 1 - 26

 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

CHAPTER 1 - An Introduction to Finance 1 - 27

 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 Capitaliza tion  Number of shares  Price per share

CHAPTER 1 - An Introduction to Finance 1 - 28

 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)

CHAPTER 1 - An Introduction to Finance 1 - 30

 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

CHAPTER 1 - An Introduction to Finance 1 - 31

 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

CHAPTER 1 - An Introduction to Finance 1 - 32

 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

CHAPTER 1 - An Introduction to Finance 1 - 33

The Global Financial Community
Table 1-7 Canada's International Investments, 2005

($ million)
Total Assets 1,016,031
Canadian direct investments abroad 465,058
Canadian portfolio investments 284,604
Portfolio foreign bonds 82,374
Portfolio foreign stocks 189,175
Other portfolio investments 13,055
Other Canadian investments 266,369
Loans 48,325
Allowances
Deposits 120,694
Official international reserves 38,030
Other assets 59,319
Total Liabilities 1,184,534
Foreign direct investments in Canada 415,561
Foreign portfolio investments 508,398
Portfolio Canadian bonds 380,017
Portfolio Canadian stocks 107,598
Portfolio Canadian money market instruments 20,783
Other foreign investments 260,575
Loans 36,107
Deposits 201,639
Other liabilities 22,829
Canada's Net International Investment Position -168,503
So urce: Statistics Canada.

CHAPTER 1 - An Introduction to Finance 1 - 34

 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

CHAPTER 1 - An Introduction to Finance 1 - 35

 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/

CHAPTER 1 - An Introduction to Finance 1 - 36

 Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
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use of the information contained herein.

CHAPTER 1 - An Introduction to Finance 1 - 37