Intro to Finance: Introduction to Finance Financial Markets and Institutions Money vs Capital Markets Primary vs Secondary Investment Banks Commercial Banks Stock Exchanges

What This Is

Financial markets and institutions play a crucial role in facilitating the flow of funds between savers and investors. They provide a platform for companies to raise capital and for investors to invest in various assets. For example, consider Apple Inc., which raised $10 billion in a bond issuance to finance its expansion plans. This transaction demonstrates the importance of financial markets and institutions in facilitating capital formation.

Key Formulas & Symbols

• Money Market: A market for short-term debt securities with maturities of one year or less.
• Capital Market: A market for long-term debt and equity securities with maturities of more than one year.
• Primary Market: The market where new securities are issued by companies, such as initial public offerings (IPOs) or bond issuances.
• Secondary Market: The market where existing securities are traded among investors, such as stock exchanges or over-the-counter (OTC) markets.
• Investment Bank: A financial institution that helps companies raise capital by underwriting and distributing securities.
• Commercial Bank: A financial institution that provides a range of banking services, including accepting deposits and making loans.
• Stock Exchange: A platform where stocks and other securities are traded among investors.
• Broker-Dealer: A firm that buys and sells securities on behalf of clients, earning a commission on each transaction.
• Market Maker: A firm that provides liquidity to a market by buying and selling securities at prevailing market prices.
• Yield Curve: A graphical representation of the relationship between bond yields and their maturities.

Step-by-Step Calculation

1. Calculate the yield to maturity (YTM) of a bond: Given the bond's face value (FV), coupon rate (C), maturity (n), and current market price (P), use the following formula:

YTM = (C × (1 + YTM)^n - P) / (FV × (1 + YTM)^n)

1. Determine the optimal capital structure: Given a company's cost of debt (r_d), cost of equity (r_e), and tax rate (t), use the following formula to calculate the weighted average cost of capital (WACC):

WACC = (D / (D + E)) × r_d + (E / (D + E)) × r_e × (1 - t)

1. Calculate the free cash flow to the firm (FCFF): Given a company's earnings before interest and taxes (EBIT), depreciation and amortization (D&A), capital expenditures (CapEx), and working capital changes (ΔWC), use the following formula:

FCFF = EBIT + D&A - CapEx - ΔWC

1. Determine the present value of a future cash flow: Given a cash flow (CF), discount rate (r), and time period (n), use the following formula:

PV = CF / (1 + r)^n

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value to reflect the company's current market capitalization.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate at which the net present value (NPV) of a project is zero, while NPV is the difference between the present value of cash inflows and outflows.
• Mistake: Ignoring the impact of taxes on WACC.
• Correction: Taxes can affect the cost of debt and equity, so include them in the WACC calculation.

Exam / CFA Tips

• Tip: Be careful with question wording, as it may imply a specific market or scenario.
• Tip: Use the correct formula for calculating YTM, WACC, and FCFF.
• Tip: Consider the impact of taxes on WACC and FCFF.

Quick Practice Problem

Apple Inc. issues a 5-year bond with a face value of $1,000 and a 5% coupon rate. The current market price is $950. What is the bond's yield to maturity?

Answer: 5.26% Explanation: Use the YTM formula to calculate the bond's yield to maturity.

Last-Minute Cram Sheet

• ⚠️ The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• The weighted average cost of capital (WACC) is a key input in capital budgeting decisions.
• The free cash flow to the firm (FCFF) is a key output in capital budgeting decisions.
• The yield curve is a graphical representation of the relationship between bond yields and their maturities.
• The stock exchange is a platform where stocks and other securities are traded among investors.
• The investment bank helps companies raise capital by underwriting and distributing securities.
• The commercial bank provides a range of banking services, including accepting deposits and making loans.
• The broker-dealer buys and sells securities on behalf of clients, earning a commission on each transaction.
• The market maker provides liquidity to a market by buying and selling securities at prevailing market prices.
• ⚠️ The WACC formula assumes a constant tax rate and cost of debt.