Fins 1612 notes
of 72
-
Upload
christineliu0110 -
Category
Documents
-
view
227 -
download
0
Transcript of Fins 1612 notes
-
8/18/2019 Fins 1612 notes
1/72
1
FINS1612: Capital Markets and Institutions
Chapter 1 : A modern financial system – an overview
1.1 Functions of a financial system
Money
o
Acts as medium of exchangeo Allows specialisation in production
o Solves the divisibility problem; ie. where medium of exchange does not represent equal value for the
parties to the transaction
o Facilitates saving
o Represents a store of wealth
Role of Markets
o Facilitate exchange of goods and services by:
Bringing opposite parties together
Establishing rates of exchange ie. prices
Makes things easier to do the exchange
Surplus Units
o Savers of funds available for lending
Deficit Units
o Borrowers of funds for capital investment and consumption
Financial instrument
o Issued by a party raising funds, acknowledging a financial commitment and entitling the holder to
specified future cash flows
Double coincidence of wants satisfied
o A transaction between two parties that meets their mutual needs
Flow of funds
o
Movement of funds through the financial system between savers and borrowers giving rise to
financial instruments
Financial system
o Comprises financial institutions, instruments and markets facilitating transactions for goods and
services and financial transactions.
o Everything and everyone is in it for the transaction to occur or take part in the market
Attributes of Financial assets
o Return or yield
Total financial compensation received from an investment expressed as percentage of the
amount invested.
o
Risk
Probability that the actual return on an investment will vary from the expected return
o Liquidity
Ability to sell an asset within a reasonable time at current market prices and for reasonable
transaction costs
Means a lot of buyers and sellers
o Time –pattern of cash flows
When the expected cash flows from a financial asset are to be received by the investor or
lender
An efficient financial system:
o
Encourages savings o Directs savings to the most efficient users
o Is a combination of assets and liabilities comprising the desired attributes of return , risk ,liquidity
and timing of cash flows
-
8/18/2019 Fins 1612 notes
2/72
2
1.2 Financial institutions
Most people have used the services of a financial institution at some stage, even if the service was simply a
basic bank account
Financial institutions may specialised in:
o Taking deposits , providing advice to corporate and government clients or offering financial contracts
such as insurance
Financial institutions are essential to the operation of the modern financial system
Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial
transactions
Institutions may be categorised by differences in the sources and uses of funds
o Depository financial institutions
o Investments banks and merchant banks
o Contractual savings institutions
o Unit trusts
Depository financial institutions
o Mainly attract the savings of depositors through on- demand deposit and tem deposit accounts; eg.
Commercial banks , building societies and credit cooperatives
o Mainly provide loans to borrowers in household and business sectors
o Eg. Banks , earn money from interest rates
Investment banks and merchant banks
o Mainly provide off-balance sheet (OBS)( not shown on the balance sheet) advisory services to
support corporate and government clients eg. Advice on mergers and acquisitions , portfolio
restructuring, finance and risk management
o May also provide some loans to clients but are more likely to advise on raising funds directly in
capital markets.
o Do not make money from interest rates but instead use the advisory fee
Contractual saving institutions
o The liabilities of these institutions are contracts that require, in return for periodic payments to the
institution, the institution to make payments to the contract holders if a specified event occurs eg.
Life and general insurance companies and superannuation funds
o The large pool of funds is then used to purchase both primary and secondary market securities
o Payouts are made for insurance claims and to retirees.
Unit Trusts
o Formed under a trust deed and controlled and managed by a trustee
o Funds raised by selling units to the public ; investors purchase units in the trust
o Funds are pooled and invested by fund managers in a range of asset classes specified in the trust
deedo Types of unit trusts include equity , property , fixed interest and mortgage trusts
o Trustee- like a contract
Equity
o Ownership interest in an asset
o Residual claim on earnings and assets
Dividend
Liquidation
o Types
Ordinary share
Hybrid ( or quasi- equity ) security Preference shares- might have some minimum periodic interest payment
Convertible notes
1.3 Financial Instruments
-
8/18/2019 Fins 1612 notes
3/72
3
Debt
o Contractual claim to:
Periodic interest payments
Repayment of principal
o Ranks ahead of equity
o Can be:
Short term ( money market instrument) or medium – to long term ( capital market
instrument)
Secured or unsecured
Negotiable ( ownership transferable ; eg. Commercial bills and promissory notes) or non-
negotiable ( eg. Term loan obtained from a bank)
Derivatives
o A synthetic security providing specific future rights that derives its price from ( help cover the risks
involved);
A physical market commodity
Gold and oil
Financial security
Interest rate sensitive debt instruments, currencies and equities
o Used mainly to manage price risk exposure and to speculate
Three basic derivative contracts
o Futures contract
o Forward contract
o Option Contract
1.4
Financial markets
Matching principle
Primary and secondary market transactions
Direct and intermediated finance
Wholesale and retail markets
Money markets
Capital markets
Matching principle
o Short-term assets should be funded with short term ( money market ) liabilities eg. seasonal
inventory needs funded by overdraft
o Longer term assets should be funded with equity or longer term ( capital market) liabilities eg.:
Equipment funded by debentures
Lack of adherence to this principle accentuated effects of frozen money markets with the
‘sub- prime’ market collapse
Primary market transactions
o The issue of new financial instrument to raise funds to purchase goods , services or assets by:
Business
Governments
Individuals
o Funds are obtained by the issuer
o Direct finance
Secondary market transaction
o The buying and selling of existing financial securities
No new funds raised and therefore no direct impact on original issuer of security
Transfer of ownership from one saver to another saver
-
8/18/2019 Fins 1612 notes
4/72
4
Provides liquidity , which facilitates the restructuring of portfolios and securities owners
Direct finance
o Users of funds obtain finance through primary market via direct relationship with providers ( savers0
o Advantages
Avoids costs of intermediation
Increases access to diverse range of markets
Greater flexibility in range of securities users can issue for different financing needs
o Disadvantages
Matching of preferences
Liquidity and marketability of a security
Search and transaction costs
Assessment of risk , especially default risk
Intermediated financial flow markets
o A financing arrangement involving two separate contractual agreements whereby the saver provides
funds to an intermediary and the intermediary provides funding to the ultimate user of the funds
o Advantages
Asset transformation
Maturity transformation
Credit risk diversification and transformation
Liquidity transformation
Economies of scale
Wholesale markets
o Direct financial flow transactions between institutional investors and borrowers
Involves larger transactions
Retail markets
o Transactions conducted primarily with financial intermediaries by the household and small- to
medium- sized business sectors Involves smaller transactions
Money Markets
o Wholesale markets in which short-term securities are issued and traded
o For short term
Capital markets
o Markets in which longer term securities are issued and traded with original term – to – maturity in
excess of one year
Summary
The Financial system is composed of financial institutions, instruments and markets facilitating transactionsfor goods and services and financial transactions
Financial instruments may be equity , debt or hybrid
Financial markets may be classified according to:
o Primary and secondary transactions
o Direct and intermediated flows wholesale and retail markets
o Money markets and capital markets
o Financial institutions
Commercial banks
Main activities
Commercial banks provide a full range of financial services
Asset Management
o Loans portfolio is tailored to match the available deposit base ( orientated around assets)
-
8/18/2019 Fins 1612 notes
5/72
5
Liability management
o Deposit base and other funding sources are managed to meet loan demand
Borrow directly from domestic and international capital markets
Provision of other financial services
Off-balance- sheet (OBS) business
Importance of banks (again):
o Asset transformation
o Maturity transformation
o Credit risk diversification & transformation
o Liquidity transformation
o Economies of scale
Source of Funds
Banks- balance sheet
Banks have a liability to give back the money
Sources of funds appear in the balance sheet as either liabilities or shareholders’ funds
Banks offer a range of deposit and investment products with different mixes of liquidity, return, maturity
and cash flow structure to attract the savings of surplus entities
Current account deposits
o Funds held in a cheque account
o Highly liquid – be able to with drawl how much you want
o May be interest or non-interest bearing
Term Deposits
o Funds lodged in an account for a predetermined period at a specified interest rate
Term: one month to five years
Loss of liquidity owing to fixed maturity
Higher interest rate than current or call accounts
Generally fixed interest rate ( banks do penalties if you do withdrawl)
Negotiable certificates of deposit (CDs)
o Issued by a bank in its own name
o Issued at a discount to face value
o Highly negotiable security
o Short term (30 to 180 days)
Debt liabilities
o
Medium- to longer term debt instruments issued by a bank
Debenture ( like a loan)
Unsecured note
Foreign currency liabilities
-
8/18/2019 Fins 1612 notes
6/72
6
o Debt instruments issued into the international capital markets that are denominated in a foreign
currency
Allows diversification of funding sources into international markets
Facilitates matching of foreign exchange denominated assets
Meets demand of corporate customers for foreign exchange products
Loan Capital and shareholders’ equity
o Sources of funds that have characteristics of both debt and equity (e.g. subordinated debentures
and subordinated notes)
Subordinated means the holder of the security has a claim on interest payments or the
assets of the issuer, after all other creditors have been paid (excluding ordinary shareholders)
Use of Funds
Uses of funds appear in the balance sheet as assets
The majority of bank assets are loans that give rise to an entitlement to future cash flows; i.e. interest and
repayment of principal:
o Personal and housing finance
o
Commercial lending
o Lending to government
Personal and Housing finance
o Housing finance
Mortgage
Amortised loan
o Investment property
o Fixed-term loan
o Credit card
Commercial lending
o
Involves bank assets invested in the business sector and lending to other financial institutions
Fixed- term loan
o A loan with negotiated terms and conditions
Period of the loan
Interest rates
Timing of interest payments
Repayment of principal
Overdraft
Bills of exchange
Leasing
Lending to government
o Treasury notes
Short-term securities issued by the government
o Treasury bonds
Medium- to longer-term securities issued by the government that pay a specified interest
coupon stream
o State government debt securities
o Low risk and low return
Off balance sheet Business
OBS transactions are a significant part of a bank’s business OBS transactions include:
o direct credit substitutes
o trade- and performance-related items
-
8/18/2019 Fins 1612 notes
7/72
7
o Commitments – Underwriting, Repos
o foreign exchange, interest-rate- and other market-rate related contracts
Direct credit substitutes
o An undertaking provided by a bank to support the financial obligations of a client.
Trade- and performance-related items
o An undertaking provided by a bank to a third party promising payment under the terms of a
specified commercial contract.
Commitments
o The contractual financial obligations of a bank that are yet to be completed or delivered.
o E.g., underwriting.- if people don’t buy the number of shares at a price or something than the bank
buys it
Foreign exchange, interest-rate- and other market rate-related contracts:
o The use of derivative products to manage exposures to foreign exchange risk, interest rate risk,
equity price risk and commodity risk (i.e. hedging)
o E.g., futures, options, foreign exchange contracts, currency swaps, forward rate agreements (FRAs)
o Also used for speculating
To the extent that these OBS activities involve risk taking and positions in derivative securities, OBS activities
raise some concerns about bank regulation
This is a particularly important concern when the size of off balance sheet activities is considered
The notional value of such activities is more than 5 times the total value of assets held by the banks
Regulation and Supervision
The GFC has focussed attention on the regulation of the financial system
A number of financial institutions collapsed during the crisis
The amount of leverage on the balance sheets of these institutions was a primary factor contributing to their
weakness (high leverage- more risky)
Debate concerning bank regulation and prudential supervision has concentrated on how regulators can
maintain a stable financial system
Capital Adequacy Standards
The business activities of financial institutions will inevitably involve the need to write-off of abnormal
business losses
The capital held by financial institutions serves as the ‘buffer’ against such losses
If capital is inadequate, a financial institution may face insolvency. This has significant implications for the
stability of the financial system
The capital adequacy standards set down in Basel II and III define the minimum capital adequacy ( hold a
minimum amount of capital) for a bank
The standards are designed to promote stability within the financial system
Functions of capital
o Source of equity funds
o Demonstrates shareholder commitment
o Provides funding for growth and source of future profits
o Write-off periodic abnormal business losses
Development of international capital adequacy standards
o Basel I (1988)
o Basel II (2008)
o
Basel III (2010)
Basel II mainly focuses on:
o Credit risk of banks’ assets and OBS business
o Market risks of banks’ trading activities
-
8/18/2019 Fins 1612 notes
8/72
8
o Operational risks of banks’ business operations
o Form and quality of capital held to support these exposures
o Risk identification, measurement and management processes adopted
o Transparency through accumulation and reporting of information
Minimum capital adequacy requirement applies to commercial banks and other institutions specified by
prudential regulators
Basel II Capital adequacy standard: Minimum risk based capital ratio of 8% (no less than 8%)
Minimum 4% held as Tier 1 capital ( there are some capital that is more reliable than others)
o Highest quality core capital
o E.g., paid-up ordinary shares; retained earnings
Remainder can be held as Tier 2 (supplementary) capital
o Upper Tier 2. E.g., mandatory convertible notes
o Lower Tier 2. E.g., term subordinated debt
Overview of basel 2 structure
Pillar 1 – Capital Adequacy Three risk components: credit risk, operational risk, and market risk.
Credit risk – risk that borrowers will not meet their commitments when due.
Basel II provides three alternative ways for a bank to measure credit risk:
o Standardised approach
o Foundation internal ratings-based approach (FIRB)
o Advanced internal ratings-based approach (AIRB)
Operational risk- exposures that may impact on normal day to day business functions of an organisation.
Eg. Internal/ external fraud, workplace safety, business practices
Main operational risk management objectives:
o
Operational objectiveso Financial impact objectives
o Regulatory objectives
-
8/18/2019 Fins 1612 notes
9/72
9
Market risk — risk of losses resulting from changes in market rates in exchange rates, interest rates, equities
and commodities
o General market risk — changes in the overall market for exchange rates, interest rates, equities, and
commodities ( overall market- effects every player in the market)
o Specific market risk — changes in the value of a security due to issuer-specific factors
o Two approaches to market risk capital requirements
Internal model—requires a statistical probability model that measures financial risk
exposures, i.e. value at risk (VaR)
Standardised approach
Pillar 2 — Supervisory review of capital adequacy
Intended to ensure banks have sufficient capital to support all risks and encourage improved risk
management policies and practices in identifying, measuring and managing risk exposures such as:
o risks incompletely/not captured in Pillar 1 and factors external to the bank, such as a changing
business cycle
o additional risk management practices such as education/ training; internal responsibilities,
delegation and exposure limits; increased provisions and reserves; and improved internal controls
and reporting practices
Four key principles of supervisory review
Pillar 3 — Market discipline
Aim is to develop disclosure requirements that allow the market to assess information on the capital
adequacy of an institution, i.e. increase the transparency of an institution’s risk exposure, risk management
and capital adequacy
Prudential supervisors to determine minimum disclosure requirements and frequency
Basel II recommends a range of qualitative and quantitative information disclosure relating to principal parts
of Pillars I and II
Basel III was developed in 2010.
Aims to enhance the risk coverage of the Basel II framework by enhancing capital adequacy requirements
Three principal aims:
o Boost the banking sector’s ability to absorb shocks arising from financial and economic stress
o Improve risk management and governance
o Strengthen banks’ transparency and disclosure
Examples:
o Increase minimum Tier 1 capital to 6% (4% in Basel II) of risk-weighted assets by 2015.
o Increase minimum Common Equity Tier 1 capital to 4.5% (2% in Basel II) of RWA by 2015.
o Improve the quality of capital (e.g. tighter definition of Common Equity Tier 1 capital to include only
common stocks, retained earnings, and other comprehensive income).
o
Minimum liquidity coverage ratio to ensure banks have sufficient high-quality liquid assets for
expected net cash outflows.
The Share Market and the Corporation
The Nature of a Corporation
Share Market
o A formal exchange facilitating the issue, buying and selling of equity securities
Publicly listed corporation
o A company whose shares are quoted and traded on a formal stock exchange
Ordinary shareo The principal form of equity issued by a corporation, which bestows a claim to residual cash flows
and ownership and voting rights
The corporation differs from other business forms
o Ownership claims are widespread and easily transferable
-
8/18/2019 Fins 1612 notes
10/72
10
o Owners (shareholders) do not affect the day- to – day affairs of the company
o Shareholders’ liability is limited to:
The issue price of shares of a limited liability company
Advantages of the corporate form
o Can obtain large amounts of finance at a relatively cheap cost
o The liquidity of securities facilitates investor diversification and encourages investment in corporate
securities (becomes less risky)
o Separation of ownership and control facilitates:
Appointment of specialised management
Greater effectiveness in the planning and implementation of strategic decisions
o ‘Perpetual succession’ – the corporate form is unaffected by changes in management or ownership
o The Corporate form is suited to large –scale operations
Disadvantages of the corporate form
o Main disadvantage arises from the separation of ownership and control
Conflict of interest between owners (principals) and managers (agents) known as the agency
problem
Management may try to run business of their own benefit, rather than that of shareholders,
ie. Maximise shareholder value (share price)
o Factors moderating conflict of interest between owners and managers
Investors’ ability to sell shares in a corporation, causing the share price to fall
Dismissal from the board at AGM by shareholders
Threat of takeover and loss of employment
Use of performance incentives, such as share options
The stock exchange
Primary market role
A stock exchange facilitates the efficient and orderly sale of new financial securities
o New floats/ initial public offerings (IPOs)
Initial listing of a corporation on the stock exchange
o Rights issue
Issue of additional shares to existing shareholders on a pro- rata basis
o Placements
Issue of new shares to selected institutional investors
o Dividend reinvestment plans
Reinvestment of dividends into corporation for additional shares
Secondary Market Role
The stock exchange facilitates trading in existing shares
o No new funds are raised by the issuing company
o An active, liquid , well –organised secondary market increases the appeal of buying new shares in
the primary market
o Market liquidity
Ratio of share turnover to market capitalisation
o Market turnover
Number of shares on issue x current share price
Managed product role
The stock exchange provides a market for trading managed products
o Equity- based managed products are professionally managed funds
-
8/18/2019 Fins 1612 notes
11/72
11
o The ‘units’ in these funds are bought and sold on the stock exchange in the same way as shares in
corporations.
Derivative market role
The stock exchange provides a market for trading equity –related derivative products
o
A derivative is a financial security that derives its price from an underlying commodity (eg. Gold) orfinancial instrument (eg. BHP shares)
o Derivative products are described as:
Exchanged- traded contracts: standardised financial contracts traded on a formal exchange
Over –the – counter contracts : non-standardised contracts negotiated between writer and
buyer
o Derivatives serve as a:
Risk management tool (hedge)
Speculative instrument
The private equity Market
Private equity is an alternative funding source for companies unable or not wanting to access equity capital
through a public issue
Source of funds
o Superannuation funds and life insurance offices
Use of funds
o Start-ups , business expansion, recovery finance for distressed companies , management buyouts
o Aim is generally to:
Improve profitability sufficiently to realise value through an IPO
Break up business to achieve return on investment
Corporations Issuing Equity in the share Market
The investment decision
The objective of financial management is to maximise shareholder value
Four main aspects of financial management
1. Investment decision (capital budgeting)
a. Invest in which assets?
2. Financing decision (capital structure)
a. How to fund the purchase of these assets
3. Liquidity (working capital) management
a.
How best to manage current assets and current liabilities (there is a trade off with how muchto hold)
4. Dividend policy decision
a. How to retain and / or distribute profits
A corporation first determines the assets in which it will invest funds according to organisational objectives
o Real assets; eg. Plant and equipment
o Financial assets; eg. Equities , bonds
Competing investment alternatives should be evaluated on the basis of shareholder wealth maximisation
Two important measures used to quantify the contribution of an investment to shareholder wealth
o Net present value (NPV)
o
Internal rate of return (IRR)
NPV
The difference between the present value of cash flows associated with an investment and the cost of the
investment
-
8/18/2019 Fins 1612 notes
12/72
12
The NPV decision rule
o Accept an investment that has a positive NPV; ie. Reject an investment with a negative NPV (choose
higher NPV)
NPV ( and IRR) determinants:
o The accuracy of the forecasted cash flows
o The discount rate ( required rate of return)
IRR
The required rate of return resulting in NPV = 0
The IRR acceptance rule
o Accept the investment if its IRR is greater than the firm’s required rate of return
Limitations of IRR
o Non-conventional cash flows
Can result in multiple IRRs
o Mutually exclusive projects
Where only one of two or more investment alternatives can be chosen, the IRR may not
choose the project with the highest NPV.
The financing decision
The financing decision concerns the capital structure used to fund the firm’s business activities
The financial objective of a corporation is to maximise return, subject to an acceptable level of risk
Returns are generated from the net cash expected cash flows derived from:
o Business risk
o Financial risk
Business risk
The level of business risk depends upon the type of operations of the business, i.e:
o Industry sector that influences the level of fixed versus variable operating costs
Also affected by:
o Sectoral growth rates
o Market share
o Aggressiveness of competitors
o Competence of management and workforce
Financial risk
Exposure to factors that impact on the value of assets, liabilities and cash flows
The level of financial risk of a company is borne by the security holders (debt and equity)
Financial risk categories
o Interest rate risk
Risk of adverse movements in interest rates
o Foreign exchange risk
Risk of adverse movements in exchange rates
o Liquidity risk
Risk of insufficient cash in the short term
Financial risk and the debt to equity ratio (D/E)
o D/E is the ratio of funds borrowed (debt) to funds contributed by shareholders (equity)
o
D/E indicates the risk of being unable to meet interest due and principal repayments associate with
use of debt. i.e. risk of insolvency
o Earnings per shares (EPS) is the net return on a company’s shares expressed in cents per share (CPS)
-
8/18/2019 Fins 1612 notes
13/72
13
If the cost of debt is less than the return achieved, issuing more debt will benefit
shareholders on account of higher EPS
However, high debt levels increase a company’s level of financial risk and, thus, the risk of
insolvency
What is the appropriate D/E ratio?
o Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in practice are:
Industry norms
Historical levels of firm’s ratio
Limit imposed by lenders through loan covenants, ie. Restrictions placed on a borrower
specified in a loan contract
Management’s assessment of the firm’s capacity to service debt.
Initial Public Offering (IPO)
Initial public offering (IPO) is an offer to investors of ordinary shares in a newly listed company on a stock
exchange
o New share issuer must meet listing requirements
o
The promoter appoints advisers (stockbroker, merchant bank, other specialists) and possibly
underwriters
o Underwriters
Ensure a company raises the full amount of the issue
Assist with advice on the structure , price , timing and marketing of the issue and allocation
of securities
Listing on a stock exchange
A company seeking to have its securities quoted on a stock exchange (ie. To join the official list ) must
comply with listing rules, which are additional to the corporations’ legislation obligations
A non-complying listed company can be suspended from quotation or delisted
Listing rule principles embrace the interests of listed entities, maintain investor protection, and maintain the
reputation and integrity of the market
Different forms of equity finance are available to established companies
Different forms of equity finance are available to established companies
o Additional ordinary shares
Rights issue, takeover issues, dividend reinvestment schemes
o Preference Shares
o Quasi- equity
Convertible notes, options, warrants
Equity funding for listed Firms
Rights issue
Issue of ordinary shares to existing shareholders
Issue pro rata eg. 1:5 or 1 for 5
Factors influencing the issue price
o Company’s cash flow requirements
o Projected earnings flows from the new investments funded by the rights issue
o
Cost of alternative funding sources
Takeover issues
-
8/18/2019 Fins 1612 notes
14/72
14
Acquiring company issues additional ordinary shares to owners of target company in settlement of the
transaction
Alleviates need for owners of acquiring company to inject cash for the purchase of the company
Dividend reinvestment schemes
Shareholders have the option of reinvesting dividends in additional ordinary shares No brokerage or stamp duty payable
Schemes may be suspended in low growth periods
Preference shares
Classed as hybrid securities ie. They have characteristic of both debt and equity
Fixed dividend rates are set at issue date
Rank ahead or ordinary shareholders in the payment of dividends and liquidation
Summary
Objective of financial management is to maximise shareholder value Four key financial management decisions involve investment, financing, liquidity (working capital ) and
dividend
Appropriate investment decision techniques are NPV and IRR
The financial decision concerns the choice of capital structure (D/E) and influences a firm’s financial risk
Additional equity can be raised through ordinary shares, preference shares, convertible notes and other
quasi- equity
-
8/18/2019 Fins 1612 notes
15/72
15
Week 4 - Equity Markets II
Share-market investment
Investors buy shares to receive returns from dividends and capital gains (losses)
Other factors encouraging investment in securities quoted on a stock exchange (SX)
o
Depth of the market Overall capitalisation of corporations listed on an SX
o Liquidity of the market
Volume of trading relative to the size of the market
o Efficient price discovery
Speed and efficiency with which new information is reflected in the current share price
Two types of risk impact on security returns
1. Systematic risk
Factors that generally impact on share prices in the market; e.g. economic growth, and changes in
interest rates and exchange rates
2. Unsystematic risk
Factors that impact specifically on the share price of a corporation; e.g. resignation of the CEO,
technology failure, board problems
Diversified Investment Portfolio
A portfolio containing a wide range of securities
Diversifies most of the unsystematic risk of the individual securities
a. Investors will not receive higher returns for unnecessarily bearing unsystematic risk
The remaining risk is systematic risk, which is measured by beta
a. Beta is a measure of the sensitivity of the price of an asset relative to the market
Expected portfolio return is the weighted average of expected returns of each share
Portfolio variance (risk) is the correlation of pairs of securities within the portfolio
Investors may take one of two approaches
1. Active investment approach
a. Portfolio structure is based on share analysis, new information and risk-return preferences
2. Passive investment approach
a. Portfolio structure is based on the replication of a specific share market index, e.g. industrial or
telecommunications sector index
Some managed funds are index funds – Portfolios are structured to fully or partially replicate a specific share market
index
Investors need to consider asset allocation within a share portfolio
o Risk versus return
o Investment time horizon
o Income versus capital growth
o Domestic and international shares
Asset allocation may be:
o strategic
o tactical
Buying and selling shares
Direct investment in shares
o Investor buys and sells shares through a stockbroker
Discount broker, i.e. phone and Internet
-
8/18/2019 Fins 1612 notes
16/72
16
Full-service advisory broker
o Consideration of liquidity, risk, return, charges, taxation, etc.
Indirect investment in shares
o Investor purchases units in a unit trust or managed fund, e.g. equity trusts
Taxation
Pre-dividend imputation (prior to 1987)
o Dividends were taxed twice - first at company level (as profits) and then at the investor’s marginal
rate
Dividend imputation (since 1987)
o Removed the double taxation of dividends
o Investors receive franking credit for the tax a company pays on a franked dividend
Capital gains tax on shares purchased
Prior to 19/9/1985 tax free
19/9/1985 –21/9/1999
o Taxpayer’s marginal tax rate applied if held less than 12 months
o Taxpayer’s marginal tax rate applied to indexed capital gain if held over 12 months
Since 21/9/1999
o 50% discounted gain if held at least 12 months; or
o indexed capital gain or 50% discounted gain if purchased 19/9/1985 –21/9/1999
Financial performance indicators
Potential investors are concerned with the future level of a company’s performance Company’s performance affects both the profitability of the company and the variability of the cash flows
Indicators of company performance
o Capital structure
o Liquidity
o Debt servicing
o Profitability
o Share price
o Risk
Capital structure
Proportion of company assets (funding) obtained through debt and equity
o Usually measured by debt to equity ratio (D/E)
Higher debt levels increase financial risk; i.e. firm may not be able to meet interest payments
o Also measured by proprietorship ratio, which is the ratio of shareholders’ funds to total assets
-
8/18/2019 Fins 1612 notes
17/72
17
Indicates firm’s longer term financial viability/stability; a higher ratio indicates less reliance
on external funding
Liquidity
The ability of a company to meet its short-term financial obligations
Measured by current ratioo Fails to consider the not very liquid nature of certain current assets, such as inventory
Measured by liquid ratio
The higher the current and liquid ratios, the better the liquidity position of a firm
Debt Servicing
Ability to meet debt-related obligations, i.e. interest and repayment of debt
Measured by debt to gross cash flow ratio
o Indicates number of years of cash flow required to repay total firm debt
Measured by interest coverage ratio
Profitability
Wide variation in the measurement of profitability
o
Earnings before interest and tax (EBIT) to total funds ratio
o Earnings per share (EPS)
o The amount of money you put in to the company and the amount you get back
EBIT to total funds ratio =
Wide variation in the measurement of profitability
o EBIT to long-term funds ratio
EBIT to long- term funds ratio =
Wide variation in the measurement of profitability (cont.)
o Return on equity (net income/equity)
o Higher ratios indicate greater profitability
Share Price
Represents investors’ view of the present value of future net cash flows of a firm
Share price performance indicators
Price to earnings ratio (P/E)o Share price divided by earnings per share
o A higher P/E indicates more growth in future net cash flows
share price to net tangible assets ratio (P/NTA)
-
8/18/2019 Fins 1612 notes
18/72
18
o Measures the theoretical premium or discount at which a firm’s share price is trading relative to its
NTA
Risk
Variability (uncertainty) of the share price
Two components1. Systematic risk (often referred to as beta)
Arises from factors affecting the whole market, e.g. state of the domestic economy and world economy
2. Non-systematic risk
Arises from firm-specific factors, e.g. management competence, labour productivity, financial and
operational risks
Can be eliminated in a well-diversified portfolio
Pricing of Shares
Share price is mainly a function of supply and demand for a share
o
Supply and demand are influenced mainly by informationo Share price is considered to be the present value of future dividend payments to shareholders
o New information that changes investors’ expectations about future dividends will result in a change
in the share price
Estimating the price of a share ( assuming that
cash flows equal dividends)
o General dividend valuation model
o Valuing a share with a constant dividend
(D0) o Valuing a share with constant dividend growth (g)
Cum-dividend and ex-dividend
o Dividends are payments made to shareholders, expressed as cents per share
o Dividends are declared at one date and paid at a later, specified date
o During the period between the two dates, the shares have the future dividend entitlement attached,
i.e. cum-dividend
o
Once the dividend is paid the shares are traded ex-dividendo Theoretically, the share price will fall on the ex-dividend date by the size of the dividend
o Example:
Bonus share issues
o Where a company has accumulated reserves, it may distribute these to existing shareholders by
making a bonus issue of additional shares
o As with dividends, there will be a downward adjustment in share price when shares go ex-bonus
o
As no new capital is raised, there is no change in the assets or expected earnings of the company Share splits
o Involves division of the number of shares on issue
o Involves no fundamental change in the structure or asset value of the company
o Theoretically, the share price will fall in the proportion of the split
-
8/18/2019 Fins 1612 notes
19/72
19
Pro-rata rights issue
o Involves an increase in the company’s issued capital
o Typically issued at a discount to market price
o Theoretically, the market price will fall by an amount dependent on the:
number of shares issued
size of the discount
A renounceable right is a right that can be sold before it is exercised
o
The value of the right is determined by Equation 6.12
Stock-market indices and published share information
Stock- market indices
Measure of the price performance of a share market or industry sector; e.g.:o Performance benchmark index
Measures overall share-market performance based on capitalisation and liquidity ie ASX200
o Tradeable benchmark index
A narrow index used as the basis for pricing certain derivative products ie, equity index
futures contracts
o Market indicator index
Measure of overall share-market performance Dow Jones, S&P500, Nikkei etc
Market Indicator indices
Price-weighted, e.g. Dow Joneso Weighting of a company proportional to its share price
Capitalisation-weighted, e.g. S&P/ASX All Ords
o Weighting of a company proportional to market capitalisation
Share-price index measures capital gains/losses from investing in an index-related portfolio
Accumulation index includes share price changes and reinvestment of dividends
Global industry classification standard (GICS) comprises 10 standard international industry sector indices; e.g.
energy, materials, industrials
Published share information
Newspapers and financial journals provide share-market information to varying degrees of detail; e.g.Australian Financial Review
Summary
-
8/18/2019 Fins 1612 notes
20/72
20
Factors a share investor should consider
o Diversification, portfolio return and risk
o Active or passive investment
o Direct or indirect investment
o Taxation
o Company financial performance indicators
o Capital structure, liquidity, debt servicing, profitability, share price, risk
Factors that influence a company’s share price
o Expected future dividends
o Bonus shares issues
o Share splits
o Pro-rata rights issues
Equity Markets III
Share Price
Share price is determined by supply and demand of a company’s shares Expectation of bad company performance causes investors to sell their shares, increasing supply and
reducing the price
Expectation of good company performance increases demand and leads to an increase in share price
What causes the shifts in demand and supply of a company’s securities on the secondary market?
Three approaches to answering this question
1. Fundamental analysis: top-down
2. Fundamental analysis: bottom-up
3. Technical analysis
Fundamental analysis
Considers macro and micro factors that impact upon cash flows and future share prices of various industry
sectors and firms
o Macro factors include interest rates, economic growth, business investment
o Micro factors are firm-specific and relate to management’s impact on company performance
Top-down approach
Considers macro factors
o Economic growth of international economies
o Exchange rates
o
Interest rateso Domestic economy
Growth rate
Balance of payments
Inflation
Wage and productivity growth
Government responses to changes in the above factors
Economic growth
The higher the growth rate in the rest of the world, the greater the demand for Australian exports
Sectors benefitting from international growth determined by source of the growth Growth can be driven by:
o increased consumer demand
o increased business investment in equipment
-
8/18/2019 Fins 1612 notes
21/72
21
Flip side of growth
Generally, greater domestic growth leads to increased profitability of firms
But high growth can lead to any of the following factors that can reduce firm profitability:
o Deterioration in balance of payments
o Increase in inflationary pressures
o
Pressure on wageso Depreciation of the exchange rate
o Rise in interest rates
Currency
Affect the domestic currency profit of exporters that quote their products in foreign currency prices
o A strengthening Australian dollar (AUD) makes these firms worse off because the AUD value of their
exports is lower
o The strength of the AUD over the past few years has led to calls for assistance from the
manufacturing industry, for example
Exchange rates also affect firms indirectlyo E.g. devaluation of currency increases cost of imports, thereby increasing inflation
Interest Rates
Have both a direct and indirect impact on a firm’s value
Direct effect on profitability
o Represents the cost of debt finance for borrowers and the return for finance providers
Indirect effect on profitability
o Rise in interest rates may indicate a slowing of economic activity
o Future reduction in profitability
A strong relationship exists between interest rates and exchange rates
Balance of payments
If current account is in deficit (i.e. total international payments exceed total international receipts):
o some export income is diverted to service debt
o need to borrow foreign currency to service debt
Indirect effect on firms’ profitability
o Government may increase interest rates to slow economic growth and control the debt
Inflation
Effect of inflation on f irm’s real profit Tax treatment of inflation
o Makes historical-based depreciation allowances inappropriate
o Combined with higher replacement costs, leads to an overstatement of after-tax profit
Inventory
o ‘Inflated’ selling price of inventory creates an illusion of inventory profits
Bottom- Up approach
Following identification of the best economies and industry sectors for investment using the top-down
approach, the bottom-up approach can be used to identify the best companies within these
Bottom-up approach considers micro factors using ratios and other measures of a firm’s financialcharacteristics and performance
Considers factors such as:
-
8/18/2019 Fins 1612 notes
22/72
22
o Accounting ratios that assess a company’s capital structure, liquidity, debt servicing, profitability,
share price and risk (see Chapter 6), observing the trend and making comparisons with firms in the
same industry
o Additional information on key management changes, corporate governance and strategic direction
Comparing Companies
Technical analysis
Explains and forecasts share price movements based on past price behaviour
Assumes markets are dominated at certain times by mass psychology, from which regular patterns emerge
Two main forecasting models
o
Moving averages (MA)o Charting
Moving Averages
Smooth out a series facilitating the identification of trends in the series
Calculation of MA
o Assuming a five-day moving average, the MA is calculated by taking the average of the price series
for the preceding five days
Trading rules
o Buy when the price series cuts the MA from below
o
Buy when the MA series is rising strongly and the price series cuts or touches the MA from above foronly a few observations
o Sell when the MA flattens or declines and the price series cuts the MA from above
o Sell when the MA is in decline and the price series cuts or touches the MA from below for only a few
observations
Charting
Investigating patterns in price charts
Several techniques
o Trend lines
o
Support and resistance lineso Continuation patterns
o Reversal patterns
Trend lines
-
8/18/2019 Fins 1612 notes
23/72
23
Trends are regular movements in share prices
Two types of trends
1. Uptrend line—connecting the lower points of rising price series
2. Downtrend line—connecting the higher points of falling price series
Return line—line drawn parallel to a trend line to create a trend channel
Critical issue is to determine when the trend line is going to change
Support and resistance lines
Support levels—where there is sufficient demand to halt further price falls
Resistance levels—where there is sufficient supply to halt further price increases
‘Strong’ levels—historical support and resistance
‘Weak’ levels—support and resistance based on more recent activity
Continuation patterns
Sideways share trading that does not normally signal a change in trend
Two types
1. Triangles—composed of a series of price fluctuations, each smaller than its predecessor Symmetrical triangle
(no change in trend); ascending triangle (uptrend); descending triangle (downtrend)
2. Pennants and flags—formed during a sharp rise in prices (‘the pole’); then trading volume reduces and
increases suddenly to take prices sharply higher
Reversal patterns
Occur after a major market move
Result in a ‘head and shoulders’ pattern
Three successive rallies and reactions, the second rally being stronger than the first and third rallies
I. Left shoulder—formed by volume-strong rally on uptrend, followed by reduced-volume reaction
II. Head—second rally increases price before reaction moves price back to previous low
III. Right shoulder—final rally marked by reduced volume indicating price weakness
Validity of technical analysis
Even where techniques have no apparent underlying validity, if they are followed by enough participants
they may impact on share price behaviour at times
More likely to forecast successfully when share prices move out of a range explained by economic andfinancial fundamentals
Ethics
Ethics is black or white , no grey area
“Ethics”
o A set of guiding moral principles or values
“Ethical Behaviour”
o Refers to behaviour that conforms to those values
Both terms are often used to imply
o
“good” ethics and “good” behaviour
So what happened?
-
8/18/2019 Fins 1612 notes
24/72
24
What else since GFC?
Ethics is not a new concept
There are no new sins; the old ones just get more publicity.
The Code of Hammurabi for Ancient Babylon (c. 1800): If a builder builds a house for a man and does not make its
construction firm, and the house which he has built collapses and causes the death of the owner of the house, the
builder shall be put to death
Tulip Speculation 1636 (Holland) – Market bubble – Futures of tulip were traded when physical tulips were no longer
available. It went up to 10k in present day USD. Investors took the word of those who promised future delivery and
then realised that there is no delivery. The collapse impacted on Holland economy.
Charles Ponzi (1882 – 1949) - Promised his investors 50% return within 45 days. All started with arbitrage of coupons
between Spain and U.S – bought for 1cent in Spain and redeem in U.S for 6 cents. But the arbitrage window closed.
He continue to pay investors with funds from new entrants whilst taking his usual cut.
Recent example (2009) - Bernard Madoff promised 12% return.
(1994) – Rogue Trader: The man who brought down Barings Derivative trader Nick Leeson covered up losses up toUSD1.4bn (2x the bank’s trading capital). Brought down the oldest English bank (1762-1995)
What’s common- Betrayal of trust
-
8/18/2019 Fins 1612 notes
25/72
25
Aligning interests to gain trust
Global survey by CFA Institute and Edelman Berland in 2013 revealed that trust among institutional and
retail investors has eroded.
o 48% said they do not trust financial services investors do what is right
o Only 15% has great deal of trust in investment management industry
When it comes to the attributes that investors value the most:o 35% said “acting in the best interest of the client”
o 17% - “ability to achieve high returns” and “commitment to ethical conduct”
o Only 7% - “amount / structure of fees”
Investors have moved beyond just good performance and are more interested in “trustworthy behaviours”
Restoring Trust
First – Embrace transparency
o Clearly articulate investment success and missteps
o Disclose conflicts of interest, quickly address problems
o
Fully disclose fees and impact Second – Demonstrate Integrity
o Resolving conflict of interest in favour clients
o Structure fees to align with clients’ risk/return objectives
Third – Improve communication
o Communicate with clients early and often throughout investment process
o Fairly represent the investments made, risk, expenses
o Avoid ambiguity in communications
A crisis of Culture
A global survey of 382 financial services executives in Sept 2013 shows:o Most firms have attempted to improve adherence to ethical standards
o Industry executives champion the importance of ethical conduct
o But, executives struggle to see the benefits of greater adherence to ethical standards
o Needs to address knowledge gaps
o Lack of understanding and communication between departments continues to be the norm
CFA Code of Ethics
Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants
in the global capital markets. Place the integrity of the investment profession and the interests of clients above my own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional
activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
ourselves and the profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve my professional competence and strive to maintain and improve the competence of
other investment professionals.
Standards of Professional Conduct
There are a total of 7 standards:
I. Professionalism
-
8/18/2019 Fins 1612 notes
26/72
26
II. Integrity of Capital Markets
III. Duties to Clients
IV. Duties to Employers
V. Investment Analysis, Recommendations, and Actions
VI. Conflicts of Interest
VII. Responsibilities as A CFA Institute Member or CFA Candidate
I (A) – Knowledge of the Law
As an investment professional, your conduct is determined by these organizations:o Government and regulatory agencies
o Licensing agencies
o Professional associations
As a member of CFA Institute or candidate in the CFA Program, you must
o understand and comply with all applicable laws.
o comply with the stricter of applicable law or the Code and Standards.
o not knowingly participate in any violation.
o dissociate from any violation.
Applicable Law
-
8/18/2019 Fins 1612 notes
27/72
27
Dissociation From Violation
I (B) Independence and Objectivity
-
8/18/2019 Fins 1612 notes
28/72
28
Avoid situations that could cause or be perceived to cause a loss of independence or objectivity in recommending
investments or taking investment action.
Maintain your professional integrity by remaining independent and objective at all times.
Avoid compromising your own or another’s independence and objectivity.
Ways in which your independence and objectivity may be compromised or perceived to be compromised
include the receipt of:o Gifts
o Invitations to lavish events
o Tickets
o Favours
o Job referrals
o Additional compensation
I (C) Misrepresentation
Must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or
other professional activities.
A misrepresentation is any untrue statement or omission of a fact or any statement that is otherwise false or
misleading
To avoid misrepresentation, consider the following action items:
o Be honest about your professional credentials and your firm’s performance
o Exercise care and due diligence when relying on third-party information
o Disclose the use of external managers
o Be forthcoming with the risk and unpredictability of investments
o Acknowledge sources of ideas and materials that are not yours
I (D) Misconduct
Avoid dishonest, fraudulent, or deceitful conduct that reflects adversely on your professional reputation, integrity, or
competence.
Trust is the epicenter of the operations of the financial market as a whole.
Your professional reputation, integrity, and competence are the starting point on this critical path to trust.
III – Duties to Clients
III (A) – Loyalty, Prudence and Care
What it means to have a duty of loyalty, act with reasonable care, and exercise prudent judgment.
-
8/18/2019 Fins 1612 notes
29/72
29
III (B) – Fair dealing
Deal with clients fairly with respect to investment recommendations and actions.
Recommend policies and procedures that will help to ensure that investment recommendations or changes
in prior recommendations are disseminated to clients fairly and objectively.
Recommend policies and procedures to ensure that all individual and institutional clients are treated in a fair
and impartial manner when taking investment actions.
Some suggested actions for fair dealing compliance
o Limit the number of people involved.
o Shorten the time frame between decision and dissemination.
o Publish guidelines for pre-dissemination behaviour.
o
Disseminate investment recommendations simultaneously.o Maintain a list of clients and their holdings.
o Develop and document trade allocation procedures.
III (C) – Suitability
In an advisory relationship, make reasonable inquiry of your client situation to make suitable investment
recommendations.
Document the client’s needs, circumstances, and investment objectives in an investment policy statement.
o Client identification
o Investor objectives
o
Investor constraintso Performance measurement benchmarks
o Review and update the investment policy statement regularly.
o Document attempts to carry out the review if circumstances prevent it.
o Develop test procedures for choosing investments that include
an analysis of the impact on the portfolio’s diversification.
a comparison of the investment risks with the client’s assessed risk tolerance.
the fit of an investment with the required investment strategy.
III (D) – Performance Presentation
Give a fair and complete presentation of performance information by:
o applying the Global Investment Performance Standards (GIPS), or
o without the GIPS standards:
considering the knowledge and sophistication of the audience to whom a performance
presentation is addressed,
-
8/18/2019 Fins 1612 notes
30/72
30
presenting the performance of the weighted composite of similar portfolios rather than
using a single representative account,
including terminated accounts as part of performance history with a clear indication of when
the accounts were terminated,
including disclosures that fully explain the performance results being reported, and
maintaining the data and records used to calculate the performance being presented.
III (D) – Preservation of confidentiality
Maintain client confidentiality related to information
1. you receive as a result of your ability to conduct a portion of the client’s business or personal affairs and
2. that arises from or is relevant to that portion of the client’s business that is the subject of the special or
confidential relationship.
Disclose client information when
1. the information concerns illegal activities on the part of the client;
2. disclosure is required by law; or
3. the client or prospective client permits disclosure of the information.
What is the simplest and the most effective way to comply to Standards III (D)
o Avoid disclosing any information received from a client except to authorised fellow employees who
are also working for the client.
If you want to disclose information received from a client that is outside the scope of the confidential
relationship and does not involve illegal activities, first ask yourself the following:
o In what context was the information disclosed? If disclosed in a discussion of work being performed
for the client, is the information relevant to that work?
o Is the information background material that, if disclosed, will enable you to improve service to the
client?
Summary: Good ethics in finance and investment industry
In finance and investment industry, opportunities to be unethical arise every day.
Ethical behaviour among investment and finance professionals is critical to maintaining public trust
Day-to-day dilemmas, simple questions to ask yourself:
o Does this violate the law?
o Is this honest?
o What if I were on the other side?
Short Term Debt
Trade Credit - is not free- no such thing as free lunch
Short-term debt is a financing arrangement for a period of less than one year with various characteristics to
suit borrowers’ particular needs
o Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds
Matching principle
o Short-term assets should be funded with short-term liabilities
o The importance of this principle was highlighted by the GFC
A supplier provides goods or services to a purchaser with an arrangement for payment at a later date
Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)
Borrow money from the bank if the interest rate is lower than the rate of trade credit From provider’s perspective
o Advantages include increased sales
o Disadvantages include costs of discount and increased discount period, increased total credit period
and accounts receivable, increased collection and bad debt costs
-
8/18/2019 Fins 1612 notes
31/72
31
Example
A ice cream stand may sign an agreement, under which the distributor agrees to provide ice cream stock under the
terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10
days. This means that the operator has 60 days to pay the invoice in full.
If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and
make an extra 20% on the ice cream sold.
However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days,
obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days.
The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is:
p.a.16.03%or 0.160298
23365
99.01.0
settlementlateandearly
betweendifferencedays
365discount%100
discount%costyOpportunit
Wal-Mart in the United states relies more on trade credit than bank borrowing
Its trade credit is 8 times the amount of capital invested by shareholders.
Bank Overdrafts
Major source of short-term finance
Allows a firm to place its cheque (operating) account into deficit, to an agreed limit ( Go negative)
Generally operated on a fully fluctuating basis
Lender also imposes an establishment fee, monthly account service fee and a fee on the unused overdraft
limit
Interest rates negotiated with bank at a margin above an indicator rate, reflecting the borrower’s credit risk
o Financial performance and future cash flows
o Length of mismatch between cash inflows and outflows
o Adequacy of collateral
Indicator rate typically a floating rate based on a published market rate, e.g. BBSW
In some countries overdraft borrower may be required to hold a credit average balance or compensating
credit balance
Commercial Bills
A bill of exchange is a discount security issued
with a face value payable at a future date
A commercial bill is a bill of exchange issued
to raise funds for general business purposes
A bank-accepted bill is a bill that is issued by a
corporation and incorporates the name of a
bank as acceptor
-
8/18/2019 Fins 1612 notes
32/72
32
Features of commercial bills—parties involved (bank-accepted bill) (cont.)
Drawer
o Issuer of the bill
o Secondary liability for repayment of the bill (after the acceptor)
o
Acceptor
o Undertakes to repay the face value to the holder of the bill at maturity
o Acceptor is usually a bank or merchant bank
o Bank acceptor is more safe than bank endorsed
Payeeo The specified party to whom the bill is to be paid, i.e. the party who receives the funds
o Usually the drawer, but the drawer can specify some other party as payee
Discounter
o The party that discounts the face value and purchases the bill
o The provider or lender of the funds
o May also be the acceptor of the bill
Endorser
o The party that was previously a holder of the bill
o Signs the reverse side of the bill when selling, or discounting, the bill
o
Order of liability for payment of the bill runs from acceptor to drawer and then to endorser The flow of funds ( bank- accepted bills)
-
8/18/2019 Fins 1612 notes
33/72
33
The flow of funds (non-bank bills)
o Alternatively, a bill can be drawn by the bank and accepted by the borrower
o
The bank is both drawer and discounter of the bill If the bank rediscounts a bill (sells to a third party), the bank becomes the endorser, creating
a bank-endorsed bill
o Funds are lent to borrower as payee
o At maturity date the borrower, as acceptor of the bill, is liable to pay face value to the holder of the
bill
Establishing a bill financing facility
o Borrower approaches bank or merchant bank
o Assessment made of borrower’s credit risk
o Credit rating of borrower affects size of discount
o
Maturity usually 30, 60, 90, 120 or 180 dayso Minimum face value usually $100 000
Advantages of Commercial bill financing
o Lower cost than other short-term borrowing forms, i.e. overdraft, fully-drawn advances
o Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest
rates)
o A bill line
Arrangement with a bank where it agrees to discount bills progressively up to an agreed
amount
o Term of loan may be extended by ‘rollover’ at maturity
Calculations: Discount securities
Calculations considered
o Calculating price—yield known
o Calculating face value—issue price and yield known
o Calculating yield
Calculating Price- yield Known
-
8/18/2019 Fins 1612 notes
34/72
34
Example 3: A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a
face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of
9.52% per annum and 9.48% per annum. Which quote should the company accept, and what amount will the
company raise?
134.23$49630)(0.0948365
365000$500
or
118.04$496
30)(0.0952365
365000$500
An alternative formula for calculating price
Calculating Face Value- issue Price and yield known
]365
maturity)todays100yield(365
price[valueFace
Example 4: A company needs to raise additional funding of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to
discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn?
191.78$507
]365
60)(0.0875365000[$500valueFace
Calculating yield
maturitytodays100)year in(days
pricebuyprice)buy-price(sell
Yield
Promissory Notes
Also called P-notes or commercial paper, they are discount securities, issued in the money market with aface value payable at maturity but sold today by the issuer for less than face value
Typically available to companies with an excellent credit reputation because:
o there is no acceptor or endorser
o they are unsecured instruments
Calculations—use discount securities formulae
Issue programs
o Usually arranged by major commercial banks and money market corporations
o Standardised documentation
o Revolving facility
o
Most P-notes are issued for 90 days By tender, tap issuance or dealer bids
Negotiable certificates of Deposit
-
8/18/2019 Fins 1612 notes
35/72
35
Short-term discount security issued by banks to manage their liabilities and liquidity
Maturities range up to 180 days
Issued to institutional investors in the wholesale money market
The short-term money market has an active secondary market in CDs
Calculations—use discount securities formulae
Inventory Finance, Accounts receivable financing and factoring
Inventory finance
Most common form is ‘floor plan finance’
Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles
o Bailment common—finance company holds title to dealership’s stock- to promote the financial
companies
Dealer is expected to promote financier’s financial products
Accounts receivable financing
o A loan to a business secured against its accounts receivable (debtors)
o
Mainly supplied by finance companieso Lending company takes charge of a company’s accounts receivable; however, the borrowing
company is still responsible for the debtor book and bad debts
Factoring
o Company sells its accounts receivable to a factoring company
Converting a future cash flow (receivables) into a current cash flow
o Factoring provides immediate cash to the vendor; plus it removes administration costs of accounts
receivable
o Main providers of factor finance are the finance companies
o Factor is responsible for collection of receivables
Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be
made to the factor
Recourse arrangement
o Factor has a claim against the vendor if a receivable is not paid
Non-recourse arrangement
o Factor has no claim against vendor company
Medium to long Term Debt
Term Loans or Fully Drawn Advances
Term loan
o A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and equipment
o Secured by mortgage over asset purchased or other assets of the firm
Fully drawn advance
o A term loan where the full amount is provided at the start of the loan
Provided by:
o mainly commercial banks and finance companies
o to a lesser degree, investment banks, merchant banks, insurance offices and credit unions
Term loan structures
-
8/18/2019 Fins 1612 notes
36/72
36
monthper $3041.49
]0.006667
600.006667)(11[
000$150R
60months12years5
0.00666712
0.08
000$150
R
n
i
A
)](1)(11
[ i i
ni
A
R
o Interest only during term of loan and principal repayment on maturity
o Amortised or credit foncier loan
Periodic loan instalments consisting of interest due and reduction of principal
o Deferred repayment loan
Loan instalments commence after a specified period related to project cash flows and the
debt is amortised over the remaining term of the loan
o Interest may be fixed (for a specified period of time; e.g. two years) or variable
o Interest rate charged on term loan is based on:
an indicator rate (e.g. BBSW or a bank’s own prime lending rate) and is also influenced by:
credit risk of borrower—risk that borrower may default on loan commitment, giving
rise to a risk premium
term of the loan—usually longer term attracts a higher interest rate
repayment schedule—frequency of loan repayments (e.g. monthly or quarterly) and
form of the repayment (e.g. amortised or interest-only loan)
Loan covenants
o Restrict the business and financial activities of the borrowing firm ( don’t want the firm to get more
risky)
Positive covenant
Requires borrower to take prescribed actions; e.g. maintain a minimum level of
working capita
Negative covenant
Restricts the activities and financial structure of borrower; e.g. maximum D/E ratio,
minimum working-capital ratio, unaudited periodic financial statements
o Breach of covenant results in default of the loan contract entitling lender to act
Calculating the loan instalment- ordinary annuity
Example 1: Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the purchase of
a new high-speed CD burner. The bank offers a $150 000 loan, amortised over five years at 8% per annum,
payable monthly. Calculate the monthly loan instalments.
Calculating the loan instalment—annuity due
])(11[i
ni
AR
periods.gcompoundinof number the
decimalaasexpressedperiodper rateinterestnominalcurrentthe
value)(presentamountloanthe
amountinstalmentthe
:where
n
i
A
R
-
8/18/2019 Fins 1612 notes
37/72
37
instalmentmonthly$375.78
57.21494
500$21
0.01)(1]0.01
840.01)(11[
500$21
84127
0.0112
0.12
500$21
R
n
i
A
Example 2: A business proprietor is purchasing a computer system for the business at a cost of $21 500. A
finance company has offered a term loan over seven years at a rate of 12% per annum. The loan will be repaid
by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments.
Mortgage Finance
A mortgage is a form of security for a loan
o The borrower (mortgagor) conveys an interest in the land and property to the lender (mortgagee)
The mortgage is discharged when the loan is repaid
If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on the property, i.e. take
possession of assets and realise any amount owing on the loan
Use of mortgage finance
o
Mainly retail home loans
Up to 30-year terms
o To a lesser degree commercial property loans
Up to 10 years as businesses generate cash flows enabling earlier repayment
Providers (lenders) of mortgage finance
o Commercial banks, building societies, life insurance offices, superannuation funds, trustee
institutions, finance companies and mortgage originators
Interest rates
o Both variable and fixed interest rate loans are available to borrowers
With fixed interest loans, interest rates reset every five years or less
o With interest-only mortgage loans, interest-only period is normally a maximum of five years
Mortgagee (lender) may reduce their risk exposure to borrower default by:
o requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value
Calculating the instalment on a mortgage loan
]n)(11
[i
i
AR
-
8/18/2019 Fins 1612 notes
38/72
38
Example 3: A company is seeking a fully amortised commercial mortgage loan of $650 000 from its bank. The
conditions attached to the loan include an interest rate of 8% per annum, payable over five years by equal
end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount.
Securitisation and mortgage finance
o Mortgage originators, commercial banks and other institutions use securitisation to manage their
mortgage loan portfolios
o Involves conversion of non-liquid assets into new asset-backed securities that are serviced with cash
flows from the original assets
o Original lender sells bundled mortgage loans to a special-purpose vehicle
That is, a trust set up to hold securitised assets and issue asset-backed securities like bonds,
providing investors with security and payments of interest and principal
The securitisation of mortgage finance suffered a large contraction during the GFC.
o Securitised mortgage assets in 2007: $215 billion
o Securitised mortgage assets in 2010: $112 billion
These falls were recorded in Australia despite the much lower default rates experienced on mortgages
compared to other parts of the world
Debentures, unsecured notes and subordinated debt
Debentures (most secure corporate bond)and unsecured notes
o Are corporate bonds
o Issued the same way as shaires
o Specify that the lender will receive regular interest payments (coupon) during the term of the bond
and receive repayment of the face value at maturity
o Unsecured notes are bonds with no underlying security attached
o
Debentures:
are secured by either a fixed or floating charge over the issuer’s unpledged assets
are listed and traded on the stock exchange
have a higher claim over a company’s assets (e.g. on liquidation) than unsecured note
holders
Issuing debentures and notes
o There are three principal issue methods
1.Public issue—issued to the public at large, by prospectus
2.Family issue—issued to existing shareholders and investors, by prospectus 3.Private placement—issued to institutional investors, by information memorandum
o Usually issued at face value, but may be issued at a discount or with deferred or zero interest
o A prospectus contains detailed information about the business
instalmentmonthly751.87$39
]0.02
200.02)(11[
000$650
2045
0.02
4
0.08
000$650
R
n
i
A
-
8/18/2019 Fins 1612 notes
39/72
39
Subordinated debt
o More like equity than debt, i.e. quasi-equity
o Claims of debt holders are ‘subordinated’ to all other company liabilities
o Agreement may specify that the debt not be presented for redemption until after a certain period
has elapsed
o May be regarded as equity in the balance sheet, improving the credit rating of the issuer
Calculations: fixed- interest securities
Price of a fixed-interest bond at coupon date
o The price of a fixed-interest security is the sum of the present value of the face value and the
present value of the coupon stream
Example 4: Current AA+ corporate bond yields in the market are 8% per annum. What is the price of anexisting AA+ corporate bond with a face value of $100 000, paying 10% per annum half-yearly coupons, and
exactly six years to maturity?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
Price of a fixed-interest bond between coupon dates
Yield of a bond- describes the total rate of return, coupon payment- amount of interest throughout the lifetime
of bond
Example 5: Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+ corporate
bond with a face value of $100 000, paying 10% per annum half-yearly coupons, maturing 31 December
2016, would be sold on 20 May 2011 at what price?
ni A
i
ni
C P
)(1])(11
[
k i
ni A
i
ni
C P )(1)(1)(11
-
8/18/2019 Fins 1612 notes
40/72
40
Examples
Most major issues are conducted in the US.
Lets looks at some corporate debt that is on issue in Australia.
o
Woolworths Notes II were issued on 24 November 2011 and will mature on 24 November 2036unless redeemed before that date.
o Notes are dated, unsecured, subordinated, cumulative notes issued by Woolworths. The Issue Price
is $100 per Note. This is also the Face Value.
Leasing
A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the
asset for an agreed period of time in return for periodic rental payments
Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the asset
Advantages of leasing for lessee over ‘borrow and purchase’ alternative
o
Conserves capitalo Provides 100% financing
o Matches cash flows (i.e. rental payments with income generated by the asset)
o Less likely to breach any existing loan covenants
o Rental payments are tax deductible
Advantages of leasing for lessor over a straight loan provided to a le
