ACCA FM (F9) Course Notes PDF

FM Course notes Syllabus A: FINANCIAL MANAGEMENT FUNCTION 4 A1: The nature and purpose of financial management 4 A2: Financial objectives and the relationship wi...

FM Course notes Syllabus A: FINANCIAL MANAGEMENT FUNCTION 4 A1: The nature and purpose of financial management 4 A2: Financial objectives and the relationship with corporate strategy 9 A3: Stakeholders and impact on corporate objectives 12 A4: Financial and other objectives in not-for-profit organisations 22 Syllabus B: FINANCIAL MANAGEMENT ENVIRONMENT 25 B1: The economic environment for business 25 B2: The Nature and Role of Financial Markets and Institutions 32 B3: The nature and role of money markets 40 Syllabus C: WORKING CAPITAL MANAGEMENT 44 C1: The nature, elements and importance of working capital 44 C2: Management of inventories, accounts receivable, accounts payable and cash 47 C3: Determining working capital needs and funding strategies 83 Syllabus D: INVESTMENT APPRAISAL 89 D1: Investment appraisal techniques 89 D2: Allowing for inflation and taxation in DCF 113 D3: Adjusting for risk and uncertainty in investment appraisal 115 Syllabus D4: Specific investment decisions 124 Syllabus E: BUSINESS FINANCE 136 Syllabus E1: Sources of and raising business finance 136 Syllabus E2: Estimating the cost of capital 150 Syllabus E3: Sources of finance and their relative costs 168 Syllabus E4: Capital structure theories and practical considerations 177 Syllabus E5: Finance for small and medium sized entities (SMEs) 183 Syllabus F: BUSINESS VALUATIONS 187 F1. Nature and purpose of the valuation of business and financial assets 187 F2. Models for the valuation of shares 189 F3: The valuation of debt and other financial assets 201 F4: Efficient Market Hypothesis (EMH) and practical considerations in the valuation of shares 202 Syllabus G: RISK MANAGEMENT 206 G1. The nature and types of risk and approaches to risk management 206 G2: Causes of exchange rate differences and interest rate fluctuations 208 G3: Hedging techniques for foreign currency risk 215 G4. Hedging techniques for interest rate risk 227 2 a W n. m C O t a c y c o  Introduction This paper is all about helping you to become a FINANCE MANAGER of a business. This means you are responsible for 3 key decisions: Investment Financing Dividends The paper also looks at the economic environment within which these decisions are made 3 a W n. m C O t a c y c o  Syllabus A: FINANCIAL MANAGEMENT FUNCTION A1: The nature and purpose of financial management Syllabus A1a: Explain the nature and purpose of financial management. Financial management is getting and using financial resources well to meet objectives Financial objectives Profit maximisation is often assumed, incorrectly, to be the main objective of a business. Reasons why profit is not a sufficient objective: 1. Investors care about the future 2. Investors care about the dividend 3. Investors care about financing plans 4. Investors care about risk management For a profit-making company, a better objective is the maximisation of shareholder wealth; this can be measured as total shareholder return (the dividend per share plus capital gain divided by initial share price) 4 a W n. m C O t a c y c o Key decisions: Investment (in projects or takeovers or working capital) need to be analysed to ensure that they are beneficial to the investor. Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives e.g. market share, quality. Finance mainly focus on how much debt a firm is planning to use. The level of gearing that is appropriate for a business depends on a number of practical issues: Life cycle - A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are unwise. Operating gearing- If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not sensible. Stability of revenue- If operating in a highly dynamic business environment then high gearing is not sensible. Security- If unable to offer security then debt will be difficult and expensive to obtain. Dividends how returns should be given to shareholders Risk management mainly involve management of exchange rate and interest rate risk and project management issues. 5 a W n. m C O t a c y c o Key Objectives of Financial Management Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to: 1. Create wealth for the business 2. Generate cash, and 3. Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested 3 key elements to the process of financial management Financial Planning Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. 6 a W n. m C O t a c y c o Financial control addresses questions such as: Are assets being used efficiently? Are the businesses assets secure? Do management act in the best interest of shareholders and in accordance with business rules? Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends: Investments must be financed in some way – however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further 7 a W n. m C O t a c y c o  Syllabus A1b: Explain the relationship between financial management and financial and management accounting Financial Management Looks at long term raising of finance and the control of resources. Financial accounting Gives information about past events generally. It is required legally and is determined by accounting standards. Looks at the business as a whole Management accounting Provides information for day to day decisions generally, to aid management. No strict rules or format Can focus on specific areas of business 8 a W n. m C O t a c y c o  A2: Financial objectives and the relationship with corporate strategy Syllabus A2a: Discuss the relationship between financial objectives, corporate objectives and corporate strategy. Corporate Objectives These are wider than purely financial ones, they look at the business as a whole Examples include: Return on investment Market share Growth Customer satisfaction Quality Once these are set appropriate financial objectives can then be set and measured Corporate strategy is the overriding plan of the company - e.g.. To become the best known brand This then feeds down to corporate objectives such as the ones we saw earlier e.g.. Market share, quality etc To help us ensure these corporate objectives are met then financial objectives are created to give the company something to measure and help control the corporate objectives progress e.g. See below 9 a W n. m C O t a c y c o  Syllabus A2b: Identify and describe a variety of financial objectives, including: i) shareholder wealth maximisation ii) profit maximisation iii) earnings per share growth Shareholder wealth maximisation (share price) Maximisation of shareholder wealth is measured by the share price (if the company is listed of course). This is because the share price is theoretically the value of all future dividends coming to the shareholders. However, sometimes a business reports a profit increase and the share price falls due to the manner in which they made the profit. This suggests that that profit is not sufficient as a business objective Share price could also rise and fall due to potential investment decisions or the fact that a new loan is being taken out or that dividends are to be increased or lowered Profit Maximisation Focusing on profits could mean undue risk and short termism. Also there is the problem that profits can be manipulated using financial accounting, unlike cash. So maybe profit maximisation focuses on financial profit too much and not enough on cash generation. Let’s now have a quick look at Earnings Per Share (EPS) 10 a W n. m C O t a c y c o Earnings Per Share1 This uses earnings (profits) rather than cash. It shows the amount of profits for each ordinary share made in the year. It is calculated as follows: Profit after tax - preference dividends Weighted average Ordinary shares Illustration Last year Current year Profits before interest and tax 22,300 23,726 Interest 3,000 3,000 Tax 5,790 6,218 Profits after tax 13,510 14,508 Preference dividends 200 200 Dividends 7,986 8,585 Retained earnings 5,324 5,723 No ordinary shares issued 100,000 100,000 What is the EPS in each year? Last year: Earnings (13,510 - 200) 13,310 Shares 100,000 EPS = 13.31p (Current year EPS = 14.31p) 1 PP Q1c 11 a W n. m C O t a c y c o  A3: Stakeholders and impact on corporate objectives Syllabus A3a: Identify the range of stakeholders and their objectives We have just seen that the primary objective of a company is the maximisation of shareholder wealth. However, there is an alternative known as the stakeholder view. This means balancing shareholder wealth with the objectives of other stakeholders. Range Objective INTERNAL Staff High salaries; safe job Managers High bonuses EXTERNAL Shareholders High share price; dividend growth Banks Minimise company risk Customer Quality service Suppliers Good liquidity Government Good accounting records; Training initiatives 12 a W n. m C O t a c y c o  Syllabus A3b: Discuss the possible conflict between stakeholder objectives Everybody wants different things - and that’s a problem the company has to try and solve For example, customers want great quality but a cheap price, unions and employees want high wages and lots of holidays, suppliers want paying asap - and all of these work against the shareholders profits to an extent Syllabus A3c: Discuss the role of management in meeting stakeholder objectives, including the application of agency theory Clearly meeting all stakeholders objectives entirely is impossible. Often they are in conflict with each other. Therefore a degree of compromise is reached. For example, Performance related pay for example is a means of satisfying both staff and shareholders. There is a fundamental problem highlighted here. The owners of the business are generally not those who manage the business. As both parties have different objectives this causes a problem. The danger that managers may not act in the best interest of the owners is known as The Agency Problem The managers are acting as agents for the owners. 13 a W n. m C O t a c y c o  Syllabus A3d: Describe and apply ways of measuring achievement of corporate objectives including: i) ratio analysis, using appropriate ratios such as return on capital employed, return on equity, earnings per share and dividend per share ii) changes in dividends and share prices as part of total shareholder return Return on Capital Employed (Accounting rate of return)2 Operating pro t (pbit) Capital Employed Capital employed can be calculated in 2 ways: TALCL (Total assets less current liabilities) Equity + LTL (Long term liabilities) ROCE indicates the profitability of a company ROCE should always be higher than the rate at which the company borrows, so that return (on capital) is higher than what we pay (interest on capital) Think of it this way - we borrow 1,000 at 10% to buy an asset. The asset makes a PBIT of 200. Is this a good ROCE? Yes because it makes a 20% (200 / 1000) ROCE when the cost of borrowing is only 10% 2 PP Q4b 14 a W n. m fi C O t a c y c o Return on Equity = PAT - Preference dividends Ordinary shares + reserves Return on Equity describes how well contributions from shareholders generated earnings for the company. Importance of Return on Equity: A company wants to maximise its use of shareholder's equity, as it is the shareholders the company must answer to on how they spent the shareholder's money. Return on Equity basically shows how any dollars of earnings were generated per dollar of equity the shareholder's provided. Service Industries have good ROCE/ROE It is worth noting that not all high-ROE/ROCE companies make good investments. Some industries require no assets, such as consulting firms and the Richard Clarke Academy! We have high ROCE - but I’m still not rich :( Other industries require huge asset bases before making a profit such as manufacturing. Therefore their ROCE wont be as high as ours (as a percentage) Highly geared companies have good ROE ROE will increase as companies increase gearing. ie They finance the business more through loans than shareholders funds. This means that return should increase, but the shareholders funds will not (loans will instead), therefore driving the ROE up. Hence the ROE and ROCE will be very high for service industries generally and not so for manufacturing. Therefore ROCE/ROE are best used to compare companies in the same industry and with similar gearing 15 a W n. m C O t a c y c o Illustration Income Statement SFP PBIT 400 NCA 1000 Interest 100 CA 800 Tax 100 Equity 1200 LTL 400 CL 200 What are the ROE and ROCE in this case? ROE 200 / 1200 = 16.67% ROCE 400 / 1600 = 25% 16 a W n. m C O t a c y c o Dividend per share = Dividends Ordinary shares Simple, but be careful if there has been a rights or bonus issue. This would probably mean a fall in the DPS but each shareholder will now have more shares, so this DPS fall is not as bad as it may first seem. Interest Cover = Pro t before Interest Interest A figure of around 3 is deemed acceptable for a stable company Obviously a higher figure is recommended if profits are quite volatile Financial Gearing = Long term Debt + preference shares Share Capital + Reserves Share capital can be either book (as above) or market value - be guided by the examiner in the question The higher the gearing the more risk the company is taking Dividend yield = Dividend per share ×100 Market price per share This basically says how much dividend did i get back as a % of the share price / cost? However, it fails to take into account any share price growth that the shareholder will ultimately receive. As DPS is used in this calculation, its limitations above also apply here. 17 a W n. m fi C O t a c y c o Price-earnings ratio = Market price per share EPS Company A Company B EPS €2 €0.20 Think about 2 different companies A & B. A has an eps of €2 and B of €0.2. Which share would you buy?? The answer, surely depends not just on the earnings per share, but also on how much the share price is! Company A Company B EPS €2 €0.20 Share Price €20 €0.40 If company A had a share price of €20 and B of €0.4 which share looks the best now? Hopefully you will see company B looks more attractive as the EPS is a bigger percentage of the share price You are now actually calculating the Price/earnings (PE) ratio shown above! 18 a W n. m C O t a c y c o NOTE! If a company has a high PE ratio like company A of 10. This means that the market feels the future prospects of the company are good. It does not expect the share to take 10 years to get its money back rather that it expects the future earnings to increase so the EPS will in time get better also. Total Shareholder Return The total return earned on a share over a period of time: dividend per share plus capital gain divided by initial share price Dividend for year + Increase in share price Share price at start of year These are very popular questions so take note… Illustration 1 Share price at the start of the year: $10 Dividend in the year: $2 Share price at the end of the year: $14 What is the total shareholder return? ($2 + $4) / 10 = 60% 19 a W n. m C O t a c y c o  Syllabus A3e: Explain ways to encourage the achievement of stakeholder objectives, including: i) managerial reward schemes such as share options and performance-related pay ii) regulatory requirements such as corporate governance codes of best practice and stock exchange listing regulations Managerial reward schemes As agents, directors may not always act in ways which increase the wealth of shareholders, a phenomenon called the agency problem. However they can be encouraged to maximise shareholder wealth by managerial reward schemes such as performance-related pay and share option schemes. Performance-related pay links part of the remuneration of directors to some aspect of corporate performance, such as levels of profit or earnings per share. One problem here is choosing the aspect of corporate performance - as managers may influence them for their own benefit rather than the benefit of shareholders, for example, focusing on short-term performance while neglecting the longer term. Share option schemes bring the goals of shareholders and directors closer together to the extent that directors become shareholders themselves. Share options allow directors to purchase shares at a specified price on a specified future date, encouraging them to make decisions which exert an upward pressure on share prices. Unfortunately, a general increase in share prices can lead to directors being rewarded for poor performance, while a general decrease in share prices can lead to managers not being rewarded for good performance. However, share option schemes can lead to a culture of performance improvement and so can bring continuing benefit to stakeholders. 20 a W n. m C O t a c y c o Regulatory requirements Regulatory requirements can be imposed through corporate governance codes of best practice and stock market listing regulations. Corporate governance codes of best practice, such as the UK Corporate Governance Code, seek to reduce corporate risk and increase corporate accountability. Responsibility is placed on directors to identify, assess and manage risk within an organisation. An independent perspective is brought to directors’ decisions by appointing non- executive directors Stock exchange listing regulations place obligations on directors: To publish regular financial reports To provide detailed information on directorial rewards To publish detailed reports on corporate governance and corporate social responsibility. 21 a W n. m C O t a c y c o  A4: Financial and other objectives in not-for-profit organisations Syllabus A4a Discuss the impact of not-for-profit status on financial and other objectives Not-for-Profit (NFP) organisations are defined as those whose mission or priority is not the pursuit or maximisation of profit. These organisations include both public sector and privately owned bodies, some of which have charitable status. The declared mission/objective of the organisation permeates the manner in which the organisation conducts its affairs and has a direct effect upon the management function. A not-for-profit organisation’s primary goal is not to increase shareholder value; rather it is to provide some socially desirable need on an ongoing basis. A not-for-profit generally lacks the financial flexibility of a commercial enterprise because it depends on resource providers who often gain no tangible benefit themselves. Thus the not-for- profit must demonstrate its stewardship of donated resources — money donated for a specific purpose must be used for that purpose. That purpose is either specified by the donor or implied in the not-for-profit’s stated mission. Budgeting and cash management are two areas of financial management that are extremely important exercises for not-for-profit organisations. The organisation must pay close attention to whether it has enough cash reserves to continue to provide services to its clientele. Cash flow can be extremely challenging to predict, because an organisation relies on revenue from resource providers that do not expect to receive the service provided. In fact, an increase in demand for a not-for-profit’s services can lead to a management crisis. The non financial objectives are often more important in not for profit organisations. However, they are harder to quantify eg Quality of care 22 a W n. m C O t a c y c o  Syllabus A4b) Discuss the nature and importance of Value for Money as an objective in not-for-profit organisations Value for money can be broken down into the following 3 sectors: (a) Economy – Buy goods at minimum cost (still paying attention to quality) (b) Efficiency – Use these goods to maximise output (c) Effectiveness – Use these goods to achieves objectives Another way of looking at these is: Economy - 'doing things at a low price' Efficiency - 'doing things the right way' Effectiveness - 'doing the right things' A nal way of looking at these is as input - process - output Inputs - Economy - get as cheap as possible given quality Process - Efficiency - perform the process as efficiently as possible Outputs - Effectiveness - These match the objectives set Input driven - Try to get as much out given limited inputs eg library Output driven - Maintaining standards even when output changes eg Prison service 23 a W n. m fi C O t a c y c o  Syllabus A4c: Discuss ways of measuring the achievement of objectives in not-for-profit organisations Non-financial information is often better able than straight financial data to measure and justify the intangible goals of Not for Profits. The high level of non-financial reporting will come at a cost, however, in terms of the time and other resources which it necessitates. Popular types include: Measuring outputs, performances or achievements against strategic/business/ operational plans; Key performance indicators Statistics related to service or activity delivery and performance, such as client numbers, user numbers, enquiry numbers, occupancy levels and similar; The performance and development of human resources, both staff and volunteers; and Reporting on external trends, including social and environmental impacts, also political and economic developments. Other creative forms of non-financial reporting include statistics on website use, complaint numbers, analysis of media coverage, and measuring board visibility and recognition. 24 a W n. m C O t a c y c o  Syllabus B: FINANCIAL MANAGEMENT ENVIRONMENT B1: The economic environment for business Syllabus B1a: Identify and explain the main macroeconomic policy targets The four major objectives are I. full employment II. price stability III. a high, but sustainable, rate of economic growth IV. keeping the Balance of Payments in equilibrium. Full employment was considered very important after the Second World War. Unemployment in the 80s was seen as an inevitable consequence of the steps taken to make industry more efficient. De-industrialisation made higher unemployment feel inevitable, and so this objective became much less important than it had been. Growth and low inflation have always been important. Without growth peoples' standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards. Sustainable growth means growth without inflation. 25 a W n. m C O t a c y c o Balance of payments The total of all the money coming into a country from abroad less all of the money going out of the country during the same period. Policies to reduce a BOP deficient: Higher Interest Rates - will act to slowdown the growth of consumer demand and therefore lead to cutbacks in the demand for imports. Fiscal policy (i.e. increases in direct taxes) might also be used to reduce aggregate demand. The risk is that a sharp fall in consumer spending might lead to a steep economic slowdown (slower growth of GDP) or an full-scale recession 26 a W n. m C O t a c y c o  Syllabus B1b & c: Define and discuss the role of fiscal, monetary, interest rate and exchange rate policies in achieving macroeconomic policy targets. objectives. Explain how government economic policy interacts with planning and decision-making in business Fiscal Policy De nition: Decisions relating to taxation and government spending with the aim of full employment, price stability, and economic growth. Discussion: By changing tax laws, the government can alter the amount of disposable income available to its taxpayers. If taxes increased consumers would have less money to spend. This difference in disposable income would go to the government instead of going to consumers, who would pass the money onto companies. Or, the government could increase its spending by purchasing goods from companies. This would increase the flow of money through the economy and would eventually increase the disposable income available to consumers. Unfortunately, this process takes time, as the money needs to wind its way through the economy, creating a significant lag between the implementation of fiscal policy and its effect on the economy. Monetary Policy De nition: The regulation of the money supply and interest rates by a central bank in order to control inflation and stabilise currency. Discussion: Monetary policy is one the two ways the government can impact the economy. By impacting the effective cost of money, the government can affect the amount of money that is spent by consumers and businesses. 27 a W n. m fi fi C O t a c y c o  Interest Rates Policy De nition: Interest rate is the percent charged for the use of money. It is charged when the money is being borrowed, and paid when it is being loaned. Discussion: When interest rates are high, fewer people and businesses can afford to borrow, so this usually slows the economy down. However, more people will save (if they can) because they receive more on their savings rate. When the central banks set interest rates it is the amount they charge other banks to borrow money. This is a critical interest rate, in that it affects the entire supply of money, and hence the health of the economy. High interest rates can cause a recession. Exchange Rate Policy De nition: Policy of government towards the level of the exchange rate of its currency. Discussion: It may want to influence the exchange rate by using its gold and foreign currency reserves held by its central bank to buy and sell its currency. A fall in the exchange rate will mean that the price of imports will rise while exporters should become more internationally competitive. Import volumes should fall whilst export volumes should rise. Output at home should rise, leading to higher economic growth and a fall in unemployment. There should be an improvement in the current account of the balance of payments too as the gap between export values and import values improves. However, higher import prices will feed through to a rise in inflation in the economy. 28 a W n. m fi fi C O t a c y c o  Target Fiscal Monetary Exchange Policy Policy Rates Growth in More Lower More Lower the money Interest Lower Spending Taxes Economy supply Rates Lower Higher Low Lower Increase money Interest Higher Inflation Spending Taxes supply Rates BOP Higher Lower Increase deficit - Interest Lower Spending Taxes reduction Rates 29 a W n. m C O t a c y c o  Syllabus B1d: Explain the need for, and the interaction with, planning and decision- making in business of: i) competition policy ii) government assistance for business iii) green policies and sustainability issues iv) corporate governance regulation Competition policy The Competition Commission prevents takeovers that are against the public interest. Competition policy aims to ensure: Wider consumer choice Technological innovation, and Effective price competition Government assistance for business Government grants available for certain investments and small business in areas such as rural development, energy efficiency, education etc Green policies Airfuel tax for example can threaten an airline business but create opportunities for other forms of transport or makers of new greener aircraft. 30 a W n. m C O t a c y c o Sustainability Sustainability means meeting present needs without harming the ability of future generations to meet their own needs, according to the United Nations. For investors, sustainable investing involves recognising that companies addressing global challenges can have strong growth potential. Investors of all kinds now consider environmental, social, and governance (ESG) factors when pursuing their investment objectives. The growing demand for eco-friendly products and ethical business practices has also led to an increase in greenwashing, which refers to misleading claims about environmental efforts made by companies. In summary, sustainability involves balancing current and future needs, while sustainable investing considers ESG factors. However, the rise in greenwashing poses challenges to accurately assessing a company's environmental impact. Corporate governance regulation Regulatory requirements can be imposed through corporate governance codes of best practice and stock market listing regulations. Corporate governance codes of best practice, such as the UK Corporate Governance Code, seek to reduce corporate risk and increase corporate accountability. 31 a W n. m C O t a c y c o  B2: The Nature and Role of Financial Markets and Institutions Syllabus B2a: Identify the nature and role of money and capital markets, both nationally and internationally To finance a business the manager has the choice of getting a loan or issuing shares. These are made through the financial markets and institutions. If the business gets funds directly they go to the financial markets If the business gets funds indirectly it is through Financial Institutions or Intermediaries such as merchant banks, pension funds and insurance companies Financial Markets A financial market allows people to easily buy and sell financial securities (such as stocks and bonds), commodities (such as precious metals) etc. General markets (many commodities) and specialised markets (one commodity) exist. Markets work by placing interested buyers and sellers in one "place", thus making it easier for them to find each other. So, Financial markets facilitate-- ▪ The raising of capital (in the capital markets); ▪ The transfer of risk (in the derivatives markets); ▪ International trade (in the currency markets) and are used to match those who want capital to those who have it. Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. 32 a W n. m C O t a c y c o In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends. As the financial markets are normally direct and no financial intermediaries used, this is called financial disintermediation Money Market (short term) The money market is the global financial market for short-term borrowing and lending. The money market is where short-term obligations such as 1) Treasury bills, 2) commercial paper and 3) bankers' acceptances are bought and sold. Here financial institutions either borrow or lend for short periods of time, typically up to thirteen months. This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. Capital Market (Long term) A capital market includes the stock market, commodities exchanges and the bond market amongst others. The capital market is ideal for raising long-term funds Along with the stock exchanges, support organisations such as brokerage firms also form part of the capital market. 33 a W n. m C O t a c y c o Euromarkets (International Long term) An overall term for international capital markets dealing in offshore currency deposits held in banks outside their country of origin. Euro means external in this context. For example, eurodollars are dollars held by banks outside the United States. It allows large companies with excellent credit ratings to raise finance in a foreign currency. This market is organised by international commercial banks. Key Features Size much bigger than the market for domestic bonds / debentures. Cheap debt finance Can be sold by investors, and a wide pool of investors share the risk Unsecured Only issued by large companies with an excellent credit rating Long-term Debt in a foreign currency Typically 5-15 years, normally in euros or dollars but possible in any currency Less regulation By using Euromarkets, banks and financiers are able to avoid certain regulatory aspects such as reserve requirements and other rules. However, the reduction in domestic regulations have made the cost savings much less significant than before. 34 a W n. m C O t a c y c o As a result, the domestic money market and Eurocurrency markets are closely integrated for most major currencies, effectively creating a single worldwide money market for each participating currency. Illustration German firm sells to buyer in the US. It receives US$1m cheque. To earn a higher return on the $1 million the German firm decides to place the funds in deposit with a bank in London, UK. One million Eurodollars have thus been created. 35 a W n. m C O t a c y c o  Syllabus B2b: Explain the role of financial intermediaries A financial intermediary is an entity who performs intermediation between two parties. This basically means that the lender gives money to the borrower indirectly as the financial intermediary sits in-between (hence the term). It is typically an institution that allows funds to be moved between lenders and borrowers. That is, savers (lenders) give funds to an intermediary institution (such as a bank), who then gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, the savers may lend the money directly to the borrower, via the financial markets. Therefore there is no intermediary and so this is known as financial disintermediation. Provide short term finance By providing a link between investors who have surplus cash and borrowers who have financing needs. The amounts of cash provided by individual investors may be small, whereas borrowers need large amounts of cash: one of the functions of financial intermediaries is therefore to aggregate invested funds in order to meet the needs of borrowers. In so doing, they provide a convenient and readily accessible route for business organisations to obtain necessary funds. Risk Transformation Small investors are likely to be averse to losing any capital value, so financial intermediaries will assume the risk of loss on short-term funds borrowed by business organisations, either individually or by pooling risks between financial intermediaries. Maturity transformation Financial intermediaries also offer maturity transformation, in that investors can deposit funds for a long period of time while borrowers may require funds on a short-term basis only, and vice versa. In this way the needs of both borrowers and lenders can be satisfied. 36 a W n. m C O t a c y c o  Syllabus B2c: Explain the functions of a stock market and a corporate bond market A stock market (also known as a stock exchange) has two main functions, to provide… 1. A way of issuing shares to people who want to invest in the company. 2. A venue for the buying and selling of shares. The first function allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. This enables investors the ability to quickly and easily sell securities. This liquidity is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller. 37 a W n. m C O t a c y c o  Syllabus B2d: Explain the nature and features of different securities in relation to the risk/ return trade- off The term "risk and return" refers to the potential financial loss or gain experienced through investments in securities. A profit is the "return". The "risk" is the likelihood the investor could lose money. If an investor decides to invest in a security that has a relatively low risk, the potential return on that investment is typically fairly small and vice-versa. Different securities—including common stocks, corporate bonds, government bonds, and Treasury bills—offer varying rates of risk and return. Treasury bills These are about as safe an investment as you can get. There is no risk of default and their short maturity means that the prices of Treasury bills are relatively stable. Long-term government bonds These on the other hand, experience price fluctuations in accordance with changes in the nation's interest rates. Bond prices fall when interest rates rise, but they rise when interest rates drop. Government bonds typically offer a slightly higher rate of return than Treasury bills. 38 a W n. m C O t a c y c o Corporate bonds Those who invest in corporate bonds have the potential to enjoy a higher return on their investment than those who stay with government bonds. This is because the risk is greater. The company may default on the bond. Investors want to make sure that the company plays fair. Therefore, the bond agreement includes a number of restrictive covenants on the company. Ordinary shares / Common stock Common stockholders are the owners of a corporation in a sense, for they have ultimate control of the company. Their votes on appointments to the corporation's board of directors and other business matters often determine the company's direction. Common stock carries greater risks than other types of securities, but can also prove extremely profitable. Earnings or loss of money from common stock is determined by the rise or fall in the stock price of the company. Preference shares While owners of preferred stock do not typically have full voting rights in the company, no dividends can be paid on the common stock until after the preferred dividends are paid. 39 a W n. m C O t a c y c o  B3: The nature and role of money markets a) Describe the role of the money markets in: i) Providing short-term liquidity to the private sector and the public sector ii) Providing short-term trade finance iii) Allowing an organisation to manage its exposure to foreign currency risk and interest rate risk. Money Markets These are for short term lending and borrowing (up to 12 months) Money market securities are essentially IOUs issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities Examples of money market instruments include treasury bills, forwards and futures The buying and selling of futures contracts here will help an organisation manage its exposure to foreign currency and interest rate risk - which we look at in much more detail later 40 a W n. m C O t a c y c o  Syllabus B3b: Explain the role of banks and other financial institutions in the operation of the money markets Lenders or savers give money to Financial Intermediaries Financial intermediaries then use this money for loans to borrowers/spenders These financial intermediaries are banks, insurance companies, pensions etc Therefore these banks and other financial institutions provide indirect finance to businesses. It’s also called financial intermediation Why not borrow/lend money directly? The banks and other financial institutions offer 2 advantages: 1) Transaction cost reduction These would be really high for individuals but banks with high volumes of transactions use economies of scale to reduce them 2) Credit Risk reduction This is due to information. The borrower knows a lot more about their ability to repay than the lender knows. This is asymmetric information. It causes credit risk Banks etc though have many specialists who can assess the borrowers ability to repay and at a cheaper cost than a lender could use individually. Hence they can reduce the credit risk for the lender Securitisation This turns illiquid assets into marketable securities (hence the name) Banks, for example, could convert their long term receivable loans into securities and selling them to big institutional investors For the banks these mortgages will have different maturity times but selling them as securities takes away this mis-match problem 41 a W n. m C O t a c y c o The security will almost always be backed by an asset e.g. a house in a mortgage backed security Syllabus B3c: Explain the characteristics and role of the principal money market instruments: i) Interest-bearing instruments ii) Discount instruments iii) Derivative products Money market instruments remember are short term and they can give interest, be discounted or be derivative based Interest Bearing Certificates of deposit (CDs) A CD is a receipt for funds deposited in a bank for a specified term and for a set rate With a CD - if they’re negotiable - they can be sold before maturity. Non-negotiable ones just pay a set amount of interest (coupon) and is repaid as normal Repurchase Agreement A repo is where 2 parties agree to buy/sell an instrument at an agreed price and then repurchase back at an agreed price a set time later Discount Instruments These don’t pay interest as such. They are issued at a discount, which effectively means the “interest” is all at the beginning Think of it from the lenders viewpoint. They wish to lend $100, but actually only need to lend $80 (discounted at the start) but are paid back the full $100. 42 a W n. m C O t a c y c o Treasury Bills These are issued by governments with maturities from 1m to 12m. They are issued at a discount to their face value Commercial paper These are unsecured with a typical term of 30days. They're issued by large organisations with good credit ratings - funding their short term investment needs Bankers Acceptance These again are issued by companies BUT are guaranteed by a bank The banks will get a fee for this guarantee - and because the risk is low (for the lender due to the bank guarantee) - the interest the companies offer on these will be low Again these are offered at a discount however they are negotiable, meaning they can be traded before maturity These are normally issued by firms who do not have a good enough credit rating to offer commercial paper 43 a W n. m C O t a c y c o  Syllabus C: WORKING CAPITAL MANAGEMENT C1: The nature, elements and importance of working capital Syllabus C1a: Describe the nature of working capital and identify its elements Working capital is simply the money needed for day to day business. This money is needed to keep the company alive so its importance cannot be over emphasised. It is the management of each current asset and each current liability that is essential to the business. Working capital = net current assets = current assets - current liabilities Current assets Current liabilities Cash Overdraft Inventories Payables