Lesson 1: Financial Markets, Institutions, and Investment Products PDF

LESSON 1: FINANCIAL MARKETS, INSTITUTIONS AND INVESTMENT PRODUCTS Functions and Participants of the Financial Markets FINANCIAL MARKETS - The meeting place for people, corporations, and institutions that either need money or have money to lend or invest. BASIC FUNCTION - Ge...

LESSON 1: FINANCIAL MARKETS, INSTITUTIONS AND INVESTMENT PRODUCTS Functions and Participants of the Financial Markets FINANCIAL MARKETS - The meeting place for people, corporations, and institutions that either need money or have money to lend or invest. BASIC FUNCTION - Getting people or its participants to move funds within the market; from those who have surplus in funds to invest or lend those who have shortage of funds. Governments – primary borrowers but may also lend if they have excess funds. Companies – relies on financial markets is where they usually rely for funding for their short-term operations. Markets - Primary market - Secondary market FUNCTIONS OF FINANCIAL MARKETS Raising Capital – important source of capital for firms that need funds for their business, also for individuals who wishes to buy a house or car. Commercial Transactions - the financial markets makes it possible for many commercial transactions to go through. Price Setting – financial markets enable determination of market prices for financial assets. Price discovery – way to determine the relative values of different items; the price which individuals are willing to buy and sell items. Asset Valuation – financial markets helps in the determination of the value of a firm and their assets, property. Arbitrage - the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset. Investing – kaya niyo na to guys Risk Management - financial markets offer a range of derivative instruments that allow participants to manage risks. Future, options and other contracts provide protection against risks. Overview of the Operations of Financial Intermediaries and Institution Financial intermediaries, such as banks and non-banking institutions, play an essential role in the financial system by channeling funds between savers and borrowers. Depository Institutions Non-depository Institutions ______________________________________ Role and Function of the Central Bank The central bank holds a central role in maintaining a country's economic and financial stability. Key functions include: Monetary Policy Regulation of Money Circulation Oversight of Inter-bank Transactions Lender of Last Resort Advisory Role ______________________________________ Types of Banks and Financial Intermediaries Banks, as the primary financial institutions, are categorized into private and government sectors. Each type of bank has distinct roles: 1. Private Banking Institutions: These include: o Universal and Commercial Banks o Thrift Banks o Rural and Cooperative Banks o Offshore Banks 2. Government Banking Institutions 3. Financial Intermediaries: o Depository Institutions o Contractual Savings Institutions o Investment Intermediaries ______________________________________ Types of Investment Products and Their Characteristics Investment products vary widely in their risk and return profiles. Here are key types: 1. Shares Example: SM Investments Corporation, Ayala Corporation. 2. Bonds Example: Philippine Government Bonds, Ayala Land Bonds. 3. Unit Trusts or Funds Example: Sun Life Prosperity Philippine Stock Index Fund, BPI Philippine Equity Fund. 4. Exchange-Traded Funds (ETFs) Example: First Metro Philippine Equity Exchange Traded Fund (FMETF). 5. Real Estate Investment Trusts (REITs) Example: Ayala Land REIT, DoubleDragon Properties Corp. ______________________________________ The Stock Market The stock market plays a crucial role in modern economies by facilitating capital formation and wealth generation. Primary Market Secondary Market Equity Market Derivative Market Investing in the stock market provides opportunities for high returns, portfolio diversification, and liquidity. Investors also benefit from long-term wealth creation, with the potential for significant capital appreciation over time. ______________________________________ Stock Market Returns Stock market returns refer to the gains or losses investors make from their investments in stocks. These returns come in two main forms: 1. Capital Gains 2. Dividends Several factors impact stock market returns, including economic conditions, company performance, interest rates, and investor sentiment. While stocks offer the potential for high returns, they also carry risks, with higher returns generally associated with higher levels of risk. ______________________________________ Stock Market Efficiency Stock market efficiency refers to how well market prices reflect all available information. According to the Efficient Market Hypothesis (EMH), stock prices always incorporate relevant information, making it difficult for investors to consistently achieve above-average returns by exploiting market inefficiencies. There are three forms of market efficiency: 1. Weak Form Efficiency 2. Semi-Strong Form Efficiency 3. Strong Form Efficiency In efficient markets, it is challenging to "beat the market" consistently. Passive investing strategies, such as index funds, are often recommended in efficient markets Role and Function of the Central Bank Central Bank - is a financial institution responsible for the formulation of monetary policy and the regulation of member banks. It typically has privileged control over the production and distribution of money and credit for a nation or a group of nations. - Central banks set specific targets for inflation and interest rates per period. Role and Function of the Central Bank Monetary Policy - Central banks use monetary policy to manage economic fluctuations and achieve price stability, which means that inflation is low and stable. - Inflation can be controlled by setting/adjusting interest rates based on market conditions. Regulating Money in Circulation - They are the authoritative body for issuing notes and coins used by a country. - Responsible for the money supply and regulation of money circulation. - Responsible for the countries reserves such as gold and cash reserves. Overseeing the Inter-bank Transactions - Setting financial rules and policies by banks and other financial institutions and to ensure that they are met and respected. - Monitor national payments systems and ensure smooth operations. Loaning Liquidity to Commercial Banks if necessary for Solvency Issues - Giving discounts, loans, advances to financial institutions in order to influence financial stability. - Lender of last resort of struggling financial institutions in complicated or precarious financial situations. Taking on an Advisory Role - Advisor of the government on economic policy matters. - Formulates and implements fiscal and monetary policies. BSP Role and Function - Monetary Policy - Monetary Options - Systemic Risk Management - Financial Supervision - Payments and Settlements System Oversight - Currency Management - Inclusive Finance - Loans and Credit Operations - International Reserves Management - International Operations - International Economic Cooperation - Economic Education Types of Banks and Other Financial Intermediaries Banks are financial institutions that lend loans, take deposits, and provide several types of other financial services. They can be classified into several types, each with its own specialized functions. It can be categorized into two groups: 1. Private Banking Institutions 1. Universal Banks 2. Commercial Banks 3. Thrift Banks 4. Rural and Cooperative Banks 5. Offshore Banks 2. Government Banking Institutions 1. Development Bank of the Philippine (DBP) 2. Land Bank of the Philippines (LBP) 3. Al-Amanah Islamic Investment Bank ( Republic Act No. 6048) A financial intermediary is a financial firm, such as a bank, that borrows funds from savers and lends them to borrowers. Basic Structure of Financial Intermediaries 1. Depository Institutions 1. Commercial Banks / Universal Banks 2. Savings and Loans Association 3. Mutual Savings Bank - a type of thrift institution originally designed to serve low-income individuals. It is a bank organized without stock which receives saving deposits and whose earnings accrue entirely to the benefit of its depositors. 4. Credit Union - are cooperative associations whose members have a common bond, such as being employees of the same firm. 2. Contractual Savings Institutions 1. Insurance Companies - specialize in writing contracts to protect their policyholders from the risk of financial losses associated with particular events. a. Life Insurance Companies b. Property and Casualty Companies 2. Pension Funds - invests contributions of workers and firms in stocks, bonds, and mortgages to provide pension benefit payments during worker's retirements. a. Defined Contribution Plan b. Defined Benefit Plan 3. Investment Intermediaries 1. Investment Banks - concentrates on providing advice to firms issuing stocks and bonds or considering mergers with other firms. 2. Mutual Funds - allow savers to purchase shares in portfolio of financial assets, including stocks, bonds, mortgages and money market securities. a. Close-end Mutual Funds b. Open-end Mutual Funds 3. Hedge Funds - financial firms organized as a partnership of wealthy investors that make relatively high risk, speculative investments. 4. Finance Companies - non-bank financial intermediaries that raise funds through sales of commercial paper and other securities and use the funds to make small loans to household and firms 5. Money Market Mutual Funds - relatively new financial institutions that have the attributed of a mutual fund but also function to some extent as a depositing institution because they offer deposit- type accounts. Types of Investment Products and their Characteristics Shares are issued by companies to raise capital or financing from investors. When you buy a share in a company, you become a part-owner of that company.  Returns: Potential for high returns through capital gains and dividends.  Risk: High volatility; value can fluctuate significantly. examples: 1. SM Investments Corporation (SM) 2. Ayala Corporation Bonds  Companies or governments can borrow money from investors by issuing bonds to raise funds.  Government. You can also redeem the bonds early without any penalties. Returns: Provide regular interest payments and return of principal at maturity. Risk: Generally lower risk than stocks,but can be affected by interest rate changes and credit risk. examples: 1. Philippine Government Bonds 2. Ayala Land Bond Unit trusts or funds  Investment product where money from investors is pooled and invested by a fund manager in a portfolio of assets. This is according to the unit trust or fund's stated investment objective and investment approach. Returns: Depends on the performance of the underlying assets. Risk: Diversification reduces risk, but it can still be subject to market fluctuations. examples: 1. Sun Life Asset Management Company, Inc. (SLAMCI): a. Sun Life Prosperity Philippine Stock Index Fund 2. BPI Asset Management and Trust Corporation: a. BPI Philippine Equity Fund Exchange-Traded Funds (ETFs)  A type of fund that is listed and traded on a stock exchange. SomeETFs have simpler cash-based structures while others are complex and involve derivatives. Returns: Track the performance of an index, sector, or asset class; can provide diversification. Risk: Varies based on the underlying assets; typically lower costs compared to mutual examples: 1. Philippine Stock Exchange Index (PSEi) 2. First Metro Philippine Equity Exchange Traded Fund (FMETF) Real Estate Investment Trusts (REITs)  Unit trust or fund that is traded on a stock exchange and is invested in a portfolio of real estate assets. Returns: Provide income through dividends and potential for capital appreciation. Risk: Influenced by real estate market conditions; less liquid than stocks but more accessible than direct real estate investments. examples: 1. Ayala Land REIT, Inc. (AREIT) 2. DoubleDragon Properties Corp. (DD) The Stock Markets  defined as the collective trading network involving company shares and their derivatives.  It plays a crucial role in modern economies by enabling money to move between investors and companies. Types of Stock Market 1. Primary Market - refers to the market where shares are issued for the first time by companies seeking to raise capital. 2. Secondary Market - refers to the market where existing shares are traded among investors after the initial public offering. 3. Equity Market - where companies sell ownership (shares) to investors. 4. Derivative Market - trading revolves around contracts like futures and options. Why Invest in Stock Market 1. Potential for High Returns 2. Ownership in Companies 3. Diversification 4. Liquidity 5. Long-Term Wealth Creation The Market for Common Stocks Types of Stock Market Transactions 1. Initial Public Offering 2. Secondary market offerings 3. Secondary markets 4. Private placement 5. Stock repurchase Initial public offering (IPO)  - a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Secondary market offerings - specific events where additional shares of a company are sold to the public after the company has already gone public. Secondary market - securities are sold by and transferred from one investor or speculator to another. Private placement - a funding round of securities which are sold not through a public offering, but rather through a private offering, mostly to a small number of chosen investors. Stock repurchase - the reacquisition by a company of its own stock. Stock Market Returns and Stock Market Efficiency Stock Market Returns  Stock markets generate returns through the buying and selling of stocks, which represent ownership in companies. Capital Gains  a price appreciation occurs when the price of a stock increases from the purchase price, allowing the investor to sell the stock at a higher price.  These gains are driven by various factors including company performance, investor sentiment, and broader economic indicators. Dividends  these are payments made by a corporation to its shareholders, usually derived from the company's profits, and paid out quarterly.  provides a steady income stream for investors, supplementing the capital gains from stock price appreciation. Interest Income (for certain securities)  securities, such as preferred stocks or bonds, that offer fixed interest payments. Stock Market Efficiency  a market is considered efficient if stock prices at any given time fully incorporate all relevant information, meaning that prices adjust quickly to new information.  Efficient Market Hypothesis (EMH) - is the central theory, states that share prices reflect all available information. Three forms: 1. Weak Form Efficiency: Stock prices reflect all past trading information, such as historical prices and volumes. Technical analysis (predicting future price movements based on past price patterns) is ineffective in this form. 2. semi-Strong Form Efficiency: Stock prices reflect all publicly available information, including financial statements, news, and economic indicators. Stock prices adjust rapidly to new public information. Fundamental analysis (analyzing financial statements to assess a stock’s value) is ineffective. 3. Strong Form Efficiency: Stock prices reflect allinformation, both public and private. Even insiders with access to non-public information cannot achieve excess returns because the market price already incorporates this information LESSON 2: INTEREST RATES The cost of money SAYLOR: https://learn.saylor.org/mod/book/view.php?id=53724 INVESTOPEDIA: https://www.investopedia.com/terms/i/interestrate.asp PAGE 110: https://drive.google.com/file/d/1hwlUGM1zG3wVTyNRkCEt5df0sasiXhx1/view?usp=drive_link INVEST: https://www.investopedia.com/terms/i/investing.asp DYK? You’re losing cash when it’s on standby. Cost of Money  It is the opportunity cost of holding cash instead of investing it, depending on the interest rate. Opportunity Cost  The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable foregone alternative. Investments  Investing involves deploying capital (money) toward projects or activities expected to generate a positive return over time.  Through stocks, notes, bonds, and more! Why Invest?  Money is working to increase its value through interests.  Money doesn’t increase its value by being on standby. Interest rates levels SAYLOR: https://learn.saylor.org/mod/book/view.php?id=53724&chapterid=37800 Interest rate  An interest rate is what a borrower pays to a lender for using their money.  Interest rates are crucial economic signals, indicating the economy's health.  Central banks, like the U.S. Federal Reserve (The Fed), adjust interest rates to manage the economy. Types of monetary policy  Expansionary Policy: Lowers interest rates to encourage borrowing and investment, aiming to reduce unemployment during a recession.  Contractionary Policy: Raises interest rates to control inflation and prevent economic bubbles, like those in real estate or stock markets. What is crowding out?  Occurs when increased government spending leads to higher interest rates.  Higher interest rates make borrowing more expensive, reducing business investments. How It Works?  Government spending boosts demand in the economy.  Increased demand raises interest rates as more money is needed.  As interest rates rise, businesses cut back on investments, reducing overall economic growth. The determinants of market interest rates FINANCIAL EDGE: https://www.fe.training/free-resources/financial-markets/determination-of-interest- rates/ LIBRE TEXT BUSINESS: https://biz.libretexts.org/Courses/Pittsburg_State_University/Business_Finance_Essentials/06%3A_The_ Financial_System_and_Interest_Rates/6.05%3A_Determinants_of_Interest_Rates PAGE 36: https://drive.google.com/file/d/1W4raQmgPhfXNGepMyV1mRObEYVvMAFU9/view?usp=drive_link YOUTUBE: https://www.youtube.com/watch?v=b_VfeLX9yVA&t=15s https://youtu.be/rLgqFIOn1Xo?si=yDDLmIG_zt7uz0f- determinants of market interest rates What is “Determination of Interest Rates”? The interest rates in an economy are determined by the forces of demand and supply of money. Demand for Money 1. Transaction demand for money (TDM): as the economy grows over time, individuals will tend to hold more of their wealth in cash/money for transactions.  2. Precautionary demand for money (PDM):the PDM arises out of individuals wanting to hold money/currency to act as a buffer for contingencies or unforeseen events that may require money to be spent. 3. Speculative demand for money (SDM): It is related to the demand to hold money based on potential investment opportunities/risks that are out there in other financial instrument. Money Demand The three main tools of monetary policy that a central bank can use to change (increase or decrease) money supply and consequently influence interest rates are open market operations, official ‘policy’ rate, and the required reserve ratio. Open Market Operations (i.e. purchases and sales of government securities/bonds to banks) is a tool of monetary policy most frequently used by the central bank to change (increase or decrease) the money supply in the economy and can be undertaken (by it) on every business or working day. Official ‘policy’ rate: though monetary policy practices differ between countries, the official ‘policy’ rate (which is a short-term ‘nominal’ interest rate) that a central bank sets and announces publicly are usually the rate at which banks can borrow from it. This is called the ‘repo’ rate, ‘discount’ rate, or ‘refinancing’ rate in some countries. Consequently, this rate affects the cost of borrowing of banks, which in turn influences domestic interest rates (short-term and long-term interest rates), bank reserves (and consequently the ability of banks to create credit), and the money supply. Required reserve ratio: the central bank can, by altering (increasing or decreasing) the required reserve ratio, change the number of funds available with banks to make loans to firms and households. This in turn ultimately brings about a change in the money supply and interest rates – that impact (increase or decrease) aggregate demand, output, and inflation in the short run. Real Risk-Free Rate of Interest 2. The Real Risk-Free Rate of Interest should represent the amount of compensation that investors feel is necessary to forego consumption today and instead save/invest that capital. a. Inflation Premium- it allows the investor/saver to compensate for any loss in purchasing power due to inflation. b. Default Risk Premium- it compensates investors for the risk of a borrower defaulting on their loan. c. Liquidity Risk Premium- it compensates investors for the difficulty of turning their investments into cash on a timely basis for close to fair market value. d. Maturity Risk Premium- it recognizes that longer-term securities are more risky than shorter-term securities. e. Special Characteristics Premium- any special features that may be attractive or unattractive to investors. 4. Term structure of interest rates INVESTOPEDIA: https://www.investopedia.com/terms/t/termstructure.asp FINANCIAL EDGE: https://www.fe.training/free-resources/financial-markets/term-structure-of-interest- rates/ PAGE 170: https://drive.google.com/file/d/1hwlUGM1zG3wVTyNRkCEt5df0sasiXhx1/view?usp=drive_link Using the yield curve to estimate future interests rates INVESTOPEDIA: https://www.investopedia.com/terms/y/yieldcurve.asp SAYLOR: https://learn.saylor.org/mod/book/view.php?id=53725&chapterid=37803 YOUTUBE: https://www.youtube.com/watch?v=MS0tY72K6-E What is Yield Curve? It is an illustration of the yields or interest rates of bonds with similar credit quality but distinct maturities is what we call a yield curve. Yield curves have three main shapes: normal upward-sloping inverted downward-sloping flat Normal Yield A normal yield curve shows low yields for shorter-maturity bonds while increasing for bonds with a longer maturity. Ex: Sample yields on the curve can include a two-year bond that offers a yield of 1%, a five-year bond that offers a yield of 1.8%, a 10-year bond that offers a yield of 2.5%, a 15-year bond offers a yield of 3.0%, and a 20-year bond that offers a yield of 3.5%. Flat Yield A flat yield curve insinuates that all maturities have similar yields, thus indicating an indeterminate economic environment. Ex: The curve shows little difference in yield to maturity among shorter and longer-term bonds. A two-year bond may offer a yield of 6%, a five-year bond of 6.1%, a 10-year bond of 6%, a 15-year bond of 6.1%, and a 20-year bond of 6.05%. Inverted Yield An inverted yield curve, short-term rate is higher than long term rate and this means that it slopes downwards. Ex: Yields on the curve can include a two-year bond that offers a yield of 10%, a five-year bond that offers a yield of 8%, a 10-year bond that offers a yield of 6%, a 15-year bond offers a yield of 4%, and a 20-year bond that offers a yield of 2%. How can investors use the curves? Investors can use the yield curve to make predictions about the economy that will affect their investment decisions. Macroeconomic factors that influence interest rate levels SAYLOR: https://learn.saylor.org/mod/book/view.php?id=53725&chapterid=37804 MONEY CONTROL: https://www.moneycontrol.com/news/business/personal-finance/explainer-six- factors-that-influence-interest-rates-in-an-economy-3549621.html YOUTUBE: https://youtu.be/vItRHYu-A88?si=X5lpzZ8gwshAwE2p WHAT IS MACROECONOMICS?  Macroeconomics is a branch of economics that studies the behavior, structure, performance, and decision-making of an economy as a whole, rather than individual markets or sectors. Macroeconomic factors that influence interest rate levels Demand for Money (Tagalog and English): Typically, in a growing economy, money is in demand. a. Manufacturing sector companies and industries need to borrow money for their short-term and long- term needs to invest in production activities. b. Citizens need money as they need to borrow for their homes, buy new cars, and other needs. higher the demand for money higher the interest rates Supply of money The supply of money refers to the total amount of money available in an economy at a given time. This includes cash, coins, and balances held in bank accounts. Like any other commodity, when the supply of money increases, its "price"—which in this case is the interest rate—tends to go down. What is a Fiscal Deficit? Fiscal deficit is a result of government expenditure exceeding government revenue. To fund this deficit, the government resorts to borrowing. Being the largest borrower in the economy, the quantum of government borrowing influences the demand for money and in turn sways interest rates. Higher the fiscal deficit, higher the government borrowing, higher the interest rates. Inflation As inflation rises, interest rates tend to increase as well Global interest rates and foreign exchange rates The Philippines, like many other countries, is affected by global interest rate trends due to its integration into the global economy. If major economies such as the United States increase their interest rates, it can lead to a stronger US dollar. This, in turn, can impact the value of the Philippine peso. What is a Central Bank? A central bank is a financial institution responsible for managing a country's monetary policy, controlling inflation, and stabilizing the currency. LESSON 3: RISK AND RETURN FUNDAMENTAL Risk and Return Fundamentals (Ducos) Learning Objectives: 1. Discuss the meaning and fundamentals of Risk and Return. 2. Describe procedures for assessing and measuring the Risk of a Single Asset. 3. Understand the meaning of Types of Risks which are Business, Operating, and Financing Risks. 4. Describe procedures for assessing and measuring the Risk of a Single Asset. 5. Understand the measurement of risks on Standard Deviation and the Coefficient of Variation. 6. Explain the risk characteristics of a Portfolio. 7. Understand the return and Standard Deviation characteristics of a portfolio 8. Describe the meaning and the relationships of Capital Asset Pricing Model (CAPM) Risk and Return Fundamentals  Risk refers to the possibility of losing money or not getting the expected outcome when you invest or make a financial decision.  Return is the profit or loss you make from an investment or decision.  Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk  Risk and return are important in business decisions and financial decisions because it can increase or decrease a firm’s share price. Types of Risk (Laurilla) A. Strategic Risk  A strategic risk occurs when a company's business strategy is faulty, or its executives fail to follow a business strategy at all.  Solutions:  Strategic Flexibility B. Operational Risk  This risk arises from within the corporation, especially when the day-to-day operations of a company fail to perform.  Solutions:  Develop a Maintenance Schedule C. Compliance Risk  It is a risk to a company's reputation or finances that's due to a company's violation of external laws and regulations or internal standards.  Solution:  Conduct Regular Safety Audits and Inspections D. People Risk  It refers to the potential for negative outcomes arising from issues related to the workforce, such as employee performance, behavior, or management.  Solution:  Conduct Skills Assessments E. External Risk  External risk is all about stuff that happens outside of a company's control.  Solution:  Regularly Conduct Drills and Simulations F. System Risk  System risk is all about the dangers linked to a company's computer systems and setup.  Solution:  Implement a Data Backup and Recovery Plan G. Credit Risk  Credit risk is the risk that a customer or borrower fails to meet their financial obligations, like payments.  Solution:  Conduct Credit Assessments Before Extending Credit H. Commodity Price Risk (Market Risk)  Commodity price risk refers to the potential financial loss arising from fluctuations in the prices of raw materials or commodities.  Solution:  Hedge Commodity Prices  Diversify Suppliers  Risk of a Single Asset, Assessment, and Measurement (Banot) What is a Single Asset? A single asset refers to an individual investment or financial product that is considered in isolation, without taking into account a portfolio of other assets. This could be:  A Stock: Shares of a particular company (e.g., Apple Inc. stock).  A Bond: A specific government or corporate bond.  A Commodity: A physical good like gold, oil, or wheat.  A Real Estate Property: A specific piece of property or real estate investment.  A Cryptocurrency: A particular digital currency like Bitcoin. When assessing the risk of a single asset, you're looking at the potential for loss or variability in returns specific to that one asset, rather than how it interacts with other assets in a portfolio. This means you're focusing on factors that directly impact the value of that specific asset, such as market conditions, interest rates, company performance (for a stock), or geopolitical events (for commodities). Understanding the risk of a single asset is crucial because it helps investors make informed decisions about whether to invest in that asset, how much to invest, and what potential risks they might face. ASSESSING THE RISK OF A SINGLE ASSET A. Qualitative Risk Assessment This method involves understanding non-quantitative aspects of the asset that could contribute to its risk. This could include:  Industry & Market Position: Is the company in a competitive, volatile industry? How strong is its position within the market?  Management Quality: The experience and track record of a company’s leadership can be key to its success or failure.  Regulatory Risks: Are there upcoming regulations or legal challenges that could impact the asset’s performance?  Macroeconomic Factors: Consider the asset's sensitivity to economic cycles, monetary policies, and geopolitical risks. B. Fundamental Analysis (For Stocks/Bonds) This involves evaluating the financial and operational health of a company to assess the risk level:  Financial Statements: Analyzing balance sheets, income statements, and cash flow statements to determine financial health.  Debt Levels: High levels of debt can increase risk, especially if the company’s earnings are insufficient to cover interest payments.  Earnings Stability & Growth: Consistent, stable earnings can suggest a lower risk compared to a company with volatile or declining profits.  Cash Flow Analysis: Strong free cash flow is a sign that the company can withstand economic downturns and has enough liquidity to meet its obligations.  Competitive Advantage (Moat): A company with a strong, durable competitive advantage (e.g., brand strength, intellectual property) typically has lower business risk. C. External Ratings & Analyst Reports  Credit Ratings (for Bonds): Credit rating agencies (like Moody's, S&P, Fitch) provide risk assessments of debt instruments. Higher-rated bonds (AAA or AA) are considered less risky, while lower-rated (junk) bonds have a higher default risk.  Analyst Reports: Investment research firms and analysts provide risk assessments and forecasts for individual stocks, based on their financial performance, industry trends, and macroeconomic conditions. D. Scenarios and Stress Testing Assessing risk under various scenarios, including both best-case and worst-case events, can give an idea of how the asset might perform in different environments. Stress testing involves evaluating how an asset would respond to extreme events, such as economic recessions, market crashes, or interest rate hikes. E. Risk Ratios and Metrics (Conceptual, No Calculations) Even though you’re not interested in the measurement part, it’s helpful to be aware of these metrics conceptually:   Beta: This measures how much an asset’s price moves in relation to the overall market. A beta above 1 means the asset is more volatile than the market, while a beta below 1 suggests it is less volatile.  Credit Ratings (for Bonds): Higher ratings imply lower credit risk, while lower ratings imply higher risk.  Qualitative Judgment on Volatility: Even without precise measurement, you can compare how much the price of an asset fluctuates compared to others in its category. Solving by Range  Has limitations Investment B is riskier because the range is larger, thus, it has the most distance from the most likely annual rate of return. It is good that it can rise up to 23% of return, but it is also risky that it can go down as low as 7%. Investment A is a much safer option since the annual rate only hovers in the most likely zone. Measures of Risk (Alcoseba) Quantitative Assessment of Measuring Risk - Coefficient of Variation and Standard Deviation  Standard Deviation: A measure of the volatility or dispersion of returns. o The higher the standard deviation, the higher the risk. o Useful in comparing risks with the same expected rate of returns. - Has error, square root of 2 only, not square root of 2% - Investment B is riskier since it has a higher standard deviation.  Coefficient of Variation (CV) o The coefficient of variation, CV, is a measure of relative dispersion (still standard deviation) that is useful in comparing risks of assets with differing expected returns. o Use of examples to compare assets with different return levels with different levels of risk. - Standard deviation of risk relative to return. Other Ways to Measure Risk  Value-at-Risk (VaR): The potential loss in value of the asset over a defined period for a given confidence interval.  Expected Shortfall (ES): The average loss expected beyond the VaR threshold.  Sharpe Ratio: Measures risk-adjusted return.  Scenario Analysis and Stress Testing: Assessing the impact of extreme events on the asset. Risk of a Portfolio (Calaycay)  An investment portfolio is any collection or combination of financial assets.  If we assume all investors are rational and therefore risk averse, that investor will always choose to invest in portfolios rather than in single assets.  Investors will hold portfolios because he/she will diversify away a portion of the risk that is inherent in “putting all your eggs in one basket.”  Diversification is enhanced depending upon the extent to which the returns on assets “move” together.  This movement is typically measured by a statistic known as “correlation” as known in the figure below. When the stocks return move in the same direction by equal percentage, it is a perfect positive correlation. Even if two assets are not perfectly negatively correlated, an investor can still realize diversification benefits from combining them in a portfolio as shown in the figure below. PORTFOLIO RISK AND RETURN Asset x, y, z, and portfolio xz have the same standard deviation. It implies that the risk is not perfectly negatively correlated, therefore it is riskier. PORTIFOLIO RISK AND STANDARD DEVIATION (ABELLA AND RAMIREZ Portfolio return reflects the overall gain or loss from an investment portfolio comprising various assets. It aims to achieve the goals set in the investment strategy while aligning with the target investors’ risk tolerance. An investment portfolio is a collection or combination of financial assets managed by an individual or organisation. These assets can include:  Stocks and Bonds  Mutual funds  Real Estate  Commodities  Other securities The primary aim of building a portfolio is to create a well-balanced, optimised mix of investments that supports specific financial goals. These goals may include capital appreciation, income generation, or wealth preservation. A thoughtfully constructed portfolio considers the investor's risk tolerance, ensuring that risk exposure aligns with their comfort level and financial situation. Through careful asset selection and management, investors seek to boost returns while mitigating risk through diversification and strategic risk management techniques. Given that investors are assumed to act rationally and are generally risk-averse, they are likely to favour investing in diversified portfolios over individual assets. Diversified portfolios typically offer a more balanced risk-return profile, making them a more attractive option compared to investing in single assets. Formula: where:  E(r)p is the expected return of the portfolio.  Wi is the weight or proportion of the portfolio invested in asset iii.  E(r)i is the expected return of asset iii. Sample Problem: Determine the expected return of portfolio and standard deviation for the following stocks: Year Asset A Proportion Asset B Proportion 1 8% 50% 16% 50% 2 10% 50% 14% 50% 3 12% 50% 12% 50% 4 14% 50% 10% 50% 5 16% 50% 8% 50% Solution: The Expected Return of Portfolio is computed as follows: Year1 = (50% x 8%) + (50% x 16%) = 12% Year2 = (50% x 10%) + (50% x 14%) = 12% Year 3 = (50% x 12%) + (50% x 12%) = 12% Year4 = (50% x 14%) + (50% x 10%) = 12% Year5 = (50% x 16%) + (50% x 18%) = 12% Standard Deviation (solution): Formula: Portfolio AB j kp 𝙠̅𝙥 kp - 𝙠̅𝙥 (kp - 𝙠̅𝙥)^2 1 12% 12% 0% 0%  2 12% 12% 0% 0% 3 12% 12% 0% 0% 4 12% 12% 0% 0% 5 12% 12% 0% 0% Total 0% Answer: Capital Asset Pricing Model (Rebusio)  CAPM’S Final Output - Asset or Portfolio’s Required Return  Capital Asset Pricing Model - to price an asset using its rate of return (so we will get rate of return here)  Question here is why is this particular asset goes down a lot worse compared to other assets? Is this asset more responsive/sensitive to market changes compared to others and why? o This asset has unique characteristic as to why it goes down a lot more compared to the other assets  Systematic Risk taken into consideration  Unsystematic Risk - irrelevant  Market Portfolio - independent variable  Return for the market Portfolio against the return for that asset  Slope = Rise/Run = beta = measures an asset's systematic risk  Cyclical Companies - high betas, highly responsive to the market o Cyclical - make or sell in demand items or services that are in demand when the economy is going well  Auto Companies  Relatively Stable Companies - low betas o Relatively Stable - relatively immune to the economic fluctuations  Public Utilities are meant to supply goods and services that are considered essential; water, gas, electricity, telephone, waste disposal, and others   Market Return - overall return of market  Asset Return - return of the individual asset itself  Plotting would not necessarily form a straight line, it is already enough if we can form a closest to a straight line that we could ever get, then that is the regression o Get the slope of the straight line (Asset S = 1.30 = Beta)  Asset S is steeper (rising or falling sharply) than Asset R, thus, the former’s beta is higher than the latter  Higher slope/beta, higher the risk  Thus, Asset S is riskier than Asset R  Beta - how responsive the asset is relative to the market 1. Positive (same direction) a. 2.0 Twice as responsive as the market - both rise and the downfall 2. Zero (no movement at all) - unaffected by the market movement 3. Negative Beta (opposite direction). -0.5 only half as responsive (if Beta is negative by half, the asset will increase by half)  The higher the numerical/absolute value, the higher the risk because it is more responsive 1. Risk-free Rate - return on risk-free environments  Usually estimated from the return on PH Government’s Securities (Treasury Bills) because the government does not have a chance of default. It is impossible for the government to never pay  However, we do not seek the return on the government’s securities. What we seek for is the return on assets/stocks/portfolio so there is an add-on because there are also investments on instruments other than the risk-free-rate investments because the higher the risk, the higher the return. So, add 2. Risk Premium - characteristics of the market and the asset a. Market Risk Premium (characteristic of the market) - additional return required b. Beta (characteristic of the asset) -  Estimates of the Other Variables  Systematic/Nondiversifiable - Beta  Risk-free Rate - 0 H Beta (no risks) 7 V (required rate of return) (0,7)  Market - 1.0 Beta 11 required rate of return (1,11)  Asset - 1.5 Beta CAPM 13 required rate of return  Historical Data - may not reflect future variability of returns so there is margin of error o Market o Asset o Risk-free Rate Return on Government’s securities  The required returns - rough approximations/estimations only  Efficient markets - market price is the actual price. However, the market is not always perfect as we have this term ‘market correction’ wherein we correct the market  Still, there is expectational relationship described by the CAPM in active markets. Practitioners still use this for its relevance and usefulness LESSON 4: COST OF CAPITAL  ABDULHAMID, MALIHA  GAMET, CHARLES ANTHONY  ADAY, JOEY  LANDAS, JAY-R ACT 222   BATARIO, VHINCE CLARK BOLIVAR, ERIKA SHAINE   SAPNO, ALLENEA SUR, ANGEL LYN  CAMAING, YASSIE Cost of Capital - Cost of capital is a calculation of the company’s minimum return that is necessary in order to justify undertaking a capital project (buying equipment, constructing a building etc.) - The company must know how much the project will generate to compensate for the cost from its construction or acquisition. - From the perspective of an investor, it’s an assessment on the return from buying/acquiring stock shares or any investments to a company. - Wise companies will only invest in projects that exceed their cost of capital and can/will generate more income to the entity. - It encompass both equity and debt cost, weighted according to the company’s capital sources IMPORTANCE: - Helps investors to assess their options - Assist capital budgeting decisions because it can lead to a economic consequence - Essential to design the ideal capital structure of the company - Can be used to evaluate the performance of other projects as compared to the cost of capital - Can be used to determine if funds are invested effectively Cost of Long-term debt Sources of Capital: A. Debt Financing - is the act of raising capital by borrowing money from a lender or a bank, to be repaid along with principal and interest at a future date. B. Equity Financing - is the process of raising capital through the sale of shares. Cost of debt is the effective interest rate that a company must pay on its long-term debt obligations, while also being the minimum required yield expected by lenders to compensate for the potential loss of capital when lending to a borrower. Components on Cost of Debt: A. Interest Rates - is an annual percentage of the principal amount a creditor charges a lender on the outstanding loan amount. B. Flotation Cost - refers to the legal, registration, audit, and underwriting fees a business incurs while issuing new securities. C. Risk Premium - is the higher rate of return borrowers pay lenders over and above the risk- free return rate. D. Tax savings- refer to the interest amount a business entity shows as the deductible amount from its income while calculating income taxes. Formula: A. Pre-Tax Cost of Debt B. After - Tax Cost of Debt Cost of Preferred Stock A company's cost of preferred stock is essentially the amount it pays in exchange for the revenue it receives from the issuance and sale of the stock. It represents the annual payout ratio of the company, divided by the total amount received from the stock issue. It is frequently used by management to assess the most efficient and cost-effective methods of capital raising. To raise money for operations or expansions, corporations can issue debt, common shares, preferred shares, and a variety of other instruments. By dividing the yearly preferred dividend by the share price on the market, they arrive at the preferred stock cost. After figuring out that rate, they can assess how it stacks up against alternative financing options. The Weighted Average Cost of Capital is also determined by taking into account the cost of preferred stock. What is Preferred Stock in a company? One type of equity that businesses may use to finance their expansion plans or other endeavors is preferred stock. Companies can raise money by selling preferred stock, just like they can with other equity capital. Because preferred shares do not have the same voting rights as common shares, preferred stock has the advantage of maintaining the ownership stake of common shareholders. In terms of flexibility, preferred stock falls between debt instruments and common equity. It is also referred to as equity and possesses the majority of the traits of equity. Preferred stock does, however, have certain similarities to bonds, such as a par value. Par value does not exist for common equity. Summary: - Unlike bonds, preferred stock dividend payments are not tax- deductible. - However, cost of preferred stock still might differ from stockholders' expected rate of return if the issuer incurs floatation costs. - The cost of preferred stock is used to calculate the weighted average cost of capital (WACC). - WACC is sometimes called the hurdle rate, or discount rate, for capital budget projects. Reminder: Don't confuse price of preferred stock with cost of preferred stock Price = Market Price Cost = Dividend Rate as a percentage of proceeds The Cost of Preferred Stock Formula: Rp = PREFERRED STOCK DIVIDEND PER SHARE / CURRENT PRICE OF PREFERRED STOCK Cost of Equity DEFINITION Investor POV: Cost of Equity is the rate of return an investor requires from an equity investment for it to be considered worth the risk. Entity POV: Cost of Equity is the required rate of return on a particular investment funded through equity. SIGNIFICANCE FOR COMPANIES AS WELL AS INVESTORS Cost of equity is an important financial concept that anyone running the company or an accounting professional must be aware of while dealing with the finances of the company. For Companies - Benchmark for Investment Projects: The cost of equity serves as a benchmark for evaluating the profitability of investment projects. A company should ideally undertake projects that offer a return higher than the cost of equity, ensuring that these projects add value to the shareholders. - Capital Structure Decisions: Cost of equity helps a company in making decisions about its capital structure, i.e., the mix of debt and equity used to finance its operations. A high cost of equity might lead a company to use more debt financing if it's cheaper, but this must be balanced against the risk of taking on too much debt. - Performance Indicator: It acts as a performance indicator. If a company's return on equity is lower than its cost of equity, it may indicate that the company is not generating sufficient returns for its shareholders, potentially leading to a decrease in stock value. For Investors - Investment Decision Making: For investors, the cost of equity is a crucial component in determining whether to invest in a particular stock. It helps in assessing whether the expected return on a stock compensates for the risk taken. - Valuation of Stocks: The cost of equity is used in various valuation models, like the Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) analysis, to estimate the fair value of a stock. This helps investors in making informed decisions about buying or selling stocks. - Risk Assessment: The cost of equity reflects the risk associated with a particular stock, especially through the beta component. Investors use this to gauge the stock's volatility and its correlation with market movements. FORMULA 1. CAPM (Capital Asset Pricing Model) Ke- Cost of Equity (This is the return that investors expect to earn from their investment in a particular asset (like a stock). It's not a guaranteed return but rather an estimate based on various factors, including the risk of the investment) Rf- Risk Free Rate (This is the return on capital that investors expect to receive on investment with zero risk.These are considered "risk-free" because they are backed by the government and are very unlikely to default.) Be- Beta of Equity (Beta measures the volatility or risk of asset relative to the overall market. Beta of 1 means the asset's price moves with the market. Beta greater than 1 represents that the asset is more volatile than the market Beta less than 1 means it's less volatile. ) ERP- Expected Risk Premium (This is the required premium over the risk free rate for investors to invest equity on a business or project instead of government bonds. It is calculated by subtracting the risk-free rate [Rf] from the expected market return or [Rm] ) Weighted Average Cost of Capital WEIGHTED AVERAGE COST OF CAPITAL (WACC) - It is also known as the minimum rate of return, cut-off rate, target rate, desired rate of return, standard rate, and hurdle rate. - Is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. - All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. Purpose of WEIGHTED AVERAGE COST OF CAPITAL (WACC) - To determine the cost of each part of the company’s capital structure based on the proportion of equity, debt, and preferred stock it has. Who Uses WACC? - The weighted average cost of capital is a core metric used by investment bankers, private equity analysts, investors, and corporate finance team members like accountants. How to Calculate WACC The weighted average cost of capital formula has two parts:  - The first determines how much of the company’s capital structure is equity and then multiplies that by the cost of equity. - The second part of the formula shows how much of the capital structure is debt and multiplies that proportion by the cost of debt. WACC FORMULA: - The simple WACC formula (with no taxation) is : WACC = r = 2 ( ri )( wi ) where: r = the weighted average cost of capital ri = the cost of the ith source of funds wi,= the weighting of the ith source of funds in the firm's capital structure With Tax Rate: WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)) Where: E = market value of the firm’s equity (market cap) D = market value of the firm’s debt V = total value of capital (equity plus debt) E/V = percentage of capital that is equity D/V = percentage of capital that is debt Re = cost of equity (required rate of return) Rd = cost of debt (yield to maturity on existing debt) T = tax rate Components of WACC a. Market Value of Equity (E) - is typically a company’s market capitalization or market cap. b. Market Value of Debt (D) - can be estimated using a company’s debt totals reported on recent balance sheets. c. Cost of Equity (Re) - is the minimum rate of return demanded by shareholders. d. Cost of Debt (Rd) - can also be estimated using the company’s credit rating. e. Corporate Tax Rate (Tc) - The cost of debt needs to be adjusted to reflect that interest payments are tax-deductible. Example: Let’s imagine a publicly traded company that only operates in the Philippines with a market cap (market value of equity) of $15,000,000. This company’s debt has a market value of $6,000,000. Using the capital asset pricing model, we found that the company’s cost of equity is 16.5%, and based on the yield to maturity of the company’s debt, its cost of debt is 8%. Since the company only operates in the Philippines, the corporate tax rate is a flat 25%. Margin Cost of Capital - Marginal Cost of Capital is the cost of additional funds to be raised by a firm. The Marginal Cost of Capital is the weighted average cost of new capital calculated by the marginal weight. The marginal weight represents the proportions of various sources of funds to be employed in raising additional funds. - Total combined cost of debt, equity, and preference, taking into account their respective weights in real worth of the company, where such cost shall indicate the cost of raising additional capital for the company. - If firms wants to spend a 20,000,000 to launch a new project, they need to find a way to pay for that. Two primary ways in which companies can raise capital: A. Debt B. Equity Purpose of Marginal Cost of Capital: - To analyze different financing alternatives and making informed decision. DISADVANTAGES: - It ignores the long-term implications of raising a new fund. - It does not aim to maximization of shareholder wealth, unlike the weighted average cost of capital. - The concept is overall a complex process requiring different assumptions. Such complex procedures can result in errors and complication in understanding if not handled properly. ADVANTAGES: - It aims to change the overall cost of capital by raising one more dollar of the fund. - It helps decide whether to raise further funds for business expansion or new projects by discounting the future cash flows with a new cost of capital. Since in this concept, the incremental cost of capital for each extra unit is considered, it helps in getting a more precise understanding and assessment of the cost implications. Thus, the investment selection is more specific and absolute. - Since the analysis done using this process is project or investment specific, This helps in evaluation of the particular investment to understand whether the return will be more than the cost. Formula: Marginal Cost of Capital = Cost of Capital of Source of New Capital Raised The weighted marginal cost of capital formula = It is calculated in case the new funds are raised from more than one source, and it is calculated as below: - Example: A company's present capital structure has funds from three different sources: equity capital, preference share capital, and debt. Now, the company wants to expand its current business. For that purpose, it intends to raise funds of $100,000. The company decided to raise capital by issuing equity in the market. According to the company’s present situation, it is more feasible to raise money through the issue of equity capital rather than debt or preference share capital. The cost of issuing equity is 10%. What is the marginal cost of capital? Solution: It is the cost of raising an additional fund dollar through equity, debt, etc. For example, in the present case, the company raised funds by issuing the additional equity shares in the market for a $100,000 cost of 10%, so the marginal cost of capital of raising new funds for the company will be 10%. Example 2: The company has a capital structure and the after-tax cost as given below from different sources of funds. The firm wants to raise the capital of $800,000 further as it plans to expand its project. Below are the details of the sources from which the money is raised. The after-tax cost of debt will remain the same as in the existing structure. First, calculate the marginal cost of capital of the company. WMCC = (50% * 13%) + (25% * 10%) + (25% * 8%) WMCC = 6.50% + 2.50% + 2.00% WMCC = 11%. Thus, the weighted marginal cost of the capital of raising new capital is 11%. Marginal Cost of Capital VS Weighted Average Cost of Capital - The MCC refers to the additional cost that the entity may incur if it tries to raise additional unit of capital, whereas the WACC refers to the average cost incurred for raising finance from various sources. - The MCC takes into account the changes in the cost of both debt and equity with change in the capital structure, whereas the WACC helps in evaluating the overall cost of capital. REFERENCES: Kenton, Will. June 8, 2024. Cost of Equity: Definition, Formula, and Example. Investopedia. https://www.investopedia.com/terms/c/costofequity.asp#:~:text=The%20cost%20of%20equity%20is,th e%20required%20rate%20of%20return. Sharma, Jaya. November 15, 2023. How to Calculate Cost of Equity?. Shiksha Online. https://www.shiksha.com/online-courses/articles/how-to-calculate-cost-of-equity-blogId-143867 Income tax - Bureau of Internal Revenue. Retrieved April 30, 2021, from https://www.bir.gov.ph/index.php/tax-information/income-tax.html https://www.wallstreetmojo.com/marginal-cost-of-capital/#h-solutions https://biz.libretexts.org/Courses/Pittsburg_State_University/Business_Finance_Essentials/10%3A_Mar ginal_Cost_of_Capital/10.01%3A_What_is_the_Marginal_Cost_of_Capital https://www.theforage.com/blog/skills/wacc#h-understanding-wacc https://corporatefinanceinstitute.com/resources/valuation/what-is-wacc-formula/ https://www.investopedia.com/terms/w/wacc.asp LESSON 5: FIRM’S CAPITAL STRUCTURE Definition of Capital (Robina Aquino) - Capital is anything that increases one’s ability to generate value or confer value and benefit to its owners. It’s a broad term that can be used to increase value across a wide range of categories, such as financial, social, physical, intellectual, etc. - Capital is a critical component of running a business from day to day and financing its future growth. While it can range from things like machinery and factories all the way to human capital like skills or intellectual and physical capabilities (among other things), capital is more often associated with cash that is being put to work for productive or investment purposes Definition of Capital Structure (Robina Aquino) - Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio. - It can also be defined as the particular distribution of debt and equity that makes up the finances of a company. It represents a mix of long-term sources or the relative proportion of these long-term securities a firm has used and its equity capital. - There is a so-called Optimal Capital Structure to be discussed later by Ms. Mirano. Types of Capital (Robina Aquino) - There are 4 types of capital; debt capital, equity capital, working capital, and trading capital. - DEBT CAPITAL: capital that is obtained through borrowing from either private or government sources. Small businesses may borrow from friends or family, online lenders, credit card companies, and federal loan programs. Established companies in the meantime may borrow from banks, other financial institutions, or issue bonds. - It requires regular repayment with interest often depending on the type of capital borrowed and the borrower’s credit score or credit history. - EQUITY CAPITAL: these are funds paid into a business by investors in exchange for common stock or preferred stock. These stocks allow investors to possibly have control over the business once a certain amount of shares are owned, dividends, and appreciation. - There’s also a distinction between private and public equity, wherein public equity is raised by listing the company's shares on a stock exchange while private equity is raised among a closed group of investors. - WORKING CAPITAL: A company's working capital is its liquid capital assets available for fulfilling daily obligations. It is a prime measure of the short-term liquidity of an organization. - It is calculated through the following two assessments: Current Assets – Current Liabilities OR Accounts Receivable + Inventory – Accounts Payable - These are the amount of funds necessary to cover the cost of operating the enterprise. A strongly positive working capital balance indicates robust financial strength, while negative working capital is considered an indicator of impending bankruptcy. - TRADING CAPITAL: it is the amount of money allocated to an individual or a firm to buy and sell various securities. Trading capital is a term used by brokerages and other financial institutions that place a large number of trades daily. - A difference between EQUITY capital and TRADING capital is that the former simply refers to the capital an entity receives from its investors, while the latter essentially refers to how much money one needs to make trades. Capital Structure: Why does it change over time? (Markaux Perreras) We now know that most of the firms start their business operations through Capital Structure. Over time, the firm will start to change its capital structure for many reasons, some of the reasons would relate as to the financial decisions of the firm internally or External factors which the firm might be compelled to change its Capital Structure over time. Some of the Reasons/Factors are Identified as to the changes for the firm’s Capital Structure: A. Company Growth / Expansion of Operations (Internal Factor) Early-stage companies often rely more on equity financing to make a kickstart on its operations at first. But then over time, the firm would be expanding and that they may need to approve new projects that needs funding, to maximise the growth of the company. if we think about it, how would the firm gather financial resources to expand its operations? 1. First, the firm cannot rely on using the Revenues as it has costs and expenses needed to be paid, even if there is net income, there won’t be enough as so to solely rely on its expansion. 2. Second, the firm cannot ask the shareholder to issue another shares as it would add another burden for the firm to pay higher dividends or the shareholder may not have enough resources to buy another shares from the firm they invested in, as they also rely on dividends from them. 3. Third, Even if the Firm has Investments which they could get possible funds/resources, those amounts will take much time before earning the desired amount for the expansion. The last and optimal option is to make the firm now rely on getting funds by Debt Financing or get Debt Capital. That is why, Financial Institutions such as Banks and etc. played a part in providing the Firm a debt capital or a change in the Firm’s Capital Structure. Other Benefits would be because Debts provide advantage over Tax payments, other than revenues/investments. B. Nature of Business / Industry (Internal Factor) Firms in different industries will use capital structures better suited to their type of business. Capital- intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service- oriented firms like software companies may prioritize equity. C. Management Strategy (Internal Factor) The Management of the firm plays an important role in achieving its Business goals and that they need to fulfill their obligations towards their Stakeholders. Some managers prefer a conservative approach with less debt, while others might pursue aggressive growth strategies that involve higher leverage. D. Market Condition (External Factor) Changes in interest rates, economic conditions, and investor sentiment can influence a company’s decision to adjust its capital structure. For example, low interest rates might encourage companies to issue more debt. Another Instance would be that the Market Value of the Firm’s Shares may change without the control of the management, because the market itself will determine the value of the entity’s share, an implication as to the change of the Equity Capital or the Firm’s Capital Structure. E. Changes made from Regulatory Authorities (External Factor) Changes in regulations or tax laws can impact the attractiveness of debt versus equity financing. Companies may adjust their capital structure to optimize their tax liabilities or comply with new regulations. Such Tax laws are CREATE Law (2021, COVID-19 Pandemic) lowers the tax rate to be paid by Corporations, and that would encourage them to have equity financin  F. Reorganization from the Firm There may be 2 possibilities that the Firm may be reorganized in or out of its environment. Inside Reorganization (Changes in Management / Recapitalization) This reorganization happens if the firm may be under bankruptcy and that there is a need to recapitalize its structure. Such plans must be fair and feasible. An internal reorganization calls for an evaluation of current management and operating policies. If current management is shown to be incompetent, it will probably be discharged and replaced by new management. Such inside reorganization would involve new management’s evaluation and possible redesign of the current capital structure is also necessary. If the firm is top-heavy with debt (as is normally the case), alternate securities, such as preferred or common stock, may replace part of the debt. Any restructuring must be fair to all parties involved. External Reorganization (Mergers / Acquisition) There may be instances where the firm would be acquired by another firm who has more resources and experience, which a Business Combination happens. Such Event would also make an impact or change in the Capital Structure of both Acquired Firm and Acquirer Firm. Or that another event would be both firms had decided to combine its resources and management to become as one entity, such instance is known as Merger Ideally the firm should be merged with a strong firm in its own industry, although this is not always possible. The savings and loan and banking industries have been particularly adept at merging weaker firms with stronger firms within the industry. External Assessment of Capital Structure (Jonathan Magallanes) External Assessment of Capital Structure A method used by outsiders to evaluate a company's financial health by looking at its capital structure. 1. Debt Ratio It’s calculated as (Debt ÷ (Debt + Equity) 2. Interest Coverage Ratio It’s calculated as Earnings Before Interest and Taxes (EBIT) divided by interest expenses (EBIT ÷ Interest). 3. Industry and Business Line Differences Different industries have different levels of acceptable debt.  4. Global Comparison Other companies often have higher debt ratios due to differences in financing options. 5. Leverage's Effect Financial leverage (using debt) can increase returns if used wisely. Capital Structure Theory (Nieryl Rivas) - A theory that addresses the relative importance of debt and equity in the overall financing of the firm. - CAPITAL STRUCTURE THEORY ( NIERYL RIVAS) CAPITAL STRUCTURE Capital Structure refers to the kinds of securities and proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long term loans and retained earnings. It is synonymously used as financial leverage or financing mix. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm. FINANCIAL STRUCTURE Financial Structure shows the pattern total financing, and it measures the extent to which total funds are available to finance the total assets of the business. CAPITAL STRUCTURE FINANCIAL STRUCTURE · It includes only the long-term sources of · It includes both long-term and short-term funds sources of funds · It means only the long-term liabilities of · It means the entire liabilities side of the the company balance sheet · It consists of equity, preference, and · Consists of all sources of capital retained earning capital · It will not be more important while · It is one of the major determinations of the determining the value of firm value of the firm a. Traditional Approach - The traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which any increase in leverage would result in a reduction in the value of the firm. b. F. Modigliani and M. Miller - The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to a company’s capital structure. Whether a firm is high on leverage or has a lower debt component has no bearing on its market value. Instead, the market value of a firm is solely dependent on the operating profits of the company. - Optimal Structure Theory (Kaye Mirano) - optimal capital structure is the mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic value. As we will see, the capital structure that maximizes the intrinsic value also minimizes the WACC. - A capital structure that has the best possible mix of debt, preferred stock, and common equity. The optimum mix should provide the lowest possible cost of capital to the firm Objectives of Capital Structure The decision on capital structure aims at the following two important objectives: 1. Maximize the value of the firm. 2. Minimize the overall cost of capital. Factors determining the Optimal Capital Structure The following factors are considered while deciding the capital structure of the firm. 1. Leverage - It is the basic and important factor, which affects the capital structure. It uses fixed – cost financing such as debt, equity, and preference share capital. It is closely related to the overall cost of capital. 2. Cost of Capital - The cost of capital constitutes the major part of deciding the capital structure of a firm. Normally long- term finance such as equity and debt consists of fixed cost while mobilization. When the cost of capital increases, the value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital. (a) Nature of the business: The use of fixed interest/dividend-bearing finance depends upon the nature of the business. If the business consists of the long period of operation, it will apply for equity rather than debt, and it will reduce the cost of capital. (b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to a large scale, it can manage the financial requirements with the help of internal sources. But if it is a small size, they will go for external finance. It consists of a high cost of capital. (c) Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. (d) Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.  3. Government policy - Promoter contribution is fixed by Company Act. It restricts to mobilize large, long term funds from external sources. Hence the company must consider government policy regarding the capital structure. EBIT-EPS Approach to Capital Structure (Markaux Perreras) Previously we have discussed the 2 theories in Capital Structure, and the concept of having an Optimal Capital Structure, which outline how the Firm may possibly build its Capital Structure. Now I would introduce an approach which a manager can use this in assessing on whether how he would balance the Debt and Equity mix of the Capital Structure. We have the approach called the EBIT-EPS Structure - The EBIT-EPS approach to capital structure is a tool businesses use to determine the best ratio of debt and equity that should be used to finance the business' assets and operations. - At its core, the EBIT-EPS approach is a way to mathematically project how a balance sheet's structure will impact a company's earnings The EBIT-EPS capital structure approach focuses on finding a capital structure with the highest EPS (earnings per share) over the expected range of EBIT (earnings before interest and taxes). The basic concept of the EBIT-EPS approach To understand how the EBIT-EPS method works, first we must understand the two primary metrics involved, EBIT and EPS. EBIT refers to a company's earnings before interest and taxes. This metric strips out the impact of interest and taxes, showing an investor or manager how a company is performing excluding the impacts of the balance sheet's composition. In terms of EBIT, it doesn't matter if a company is overloaded with debt or has no loans at all. EBIT will be the same either way. EPS stands for earnings per share, which is the profit the company generates including the impact of interest and tax obligations. EPS is particularly helpful to investors because it measures profits on a per share basis. If a company's total profit is soaring but its profit per share is declining, that's a bad thing for the investor owning a fixed number of shares. EPS captures this dynamic in a simple, easy to understand way. The EBIT-EPS analysis is an important tool in the hands of the financial manager to get an insight into the firm’s capital structure management. He can consider the possible fluctuations in the EBIT and examine their impact on EPS under different financial plans. If the probability of earning a rate of return on the firm’s assets less than the cost of debt is insignificant, a large amount of debt can be used by the firm to increase the earnings per share. The ratio between these two metrics can show investors and management how the bottom line results, the company's EPS, relates to its performance independent of its capital structure, its EBIT. For example, let's say a company wants to maintain stable EPS but is considering taking out a new loan to grow its balance sheet. In order for EPS to remain stable, the company's EBIT must also increase at least as much as the new interest expense from the debt. If EBIT increases the same as the next interest expense, then EPS should remain stable, assuming no change in taxes. Considering Risk in EBIT-EPS Analysis (Faye Tiu) - In Earnings Before Interest and Taxes – Earning Per Share or EBIT-EPS they don’t consider their risk factors,but let’s first recall the meaning of earning per share. According to PAS 33, it is a form of profitability ratio which provides a measure of how much profit or loss each ordinary share has earned during the period. - EBIT-EPS analysis’ priority is to maximize the earning per share, which ignores a lot of factors and risks, which will be beneficial to the company for a short period of time, but will be disadvantageous in the long run. - Ignoring economic factors like interest rates, a crucial factor where investors base their decisions whether to invest or not. Furthermore, interest rates fluctuate constantly which makes it more riskier and unstable, resulting in lower revenues and earnings which will be reflected in a lower stock price. - EBIT-EPS also doesn’t address the risk of overcapitalization, high equity doesn’t signify that an entity is generating revenue, it only makes the company look more valuable than what it is perceived to be. In effect, the company can only apply for high interest loans. Basic Shortcoming of EBIT-EPS Analysis (Markaux Timothy Perreras) - As Ms. Tiu discussed, The fact that this approach fails to explicitly consider risk involved is the major shortcoming of this method. As firm obtains more debt (its financial leverage increases), the risk also increases and shareholders will require higher returns to compensate for the increased financial risk. Therefore, this approach is not completely appropriate because it does not consider one of the key variables (risk), which is necessary for maximization of shareholders’ wealth. DRAWBACKS (Inherent Limitations) - there is also limitation in using this method which: The EBIT-EPS approach is not always the best tool for making decisions about capital structuring. The EBIT-EPS approach places heavy emphasis on maximizing earnings per share rather than controlling costs and limiting risk. It's important to keep in mind that as debt financing increases, investors should expect a higher return to account for the greater risk; this is known as a risk premium. The EBIT-EPS approach does not factor this risk premium into the cost of financing, which can have the effect of making a higher level of debt seem more advantageous for investors than it actually is. Limitations: (i) No Consideration for Risk Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business the reverse of this situation arises-which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis. (ii) Contradictory Results It gives a contradictory result where under different alternative financing plans new equity shares are not taken into consideration. Even the comparison becomes difficult if the number of alternatives increase and sometimes it also gives erroneous result under such situation. (iii) Over-capitalization This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point, additional capital cannot be employed to produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis. Optimal Capital Structure - Optimal Capital Structure is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital and minimizing the Weighted Average Cost of Capital is one way to optimize the lowest cost mix of financing - Lower Cost of Capital -> Higher Firm Valuation - Higher Cost of Capital -> Lower Firm Valuation What Determines the OCS? - To determine the company’s optimal capital structure, the companies needs to take into account the factors such as WACC of capital, risk and expected return, business risk, industry averages, the potential cost of financial distress, company’s tax status, and application of financial models for this purpose - Corporate Lifecycle - The capital structure of a company tends to shift toward a greater proportion of debt as opposed to equity in the latter stages of its lifecycle. - Tax-Deductibility of Interest - Given the tax-deductibility of interest expense – where interest reduces the pre-tax income (EBT) line item on the income statement – an increase in leverage causes the firm valuation to initially rise. - Business Risk - It is the risk inherent to the operating performance of a firm, assuming no debt. - Bankruptcy Risk - is the likelihood that a company will be unable to meet its debt obligations. It is the probability of a firm becoming insolvent due to its inability to service its debt. - Agency Costs - Are the risk of discrepancies forming between management and stakeholders, which is often termed the principal-agent problem, where differences in viewpoints can cause the company to incur steep losses (and a reduction in valuation). - Lender Risk-Appetite (Tolerance) - The aggregate level and types of risk a financial institution is willing to assume within its risk capacity to achieve its strategic objectives and business plan.