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Managing Financial Issues Part Six Chapter Fifteen Money, Banking and Securities Markets Learning Objectives Define money and identify the different forms it takes in the nation’s money supply.

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slide1

Managing Financial Issues

Part Six

Chapter Fifteen

Money, Banking and Securities Markets

learning objectives
Learning Objectives
  • Define money and identify the different forms it takes in the nation’s money supply.
  • Describe the different kinds of financial institutions that make up the Canadian financial system an explain the services they offer.
  • Explain the functions of the Bank of Canada and describe the tools it uses to control the money supply.
  • Discuss the value of common stock and preferred stock to shareholders and describe the secondary market for each type of security.
  • Describe the investment opportunities offered by mutual funds and commodities.
  • Explain the process by which securities are bought and sold and regulated

© 2003 Pearson Education Canada Inc.

money
Money
  • any object generally accepted by people as payment for goods and services
  • portable: lightweight and easy to handle
  • divisible: easily broken down to match the value of goods
  • durable: must not spoil or easily wear out
  • stable: must be stable enough to hold its value over time apart from minor fluctuations

© 2003 Pearson Education Canada Inc.

functions of money
Functions of Money
  • medium of exchange: a single medium of exchange for goods and services instead of barter
  • store of value: stores value and can be used for future purchases
  • unit of account: allows measurement of the relative value of goods and services

© 2003 Pearson Education Canada Inc.

the money supply
The Money Supply
  • buyers and sellers must agree of the value of money
  • the value of money is dependent on its supply
    • as supply increases, value decreases
    • as supply decreases, value increase
  • consists of both M-1 and M-2 forms of money

© 2003 Pearson Education Canada Inc.

m 1 m 2 money suppl ies
M-1 & M-2 Money Supplies
  • M-1: the most liquid forms of money
    • currency: paper money and coins issued by the Canadian government
    • demand deposits: money in chequeing accounts which can be transferred to others by cheque
  • The above plus:
    • savings deposits: savings account holdings
    • time deposits: deposit requiring prior notice before withdrawal of funds
    • money market mutual fund investments: funds operated by investment companies that pool together the money from many investors
  • measures the store of monetary value which is available for making financial transactions

© 2003 Pearson Education Canada Inc.

credit cards

$

Credit Cards
  • not included in M-1 or M-2 Money Supplies
  • major source of consumer spending
  • are a substitute for money, but they are not money
  • are privately issued and very profitable due to annual fees (not all) and 2-5% of total revenues remitted from accepting merchants

© 2003 Pearson Education Canada Inc.

financial intermediaries
Financial Intermediaries
  • traditionally consisted of four financial pillars:
    • chartered banks
    • alternate banks (trust companies, credit unions, caisses populaires)
    • life insurance companies and specialized lending and saving intermediaries
    • investment dealers
  • changes due to deregulation of the banking industry

© 2003 Pearson Education Canada Inc.

pillar 1 chartered banks
Pillar #1: Chartered Banks
  • a privately owned, profit-oriented, financial intermediary
  • largest and most important of financial institutions
  • each bank has many branches
  • Schedule A Banks: must be Canadian-owned with no more than 10% of voting shares with controlled by a single interest (90% of all bank assets)
  • Schedule B Banks: may be foreign-owned and need not meet the 10% limit (foreign-owned bank deposits cannot exceed 8% of the total domestic assets of all banks)

© 2003 Pearson Education Canada Inc.

services offered by banks
pension services (retirement savings)

trust services (estate management and funds management)

international services (currency exchange, letters of credit)

financial advice

buy/sell securities

electronic technologies (ATM machines, funds transfer, debit card, telephone and Internet banking, smart card, e-cash transferred through digital electronic signals)

bank deposits

bank loans

bank accounts

Services Offered by Banks

© 2003 Pearson Education Canada Inc.

bank deposits
Bank Deposits
  • accept deposits from some customers to obtain money to lend to others, including:
    • chequing accounts (chequable deposits)
    • term deposits (money that remains with the bank for a period of time with interest paid to the depositor)

© 2003 Pearson Education Canada Inc.

bank loans
Bank Loans
  • major source of short-term financing for business
  • banks prefer to finance inventories or accounts receivable rather than provide long-term loans to many businesses
  • secured loan: backed by collateral (eg: inventory)
  • unsecured loan: not backed by property
  • prime rate of interest: lowest rate charged to borrowers (enjoyed by some large firms with excellent credit ratings)

© 2003 Pearson Education Canada Inc.

banks as creators of money
Banks as Creators of Money

© 2003 Pearson Education Canada Inc.

changes to the banking industry
Changes to the Banking Industry
  • U.S.-based banks may compete in the Canadian market
  • banks may own securities dealers
  • banks may own insurance companies and sell commercial paper
  • banks may create mutual fund subsidiaries
  • trust companies have been taken over by banks or have been reduced in their importance

© 2003 Pearson Education Canada Inc.

the bank of canada
The Bank of Canada
  • the central bank of Canada
  • managed by a Board of Governors
  • regulates operations of the chartered banks
  • manages the economy by expanding or restricting the economy by manipulating the money supply

© 2003 Pearson Education Canada Inc.

monetary policy actions of the bank of canada
Monetary Policy Actions of the Bank of Canada

© 2003 Pearson Education Canada Inc.

pillar 2 alternate banks
Pillar #2: Alternate Banks
  • trust companies
    • safeguard funds and estates entrusted to it
    • serves as a trustee, transfer agent and registrar for corporations
  • credit unions (caisses populaires)
    • cooperative savings and lending institution formed by a group of individuals with common interests
    • offer savings accounts, loans, mortgages to members
    • also invest its own funds in corporate and government securities

© 2003 Pearson Education Canada Inc.

pillar 3 specialized lending and savings intermediaries
Pillar #3: Specialized Lending and Savings Intermediaries
  • life insurance firms
  • financial corporations
  • venture capital or development firms
  • pension funds

© 2003 Pearson Education Canada Inc.

life insurance firms
Life Insurance Firms
  • life insurance companies: a mutual or stock company that shares risks with its policy holders for payment of premiums
  • some money from premiums is lent back out
  • substantial investors in real estate, mortgages and government bonds
  • largest financial intermediaries in Canada next to the chartered banks

© 2003 Pearson Education Canada Inc.

financial corporations
Financial Corporations
  • sales finance company:
    • finances installment purchases made by individuals or businesses
    • loans are secured by the item being financed (eg: computer)
  • consumer finance company:
    • makes personal loans to consumers
    • collateral may or may not be required

© 2003 Pearson Education Canada Inc.

venture capital or development firms
Venture Capital or Development Firms
  • provides funds for new or expanding firms that it believes have great potential
  • charges higher than normal interest rates due to increased risk of the ventures being funded
  • obtains funds from individual investors, financial intermediaries, retained earnings

© 2003 Pearson Education Canada Inc.

pension funds
Pension Funds
  • accumulate cash that will be paid out to subscribers in the future in the form of pension income
  • money is invested until it is needed
  • investments include stocks and bonds, mortgages

© 2003 Pearson Education Canada Inc.

pillar 4 investment dealers
Pillar #4: Investment Dealers
  • stock brokers or underwriters
  • distribute new stock and bond issues (underwriting)
  • facilitate trading of stock and bond on exchanges (brokerage)

© 2003 Pearson Education Canada Inc.

exchange rates and international trade
Exchange Rates and International Trade
  • exchange rates influence the willingness of Canadians to invest abroad and buy imported items (or vica versa)
  • a trade surplus occurs when Canada is exporting more products than it is importing (more likely to occur when the Canadian dollar is undervalued)
  • a trade deficit occurs when Canada is importing more products than it is exporting (more likely to occur when the Canadian dollar is overvalued)

© 2003 Pearson Education Canada Inc.

securities
Securities
  • stocks and bonds, which represent a secured-asset claim on the part of investors, which can be bought and sold
  • primary securities market: sale and purchase of newly issued stocks or bonds offered by firms and governments
  • secondary securities market: sale and purchase of previously issued stocks and bonds
  • investment banker: financial specialists who issue new securities

© 2003 Pearson Education Canada Inc.

characteristics of common stocks
Characteristics of Common Stocks
  • market value: the current price of one share of a stock in the secondary securities market (the real value of the stock)
  • capital gains: profits from the sale of an asset (including stocks) for a higher price than what if was purchased for
  • book value: shareholders’ equity divided by the number of shares of common stock outstanding (of limited usefulness in evaluating investments)
  • par value: the value of a stock set arbitrarily by the issuing company

© 2003 Pearson Education Canada Inc.

preferred stock
Preferred Stock
  • issued with a stated par value
  • dividends paid based on a percentage of a par value
  • may be callable:
    • investors required to sell their shares as called for a call price as determined by an agreement between the shareholders and the firm

© 2003 Pearson Education Canada Inc.

stock exchanges
Stock Exchanges
  • voluntary organization of individuals formed to provide an institutional setting where members can buy and sell stock for themselves and their clients in accordance with the rules of the exchange
  • to become a member a firm must purchase seats (memberships)
  • only members (or their representatives) are allowed to trade on the exchange
  • all trading must go through members of the exchange

© 2003 Pearson Education Canada Inc.

brokers
Brokers
  • individuals licensed to buy and sell securities for customers in the secondary market (those who are not members of the exchange)
  • are paid a commission for placing the order
  • may also provide other financial services
  • individuals may bypass brokers and buy and sell stocks over the Internet

© 2003 Pearson Education Canada Inc.

bonds
Bonds
  • firms and governments “borrow” money from investors by selling bonds
  • bond is a written promise that the borrower (firm) will pay the lender (investor) at a stated future date, the principal plus a stated rate of interest
  • bonds differ from one another in terms of maturity (payment date), tax status, potential yield (interest rate)
  • several services rate the quality of various bonds

© 2003 Pearson Education Canada Inc.

government bonds
Government Bonds
  • issued by governments (federal, provincial, local)
  • backed by government (eg: Canada Savings Bonds)
  • municipal bonds may be used to raise money for schools, etc.

© 2003 Pearson Education Canada Inc.

corporate bonds
Corporate Bonds
  • secured: assets are pledged as security for the bond-if interest cannot be paid the assets can be sold
  • unsecured: also known as “debentures”, these bonds are not backed by any security (debentures are only sold by financially strong corporations simply because investors would not buy a debenture from a financially weak firm)
  • bearer (coupon) bonds: bond holders must clip coupons from the bond and submit them to receive interest payments - anyone with the coupon may redeem it

© 2003 Pearson Education Canada Inc.

mutual funds
Mutual Funds
  • a company pools the resources of many investors and uses funds to purchase various types of financial securities (a portfolio)
  • different funds have different goals (stability, growth, etc.) and different levels of risk
  • no-load fund: investors are not charged a sales commission when they buy into or sell out of a fund (as they would be with a “load fund”)
  • allow small investors to have access to professionally managed investments

© 2003 Pearson Education Canada Inc.

commodities
Commodities
  • futures contract: an agreement to purchase specific amounts of a commodity at a certain price on a set date in the future
  • commodities market: a market in which futures contracts are traded
  • many things can affect the future value of a commodity making buying futures a very risk investment
  • investors need not pay the full amount of the contract on purchase, but may buy on “margin”, with a minimal amount as a down payment

© 2003 Pearson Education Canada Inc.

reading stock quotations
Reading Stock Quotations

Sales

(Total number of

shares traded)

Close

(Last price paid

at close of trading)

Stock

High

(Highest price paid

per share for the day

was $29.15)

Change

(Difference between

today’s price and

previous day’s. A

.40 decrease)

Low

(Lowest price paid

per share for the day

was $28.50)

© 2003 Pearson Education Canada Inc.

reading bond quotations
Reading Bond Quotations

Maturity Date

(April 8, 2022)

Coupon

(interest rate %)

Company Name

Change

(Closing

price up

$1.11 from

previous day)

Price

(Last transaction

price = $138.50)

Yield

(Annual interest

Market price)

© 2003 Pearson Education Canada Inc.

reading the market
Reading the Market
  • market indexes summarize trends in the stock market and specific industries: Dow Jones Industrial Average, Standard & Poor’s Composite Index, NYSE Index, TSE 300, NASDAQ Composite Index
  • bear market: a period of falling stock prices where investors the premise that the stock price will continue to fall
  • bull market: a period of rising stock prices where investors will buy on the premise that the stock price will continue rise

© 2003 Pearson Education Canada Inc.

placing an order
Placing an Order
  • market order: an order to a broker to buy or sell a security at the current market price
  • limit order: an order to buy a certain security but only if its price is less than, or equal, a certain level
  • stop order: order to sell a certain security if its price falls to a certain level or below
  • round lot: the purchase or sale of shares in unit of 100
  • odd lot: the purchase or sale of shares in units of other than 100

© 2003 Pearson Education Canada Inc.

margin trading
Margin Trading
  • an investor makes a downpayment of a portion of the price at placement of the order with the rest financed by the broker
  • the broker borrows the amount from the bank , secured by stock
  • the broker charges the investor a higher rate of interest than he/she pays the bank
  • investors can pay off the financing when they sell the stock, hopefully at a profit
  • everybody wins

© 2003 Pearson Education Canada Inc.

short sale
Short Sale
  • an investor sells shares from the broker without paying for them
  • the investor is “borrowing” the shares from the broker for a period of time
  • in order to return the borrowed shares, the investor must purchase the equal number of shares later and return them to the broker
  • the investor earns money if he/she can buy the shares to return to the broker for a lower price than the broker sold them for (their profit is in the spread between the selling price and the purchasing price)

© 2003 Pearson Education Canada Inc.

slide41

Managing Financial Issues

Part Six

Chapter Sixteen

Financial Decisions and Risk Management

learning objectives42
Describe the responsibilities of a financial manager.

Identify four sources of short-term financing for businesses.

Explain the distinction between insurable and non-insurable risks

Distinguish among the different types of business insurance

Distinguish between the various sources of long-term financing and explain the risks entailed by each type.

Explain how risk affects business operations and identify the five steps in the risk-management process.

Learning Objectives

© 2003 Pearson Education Canada Inc.

finance
Finance
  • business function involving decision-making about:
    • long-term investments and obtaining the funds to pay for them
    • conducting daily financial activities
    • managing the risks taken by the firm

© 2003 Pearson Education Canada Inc.

financial managers
Financial Managers
  • are responsible for planning and overseeing the financial resources of a firm including:
    • cash flow management
    • financial control
    • financial planning

© 2003 Pearson Education Canada Inc.

cash flow management
Cash Flow Management
  • managing the pattern of cash inflows (revenues) and outflows (debt payments)
  • investing the funds that are not needed to service the debt
  • all funds must be either committed to maintaining the firm, or earning interest, not sitting idle

© 2003 Pearson Education Canada Inc.

financial control
Financial Control
  • checking actual performance against strategic plans to make sure that the desired financial status is achieved
  • making adjustments as required to achieve goals as plans change, or do not work as intended
  • preparing budgets to insure that sufficient cash is on hand to meet operational and debt service requirements
  • actual results which vary from the budget need explanation and adjustment

© 2003 Pearson Education Canada Inc.

financial planning
Financial Planning
  • a plan for achieving a desired financial status in the future
  • projections of revenue flows
  • sources and planned uses of funds
  • timing of when funds will be required

© 2003 Pearson Education Canada Inc.

managing short term operating expenses
Managing Short-Term (Operating) Expenses
  • accounts payable: main source of short-term debt
  • accounts receivable: estimation of cash inflow and development of a credit policy to insure timely payment
  • inventory: goods awaiting sale for future revenue
    • raw materials (unassembled product)
    • work-in-progress (goods being manufactured)
    • finished goods (goods completed and awaiting sale)

© 2003 Pearson Education Canada Inc.

managing long term expenditures
Managing Long-Term Expenditures
  • funding assets such as buildings which have a long life and a lasting value
  • not normally sold or converted to cash
  • acquisition requires a large investment which will tie up the firm’s resources for a very long period of time
  • unique characteristics make financing challenging

© 2003 Pearson Education Canada Inc.

short term sources of funds
Short-Term Sources of Funds
  • allows firms to cover operational expenses and implement short-term plans, includes:
    • trade credit
    • secured and unsecured short-term loans
    • pledging accounts receivable
    • factoring account receivable

© 2003 Pearson Education Canada Inc.

trade credit
Trade Credit
  • firms may buy supplies on credit, usually 30 days:
  • open book credit: sellers simply ship goods which the firm buys on its credit account, expecting that payment will follow as per the nature of the account
  • promissory note: buyers sign promise-to-pay agreements before merchandise is accepted, stipulating how much will be paid and when
  • trade draft: buyers sign a statement of payment terms attached to merchandise by the seller (once signed it is called a “trade acceptance”)

© 2003 Pearson Education Canada Inc.

secured short term loans
Secured Short-Term Loans
  • a short-term loan for which the borrower is required to put up collateral (security) such as an asset, inventory or accounts receivable
  • if the borrower defaults the collateral is seized
  • administrative burden of processing such loans is costly and cumbersome
  • interest rates are usually lower than for unsecured loans
  • appeal to firms whose credit rating is not sufficient (or who are too new) to qualify for unsecured loans

© 2003 Pearson Education Canada Inc.

unsecured short term loans
Unsecured Short-Term Loans
  • a short-term loan in which the borrower is not required to put up collateral
    • lines of credit
    • revolving credit agreements
    • commercial paper

© 2003 Pearson Education Canada Inc.

lines of credit
Lines of Credit
  • a standing agreement between a bank and a firm in which the bank specifies the maximum amount it will make available to the borrower for a short-term unsecured loan
  • the borrower draws on funds as they are needed
  • banks are the usual lenders
  • the banks do not agree that the funds will always be available as needed

© 2003 Pearson Education Canada Inc.

revolving credit agreements
Revolving Credit Agreements
  • a guaranteed line of credit for which the firm pays the bank interest on borrowed funds, as well as a fee for extending the line of credit
  • the banks guarantee availability of the funds as they are needed by the firm
  • the firm does not have to borrow funds if it doesn’t need them
  • the bank charges a “commitment fee” for keeping the line of credit open for the firm

© 2003 Pearson Education Canada Inc.

commercial paper
Commercial Paper
  • a firm sells unsecured notes for less than their face value, then repurchases them in 30 to 270 days for the face value
  • investors make money on the spread between the face value of the investment and what they actually paid for it
  • since commercial paper is an unsecured note, only creditworthy firms are able to sell them successfully
  • the cost of commercial paper to the borrowing firm is usually less than prevailing interest rates

© 2003 Pearson Education Canada Inc.

factoring accounts receivable
Factoring Accounts Receivable
  • firms can raise money quickly by selling their accounts receivable to a factor
  • the factor pays only a portion of the value of the accounts receivable an attempts to collect them to obtain a return on their investment
  • often, the receivables factored may be old and not creditworthy, in which case the firm would only receive a small percentage of the total value of the receivables

© 2003 Pearson Education Canada Inc.

sources of long term funds
Sources of Long-Term Funds
  • long-term financing is needed to cover long-term uses of cash (buildings, equipment, etc.)
  • firms may:
    • seek long-term funds through borrowing from outside (debt financing)
    • seek long-term finds through internal financing (equity financing)

© 2003 Pearson Education Canada Inc.

debt financing
Debt Financing
  • long-term loans: borrowing money for 3 to 10 years at a fixed or floating interest rate
    • loans are quick to process and do not require divulging business plans or the purpose for the loan
  • corporate bonds: a promise by the issuing company (the borrower) to pay the holder (the lender) a certain amount of money on a specified date (maturity date), with interest payments in the interim
    • assets may be pledged against the bond

© 2003 Pearson Education Canada Inc.

equity financing
Equity Financing
  • common stock: a firm sells ownership in its firm by issuing shares of common stock, and investors buy the stock hoping that it will go up in price as the firm prospers
  • retained earnings: financing through money kept in the firm and not paid out in dividend to shareholders (may result in lower share prices due to lower dividends making the stock less attractive to investors)

© 2003 Pearson Education Canada Inc.

hybrid financing preferred stock
Hybrid Financing: Preferred Stock
  • preferred shares require fixed payments as do bonds
  • unlike bonds, preferred shares do not have a maturity date
  • the shareholders receive a dividend if the firm can afford it
  • if the firm cannot afford it, preferred shareholders get paid first when dividends become available
  • preferred shareholders have no voting rights so the control of the firm is not affected

© 2003 Pearson Education Canada Inc.

debt vs equity financing
Debt vs. Equity Financing
  • the mixture of debt and equity which makes the financial base of the firm to meet its need for long-term funds and maximize shareholders’ wealth
  • contain targets for each (eg: 40% debt, 60% equity) to strike a balance
  • choosing the right target requires careful consideration of risk and expenses
  • more equity: no debt obligations but expensive
  • more debt: less expensive but higher risk

© 2003 Pearson Education Canada Inc.

comparing debt equity financing
Comparing Debt & Equity Financing
  • When must it be repaid?
  • Will it make claims on income?
  • Will it have claims on assets?
  • Will it affect management control?
  • How are taxes affected?
  • Will it affect management flexibility?

© 2003 Pearson Education Canada Inc.

the risk return relationship
The Risk-Return Relationship

Shows the amount of risk and the likely rate of return on various financial instruments

© 2003 Pearson Education Canada Inc.

risk management
Risk Management
  • conserving a firm’s financial power or assets by minimizing the financial effect of accidental losses
  • risk: uncertainty about future events
  • speculative risk: the chance for gain or loss
  • pure risk: only the chance of loss

© 2003 Pearson Education Canada Inc.

the risk management process
The Risk-Management Process

© 2003 Pearson Education Canada Inc.

risk avoidance and control
Risk Avoidance and Control
  • risk avoidance: refusing to participate in risky ventures
  • risk control: techniques to prevent losses, or minimize their impact
  • risk retention: covering a firm’s unavoidable losses with it own risk transfer: transferring risk to another party by contract

© 2003 Pearson Education Canada Inc.