MANAGEMENT OF CASH
April 27, 2010
Cash is a non-earning asset. Excessive cash balances reduce the rate of return on equity and the value of a firm’s stock. The goal of cash-management is to minimize the amount of cash a firm must hold in order to conduct its normal business activities yet at the same time to have sufficient cash to:
· Take trade decisions
· Maintain its credit rating
· Meet unexpected cash needs
Firms hold cash for the following reasons:
- Transaction balances are held to provide the cash needed to conduct normal business operations – to make purchases and other payments. For transaction purposes, a firm may invest in short-term marketable securities.
- Speculative balances to enable the firm take advantage of favorable business opportunities eg. Bargain purchases, trade discounts, attractive interest rates and in international trade, favorable exchange rate fluctuations. It can also be for investment purposes. However, most firms do not engage in speculations especially if they can borrow easily and they can also use marketable securities to satisfy their speculative needs.
- Precautionary balances to meet future contingencies or emergencies. It is considered as a safety margin to act as a financial reserve. This may be in cash or in highly-liquid and low-risk marketable securities.
- Compensating balances to offset the banking costs incurred through the provision of banking services such as check clearing. Banks usually require companies to maintain some deposit in low-interest or non-interest bearing accounts to cater for the services they render to these companies.
When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The opportunity cost is the interest income that could have been earned in the next best use of that cash e.g. investment in marketable securities.
Cash planning is a technique used to plan and control the use of cash. It helps to anticipate future cash flows and the needs of the firm and reduces the possibility of idle cash balances and cash deficits. It protects the financial condition of the firm by developing a projected cash statement from a forecast of expected cash inflows and out flows for a period.
Cash should be well managed to ensure that the firm has sufficient cash levels at all times to facilitate the smooth flow of its operations. In order to balance the cash inflows and outflows, a firm should follow the following strategies:
1. Prepare a periodic Cash Plan. This will be in the form of a cash budget which will forecast the expected receipts and expenditures of a firm for a period of time and can be used to indicate periods when the firm will have cash deficits or surpluses.
2. Invest Surplus Cash. If the firm has surplus cash during a particular period, it should be invested in short-term investments like bonds and shares so as to earn a return and act as a reserve of cash in times of emergencies.
3. Manage Cash-Flows. There should be proper control of cash receipts and payments so as to ensure the firm doesn’t default on its obligations when they fall due.
4. Maintain Optimum Cash Balances. This is the ideal level of cash-balance a firm should maintain at all times- just enough to facilitate the smooth flow of the company’s operations. The cost of excess cash and the danger of cash deficiency should be matched to determine the optimum level of cash balances.
This is a summary statement of a firm’s expected cash receipts and payments over a specific period of time. A cash budget projects cash inflows and outflows over some specified period of time. The basis is mostly the sales forecast and the level of assets that will be required to meet those forecasts. A cash budget can be created for any interval but firms typically use a monthly cash budget for the coming year, mostly for planning purposes and a daily or weekly budget for actual cash control.
A typical cash budget consists of three sections:
1. Sales and Expenses worksheet that summarizes the firm’s sales income and expenses incurred in purchasing materials
2. Cash Gain or Loss section that indicates the cash inflows and outflows with the ‘bottom line’ indicating either a gain or loss
3. Cash surplus or Loan requirement (Net Cash Balances) section that summarizes the firm’s surplus cash held or total loans needed.
This will be estimated by deducting total expenses for a given period e.g. a month from the total cash receipts for that period. The result will either indicate a surplus or deficit.
-In case of surplus, it can be invested in bonds, equities or in savings accounts
- In case of a deficit, it can be bridged by:
a) Borrowing short-term funds e.g. through overdrafts.
b) Delaying capital expenditures until the firm’s cash position improves.
c) Requesting suppliers for a longer credit period.
d) Delay payment of taxes.
e) Postpone payment of dividends.
NB: - Since the cash budget represents a forecast, all the values shown are expected values.
– If the firm’s inflows and outflows are not uniform over the budget interval, the cash budget for that period will overestimate or underestimate the firm’s cash needs.
– A cash budget can be used to help set the firm’s target cash balance i.e. the desired cash balance that a firm plans to maintain in order to conduct business. The target balance can be adjusted over time depending on the size of the firm’s operations during various business cycles
– Even though depreciation amounts do not appear directly in the budget, they still affect the amount of taxes shown
1. Helps determine future cash flows thus enabling the company to plan for its financing.
2. Helps management know when to borrow and how much to borrow.
3. Helps in determining when there will be a cash surplus so management can plan for its use i.e. whether to pay dividends or invest in short-term securities.
4. Helps management to control expenditure based on the forecasted income and expenditure.
5. Assists management in planning for its obligations and knowing when and how to meet those obligations.
6. Strengthens the liquidity position of a company since it helps a company know its accurate cash position and what measures to take depending on its position.
Disadvantages of Cash Budgeting
1. Uncertainty – It assumes that everything remains constant while in reality, anything can actually happen.
2. Forecasting budgets isn’t always accurate since one can predict expenses but can’t accurately predict income / sales
3. Requires highly skilled personnel to forecast and prepare a cash budget
4. If there is any deviation from the fixed budget, a new budget has to be designed again.
A primary responsibility of a financial manager is to maintain a sound liquidity position of the
firm so that payments are settled in time. The amount of cash balances to be maintained depends
on the risk-return trade-off.
1. If a firm maintains small cash balances, its liquidity position weakens but its profitability
improves because the funds are invested in other profitable opportunities e.g. marketable
securities. When the firm needs cash, it can sell its marketable securities or borrow.
2. If on the other hand, a firm keeps high cash balances, it will have a strong liquidity position
but its profitability will be low. The potential profit foregone by holding large cash balances
is an opportunity cost to the firm. A firm should therefore maintain optimum cash balances
– not too much and not too little.
The firm’s cash management system should strive to achieve two prime objectives:
1) Enough cash must be on hand to dispense effectively any disbursements that arise in the course of business.
2) The firm’s investment in idle cash balances must be reduced to a minimum.
Effective cash management encompasses proper management of cash inflows and outflows which entails:
a) Synchronizing cash flows – cash inflows coinciding with cash outflows – so as to reduce cash
balances, decrease bank loans, lower interest expenses and increase profits.
b) Using float which is the difference between the firm’s cashbook balances and bank cash
balances. Float management involves controlling the collection and disbursement of cash. The objective in cash collection is to speed up collections and reduce the lag between the time customers pay their bills and the time cash becomes available. The objective in cash disbursement is to control payments and minimize the firm’s costs associated with making payments. Net float is the difference between the balance shown in the firm’s cash book and the balance on the bank’s records. Float reduction can result in considerable benefits in terms of 1) usable funds being released for company use and 2) in the returns produced on these freed funds.
Reasons for a lengthy float.
- Transmission delay due to payments made through the post.
- Delay in banking the payments received.
- Clearance delay – the time needed for a bank to clear a check.
To determine the optimum cash balance, we can use two models:
1. Baumol model – for optimum cash balances under certainty
2. Miller-Orr model – for optimum cash balances under uncertainty.
This model provides a formal approach for determining a firm’s optimum cash balance under certainty.
The method considers cash management to be similar to inventory management. The firm attempts
to minimize the sum of its cost of holding cash and the cost of converting marketable securities
to cash. The model makes the following assumptions:
· The firm is able to forecast its cash needs with certainty.
· The firm’s cash payments occur uniformly over a period of time.
· The opportunity cost of holding cash is known and it does not change over time.
· The firm will incur the same transaction cost whenever it converts securities to cash.
The formula for the optimum cash balance is:
C* = √2cT/k where: C*= optimum cash balance
c = cost per transaction, i.e. cost of replenishing cash
T = total cash needed during the year for transaction purposes
k = opportunity cost of holding cash balance. This is the interest rate on marketable securities.
The optimum cash balance will increase with increase in the per transaction cost and total cash required and decrease with opportunity cost.
CAPITAL BUDGETING
April 27, 2010
Any prudent financial manager will be concerned as to how efficiently he can allocate funds at his disposal to various ventures available in the investments market. To a company, investment should be a continuous process if it is to survive in the future. It is important because it affects:
1. The size of the company
2. The risk of the finance invested
3. The company’s growth prospects.
A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period
of time in the future. An operating expenditure is an outlay of funds resulting in benefits received within one year. Fixed assets outlays are capital expenditures although not all capital expenditures are classified as fixed assets. The basic motives for capital expenditures are:
§ To obtain some other less tangible benefit over a long period e.g. R & D, management consulting and advertising
Capital expenditure decisions refer to all investment decisions in a firm and require careful planning of the company’s funds. This is referred to as capital budgeting.
Capital budgeting is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year. Capital budgeting decisions generally refer to either replacement decisions or expansion decisions. Replacement decisions involve the purchase of capital assets to take the place of existing assets to maintain or improve existing operations. Expansion decisions involve the purchase of capital projects and adding them to existing assets to increase existing operations. The investment decisions call for budgeting of all investible finances in areas such as:
i) Purchase of new assets
ii) Research and development
iii) Development of new product lines
iv) Expansion and modernization of existing plants and machinery so as to meet current needs of the company.
All these decisions are long-term and are expected to generate benefits for a long period in the future.
Some of the capital budgeting decisions involve independent projects while others involve mutually exclusive projects. Independent projects are projects whose cash flows are not affected by decisions made about other projects. Mutually exclusive projects are a set of projects in which the acceptance of one project means the rejection of the others.
1. Capital budgeting decisions define a company’s strategic direction.
If viable, they have the effect of increasing the value of a company’s shares in the stock exchange and hence the shareholders’ investment if they result in viable ventures.
They expose a company’s money to a risk depending on the nature of the investment and, if badly made, they can lead to a company’s receivership and consequently liquidation.
2. The results of capital budgeting decisions are long term and make the firm lose some of its flexibility. The decisions, once taken, are irreversible and therefore call for prudent management attitudes towards all investment decisions.
3. Timing is very important since capital assets must be available when they are needed.
Capital projects are developed by the firm using the following procedures:
1. Proposal generation. Proposals are made at all levels within a business organization and are reviewed by the finance personnel. Proposals requiring huge cash outlays are carefully scrutinized than less costly ones.
2. Review and analysis. Formal reviewand analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Once the analysis is complete, a summary report is submitted to decision makers.
3. Decision making. Firms typically delegate capital expenditure decision making on the basis of amount limits. Generally, the board of directors must authorize expenditures beyond certain amounts. Often plant managers are given authority to make decisions necessary to keep the production work moving.
4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored, actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.
NB: Each procedure is important. However, review and analysis and decision making (procedure 2 & 3) consume the majority of time and effort.
STEPS IN THE CAPITAL BUDGETING PROCESS
1. Determine the cost of the project.
2. Estimate the expected cash flows from the project, including the salvage value of the asset at the end of its expected useful life.
3. Estimate the riskiness of the projected cash flows.
4. Determine the appropriate rate of return to use to discount the cash flows
5. Find the present value of the expected cash flows to obtain an estimate of the asset’s value to the firm.
6. Compare the present value of the expected cash inflows with the investment or cost required to acquire the asset; If the PV of the cash flows exceeds the cost, the project should be accepted. Otherwise, it should be rejected.
Alternatively, the expected rate of return on the project can be calculated and if this rate of return exceeds the rate of return considered appropriate for the project, it should be accepted.
If a firm identifies or creates an investment opportunity with a present value greater than its cost, the value of the firm will increase. The more effective the firm’s capital budgeting procedures, the higher the price of its stock.
CAPITAL RATIONING
This can be defined as that situation where a business is constrained by both external and internal factors such that it cannot manage to raise necessary funds from the financial markets to invest in all viable ventures available to such a company from the investment markets.
Under such a situation it will be necessary for such a company to select projects as follows:
Rank investments according to their profitability using PI or IRR
Choose projects according to their rank, beginning with the most highly ranked ventures going downward until the finances available are exhausted.
The main objective in capital rationing should be to maximize the company’s profits subject to budget constraints.
1. Economic conditions prevailing may not be the best eg. a recession which may limit the company’s ability to raise finance in particular debt finance from capital markets
2. If there are conditions where floatation issues are expensive that it would be uneconomical to issue shares or debentures
3. If there are credit controls or a credit squeeze in the lending market that make it difficult for a company to raise debt finance in the market
4. Size of the company may also limit the company’s ability to raise finance eg a small company may be seen as a credit risk or lack the assets to pledge as security for loans
5. If the company is already highly leveraged thus hindering it from raising more debt finance
6. If company’s owners’ do not want to dilute their shareholding or lose control by issuing more shares or borrowing heavily, which may cause a dilution in their shareholding thus the company resorts to capital rationing in order to preserve the owners’ control.
STOCK VALUATION
April 27, 2010
Stocks are an investment to the stockholders and a source of finance to the company; thus their valuation is of paramount importance to the two parties due to the following reasons:
1) To the actual shareholder the value of his shares indicates to him the magnitude of his capital gain on the shares.
2) The value of the shares will indirectly reveal the performance of the company because high share values reflect a high demand of the company’s shares which will be possible if the company’s performance is viewed favorably by the potential investors.
3) The value of the shares is important to a potential shareholder because it will reflect the cost of investment in shares and it is on the basis of this value that he can compute the return on his investment using the dividend yield:
Dividend Yield = Dividend per share X 100
Market Price per share
The above return can be compared with the bank rate to determine whether the
investment in shares is viable or not.
4) To the company, the value of the shares reflects the opinion of potential investors in the company’s shares. If the value is too low, it usually reflects a negative opinion which may make it very difficult for the company to raise further finance by way of trade credit and debt finance.
FACTORS THAT INFLUENCE THE VALUE OF THE SHARE
1. Profitability of the company – It is usually assumed that profitable companies pay
good and stable dividends and this increases the market price of their shares due to the high demand of such shares.
2. Dividend policy of the company – This is the frequency and the amount of
dividends a company pays to its common shareholders.
3. Retention policy of the company – Normally those companies which retain a lot
of their earnings and declare small dividends, will experience lower share market
prices in the short-run but in the long-run the market values will increase if the
retained earnings are invested to yield returns which will be given to the shareholders.
4. Price-earnings ratio of the company – This will indicate the pay-back period of a
share and the lower the P/E ratio the shorter the pay-back period and the more favorable the company’s shares will be to potential shareholders as they will be assured of recovering their initial investment earlier. However, this depends on the dividend policy of the firm.
5. The size of the company – Usually companies in their growing stages do not
attract potential investors due to their size. They may not have accumulated sufficient assets and may also not qualify to be quoted on the stock exchange and this would tend to lower the value of their shares as their demand would be low.
6. Growth prospects of the company – Companies with ambitious expansion or
growth programmes will retain most of their earnings to facilitate growth. In the short-run they may pay no dividends which would tend to lower the share values. Investors who are far-sighted tend to buy such shares of potential growing companies for speculative reasons in the hope that they will get higher returns in the future. In this case the investments must be spread over several types of securities to spread risks should such a speculation work against the hopes of investors.
7. Political circumstances / Prevailing atmosphere – Stability in political
atmosphere is conducive to stable economic performance of a given country especially to long-term investments. Shares are long-term investments and investors have a higher demand for shares of companies operating in politically stable countries.
8. Attitudes of both actual and potential investors – Investors may speculate on a
number of things regarding the company’s performance. For instance, they may speculate about the areas in which the company is operating or the composition of its management, both of which they may view negatively. This would in turn tend to lower the share prices of the company affected.
SOURCES OF SHORT-TERM AND MEDIUM-TERM FUNDS
April 27, 2010
Short-term funds are usually for up to three years or less while medium-term loans are for about three years to five years.
1. Bank Lending
This is usually a short-term loan for up to 3 years and an overdraft. Interest on a bank overdraft is charged at a variable rate on the amount by which the company is overdrawn from day to day. The limit of the overdraft is set by the bank.
2. Leasing Transactions
a) Sale and Leaseback – This is where a company obtains finance by selling its property e.g. A building and renting it back.
b) Operating Leases– These are rental agreements between a lessor and a lessee whereby:
i) The lessor who owns a capital asset supplies the asset e.g. Equipment to the lessee and is responsible for servicing and maintaining the leased equipment.
ii) The lessee makes payments under the terms of the lease to the lessor for a specified period of time which is less than the economic life of the asset.
iii) At the end of the lease period, the lessor takes back his asset and can lease it to another person or sell the asset second-hand.
NB – Assets under operating leases do not have to be shown in the lessee’s balance sheet.
i) Lessee is responsible for servicing and maintenance of the asset.
ii) Lease has a primary period which covers all or most of the useful economic life of the asset
iii) At the end of the primary period, the lessor can allow the lessee to keep the asset at a low nominal rent or sell the asset and keep most of the sale proceeds and only pay a small percentage to the lessor.
This is a form of instalment credit where a company or individual purchases goods on credit and pays for them by instalments. These transactions usually involve a finance house that provides funds to purchase a fixed asset on hire purchase.
This is where the government may provide finance in form of grants and other forms to companies especially in high-technology industries. However, this assistance is severely restricted.
5. Foreign Currency Markets (International Borrowing)
These are international markets dealing with foreign currencies. Funds are deposited with a bank outside the country of origin of the funds and the funds are then lent out on a short-term basis eg. 3 months. Most foreign currency lending takes place between banks of different countries and is in the form of negotiable certificates of deposit.
6. Eurobonds
These are bonds issued in European capital markets and are denominated in a currency which often differs from that of the country of issue and sold internationally.
They are long-term loans raised by international companies in several countries at the same time.
7. Commercial Paper
A commercial paper is a short-term financial instrument issued in the form of unsecured promissory notes with a fixed maturity date. A promissory note is a written promise to pay at a fixed future date, the amount shown on the note.
8. Accounts payable (trade credit) and accruals
Accounts payable is a spontaneous source of financing as it arises in the normal course of business. A business can make its purchases on credit and pay later depending on the credit terms given. Accruals are considered to be free as they generally have no interest paid on them. They are deferred and paid later and therefore provide a free source of financing.
9. Retained earnings
Companies can also raise money through retained earnings. These are the undistributed profits
that are retained within the business. The funds are available within the business and can be
utilized in the operations of the business.
1. Short-term loans can be obtained faster than long-term funding.
2. The costs associated with short-term funds are lower than for long-term funding.
3. Short-term credit agreements do not always constrain a firm’s future actions as the long-term funds. I.e. long-term funds may have provisions that constrain a firm from undertaking some actions.
1. Interest costs on long-term loans may be relatively stable or even fixed and can easily be estimated for the future. Short-term interest costs may fluctuate widely and at times be very high. They may easily create a burden for the firm.
2. If a firm borrows heavily on short-term, it may be unable to repay and may be forced into liquidation.
The following factors determine the borrowing:
1. The currency required by the company
2. The cost of finance ie. Interest rates differ and must be considered
3. Timing and speed – it may be possible to raise money faster in foreign currency markets than in a domestic market
4. Security – a company should consider the security provided for loans
5. Size of the loan and size of the company – a large multinational can raise large sums in a foreign currency market easier than a small company.
SOURCES OF LONG-TERM FUNDS
April 27, 2010
Long-term funds are those that are borrowed for a long-period usually five-years or more.
These funds may be raised in the following ways:-
A) New Issues of Share Capital usually in form of common or ordinary stock. This may be through:
i) Rights Issue
ii) A placing
i) Rights Issue
This is a method of raising new share capital by means of an offer to existing shareholders inviting them to subscribe cash for new shares in proportion to their existing holdings. Eg. A rights issue on a one for four basis at $ 2.80 per share means that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold at a price of $ 2.80 per new share. Any company, private or public can make a rights issue.
1. They are cheaper than offering shares for sale to the general public because no prospectus is required, the administration is simpler and the cost of underwriting will be less.
2. Rights Issues are beneficial to existing shareholders than to the general public since they are issued at a discount to the current market price and this discount would be enjoyed by whoever buys the shares when they are offered to the public.
3. Relative voting rights of shareholders are unaffected if they all take up their rights. A rights issue price must be one that is
i) low enough to secure acceptance of the shareholders
ii) not too low to avoid excessive dilution of earnings per share
Instead of offering all shares to the public they are instead offered to a small number of investors such as pension funds or insurance companies. Placings are much cheaper although they have the disadvantage of having the shares not being available for trading after they have been floated. This is a problem especially for small companies.
NB: Return on equities consists of both dividends and capital gains (or losses) in the share price. This is the cost of equity funds.
This is a long-term debt capital raised by a company and attracts interest at a fixed rate, usually paid half-yearly. Holders of loan-stock are therefore long-term creditors of the company.
Loan-stock has a nominal value which is the debt owed by the company and interest is paid at a stated ‘coupon yield’ on this amount. For example, a 10% loan stock means that the coupon yield is 10% of the nominal value of the stock. The rate is the gross rate before tax.
Debentures – are a form of loan stock. They are written acknowledgements of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.
Features of Loan-stock and Debentures
1. Loan stock and debentures are usually secured either by a fixed charge on specific assets or a group of assets or by a floating charge on certain assets of the company. In case of default, the lender can lay claim on any asset of the company as long as there is no prior claim on that asset by any other lender.
2. They are usually redeemable i.e. They have a maturity date when they are paid back either at par or at a value above par. They are issued for a term of ten years or more.
3. Most redeemable stock have an earliest and a latest redeemable date e.g. A 12% debenture stock 2012/2014 is redeemable at any time between the earliest specified date in 2012 and the latest date in 2014. The issuing company can choose the date.
4. Some loan-stock have no redemption date i.e. Irredeemable or undated. Undated loan-stock can be redeemed by a company that wishes to pay off the debt but there is no obligation for the company to do so.
5. Loan-stock or Debt capital is an attractive source of finance because interest charges have a tax relief i.e. They reduce the profits chargeable to corporation tax.
Example
Company A has an issue of $ 1,000,000 7 ½% preference shares. Company B has 10% loan-stock of $ 1,000,000. Both companies have a profit before tax and interest of $ 1,500,000. The basic rate of income tax is 25% and the corporate tax rate is 30%.
Calculate the profits available to ordinary/common shareholders.
COMPANY A COMPANY B
$ ‘000 $ ‘000
Profit before tax and interest 1,500 1,500
Less Interest (10 % * 1,000,000) - 100
Profit before tax 1,500 1,400
Less tax 30 % 450 420
Profit after tax 1,050 980
Less preference dividend 75 -
Funds Available to shareholders 975 980
NB
1. The preference dividend is the amount actually paid. In the hands of the recipient, it will have a gross value for tax purposes of $100 being $75 + (25/75 * $75) and this is the same to an investor as 10% from the same stock.
2. The difference in amount available to equity shareholders of $5,000 is due to the difference between the rate of income tax 9hence 25% of 100,000 gross dividend) and the rate of corporation tax (hence 30% of $ 100,000 interest paid).
Reasons
1. Interest charges may be very high making debt capital quite expensive even after tax relief. Interest yields are higher than dividend yields on equity shares.
2. Heavy borrowing increases the financial risks for ordinary shareholders. A company must be able to pay the interest charges and eventually repay the debt from its cash resources and at the same time maintain a healthy balance sheet which does not deter would be creditors. There might be insufficient security for a new loan.
3. There might be restrictions on a company’s power to borrow:-
a) in the articles of association where there may be a limitation
b) trust deeds of existing loans may limit borrowing
c) Borrowing may be limited by the attitude of would be lenders who may expect something e.g. Security in form of a charge on a given asset, certain debt ratio or gearing ratio or a certain rate of interest cover.
The Stock Exchange
The Stock Exchange is a primary capital market in which companies and other institutions can raise funds by issuing shares or loan stock but it is more important as a secondary market for buying and selling existing securities. Dealers on the stock exchange are of 2 types: -
1. Market Makers or Security Dealers
These are the dealers in shares of selected companies whose duty is to ‘make a market’ in the shares of each of these companies. They must be members of the stock market. They quote the ‘bid price’ (the asking price) and the ‘ask price’ (selling price) for the shares and they decide on the share price. They also bring new companies to the market.
The dealer’s profit is the difference between the bid and ask prices which is also known as ‘bid-ask’ spread.
They act on behalf of individual clients who wish to buy or sell some of their shares or debentures. They earn a commission for their services, payable to the client.
This is a large collection of brokers and dealers working in different locations and doing their business according to their own procedures and rules, not according to a set of market rules.
They are connected electronically by telephones and computers and provide trading in unlisted securities.
This is a specific type of secured loan. Companies can place title deeds of freehold or long leasehold property as security with a bank or other mortgage brokers and receive cash on loan, usually repayable over a specified period.
Financial Institutions and Markets
April 27, 2010
SOURCES OF FUNDS FOR BUSINESS ORGANISATIONS
Most firms have ongoing needs to raise cash to fund investments. They can obtain funds from external sources or from internal sources. On the other hand, some firms and individuals have surplus funds that they may need to invest. People and organizations wanting to borrow money are brought together with those having surplus funds in the financial markets.
Financial markets are institutions and procedures that facilitate transactions in all types of financial claims. They are forums where suppliers of funds and those who require the funds can transact business directly. There are many different financial markets dealing with different types of instruments and serving different types of customers. Financial institutions are intermediaries that channel the savings of individuals, businesses and governments into loans or investments. They are required by law to operate within established regulatory guidelines. Major financial institutions include:
- Commercial banks - savings and loan institutions
- Insurance companies - pension funds
- Credit unions - mutual funds
These institutions attract funds from individuals, businesses and governments, combine them and make loans to individuals and businesses. Financial institutions actively participate in the financial markets as both suppliers and demanders of funds.
Financial markets act as the vehicle through which the forces of demand and supply for a specific type of financial claim are brought together. The two key financial markets are the money markets and the capital markets.
Money markets are those that deal with short-term debt instruments or marketable securities with maturities of one year or less e.g. Treasury bills, commercial paper etc. Money market is represented by current assets on the balance sheet.
Capital markets are markets for long-term debt such as bonds and stocks which are generally one year or more. Examples are bonds which are long-term debt instruments used by business and governments to raise large sums of money from a diverse groups of lenders.
Another example is common stock and preferred stock. Common stockholders earn a return by receiving dividends or by realizing increases in their share prices. Preferred stockholders receive a fixed periodic dividend that must be paid prior to payment of any common-stock dividends.
To raise money, firms can use either private placements or public offerings.
Private placements involve the sale of a new security issue, typically bonds or preferred stock directly to an investor or a group of investors such as an insurance company or pension fund.
Public offering is the sale of either bonds or stocks to the general public. Initial public offering market (I.P.O) is when a company offers its shares to the public for the first time.
3. Primary markets and Secondary Markets
A Primary market is a financial market in which new securities are sold. It is the only issue in which the issuer is directly involved in the transaction i.e. the company actually receives the proceeds from the sale of securities.
Secondary markets are markets in which pre-owned or existing securities are traded among investors.
4. Eurocurrency Market
This is the international equivalent of the domestic money market. It is a market for short-term bank deposits denominated in U.S dollars or other easily convertible currencies. Euro-currency deposits arise when a corporation or individual makes a bank deposit in a currency other than the local currency of the country where the bank is located. E.g. If a multinational corporation deposits U.S dollars in a London bank, this would create a Eurodollar deposit (a dollar deposit in a London bank).
In spot markets, assets traded are bought or sold “on the spot” delivery (immediately or within a few days).
In futures markets, assets are bought or sold for delivery at some future date.
Depending on an organization’s size and scope of operations, it may be able to borrow all over the world or it could be confined to a small local area.
