Textbook Notes (363,507)
Canada (158,391)
RSM100Y1 (431)
Chapter 16

chapter 16,17 appendix D,E.doc

20 Pages
Unlock Document

University of Toronto St. George
Rotman Commerce
Michael Khan

Chapter 16 Managing Financial Resources Understanding the financial system In Canada, Households are generally net savers. Businesses and governments are net users. As people age, they often move form being net borrows to being net savers. Funds can be transferred between savers and users in two ways: directly and indirectly. A direct transfer means that the user raises the needed funds directly from savers. (Do occur, but most funds flow through financial markets or financial institutions.) Types of securities Securities, also called financial instruments, represent the obligations of the issuers- businesses and governments- to provide the purchaser with the expected or stated returns on the funds invested or loaned. Three categories: money market instruments, bonds, and shares (also known as stock) Money market instrument and bonds are debt securities. Shares are units of ownership in public corporations. Money Market Instruments are short-term debt securities issued by governments, financial institutions, and corporations. All money market instruments mature within one year from the date of issue. They are generally low-risk securities and are purchased by investors when they have surplus cash. Ex: Canadian Treasury bills, commercial paper, and bank certificates of deposit. Treasury bills are sold with a maturity date of 30, 90, 180, 360 days and must be a minimum of $1000. They are virtually risk-free and are easy to resell. Commercial paper refers to securities sold by corporations, such as Telus. These securities mature in 1 to 270 days from the date of issue. It is slightly riskier than Treasure bills, but it is still considered to be a very low risk security. A certificate of deposit (CD) is a time deposit at a financial institution, such as a commercial bank, a savings bank, or a credit union. -Size and maturity date can vary -CDs of $100,000 or less per depositor are insured by the (CDIC). CDs in larger denominations are not federally insured but can be sold more easily before they mature. Bonds Bondholders are creditors of a corporation or government body. That means their claim on the firm’s assets must be satisfied before any claims of shareholders if the firm enters into bankruptcy, reorganization, or liquidation. Types of bonds: Government bonds, such as Canada Savings Bonds, are bonds sold by the Canadian government. Government bonds are backed by the full faith and credit of the Canadian government, which means they are the least risky of all bonds. 1. Municipal bonds are bonds issued by municipal governments. Two types: 1) Corporate bonds include a diverse group of bonds. They often vary depending on the collateral- the property pledged by the borrower- that backs the bond. A secured bond is backed by a specific pledge of company assets. Unsecured bond are called debentures. These bonds are backed only by the financial reputation of the issuing corporation. 2. Mortgage-backed corporate bonds also called mortgage-backed securities (MBSs). These bonds are backed by a pool, or group, of mortgage loans purchased from lenders, such as chartered banks. Quality ratings for bonds Two factors affect the price of a bond: 1) Risk The best-known bond rating organizations are Standard & Poor’s (S & P), Moody’s, and Fitch. Bonds with ratings of BBB and above are classified as investment-grade bonds. Bonds with ratings of BB and below are classified as speculative bonds, or junk bonds. Junk bonds attract investors because they offer high interest in exchange for greater risk. 2) Interest rate All other things being equal, the higher the interest rate, the higher the price of a bond. *The other important influence on bond prices is the market interest rate. As market interest rates rise, bond prices fall. As market interest rates fall, bond prices rise. A call provision allows the issuer to redeem, or cash, the bond before its maturity at a specified price. (Issuers tend to call bonds when market interest rates are declining.) Shares Common shares The basic form of corporation ownership is common shares. Purchasers of common shares are the true owners of a corporation. Holders of common shares: 1) Vote on major company decisions 2) Expect some sort of return, such as cash dividend payments, expected increase in the value of the shares, or both. Holders of common shares are said to have a residual claim on company assets. Preferred shares - Holders of preferred shares receive preference in payment of dividends. - If a company is dissolved, holders of preferred shares have claims on the firm’s assets that are ahead of the claims of holders of common shares. - Holders of preferred shards rarely have voting rights. Also, they are paid fixed dividends, regardless of how profitable the firm becomes. EQUITY Convertible Securities This feature gives the bondholder or holder of preferred shards the right to exchange the bond or preferred shares for a fixed number of common shares. Convertible bonds pay lower interest rates than bonds without conversion features, which helps to reduce the issuing firm’s interest expenses. Investors are willing to accept lower interest rates because they value the possibility of additional gains if price of the firm’s shares increase. Financial Markets Financial markets are markets where securities are issued and traded. Primary markets are financial markets where firms and government issue securities and sell them initially to the general public. When a company offers shares for sale to the general public for the first time, it is called an initial public offering (IPO). Announcements of new bond and share offerings appear daily in business publications. These announcements are often in the form of a simple black-and-white ad called a tombstone. Securities are sold to the investing public in two ways: 1) Open auctions Almost all securities sold through open auctions are Government of Canada securities. 2) Investment bankers Sales of most corporate and municipal securities are made trough financial institutions such as TD securities. These institutions purchase the issue from the firm or government and then resell the issue to investors. This process is known as underwriting. Financial institutions underwrite shares and bond issues at a discount. That means they pay the issuing firm or government less than the price that financial institutions charge investors. (The discount usually averages 5 percent for all types of securities. For IPO, between 7% to 10%) Secondary market is a collection of financial markets where previously issued securities are traded among investors. [Media reports of share and bond trading] Understanding Stock Markets Stock markets, or exchanges, are markets where shares of stock are bought and sold by investors. The Toronto Stock Exchange -Canadian largest stock exchange -Firm must apply for a listing and meet certain listing requirements to be traded on TSX and must continue to meet requirements each year to remain listed. -Corporate bonds trading is less than 1% of the total value of securities traded on the TSX during a typical year. Foreign Stock Markets -The NYSE is the world’s largest stock market. -The Nasdaq Stock Market is the world’s second largest stock market. It is a computerized communications network that links member investment firms. It is the world’s largest intranet. All trading on Nasdaq takes place through its intranet, not on a trading floor. ECNs and the Future of Stock Markets The fourth market is the direct trading of exchange-listed stocks off the floor of the exchange. The fourth market has begun to open up to smaller, individual investors through markets called electronic communication networks (ECNs). Investor Participation in the Stock Markets Use the services of a brokerage firm to buy or sell shares. Two examples of brokerage firms are Edward Jones and TD waterhouse. Investors establish an account with the brokerage firm and then enter orders to trade shares. The most common type of order is a market order. This order instructs the broker to obtain the best possible price- the highest price when selling and the lowest price when buying. Another popular type of order is called limit order. It sets a price ceiling when buying or a price floor when selling. Financial Institutions Financial institutions are intermediaries between savers and borrowers that collect funds from savers and then lend the funds to individuals, businesses, and governments. Traditionally, financial institutions have been classified into depository institutions and non- depository institutions. Depository institutions accept deposits that customers can withdraw on demand. Nondepository institutions include life insurance companies, such as Manulife Financials; pension funds, such as the Ontario Teacher’s Pension Plan; and mutual funds. COMMERCIAL BANKS How bank operates Bank raises funds by offering customers a variety of chequing and savings deposits. The bank then pool, or combine these deposits and lend most of them out in the form of consumer and business loans. Banks make money mostly because the interest rate they charge borrowers is higher than the rate of interest they pay depositors. Electronic Banking Each year, more and more funds move through electronic funds transfer systems (EFTSs). EFTSs are computerized systems for conducting financial transactions over electronic links. One of the original forms of electronic banking, the automated teller machine (ATM) continues to grow in popularity. Online banking Canadian can choose from two types of online banks: Internet-only banks, such as PC Financial, and traditional bricks-and-mortar banks that also have websites, such as RBC and CIBC. Deposit Insurance Most commercial bank deposits are insured by Canada Deposit Insurance Corporation. The CDIC was formed in 1967 to build public confidence in the banking system. CREDIT UNIONS Credit unions also serve a significant segment of the financial community. Credit unions are designed to serve consumers, not businesses. Credit unions raise funds by offering members several different chequing and saving accounts. Credit unions then lend these funds to members. Because credit unions are not-for-profit institutions, consumers often prefer them over commercial banks and other financial institutions. Credit unions often: - Pay higher rates of interest on deposit - Charge lower rates of interest on loans - Charge fewer fees NONDEPOSITORY FINANCIAL INSTITUTIONS Generally, these institutions do not offer chequing accounts (demand deposits). Three examples on Nondepository financial institutions are insurance companies, pension funds, and finance companies. Insurance companies Household and businesses buy insurance to transfer risk from themselves to the insurance company. The insurance company accepts the risk in return for a series of payments, called premiums. During a typical year, insurance companies collect more in premiums than they pay in claims. Insurance companies are a major source of short-and long-term financing for businesses. Pension funds They are set up by employers and are funded by regular contributions from employers and employees. Because pension funds have predictable long-term cash inflows and very predictable cash outflows, they invest heavily in assets, such as common stocks and real-estate. Since the financial crisis, the asset mix has shifted to include more foreign investment and fewer CA assets. Finance Companies Consumer and commercial finance companies offer short-term loans to borrowers. [Ford Credit and John Deere Capital Corporation] A commercial finance company supplies short-term funds to businesses that use their tangible assets as collateral for the loan. MUTUAL FUNDS Mutual funds are financial intermediaries that raise money from investors by selling shares. Mutual fund investors are indirect owners of a portfolio of securities. Less than half of mutual fund assets are invested in company shares. Money market mutual funds are also popular. These funds invest in money market instruments such as commercial paper. The role of the bank of Canada Created in 1935, the bank of Canada is the central bank of Canada and an important part of the nation’s financial system. The bank of Canada has four basic responsibilities: regulating monetary policy, designing and issuing bank notes, regulating the financial system, and managing funds for the federal government and other clients. MONETARY POLICY - Control the supply of money and credit If the bank pushes interest rates up, the growth rate in the money supply will slow, economic growth will slow, and inflationary pressures will ease. *Vice Versa* The two common measures of the money supply are called M1 and M2. M1 consists of currency in circulation and the balances in bank chequing accounts. M2 equals M1 plus balances in some savings accounts and money market mutual funds. The bank has two major policy tools for controlling the growth in the supply of money and credit: the discount rate and open market operations. The discount rate is the interest rate at which chartered banks make short-term loans to member banks. The discount rate is often referred to as the bank rate. If the bank wants to slow the growth rate in the money supply, it increases the bank rate. (This increase makes it more expensive for banks to borrow funds) Banks, in turn, raise the interest rates they charge on loans to consumers and businesses. ----------Slowdown in economic activity. Open market operations, the one used more often, the technique of controlling the money supply growth rate by buying or selling Canadian government securities. If the Bank buys government securities, the money it pays enters circulation, where it increases the money supply and lowers the interest rates. *Vice Versa* When the Banks uses open market operations it uses as its benchmark, or guideline, the so-called overnight rate- the rate at which banks lend money to each other overnight. Transactions in the foreign exchange markets also affect the Canadian money supply and interest rates. The bank can lower the exchange value of the dollar by selling dollars and buying foreign currencies. Historically, the Bank also influenced the money supply by controlling the reserve requirement. The reserve requirement was the percentage of cash that banks were required to maintain for immediate withdrawal by customers. [In 1992, the Bank removed reserve requirement] REGULATION OF THE FINANCIAL SYSTEM Bank Regulation Banks are among the nation’s most heavily regulated businesses. The main purpose of bank regulation is to ensure public confidence in the safety and security of the banking system. Government Regulation of the Financial Markets Insider trading is defined as the use of material non-public information about a company to make investment profits. Industry Self-Regulation The securities markets are also heavily self-regulated by professional associations and the major financial markets. The rules and regulations are designed to ensure fair and orderly markets. They also promote investor confidence and benefit all participants. {Market Surveillance p464} The financial system: a global perspective Of the 50 largest banks in the world (measured by total assets), only three are Canadian – RBC (34 ), TD Bank, and the Bank of Nova Scotia. NOTES: Chapter 17 Financial Management The role of the financial manager Financial managers are the executives who develop and carry out their firm’s financial plan and decide on the most appropriate sources and uses of funds. CEO-CFO-Vice-president of financial planning, treasurer, controller The vice president for financial management or planning is responsible for preparing financial forecasts and analyzing major investment decisions related to new products, new production facilities, and acquisitions. The treasurer is responsible for all of the company’s financing activities; including cash management, tax planning and preparation, and shareholder relations. The treasurer also works on the sale of new security issues to investors. The controller is the chief accounting manager. The controller’s functions include keeping the company’s books, preparing financial statements, and conducting internal audits. Risk-return trade off: the process of maximizing the wealth of the firm’s shareholders by striking the right balance between risk and return. Financial managers must also adapt to changes in the financial system. Financial planning Financial plan is a document that specifies the funds needed by a firm for a period of time, the timing of cash inflows and outflows, and the most appropriate sources and uses of funds. Operating plans are short-term financial plans that focus on no more than a year or two in the future. Strategic plans are financial plans that have a much longer time horizon, up to 5/10 years. A financial plan is based on forecasts of several items: production costs, purchasing needs, plants and equipment expenses, and sales activities for the period covered. 3 steps for preparing a financial plan: 1)A forecast of sales or revenue over some future time period 2) The CFO uses the sales forecast to decide on the expected level of profits for future periods. 3) Estimate how many additional assets the firm will need to support the projected sales Depending on the type of industry, some businesses need more assets than other businesses to support the same amount of sales. {Asset intensity}. Manufacturing is a more asset-intensive business than retailing. Financial control is a process of comparing actual revenues, costs, and expenses with the forecasted amounts. Managing Assets Short-Term Assets are also called current assets. These assets consist of cash and assets than can be, or are expected to be, converted into cash within a year. The major current assets are cash, marketable securities and inventory. ~One tool for assessing how well receivables are being managed is to calculate the accounts receivable turnover over two or more time periods in a roll. ~Inventory turnover ratio can be early warning signs of difficulties ahead. ~Capital investment analysis is the process financial managers use when deciding whether to invest in long-lived assets. Firms make two basic types of capital investment decisions: expansion and replacement.” Managing International Assets Challenges: Exchange rates Exchange rates can vary widely from year to year, which creates a problem for any company that has international assets. Reducing the risks of exchange rate fluctuations will improve the financial performance of the firm, which can have a positive impact on its share price. Sources of funds and capital structure Debt capital consists of funds obtained through borrowing. Equity capital consists of funds provided by the firm’s owners when they reinvest their earnings, make additional contributions, liquidate assets, issue shares to the general public., or raise capital from outside investors. Capital structure: the mix of a firm’s debt and equity capital. Leverage increasing the rate of return on funds invested by borrowing funds. As the company uses more debt, the risk to the company increases: the firm needs to make the interest payments on the money borrowed, regardless of the amount of cash flow coming into the company. Choosing more debt increases the fixed costs a company must pay, more sensitive to any change in sales revenues. Leverage and Capital Structure Decisions The key to managing leverage is to ensure that a company’s earnings remain larger than its interest payments, which increases the leverage on the rate of return on shareholder’s investments. Downside of debt capital: 1) Risky 2) Another problem with borrowing money is that relying too much on borrowed funds may reduce management’s flexibility in future financing decisions. Downside of equity capital: 1) New equity is sold, the control of the existing shareholders is weakened, and the outcome of these votes could potentially change. 2) Equity capital is more expensive than debt capital. Creditors have a senior claim to the assets of a firm before the shareholder’s claims. Dividends are not tax-deductible. Mixing Short-Term and Long-Term Funds Short-term funds consist of current liabilities, and long-term funds consist of long-term debt and equity. Short-term funds are generally less expensive than long-term funds, but they expose the firm to more risk. Short-term funds need to be renewed, or rolled over, frequently. Short-term interest rates can be unstable. Another risk of relying on short-term funds is availability. Even financially healthy firms can occasionally find it difficult to borrow money. Most firms choose to finance all of their long-term assets, and even a portion of their short- term assets, by using long-term funds. Dividend Policy Dividends are periodic cash payments to shareholders. The most common type of dividend is paid quarterly and is often called a regular dividend. Earnings that are paid in dividends are not reinvested in the firm and don’t contribute additional equity capital. Firms are under no legal obligation to pay dividends to shareholders. Factors that are considered when deciding on a company’s dividend policy: The firm’s investment opportunities A firm with more limited investment opportunities generally pays more in dividends. The main purpose of share buy-backs is to raise the market value of the remaining shares, which benefits the shareholders. Short-Term Funding Options Short-term sources of funds are repaid within one year. The three major sources of short-term funds are trade credit, short-term loans, and commercial paper. Trade Credit Trade credit is extended by suppliers when a firm receives goods or services and agrees to pay for them at a later date. -Upside: its easy availability -Downside: the amount a company can borrow is limited to the amount it purchases Short-term loans Loans from commercial banks are a significant source of short-term financing for businesses. Two types of short-term bank loans: 1) Line of credit A line of credit specifies the maximum amount the firm can borrow over a period of time, usually a year. The bank is under no obligation to actually lend the money. It will only lends money when funds are available. Most lines of credit require the borrower to repay the original amount, plus interest, within one year. 2) Revolving credit agreements It is basically a guaranteed line of credit- the bank guarantees that the funds will be available when needed. Banks typically charge a fee, on top of interest, for revolving credit agreements. The cash budget is an important tool when deciding on the size of a line of credit. The cash budget shows the months when additional financing will be needed / when borrowed funds can be repaid. Commercial finance companies also make short-term loans to businesses. Loans from commercial finance companies are often secured by using accounts receivable or inventory as collateral. Factoring is another form of short-term financing that uses accounts receivable. The business sells its accounts receivable at a discount to either a bank or a finance company – which is called a factor. The cost of the transaction depends on the size of the discount. Commercial Paper Commercial Paper is a short-term IOU sold by a company. Most commercial paper is unsecured. It is an attractive source of financing because large amounts of money can be raised at interest rates that are usually 1 to 2 percent less than the interest rates charged by banks. Sources of Long-Term Financing Organizations acquire long-term financing from three sources. The first source is long-term loans from financial institutions such as commercial banks, life insurance companies, and pension funds. A second source is bonds-certificates of indebtedness- sold
More Less

Related notes for RSM100Y1

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.