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. • 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 • 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 • 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 • 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 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 • 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 • 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 • 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.
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 • 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 • 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 © 2003 Pearson Education Canada Inc.
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 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 © 2003 Pearson Education Canada Inc.
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 • life insurance firms • financial corporations • venture capital or development firms • pension funds © 2003 Pearson Education Canada Inc.
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 • 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 • 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 • 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 • 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 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 • 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 • 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 • 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 • 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 • 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 • 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 • 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 • 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 • 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 • 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 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 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 • 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 • 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 • 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 • 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.
Managing Financial Issues Part Six Chapter Sixteen Financial Decisions and Risk Management
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 • 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 • 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 • 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 • 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 • 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 • 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 • 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 • 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.