module 2 sources of funds. framework funds flow in the economy money markets capital markets a....

Module 2

Sources of Funds

Framework

•Funds flow in the economy•Money Markets•Capital Markets

A. Intro to financial markets

•Types of business loans•The loan process•The 6C’s of Credit

B. Business Loans

•Cash Flow notations•Simple Interest•Compound Interest•Present and Future Value

C. Time Value of Money

What is an investment?

An asset or property right acquired for profit

Risks:

Liquidity Risk

Market Risk

Inflation Risk

Credit Risk

General investment classes

Savings deposits Time deposits Life insurance policies Bonds Money market placements Houses, apartments and building

ownership Land ownership Business ownership Education and training Foreign exchange investments Precious tangibles

Financial markets

What is a financial market? Offers and sales occur in two distinct

ways Primary market Secondary market

Financial institutions such as banks act as intermediaries

Financial Markets

Money Market

Capital Market

Forex Market

Derivatives Market

•Debt•Equity

•Spot•Forward

•Options•Swaps•Futures•Structured Products

•Tbills•Tnotes•CPs•BAs

Money Market vs. Capital Market•Short-term•Government bonds•Large denominations•Institutional investors

Money market instruments

Treasury Bills and notes

Certificates of deposit

Commercial papers

Banker’s acceptance

-Government raises money by selling notes to the public-Investors buy the bills at a discount from the stated maturity value. At maturity, the investor will get the face value.- Notes: longer-term and may give periodic interest

- Starts with an order to a bank by a bank’s customer to pay a sum of money at a future date (similar to post-dated check)-When the bank endorses the order for payment as “accepted,” it assumes responsibility for ultimate payment to the holder of the acceptance.- The acceptance may be traded in secondary markets like any other claim on the bank.

- A time deposit- May not be withdrawn on demand- The bank pays interest and principal at maturity- Usually insured by government insurance (PDIC)

- Large, well-known companies may issue debt instead of borrowing from banks- Usually pays interest and gives back the principal upon maturity

Money market instruments

Repos

Demand loans

Term loans

-The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. -The increase in the price is the overnight interest. -The dealer thus takes out a one-day loan from the investor, and the securities serve as collateral.-Reverse repo: mirror image of a repo

- Mechanism used by banks to adjust their daily reserve positions-Interbank borrowing and lending

-Loans to banks for a definite period of time

Types of transactions

Straight sale

Repurchase agreement

- Direct sale to an investor up to maturity date

Ex: A dealer bought a Meralco CP on Jan 1 2008 to mature on May 31 2008 with a 15% interest p.a. Supposing on April 6, a client went to the dealer and said he has excess funds up to May 31 (45 days). The dealer sold the note to the client at 13% p.a. On the maturity date, the client received the principal plus the corresponding interest. The bank earned 2% on the transaction.

- Repurchase (RP) – the commercial bank sells to the central bank using securities as collateral.

- Reverse repurchase (RRP) – the commercial bank lends to the central bank and the central bank gives securities as collateral.

Capital market instruments

Features of good investments

1. Safety of the value of the investment

2. Saleable investments3. Stability of income4. Taxes

Framework




B. Business Loans



How are loans made?

Find prospective loan customers

Evaluate character and sincerity of purpose

Make site visits and evaluate credit record

Evaluate financial condition

Assess possible loan collateral and sign the loan agreement

Monitor compliance with loan agreement and other customer service needs

What makes a good loan?

1 Is the borrower creditworthy?

2Can the loan agreement be properly structured and documented?

3Can the lender perfect its claim against the assets or earnings of the customer?


6 C’s of Lending

CHARACTER

CAPACITY

CASH

• Well-defined purpose for requesting credit

• serious intention to repay

• Authority to request the loan

• Minors, corporations

• Ability to generate enough cash to repay the loan


6 C’s of Lending

COLLATERAL

CONDITIONS

CONTROL

• Does the borrower have adequate net worth or own enough quality assets to support the loan?

• Recent trends in borrower’s line of industry

• Changes in law and regulation could adversely affect the borrower

• Loan request meets the lenders and regulatory authorities standard for loan quality

Loan agreement must meet borrower’s needs for funds with a comfortable repayment schedule Lend less or more money over a longer or

shorter period than requested Must protect the lender and those the

lender represents Process of recovering lender’s funds

must be carefully spelled out in a loan agreement

2Can the loan agreement be properly structured and documented?

Reasons for taking collateral If the borrower cannot pay, the pledge

fo collateral gives the lender the right to seize and sell those assets designated as loan collateral, using the proceeds of the sale to cover what the borrower didn’t pay back.

Gives physical advantage over the borrower (borrower feels more obliged to repay the loan)


Personal guarantees and pledges made by the business owners

or consignors of the loan

Common types of collateral

Accounts receivables

Factoring Inventory Real property Personal property Personal

guarantees

Resources on customer’s B/S

and collateral pledged

Expected profit, income

or cash flow

Amount owned = Loan P+I –deposits

Safety zones surrounding loaned funds


Types of business loans

Self-liquidating inventory loans

Working capital loans Interim construction

financing Security dealer

financing Retailer and equipment

financing Asset-based loans (AR

financing, factoring and inventory financing)

Syndicated loans

Term loans to support the purchase of equipment, rolling stock and structures

Revolving credit financing

Project loans Loans to support

acquisitions of other business firms

Short-Term Loans Long-Term Loans

What do banks look for in FS?

Historical analysis What are the trends in costs and profit?

Financial ratio analysis Ability to control expenses Operating efficiency in using resources to

generate sales Marketability of product line Coverage that earnings provide over financing

costs Liquidity position, indicating availability of ready

cash Track record of profitability Financial leverage Contingent liabilities

Comparison with industry performance

The 4 basic questions

1. How liquid is the firm?2. Is management generating

adequate operating profits on the firm’s assets?

3. How is the firm financing its assets?

4. Are the owners (stockholders) receiving an adequate return on their investment?

Framework




B. Business Loans



What is the time value of money?

A dollar today is worth more than a dollar in the future.

WHY? Because a dollar can be invested

today and earn interest for the future

Because a dollar today can be eroded by inflation

TVM = Opportunity cost

Simple Interest

Suppose you place $100 in a savings account that pays 6% interest per year. How much interest will you get at the end of 1 year? How much total money will you get at the end of 1 year? At the end of 5 years?

Formula Toolbox:Interest Payment = Principal x Rate x TimeTime = actual no of days /360 days

Compound Interest

Suppose you place $100 in a savings account that pays 6% interest per year. How much interest will you get at the end of 1 year? How much total money will you get at the end of 1 year? At the end of 5 years?

Formula Toolbox:Future Value (FV) = PV*(1+i)n

Present Value (PV) = FV*(1+i)-n

Present Value and Future Value

If we place $1,000 in a savings account paying 5% interest compounded annually, how much will our account accrue in 10 years?

If we invest $500 in a bank where it will earn 8% compounded annually, how much will it be worth at the end of 7 years?

How many years will it take for your initial investment of $7,753 to grow to $20,000 if it is invested at 9% compounded annually?

If you like to buy a new laptop that will cost P20,000 10 years from now, at what rate should you invest your savings of P11,167?

Question Fred Moreno has found an institution

that will pay him 8% p.a. interest compounded quarterly on a P10,000 deposit. If he leaves his money in this account for 24 months, how much will money will he have at the end of 1 year? At the end of 2 years?

How much will he have at the end of 2 years if the interest rate is 8% p.a. compounded semi-annually? Compounded monthly?

Making interest rates comparable

Future Value (FV) = PV*(1+i/m)n*m

m = number of times per year that the interest is compounded

N = number of years Effective annual rate for compounding:

(1+i/m)m - 1 Continuous compounding: PV x ei*n

Exercise

Joseph is a friend of yours. He has plenty of money but little financial sense. He received a gift of 12,000 for his recent graduation band is looking for a bank in which to deposit the funds. BPI is offering an account with an annual interest rate compounded 2.85% semi-annually, while PSbank offers an account with a 2.75% annual interest compounded monthly. Calculate the value of the two accounts at the end of one year and recommend to Joseph which account he should choose.

Annuities

Annuities are equal amounts of payments occurring for a consecutive time periods (amortization payments)

What is the present value of a 10 year $1,000 annuity discounted back to the present at 5%?

Formula Toolbox:

i

iAFV

n 1)1(

n

n

ii

iAPV

)1(

1)1(

Perpetuities

A perpetuity is an annuity that continues forever; that is, for every year from its establishment it pays the same dollar amount.

Example: preferred stock that yields a constant dollar dividend indefinitely

Formula Toolbox:

i

PPPVperpetuity

Where: PP = constant dollar amount provided by the perpetuityi = annual interest or discount rate

Exercise1. (Comprehensive present value) You are trying to plan

for retirement in 10 years and currently you have $100,000 in savings account and $300,000 in stocks. In addition, you plan to add to your savings by depositing $10,000 per year in your savings account at the end of each of the next five years and then $20,000 per year at the end of each year for the final five years until retirement.a. Assuming your savings account returns 7%

compounded annually and your investment in stocks will return 12% compounded annually, how much will you have at the end of 10 years? Ignore taxes.

b. If you expect to live for 20 years after you retire, and at retirement you deposit all of your savings in a bank account paying 10%, how much can you withdraw each year after retirement (20 equal withdrawals beginning one year after you retire) to end up with a zero balance at death?

2. How many years would it take for your investment to grow fourfold if it were invested at 16% compounded semi-annually?

Exercise1. (Comprehensive present value) You found

the woman of your dreams and she agreed to marry you in 5 years. You currently have Php 150,000 in savings and P15,000 in stocks. You have deposited your savings in a TD yielding 6.5% semi-annually, while the expected rate of return of your stock is 9.75%. To save for the wedding, you vowed to deposit Php 50,000 per year for the next five years at a bank deposit yielding 5.25%.

a. How much money can you spend in your wedding?

b. If your wedding planner told you that the cost of your dream wedding is php 875,000, how much should you save each year (in a deposit yielding 5.25%) to be able to afford your wedding?

module 2 sources of funds. framework funds flow in the economy money markets capital markets a....

Documents

time value of money

maturity slide

sum of money

secondary markets

sources of funds slide

future value

definite period of time

lending loans