seminar in finance

8/2/2019 Seminar in Finance

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An Introduction to Capital Structure

Why Capital Structure Matters To Your Investments

By Joshua Kennon, About.com Guide

.See More About:balance sheetfinancial ratiosdebt to equity

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You often hear corporate officers, professional investors, and analysts discuss a company's capital

structure. You may not know what a capital structure is or why you should even concern yourself with it,but the concept is extremely important because it can influence not only the return a company earns for

its shareholders, but whether or not a firm survives in a recession or depression. Sit back, relax, and

prepare to learn everything you ever wanted to know about your investments and the capital structure

of the companies in your portfolio!

Capital Structure - What It Is and Why It Matters

The term capital structure refers to the percentage of capital (money) at work in a business by type.

Broadly speaking, there are two forms of capital: equity capital and debt capital. Each has its ownbenefits and drawbacks and a substantial part of wise corporate stewardship and management is

attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. This is

true for Fortune 500 companies and for small business owners trying to determine how much of their

startup money should come from a bank loan without endangering the business.

Let's look at each in detail:

Equity Capital: This refers to money put up and owned by the shareholders (owners). Typically, equity

capital consists of two types: 1.) contributed capital, which is the money that was originally invested in

the business in exchange for shares of stock or ownership and 2.) retained earnings, which represents

profits from past years that have been kept by the company and used to strengthen the balance sheet

or fund growth, acquisitions, or expansion.

Many consider equity capital to be the most expensive type of capital a company can utilize because its

"cost" is the return the firm must earn to attract investment. A speculative mining company that is

looking for silver in a remote region of Africa may require a much higher return on equity to get

investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from

toothpaste and shampoo to detergent and beauty products.


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Debt Capital: The debt capital in a company's capital structure refers to borrowed money that is at

work in the business. The safest type is generally considered long-term bonds because the company has

years, if not decades, to come up with the principal, while paying interest only in the meantime.

Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart

and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to meet

day-to-day working capital requirements such as payroll and utility bills. The cost of debt capital in thecapital structure depends on the health of the company's balance sheet - a triple AAA rated firm is going

to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may

have to pay 15% or more in exchange for debt capital.

Other Forms of Capital: There are actually other forms of capital, such as vendor financing where a

company can sell goods before they have to pay the bill to the vendor, that can drastically increase

return on equity but don't cost the company anything. This was one of the secrets to Sam Walton'ssuccess at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter &

Gamble, in effect, using PG's money to grow his retailer. In the case of an insurance company, the

policyholder "float" represents money that doesn't belong to the firm but that it gets to use and earn an

investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The

cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often

comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle class individuals believe that the goal in life is to be debt-free (see Should I Pay Off My

Debt Or Invest?). When you reach the upper echelons of finance, however, that idea is almost

anathema. Many of the most successful companies in the world base their capital structure on one

simple consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3%

inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in

debt capital in your overall capital structure.

Of course, how much debt you take on comes down to how secure the revenues your business

generates are - if you sell an indispensable product that people simply must have, the debt will be much

lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this

is where managerial talent, experience, and wisdom comes into play. The great managers have a knack

for consistently lowering their weighted average cost of capital by increasing productivity, seeking out

higher return products, and more.


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To truly understand the idea of capital structure, you need to take a few moments to read Return on

Equity: The DuPont Model to understand how the capital structure represents one of the three

components in determining the rate of return a company will earn on the money its owners have

invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks,

it's knowledge you simply must have.

Definition of 'Cost Of Funds'The interest rate paid by financial institutions for the funds that they deploy in their business. The costof funds is one of the most important input costs for a financial institution, since a lower cost will

generate better returns when the funds are deployed in the form of short-term and long-term loans toborrowers. The spread between the cost of funds and the interest rate charged to borrowersrepresents one of the main sources of profit for most financial institutions.

Investopedia explains 'Cost Of Funds'For lenders such as banks and credit unions, cost of funds is determined by the interest rate paid todepositors on financial products including savings accounts and time deposits. Although the term costof funds usually refers to financial institutions, most corporations that rely on borrowing are impacted

by the costs they must incur to gain access to capital.

Read more:http://www.investopedia.com/terms/c/costoffunds.asp#ixzz1oGTdZFez

Money

Money is anyobjector record that is generally accepted aspaymentforgoods and servicesandrepayment ofdebtsin a givencountryor socio-economic context.[1][2][3]The main functions ofmoney are distinguished as: amedium of exchange; aunit of account; astore of value; and,occasionally in the past, astandard of deferred payment.[4][5]Any kind of object or secureverifiable record that fulfills these functions can serve as money.

Money originated ascommodity money, but nearly all contemporary money systems are basedonfiat money.[4]Fiat money is without intrinsicuse valueas a physical commodity, and derivesits value by being declared by a government to belegal tender; that is, it must be accepted as aform of payment within the boundaries of the country, for "all debts, public and private".

Themoney supplyof a country consists ofcurrency(banknotes and coins) andbank money(thebalance held inchecking accountsandsavings accounts).Bank moneyusually forms by far thelargest part of the money supply.[6][7][8]
http://www.investopedia.com/terms/c/costoffunds.asp#ixzz1oGTdZFezhttp://www.investopedia.com/terms/c/costoffunds.asp#ixzz1oGTdZFezhttp://www.investopedia.com/terms/c/costoffunds.asp#ixzz1oGTdZFezhttp://en.wikipedia.org/wiki/Objecthttp://en.wikipedia.org/wiki/Objecthttp://en.wikipedia.org/wiki/Objecthttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Money#cite_note-0http://en.wikipedia.org/wiki/Money#cite_note-0http://en.wikipedia.org/wiki/Money#cite_note-2http://en.wikipedia.org/wiki/Money#cite_note-2http://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Standard_of_deferred_paymenthttp://en.wikipedia.org/wiki/Standard_of_deferred_paymenthttp://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Use_valuehttp://en.wikipedia.org/wiki/Use_valuehttp://en.wikipedia.org/wiki/Use_valuehttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Transactional_accounthttp://en.wikipedia.org/wiki/Transactional_accounthttp://en.wikipedia.org/wiki/Transactional_accounthttp://en.wikipedia.org/wiki/Savings_accounthttp://en.wikipedia.org/wiki/Savings_accounthttp://en.wikipedia.org/wiki/Savings_accounthttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Money#cite_note-5http://en.wikipedia.org/wiki/Money#cite_note-5http://en.wikipedia.org/wiki/Money#cite_note-7http://en.wikipedia.org/wiki/Money#cite_note-7http://en.wikipedia.org/wiki/Money#cite_note-7http://en.wikipedia.org/wiki/Money#cite_note-5http://en.wikipedia.org/wiki/Money#cite_note-5http://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Savings_accounthttp://en.wikipedia.org/wiki/Transactional_accounthttp://en.wikipedia.org/wiki/Bank_moneyhttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Use_valuehttp://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Money#cite_note-mankiw-3http://en.wikipedia.org/wiki/Standard_of_deferred_paymenthttp://en.wikipedia.org/wiki/Store_of_valuehttp://en.wikipedia.org/wiki/Unit_of_accounthttp://en.wikipedia.org/wiki/Medium_of_exchangehttp://en.wikipedia.org/wiki/Money#cite_note-2http://en.wikipedia.org/wiki/Money#cite_note-0http://en.wikipedia.org/wiki/Money#cite_note-0http://en.wikipedia.org/wiki/Countryhttp://en.wikipedia.org/wiki/Debtshttp://en.wikipedia.org/wiki/Goods_and_serviceshttp://en.wikipedia.org/wiki/Paymenthttp://en.wikipedia.org/wiki/Objecthttp://www.investopedia.com/terms/c/costoffunds.asp#ixzz1oGTdZFez


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HistoryMain article:History of money

The use ofbarter-like methods may date back to at least 100,000 years ago, though there is noevidence of a society or economy that relied primarily on barter.[9]Instead, non-monetarysocieties operated largely along the principles ofgift economicsanddebt.[10][11]When barter did

in fact occur, it was usually between either complete strangers or potential enemies.[12]

Many cultures around the world eventually developed the use ofcommodity money. Theshekelwas originally a unit of weight, and referred to a specific weight ofbarley, which was used ascurrency.[13]The first usage of the term came fromMesopotamiacirca 3000 BC. Societies in theAmericas, Asia, Africa and Australia usedshell moneyoften, the shells of the moneycowry(Cypraea moneta L. or C. annulus L.). According toHerodotus, theLydianswere the first peopleto introduce the use of gold andsilver coins.[14]It is thought by modern scholars that these firststampedcoinswere minted around 650600 BC.[15]

The system ofcommodity moneyeventually evolved into a system ofrepresentative

money.[citation needed] This occurred because gold and silver merchants or banks would issuereceipts to their depositorsredeemable for thecommodity moneydeposited. Eventually, thesereceipts became generally accepted as a means of payment and were used as money. Papermoney orbanknoteswere first used inChinaduring theSong Dynasty. These banknotes, knownas "jiaozi", evolved frompromissory notesthat had been used since the 7th century. However,they did not displace commodity money, and were used alongside coins. Banknotes were firstissued in Europe byStockholms Bancoin 1661, and were again also used alongside coins. Thegold standard, amonetary systemwhere the medium of exchange are paper notes that areconvertible into pre-set, fixed quantities of gold, replaced the use of gold coins as currency in the17th-19th centuries in Europe. These gold standard notes were madelegal tender, andredemption into gold coins was discouraged. By the beginning of the 20th century almost all

countries had adopted the gold standard, backing their legal tender notes with fixed amounts ofgold.

AfterWorld War II, at theBretton Woods Conference, most countries adopted fiat currenciesthat were fixed to theUS dollar. The US dollar was in turn fixed to gold. In 1971 the USgovernment suspended the convertibility of the US dollar to gold. After this many countries de-pegged their currencies from the US dollar, and most of the world's currencies became unbackedby anything except the governments' fiat of legal tender and the ability to convert the money intogoods via payment.

Etymology

The word "money" is believed to originate from a temple ofHera, located onCapitoline, one ofRome's seven hills. In the ancient world Hera was often associated with money. The temple ofJuno Monetaat Rome was the place where the mint of Ancient Rome was located.[16]The name"Juno" may derive from the Etruscan goddessUni(which means "the one", "unique", "unit","union", "united") and "Moneta" either from the Latin word "monere" (remind, warn, or instruct)or the Greek word "moneres" (alone, unique).
http://en.wikipedia.org/wiki/History_of_moneyhttp://en.wikipedia.org/wiki/History_of_moneyhttp://en.wikipedia.org/wiki/History_of_moneyhttp://en.wikipedia.org/wiki/Barterhttp://en.wikipedia.org/wiki/Barterhttp://en.wikipedia.org/wiki/Barterhttp://en.wikipedia.org/wiki/Money#cite_note-8http://en.wikipedia.org/wiki/Money#cite_note-8http://en.wikipedia.org/wiki/Money#cite_note-8http://en.wikipedia.org/wiki/Gift_economicshttp://en.wikipedia.org/wiki/Gift_economicshttp://en.wikipedia.org/wiki/Gift_economicshttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Money#cite_note-9http://en.wikipedia.org/wiki/Money#cite_note-9http://en.wikipedia.org/wiki/Money#cite_note-9http://en.wikipedia.org/wiki/Money#cite_note-Graeber.2C_David_pp._153-154-11http://en.wikipedia.org/wiki/Money#cite_note-Graeber.2C_David_pp._153-154-11http://en.wikipedia.org/wiki/Money#cite_note-Graeber.2C_David_pp._153-154-11http://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Shekelhttp://en.wikipedia.org/wiki/Shekelhttp://en.wikipedia.org/wiki/Shekelhttp://en.wikipedia.org/wiki/Barleyhttp://en.wikipedia.org/wiki/Barleyhttp://en.wikipedia.org/wiki/Barleyhttp://en.wikipedia.org/wiki/Money#cite_note-12http://en.wikipedia.org/wiki/Money#cite_note-12http://en.wikipedia.org/wiki/Money#cite_note-12http://en.wikipedia.org/wiki/Mesopotamiahttp://en.wikipedia.org/wiki/Mesopotamiahttp://en.wikipedia.org/wiki/Mesopotamiahttp://en.wikipedia.org/wiki/Shell_moneyhttp://en.wikipedia.org/wiki/Shell_moneyhttp://en.wikipedia.org/wiki/Shell_moneyhttp://en.wikipedia.org/wiki/Cowryhttp://en.wikipedia.org/wiki/Cowryhttp://en.wikipedia.org/wiki/Cowryhttp://en.wikipedia.org/wiki/Herodotushttp://en.wikipedia.org/wiki/Herodotushttp://en.wikipedia.org/wiki/Herodotushttp://en.wikipedia.org/wiki/Lydianshttp://en.wikipedia.org/wiki/Lydianshttp://en.wikipedia.org/wiki/Lydianshttp://en.wikipedia.org/wiki/Silver_coinhttp://en.wikipedia.org/wiki/Silver_coinhttp://en.wikipedia.org/wiki/Money#cite_note-13http://en.wikipedia.org/wiki/Money#cite_note-13http://en.wikipedia.org/wiki/Money#cite_note-13http://en.wikipedia.org/wiki/Coinshttp://en.wikipedia.org/wiki/Coinshttp://en.wikipedia.org/wiki/Coinshttp://en.wikipedia.org/wiki/Money#cite_note-14http://en.wikipedia.org/wiki/Money#cite_note-14http://en.wikipedia.org/wiki/Money#cite_note-14http://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Banknoteshttp://en.wikipedia.org/wiki/Banknoteshttp://en.wikipedia.org/wiki/Banknoteshttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Song_Dynastyhttp://en.wikipedia.org/wiki/Song_Dynastyhttp://en.wikipedia.org/wiki/Song_Dynastyhttp://en.wikipedia.org/wiki/Jiaozi_(currency)http://en.wikipedia.org/wiki/Jiaozi_(currency)http://en.wikipedia.org/wiki/Jiaozi_(currency)http://en.wikipedia.org/wiki/Promissory_noteshttp://en.wikipedia.org/wiki/Promissory_noteshttp://en.wikipedia.org/wiki/Promissory_noteshttp://en.wikipedia.org/wiki/Stockholms_Bancohttp://en.wikipedia.org/wiki/Stockholms_Bancohttp://en.wikipedia.org/wiki/Stockholms_Bancohttp://en.wikipedia.org/wiki/Gold_standardhttp://en.wikipedia.org/wiki/Gold_standardhttp://en.wikipedia.org/wiki/Monetary_systemhttp://en.wikipedia.org/wiki/Monetary_systemhttp://en.wikipedia.org/wiki/Monetary_systemhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/World_War_IIhttp://en.wikipedia.org/wiki/World_War_IIhttp://en.wikipedia.org/wiki/World_War_IIhttp://en.wikipedia.org/wiki/Bretton_Woods_Conferencehttp://en.wikipedia.org/wiki/Bretton_Woods_Conferencehttp://en.wikipedia.org/wiki/Bretton_Woods_Conferencehttp://en.wikipedia.org/wiki/US_dollarhttp://en.wikipedia.org/wiki/US_dollarhttp://en.wikipedia.org/wiki/US_dollarhttp://en.wikipedia.org/wiki/Herahttp://en.wikipedia.org/wiki/Herahttp://en.wikipedia.org/wiki/Herahttp://en.wikipedia.org/wiki/Capitolinehttp://en.wikipedia.org/wiki/Capitolinehttp://en.wikipedia.org/wiki/Capitolinehttp://en.wikipedia.org/wiki/Juno_Monetahttp://en.wikipedia.org/wiki/Juno_Monetahttp://en.wikipedia.org/wiki/Money#cite_note-15http://en.wikipedia.org/wiki/Money#cite_note-15http://en.wikipedia.org/wiki/Money#cite_note-15http://en.wikipedia.org/wiki/Uni_(mythology)http://en.wikipedia.org/wiki/Uni_(mythology)http://en.wikipedia.org/wiki/Uni_(mythology)http://en.wikipedia.org/wiki/Uni_(mythology)http://en.wikipedia.org/wiki/Money#cite_note-15http://en.wikipedia.org/wiki/Juno_Monetahttp://en.wikipedia.org/wiki/Capitolinehttp://en.wikipedia.org/wiki/Herahttp://en.wikipedia.org/wiki/US_dollarhttp://en.wikipedia.org/wiki/Bretton_Woods_Conferencehttp://en.wikipedia.org/wiki/World_War_IIhttp://en.wikipedia.org/wiki/Legal_tenderhttp://en.wikipedia.org/wiki/Monetary_systemhttp://en.wikipedia.org/wiki/Gold_standardhttp://en.wikipedia.org/wiki/Stockholms_Bancohttp://en.wikipedia.org/wiki/Promissory_noteshttp://en.wikipedia.org/wiki/Jiaozi_(currency)http://en.wikipedia.org/wiki/Song_Dynastyhttp://en.wikipedia.org/wiki/Chinahttp://en.wikipedia.org/wiki/Banknoteshttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Representative_moneyhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Money#cite_note-14http://en.wikipedia.org/wiki/Coinshttp://en.wikipedia.org/wiki/Money#cite_note-13http://en.wikipedia.org/wiki/Silver_coinhttp://en.wikipedia.org/wiki/Lydianshttp://en.wikipedia.org/wiki/Herodotushttp://en.wikipedia.org/wiki/Cowryhttp://en.wikipedia.org/wiki/Shell_moneyhttp://en.wikipedia.org/wiki/Mesopotamiahttp://en.wikipedia.org/wiki/Money#cite_note-12http://en.wikipedia.org/wiki/Barleyhttp://en.wikipedia.org/wiki/Shekelhttp://en.wikipedia.org/wiki/Commodity_moneyhttp://en.wikipedia.org/wiki/Money#cite_note-Graeber.2C_David_pp._153-154-11http://en.wikipedia.org/wiki/Money#cite_note-9http://en.wikipedia.org/wiki/Money#cite_note-9http://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Gift_economicshttp://en.wikipedia.org/wiki/Money#cite_note-8http://en.wikipedia.org/wiki/Barterhttp://en.wikipedia.org/wiki/History_of_money


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In the Western world, a prevalent term for coin-money has beenspecie, stemming from Latin inspecie, meaning 'in kind'.[17]

Functions

In the past, money was generally considered to have the following four main functions, which

are summed up in arhymefound in older economics textbooks: "Money is a matter of functionsfour, a medium, a measure, a standard, a store." That is, money functions as amedium ofexchange, aunit of account, astandard of deferred payment, and astore of value.[5]However,modern textbooks now list only three functions, that ofmedium of exchange,unit of account,andstore of value, not considering a standard of deferred payment as a distinguished function,but rather subsuming it in the others.[4][18][19]

There have been many historical disputes regarding the combination of money's functions, somearguing that they need more separation and that a single unit is insufficient to deal with them all.One of these arguments is that the role of money as amedium of exchangeis in conflict with itsrole as astore of value: its role as a store of value requires holding it without spending, whereas

its role as a medium of exchange requires it to circulate.[5]

Others argue that storing of value isjust deferral of the exchange, but does not diminish the fact that money is a medium of exchangethat can be transported both across space and time.[20]The term 'financial capital' is a moregeneral and inclusive term for all liquid instruments, whether or not they are a uniformlyrecognized tender.

Medium of exchange

Main article:Medium of exchange

When money is used to intermediate the exchange of goods and services, it is performing afunction as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as

the 'double coincidence of wants' problem.

Unit of account

Main article:Unit of account

A unit of accountis a standard numerical unit of measurement of the market value of goods,services, and other transactions. Also known as a "measure" or "standard" of relative worth anddeferred payment, a unit of account is a necessary prerequisite for the formulation of commercialagreements that involve debt. To function as a 'unit of account', whatever is being used as moneymust be:

Divisible into smaller units without loss of value; precious metals can be coined from bars, ormelted down into bars again.

Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is whydiamonds, works ofartorreal estateare not suitable as money.

A specific weight, or measure, or size to be verifiably countable. For instance, coins are oftenmilled with areeded edge, so that any removal of material from the coin (lowering its

commodity value) will be easy to detect.
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Store of value

Main article:Store of value

To act as a store of value, a money must be able to be reliably saved, stored, and retrievedandbe predictably usable as a medium of exchange when it is retrieved. The value of the moneymust also remain stable over time. Some have argued thatinflation, by reducing the value of

money, diminishes the ability of the money to function as a store of value.

[4]

Standard of deferred payment

Main article:Standard of deferred payment

While standard of deferred paymentis distinguished by some texts,[5]particularly older ones,other texts subsume this under other functions.[4][18][19]A "standard of deferred payment" is anaccepted way to settle adebta unit in which debts are denominated, and the status of money aslegal tender, in those jurisdictions which have this concept, states that it may function for thedischarge of debts. When debts are denominated in money, the real value of debts may changedue toinflationanddeflation, and for sovereign and international debts viadebasementand

devaluation.

Measure of Value

Money, essentially acts as a standard measure and common denomination of trade. it is thus abasis for quoting and bargaining of prices. It has significantly in developing efficient accountingsystems. But the most important usage is that it provides a method to compare the values ofdissimilar objects.

Money supplyMain article:Money supply

In economics, money is a broad term that refers to any financial instrumentthat can fulfill thefunctions of money (detailed above). These financial instruments together are collectivelyreferred to as themoney supplyof an economy. In other words, the money supply is the amountof financial instruments within a specific economy available for purchasing goods or services.Since the money supply consists of various financial instruments (usually currency, demanddeposits and various other types of deposits), the amount of money in an economy is measuredby adding together these financial instruments creating a monetary aggregate.

Modern monetary theory distinguishes among different ways to measure the money supply,reflected in different types of monetary aggregates, using a categorization system that focuses ontheliquidityof the financial instrument used as money. The most commonly used monetaryaggregates (or types of money) are conventionally designated M1, M2 and M3. These aresuccessively larger aggregate categories: M1 is currency (coins and bills) plusdemand deposits(such as checking accounts); M2 is M1 plussavings accountsandtime depositsunder $100,000;and M3 is M2 plus largertime depositsand similar institutional accounts. M1 includes only themost liquid financial instruments, and M3 relatively illiquid instruments.
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Another measure of money, M0, is also used; unlike the other measures, it does not representactualpurchasing powerby firms and households in the economy. M0 isbase money, or theamount of money actually issued by thecentral bankof a country. It is measured as currencyplus deposits of banks and other institutions at the central bank. M0 is also the only money thatcan satisfy thereserve requirementsofcommercial banks.

Market liquidity

Main article:Market liquidity

Market liquidity describes how easily an item can be traded for another item, or into the commoncurrency within an economy. Money is the most liquid asset because it is universally recognisedand accepted as the common currency. In this way, money gives consumers thefreedomto tradegoods and services easily without having to barter.

Liquid financial instruments are easilytradableand have lowtransaction costs. There should beno (or minimal)spreadbetween the prices to buy and sell the instrument being used as money.

Types of moneyCurrently, most modern monetary systems are based on fiat money. However, for most ofhistory, almost all money was commodity money, such as gold and silver coins. As economiesdeveloped, commodity money was eventually replaced byrepresentative money, such as thegoldstandard, as traders found the physical transportation of gold and silver burdensome. Fiatcurrencies gradually took over in the last hundred years, especially since the breakup of theBretton Woods systemin the early 1970s.

Commodity money

Main article:Commodity money

Many items have been used ascommodity moneysuch as naturally scarceprecious metals,conch shells,barley, beads etc., as well as many other things that are thought of as havingvalue.Commodity money value comes from the commodity out of which it is made. The commodityitself constitutes the money, and the money is the commodity.[21]Examples of commodities thathave been used as mediums of exchange includegold,silver,copper,rice, salt, peppercorns,large stones, decorated belts, shells, alcohol, cigarettes, cannabis, candy, etc. These items weresometimes used in a metric of perceived value in conjunction to one another, in variouscommodity valuation orPrice Systemeconomies. Use of commodity money is similar to barter,but a commodity money provides a simple and automaticunit of accountfor the commoditywhich is being used as money. Although somegold coinssuch as theKrugerrandare considered

legal tender, there is no record of their face value on either side of the coin. The rationale for thisis that emphasis is laid on their direct link to the prevailing value of their fine goldcontent.[22]American Eaglesare imprinted with their gold content and legal tenderface value.[23]

Representative money

Main article:Representative money
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In 1875 economistWilliam Stanley Jevonsdescribed what he called "representative money," i.e.,money that consists oftoken coins, or other physical tokens such as certificates, that can bereliably exchanged for a fixed quantity of a commodity such asgoldorsilver. The value ofrepresentative money stands in direct and fixed relation to the commodity that backs it, while notitself being composed of that commodity.[24]

Fiat money

Main article:Fiat money

Fiat money or fiat currency is money whose value is not derived from any intrinsic value orguarantee that it can be converted into a valuable commodity (such as gold). Instead, it has valueonly by government order (fiat). Usually, the government declares the fiat currency (typicallynotes and coins from a central bank, such as theFederal Reserve Systemin the U.S.) to belegaltender, making it unlawful to not accept the fiat currency as a means of repayment for all debts,public and private.[25][26]

Somebullion coinssuch as theAustralian Gold NuggetandAmerican Eagleare legal tender,however, they trade based on themarket priceof the metal content as acommodity, rather thantheir legal tenderface value(which is usually only a small fraction of their bullion value).[23][27]

Fiat money, if physically represented in the form of currency (paper or coins) can be accidentallydamaged or destroyed. However, fiat money has an advantage over representative or commoditymoney, in that the same laws that created the money can also define rules for its replacement incase of damage or destruction. For example, the U.S. government will replace mutilatedFederalReserve notes(U.S. fiat money) if at least half of the physical note can be reconstructed, or if itcan be otherwise proven to have been destroyed.[28]By contrast, commodity money which hasbeen lost or destroyed cannot be recovered.

Currency

Main article:currency

Currency refers to physical objects generally accepted as amedium of exchange. These areusually thecoinsandbanknotesof a particular government, which comprise the physical aspectsof a nation'smoney supply. The other part of a nation's money supply consists ofbank deposits(sometimes calleddeposit money), ownership of which can be transferred by means ofcheques,debit cards, or other forms of money transfer. Deposit money and currency are money in thesense that both are acceptable as a means of payment.[29]

Money in the form of currency has predominated throughout most of history. Usually (goldor

silver) coins of intrinsic value (commodity money) have been the norm. However, nearly allcontemporary money systems are based onfiat moneymodern currency has value only bygovernment order (fiat). Usually, the government declares the fiat currency (typically notes andcoins issued by thecentral bank) to belegal tender, making it unlawful to not accept the fiatcurrency as a means of repayment for all debts, public and private.[25][26]

Commercial bank money

Main article:Demand deposit
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Commercial bank money or demand depositsare claims against financial institutions that can beused for the purchase of goods and services. A demand deposit account is an account from whichfunds can be withdrawn at any time by check or cash withdrawal without giving the bank orfinancial institution any prior notice. Banks have the legal obligation to return funds held indemand deposits immediately upon demand (or 'at call'). Demand deposit withdrawals can beperformed in person, via checks or bank drafts, usingautomatic teller machines(ATMs), orthroughonline banking.[30]

Commercial bank money is created throughfractional-reserve banking, the banking practicewherebankskeep only afraction of theirdepositsinreserve(as cash and other highly liquidassets) and lend out the remainder, while maintaining the simultaneous obligation to redeem allthese deposits upon demand.[31][32]Commercial bank money differs from commodity and fiatmoney in two ways, firstly it is non-physical, as its existence is only reflected in the accountledgers of banks and other financial institutions, and secondly, there is some element of risk thatthe claim will not be fulfilled if the financial institution becomes insolvent. The process offractional-reserve banking has a cumulative effect ofmoney creationby commercial banks, as itexpandsmoney supply(cash and demand deposits) beyond what it would otherwise be. Becauseof the prevalence of fractional reserve banking, thebroad money supplyof most countries is a

multiple larger than the amount ofbase moneycreated by the country'scentral bank. Thatmultiple (called themoney multiplier) is determined by thereserve requirementor otherfinancial ratiorequirements imposed by financial regulators.

Themoney supplyof a country is usually held to be the total amount of currency in circulationplus the total amount of checking and savings deposits in the commercial banks in the country.In modern economies, relatively little of the money supply is in physical currency. For example,in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7billion (about 10%) consisted of physical coins and paper money.[33]

Monetary policyMain article:Monetary policy

When gold and silver are used as money, the money supply can grow only if the supply of thesemetals is increased by mining. This rate of increase will accelerate during periods ofgold rushesand discoveries, such as when Columbus discovered the new world and brought back gold andsilver to Spain, or when gold wasdiscovered in California in 1848. This causes inflation, as thevalue of gold goes down. However, if the rate ofgold miningcannot keep up with the growth ofthe economy, gold becomes relatively more valuable, and prices (denominated in gold) will drop,causing deflation. Deflation was the more typical situation for over acenturywhen gold andpaper money backed by gold were used as money in the 18th and 19th centuries.

Modern day monetary systems are based on fiat money and are no longer tied to the value ofgold. The control of the amount of money in the economy is known as monetary policy.Monetary policy is the process by which agovernment, central bank, ormonetary authoritymanages themoney supplyto achieve specific goals. Usually the goal of monetary policy is toaccommodateeconomic growthin an environment of stable prices. For example, it is clearlystated in theFederal Reserve Actthat theBoard of Governorsand theFederal Open Market
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Committeeshould seek to promote effectively the goals of maximum employment, stableprices, and moderate long-term interest rates.[34]

A failed monetary policy can have significant detrimental effects on an economy and the societythat depends on it. These includehyperinflation,stagflation,recession, highunemployment,shortages of imported goods, inability to export goods, and even total monetary collapse and theadoption of a much less efficient barter economy. This happened in Russia, for instance, after thefall of the Soviet Union.

Governments and central banks have taken both regulatory andfree marketapproaches tomonetary policy. Some of the tools used to control the money supply include:

changing theinterest rateat which the central bank loans money to (or borrows money from)the commercial banks

currency purchases or sales increasing or loweringgovernment borrowing increasing or loweringgovernment spending manipulation ofexchange rates raising or lowering bank reserve requirements regulation or prohibition ofprivate currencies taxation or tax breaks on imports or exports of capital into a country

In the US, theFederal Reserveis responsible for controlling the money supply, while in theEuroareathe respective institution is theEuropean Central Bank. Other central banks with significantimpact on global finances are theBank of Japan,People's Bank of Chinaand theBank ofEngland.

For many years much of monetary policy was influenced by aneconomic theoryknown asmonetarism.Monetarismis an economic theory which argues that management of the money

supply should be the primary means of regulating economic activity. The stability of the demandfor money prior to the 1980s was a key finding ofMilton FriedmanandAnna Schwartz[35]supported by the work ofDavid Laidler,[36]and many others. The nature of the demand formoney changed during the 1980s owing to technical, institutional, and legal factorsand theinfluence of monetarism has since decreased.
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Financial institutionFrom Wikipedia, the free encyclopedia

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Infinancial economics, a financial institution is aninstitutionthat providesfinancial servicesfor its clients or members. Probably the most important financial service provided by financialinstitutions is acting asfinancial intermediaries. Most financial institutions areregulatedby thegovernment.

Broadly speaking, there are three major types of financial institutions:[1]

1. Deposit-taking institutions that accept and manage deposits and makeloans, includingbanks,building societies,credit unions,trust companies, andmortgage loancompanies

2. Insurancecompanies andpension funds; and3. Brokers,underwritersandinvestment funds.

[edit] Function

Financial institutions provide service as intermediaries of financial markets. They are responsiblefor transferring funds from investors to companies in need of those funds. Financial institutionsfacilitate the flow of money through the economy. To do so, savings arisk brought to providefunds for loans. Such is the primary means for depository institutions to develop revenue. Shouldtheyield curvebecome inverse, firms in this arena will offer additional fee-generating servicesincluding securities underwriting, and pre. fds

[edit] Corporate valuationRelative metrics :Price/EquityPrice/Book Value

Use Equity Multiples (as opposed to Enterprise Multiples). To consider how valuing a FinancialInstitution's balance sheet is different from a non-Financial firm, consider how an industrial firmwields capital machinery (asset) and the loans (liabilities) it used to finance that asset. The line isblurred in Financial Institutions, which must hold deposit accounts (liabilities) to fuel the
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issuance of loans (assets). The same accounts are considered loans as they are held in ownershipnot of the bank, but of the individual client.

Dividend Discount Model : Earnings-per-share

Dividends-per-share

Discounted Cash Flow (DCF) Model : You'll need the FCFE (Free Cash Flow for Equity),which is the amount of money that is returned to shareholders. Calculate an FCFF (Free CashFlow to the Firm):EBIT(1-tax rate) -Capital Expenditures+ (Depreciation & Amortization) -(Net increase in working capital)= FCFF

FCFF-Debt+Cash=FCFE

Use the Capital Asset Pricing Model, not the Weighted Average Cost of Capital (for the samereasons one uses Equity Multiples in relative valuation) to determine thecost of equity(thereturn required by shareholders to make the decision to invest in a financial institutions)

Excess Return Model : A model where valuation is expressed as the sum of capital investedcurrently in the firm and the present value of dollar excess returns that the firm expects to makein the future.[1]

[edit] Standing settlement instructions

Standing Settlement Instructions (SSIs) are the agreements between two financial institutionswhich fix the receiving agents of eachcounterpartyin ordinary trades of some type. Theseagreements allowtradersto make faster trades since time used to settle the receiving agents isconserved. Limiting the trader to an SSI also lowers the likelihood of afraud.

[edit] RegulationSee also:Financial regulation

Financial institutions in most countries operate in a heavily regulated environment as they arecritical parts of countries' economies. Regulation structures differ in each country, but typicallyinvolve prudential regulation as well as consumer protection and market stability. Somecountries have one consolidated agency that regulates all financial institutions while others haveseparate agencies for different types of institutions such as banks, insurance companies andbrokers.

Countries that have separate agencies include theUnited States, where the key governing bodiesare theFederal Financial Institutions Examination Council(FFIEC),Office of the Comptroller ofthe Currency- National Banks,Federal Deposit Insurance Corporation(FDIC) State "non-member" banks,National Credit Union Administration(NCUA) - Credit Unions,FederalReserve(Fed) - "member" Banks,Office of Thrift Supervision- National Savings & LoanAssociation, State governments each often regulate and charter financial institutions.
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Countries that have one consolidated financial regulator includeUnited Kingdomwith theFinancial Services Authority, Norway with theFinancial Supervisory Authority of Norway,Hong Kong withHong Kong Monetary Authorityand Russia withCentral Bank of Russia. SeealsoList of financial regulatory authorities by country.

Financial market

A financial market is a market in which people and entities cantradefinancialsecurities,commodities, and otherfungibleitems of value at lowtransaction costsand at prices that reflectsupply and demand. Securities include stocks and bonds, and commodities include preciousmetals or agricultural goods.

There are both general markets (where many commodities are traded) and specialized markets(where only one commodity is traded). Markets work by placing many interested buyers andsellers, including households, firms, and government agences, in one "place", thus making iteasier for them to find each other. An economy which relies primarily on interactions betweenbuyers and sellers to allocate resources is known as amarket economyin contrast either to acommand economyor to anon-market economysuch as agift economy.

Infinance, financial markets facilitate:

The raising ofcapital(in thecapital markets) The transfer ofrisk(in thederivatives markets) Price discovery Global transactions with integration of financial markets The transfer ofliquidity(in themoney markets) International trade(in thecurrency markets)

and are used to match those who want capital to those who have it.

Typically a borrower issues areceiptto the lender promising to pay back the capital. Thesereceipts aresecuritieswhich may be freely bought or sold. In return for lending money to theborrower, the lender will expect some compensation in the form ofinterestordividends. Thisreturn on investment is a necessary part of markets to ensure that funds are supplied to them.

[edit] Definition

Ineconomics, typically, the term marketmeans the aggregate of possible buyers and sellers of a

certain good or service and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations thatfacilitate the trade in financial securities, e.g., astock exchangeorcommodity exchange. Thismay be a physical location (like theNYSE, BSE, NSE) or an electronic system (likeNASDAQ).Much trading of stocks takes place on an exchange; still,corporate actions(merger, spinoff) areoutside an exchange, while any two companies or people, for whatever reason, may agree to sellstock from the one to the other without using an exchange.
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