Module 2 Sources of Funds
Dec 25, 2015
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
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- A time deposit- May not be withdrawn on demand- The bank pays interest and principal at maturity- Usually insured by government insurance (PDIC)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
•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
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?
1 Is the borrower creditworthy?
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
1 Is the borrower creditworthy?
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)
3Can the lender perfect its claim against the assets or earnings of the customer?
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
3Can the lender perfect its claim against the assets or earnings of the customer?
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
•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 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?