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1. What is Finance

2. The Four Basic Principles of Finance

3. Three Types of Business Organizations

4. The Goal of the Financial Manager

5. Agency Problems

Learning Objectives Three questions addressed by the study of finance

1. Identify the 3 primary business decisions 1. What long-term investments should the
that financial managers make. firm undertake?
2. Memorize the 4 principles of finance that 2. How should the firm fund these
form the basis of financial management for investments?
both businesses and individuals.
3. How can the firm best manage its cash flows
3. Identify the key differences between 3 major as they arise in its day-to-day operations?
legal forms of business.
The Four Basic Principles of Finance
4. Understand the role of the financial manager
within the firm and the goal for making 1. Money has a time value.
financial choices.  A dollar received today is more valuable
What is Finance? than a dollar received in the future (due to
interests, investment returns,…)
 Finance is all about money .
2. There is a risk-return trade-off.
 Finance means the study of managing money
and finding the required funds.  One shall take extra risk only if one expects
to be compensated for extra return.
 It includes activities like investing, borrowing,
lending, budgeting, saving, and forecasting. 3. Cash flows are the source of value.

 Profit is an accounting concept designed to

measure a business’s performance over an
interval of time.

 Cash flow is the amount of cash that can

actually be taken out of the business over
this same interval.
4. Market prices reflect information.  There is no separation between the partnership
and the owners with respect to debts or being
 Investors respond to new information by
buying and selling their investments.
 Advantages:
Three Types of Business Organizations
• Relatively easy to start
• Taxed at the personal tax rate
• Access to funds from multiple sources or

 Disadvantages:

• Partners jointly share unlimited liability

Limited Partnership

Sole Proprietorship • In limited partnerships, there are two

classes of partners: general and limited.
 It is a business owned by a single individual that • The general partners runs the business and
is entitled to all the firm’s profits and is face unlimited liability for the firm’s debts,
responsible for all the firm’s debt. while the limited partners are only liable on
 There is no separation between the business and the amount invested.
the owner when it comes to debts or being sued. Corporation
 Sole proprietorships are generally financed by  A corporation is an artificial being created by
personal loans from family and friends and operation of law, having the right of
business loans from banks. succession and the powers, attributes and
 Advantages: properties expressly authorized by law or
incident to its existence
• Easy to start
• No need to consult others while making  Corporation can individually sue and be
decisions sued, purchase, sell or own property, and its
• Taxed at the personal tax rate personnel are subject to criminal
punishment for crimes committed in the
 Disadvantages: name of the corporation.
• Personally liable for the business debts  Corporation is legally owned by its current
• Ceases on the death of the proprietor stockholders.
Partnership  The Board of directors are elected by the
 A general partnership is an association of two or firm’s shareholders. One responsibility of the
more persons who come together as co-owners board of directors is to appoint the senior
for the purpose of operating a business for management of the firm.
profit. Corporation Pros & Cons

 Advantages
 Liability of owners limited to invested  While managers have to cater to all the
funds stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular
 Life of corporation is not tied to the
attention to the owners of the corporation, i.e.,
 Easier to transfer ownership
 If managers fail to pursue shareholder wealth
 Easier to raise Capital maximization, they will lose the support of
investors and lenders. The business may cease
 Disadvantages
to exist and ultimately, the managers will lose
 Greater regulation their jobs
 Double taxation of dividends Corporate Mission Statements: Examples

 “To achieve sustainable growth, we

have established a vision with clear
goals: Maximizing return to
shareholders while being mindful of our
overall responsibilities” (part of Coca-
Cola’s mission statement)

 “Our final responsibility is to our

stockholders …when we operate
according to these principles, the
stockholders should realize a fair
return” (part of Johnson & Johnson’s

 “Optimize for the long-term rather

than trying to produce smooth earnings
for each quarter” -- Google.

Agency Relationships

 An agency relationship exists

whenever a principal hires an agent to
act on their behalf

 Within a corporation, agency

relationships exist between:
The Goal of the Financial Manager
• shareholders and managers
 The goal of the financial manager must be
consistent with the mission of the corporation.

• To maximize firm value shareholder’s

wealth (as measured by share prices).
Shareholders versus Managers

 Managers are naturally inclined to act in their

own best interests
 But the following factors affect managerial
• compensation plans
• direct intervention by shareholders
• threat of firing
• threat of takeover
• Board of Directors
Money Market are wholesale markets because
MONEY MARKETS most transactions are very large, and are usually in
The Money Markets Defined excess of 1 million

• A segment in financial market in which short- Why Do We Need the Money Markets?
term and highly liquid securities (money market • It is because the banking industry is subject
securities) are traded to more regulations and governmental costs
TWO PARTIES INVOLVED: than the money markets. In situations
where the asymmetric information problem
is not severe, the money markets have a
distinct cost advantage over banks in
providing short-term funds.
Money Market Cost Advantages
• The advantage of Money Market over Banks
is Interest-rate regulations.
• Because of the Interest-rate regulations in
banks during the late 1970s and early
1980s when inflation pushed short-term
• Money Market Securities have three basic interest rates above the level that banks
characteristics in common: could legally pay, Investors pulled their
➢ They are usually sold in large money out of banks and put it into money
denominations market security accounts offered by many
➢ They mature in one year or less from their brokerage firms
original issue date. Most money market Three-Month Treasury Bill Rate and Ceiling Rate
instruments mature in less than 120 days on Savings Deposits at Commercial Banks, 1933 to
➢ They have low default risk 1986
• Example:
• Certificates of Deposit
• Money Market Funds
• Treasury Bills
• Short-term Security Loans
• Repurchase Agreement
• Transactions are arranged over the phone and
are completed electronically • These new investors caused the money markets
to grow rapidly
• Because of this, money market
securities usually have an active • Commercial bank interest-rate ceilings were
secondary market removed in March 1986, but by then the retail
money markets were well established.
The Purpose of the Money Markets
• It serves as an ideal place “warehouse” for a • issuer of banker's acceptance and
firm or financial institution’s surplus funds until repurchase agreement
they are needed again because of well-
• Borrow to fund their loan portfolio
developed secondary market
• Dealers in the market for the over the
• Investors use the money market as an
counter interest rate derivatives
interim investment that provides a higher
return than holding cash or money in • Provide commitments that help ensure
banks investors
• The money markets provide a means to 4. Businesses
invest idle funds and to reduce
• used money market to warehouse surplus
opportunity cost.
funds and raise short-term funds
• It also provides a low-cost source of funds to
• part of their cash management
firms, the government, and intermediaries that
need a short-term infusion of funds. 5. Investment Companies
Participants in the Money Market • make market for money market
1. US Treasury Department/ Bureau if Treasury – • they ensure that sellers can readily market
Philippines their securities
• Always demander of money 6. Finance Companies
• US treasury is the largest borrower • raise funds in money market by selling
worldwide commercial paper
• Short-term issues enables them to raise • lends funds to individuals
funds until tax revenues are received
7. Insurance Companies
• Philippines issues peso dominated short-
• must maintain liquidity because of their
term securities
unpredictable need for funds; sell large
2. Federal Reserve System/ Bangko Sentral ng money market securities to raise money
8. Pension Funds
• Key participant in money market
• sells if interests rates should be raised and • maintain funds in money market
buy if interest rates should be lowered instruments in readiness for investment in
• In the Philippines, Bangko Sentral ng stocks and bonds
Pilipinas is the central banking system
9. Individuals
• Three monetary policy: control reserves,
open market operations and set targets on • allow small investors to participate in the
interest rates ,money market by aggregating their funds
3. Commercial Banks to invest in large- denomination money
market securities
• buys treasury securities; sell certificates of
deposit and make short-term loans; offer 10. Dealers and Brokers
individual investors accounts that invest in
money market securities
• Play a key role in marketing new issues of Liquid Market : a market which
money market instruments and providing securities can be bought and sold quickly
secondary markets for outstanding issues and with low transaction costs
11. Government- Sponsored Enterprises
➢ Treasury Bill Auctions
• Group of privately-owned financial
• The Treasury accepts the bids offering the
intermediaries with certain unique ties to
highest price.
federal government
➢ Competitive bidding
• Raise funds for farming and housing sector
of economy Bids are accepted in ascending order of
yield until it reach the offering amount. Each
Money Market Instruments
accepted bid is then awarded at the highest
1. Treasury Bills yield paid to any accepted bid.
• The most widely held and most liquid
➢ Non-competitive bidding
• The Bureau of the Treasury is the agent for Bids include only the amount of securities
the distribution of these government the investor wants. The price is set as the
securities. highest yield paid to any accepted competitive
• There are three tenors of Treasury Bills: (1) bid.
91 day (2) 182-day (3) 364-day Bills
➢ Treasury Bill Interest Rates
➢ Discounting • Treasury bills are very close to being risk-
• Discount rate
𝑭−𝑷 𝟑𝟔𝟎 2. Federal Funds
𝒊𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 = ×
𝐅 𝒏
• Federal funds are short-term funds
where 𝒊𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 = annualized discount rate transferred between financial institutions,
P = purchase price usually for a period of one day.

F = face or maturity value ➢ Purpose of Federal Funds

n = number of days until maturity • To provide banks with an immediate
infusion of reserves.
➢ Investment rate
➢ Federal Funds
𝑭−𝑷 𝟑𝟔𝟓
• 𝒊𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = × Terms for Fed Funds
𝐏 𝒏

• Fed funds are usually overnight investments

➢ Risk
Federal Funds Interest Rates
• Treasury bills have virtually zero default
• The forces of supply and demand set the
fed funds interest rate.
• The market for Treasury bill is extremely
deep and liquid.
Deep Market : a market with many
3. Repurchase Agreements
different buyers and sellers
• Repurchase agreements (repos) work much • direct placements- the issuer bypasses the
the same as fed funds except that non- dealer and sells directly to the end investor.
banks can participate.
6. Banker’s Acceptances
➢ The Use of Repurchase Agreements
• an order to pay a specified amount of
• Securities dealers use the repo to manage money to the bearer on a given date
their liquidity and to take advantage of
anticipated changes in interest rates.
7. Eurodollars
➢ Interest Rate on Repos
• Refers to US dollar-denominated deposits at
• Because repos are collateralized with foreign banks or at the overseas branches
Treasury securities, they are usually low-risk of American banks.
investments and therefore have low • Time deposits with fixed maturities, they
interest rates. are to a certain liquid.
• Market is not limited to dollars.
4. Negotiable Certificate of Deposit
• a bank-issued security that documents a
➢ Eurodollar Market
deposit and specifies the interest rate and
• Depositors often receive a higher return on
the maturity date.
a dollar deposit in the Eurodollar market
➢ Terms of Negotiable Certificates of Deposit
than in their domestic market.
• Negotiable CDs typically have a maturity of
• Received more favorable rate because they
one to four months. Some have six-month
are not subject to the same regulation
maturities, but there is little demand for
ones with longer maturities.
• Willing to be able to accept narrower
➢ Interest Rate on CDs
spreads between the interest paid on
• similar to the rate paid on other money deposits and the interest earned on loans
market instruments
➢ London Interbank Market
5. Commercial Paper
• Banks from around the world buy and sell
• unsecured promissory notes, issued by
overnight funds in this market.
corporations, that mature in no more than
• London interbank bid rate (LIBID)- rate paid
270 day
by banks buying funds
➢ Terms and Issuance
• London interbank offer rate (LIBOR)- funds
• Commercial paper always has an original offered for sale in the market.
maturity of less than 270 days.
Comparing money market instruments
• Most commercial paper actually matures in
20 to 45 days. • Interest Rates

➢ Market for Commercial Paper • Liquidity

• Nonbank corporations use commercial • Maturities

paper extensively to finance the loans that
they extend to their customers.
Interest Rates
• Some of the larger issuers of commercial
paper choose to distribute their securities • Appear to move closely together over time
with direct placements.
• Priced competitively
• Closed substitutes
• Example: The central bank of the Philippines
left its key overnight reverse repurchase
facility rate unchanged at 4.5% on its June
20th 2019 meeting, while markets had
expected it at 4.25%.
• Refers to how quickly, easily and cheaply it
can be converted into cash
How money market securities are valued
• money market securities use the method of
discounting the future maturity value back
to the present to know its price.
𝑷𝑽 =
(𝟏 + 𝒊)𝒏


• If an investor buys a T-bill with a 90-day

maturity and $50,000 par value for $48,500
and holds it to maturity, what is the

• A newly issued T-bill with a $10,000 par

value sells for $9,750, and has a 90-day
maturity. What is the discount?

• An investor buys a T-bill with a 180 days to

maturity and $250,000 par value for
$242,000. He plans to sell it after 60 days,
and forecasts a selling price of $247,000 at
that time. What is the annualized yield based
on this expectation?

• . Assume investors require a 5 percent

annualized return on a six-month T-bill with
a par value of $10,000. The price investors
would be willing to pay is $_______.


The capital Markets Defined


Why Do We Need the capital Markets?

• Equity Instruments

Where can he get the money from? • Insurance Instruments

• Foreign Exchange Instruments

• Hybrid Instruments

Significance and functions of the capital market

• Mobilization Of Savings

• Capital Formation

• Provision Of Investment Avenue

• Speed Up Economic Growth And


• Proper Regulation Of Funds

• Service Provision

Major suppliers of funds in the capital market:

• Commercial Banks

• Insurance Companies

• Business Corporations

• Retirement Funds

Major borrowers in the capital market:

• Treasury Departments
Meaning of capital market
• Corporations
• Capital market is the part of financial system
which is concerned with raising funds by • Security Dealers
dealing in shares, bonds and long-term Two types of capital market
• Primary Market
• It is the market where investment
instruments like bonds, equities and ➢ The market which shares, debentures and other
mortgages are traded. securities are sold for the first time for collecting
long-term capital; this issue is called Initial
Capital Market Cost Advantages Public Offering (IPO)
o The capital market offers both long-term and ➢ This market is concerned with new issues.
overnight funds Therefore, the primary market can also be called
“New Issues Market”.
o The different kinds of financial instruments that ➢ Secondary Market
are traded in the capital markets are:
➢ The market in which the buying and selling of the • The par, face, or maturity value of the bond
previously issued securities are already done. (they all mean the same thing) is the amount
➢ There are two types of exchanges in the that the issuer must pay at maturity.
secondary market for capital securities:
• The coupon rate is the rate of interest that the
organized exchanges and over-the-counter
issuer must pay, and this periodic interest
payment is often called the coupon payment.

• This rate is usually fixed for the duration of the

• Whereas most money market transactions bond and does not fluctuate with market
originate over the phone, most capital interest rates.
market transactions, measured by volume,
• If the repayment terms of a bond are not met,
occur in organized exchanges. An organized
the holder of a bond has a claim on the assets of
exchange has a building where securities
the issuer.
(including stocks, bonds, options, and
futures) trade. Exchange rules govern trading • Long-term bonds traded in the capital market
to ensure the efficient and legal operation of include long-term government notes and bonds,
the exchange, and the exchange’s board municipal bonds, and corporate bonds.
constantly reviews these rules to ensure that
they result in competitive trading.
• Instead of the typical lender-borrower set up
where the borrower approaches the lender to
Types of bonds ask for some money, a bond will have the
borrower (bond issuer) produce a contract
(bond) that states the terms of payments back
to the lender (bondholder).

• The borrower is the one setting the terms, not

the lender.

• It’s more flexible for the borrower as they cans

et up bonds with multiple bondholders instead
of just dealing with one.

• It’s a great way of raising enormous amount of

capital without being tied to a singular lender-
this is why bonds are heavily-leveraged by the
Features of bonds government ad big corporations.
• Bonds are securities that represent a debt owed • Bonds can be traded too! If you’re a bondholder,
by the issuer to the investor. you can actually sell your bonds in the stock
• Bonds obligate the issuer to pay a specified
amount at a given date, generally with periodic
interest payments.
• If you prefer not to wait for bond’s maturity for amount of interest in the form of coupon
whatever reason (or strategy), this option makes payments and returns the principal to the
it more flexible as a financial vehicle. investor (bondholder in the case of bonds)
upon maturity.
Benefits of Investing in Bonds
1. Maturity-based bonds
• Provides better returns on your money
• Bonds categorized based on the length of
compared to banks
time it will mature.
• Serves as another investment tool for ➢ Treasury Bills (T-bills)
diversifying your investments
• Bonds that mature in less than 1 year (short
• Lets you preserve your capital and earn interest term). The most common tenors (length of
from it at the same time maturity) for T-bills are 91 days, 181 days, and
364 days.
• Generally viewed as safer than stocks as its less
volatile in nature (especially short and medium- • Pros:
length bonds)
o Matures in less than a year (shorter
• Bonds are tradeable (liquid) investment time frame)

• Bondholders receive some form of protection o Sold at a discount from their face value but
for their investment, when a company goes the investor will get the full amount upon
bankrupt, the bondholders typically receive a maturity (works like a zero-coupon bond)
portion (if not the face value) of their investment
• Cons:
• There are different types of bonds that you can
o Doesn’t pay income or coupon interest
choose from
➢ Treasury Bonds (T-bonds)
Types of bonds
• Bonds that have tenors of more than 1 year.
➢ Maturity-Based Bonds The most common maturity lengths for T-
bonds are 2-year, 5-year, 7-year, 10-year,
• Treasury Bills (T-Bills)
20-year, and 30-year bonds.
• Treasury Bonds (T-Bonds) • Pros:
– Pays investor coupon interest (fixed
➢ Issuer-Based Bonds
income) at fixed intervals for the
• Treasury Securities duration of the bond
• Agency/Government Bonds • Cons:
– Can present a higher risk due to the
• Municipal Bonds longer length of time before it
• Corporate Bonds matures

Types of Bonds

• Bonds are considered the most common

type of fixed income securities, which is
defined as debt instruments that pay a fixed
Treasury notes and bonds • Treasury notes also are auctioned. Treasury are
sold in increments. The price of the note may
fluctuate based on the results of the auction. It
may be equal to, less than, or greater than the
note's face value.

Treasury bonds

• Treasury bonds or T-bonds, are often referred to

as long bonds because they take the longest to
mature of the government-issued securities.
They are offered to investors in a term of 30
years to maturity.

• Purchasers of T-bonds receive a fixed-interest

payment every six months. They pay the highest
interest rates of the three types of government
securities because they require the longest term
of the investment. For the same reason, the
Treasury notes and bonds prices at which they are issued fluctuate more
than the other forms of government investment.
• Treasury Notes and Treasury Bonds are
considered the safest. Treasury Notes and • A bond's price and its yield are determined
Bonds, FXTNs and RTBs as they are commonly during the auction. After that, T-bonds are
called, are medium- to long-term government traded actively in the secondary market and can
securities that pay interest regularly (known as be purchased through a bank or broker.
interest coupon payments). • Individual investors often use T-bonds to keep a
• This type of investment is “virtually” risk-free. It portion of their retirement savings risk-free, to
is considered zero-risk because it is a direct, provide a steady income in retirement, or to set
unconditional and general obligation of the aside savings for a child's education or other
Republic of the Philippines. major expenses. Investors must hold their T-
bonds for a minimum of 45 days before they can
Treasury notes be sold on the secondary market.
• treasury notes, are similar to T-bonds, but are Treasury notes and bonds
offered in a wide range of terms as short as two
years and no longer than 10 years. T-notes also • Federal government notes and bonds are free of
generate interest payments twice a year. But default risk because the government can always
because the terms offered by T-notes are lower print money to pay off the debt if necessary. This
than T-bonds, they offer lower yields does not mean that these securities are risk-free

• The 10-year T-note is the most closely watched ❖ MARTHA JANE ACHONDO
government bond. It is used as a benchmark rate Treasury Bond Interest rates
for banks to calculate mortgage rates.
❖ Treasury bonds have very low interest rates
because they have no default risk.
❖ The Treasury yield is the interest rate that ❖ STRIPS are also called zero-coupon securities
the U.S. government pays to borrow money because the only time an investor receives a
for different lengths of time. payment during the life of each STRIPS
component is when it matures.

Type Maturity Agency Bonds (Treasury notes and bonds)

• Issuers of Agency Bonds

• CASE (The 2007 - 2009 Financial Crisis and the

Treasury bill Less than 1 year Bailout of Fannie Mae and Freddie Mac)

Municipal Bonds

Treasury note 1 to 10 years • General obligation bonds

• Revenue bonds
Treasury bond 10 to 30 years
✓ Issuers of Agency Bonds

1. Student Loan Marketing Association (Sallie

Treasury Inflation-Protected Securities (TIPS) Mae)

In 1997 the Treasury Department began offering an 2. Farmers Home Administration

innovative bond designed to remove inflation risk 3. Federal Housing Administration
from holding treasury securities. The inflation-
indexed bonds have an interest rate that does not 4. Veterans Administrations
change throughout the term of the security. 5. Federal Land Banks
However, the principal amount used to compute the
✓ Risk on Agency Bonds
interest payment does change based on the
consumer price index. At maturity, the securities are ➢ The risk on agency bonds is actually very
redeemed at the greater of their inflation-adjusted low.
principal or par amount at original issue.
➢ They are usually secured by the loans that
Treasury STRIPS are made with the funds raised by the bond
❖ Treasury began issuing to depository institutions
bonds in book entry form called Separate ➢ In addition, the federal agencies may use
Trading of Registered Interest and Principal their lines of credit with the Treasury
Securities, more commonly called STRIPS. Department should they have trouble
meeting their obligations.
❖ Treasury STRIPS are bonds that are sold at a
discount to their face value. The investor does ➢ Finally, it is unlikely that the federal
not receive interest payments but is repaid the government would permit its agencies to
full face value when the bonds mature. default on their obligations.
investors will be satisfied with lower interest
rates on tax-exempt bonds.
-This was evidenced by the bailout of the Federal
National Mortgage Association (Fannie Mae) and • You can use the following equation to determine
the Federal Home Loan Mortgage Corporation what tax-free rate of interest is equivalent to a
(Freddie Mac) in 2008. Faced with taxable rate:
port_x0002_folios of subprime mortgage loans,
they were at risk of defaulting on their bonds before
the government stepped in to guarantee payment. Example:

Agency Bonds

❖ an agency bond is a security issued by a

government-sponsored enterprise or by a
federal government department other than the
U.S. Treasury.

❖ Congress has authorized a number of U.S.

agencies, also known as
government_x0002_sponsored enterprises
(GSEs), to issue bonds.

❖ The government does not explicitly guarantee

agency bonds, though most investors feel that Two types of Municipal Bond
the government would not allow the agencies to
default. General obligation

CASE : bonds do not have specific assets pledged as

security or a specific source of revenue allocated for
The 2007–2009 Financial Crisis and the Bailout of their repayment. Instead, they are backed by the
Fannie Mae and Freddie Mac “full faith and credit” of the issuer.

Type of Bonds Revenue bonds

1. MUNICIPAL BONDS by contrast, are backed by the cash flow of a

particular revenue-generating project.
• Municipal bonds are securities issued by local,
county, and state governments.

• The proceeds from these bonds are used to

finance public interest projects, such as schools,
utilities, and transportation systems.

• Interest earned on municipal bonds that are

issued to pay for essential public projects are
exempt from federal taxation.

• As we saw in Chapter 5, this allows the

municipality to borrow at a lower cost because
Risk in the Municipal Bond Market of directors,which represents the corporation’s
Municipal bonds are not default-free
2. Call Provisions
For example, a study by Fitch Ratings reported a
0.63% default rate on municipal bonds. Most corporate indentures include a call provision,
which states that the issuer has the right to force the
✓ Abdul Raffy M. Ampang
holder to sell the bond back.
2. Corporate Bonds
➢ The bond indenture 3. Conversion
– Is a contract that states the lender’s rights
Some bonds can be converted into shares of
and privileges and the borrower’s
common stock.This feature permits bondholders to
obligations. Any collateral offered as security
share in the firm’s good fortunes if the stock price
to the bondholders is also described in the
✓ Fatmah Alniah M. Boloto

Types of corporate bonds

1. Secured bonds

Are those that are collaterized by an assets such

as property, equipment, or by another income

2. Unsecured Bonds

Are those secured by a specific asset but rather

Characteristics of Corporate Bonds
by “the full faith and credit” of the issuer.
▪ Restrictive Covenants
3. Junk Bonds
▪ Call Provisions
are bonds that carry a higher risk of default than
▪ Conversion most bonds issued by corporations and

The Internal Revenue Service did not care for

this method of payment, however, because it made
tracking interest income difficult.

Bearer bonds have now been largely

replaced by registered bonds, which do not have
coupons. Instead, the owner must register with the
firm to receive interest payments.

1. Restrictive Covenants

A corporation’s financial managers are hired,

fired, and compensated at the direction of the board
Credit default Swap(CDS)

o In 1995 J.P Morgan introduced the CDS a

new way to insure bonds.

o In 2000 Congress passed the Commodity

Futures Modernization Act, which removed
derivatives securities, such as CDS, from
regulatory oversight. Additionally , it
preempted states from enforcing gaming
laws on these types of securities.

o Between 2000 and 2008, major CDS players

included AIG, Lehman Brothers, and Bear



o A contract by a third party (guarantor) to back

the debt of a second party (the creditor) for its
payments to the ultimate debtholder (investor).

o Financially weaker security issuers frequently

purchase Financial Guarantees to lower the risk
of their bonds.

o It ensures that the lender (bond purchaser) will

be paid both principal and interest in the event OVERSIGHT OF THE BOND MARKETS
the issuer defaults.
o Bonds typically trade over the counter,
o Financial guarantees can result in a higher credit where transaction details can be hidden
rating, lowering the cost to the issuer. from public.
EXAMPLE: o To open this market to scrutiny, in 2002 the
o Let's assume XYZ Company has a subsidiary Securities and Trade Commission created a
named ABC Company. ABC Company would like trade reporting and compliance engine
to build a new plant and thus would like to (TRACE).
borrow $10 million from a bank. The bank will o TRACE has two significant missions:
probably require XYZ Company to provide a
financial guarantee of the loan. By doing so, XYZ 1. Rules that say which bond transactions must
Company agrees to repay the loan using cash be publicly reported.
flows from other parts of its business if ABC 2. The establishment of a trading platform that
Company is unable to generate enoughcash on makes transaction data readily available to
its own to repay the debt. the public.
TRACE When the bond price is at par, the current
yield equals the yield to maturity. This means that
the nearer the bond price is to the bond’s par
value, the better the current yield will approximate
Under the Financial Industry the yield to maturity.
Regulatory Authority (FINRA).

Formerly the National Association of

Securities Dealers (NASD).

In 2007 it was created to consolidate the regulatory

and oversight functions of NASD with those of the
New York Stock Exchange.
The general characteristics of the current
yield (the yearly coupon payment divided by the
bond price) can be summarized as follows: The
current yield better approximates the yield to
maturity when the bond’s price is nearer to the
bond’s par value and the maturity of the bond is
longer. It becomes a worse approximation when
the bond’s price is further from the bond’s par
value and the bond’s maturity is shorter.
Regardless of whether the current yield is a good
approximation of the yield to maturity, a change in
the current yield always signals a change in the
same direction of the yield to maturity.

o Current Yield – is an approximation of the

yield to maturity on coupon bonds that is
Sample problems
often reported because it is easily calculated.
It is defined as the yearly coupon payment
divided by the price of the security.
Present Value
of Principal = Face Value * (1+i)^-n
Present Value
of Annuity
Payments = FV * CR * [1-(1+i)^-n]
Bond Price > Face Value = Premium = Coupon Rate > YTM
Bond Price < Face Value = Discount = Coupon Rate < YTM

A 12-year bond has a 9 percent annual coupon, a

yield to maturity of 8 percent, and a face value of
$1,000. What is the price of the bond?
Present Value of Principal = 1,000 * (1+.08)^-12 = 397.11
+ 1-(1+i)^-n 80 + (1000-865)/11
= 9.89%
Present Value of Annuity Payments = 1000*.09*[1-(1+.08)^-12]/(.08) = 678.25 i
Bond Price = = 1,075.36
Bond Price > Face Value = Premium = Coupon Rate > YTM
Consider a $1,000 par value bond with a 7 percent
Bond Priceintend
< Face Value to purchase
= Discount a 10-year,= $1,000
Coupon Rate face
< YTM value annual coupon. The bond pays interest annually.
bond that pays interest of $60 every 6 months. If
There are 9 years remaining until maturity. What is
your YTM is 10 percent with semiannual
the current yield on the bond assuming that the
compounding, how much should you be willing to
required return on the bond is 10 percent?
pay for this bond?
Present Value of Principal = 1,000 * (1+.10)^-9 = 424.1
Present Value of Principal = 1,000 * (1+.05)^-20 = 376.89 Present Value of Annuity Payments = 1000*.07*1-(1+.10)^-9/(.10) = 403.13
Bond Price = = 827.23
Present Value of Annuity Payments = 1000*.06*1-(1+.05)^-20/(.05) = 747.73 Current Yield Coupon Price /Bond Price
Bond Price = = 1,124.62
Current Yield = 70/827.23 = 8.46%
A $1,000 par value bond pays quarter interest of 14
% and will mature in 10 years. If your YTM is 12 A corporate bond matures in 14 years. The bond has
percent for quarterly payments, how much should an 8 percent coupon semi annually and a par value
you be willing to pay for this bond? of $1,000. The bond is callable in five years at a call
price of $1,050. The price of the bond today is
Present Value of Principal = 1,000 * (1+.03)^-40 = 306.57 $1,075. What is the yield to call?
Present Value of Annuity Payments = 1000*.035*1-(1+.03)^-40/(.03) = 809.02
Bond Price = = 1,115.59

Palmer Products has outstanding bonds with an

annual 8 percent coupon. The bonds have a par
value of $1,000 and a price of $865. The bonds will
mature in 11 years. What is the yield to maturity on 40 + (1050-1075)/10
the bonds? YTC =
= 3.52% 7.04%
PROBLEM 7 A stock is an investment. When you purchase a
company's stock, you're purchasing a small piece of
Kennedy Gas Works has bonds that mature in 10
that company, called a share.
years, and have a face value of $1,000. The bonds
have a 10 percent for quarterly coupon. The bonds Investors purchase stocks in companies they think
may be called in five years. The bonds have a yield will go up in value.
to maturity of 8 percent and a yield to call of 7.5
percent. What is the bonds’ call price?
A sum of money paid regularly (typically
quarterly) by a company to its shareholders out of
its profits (or reserves).

Stock VS Bonds


Any person, company, institution or other person

owning one or more of a company’s share and on
whose name the company has issues a share
certificate is called the company’s stockholder.


• Common stock is a type of security that

represents ownership of equity in a company.

• There are other terms – such as common share,

ordinary share, or voting share – that are
Chapter 13: Stock markets equivalent to common stock.

✓ Nasheb Macabato PREFERRED STOCK

1. Investing in stocks • Preferred stock is a form of stock which may

have any combination of features not possessed
• Stock vs Bonds by common stock including properties of both
• Stockholders an equity and a debt instrument, and is generally
considered a hybrid instrument.
• What Are Common Stocks?
✓ First, because preferred stockholders receive a
• What Are Preferred Stocks? fixed dividend that never changes, a share of
• How Are Stocks Sold? preferred stock is as much like a bond as it is like
common stock.
➢ What Is A Stock? ✓ Second, because the dividend does not change,
A stock is a type of investment that represents an the price of preferred stock is relatively stable.
ownership share in a company. ✓ Third, preferred stockholders do not usually
vote unless the firm has failed to pay the
promised dividend.
✓ Finally, preferred stockholders hold a claim on arbitrage mechanism designed to keep it trading
assets that has priority over the claims of close to its net asset value, although deviations
common shareholders but after that of creditors can occasionally occur.
such as bondholders.
Lao, Jehanoding

2. Computing the Price of Common Stock

❖ The One-Period Valuation Model

P0 = D1 + P1
(1 + ke) (1 + ke)
where :
P0 = the current price of the stock. The zero
subscript refers to time period zero, or the
D1 = the dividend paid at the end of year 1.
HOW ARE STOCKS SOLD? ke = the required return on investments in
Organized Securities Exchanges
P1 = the price at the end of the first year. This
• Organized Securities exchanges are tangible is the assumed sales price of the stock.
organizations that act as secondary markets
in which outstanding securities are resold. • Future discounted value

Over-the-Counter Markets

• This market is not organized in the sense of

having a building where trading takes place.
Example: The One-Period Valuation Model
• Instead, trading occurs over sophisticated
Suppose that you have some extra money to
telecommunications networks.
invest for one year. After a year you will need
lternative Trading Systems (ATSs) and Multilateral to sell your investment to pay tuition. After
Trading Facilities (MTFs) watching Wall Street Week on TV you decide
that you want to buy Intel Corp. stock. You call
• ATSs are trading systems that bypass traditional
your broker and find that Intel is currently
exchanges and allow for buyers and sellers of
selling for $50 per share and pays $0.16 per
securities to deal directly with each other.
year in dividends. The analyst on Wall Street
• ATSs and MFTs are typically used for large Week predicts that the stock will be selling for
transactions among institutional investors. $60 in one year. Should you buy this stock?
Exchange Traded Funds Find the value of the Intel stock given the
• An exchange-traded fund is an investment fund figures reported above. Assume that after
traded on stock exchanges, much like stocks. careful consideration you decide that you
would be satisfied to earn 12% on the
• An ETF holds assets such as stocks, commodities, investment.
or bonds and generally operates with an
P0 = $ 0.60 + $60
(1 + 0.12) (1 + 0.12) 1. Dividends are assumed to continue growing at a
constant rate forever.
= $.14 + $53.57
2. The growth rate is assumed to be less than the
= $53.71 required return on equity, ke. --Myron Gordon
❖ The Generalized Dividend Valuation Model Example:
• The one-period dividend valuation model
can be extended to any number of periods. The generalized d
The concept remains the same.
price of stock
present value
• The generalized dividend model says that
the price of stock is determined only by the
present value of the dividends and that
nothing else matters.
❖ Earnings Price Valuation Method

• The price earnings ratio (PE) is a widely

watched measure of how much the market
is willing to pay for $1 of earnings from a
❖ The Gordon Growth Model firm. The PE ratio can be used to estimate
the value of a firm’s stock.
• Many firms strive To increase their
dividends at a constant rate each year.

A high PE has two interpretations:

1. A higher-than-average PE may mean that the

market expects earnings to rise in the future.
This would return the PE to a more normal level.

2. A high PE may alternatively indicate that the

market feels the firm’s earnings are very low risk
and is therefore willing to pay a premium for


This model is useful for finding the value of stock,

given a few assumptions:
A piece of property or a building will sell to
the buyer who can put the asset to the most
productive use. Consider why one company often
pays a substantial premium over current market
prices to acquire ownership of another (target)
✓ Apiran Macagaan
company. The acquiring firm may believe that it can
3. How the market sets security prices
put the target firm’s asset to work better than they
Example: are currently and that this justifies the premium
Suppose you go to an auto auction. The cars are
available for inspection before the auction begins Superior information about an asset can
and you find a little Mazda Miata that you like. You increase its value by reducing its risk
test drive it in the parking lot and notice that it
When you consider buying a stock, there are
makes a few strange noises, but you decide that you
many unknowns about the future cash flows. The
would still like the car. You decide $5,000 would be
buyer who has the best information about these
a fair price that would allow you to pay some repair
cash flows will discount them at a lower interest rate
bills should the noises turn out to be serious. You
than will a buyer who is very uncertain.
see that the auction is ready to begin, so you go in
and wait for the Miata to enter. APPLYING TO STOCK VALUATION

Suppose there is another buyer who also spots the Suppose that Daniel are considering the
Miata. He test-drives the car and recognizes that the purchase of stock expected to pay dividends of $2
noises are simply the result of worn brake pads that next year (D = $2) . The firm is expected to grow at
he can fix himself at nominal cost. He decides that 3% infinitively (g = 3%). Daniel quite uncertain about
the car is worth $7,000. He also goes in and wait for both constancy of the dividend stream and the
the Miata to enter. accuracy of the estimated growth rate. To
compensate himself for this risk, he require a return
of 15%.
Now suppose, Jennifer, another investor,
$4,000 $4,500 has spoke with industry insiders and feels more
confident about the projected cash flows. Jennifer
$5,000 $5,100
requires only a 12% return because her perceived
First, the price is set by the buyer willing to pay the risk is lower than yours.
highest price
Bud, on the other hand, is dating the CEO of
The price is not necessarily the highest price the the company. He knows with near certainty what
asset could fetch, but it is incrementally greater than the future of the firm actually is. He thinks that both
what any buyer is willing to pay. estimated growth rate and the estimated cash flows
are lower than what they will actually be in the
Second, the market price will be set by the buyer
future. Because he sees almost no risk in this
who can take best advantage of the asset.
investment, he requires only at a 7% return.


DANIEL 15% $16.67 The Dow Jones Industrial Average (DJIA) is an index
composed of 30 “blue chip” industrial firms.
JENNIFER 12% $22.22
On May 26, 1896, Charles H. Dow added up the prices
BUD 7% $50.00
of 12 of the best-known stocks and created an average
by dividing by the number of stocks. In 1916 eight
more stocks were added, and in 1928 the 30-stock
The point of this section is that the players in
average made its debut.
the market, bidding against each other, establish the
market price. When new information released
about a firm, expectation change, and with them,
prices change. New information can cause changes
in expectations about the level of future dividends
or the risk of dividends.

Since market participants are constantly

receiving new information and constantly revising
their expectations, it is reasonable that stock prices
are constantly changing as well.

4. Errors in valuation
--- Dimaro

5. Stock market indexes

◼ Mohammad Hanin Dipatuan

A stock market index is used to monitor

the behavior of a group of stocks. By reviewing the
average behavior of a group of stocks, investors are
able to gain some insight as to how a broad group of
stocks may have performed.

Various stock market indexes are reported to give

investors an indication of the performance of
different groups of stocks.

History of the Dow Jones Industrial Average

1. Buying Foreign Stocks ---- Dianalan N.
2. Regulation of the Stock market ----Gamama A.