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FINANCIAL MARKETS Brennan John Rivera, CPA
Course Code:
Fin. 2
Course Description: This course aims to develop students understanding of the basic principles of financial markets and provides an introduction how assets are valued and traded in those markets. The course considers stock market prices and returns; stock market risk and the influence of risk on the pricing of shares. It also considers exchange rates, interest rates and the pricing of bonds; and the characteristics and pricing of financial futures and options. But the most important contribution of this course to your future career is how to use the latest academic insights to better assess risks and returns, and the trade off between the two in your future decision making. Course Intended Learning Outcomes: At the end of the semester the student are expected to: 1. recognize the basic principles of financial markets 2. determine how assets are valued and traded in the financial markets 3. relate how academic insights in financial markets assess the risks and returns in coming up business decision making 4. distinguish financial intermediary from financial markets 5. explain how investment market operates 6. recognize the concept of time value of money (TVM) Course Requirements:
Assessment Tasks - 60% Major Exams - 40% Periodic Grade 100%
PRELIM GRADE MIDTERM GRADE FINAL GRADE
: 60% (Activity 1-4) + 40% (Prelim exam) : 30% (Prelim Grade) + 70 % [60% (Activity 5-7) + 40% (Midterm exam)] : 30% (Midterm Grade) + 70 % [60% (Activity 8-10) + 40% (Final exam)]
Table of Contents
Module 1.
Financial System
1
Introduction
1
Learning Outcomes
2
Lesson 1.
The Basic Functions of Financial System
2
Lesson 2.
Financial Intermediary
3
Lesson 3.
Money Market
6
Lesson 4.
Capital Market
8
Lesson 5.
Types of Capital Market
9
Lesson 6.
Other Examples of Financial Markets
10
Assessment task 1
11
Summary
12
References
12
Module 2.
Investment Market
14
Introduction
14
Learning Outcomes
14
Lesson 1.
Functions of Investment Banker
14
Lesson 2.
Investing Procedures
16
Lesson 3.
Trading Transaction Fees / Taxes
20
Assessment task 2
23
Summary
23
References
24
Module 3
Time Value of Money
25
Introduction
25
Learning Outcomes
26
Lesson 1.
Understanding the Concept of Time Value of Money
27
Lesson 2.
Future Values of Money
27
Lesson 3.
Intrayear Compounding Interest
29
Lesson 4.
Future Value of an Annuity
31
Lesson 5.
Present Value at Compounded Interest
33
Lesson 6.
Application of Future and Present Value of
Lesson 7.
Money
36
Annual Percentage Return
38
Assessment task 3
40
Summary
40
References
40
MODULE 1 FINANCIAL MARKETS
Introduction Financial Markets, from the name itself, are a type of marketplace that provides an avenue for sale and purchase of assets such as bonds, stocks, foreign exchange, and derivative. Often, they are also called capital markets, but they mean one and the same thing. Simply put, businesses and investments can go to financial markets to raise money to grow their business and to make more money, respectively. To state it more clearly, let us imagine a bank wherein individual maintains a savings account. The bank can use their money and the money of other depositors to loan to other individuals and organizations and charge an interest fee. The depositors themselves also earn and see their money grow through the interest that is paid to it. Therefore, the serves as a financial market that benefit both the depositors and the debtors (corporate finance institute.com, n.d.).. This module exposes the students to the functions of financial system. It will also touch difference between financial market and intermediary and give emphasis on the different types of capital market (corporate finance institute.com, n.d.).
Learning Outcomes At the end of the chapter, students should be able to:
1. Explain the necessity of financial intermediary 2. Differentiate financial intermediary from financial market 3. Identify the advantages and disadvantages of using financial intermediary 4. Discuss the different types of capital markets 5. Enumerate the different financial instruments used in the money market 6. Distinguish the primary market from secondary market
Lesson 1. The Basic Functions of Financial System (De Haan, Oosterloo, & Schoenmaker, 2012) Having a well-functioning financial system in place that directs funds to their most productive uses is a crucial prerequisite for economic development. The financial system consists of all financial intermediaries and financial markets, and their relations with respect to the flow of funds to and from households, governments, business firms, and foreigners, as well as the financial infrastructure. The main task of the financial system is to channel funds from sectors that have a surplus to sectors that have a shortage of funds. In doing so, the financial sector performs two main functions: (1) reducing information and transaction costs, and (2) facilitating the trading, diversification, and management of risk. Specific functions include the following: 1. Promote savings. Through the various markets in the financial system, the savings of different surplus spending units turn into investments because these market offers a potential rate of return for a relatively low risk.
2. Enable payment. The financial system has the best and most expedient mechanisms in facilitating payments when purchasing goods and services, e.g. the checking accounts that commercial banks as well as other types authorized banks offer. 2
3. Protect against risks. Through the sale of life, property, and accident insurance policies by Insurance companies, the financial market has become necessary to entrepreneurs, consumers and the government. Insurance companies offer protection from practically all kinds of risk.
4. Present a means to wealth. The different financial markets are excellent placements for savings that various economic units accumulate. These markets offer the highest interest rate and a wide range of maturity to suit any investor’s plans. They also serve as a means to wealth, i.e. they preserve the value of the funds until the funds are used and they generate earnings at the same time.
5. Provide liquidity. The numerous financial instruments used to store the wealth possessed the different economic units can readily be converted into cash with little or no risk of loss. The financial system provides this service to savers who hold financial instruments and are in need of cash.
6. Provide credit facilities. Aside from expediting the conversion of savings into investments and providing liquidity, markets are also making credit facilities available to consumers and investors whether for spending or for any other purpose.
Lesson 2. Financial Intermediary (Prachi, 2019) An individual who would want to invest his/her savings to earn additional income will surely go to a bank to open a savings or a time deposit account. The deposit he/she makes, in turn are used by the bank to lend to borrowers. Here, the bank is not obliged to tell the depositor where his/her money is going. The only obligation of the bank is to safekeep the money and pay the stipulated interest. The function of the bank, in short is to act like a middleman. It obtains money from providers (investors) and lends it to the users (borrowers). Where would a firm or government agency go if they want to raise money to finance a business for example? Should it approach individuals or firms with surplus money and ask them to lend funds in exchange for interest? Most individuals or firms do not approach the 3
financial markets directly, rather they use middleman or financial intermediaries. An investment bank is also a financial intermediary. It does not accept deposits but provides funds to individuals or companies that need them. When firms and government agencies want to raise money by issuing bonds or commercial papers, they can go the investment bank. Financial intermediary is the organization which acts as a link between the investor and the borrower, to meet the financial objectives of both the parties. These can be seen as business entities which accept deposits from the depositors or investors (lenders) by allowing them low interest on their sum. Further, these organizations, lend this amount to the individuals and firms (borrowers) at a comparatively high rate of interest to make their margin. A financial intermediary brings together the users and the providers of funds without having them meet face to face. For this reason, they are also known to engage in an indirect form of funds channeling. Actually, people and firms can go directly to the providers and users of funds. By doing so, the use of financial intermediary is eliminated, resulting in a higher return. However, if this is the case, why do some people and businesses still tap the services of financial intermediaries (Prachi, 2019)?
1. Financial intermediaries hire highly qualified people to investments.
assess risky
Investing through a financial intermediary is less risky than
lending directly. With years of experience in lending, it can determine which individuals or firms are capable of paying obligations.
2. Financial intermediaries know how to diversify. Instead of placing money in a singe investment, they distribute it among different investment opportunities. They can combine stocks, bonds, mutual funds and fixed income securities in a portfolio.
3. Hiring financial intermediaries has a cost advantage or economy of scale. If a firm needs substantia amount of money, it takes time and resources before the amount needed is raised. With the help of financial intermediary, the money invested can be pooled and lent it to the firm.
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4. Financial intermediaries reconcile the conflicting interests of the users and lenders of funds. Normally, lenders prefer to lend their money on a short-term basis while borrowers prefer to have the money on a long-term basis to provide liquidity. With the presence of financial intermediary, regardless of the conflicting interests between the providers and users of funds, the demands and preferences of the two can be made compatible, e.g. the loan can be provided on a long-term basis but the lenders can withdraw their money anytime that it is needed.
5. Financial intermediaries provide savers with liquidity. Liquidity is the ability to convert assets into a spendable form, i.e., money quickly. A house is an illiquid asset; selling one can take a deal of time. If an individual saver ends money directly to another person, the loan can be an illiquid asset. If the lender suddenly needs cash, he/she must either persuade the borrower to repay quickly, which may not be possible, or he/she must find someone else who will buy the loan from him/her, which may be very difficult.
Types of Financial Intermediaries (Prachi, 2019) Banks: The central and commercial banks are the most well-known financial intermediaries simplifying the lending and borrowing process, along with providing various other services to its customers on a large scale. Credit Unions: These are the cooperative financial units which facilitate lending and borrowing of funds to provide financial assistance to its members. Non-Banking Finance Companies: A NBFC is a financial company engaged in activities such as advancing loans to its clients at a very high rate of interest. Stock Exchanges: The stock exchange facilitate the trading of securities and stocks, and in every trading activity, it charges the brokerage from each party which is its profit. Mutual Fund Companies: The mutual fund organizations club the amount collected from various investors. These investors have identical investment objectives and risk-taking ability. The funds are then collectively invested in the securities, bonds, and other investment options, to ensure a capital gain in the long run. 5
Insurance Companies: These companies provide insurance policies to the individuals and business entities to secure them against accident, death, risk, uncertainties and default. For this purpose, they accept deposits in the form of premium, which is pooled into profitable investments to gain returns. The insured person can claim the money in case of any mishap as per the agreement. Financial Advisers or Brokers: The investment brokers also collect the funds from various investors to invest it in the securities, bonds, equities, etc. The financial advisers even provide guidance and expert opinions to the investors. Investment Bankers: These banks specialize in services like initial public offerings (IPO), other equity offerings, proving for mergers and acquisitions, institutional client’s broker services, underwriting debts, etc. As a result of constant mediation, between the investor or public and the companies issuing securities.
Lesson 3. Financial Market A financial market is a mechanism in which buyers and sellers trade financial assets such as stocks, bonds, currencies and derivatives. Unlike financial intermediaries, it is not a source of funds but a link to provide a forum in which suppliers of funds and buyers of loans/investment can transact business directly (Khan, et al 2006). Financial markets are generally characterized as having formal regulations; transparent pricing; basic regulations on trading, costs and fees; and market forces which determine the prices of the securities that are being traded. Here, the providers of funds know where their money is being invested or lent to. There are two types of financial markets, the money market and the capital market (Khan, et al 2006)..
Money Market The money market is a market intended for short-term placements. A placement takes at most one year to mature. Money market exist because individuals or firms look for temporary investments where their idle funds can be placed to earn income. To some extent, companies look for short-term financing to support their seasonal needs. Because of money markets, the temporary needs of the providers and users of funds meet (Khan, et al 2006). 6
Money market instruments There are various money market instruments traded in the money market (Khan, et al 2006).
1. Certificate of deposit is a time deposit in which the depositor has to wait for a certain number of days before the stated fixed interest is earned. The interest given depends on the range of the amount deposited and the number of days stipulated. The higher the amount deposited, the higher the interest received.
2. Commercial paper is an unsecured promissory note with a fixed maturity of 1 up to 270 days. Commercial paper is a money-market security issued by a high credit rating companies to raise money to meet short-term obligations. Firms offering this kind of financing instrument are not required to offer a collateral because of their excellent credit rating from a recognized credit-rating agency. It is usually sold at a discounted price and provides a higher repayment rate than bonds.
3. Repurchase agreement is a financial instrument in which one party sells a financial instrument to another at a specified price with the commitment to repurchase the financial instrument at a fixed amount at a specified date. Many repos have a maturity date of 1 to 2 weeks. However, other repos can be extended to one month or to a longer period of time. Normally, repos are issued with a fixed period, but open-ended agreements are also possible.
4. Treasury bills are an obligation incurred by the national government. The interest is usually higher than the savings or time deposit. T-bills are issued through a competitive bidding process at a discount from par, which means that rather than paying fixed interest payments, the return expected by the investor is capital appreciation. T-bills are regarded as a risk-free investment because the government guarantees their payment.
5. Bankers acceptance is a bank draft in which a bank is required to pay the holder a specified amount on a specified date. It has a maturity of 90 days from date of 7
issue, which can be extended to 180 days. People who invest in bank draft expects a capital appreciation. At the time of purchase, these drafts are sold at a discount and their value increases as it approaches the maturity date.
Lesson 4. Capital Market If the money market is intended for short-term financial instruments, the capital market is intended for long-term financial instruments. Included in the capital market are issuances of securities and long-term obligations by businesses and government agencies. Some of the financial instruments have no maturity date (as in the case of common and preferred stocks) while others have a maturity date that lasts for more than one year (as in the case of bonds). The funds that comprise the firm’s capital structure are raised in the capital market (Keown, 2005). There are two important elements of a capital market (Keown, 2005).
1. Organized security exchanges. A security exchange operates under the rules and regulations formulated by an exchange. Investors actively trading on the exchange are aware of the rules and conduct trades accordingly. In the Philippines, the most active security exchange is the Philippine Stock Exchange. The transactions in organized security exchanges are made in already outstanding securities. 2. Over the counter markets. Over the counter markets are involved in the buying and selling of financial instruments but not of organized security exchanges. These are stocks of corporations that are registered with and licensed by the SEC to sell stocks to the public which are not traded in the PSE. The OTC market is the result of the intangible relationships among sellers and purchasers of securities who are linked by a telecommunication network (Gitman, et al., 2006). The transactions are performed by means of direct inquiries to the concerned corporations and negotiations between the buyers and sellers in any form.
Types of Capital Market The capital market is involved in transactions involving long-term financial instruments. The capital market is classified as follows (Keown, 2005): 8
1. Primary market is a venue where firms and government agencies raise money by issuing financial instruments like stocks or bonds for the first time. The proceeds from the issues are sent directly to the issuer. The dealer normally earns a commission built into the price of the financial instrument. Once the securities are sold to the public for the first time, they are called initial public
offering.
Players in the Primary Market (Keown, 2005) •
Issuers. These are either public or private corporations. Funds are raised by means of public issues, rights issues or private placements.
•
Financial instruments. These are the instruments purchased by the investors. They may take the form of bonds, equities, warrants, etc.
•
Financial intermediaries. These are the financial institutions which facilitate the issuance of the securities. Examples include universal and investment banks.
•
The Investors. These are the individuals or firms with extra funds who are willing to invest in the securities offered.
2. Secondary Market also called the aftermarket. It is where the financial instruments that are already issued are traded. The secondary market allows the primary market where the proceeds go the issuing corporation, in the secondary market, the securities are sold by the investor to another investor for purpose of gaining profit or minimizing loss. The gain or loss is based on the trading price of the instrument in an organized market such as the PSE. It is also in the secondary market where the current market price of the instrument is determined.
Other Examples of Financial Markets
(Keown, 2005)
1. Bond Market is where the long-term debt instruments are issued by firms and government agencies to raise money. It is also where participants can buy and sell bonds. The participants are individuals, the government, or 9
private firms who have extra money and are looking for a venue where they can invest it to generate additional income in the form of interest and capital gain on bonds.
2. Commodity Market is where raw or primary commodities are traded. The commodities are traded on a regulated commodities exchange where they are bought and sold in standardized contracts. Forward contract and future contracts are normally used in executing exchanges in this kind of market. Normally, farmers hedge to insure against poor harvest by purchasing futures contracts in the same commodity. If a farmer has significantly less of its product to sell due to calamities or infestations, the loss incurred is covered by the profit on the market. Examples of commodities markets are corn, sugar, coffee, cotton, copra and tea.
3. Stock Market is where publicly listed stocks are bought and sold. If a firm wants to raise money in the form of stocks, it normally goes to an investment banker to facilitate the sale. This is in the form of an initial public offering (IPO) where stocks are sold for the first time to the general public. However, the stock market facilitates the subsequent selling of the stock. Participants in the stock market range from small individual stock investors to large hedge fund traders who can be based anywhere. Their orders usually end up in the stock exchange with the stock broker who executes the order.
4. Derivatives Market provides instruments to help manage financial risks. The market can be divided into two: exchange traded derivatives and over the counter derivatives. Examples of derivatives markets are futures market, insurance market and options market. 5. Foreign Exchange Market is a venue for the exchange of currencies. Banks normally assume the role of foreign exchange market
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Assessment Task 1
Given the following situation,
in a separate sheet of yellow pad paper,
answer the following questions: “ The unprecedented breakout of the COVID-19 Pandemic resulted to severe financial crises in the country. “
a. Which among the different types of intermediaries should be adopted by the Philippines to address the problem? Justify your answer. (20 pts) b. How is the foreign exchange market situation? (10 pts)
Summary
•
affected by such
c. Would you advise investors to buy more stocks given the said
Financial market is a market place where buying and selling activities of stocks, assets and other capital resources take place for the purpose of generating more financial resources.
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An efficient and effective financial system redirects financial resources to the sectors who most need it. The economic unit or sector with shortage will be filled in by the units/ sectors with surplus.
•
Capital market is a long-term financial instrument, while money market is a shortterm financial instrument.
•
Primary market is a venue where firms and government agencies raise money by issuing financial instruments like stocks or bonds for the first time.
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•
Secondary Market also called the aftermarket. It is where the financial instruments that are already issued are traded.
References De Haan, J., Oosterloo,S., & Schoenmaker,D.2012). Functions of the Financial System.
Financial Markets and Institutions: A European Perspective . Cambridge: Cambridge University Press. doi:10.1017/CB09781139198943.004 Bernstein, P.L., & Damodaran, A. (1998). Investment Management. Wiley Frontiers Finance
https://www.amazon.com/Investment-Management-Peter-L-
Bernstein/dp/0471197165 Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9 th Edition).Blackwell Publishing Limited, Florida. Brealy, R.A, Myers, S.C., & Marcus, A.J. (2007) The Fundamentals of Corporate Finance (5th Edition), Mc Graw Hills Company. USA. Brigham, E.F., & Houston, J.F. (2011) Fundamentals of Financial Management , (9th Edition) Engler, G.N. (1978). Business Financial Management. Texas Business Publication Timbang, Ferdinand L. Financial Management Part II Gitman, L.J. & Zutter C.J. (2006). Principles of Managerial Finance. The Apprentice Hall Series 3rd Edition. Retrieved from: https://baixardoc.com/documents/principles-ofmanagerialfinance-13th-edition-by-l-j-gitman-c-j--5d1a6eb8af43a
Keown, A. J., Martin, D., Petty, W. & Scott, D. (2005) Financial Management: Principles and Applications, 10th Edition. Virginia Polytechnic Institute and State University. Retrieved from: https://theinvestorsbook.com/financial-intermediaries.html
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MODULE 2 Investment Market
Introduction If you are not a seasoned investors, then the word investment must be something intimidating because of the constantly changing financial market situation. If you are not a risk taker, so you will take off investment. But you need to invest for your future. Investment markets collect funds from institutional and retail investors, and are entrusted with making investments in financial instruments according to the strategies agreed upon with the investors. This module will introduce you to the functions of investment banker in encouraging more investors so as to raise capital investment to improve the financial system of the economy.
Learning Outcomes At the end of this module, the students are expected to :
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1. relate the similarities of investment markets and financial markets; 2. determine the roles of the investment banker in maintaining financial stability of an economy;. 3. illustrate the step-by-step investment procedures; and 4. interpret the diagram showing the investment trading cycle.
Lesson 1. Funtions of Investment Banker (Depersio, 2019) The investment banker is a middleman engaged in raising long-term funds for businesses and government agencies. He provides advice to the issuing corporation on the prices and the securities to be issued. The usual functions of investment bankers are as follows (Depersio, 2019): 1. Originate securities issues through negotiations between the officer of the issuing firm and officers of the investment bank. a. The initial discussions are concerned with determining the amount of capital to be raised, the security to be issued and the particular terms and conditions on the issue. b. The investigation looks into the financial capability of the firm if the issuances of the securities satisfy the investors. CPA’s are hired scrutinize the books, audit and develop the required financial statements. Lawyers are hired to investigate the legal aspects of the issue.
c. The negotiation finalizes the details concerning the securities to be issued. The spread of the underwriter (the difference between the price of the security to be issued and the amount to be remitted in addition to out of pocket costs incurred by the investment bank) are also computed.
d. The registration ensures that all requirements on the new issues are submitted to the SEC where all the material information about the security is disclosed.
2. Underwrite the issues by guaranteeing their sale in the primary capital market.
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3. Manage the distribution of the securities to the ultimate investors. Members of the underwriting syndicate form a selling group consisting of dealers who will contact the ultimate investors.
4. Give advice to the corporate clients on long-term financial matters
Lesson 2. Investing Procedures (PSE, Inc. 2019) The process of investment involves careful study and analysis of the various classes of assets and the risk-return ratio attached to it (PSE, Inc. 2019). 1. Choose a stockbroker. The PSE has a complete list of information on the trading participants who are authorized and qualified to trade securities. This list is also available on the PSE’s website and the telephone directory’s government and business listings in the yellow pages under the category of stock and bonds broker.
2. Open an account and fill out a customer information form and submit identification papers for verification. The stockbroker will then assign a trader or agent to assist the investor in either buying or selling any listed security. 3. Give the order to the trader, and then ask for the confirmation receipt. The buy or sell orders are relayed to the stockbroker’s dealer for confirmation. In an automated system as in that of PSE, the order is keyed in through a trading terminal and automatically matched.
4. Pay before the settlement date. The delivery or payment should be made before the settlement date of T+3 (trading day + 3 days). For traditional stockbrokers, the settlement of transactions is usually done after 3 working days from the transaction date.
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5. The investor shall receive from his/her broker either the proceeds of the sale of his/her stocks (after 3 business days) or proofs of ownership of the stocks he/she bought (confirmation receipt and invoice) All equity transaction, whether buying or selling, have a settlement period of T+3. This means that a seller should deliver the stock certificate, if any, to his/her broker and the buyer must have paid the cost of the transaction to his/her broker within 3 working days after the trade is done. Historically, the settlement is done manually (i.e., 27-day cycle). With scripless trading, wherein the settlement is done via the book entry system (through the Philippine Central Depositary or PCD), transactions are settled on the third day after the trade date. Under this system, the investor has the option to hold on to his/her certificate (uplift) or deposit (lodge) this certificate in the PCD through his/her broker-participant account. Figure 1 shows how investment trading cycle operate. This is actually based from the data from the Philippine Stock Exchange, Inc., ( 2019 )
Buying Investor
Selling Investor
PSE
Broker
Broker
PDTC (Depository)
Settlement Banks
SCCP Clearing House PDTC (Depositary)
Settlement Banks
Broker
Broker
Buying Investor
Selling Investor 16
Figure 1.
Trading Cycle (Source: Philippine Stock Exchange Inc 2019)
Board Lot System Equity trading is done using the board lot or round lot system. The board lot determines the minimum number of shares an investor can buy or sell at a specific price range. Therefore, the minimum amount of initial investment varies and depends on the market price of the stock as well as its corresponding board lot. The prices of stocks move through a scale of minimum price fluctuations (PSE, Inc., 2019). Table 1. Board Lot System (PSE, Inc., 2019) Market Price (Php) Tick Size
Lot Size
0.0001 to 0.0099
0.0001
1,000,000
0.0100 to 0.0490
0.0010
100,000
0.0500 to 0.2490
0.0010
10,000
0.2500 to 0.4950
0.0050
10,000
0.5000 to 4.9900
0.0100
1,000
5.0000 to 9.900
0.0100
100
10.0000 to 19.9800
0.0200
100
20.0000 to 49.9500
0.0500
100
50.0000 to 99.9500
0.0500
10
100.0000 to 199.9000
0.1000
10
200.0000 to 499.8000
0.2000
10
500.0000 to 999.5000
0.5000
10
1000.0000 to 1999.0000
1.0000
5
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2000.0000 to 4998.0000
2.0000
5
Buying Transaction Mr. X wishes to buy a stock whose market price is about Php 10.00. Based on the board lot table, the number of shares he can buy at a regular transaction should be in multiple of 100 shares. In this case, if Mr. X wants to buy 100 shares (which is a multiple of 100 shares), his required cash outflows are as follows: Market price/share Number of shares to be bought
10.00 x
1,000 10,000.00
Brokers commission*(0.25% +12% VAT)
+
28.00
SEC Fee (value x .005%)
+
0.50
PSE Transaction fee (value x.005%)
+
0.50
SCCP Fee (transaction value x 0.01%)
+
1.00
Total cash outlay
10,030.00
* The brokers commission varies depending on the value of the transaction, with a maximum allowable commission rate of 1.5% (See Table 1) Note: If a buying client chooses to receive and maintain a physical certificate in his/her name, an upliftment/withdrawal fee of Php 50.00 per certificate issuance request and transfer fee of Php 100.00 +12% VAT are charged. In the illustration above, the combined upliftment/withdrawal fee and transfer fee to be paid by the buying client amount to Php 162.00 (Php 50.00 + Php 112.00).
Selling Transaction Ms. Y wishes to sell a stock that is trading at Php 10.00. Based on the board lot table, the number of shares she can sell at a regular transaction should be in multiples of 100 shares. In this case, If Ms. Y wants to sell 1,000 shares (which is a multiple of 100 shares), her cash inflow is as follows:
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Market price/share Number of shares to be bought
10.00 x
1,000 10,000.00
Brokers commission*(0.25% +12% VAT)
-
28.00
Stock transaction tax **(value x 0.5%)
-
50.00
SEC Fee (value x .005%)
-
0.50
PSE Transaction fee (value x.005%)
-
0.50
SCCP Fee (transaction value x 0.01%)
-
1.00
Net cash receivable
9,920.00
*The brokers commission varies depending on the value of the transactions with a maximum allowable commission rate of 1.5% (See Table 2). **The stock transaction tax is levied on sellers only. Note: If a selling client has certificates, he/she needs to convert them into book-entry form in the PCD system. A cancellation fee of Php 20.00 +12% VAT and a transfer fee of Php 100.00 + 12% VAT are charged. In the illustration above, the combined cancellation and transfer fees to be paid by the selling client amount to Php 134.40 (Php 22.40 + 112.00)
Lesson 3. Trading/Transaction Fees and Taxes Brokerage Commission A stockbroker is compensated for his/her services in the execution of orders on the Exchange through commission charges which are paid to him/her by both the buyer and the seller. For trade transactions covering equity and equity related products, the maximum commission rate is 1.5% of the total transaction cost in addition to the 12& VAT. The minimum commission depends on the amount of the transaction (PSE, Inc., 2019). (See Table 2).
Upliftment / Withdrawal Fee 19
If a buying client opts to have a stock certificate issued in his/her name, he/she must take the request through his/her broker who will then issue the upliftment request through the PDC system. Upon receipt, the PDTC will then submit the request to the transfer agent for the issuance of the certificate. The PDTC will charge the broker an upliftment/withdrawal fee of Php 50 per certificate issuance request. The transfer agent will charge his/her usual issuance certificate on top of the PDTC’s upliftment/withdrawal fee (PSE, Inc., 2019). Cancellation Fee If a selling client has physical certificate, he/she must have the certificates converted into book-entry form in the PDTC system by requesting (through his/her broker) for a direct transfer with the transfer agent, which costs Php 100 (plus 12% VAT) per certificate for the transfer of ownership of shares to the PDTC Nominee Corporation. In addition to the DT fee, a client must pay a cancellation fee of Php 20.00 (plus 12% VAT) to the transfer agent for the cancellation of the certificates to be lodged in the PDTC for the lodgment of shares. This tax applicable only to listed equities (PSE, Inc., 2019). Stock Transaction Tax The sale of equities listed and traded in the Philippine Stock Exchange is subject to stock transaction tax of ½ of 1% (50 basis points) of the value of the transaction to be charged to the seller in lieu of the capital gains tax. The sale, barter, or exchange of the shares of stock listed and traded in the PSE are exempt from documentary stamp tax (PSE, Inc., 2019). Withholding Tax Under the Internal Revenue Code of 1997, and except in cases where tax treaties are in force, the dividends received from domestic corporations are subject to a withholding tax of 10%, if the recipient is a citizen or resident alien; 20% if the recipient is a non-resident individual engaged in trade or business in the Philippines; 25%
if the recipient is a
nonresident individual not engaged in trade or business in the Philippines; 30%if the recipient is a non-resident foreign corporation. Dividends received by domestic and resident foreign corporations are not subject to tax. The rate of income tax withheld on the dividends paid to a non-resident foreign corporations may be reduced to 15% if the country in which the nonresident foreign corporation is domiciled (a) imposes no taxes on foreign-source dividends or (b) allows a credit against tax due from the foreign non-resident corporation for taxes deemed to have been paid in the Philippines equivalent to 15% of such dividends (PSE, Inc., 2019). 20
Table 2.
Transaction Fees (Philippines
Stock Exchange, 2019) https://www.pse.com.ph/stockMarket/home.html
Type of Fee
Inc.
Rate Transaction Value
Minimum Commission
Brokerage
P100 million and below
0.25%
Commission
Above 100 Million up to 500 Million
0.15% but not less than 250,000
Above 500 Million up to 1 Billion
0.125% but not less than 750,000
Above 1 Billion up to 5 Billion
0.1% but not less than 1.25 M
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Above 5 Billion up to 10 Billion
0.075% but not less than 5 M
Above 10 Billion
0.05% but not less than 7.5 M
Upliftment/Withdrawal fee
Php 50 per certificate
Cancellation Fee
Php 20 +12% VAT
Stock Transaction
0.50% of the value of the transaction
Tax Withholding Tax
Filipino citizen or resident alien; 10% of the dividends received Non-resident
individual
engaged
in
trade or business in the Philippines 20% of the dividends received Non-resident individual not engaged in trade or business in the Philippines 25% of the dividends received Non-resident foreign corporation 30% of the value of the dividends received Investment management fees are charged as a percentage of the total assets managed. Example: An investment advisor who charges 1% means that for every $100,000 invested, you will pay $1,000 per year in advisory fees.
1. Make a compilation of the top 20 successful investment companies in the Philippines. Put in a clear folder (5” x 11”) 2. Why do you think they were able to sustain their status of top Describe the contributing factors that contribute to their success in the investment market. 3. Suggest at least 5 feasible and stable investment activity
Assessment task 2
2
Summary •
Investment markets collect funds from institutional and retail investors, and are entrusted with making investments in financial instruments according to the strategies agreed upon with the investors.
•
The investment banker is a middleman engaged in raising long-term funds for businesses and government agencies
•
The process of investment involves careful study and analysis of the various classes of assets and the risk-return ratio attached to it.
•
Investment management fees are charged as a percentage of the total assets managed. Example: An investment advisor who charges 1% means that for every $100,000 invested, you will pay $1,000 per year in advisory fees.
References Bernstein, P.L., & Damodaran, A. (1998). Investment Management. Wiley Frontiers Finance. Retrieved from: https://www.amazon.com/Investment-Management-PeterLBernstein/dp/0471197165 23
Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9th Edition).Blackwell Publishing Limited, Florida. Brealy, R.A, Myers, S.C., & Marcus, A.J. (2007) The Fundamentals of Corporate Finance (5th Edition), Mc Graw Hills Company. USA. Brigham, E.F., & Houston, J.F. (2011) Fundamentals of Financial Management , (9th Edition) Dispersio, L. (2019). Retrieved from: https://www.investopedia.com/articles/professionals/121515/investment-bankerjobdescription-average-salary.asp Engler, G.N. (1978). Business Financial Management. Business Publication, Inc., Dallas, Texas. Philippine Stock Exchange, Inc.(2019).Retrieved from: https://www.pse.com.ph/stockMarket/home.html Timbang, Ferdinand L. (2016). Financial Management Part 2 . Manila, C & E Publishing , Inc. 1st edition.
Module 3 Time Value Of Money
24
Introduction In business finance managers rely on the concept of time value of money which states that the amount of money today is different from what it will be in the future. Because of this difference, a finance manager makes computations carefully before arriving at a decision. For instance, an insurance company that pays Php 500,000 after 20 years to a policyholder receives a premium payment of Php 12,500 per year. For 20 years, the premium payment made by the policyholder will amount to a sum of Php 250,000 only. Why is the insurance company willing to sacrifice the other Php 250,000? The answer to the question is simple i.e. the insurance company believes that it can do much more using the Php 12,500 that it actually receives every year. The firm believes that the expected return will exceed what is willing to pay the policyholder (Timbang, 2016). This module explains why the time value of money is a critical consideration in fi nancial and investment decisions. It helps individuals and firms determine how much money must be placed today to accumulate a future sum given an interest rate for a given period. Thus, the placement may be either in lump-sum or regular intervals, and at the beginning or at the end of the period. Likewise, the time value of money helps determine how much interest will earn if placed today at a certain rate for a certain period (Timbang, 2016).
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Students will also be exposed to the computation of the compounding interest of money invested in the financial markets. It determines the future amount of money earned if an investment is made at the present. It is also used to ascertain how much money should be invested to acquire a target amount in the future, e.g. pension funds for retiring employees, sinking funds for long-term obligations, etc. Discounting, the opposite of compounding is used to evaluate future cash flows associated with capital budgeting projects and the valuation of bonds and stocks (Timbang, 2016).
Learning Outcomes At the end of this module, the students are expected to: 1. elucidate the concept of time value of money 2. compute the time value of money in various situations 3. solve problems using the time value of money 4. explain the importance of the time value of money in the decision-making process 5. enumerate the other areas in financial management where the time value of money is applied
Lesson 1. Understanding the Concept of Time Value of Money (Chen, 2020) The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.
The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. For example, money deposited into a 26
savings account earns a certain interest rate and is therefore said to be compounding in value (Chen, 2020).
Lesson 2. Future Value (Timbang, 2016)
A peso actually received today is worth more than a peso to be received tomorrow. This valuation holds true because of interest money can earn after having been invested. Compounding interest means that the interest not withdrawn also earns interest, i.e. the interest itself also earns interest. Knowing how much interest is earned on the money placed in the present helps individuals decide whether or not to look for other investment opportunities(Timbang, 2016). For better understanding of the concept of compounding, the following symbols are defined: FV PV r
= = =
future value (present +interest) or the amount of money at year end n principal value rate
i
=
annual interest rate
=
number of periods
n
If the amount PV at year 0 is placed at a rate I, then
FV
=
PV (1+i) ^n
In this case, if PV=1000, i=12% and n=4, the result is: FV=1,000 (1.12) ^4 =1,573
Example: Mario Orio place Php 1,000 in a savings account earning 7% interest compounded annually. How much money will he accumulate after 5 years? 27
FV=PV(1+i) ^n FV= 1,000(1+.07) ^5 =1,403 Example: Lackie Tyan invested a large sum of money in ZZZ Corporation. The company pays a Php 3 dividend per share. The dividends are expected to increase by 15% per year for the next 3 years. Lackie wants to project the dividends from years 1 to 3. At year 1 FV=PV(1+i) ^n =3(1+i) ^1 =3(1.15) =3.45 At year 2 FV=3(1+i) ^2 =3(1.322) =3.97 At year 3 FV=3(1.15) ^2 =3(1.521) =4.56
Lesson 3. Intra-year Compounding (Timbang, 2016) Interest is often compounded more than once a year. Banks and other financial institutions accepting placements compound interest quarterly, daily, or even continuously. If
28
interest is compounded many times a year, the general formula for solving the future value is: FV
= PV (1+1/m) ^t x m
The number of conversion periods for 1 year is denoted by m while the total number of conversion periods for the whole investment term is denoted by n. Conversion periods are usually expressed by any convenient length of time and usually taken as an exact division of the year, e.g. monthly, quarterly, semi-annually and annually. When the conversion periods are: Annually
m=1
Semi=Annually
m=2
Quarterly
m=4
Monthly
m=12
The total number of conversion periods for the whole term n can be found from the relation: n = time x number of conversion periods per year m n
=t x m
Thus, the term 5 years compounded Annually
5x1
n
=5
Semi=Annually
5x2
n
=10
Quarterly
5x4
5 x 12
n
n
=20 Monthly
=60
The Interest rate is usually expressed as an annual or yearly rate, and must be changed to the interest rate per conversion period or periodic rate i and can be found from the relation: i
=
interest rate r
conversion period per year m Thus, the interest rate at 9% compounded. annually 9% ÷ 1 i=9.00% semi-annually 9% ÷ 2 i=4.50% 29
quarterly
9% ÷ 4
i=2.25%
monthly
9% ÷ 12
i=0.75%
The formula reflects a more frequent compounding (t x m) at a smaller interest rate per period (i/m). The future value increases as m increases. Thus, continuous compounding results in the maximum possible future value at the end of n periods for a given rate of interest. Example Assume that P=1,000, i=12% and n=4 years. Thus: Annual compounding (m=1)
FV=1,000(1.12)^4x1 =1,000(1.574)^4 =1,574
Semi-annual compounding (m=2)
FV=1,000(1+0.12/2)^4x2 = 1,000(1.06)^8 =1,000(1.594) =1,594
Quarterly compounding (m=4)
FV=1,000(1+0.12/4)^4x4 = 1,000(1.03)^16 =1,000(1.605) =1,605
Monthly compounding (m=12)
FV=1,000(1+0.12/12)^4x12 = 1,000(1.01)^4 =1,000(1.612) =1,612
Lesson 4. Future Value of an Annuity (Timbang, 2016) An annuity is defined as a series of equal payments (or receipts) made at fixed intervals for a specified number of periods. If the payment occurs at the end of the period, it is called
ordinary annuity. Examples are mortgages on housing, car loans and bank loans. If the payment occurs at the beginning of the period, it is called annuity due. Life and car insurance premiums and rental payments are some typical examples of an annuity due. 30
Between the two types of annuities, the ordinary annuity is more common practice (Timbang, 2016). Example: Aiza wants to determine the sum of money she will have in her savings account at the end of 5 years by depositing Php 1,000 at the end of each year for the next 5 years. The annual interest rate is 8%
Table 3. Future Value Factor / Year Year
Savings
Future Value Factor
Future Values
1
1,000
(1.08)^4
1,360.49
2
1,000
(1.08)^3
1,259.71
3
1,000
(1.08)^2
1,166.40
4
1,000
(1.08)^1
1,080.00
5
1,000
(1.08)^0
1,000.00
0
5,866.60 Each deposit is made at the end of the year and compounded at the end of the period n. The sum of the compounded deposits is the future value of an annuity. Another way of solving this problem is by using the future value of an annuity formula. Assume the following: FV = amount of an annuity PV = present value of an annuity A
=
annuity due
Thus FV
= A ((1+i)^n-1)/i) =1,000 ((1+.08)^4-1)/0.08 =5,866.60
Example: 31
Aiza wants to determine the sum of money she will have in her savings account at the end of 5 years by depositing Php 1,000 at the beginning of the year for the next 5 years. The annual interest rate is 8%.
0 1,000
1 1,000
2 3 4 1,000 1,000 1,000
5 1,080.00 1,116.40 1,259.71 1,360.49 1,469.33
(1.08)^1 (1.08)^2 (1.08)^3 (1.08)^4 (1.08)^5
6,335.93 Since the deposits started at the beginning of each year, more interest is earned as compared to deposits made at the end of the year. Another way of solving this problem is by using the future value of an annuity formula. Again, the formula to be given will only be useful if it has an equal cash flow. The formula is as follows:
Fva
=A (1+i)^n-1 (1+i) i
=1000 (1+.08)^(1.08) 0.08
= 6,335.93
Lesson 5. Present Value at Compounded Interest (Timbang, 2016) The present value of a future sum is the amount that must be invested today at compound interest to reach a desired sum in the future. The process of calculating present values, or discounting, is usually the opposite of finding the compounded future value. In connection with present value calculations, the interest rate is called the discount rate. Recall that:
32
FV
= PV(1+i)^n
Therefore, by simple transposition PV
= FV
or FV=(1+i)^-n
(1+i)^n Example: Roval Toro is given the opportunity to receive Php 50,000 10 years from now. If he can earn 15% on his investment compounded annually, what is the most he should pay to benefit from this opportunity? PV
= FV (1+i)^-n = 50,000 (1.15)^-10 =50,000 (0.247) =12,350.00
Present Value of an Annuity Interest received from bonds, pension funds, and insurance obligations all involve annuities. To compare these financial instruments, the present value of each must be known (Timbang, 2016). The present value of an annuity can be found using the following equation. PVa
=A 1- (1+i)^n i
Example: Martha Fobre is offered the opportunity to receive the following equal cash flow over the next 3 years. 33
Year
Revenue
1
10,000
2
10,000
3
10,000
If she must earn a minimum of 8% on her investment, what is the most she should pay today? The present value of the equal cash flow is as follows: Year
Amount
Present Value
1
10,000
0
2
10,000
9,259.26
3
10,000
8,573.39
4
10,000
7,938.32 25,770.97
Martha has to deposit Php 25,770.97 to receive a yearly amount of Php 10,000 for three years. Another way of solving this problem is by using the present value of an annuity formula. The formula to be given is only useful if it has an equal cash flow. The formula is as follows. PVa
=A 1- (1+i)^n i
Present Value of Unequal Cash Flows Time value of money problems may revolve around a series of payments or cash receipts. However, not every situation involves a single amount of annuity. A problem may involve an unequal cash flow each period for a certain number of years. The present value of unequal cash flows is the sum of the present values of each unequal cash flow (Timbang, 2016). Example: Xenetea Trias was offered the opportunity to receive the following unequal cash flows over the next 3 years. 34
Year
Revenue
1
10,000
2
12,500
3
9,500
If she must earn a minimum of 8% on her investment, what amount should she pay today? The present value of unequal cash flows of revenue is as follows: Year
Revenue
(1+i)^-n
Present Value
1
10,000
0.926
9,260.00
2
12,500
0.857
10,712.50
3
9,500
0.794
7,543.00 27,515.50
Lesson 6. Applications of Future and Present Value (Timbang, 2016) Future and present values have numerous applications in financial and investment decisions. They are useful in decision-making whether for personal reasons (e.g. how much deposit must be made to acquire a certain amount of money, amortize a loan, or pay off a sinking fund?) or corporate reasons (e.g., capital budgeting, bond and stock valuation and right financing mix) (Timbang, 2016). An individual may want to know the annual deposit (or payment) necessary to accumulate a future sum. To determine the future amount, the formula in computing the future value of an annuity can be used. Example: Ziram Ilamu is interested to know the equal annual, end of year deposits required to accumulate Php 15,000 at the end of 10 years when her son enters college. The interest rate is 12%. The annual deposits are as follows. 35
FVa
=
A (1+i)^n-1 i
15,000
=
A (1+0.12)^10-1 0.12
15,000
=
A (17.549)
A
=15,000/17.549
A
=854.75
If Ziram Ilamu deposits 854.75 at the end of every year for 10 years at 12% interest, she will accumulate 15,000 at the end of the fifth year.
Amortized Loans Payments of obligations are made in equal installments which may be monthly, quarterly, semi-annually or annually. Amortized loans include housing loans and auto loans. Other loans are classified as long-term loans. The periodic payment can be computed using the present value of an annuity of 1. PVa
=
A 1-(1+i)^-n i
A
=
PVa 1-(1+i)^-n i
Example Ferlie Shells has a 60-month auto loan of Php 650,000 at a 12% annual interest rate. She wants to find out how much the monthly payment should be. A
=
PVa 36
1-(1+i)^-n i A
=650,000
A
1-(1.01)^-60 0.01 =650,000 44.955
A =14,458.90 To repay the principal and interest on a Php 650,000 12% 60-month auto loan, She has to pay Php 14,458.90 a month for the next 60 months. Example : Assume that a firm borrows Php 120,000 to be repaid annually for the next 5 years. The creditor-bank stipulated a 12% interest. Compute the amount of each payment. A
= 120,000
A
= 120,000
1-(1.12)^-5
3.605
0.12
=33,287.10
Each loan payment made is distributed partly to the interest and partly to the principal. the breakdown is often displayed in a loan amortization schedule. The interest component is largest in the first period and subsequently declines, whereas the principal portion is smallest in the first period and increases thereafter. Example: Using the same data in example, the amortization schedule is as follows:
Table 3. Sample Amortization Schedule Year
Payment
Interest
Principal Payment
0
Balance 120,000.00
1
33,287.10
14,400.00
18,887.10
101,112.90
2
33,287.10
12,133.55
21,153.55
79,959.35
3
33,287.10
9,595.12
23,691.98
56,267.37
4
33,287.10
6,752.08
26,535.02
29,732.35
5
33,287.10
3,567.88
29,732.35
0 37
166,435.50
46,448.63
120,000.00
Lesson 7. Annual Percentage Return (Timbang, 2016) The different types of financial instruments use various compounding periods. Bonds, for instance usually pay interest semi-annually, banks pay on deposits quarterly, and firms offering credit cards pay interest monthly. If an investor wants to compare financial instruments with different compounding periods, a mathematical tool should be used to make the comparison possible. For this purpose, the effective annual rate also known as
annual percentage rate is used (Timbang, 2016). Where: r
=
nominal rate
m
=
number of compounded periods in a year
Example: If the nominal rate is 12% compounded quarterly, the APR is: APR
= (1+r/m)^m – 1.0 = (1+0.12/4) ^4 – 1.0 =1.255 – 1.0 =12.55%
This means that if an investment offers 12% interest compounded quarterly, the investor is actually receiving an APR or effective interest rate of 12.55%. That is to say, if one investment offers a 12% interest compounded quarterly while the other one offers a 12.55% interest compounded annually, the same amount of money will be received at the end of the year.
38
39
$150,000 in etotal cash flows amount to f(ca23415EprUnGiveeachTotal Cash Flowb. Comparehe undiscounteda) erc4$320llows Compute for the following. Given the uneven streams of cash flows shown in the following
Assessment task 3
table, answers parts A & B: Cash Flow Stream
End of Year
A
B
1
Php 50,000
Php 10,000
2
40,000
20,000
3
30,000
30,000
4
20,000
40,000
5
10,000
50,000
Undiscounted
Php 150,000
Php 150,000
Total
a. Find the present value of each stream, using a 15 percent discount rate b. Compare the calculated present values, and discuss them in the light of the fact that the undiscounted toal cash flows amount to Php 150,0000 in each case
Assume that you just won the state lottery . Your prize can be taken either in the form of Php 40,000 at the end of the next 25 years or as a single payment of Php 500,000 paid immediately. a. If you expect to be able to earn 5% annually on your investments over the next 25 year (i.e. 5 % is the appropriate discount rate), ignoring taxes and other considerations, which alternative should you take? Assume that your only decision criteria is selecting the options with the highest present value.
40
Find the present value of discountedm in light of tsent10 5 of Year,nd (b):flowsstre$150,000 00,,hegdiscount rate.valu 40,0032tunevem, using showStrble, the s,ach cas$10,50,000 amcalculaA$150,000 e fact that nd discuss swerinstrB 0the 15 msparts ed of Assessment task 3
41
Summary •
Time value of money is based on the idea that people would rather have money today than in the future.
•
Given that money can earn compound interest, it is more valuable in the present rather than the future.
•
The formula for computing time value of money considers the payment now, the future value, the interest rate, and the time frame.
•
The number of compounding periods during each time frame is an important determinant in the time value of money formula as well.
References Bernstein, P.L., & Damodaran, A. (1998). Investment Management. Wiley Frontiers Finance. Retrieved
from:
https://www.amazon.com/Investment-Management-Peter-
LBernstein/dp/0471197165
42
Block S.B., & Hirt, G.A. (2006) Foundations of Financial Management (9th Edition).Blackwell Publishing Limited, Florida. Timbang, Ferdinand L. (2016). Financial Management Part 2 . Manila, C & E Publishing , Inc. 1st edition. Time Value of Money Practice Problems & Solutions. (2016). Retrieved from: https://www.studocu.com/en-us/document/wichita-stateuniversity/financialmanagement-ii
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