The Financial Environment and Sources of Finance Study Guide for Sources of Finance
Financial Markets Overview
Definition and Function: Financial markets are institutions and procedures that facilitate transactions in all types of financial claims. Their primary role is to allocate savings to the best investments. They provide a forum where suppliers of funds and demanders of funds can transact business directly.
Market Components: Financial markets consist of two main sectors based on the duration of the claims:
Money Market: Handles transactions in short-term marketable securities.
Capital Market: Handles transactions in long-term securities.
Investment Benefits: Using financial markets to invest in financial assets (such as stocks) offers distinct advantages compared to opening a personal business with a set amount of capital, such as :
Reduce Risk through Diversification: Instead of investing all funds in one business, an investor can place each into the stocks of different companies. This diversification reduces risk because it is unlikely all companies will fail simultaneously.
Low Time Commitment: Managing a portfolio is less time-intensive than running a business.
Limited Liability: Investors are generally only liable for the amount they have invested.
Low/No Expertise Needed: Professional management in corporations reduces the need for personal business expertise.
Ease of Entry and Exit: Financial assets are generally easier to buy and sell than physical business assets.
Continuous Valuation: Financial markets provide ongoing feedback on the value of wealth.
Importance of Financial Markets
Economic Impact: Without financial markets, savings would be restricted to real assets, and funds could not be transferred to parties who need them. This would result in:
Less capital formation.
Inability to finance innovative ideas.
Slower economic growth.
Lesser overall wealth for the economy.
Role of Intermediaries: Investment banks or financial intermediaries typically link suppliers (providers) and demanders (users) of finance.
Financial Institutions and Transfer of Funds
Financial Institutions: These are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments.
Individuals: Generally net suppliers of funds.
Businesses and Governments: Generally net demanders of funds.
Methods of Fund Transfer:
Direct Transfer: Borrowers (demanders) obtain funds directly from savers (suppliers) by selling securities (claims on future income) without an intermediary. Examples include dividend reinvestment plans, purchasing government-issued treasury bonds, and private placements.
Indirect Transfer (Investment Banks): Investment banks act as underwriters, buying new securities from borrowers and reselling them at higher prices to savers. Examples include Initial Public Offerings (IPOs). Notable firms include Merrill Lynch, Goldman Sachs, CIMB, and various Malaysian merchant banks like RHB Sakura and Affin.
Indirect Transfer (Financial Intermediaries): Intermediaries pool savings from savers and provide loans to borrowers. The intermediary has separate contracts with both parties (e.g., a savings account contract with the saver and a loan contract with the borrower). Examples include banks and the Employees Provident Fund (EPF).
Categories of Financial Markets
By Maturity Period:
Money Market: Focuses on short-term securities with a maturity of one year or less. These are considered low-risk. Typical instruments include:
T-Bills (Government-issued).
Certificates of Deposits (CDs) (Commercial bank-issued).
Commercial Paper (Large company-issued).
Bankers’ Acceptance (Firm-issued bank draft).
Capital Market: Focuses on long-term securities with a maturity longer than one year. These facilitate the transfer of financial assets and provide liquidity. Instruments include:
T-bonds (Government-issued).
Corporate bonds.
Stocks (Equities).
Mortgage-Backed Securities.
By Originality of Issues:
Primary Market: The market for new security issues. The issuing firm receives the proceeds, and the total stock of financial assets in the economy increases. Corporations or governments are directly involved.
Secondary Market: The market for horizontal trading of previously issued securities (e.g., Bursa Malaysia, NYSE). The issuing firm receives no funds; proceeds transfer between investors. These markets provide liquidity and pricing guidelines for new issues.
Stock Exchanges and Listing Requirements
Stock Exchange Functions: Tangible entities where instruments are traded. They provide a continuous market, establish fair prices, and help businesses raise capital. Trading often involves specialists who earn money on the "spread" (bid price minus ask price).
Listing in Malaysia (Bursa Malaysia):
Main Market: Typically for large companies with paid-up capital exceeding .
ACE Market: For fast-growing companies with paid-up capital between and .
LEAP Market: The Leading Entrepreneur Accelerator Platform, launched on July 25, 2017. Designed for SMEs with a paid-up capital around . It is targeted at sophisticated, high-net-worth investors and risk seekers.
The Malaysian Financial System
Dual System: Malaysia operates both a Conventional and an Islamic financial system.
Main Regulatory Authorities: Governed by the Central Bank Act (CBA) 2009.
Conventional: Governed by the Financial Services Act 2013, covering commercial banks, investment banks, and insurers.
Islamic: Governed by the Islamic Financial Services Act 2013, covering Islamic banks, Takaful operators, and Shari'ah-compliant operations.
Seven Federal GLICs (Government-Linked Investment Companies):
Minister of Finance (MoF) Inc.
Employees Provident Fund (EPF).
KWAP (Kumpulan Wang Persaraan).
Lembaga Tabung Angkatan Tentera (LTAT).
Lembaga Tabung Haji.
Khazanah Nasional.
Permodalan Nasional Berhad (PNB).
Functions and Methods of Investment Banking
Core Functions:
Underwriting: Assuming risk by buying the entire security issue from a firm to resell to the public.
Distributing: Moving securities to ultimate investors.
Advising: Providing guidance on timing, security type, and pricing.
Distribution Methods:
Negotiated Purchase: The firm selects an investment banker to negotiate terms.
Competitive Bid: Bankers bid for the right to underwrite; the firm chooses the highest price.
Best Efforts: The banker sells as much as possible for a commission without guaranteed underwriting (no risk to the banker).
Privileged Subscription: Marketing to specific groups like current employees or stockholders.
Direct Sale: Selling directly to the public without an investment banker (e.g., Private placement).
Public Offering and Private Placement
Public Offering: Securities are available to the general public.
Initial Public Offering (IPO): First-time sale where a private limited (unquoted) company becomes public listed (quoted).
Seasoned Offering: New shares issued by an already listed company.
Private Placement: Securities sold to a limited number of institutional investors (e.g., pension funds).
Advantages: Faster funding, lower flotation costs, and higher flexibility in terms.
Disadvantages: Higher interest rates/lower issue prices to compensate for risk, limited fund volume, and restrictive covenants.
Specific Issuance Methods
Offer for Sale: Selling shares at a fixed price. If the price is too high, it leads to under-subscription; if too low, it leads to over-subscription and dilution of ownership.
Offer for Sale by Tender: Investors tender prices at or above a fixed minimum. Shares are allotted at the "striking price" (the highest price to fill the issue). Drawbacks include uncertainty of total funds and heavy influence by institutional tenders.
Rights Issue: Offering new shares to existing shareholders in proportion to their current holdings (e.g., a one-for-four basis).
Pre-emptive Rights: Existing shareholders have the first right to subscribe.
Advantages: Cheaper (no prospectus), discount for shareholders, and maintenance of voting rights.
Issuing and Flotation Costs
Risk Correlation: Costs are highest for common stock, followed by preferred stock, then bonds.
Economies of Scale: As the size of the issue increases, the flotation cost per unit decreases as fixed costs are spread thinner.
Typical Costs: Underwriting fees, listing fees, legal/auditor fees, printing and advertising costs.
Pecking Order Theory: Internal equity (cheaper) < Debt < External equity (most expensive).
Efficient Market Hypothesis (EMH)
Core Theory: Stock markets react immediately to all available information, resulting in "fair prices." Investors cannot consistently beat the market using common strategies.
Forms of Efficiency:
Weak Form: Prices reflect only historical price information.
Semi-strong Form: Prices reflect all publicly available information and past prices.
Strong Form: Prices reflect all information, including private and public.
Implications for Investors: Expected returns equal required returns. Abnormal returns are usually due to chance.
Implications for Finance Managers:
Focus on maximizing Net Present Value (NPV).
Investors cannot be misled by "window dressing" or optimistic accounts.
Market determines required return levels; managers cannot easily change this view.
Takeovers do not rely on finding "undervalued" firms, as all are fairly valued by the market.
Questions & Discussion
Scenario: You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?
Response: No. If the market is efficient, this news is already incorporated into the stock price by the time you hear it, making it too late to capitalize on the information.