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By the end of the lecture, you would be able to calculate yield (return)
for the above question.
0
Lecture 3: Financial Markets and Institutions, Financial Statements, Cash Flow,
and Taxes, and Interest Rates
Learning Objectives
• Identify the different types of financial markets and financial
institutions and explain how these markets and institutions
enhance capital allocation
• Explain what the yield curve is and what determines its shape
1
AB1201:
Financial Management
3
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
4
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Business Dollars
Savers
• Investment banks
Securities Investment Securities
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
• Financial intermediaries
Business’ Intermediary’s
Securities Securities
Financial
Business Intermediary Savers
Dollars Dollars
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
What is a Market?
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
8
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
9
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Lessons Learnt 1
• There are three ways to transfer the capital—
direct transfer, transfer through investment banks
and financial intermediaries.
• Financial markets can be classified based on
different dimensions.
• There are many types of financial institutions
such as commercial bank, investment bank,
mutual fund, hedge fund, insurance company,
etc.
10
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Balance
Sheet
Statement Statement
of Cash
Financial of
Flows Statements Stockholders’
Equity
Income
Statement
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
13
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Stockholders’ Equity
(Common stock + Retained
earnings) must equal Total
assets – Total Liabilities
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Income Statement
2014 2013
Sales $2,325,967 $2,220,607
Cost of goods sold 1,869,326 1,655,827
Other expenses 287,663 273,870
Total operating costs excluding
$2,156,989 $1,929,697
depreciation and amortisation
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Other Data
EPS
2014 2013
EPS (Earnings per share) $0.67 $1.50
DPS (Dividends per share) $0.5854 $1.42
Book value per share $6.62 $6.53
CC
Stock price $15.60 $21.80
Share outstanding 100,000 100,000
Tax rate 40% 40%
BVPS
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
19
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
20
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
21
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Lessons Learnt 2
• There are four key financial statements.
• Balance sheet provides a snapshot of a firm’s
financial position at one point in time.
• Income statement summarises a firm’s revenues and
expenses over a given period of time.
• Interest paid is tax deductible for corporations while
dividends paid is not since they are paid out of
after-tax income.
22
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Interest Rates
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
24
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
25
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
• Production opportunities
• Expected inflation
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
27
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
28
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
29
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
30
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
r = r* + IP + DRP + LP + MRP
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
r= r* + IP + DRP + LP + MRP
32
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
IP MRP DRP LP
S-T Treasury
L-T Treasury
S-T Corporate
L-T Corporate
33
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Lessons Learnt 3
r= r* + IP + DRP + LP + MRP
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
35
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
INFL t
IPN t 1
N
36
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
37
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
MRPt = 0.1% (t – 1)
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
39
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
• Assume r* = 3%,
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%
Years to
0 Maturity
0 1 5 10 15 20
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Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
44
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Lessons Learnt 4
• Term structure shows relationship between
interest rates (or yields) and maturities.
• The yield curve is a graph of the term structure.
• To construct the Treasury yield curve, the IP and
MRP are added to r*.
• Corporate yield curves are higher than that of
Treasury securities due to DRP and LP
• Macroeconomic factors influence interest rates
45
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Where do We Stand?
• Financial markets aid in the allocation of funds
– Different types of institutions and markets
• Balance sheet and income statements
• Cost of money or an interest rate is affected by
– Production opportunities, time preferences for consumption,
risk, and inflation
• Interest rate = r* + IP + DRP + LP + MRP
• Term structure of interest rates shows relation between
interest rates and maturity
– Yield curve
46
Lecture 3 Revisiting Question of the Week
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Lecture 3 Revisiting Question of the Week
r* = 4%,
inflation1-2 = 2%, inflation3-6 = 3%, inflation7onwards = 4%,
MRP = 0.2(t-1), DRP = 0.6%, LP = 0.3%,
Computing IP:
48
Lecture 3 Revisiting Question of the Week
Computing MRP:
Computing r: