Professional Documents
Culture Documents
FIMA 30073
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TABLE OF CONTENTS
WEEK PAGE
Course Outline 5
Course Plan 5
Grading System 12
2-3 Strategic Financing Decisions 14
Objectives 14
Lecture 14
Assignment 27
Activity 27
4-5 Tactical Financing Decisions 29
Objectives 29
Lecture 29
Assignment 33
Activity 33
6 Risk Management 33
Objectives 35
Lecture 36
Assignment 40
Activity 40
7 Bankruptcy 41
Objectives 41
Lecture 41
Assignment 43
Activity 43
8 Reorganization and Liquidation 44
Objectives 44
Lecture 44
Assignment 53
Activity 53
MIDTERM EXAMINATION
10 Corporate Mergers and Consolidation 55
Objectives 55
Lecture 55
Assignment 59
Activity 60
11 Corporate Financial Distress 61
Objectives 61
Lecture 61
Assignment 64
Activity 64
12-13 Multinational Financial Management 65
Objectives 66
Lecture 66
Assignment 71
Activity 71
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Objectives 72
Lecture 72
Assignment 75
Activity
75
16-17 Basic International Finance
76
Objectives
76
Lecture
77
Assignment
83
Activity
83
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Course Description : This course extends and expands the materials covered in Financial
Management. The topics covered in this course include strategic financing decisions such as
capital structure and dividend policy decisions; tactical financing decisions such as initial public
offerings, financial restructuring, and lease financing; and special topics such as risk
management, bankruptcy, reorganization and liquidation, corporate mergers and acquisitions.
3. Strong Service Orientation Exhibit positive service mindset and Explain the relevant
value-driven service approaches financial issues and able to
analyze them objectively.
Engage in lifelong learning with a
4. Passion to Life-Long passion to keep current with national
Learning and global developments Acquire values in the
financial managementof
Employ national and global various industries as
5. Sense of Nationalism and decision makers.
perspectives to analyze issues
Global Responsiveness
Participate in community-based
6. Community Engagement projects that make a difference in the
civic life of communities
Lease Financing
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
distress
Signs of financial distress Recognize the reasons for
Causes of financial distress corporate financial distress and
How to manage financial learn the different alternative
distress solutions applicable.
Week 14 Cases in Capital Structure and Apply the theories learned by Case Analysis and
Dividend Policy analyzing case problems presentation
Week 15 Cases in IPO, Financial Apply the theories learned by Case Analysis and
Restructuring and Lease Financing analyzing case problems presentation
Week 16 Cases in Risk Management, Apply the theories learned by Case Analysis and
Bankruptcy, Reorganization and analyzing case problems presentation
Liquidation
Week 17 Cases in Corporate Mergers and Apply the theories learned by Case Analysis and
Multinational Financial Management analyzing case problems presentation
Quizzes
Attendance
Recitation
Projects/Assignments/Seatwork/Case Study
Midterm / Final Examinations 30%
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
100%
Approved by:
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Analyze complex financial data for making effective decisions.
2. Apply capital structure theory for making effective financing decisions.
3. Evaluate the company’s capital structure.
4. Provide for valuable insights on capital structure optimization.
5. Develop appropriate dividend policy.
TO DO LIST:
In order to successfully complete Module 1 Week 2 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Strategic Financing Decisions
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Capital Structure is the mix of financial securities used to finance the firm.
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s
equity.
V=B+S
If the goal of the management of the firm is to make the firm as valuable as possible,
then the firm should pick the debt-equity ratio that makes the pie as big as possible.
Business Risk
Company Tax exposure
Financial Flexibility
Management Style
Growth Rate
Market Condition
Cost of Fixed Assets
Size of Business Organization
Nature of business Organization’s
Elasticity of Capital Structure
BUSINESS RISK
Factors:
◦ Demand variability
◦ Sales price variability
◦ Input cost variability
◦ Ability to develop new products
◦ Foreign exchange exposure
◦ Operating leverage (fixed vs variable costs)
FINANCIAL RISK
The additional risk placed on the common stockholders as a result of the decision to
finance with debt
If the same firm is now capitalized with 50% debt and 50% equity – with five people
investing in debt and five investing in equity
The 5 who put up the equity will have to bear all the business risk, so the common stock
will be twice as risky as it would have been had the firm been all-equity (unlevered).
Financial leverage concentrates the firm’s business risk on the shareholders because
debtholders, who receive fixed interest payments, bear none of the business risk.
FINANCIAL RISK
ADVANTAGES OF DEBT
DISADVANTAGES OF DEBT
Higher debt ratios lead to greater risk and higher required interest rates (to compensate
for the additional risk)
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Dividend
Dividend refers to the corporate net profits distributed among shareholders. Dividends can be
both preference dividends and equity dividends. Preference dividends are fixed dividends paid
as a percentage every year to the preference shareholders if net earnings are positive. After the
payment of preference dividends, the remaining net profits are paid or retained or both
depending upon the decision taken by the management.
Dividend Decision
It’s a decision made by the directors of a company. It relates to the amount and timing of any
cash payments made to the company stockholders. The decision is an important one for the
firm as it may influence its capital structure and stock price. In addition, it may determine the
amount of taxation that stockholders should pay.
TYPES OF DIVIDENDS
1. Interim Dividend
2. Proposed Dividend
3. Final Dividend
4. Unclaimed Dividend
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
5. Liquid Dividend
6. Stock Dividend
7. Dividend in Asset Form
In order to better understand the relationship between dividend policy and the value of the firm,
different theories have been advanced. These theories can be grouped into two categories:
a. Theories that consider dividend decisions to be irrelevant and
b. Theories that consider dividend decisions to be an active variable influencing the value
of the firm.
The following are some of the models that have critical evaluation on these points
1. Walter’s model on the Relevance of Dividends
2. Gordon’s model on the Relevance of Dividends and
3. The Miller-Modigliani(MM) Hypothesis about Dividend Irrelevance.
These models shall be explained in the subsequent
DETERMINANTS OF DIVIDEND POLICY
1. STABILITY OF EARNINGS
2. LIQUIDITY OF FUNDS
3. PAST DIVIDEND RATES
4. RATE OF ASSET EXPANSION
5. PROFIT RATE
6. ABILITY TO BORROW
7. CONTROL
8. NEED TO REPAY DEBIT
9. MAINTENANCE OF A TARGET DIVIDEND
10. NATURE OF OWNERSHIP
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
TYPES OF DIVIDEND
• Regular dividend
• Interim dividend
• Stock dividend
• Script dividend
• Bond dividend
• Property dividend
• Proposed dividend
• Unclaimed dividend
• Liquid dividend
• Cash dividend
WALTER’S MODEL
Introduction:
Professor James E Walter argues that the choice of dividend policy almost always affect the value of the
firm. His model, one of the earlier theoretical works, shows the importance of relationship between the
firm’s rate of return(r) and its cost of capital(k) in determining the dividend policy that will maximize the
shareholders wealth.
ASSUMPTION
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Growth firm: Internal rate more than the opportunity cost of capital For example:
Normal firm : Internal rate equals opportunity cost of capital For example
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Declining firm : internal rate less than opportunity cost of capital For example
Here you can see that all price is similar for all the three firms, now if we compute the new price
for all the firms. Take dividend is Rs 2 instead of Rs4 other things remain same
The result also change in growth firm Rs 31.11 normal firm Rs 26.67 declining firm Rs 22.22
No external financing
Constant return
Constant opportunity cost of capital
GORDON’S MODEL
• Gordon’s theory contends that dividends are relevant. This model is of the view
that dividend policy of a firm affects its value.
• He relates the market value of the firm to the dividends of the firm.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
MILLER-MODIGLIANI MODEL
According to him, under a perfect market situation the dividend policy of a firm is irrelevant, as it
does not affect the value of the firm.
A firm operate in perfect capital market condition may face one of the following three situation
regarding the payment of dividends:
1.The firm has sufficient cash to pay dividends
2. 1.The firm does not have sufficient cash to pay dividends & therefore issue new share to
finance dividends
3.The firm does not pay dividend, but shareholder need cash
In first situation, shareholder get cash but the firm’s assets reduce(its cash balance)
In second situation, two transaction take place: first existing shareholder get dividends but they
lose value of their claim on assets reduces.
Second new shareholders part their cash in exchange for new shares at “FAIR PRICE PRE
SHARE.”
In third situation, shareholder can create a “HOME MADE DIVIDEND” by selling their share at
market price
If the firm does not pay dividend the value per share will be 220/2=110Rs
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
ASSUMPTIONS
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at Rs100
each. The firm is expecting to pay a dividend of Rs5 per share at the end of the current financial
year. The company’s expected net earnings are Rs250,000 and the new proposed investment
requires Rs500,000. Prove that using MM model, the payment of dividend does not affect the
value of the firm.
LIMITATION OF MM MODEL
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
A company can’t develop its capital structure without understanding its future
revenues and investment requirements. Once those prerequisites are in place, it
can begin to consider changing its capital structure in ways that support the
broader strategy. A systematic approach can pull together steps that many
companies already take, along with some more novel ones.
The case of one global consumer product business is illustrative. Growth at this
company we’ll call it Consumerco has been modest. Excluding the effect of
acquisitions and currency movements, its revenues have grown by about 5
percent a year over the past five years. Acquisitions added a further 7 percent
annually, and the operating profit margin has been stable at around 14 percent.
Traditionally, Consumerco held little debt: until 2001, its debt to enterprise value
was less than 10 percent. In recent years, however, the company increased its
debt levels to around 25 percent of its total enterprise value in order to pay for
acquisitions. Once they were complete, management had to decide whether to
use the company’s cash flows, over the next several years, to restore its previous
low levels of debt or to return cash to its shareholders and hold debt stable at the
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
First, Consumerco’s executives forecast the financing deficit or surplus from its
operations and strategic investments over the course of the industry’s business
cycle—in this case, three to five years.
Next, Consumerco set a target credit rating and estimated the corresponding
capital structure ratios. Consumerco’s operating performance is normally stable.
Executives targeted the high end of a BBB credit rating because the company, as
an exporter, is periodically exposed to significant currency risk (otherwise they
might have gone further, to a low BBB rating). They then translated the target
credit rating to a target interest coverage ratio (EBITA to interest expense) of 4.5.
Empirical analysis shows that credit ratings can be modeled well with three
factors: industry, size, and interest coverage. By analyzing other large consumer
product companies, it is possible to estimate the likely credit rating at different
levels of coverage.
Finally, executives set a target debt level of €5.7 billion for 2008. For the base
case scenario in the left-hand column at the bottom half of Exhibit 2, they
projected €1.9 billion of EBITA in 2008. The target coverage ratio of 4.5 results in
a debt level of €8.3 billion. A financing cushion of spare debt capacity for
contingencies and unforeseen events adds €0.5 billion, for a target 2008 debt
level of €7.8 billion.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Executives then tested this forecast against a downside scenario, in which EBITA
would reach only €1.4 billion in 2008. Following the same logic, they arrived at a
target debt level of €5.7 billion in order to maintain an investment-grade rating
under the downside scenario.
Exhibit 2
Exhibit 3
The final step in this approach is to determine how the company should move to
the target capital structure. This transition involves deciding on the appropriate
mix of new borrowing, debt repayment, dividends, share repurchases, and share
issuances over the ensuing years.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
While these tax and signaling effects are real, they mainly affect tactical choices
about how to move toward a defined long-term target capital structure, which
should ultimately support a company’s business strategies by balancing the
flexibility of lower debt with the discipline (and tax savings) of higher debt.
ACTIVITY 1
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Plan public offerings in compliance with the Securities and Exchange Commission (SEC)
regulations.
2. Compare and contrast the use of lease financing, warrants, and convertible securities in
evaluating a firm's financing options.
TO DO LIST:
In order to successfully complete Module 2 Week 4 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Tactical Financing Decisions.
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Business Management:
CAPITAL RESTRUCTURING
Just like renovating your house can make it more attractive, capital restructuring makes
companies attractive to potential stakeholders, reduces costs, increases efficiency, increases
EPS and gives better returns.
Companies, like individuals, never stop evolving. Competitive pressures, shareholders'
demands, management decisions and regulatory and political environment, all warrant that
companies keep on reinventing themselves and adapt to change. Operational, managerial and
financial dimensions may therefore, often be subject to restructuring. Approaches of
restructuring that a company may adopt include expansion, sell-offs, corporate control, and
changes in ownership structure.
Share repurchase or buy-back is one of the most important strategies that a firm uses to
restructure by changing its ownership structure. A company can use the share repurchase
route when it has excess cash. The excess cash therefore, can be made to work on a better
investment. The company can also buy back its shares from the market to thwart a hostile
takeover bid. A buy-back also generally results in an increase in the EPS because the number
of outstanding shares reduces.
Share repurchases or buy back may provide many benefits to companies. Share
repurchases are one-time returns of cash. Rather than paying dividends companies can utilise
excess cash to buy-back their shares. Repurchase may offer tax buffer to stockholders,
because the stockholders' gains will be taxed at capital gains rate, which is usually lower than
the ordinary income tax rate. Apart from these, share buy-backs can be affected in a short time
facilitating fast capital restructuring. Historical data also shows that markets perceive share
repurchase as a positive signal.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
However, on the flip side it is possible that repurchase of shares might send negative
signals; because the market might think that the company has no profitable ventures to invest
in. Since repurchases erode cash resources, the company might also lose on growth
opportunities. Lastly, if the repurchase decision is mismanaged, the company could risk
insolvency.
The shares that companies wish to buy back are the outstanding shares of the common stock.
They might be with the common investors or might be in the possession of some large
investors. The firm usually offers a premium to shareholders above the market price of the
share while repurchasing them. What are the methods that a firm can employ?
The buy-back methods include repurchase tender offer, open market purchases, and
privately negotiated repurchases. The firm might issue a cash tender offer in the open market
to repurchase its shares. The tender offer usually sets forth the number of shares that the
company wishes to repurchase as well as the price at which it will repurchase the shares. The
tender offer is also a time-bound offer and states the period for which the offer would be
extended. Tender offers are mostly used for large equity repurchases.
In developed markets open market repurchases occur more often than tender offers because
they are much cheaper to administer. Open market purchases can also be spread over longer
time periods than tender offers. Open market purchases offers are most often used for small
equity repurchases.
Negotiated purchases might be used to thwart the actions of a raiding company, which is trying
to mop the shares of the target company from the market. Negotiated purchases involve a small
number of investors who hold significant chunks of a firm's shares.
Besides being a strictly financial decision, share buy-back is also an information signal
to the market. For example, if the firm offers to buy-back its shares at a very high premium, it
might send a signal that the firm believes that its stock is undervalued. The decision to go for
share buy-back or invest the spare cash in other activities is a tough one. Usually, managers
and shareholders have different views on the issue. However, the management-shareholder
conflict can be resolved when there are large shareholders who can monitor and discipline the
management.
What is IPO?
•New capital - Almost all companies go public primarily because they need money to expand the
business
•Future capital - Once public, firms have greater and easier access to capital in the future
•Mergers and acquisitions
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
- Its easier for other companies to notice and evaluate a public firm for potential
synergies
- IPOs are often used to finance acquisitions
1.It must have a pre-issue net worth of not less than Rs. 10,000,000 (Rupees One crore) in 3
out of the preceding 5 years, with a minimum net worth to be met during the 2 immediately
preceding years.
2.It must have a track record of distributing dividends for at least 3 out of the immediately
preceding 5 years, and
3.The issue size, i.e., the offer through the offer document, the firm allotment and the promoter’s
contribution through the offer document, should not exceed five times the pre-issue net worth as
per the last available audited account, either at the time of filing the draft offer document with
the Securities and Exchange Board of India (“SEBI”) or at the time of opening of the issue.
• If the above conditions are not satisfied, then the IPO can be made only through a book-
building process, provided that sixty percent (60%) of the issue size must be allotted to Qualified
Institutional Buyers (“QIBs”).
LEASING
DEFINITION
A written agreement under which a property owner allows a tenant to use the property for a
specified period and time.
The lessee(person who taking out a lease) agrees to pay number of fixed and flexible
installments over an agreed period to lessor, who remains the owner of asset(item) throughout
the period of the lease.
ADVANTAGES
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
DISADVANTAGES
TYPES OF LEASING
FINANCE LEASE (CAPITAL LEASE)
OPERATING LEASE
LEVERAGED LEASE
SALE AND LEASE BACK
DIRECT LEASE
Leasing Practice
This step is also made by the leassee. The remaining participants in the leasing transaction can
only facilitate or hinder the informed decision by the lessee.
It is obvious that in order to continue along the steps of the leasing practice, the leassee must
make an affirmative decision. Let us explore the most common reasons for using the leasing
service. These include:
• „Credit reason“ – this reason for using the service comes from the lack of the
necessary funds for purchase of the asset. The leasing service provides the
necessary financial means to achiev this. This is also the most popular reason for
using leasing in Bulgaria.
• „Tax reason“ – optimization of the volume of taxes paid and the dates on which
this is done. This is a driving force only for corporate leassees with good tax
planning. With the right approach it is possible to reach a tax effect from the
leasing deal up to 50% from the purchase price /this of course varies in
accordance with tax regimes in various countries for various assets/. In Bulgaria
this is the main reason for using “operational leasing’. The tax practice in
Bulgaria /as opposed to developed markets/ has made it almost impossible for
physical persons – leaseess to use whatever tax reduction.
• „Optimisation of service“ /possible only for leased cars/ – this is again mostly
used by corporate leassees, who chose full service operational leasing or at least
include some of the car service into the leasing deal. The added value for the
lessee and the reason for using this form of leasing is that the lessor organizes
and catters for the on-going service of the car. Hence the lessee does not need
in-house employees to take care of the auto park. The full service in some
developed markets also includes fuel management. In Bulgaria including the fuel
to the leasing service is still not offered.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
• „Decreasing risk“ – leasing can transfer various kinds of risk to the lessor. This
gives a potent motivation to some risk-sensitive lessees for using the leasing
service. Such risks may be the inflation risk /in 2017 in Bulgaria the interest rates
on some leasing contracts fall behind the inflation rate/, the risk of total asset loss
/even if fully covered by insurance, such a risk always exists/, market risk /this is
applicable in the existance of a residual value in the leasing contract/, etc. Some
of the mitigated risk are solely a function of the size of the leasing company. For
example if it is possible for a vendor to refuse cover of a disputed guaranty issue
to a client with one car, his refusal to honor the guaranty to a large leasing
company is highly unlikely. The risk reduction is useful both to corporate lessees
as well as individual clients.
In conclusion of this article on the “Lease decision” we will mention the location where the offers
were received and the decision to use the leasing service taken by the lessee. Most often, this
is not the office of the Chief Financial Officer, the Office of Market Research Employees, the
Chief Accountant’s Room, or even the living-room of the lessee. Most often, the place of receipt
of all the documents related to the leasing transaction and the decision to use leasing as a
service is the place of sale of the leasing asset, etc. point of sale / POS /. This is where many
lessors focus their advertising and marketing efforts. Bulgaria is no exception. Let’s hope that all
efforts are aimed at helping the future lessee make an informed decision for using the service.
ACTIVITY 2
1. It is the process of selling securities to public in primary market.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Analyze the financial environment in which a firm operates, evaluate the corporate risk,
and use effective risk management techniques to minimize risk.
TO DO LIST:
In order to successfully complete Module 3 Week 6 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Risk Management.
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Why is it important?
• Risk affects all aspects of your project – your budget, your schedule, your scope, the
agreed level of quality, and so on
• Increase probability of positive event.
• Reduce the occurrence of negative event.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Identify Risk
• Which risk has more probability of affecting the project?
• SWOT Analysis
• Information gathering
• Check-list Analysis
• Assumption Analysis
– Exploit
– Share
– Enhance
The risk management process is a framework for the actions that need to be taken. There are
five basic steps that are taken to manage risk; these steps are referred to as the risk
management process. It begins with identifying risks, goes on to analyze risks, then the risk is
prioritized, a solution is implemented, and finally, the risk is monitored. In manual systems, each
step involves a lot of documentation and administration. Now let’s look at how these steps are
carried out in a more digital environment.
The first step is to identify the risks that the business is exposed to in its operating environment.
There are many different types of risks – legal risks, environmental risks, market risks,
regulatory risks, and much more. It is important to identify as many of these risk factors as
possible. In a manual environment, these risks are noted down manually. If the organization has
a risk management solution employed all this information is inserted directly into the system.
The advantage of this approach is that these risks are now visible to every stakeholder in the
organization with access to the system. Instead of this vital information being locked away in a
report which has to be requested via email, anyone who wants to see which risks have been
identified can access the information in the risk management system.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Once a risk has been identified it needs to be analyzed. The scope of the risk must be
determined. It is also important to understand the link between the risk and different factors
within the organization. To determine the severity and seriousness of the risk it is necessary to
see how many business functions the risk affects. There are risks that can bring the whole
business to a standstill if actualized, while there are risks that will only be minor inconveniences
in analyzed. In a manual risk management environment, this analysis must be done manually.
When a risk management solution is implemented one of the most important basic steps is to
map risks to different documents, policies, procedures, and business processes. This means
that the system will already have a mapped risk framework that will evaluate risks and let you
know the far-reaching effects of each risk.
Risks need to be ranked and prioritized. Most risk management solutions have different
categories of risks, depending on the severity of the risk. A risk that may cause some
inconvenience is rated lowly, risks that can result in catastrophic loss are rated the highest. It is
important to rank risks because it allows the organization to gain a holistic view of the risk
exposure of the whole organization. The business may be vulnerable to several low-level risks,
but it may not require upper management intervention. On the other hand, just one of the
highest-rated risks is enough to require immediate intervention.
Every risk needs to be eliminated or contained as much as possible. This is done by connecting
with the experts of the field to which the risk belongs to. In a manual environment, this entails
contacting each and every stakeholder and then setting up meetings so everyone can talk and
discuss the issues. The problem is that the discussion is broken into many different email
threads, across different documents and spreadsheets, and many different phone calls. In a risk
management solution, all the relevant stakeholders can be sent notifications from within the
system. The discussion regarding the risk and its possible solution can take place from within
the system. Upper management can also keep a close eye on the solutions being suggested
and the progress being made from within the system. Instead of everyone contacting each other
to get updates, everyone can get updates directly from within the risk management solution.
Not all risks can be eliminated – some risks are always present. Market risks and environmental
risks are just two examples of risks that always need to be monitored. Under manual systems
monitoring happens through diligent employees. These professionals must make sure that they
keep a close watch on all risk factors. Under a digital environment, the risk management system
monitors the entire risk framework of the organization. If any factor or risk changes, it is
immediately visible to everyone. Computers are also much better at continuously monitoring
risks than people. Monitoring risks also allows your business to ensure continuity. We can tell
you How you can create a risk management plan to monitor and review the risk.
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Even under a digital environment, the basics of the risk management process stay the same.
What changes is how efficiently these steps can be taken, and as it should be clear by now,
there is simply no competition between a manual risk management system and a digital one.
There are also many new risks that businesses are facing for the first time in 2019, and modern
problems require modern solutions.
Risk Management
Risk management is an important business practice that helps businesses identify, evaluate,
track, and mitigate the risks present in the business environment. Risk management is practiced
by the business of all sizes; small businesses do it informally, while enterprises codify it.
Businesses want to ensure stability as they grow.
Managing the risks that are affecting the business is a critical part of this stability. Not knowing
about the risks that can affect the business can result in losses for the organization. Being
unaware of a competitive risk can result in loss of market share, being unaware of financial risk
can result in financial losses, being aware of a safety risk can result in an accident, and so on.
Businesses have dedicated risk management resources; small businesses may have just one
risk manager or a small team while enterprises have a risk management department. People
who work in the risk management domain monitor the organization and its environment.
They look at the business processes being followed within the organization and they look at the
external factors which can affect the organization one way or the other. A business that can
predict a risk will always be at an advantage. A business that can predict a financial risk will limit
its investments and focus on strengthening its finances. A business that can assess the impact
of a safety risk can devise a safe way to work which can be a major competitive advantage. If
we think of the business world as a racecourse then the risks are the potholes which every
business on the course must avoid if they want to win the race.
Risk management is the process of identifying all the potholes, assessing their depth to
understand how damaging they can be, and then preparing a strategy to avoid damages. A
small pothole may simply require the business to slow down while a major pothole will require
the business to avoid it completely. Knowing the severity of a risk and the probability of risk
helps businesses allocate their resources effectively. If businesses understand the risks that
affect them then they will know which risks need the most attention and resources and which
ones the business can disregard. Risk management allows businesses to act proactively in
mitigating vulnerabilities before any major damage is incurred. There are different types of risk
management strategies and solutions for different types of risks.
Risk management is an important business practice that helps businesses identify, evaluate,
track, and mitigate the risks present in the business environment. Risk management is practiced
by the business of all sizes; small businesses do it informally, while enterprises codify it.
Enterprise risk management is a domain of governance that deals with the operational,
environmental, financial, regulatory, market, and other risks that affect the outlook and planning
of large enterprises. It is often abbreviated as ERM. Businesses prefer to use ERM software
solutions to streamline risk management.
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Risk management is important because it tells businesses about the threats in their operating
environment and allows them to preemptively mitigate risks. In the absence of risk
management, businesses would face heavy losses because they would be blindsided by risks.
If you want to see what a risk management solution like Predict360 can do for your organization,
simply sign up to get a live demo of Predict360’s most exciting features by getting in touch with
us through chat, or by filling the Contact Us form.
ACTIVITY 3
1. It is the process of identifying and migrating risk.
2. It is a framework for the actions that need to be taken.
3. It is an uncertain event that may have positive or negative impact on the project.
4. It is a domain of governance that deals with the operational, environmental,
financial, regulatory, market and other risks that affect the outlook and planning of
large enterprises.
5. It is an important business practice that helps businesses identify, evaluate, track,
and mitigate the risk present in the business environment.
6.-10. What are the Five (5) Basic Steps that are taken to manage risk.
11.-15. List down the Five (5) things under “Identify Risk”
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WEEK 7–BANKRUPTCY
OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Recognize bankruptcy as a part of the business cycle
2. Learn the different types of bankruptcy and its process and consequences
TO DO LIST:
In order to successfully complete Module 4 Week 7lesson, students are required to do the
following:
1. Join: the discussion on the topics about Bankruptcy.
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Bankruptcy
A legal proceeding involving a person or business that is unable to repay outstanding
debts
All of the debtor's assets are measured and evaluated, whereupon the assets are used
to repay a portion of outstanding debt
Types of Bankruptcy
Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s
management.
Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed
firm’s creditors.
Reasons
Market Conditions
Financing
Poor Decision Making
Other Causes
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When you file for Chapter 7 bankruptcy, the court places an automatic temporary stay on your
current debts. This stops creditors from collecting payments, garnishing your wages, foreclosing
on your home, repossessing property, evicting you or turning off your utilities. The court will take
legal possession of your property and appoint a bankruptcy trustee to your case.
The trustee’s job is to review your finances and assets and oversee your Chapter 7 bankruptcy.
They will sell certain property the bankruptcy won’t let you keep (nonexempt property) and use
the proceeds to repay your creditors. The trustee will also arrange and run a meeting between
you and your creditors—called a creditor meeting—where you’ll go to a courthouse and answer
questions about your filing.
The list of property you don’t have to sell or turn over to creditors (exempt property), and the
total value that you can exempt, varies by state. Some states let you choose between their
exemption list and the federal exemptions. But most Chapter 7 bankruptcy cases are “no asset”
cases, meaning all of the person’s property is either exempt or there’s a valid lien against the
property.
At the end of the process, approximately four to six months from your initial filing, the court will
discharge your remaining debts (meaning you don’t need to pay them anymore). However,
some types of debts generally aren’t dischargeable through bankruptcy, including child support,
alimony, court fees, some tax debts and most student loans.
You can choose to file for bankruptcy on your own or hire an attorney to help. Some legal aid
centers and nonprofit credit counseling agencies may also be able to offer you free assistance.
Once you determine that you're eligible, the process will be largely the same:
1. Attend counseling: It starts with an individual or group credit counseling course from an
approved credit counseling agency, which may take place online or over the phone. You must
do this within 180 days of filing, although there are sometimes exceptions during emergencies
or if there aren't enough approved agencies offering the service.
2. File your forms: On your bankruptcy forms you'll list your property, exemptions, creditors,
income, recent transactions and other financial information. If you have secured debts, you'll
need to decide whether you want to pay off the debt, continue making payments or surrender
the property to the creditor. There's a fee to file the forms, although you can also request a fee
waiver based on your income.
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3. Send verification documents to the trustee: Once the court accepts your filing, you'll
need to send documents to the bankruptcy trustee who will verify your bankruptcy forms. These
could include recent bank statements, tax returns, paychecks and business documents.
4. Creditor meeting: Attend the creditor meeting with the trustee and answer questions
about your paperwork and situation. The meeting is often brief, and your creditors may choose
not to attend.
5. Attend budget counseling: Within 60 days of the creditor meeting, you must complete a
second course from a counseling agency. Don't forget to submit your certificate of completion to
the court, or the court may close your case.
6. Wait for the discharge notice: Once the court receives your certificate of completion, and
often within 60 to 75 days of the creditor meeting, it can discharge your debts. During this time,
you might have to give the trustee your nonexempt property, but don't sell or give anything to
anyone else you have the trustee's permission.
Filing bankruptcy can be financially, physically and emotionally draining. However, it may be
your best option when bills keep piling up and you don't have the means to pay your creditors.
It's also possible to recover from bankruptcy and rebuild your finances and credit, but it will take
time.
ACTIVITY 4
1. A legal proceeding involving a person or business that is unable to repay
outstanding debts.
2. A bankruptcy petition filed in federal court by the distressed firm’s creditors.
3. A bankruptcy petition filed in federal court by the distressed firm’s management.
4. His job is to review your finance and assets and oversee your Chapter 7
Bankruptcy.
5. It is a meeting that arranges and run by a trustee between you and your creditors.
10-15 List down the six (6) Steps on how to file for bankruptcy.
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
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OBJECTIVES:
At the end of this lesson, the students are expected to:
TO DO LIST:
In order to successfully complete Module 5 Week 10 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Reorganization and Liquidation.
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Introduction
Insolvency Vs Bankruptcy
The term insolvent and bankrupt are often used interchangeably. Such usage is
technically incorrect. Insolvent refers to the financial condition of a person or
business enterprise whereby the sum of debts is greater than all of the fair value
of its property. On the other hand, bankrupt refers to a legal state.
Bankruptcy Liquidation
Bankruptcy liquidation refers to the process that involves the realization (sale) of
the assets of an individual or a business enterprise and the distribution of the
cash proceeds to the creditors of the individual or enterprise. There are four
classes of creditors in bankruptcy liquidation. There are:
i. Real property
ii. Personal property
iii. Property claimed as exempt
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ii. The debtor is not paying debts within 120 days prior to the date of the
petition
Administrative costs
Claims arising in the course of the debtors business or financial affairs
after the commencement of a creditors’ bankruptcy proceeding but before
the appointment of a trustee or order for relief.
Claims for wages, salaries, and commissions (including vacation,
severance, and sick leave pay not in excess of $4000 per claimant) earned
within 90 days before the date of filing petition for bankruptcy or cessation
of the debtor’s business.
Claims for contributions to employee benefit plans arising within 180 days
before the date of filing the petition for bankruptcy cessation of the debtor’s
business.
Claims by producers of grain against a grain storage facility or by
fisherman against a fish storage or processing facility not in excess of
$4000 per claimant
Claims for cash deposited for goods/ services for the personal, family, or
household use of the depositor, not in excess of $1800 per claimant.
Claims for alimony, maintenance, or support of a spouse, former spouse or
child of the debtor, under a separation agreement, divorce decree, or court
order.
Claims or government entities for various taxes or duties, subject to
varying time limitations.
Note that settlement of the above debts would be in the order specified.
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Role of Creditors
As indicated above, within a period of 10 to 30 days after order for relief, the
court calls a meeting of the creditors. One of the responsibility of the creditors is
to appoint a trustee to manage the debtor’s estate. A majority vote is required for
actions by creditors in appointing the trustee.
v. Invalidate a preference
Discharge of Debtor
Discharge refers to the release of the debtor from all unliquidated debts. It is the
court that determines the debtor’s discharge. The role of the trustee is to liquidate
the debtor’s property and pay the necessary claims.
After all properties have been liquidated, all secured and priority creditor claims
have been paid, and all remaining cash has been paid to unsecured, nonprority
creditors.
Discharge of the debtor does not include:
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Bankruptcy Reorganization
When a business becomes insolvent, it does not have enough cash to meet its
interest and principal payments. Then the decision must be made whether to
dissolve the firm through liquidation or to permit it to reorganize and thus stay
alive. The decision to force a firm to liquidate versus permit it to reorganize
depends on whether the value of the reorganized firm is likely to be greater than
the value of the firm’s assets if they are sold off piecemeal. The issue of
liquidation was discussed earlier.
In a reorganization, a committee of unsecured creditors is appointed by the court
to negotiate with the management on the terms of a potential reorganization., the
reorganization may call for a restructuring of the firm’s debt. The restructuring of
debts involve:
The purpose of restructuring is to reduce the financial charges to a level that the
firm’s cash flows can support.
In addition to committee, the court may appoint trustee to oversee the
reorganization.
1. Prepare and file a list of creditors in court. The list includes class of
creditors and their claims and lest of stockholder of each class.
2. Investigate the acts, conduct, property, liabilities, and business operations
on the enterprise. The trustee indicates the desirability of continuing
operations.
3. Report to the bankruptcy judge any facts ascertained as to fraud against or
mismanagement of the debtor enterprise.
Plan of Reorganization
The management or trustee is required to submit the plan of the organization to
the bankruptcy court. The same plan may also be given to the creditors and
stockholders of the enterprise. The purpose of submitting the plan of
reorganization is for confirmation by the bankrutpcy court. Before the plan of
reorganization is confirmed by the court, the plan must be accepted by the
following parties:
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1. Majority of the creditors, whose claims must account for two thirds of the
total liabilities.
2. Stockholder owning at least two thirds of the outstanding capital stuck of
each class.
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1. Deposit Br 40,000 with escrow agent, to cover liabilities with priority and
costs of reorganization proceedings (Br. 7000). Salaries and wages and
employee income taxes payable are liabilities with priorities.
2. Amend articles of incorporation to provide for 10,000 shares of authorized
common stock of Br.1 par. The new common stock is to be exchanged on
a share for share basis for the 600 shares of outstanding Br.100 par
common stock.
3. Extend due date of unsecured notes payable to suppliers totaling Br.
50,000 for three years until December 31,2007. Increase the interest rate
on te notes from the stated rate of 10% to 12%.
4. Exchange 2000 shares of new Br.1 par common stock (at current fair value
of Br.20 a share) for unsecured notes payable to suppliers totaling Br.
40,000.
5. Pay suppliers 60 cents per dollar of trade accounts payable owed.
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Assuming that fresh start reporting is appropriate for the company under
consideration after the plan of organization has been carried out. The following
journal entry is made to eliminate retained earnings deficit.
Paid in capital in excess of par 29000
ACTIVITY 5
1. It refers to the financial condition of a person or business enterprise whereby the
sum of debts is greater than all of the fair value of its property.
2. It refers to the process that involves the realization of the assets of an individual
or a business enterprise.
3. According to this code, any person may file a petition in a court for the voluntary
liquidation.
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OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Differentiate merger from consolidation
2. Describe merger and consolidation
3. Identify the advantages and disadvantages of mergers and consolidation
4. Explain the merger and consolidation process
TO DO LIST:
In order to successfully complete Module 6 Week 10 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Corporate Mergers and Consolidation.
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
When one company invests in another, you may hear it described as an amalgamation,
merger, acquisition or consolidation. In casual conversation, the terms may be used
interchangeably, but they have separate definitions. The outcomes range from combining two
companies into a third, totally new business to company A becoming the majority stockholder
of company B.
In a merger, Company A and Company B become one corporation, calling itself by Company
A's name. Consolidation's business meaning is that Company A and Company B become a
new corporation, named Company C.
Amalgamation, merger, acquisition and consolidation all involve corporations combining their
assets, but each means something different.
Merger. Two corporations become one. For example, suppose Company A and Company B
merge into a single organization. To do this, Company A, called the survivor company,
assumes all the assets and liabilities of Company B, which ceases to exist. The survivor
company keeps the Company A name.
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Amalgamation. Company A takes over B and possibly C and D as well. This can be done by
merger, consolidation or acquisition.
There are multiple types of mergers, acquisitions, consolidations and amalgamations. The
effect on stockholders and the legal issues vary with the category and type of combination.
Corporate leaders and investors may prefer the status quo rather than putting themselves
under the control of some new business entity. However, there are often advantages to
turning Company A and B into a single organization.
Creating a stronger company. A and B may be no match for C, which dominates the industry.
Combine A and B together and they become the big dog in the field. They'll also have more
resources and the best employees of both corporations to draw on.
Eliminating competition. If A buys up B, it no longer has to worry about B as a rival.
A larger company has the clout to arrange cheaper terms for its financing.
Bigger companies have more bargaining power with suppliers and clients.
Amalgamating with B may give A access to new markets, new technologies or new clients.
Stockholders have a vested interest in what happens to the company they own shares in. The
effect on them depends on how the combination takes place.
In a merger or a consolidation, for instance, Company A may offer to buy up shares from
Company B's stockholders or to swap them for shares in the combined company. A majority of
shareholders have to vote in favor of combining; naysayers can refuse to swap shares and
ask for cash based on the appraised value of their stock.
A stock acquisition doesn't require a shareholder vote, but A will have to offer enough to B's
stockholders to collect the number of shares it wants. An asset acquisition doesn't usually
require a shareholder vote. Neither does a "short-form" merger in which Company A owns at
least 90% of B's stock.
Types of Mergers
There are multiple types of mergers and acquisitions, depending on whether the companies
compete, do business or exist in unrelated worlds.
In a conglomerate merger, A and B are in separate industries. Amazon, for example, merged
with the Whole Foods grocery chain in 2017, giving the chain badly needed financial support.
In return, Amazon established a niche in the grocery business and acquired valuable real
estate in hundreds of upscale neighborhoods.
Horizontal mergers take place between competing companies. If Whole Foods had merged
with the Kroger chain, that would have been horizontal. This strategy reduces competition and
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Product extension mergers take place between companies that operate in the same market
and have related products.
Consolidate To Transform
In some mergers or consolidations, the strategy is a big-picture one. Company A doesn't want
to become more powerful in the industry, it wants to transform the industry or itself.
Executives in highly competitive cut-throat industries sometimes hope that consolidating will
reduce price competition. That makes it easier for everyone in the industry to earn a higher
return on investment. Unfortunately, unless consolidation reduces the players to three or four
companies, it's unlikely to transform pricing strategies much.
The reverse merger is a special case, involving a private company that has mixed thoughts
about going public. Selling stock in an initial public offering (IPO) is a good way to raise
capital, but it can also dilute the owners' control of the business.
One solution is to use stock acquisition to buy up a controlling interest in a company that's
already trading publicly. The two companies merge, with the private company's shareholders
becoming majority shareholders in the public company. The private company eventually
becomes a wholly-owned subsidiary of the publicly traded corporation, but with no risk to the
owners' control.
The short-form merger is another useful option because it dispenses with much of the ordinary
merger paperwork. It requires Company A to already own around 90 percent of B's stock,
though some states set a slightly different percentage. The minority stockholders in B have no
power to block the sale, so state laws allow Company A to waive many of the meetings
normally required.
An asset acquisition allows Company A to pick and choose the assets it wants, which could
be land, equipment or intellectual property. However, B's management doesn't have to say
yes if the price isn't fair. It may take a flock of accountants, analysts and appraisers to
determine if A's offer for the assets is a good one.
By slashing Company B's costs or boosting revenues, A turns B into a dependable source of
cash.
The industry's putting so much product on the market that everyone suffers. Buying Company
B and reducing production may increase prices for A's products.
If B suffers from limited marketing or sales and A has a first-rate sales department, A can
channel B's products through A's larger sales force.
If Company A is, say, a tech firm, it may want to buy up smaller firms with products that match
up with its own. This is often quicker and cheaper than investing in its own R&D.
Company A sees Company B is in on the ground floor in a new industry. Acquiring B gives A
access to the new field.
If the acquisition price is too high, the purchase isn't such a good deal. However, if Company
B's value or stock price drops temporarily, A may be able to snatch it up at a bargain price.
In a consolidation or merger, for example, the successor or survivor company inherits the
whole package: all of the original company's assets but all their liabilities too. Company A may
be in a position to shrug that off, as when Amazon purchased Whole Foods, but not
everyone's that well-placed.
If Company A buys a majority stake in B, the liabilities remain B's legal responsibility, but as A
now owns B, they still have to be dealt with. Acquiring B's assets, on the other hand, enables
A to avoid any liability issues, with a few exceptions:
Company A expressly guarantees it will assume B's liabilities, or makes an implied guarantee.
Company A continues the seller's business and retains the same staff B's always had.
The sale is a fraudulent maneuver designed to avoid liability.
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Another way to think about combining companies is that there are two types of mergers and
acquisitions: hostile and friendly. In a friendly takeover, Company B's management and board
are willing to go along. In a hostile takeover, they reject Company A's offer and oppose the
merger, acquisition or consolidation.
Company A is in a different industry and B's board don't think it'll operate well in B's world.
B's board is concerned A just wants to strip mine B's assets and then leave B on life support.
B's board or management believe they'll lose out in a consolidation, even if the shareholders
do well.
Company A can still take its case directly to the shareholders. It can make them an offer for
their shares or it can try to persuade them to vote out the board and install members who will
be more supportive of consolidation.
Success or Failure?
There are many reasons why acquisitions and mergers often fail:
The purchase price is too steep. Getting control of Company B or its assets often requires
paying more than B is worth.
Managers often overestimate their ability to judge the value of the target company or to
manage it well once they control it.
Company A's management team may not be acting in the company's interest. The A team
may hope they'll be rewarded with bigger salaries and bonuses once they're in charge of a
bigger corporation.
Blending the companies proves tougher than expected. Deciding which plants to close, which
employees to lay off and which brands to discontinue won't be easy.
2. Give example companies and state the reason why they are combined.
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ACTIVITY 1
1. Two corporations become one. For example, suppose Company A and Company
B merges into a single organization.
3. Companies A and B join together to become a new business, Company C, the new
business is known as the successor company.
5. It takes place between companies that operate in the same market and have
related products.
8. It is a special case involving a private company that has mixed thoughts about
going public.
9. It is another useful option because it dispense with much of the ordinary merger
paperwork.
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OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Identify the different financial distress, its causes and ways to manage them.
2. Recognize the reasons for corporate financial distress and learn the different alternative
solutions applicable.
TO DO LIST:
In order to successfully complete Module 7 Week 11 lesson, students are required to do the
following:
1. Join: the discussion on the topics about Corporate Financial Distress
2. Follow: Online Netiquette
3. Submit: the required output for this module on or before the given deadline.
LECTURE:
Ignoring the signs of financial distress before it gets out of control can be devastating. There
may come a time when severe financial distress can no longer be remedied because the
company or individual's obligations have grown too high and cannot be repaid. If this happens,
bankruptcy may be the only option.
KEY TAKEAWAYS
• Financial distress happens when revenues or income no longer meet or pay for the
financial obligations of an individual or organization.
• Financial distress is often a harbinger of bankruptcy, and can cause lasting damage to
one's creditworthiness.
• In order to remedy the situation, a company or individual may consider options such as
restructuring debt or cutting back on costs.
If a company or individual experiences a period of time when it cannot pay its debts, bills, and
other obligations by their due date, they are likely experiencing financial distress.
Examples of a firm's expenses that must be paid may include financing such as paying interest
on debts, opportunity costs of projects, and employees who aren't productive. Employees of a
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distressed firm usually have lower morale and higher stress caused by the increased chance of
bankruptcy, which could force them out of their jobs. Companies under financial distress may
find it difficult to secure new financing. They may also find the market value of the firm falls
significantly, as customers cut back on new orders, and suppliers change their terms of delivery.
Looking at a company's financial statements can help investors and others determine its current
and future financial health. For example, negative cash flows appearing in the company's cash
flow statement is one red flag of financial distress. This could be caused by a large disparity
between cash payments and receivables, high interest payments, and/or a drop in working
capital.
Individuals who experience financial distress may find themselves in a situation where their debt
servicing costs are much more than their monthly income. These debts or obligations include
items such as home or rent payments, car payments, credit cards, and utility bills. People who
experience situations like these tend to go through it for an extended period of time and may
ultimately be forced to relinquish assets secured by their debts and lose their home or car, or
face eviction.
Individuals who experience financial distress may be subject to wage garnishments, judgments,
or legal action from creditors.
There are multiple warning signs that could indicate a company is experiencing financial
distress, or is about to in the near-term. Poor profits may point to a company that is financially
unhealthy. Struggling to break even suggests a business that cannot sustain itself by generating
internal funds and must instead raise capital externally. This increases the company’s business
risk and lowers its creditworthiness with lenders, suppliers, investors, and banks. Limiting
access to funds typically results in a company (or individual) failing.
Declining sales or poor sales growth indicates that demand is not there for a company’s
products or services based on its existing business model. When expensive marketing
campaigns result in no growth, consumers may no longer be satisfied with their offerings and
the company may be forced to close down. Likewise, if a company offers poor quality products
or services, consumers will start buying from competitors, eventually forcing a business to close
its doors as well.
When debtors take too much time paying their debts to the company, cash flow may be severely
stretched. The business or individual may be unable to pay its own liabilities. The risk is
especially enhanced when a company has just one or two major customers.
As difficult as it may seem, there are some ways to turn things around and remedy financial
distress. One of the first things many companies do is to review their business plans. This
should include both its operations and performance in the market, as well as setting up a target
date to accomplish all its goals.
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COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Another consideration is where to cut costs. This may include cutting staff or even cutting back
on management incentives, which can often be costly to a business' bottom line.
Some companies may consider restructuring their debts. Under this process, companies that
cannot meet their obligations can renegotiate their debts and change their repayment terms in
order to improve their liquidity. By restructuring, they can continue operations.
For individuals who experience financial distress, the tips to remedy the situation are similar to
those listed above. Those affected may find it prudent to cut back on unnecessary or excessive
spending habits such as dining out, travel, and other purchases that may be deemed a luxury.
Another option may be credit counseling. With credit counseling, a counselor renegotiates a
debtor's obligations, allowing him or her to avoid bankruptcy. Debt consolidation is another
method for reducing monthly debt obligations by rolling high-interest debts such as credit cards
into a single, lower-interest personal loan.
One factor contributing to the financial crisis of 2007-2008 was the government’s history of
providing emergency loans to distressed financial institutions in markets believed "too big to
fail". This created an expectation for parts of the financial sector being protected against losses,
known as moral hazard. The federal financial safety net is supposed to protect large financial
institutions and their creditors from failure to reduce systemic risk to the financial system.
However, these guarantees also encouraged imprudent risk-taking that caused instability in the
very system the safety net was supposed to protect.
Because the government safety net subsidizes risk-taking, investors who feel protected by the
government may be less likely to demand higher yields as compensation for assuming greater
risks. Likewise, creditors may feel less urgency for monitoring firms implicitly protected.
Excessive risk-taking means firms are more likely to experience distress and may require
bailouts to stay solvent. Additional bailouts may erode market discipline further.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
ACTIVITY 2
TRUE OR FALSE
1. Financial distress happens when revenues or income no longer meet or pay for
the financial obligations of an individual or organization.
2. The government safety net may then important attractive option in times of
financial distress.
3. Excessive risk-taking means firms are more likely to experience distress and
may require bailouts to stay solvent. Additional bailouts may erode market
discipline further.
4. Debt consolidation is another method for reducing monthly debt obligations by
rolling high-interest debts such as credit cards into a single, lower-interest
personal loan.
5. Ignoring the signs of financial distress after it gets out of control can be
devastating.
6. Resolution plans or corporate "living wills" may be an important method of
establishing credibility against bailouts.
7. Struggling to break even suggests a business that cannot sustain itself by
generating internal funds and must instead raise capital internally.
8. Declining sales or poor sales growth indicates that demand is there for a
company’s products or services based on its existing business model.
9. Looking at a company's financial statements can help investors and others
determine its current and future financial health.
10. Financial distress is often a harbinger of bankruptcy, and can cause lasting
damage to one's creditworthiness.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
OBJECTIVES:
At the end of this lesson, the students are expected to:
1. Describe financial management of a multinational firm
2. Discuss licensing and franchising
3. Identify the risks involved in multinational financial management
TO DO LIST:
In order to successfully complete Module 2 Week 4 lesson, students are required to do the
following:
4. Join: the discussion on the topics about Multinational Financial Management
5. Follow: Online Netiquette
6. Submit: the required output for this module on or before the given deadline.
LECTURE:
Financial management is mainly concerned with how to optimally make various corporate
financial decisions, such as those pertaining to investment, capital structure, dividend policy,
and working capital management, with a view to achieving a set of given corporate objectives.
Why do we need to study “international” financial management? The answer to this question is
straightforward: We are now living in a highly globalized and integrated world economy.
American consumers, for example, routinely purchase oil imported from Saudi Arabia and
Nigeria, TV sets and camcorders from Japan, Italy, and wine from France. Foreigners, in turn,
purchase American-made aircraft, software, movies, jeans, wheat, and other products.
Continued liberalization of international trade is certain to further internationalize consumption
patterns around the world.
Like any finance function, international finance, the finance function of a multinational firm has
two functions namely, treasury and control. The treasurer is responsible for financial planning
analysis, fund acquisition, investment financing, cash management, investment decision and
risk management. On the other hand, controller deals with the functions related to external
reporting, tax planning and management, management information system, financial and
management accounting, budget planning and control, and accounts receivables etc.
International Trade
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
According to industry experts, international trade is simply the exchange of goods, services, and
capital across international boundaries. Whatever you trade with other nations of the world
brings in significant returns that represent a significant share of GDP (Gross Domestic Product).
It is a vital source of income for developing countries that allow them to improve their country’s
infrastructure, facilities, communication, distribution channels, low per capita income, low
literacy rate, low rates of capital investments, low wages, high-interest rates, technology, and
overall social, political, and economic conditions.
International trade has long existed in one form or another across the globe through important
trade routes like Silk Road, Amber Road, Uttarapatha, Atlantic slave trade, salt roads, etc… So,
it’s not surprising for us that a larger trade transit has developed and established over the years.
Americans leading from the front have established their currency to an extent that now trades
around the world is dollars. Looking at the bigger picture, it is advanced technology,
industrialization, globalization, convenient ways of transportation, outsourcing, and
multinationals that have all played a significant role in bringing international trade to the top.
Multinational Activity
Multinational organizations are the major driving forces behind successful multinational
activities. Sharing of information, knowledge, expertise, innovative techniques of handling
business and trade activities have intensified the growth potentials of organizations across
international borders and territories by making healthy or savvy investments. The exchange of
ideas, goods, services, and capital across MNCs have enabled companies to increase their
overall performance and productivity. It’s safe to say that multinational activity and international
trade go hand in hand, as both are healthy for a country’s economic growth and development.
Sometimes they may be used interchangeably, but both keep the economic and financial
equation positive—if done properly.
International Trade
•Obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names) in
exchange for fees or some other specified benefits
•Allows firms to use their technology in foreign markets without a major investment and without
transportation costs that result from exporting
•Major disadvantage
•Franchising
•Obligates a firm to provide a specialized sales or service strategy, support assistance, and
possibly an initial investment in the franchise in exchange for periodic fees
•Allows penetration into foreign markets without a major investment in foreign countries
•Joint Ventures
•A venture that is jointly owned and operated by two or more firms. A firm may enter the foreign
market by engaging in a joint venture with firms that reside in those markets
•Allows two firms to apply their respective advantages in a given project
•Acquisitions of firms in foreign countries allows firms to have full control over their foreign business
and to quickly obtain a large portion of foreign market share
•Subject to the risk of large losses because of larger investment
•Liquidation may be difficult if the foreign subsidiary performs poorly
are also determined to make their economy growthrough international business that has
therefore become a inevitable part of their economic policy. The objective behind
international business can be looked at:
All companies have products, which pass through different stages of their life cycles. After
the product reaches the last stage of the life cycle called the declining stage in one country, it isi
mportant for the company to identify other countries where the whole cycle process
could been cashed. For example, Enfield India reached maturity and declining stage in India
for the 350cc motorcycle. The company entered Kenya, West Indies, Mauritius and
other destinations where the heavy engine two-wheeler became popular. The
Suzuki 800 cc vehicle reached the last stage of its life cycle in Japan and entered
India in the early 1980’s, where it is still doing g o o d b u s i n e s s t o d a y . H P
l a p t o p s a r e m o v i n g a l l t h e d e v e l o p i n g c o u n t r i e s t h e m o m e n t t h e y reached
maturity in the U.S. market.
Even if companies expand their business at home, they may still look overseas for new markets
and better prospects. For example, Arvind mills expanded their business by either
setting up u n i t s o r o p e n i n g w a r e h o u s e s a b r o a d . R a n b a x y ’ s g r o w t h i s
m a i n l y a t t r i b u t e d t o g e o g r a p h i c expansion every year to new territories.
ArobindoPharma, Cipla and Dr. Reddys follow the same.
The younger generation of business families has considerable International exposure. They are
willing to take risks and challenges And also create opportunities for their
business. LaxmiMittal has Emerged as the steel king of the world and Vijay Mallya
of the UB Group took a m a j o r r i s k i n s e t t i n g u p o p e r a t i o n s i n S o u t h A f r i c a .
K u m a r B i r l a e x p a n d s t o A u s t r a l i a a n d Europe through acquisitions.
4.Corporate ambition:
Every corporate in the country has strategic plans to multiply its sales turnover. In case some
of the ventures fail, others will offset the losses because of multi-location operations. For
example, Coco Cola is still to day not earning any profit in a number of countries. But this will
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
not affect the company because more than a hundred countries are contributing to offset losses.
Kellogge cannot think of profits in India for further five years. They are ambitious to be visible
and then revenue.
5.Technology advantage:
Some companies have outstanding technology through which they enjoy core
competency. There is a need for such technology in all countries. Biocon, Infosys,
Gharda chemicals are known for their core competency in biotechnology, IT and
pesticides respectively and a huge d e m a n d e x i s t s t h r o u g h o u t t h e w o r l d f o r
t h e i r t e c h n o l o g y . T h e r m a x , I o n E x c h a n g e , B h a r a t Heavy Electricals and Larsen &
Toubro have marched ahead in International business.
Prior to profits and revenue generation, many companies first build their corporate
image abroad. Once the image is built, generating revenues is a comparatively easy task.
Samsung and LG built their image in India for the first three years and generation of revenue
and profits has been considerable, as they have expanded to semi-
urban and rural India as well. Today their market share and penetration levels have gone far
ahead of other players in India.
8.Labour advantage
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Current approvals of Special economic zones, Agrizones and Technology parks by Ministry
of Commerce & Industry give new dimensions to international business. The companies setting
up units in SEZ’s enjoy innumerable benefits and competitiveness.
Foreign exchange earning is necessary to balance the payments for imports. India imports
crude oil, defenseequipments, essential raw materials and medical equipments for which the
payments have to be made in foreign exchange. If the exports are high and imports
are low it indicates a s u r p l u s b a l a n c e o f p a y m e n t . O n t h e o t h e r h a n d i f
i m p o r t s a r e h i g h a n d e x p o r t s a r e l o w i t indicates an adverse balance of
payment, which all economies would want to avoid. A vast majority of the nations in the
world are facing adverse balance of payment.
2.Interdependency of nations
From time immemorial, nations have depended on each other. Even during the era
of Indus valley civilization, Egypt and the Indus Valley depended on each other for various
items. Today, India depends on the Gulf regions for crude oil and in turn the Gulf region
depends on India for tea, rice etc. Developed countries depend on developing
countries for primary goods, whereas developing countries depend on developed
countries for value added finished products. No single country is endowed with all the
resources to survive on her own.
The theories of absolute advantage, comparative advantage and competitive advantage, which
have
been propounded by classical economists, indicate that a few nations hav
e certainadvantages of resources. The resources may be in the form of
labouror infrastructure
or t e c h n o l o g y o r e v e n a p r o c t i v e p o l i c y o f t h e g o v e r n m e n t . S u c h t
h e o r i e s a r e r e m a i n i n g foundations till today, for international business practices with
few changes and trends.
4.Diplomatic relations
Diplomacy and trade always go hand in hand. Many sovereign nations send their
diplomatic representatives to other countries with a motive of promoting trade besides
maintaining cordial relations. Indian diplomats in Latin America have done a
remarkable job of promoting India’s
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
ACTIVITY 3
Define the following terminologies:
1. International Trade
2. The Contribution of International Trade
3. Multinational Activity
4. Licensing
5. Franchising and Joint Ventures
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
OBJECTIVES:
At the end of this lesson, the students are expected to:
4. Describe financial management of a multinational firm
5. Discuss licensing and franchising
6. Identify the risks involved in multinational financial management
TO DO LIST:
In order to successfully complete Week 14-5 lesson, students are required to do the following:
7. Join: the discussion on the topics about Special topics on Financial Management
8. Follow: Online Netiquette
9. Submit: the required output for this module on or before the given deadline.
Lecture:
Working capital represents the difference between a firm’s current assets and current liabilities.
The challenge can be determining the proper category for the vast array of assets and liabilities
on a corporate balance sheet and deciphering the overall health of a firm in meeting its short-
term commitments.
Assessing the health of a company in which you want to invest involves understanding its
liquidity—how easily that company can turn assets into cash to pay short-term obligations. The
working capital ratio is calculated by dividing current assets by current liabilities.
So, if XYZ Corp. has current assets of $8 million, and current liabilities of $4 million, that's a 2:1
ratio—pretty sound. But if two similar companies each had 2:1 ratios, but one had more cash
among its current assets, that firm would be better able to pay off its debts quicker than the
other.
2. Quick Ratio
Also called the acid test, this ratio subtracts inventories from current assets, before dividing that
figure into liabilities. The idea is to show how well current liabilities are covered by cash and by
items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into
liquid assets.
If XYZ has $8 million in current assets minus $2 million in inventories over $4 million in current
liabilities, that's a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less
than that may be okay because it means they turn their inventories over quickly.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
If a company has zero or negative earnings (i.e. a loss) then earnings per share will also be
zero or negative.
If, for example, a company closed trading at $46.51 a share and EPS for the past 12 months
averaged $4.90, then the P/E ratio would be 9.49. Investors would have to spend $9.49 for
every generated dollar of annual earnings.
Note that if a company has zero or negative earnings, the P/E ratio will no longer make sense,
and will often appear as N/A for not applicable.
When ratios are properly understood and applied, using any one of them can help improve your
investing performance.
Even so, investors have been willing to pay more than 20 times the EPS for certain stocks if
hunch that future growth in earnings will give them an adequate return on their investment.
5. Debt-Equity Ratio
What if your prospective investment target is borrowing too much? This can reduce the safety
margins behind what it owes, jack up its fixed charges, reduce earnings available for dividends
for folks like you and even cause a financial crisis.
The debt-to-equity (D/E) is calculated by adding outstanding long and short-term debt, and
dividing it by the book value of shareholders' equity. Let's say XYZ has about $3.1 million worth
of loans and had shareholders' equity of $13.3 million. That works out to a modest ratio of 0.23,
which is acceptable under most circumstances. However, like all other ratios, the metric has to
be analyzed in terms of industry norms and company-specific requirements.
Let's say net earnings are $1.3 million and preferred dividends are $300,000. Take that and
divide it by the $8 million in common equity. That gives a ROE of 12.5%. The higher the ROE,
the better the company is at generating profits.
in isolation - always combine ratios and metrics to get a complete picture of a company's
prospects.
Altman Z-Score
The Altman Z-score is the output of a credit-strength test that gauges a publicly-traded
manufacturing company's likelihood of bankruptcy. The Altman Z-score is based on five
financial ratios that can calculate from data found on a company's annual 10-K report. It uses
profitability, leverage, liquidity, solvency, and activity to predict whether a company has a high
probability of becoming insolvent.
The Altman Z-score is a formula for determining whether a company, notably in the
manufacturing space, is headed for bankruptcy. The formula takes into account profitability,
leverage, liquidity, solvency, and activity ratios. An Altman Z-score close to 1.8 suggests a
company might be headed for bankruptcy, while a score closer to 3 suggests a company is in
solid financial positioning.
Where:
A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with
scores above 3 are not likely to go bankrupt. Investors can use Altman Z-scores to determine
whether they should buy or sell a stock if they're concerned about the company's underlying
financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is
closer to 3 and selling or shorting a stock if the value is closer to 1.8.
Special Considerations
In 2007, the credit ratings of specific asset-related securities had been rated higher than they
should have been. The Altman Z-score indicated that the companies' risks were increasing
significantly and may have been heading for bankruptcy.
Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These
companies' credit ratings were equivalent to a B. This indicated that 50% of the firms should
have had lower ratings, were highly distressed and had a high probability of becoming bankrupt.
Altman's calculations led him to believe a crisis would occur and there would be a meltdown in
the credit market. Altman believed the crisis would stem from corporate defaults, but the
meltdown began with mortgage-backed securities. However, corporations soon defaulted in
2009 at the second-highest rate in history.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
In 2012, he released an updated version called the Altman Z-score Plus that one can use to
evaluate public and private companies, manufacturing and non-manufacturing companies, and
U.S. and non-U.S. companies. One can use Altman Z-score Plus to evaluate corporate credit
risk. The Altman Z-score has become a reliable measure of calculating credit risk.
1. Using the different Key Ratio of Financial Management, look for updated financial
statements and apply the different ratios stated in the lecture.
ACTIVITY 5
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
OBJECTIVES:
At the end of this lesson, the students are expected to:
7. Describe financial management of a multinational firm
8. Discuss licensing and franchising
9. Identify the risks involved in multinational financial management
TO DO LIST:
In order to successfully complete Week 14-15 lesson, students are required to do the following:
10. Join: the discussion on the topics about Basic International Finance
11. Follow: Online Netiquette
12. Submit: the required output for this module on or before the given deadline.
An initiative known as the Bretton Woods system emerged from a 1944 conference attended by
40 nations and aims to standardize international monetary exchanges and policies in a broader
effort to nurture post World War II economic stability.
International finance deals with the economic interactions between multiple countries, rather
than narrowly focusing on individual markets. International finance research is conducted by
large institutions such as the International Finance Corp. (IFC), and the National Bureau of
Economic Research (NBER). Furthermore, the U.S. Federal Reserve has a division dedicated
to analyzing policies germane to U.S. capital flow, external trade, and the development of global
markets.
The Mundell-Fleming Model, which studies the interaction between the goods market and the
money market, is based on the assumption that price levels of said goods are fixed.
International Fisher Effect is an international finance theory that assumes nominal interest rates
mirror fluctuations in the spot exchange rate between nations.
The optimum currency area theory states that certain geographical regions would maximize
economic efficiency if the entire area adopted a single currency.
Purchasing power parity is the measurement of prices in different areas using a specific good or
a specific set of goods to compare the absolute purchasing power between different currencies.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Interest rate parity describes an equilibrium state in which investors are indifferent to interest
rates attached to bank deposits in two separate countries.
The Bretton Woods system was created at the Bretton Woods conference in 1944, where the 40
participating countries agreed to establish a fixed exchange rate system. The collective goal of
this initiative was to standardize international monetary exchanges and policies in a broader
effort to create post World War II stability.
The Bretton Woods conference catalyzed the development of international institutions that play
a foundational role in the global economy. These include the International Monetary Fund (IMF),
a consortium of 189 countries dedicated to creating global monetary cooperation, and the
International Bank for Reconstruction and Development, which later became known as the
World Bank.
Special Considerations
International trade is arguably the most important influencer of global prosperity and growth. But
there are worries related to the fact the United States has shifted from being the largest
international creditor, to becoming the world's largest international debtor, absorbing excess
amounts of funding from organizations and countries on a global basis. This may affect
international finance in unforeseen ways.
International finance involves measuring the political and foreign exchange risk associated with
managing multinational corporations.
• Currencies
• Market and policy variables (exchange rates, interest rates, risk, ratings)
• Markets: the (physical or virtual) places or ‘centres’ where financial transactions take
place
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
A world of currencies
• When dealing with IF one has to face the problems of having different currencies and
how to exchange one for another (through exchange rates).
• Not only money and bank deposits but also financial assets are denominated in a
national currency.
• Reserve currencies are those mostly used in international transactions (US $, Euro,
yen, once the British pound).
• Central banks normally hold relevant quantities of reserve currencies to use in the
money and exchange markets for their operations in addition to gold.
• The IMF Special Drawing Rights (SDR) is an international currency albeit it is not
physical but only serves as an accounting unit.
• The US $ still accounts for 60% of all international reserves (Table on distribution of
international reserves)
Gold still represents an important share of international reserves (see IMF statistics).
Most of gold is held by central banks and the IMF but private institutions like investment funds
also have gold in their asset portfolios.
The US and most European countries hold more than 70% of their foreign reserves in gold bars.
Gold still represents an important store of value. Albeit its price changes daily on a market
basis, its value does not depend on ‘trust’ like in the case of currencies.
Exchange rates
• Exchange rates determine the rate of change in the market of a currency with another
(or with gold).
• The US $/euro exchange rate is the number of $ units that are needed to get 1 euro.
• When left to market forces exchange rates may vary considerably and even abruptly.
• When the euro was introduced on Jan. 1 1999 its value was initially set at 1.17$ but at
the beginning of 2002 it went to 0.85$. Its quotation is now around 1.25$.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
• Most countries define their exchange rate in ‘direct terms’, that is ‘units of national
currency against 1unit of a foreign currency’ (UK is an exception). This is sometimes
called ‘uncertain for certain’.
• One has always to make sure of what is the currency at the numerator and which one at
the denominator
• The determination of an exchange rate may be left to market forces (demand and supply
of currencies) or may be fixed in terms of another currency or benchmark (e.g. gold).
What ‘regime’ to chose is a political decision.
• Before WWI, exchange rates were internationally set in terms of gold and were thus
fixed (gold standard), not left to market forces.
• After WWI till 1971-73 exchange rates were fixed in terms of the US $ which was the
dominant reserve currency.
• In the present ‘system’ we observe a large variety of exchange rates regimes (a non-
system?). Flexible regimes are as much frequent as fixed regimes.
• There is no theoretical or empirical evidence that a given regime is better than another
(in terms of growth and employment creation or in terms of financial stability)
• The exchange rates of the major reserve currencies are left to market forces
• The ‘interbank foreign exchange market’ (i.e. the market where international banks
exchange deposits in different currencies) is the largest financial market in the world,
with an average turnover of $4 trillion per day.
• The changes or levels of an exchange rate have important effects on sales prices and
costs of imported goods and raw materials and hence influence the profits of importers
and exporters (see Exhibit 1.1 Currency matters: corporate experiences )
• They influence a country’s BoP and inflation rate through the valuation of exports and
cost of imports especially of oil and raw materials.
• They may be related to the persistence of external imbalances at the global level
(consider the debate on the overvaluation of chinese yuan).
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
• Exchange rate ‘regime’: is the type of criterion that a country choses to set the value of
its exchange rate, whether flexible (i.e. determined by market forces) or fixed or any
other form between these two extremes.
Interest rates
• Interest rates are another fundamental factor of IF. They influence in a significant way
cross border financial flows searching for the best risk/return combinations.
• Interest rates indicate the returns on financial assets and vary according to the degree of
liquidity and the risk embedded in each asset (bank deposits, corporate bonds, treasury
bonds, investment funds, etc)
• Market interest rates vary on a daily basis but are influenced by the ‘policy’ rates set by
the monetary authorities. These are the rates at which central banks lend money to the
commercial banks (e.g. the FED overnight rate).
Economic theory has paid a lot of attention to the equilibrium level of interest rates in an
international economy
Risk
• Interest rates vary according to the degree of risk embedded in financial assets. The
higher the risk for the lender or the investor to get his money back, the higher the
interest rate that he demands.
• International investors face all kinds of risk that are typical in the activity of
lending/borrowing money: i.e. credit risk, operational risk, etc. What kinds of (additional)
risks an international investor face?
• Exchange rate risk: when investing in an asset denominated in a foreign currency, the
exchange rate prevailing at the end of the investment period is going to affect
significantly the final return. Ex. An European investor buying US Treasury bonds at
$/€=1.2 will sustain a reduction in his return if at the end of the period $/€=1.3 (the dollar
has depreciated vis-à-vis the euro).
• Country risk: the risk that a country may default (totally or partially) on its foreign
obligations due to economic, political or social problems. Ex. In Europe a measure of
country risk is given by the spread between returns on Government bonds using
German bonds as the risk-free benchmark.
• Exchange rate risk and country risk are normally (positively) related. The higher the
probabilty that a country may default on its debt, the higher the risk of a
devaluation/depreciation of its currency (e.g. Argentina’s 2001 default).
Risk aversion
• Individuals and investors are normally risk adverse. There a two fundamental ways to
cope with risk.
2. Hedging(especially against ex. rate risk): special types of contracts designed to enable
investors as well as importers and exporters to cover the risk of unexpected changes in
exchange rates
Systemic Risk
• SR is the risk that a crisis may involve an entire region or even the global economy.
• A systemic crisis can originate in a single country (or region) and spill over to the entire
system through various financial and real channels (‘contagion’ or ‘domino’ effect).
• The financial system with its multiple links is a major channel of transmission of shocks.
• In a systemic crisis rational behaviour – like running away from too risky assets or
countries – may be heightened by irrational components (herding or panic).
• Large financial institutions (like Lehman Brothers) may be ‘too large to fail’ and hence be
classified as ‘systemically’ important.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
Systemic risk in the globalized economy is drawing a lot of attention on the part of both
economists and policy makers.
Ratings
• Ratings help assess the creditworthiness of firms, banks and countries (government
bonds) when they operate internationally. They are a measure of the ‘quality’ of credits.
• Standard&Poors, Moody’s and Fitch are the best known (international) rating agencies
but there are a lot more.
• Ratings go from AAA of Std&Poors (Aaa for Moody’s and Fitch) to Bbb or ‘C’ (junk
bonds.) Assets with a rating above BBB are said ‘investment grade’.
• Institutional Investors also rely on ratings in their investment decisions. Fund managers
may set a threshold rating above which investments are allowed (this implies that if an
asset that is present in the fund portfolio falls below the threshold rating it is to be
dismissed).
- failing in predicting financial/corporate crises thus issuing downgrades when it is too late
(see Lehman Brothers)
- aggravating financial or corporate crises due to the wrong timing of downgradings (see
the recent downgrading of several European countries during the euro crisis)
- being in a conflict of interest as they are paid by the firms that ask to be rated.
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Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
COLLEGE OF ACCOUNTANCY AND FINANCE /rcd
Department of Financial Management /
ACTIVITY 6
1. Diversification
2. Hedging
3. Ratings
4. Risk
5. Interest rates
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