Chapter 3 – Business and the financial markets

Presentation by: James Williams

 The roles of the financial markets

 The financial markets in Australia, and indeed in

any country, fulfil many roles, not least of which are:
• Provision of platforms where the supply of funds by
surplus units and the demand for funds by deficit
units may be reconciled and priced through trading
• Facilitation of business and trade
• Facilitation of savings by individuals to allow for
future consumption
• Provision of financial services which allow
participants to balance their risk tolerance with their
requirements for both returns and cash.
 The roles of the financial markets

 In Australia, savers are typically individuals and

foreign entities.
 The borrowers are usually businesses and
governments.
 Apart from the savers and borrowers, there are
other entities in the markets that provide financial
services and, additionally, who oversee the
markets.
 The first group is composed of the financial
institutions and the second of the regulators.
 Financing business operations

Direct finance

 Direct finance takes place when the saver who is

the supplier of funds makes a deal directly with the
business that needs the funds.
 With direct funding, the supplier must know the
entity that needs the funds. If the supplier does not
know of an entity needing funds, then no supply can
be made.
 Transactions costs are the costs, in terms of both
time and explicit cash costs, of effecting a
transaction or deal.
 Financing business operations

Direct finance

 Hoarding is savings held outside the financial

system and thus not available for investment.
 Financing business operations

Intermediated finance

 Intermediate finance takes place through an

intermediary or a financial institution.
 Intermediated finance is much more common than
direct finance.
 They provide services at costs which are less than
the transactions costs savers and borrowers would
have to bear if there were no financial institutions.
 Types of financial institutions

Authorised deposit-taking institutions (ADIs)

 ADIs, which are registered under the Banking Act

1959, comprise the banks, building societies and
credit unions.
 Building societies and credit unions use the mutual
or cooperative society as their business structures.
 In terms of size, the banks dominate the ADI
markets.
 ADIs take deposits from savers and lend that
money out to borrowers, both individuals and
businesses, who need funds.
 Types of financial institutions

Registered financial corporations (RFCs)

 RFCs include money market corporations, pastoral

finance companies, finance companies, general
financiers and intra-group financiers.
 These companies are registered under the Financial
Sector (Collection of Data) Act 2001.
 There are other financial institutions, such as
superannuation funds and insurance companies,
that operate in the financial markets but provide
business finance only in a round-about way.
 Classifying the markets

 The market classifications that will be discussed

here are:
• primary and secondary
• public and private
• money and capital

 None of these markets has a single physical

presence.
 The financial markets are either electronic or
physically decentralised.
 Classifying the markets

 An important function of markets is that they allow

price discovery.
discovery
 Price discovery is the process of finding and settling
on a price which is acceptable to both parties to a
transaction.
 Classifying the markets

Primary and secondary markets

 The primary market is the market in which

securities are offered for the first time.
 Securities are documents that provide evidence of
a loan or the purchase of shares, a bond or a
commercial bill.
 The secondary markets deal with sales of
securities that have been issued by their respective
firms in the past and do not increase the stock of
securities.
 Classifying the markets

Primary and secondary markets

 The Australian Stock Exchange (ASX) is a prime

example of a secondary market principally for the
trading of equities, but also for trading selected debt
instruments.
 The existence of active secondary markets for
securities supports the primary markets by supplying
liquidity, confidence and the ability to manage risk.
 The secondary markets act as a price-discovery
mechanism for the primary markets when new
issues are contemplated.
 Classifying the markets

Public and private markets

 Public issues are issues of securities to the public

and require the release of a prospectus.
 A prospectus is a document that provides details of
a new issue of securities to the public.
 It normally contains details of past financial
performance and projected future performance. It
may also contain taxation implications for investors.
 Prospectuses must be approved by ASIC.
 Classifying the markets

Public and private markets

 Private placements are issues of securities made

by negotiation directly with purchasers.
 Normally public issues are larger than private
placements.
 A private placement takes place by negotiation
between the firm or its agent and selected private
individuals or financial institutions. No prospectus or
special reports are necessary.
 Classifying the markets

Public and private markets

 Even though this process may be facilitated by a

merchant bank or other financial institution, its cost
normally is quite low in comparison with costs
associated with a public offering.
 A merchant bank is a financial institution which is
not registered or regulated under the Banking Act
1959 but which carries out many of the functions of
a bank, especially in the wholesale or commercial
banking areas.
 Classifying the markets

Public and private markets

 In comparison to public issues, funds can usually be

raised much more quickly through a private
placement.
 In recent years, many firms have raised funds by
both methods. Often a public offering has followed
several private placements, as existing shareholders
apply pressure to be included in raising additional
funds. Their argument is that their holdings are
diluted each time a private placement is made to
other parties.
 Classifying the markets

Money and capital markets

 Money markets deal in short-term debt; that is,

debts that has less than one year to maturity.
 For businesses looking for funds, the major
instruments traded are bank bills and commercial
bills (promissory notes).
 The RBA, for the Commonwealth Government, uses
repurchase agreements (repos) over longer-term
securities to achieve short-term funding.
 Classifying the markets

Money and capital markets

 Repurchase agreements (repos) are securities that

are bought or sold with an agreement to reverse the
original transaction at a later date.
 Certificates of Deposit (CDs) are issued by banks
normally for periods ranging from a few days up to
180 days. They are essentially loans issued by
banks and are payable to the bearer (current
holder).
 Classifying the markets

Money and capital markets

 Capital markets deal in long-term instruments; that

is, instruments with maturities greater than one year.
 Long-term corporate debt – such as that involved
with the issue of debentures, secured or unsecured
notes, leases and loans with terms greater than one
year – as well as the equity instruments such as
shares and convertible notes are all issued and
traded in this market.
 Debt and equity

 Business needs funds to operate.

 There are three sources of funds:
1. equity (funds supplied by the owners)
2. debt (funds supplied by the lenders)
3. revenue (funds supplied by customers)
 How does a business owner decide which source
of funds or which combination of funding is best?
 This decision encompasses what is called the
financial structure of the business.
 Debt and equity

 The financial structure is the mix of debt and equity

or all of the items which appear in the liability section
of the balance sheet and which funds the assets
owned by the business.
 The balance sheet shows values relating to the
business at a point in time.
 Equity equals assets minus liabilities (E = A – L).
 In accordance with the assumption that business
managers desire to maximise owners’ wealth, the
aim in planning and designing financial structure is
to minimise the cost of raising and using funding.
 Debt and equity

 The maturity or term to maturity of funds is the

time that the contract stipulates may elapse before
the funds are to be repaid.
 Apart from the need for funds to have appropriate
maturity to suit the financing task at hand, there are
other issues which a financial manager must
consider. The most important are:
• the effect of debt on risk
• the effect of debt on control
• the varying taxation treatments of servicing payments
to debt and equity.
 Debt and equity

The effect of debt on risk

 Interest rates in the debt markets are set effectively

by the supply and demand for funds and the
perceived individual risk of each lending proposal.
 Risk in finance is defined as the chance that the
actual outcome from an investment will be different
from the expected outcome.
 Funds raised in the market as debt will often be
cheaper than equity funds.
 However, debt leads to increases in financial risk.
risk
 Debt and equity

The effect of debt on risk

 Financial risk is the risk involved in using debt as a

source of finance.
 Financial distress occurs when a firm’s financial
obligations cannot be met or can be met only with
major difficulty.
 Financial distress can become so acute that the firm
fails.
 In such cases, liquidators are appointed.
 Debt and equity

The effect of debt on risk

 Liquidators are specialist professionals who identify

the assets and liabilities of each failed business,
liquidate the assets at the best prices available,
identify the order in which creditors will be repaid
and eventually pay creditors to the extent to which
funds are available.
 Creditors with recognised first charges (security of
first ranking) over assets are normally paid first and
often are paid in full.
 Debt and equity

The effect of debt on control

 Normally, providers of debt funding have little or no

control over the operations of a business.
 However, anecdotal evidence tends to suggest that
this has not always been so in the case of small
businesses.
 Notwithstanding these cases, lenders, unlike
shareholders or partners, have no voting rights at
firm meetings.
 Debt and equity

The effect of debt on control

 However, once a firm defaults, lenders are able to

exert considerable influence to try to protect their
interests.
 This influence may be brought to bear through the
appointment of administrators, receivers or
liquidators.
 Debt and equity

The effect of varying taxation treatments of

payments to debt and equity

 Interest is a tax deductible expense for firms where

that interest expense is incurred for the purposes of
gaining assessable income.
 Dividends, on the other hand, are not tax deductible.
 However, the difference in tax treatment for interest
and dividends is not relevant to a financial
manager’s funding decisions where the tax
payments of the company are fully integrated with
the taxation of its shareholders through dividend
imputation.
 Debt instruments

 The principal sources of debt for businesses are

other businesses, financial institutions and the
financial markets. The principal instruments are:
• trade credit
• overdrafts
• inventory for floor plan finance
• commercial bills
• long-term bank loans
• debentures and unsecured notes
• corporate bonds.
 Debt instruments

 Trade credit is granted by one firm to another to

facilitate trade. The granting of credit allows a
purchase to be made without the immediate
payment of cash or the use of a credit card.
 Overdrafts are provided by financial institutions on
current or cheque accounts. An overdraft is a
permitted over-drawing of funds beyond the credit
balance in the account.
 Debt instruments

 Inventory finance or floor-plan finance is normally

provided by finance companies. It is provided to car
and whitegoods dealers to buy stock to place on
showroom floors and is secured by the stock itself.
 Commercial bills/promissory notes are
marketable debt securities which represent
promises by the borrowers to repay the face value
of the instrument at a stated future date. Maturities
normally range from 30 to 180 days.
 Debt instruments

 Face value is the amount that will be repaid upon

maturity of the bond. It is specified at the time the
bond is issued.
 Long-term bank loans come in many forms with
many variations in conditions. Some of the most
popular are fully drawn advances, instalment loans
and interest-only loans.
 Debentures are unsecured notes are sources of
finance limited to companies and, in Australia,
normally limited to finance companies and general
financiers.
 Debt instruments

 Debentures are fixed-term debt securities issued

under a prospectus. They are secured by assets.
 Unsecured notes are fixed-term debt securities
issued under a prospectus. Unlike debentures, they
are not secured by assets.
 Corporate bonds are debt instruments where the
issuer receives the face value of the bonds at the
outset and pays a coupon,
coupon usually six-monthly. The
face value is repaid when the bonds mature.
Corporate bonds are normally secured.
 Debt instruments

 The coupon is the stated rate of interest paid on a

bond.
 Because of the lack of a formal security mechanism,
credit rankings carried out by ratings firms such as
Moody’s and Standard & Poor’s are extremely
important.
 Corporate bonds in Australia are ranked AAA, AA, A
and BBB, with AAA being the highest ranking (that
is, the bond with the lowest perceived credit risk).
 BBB rated bonds are known as junk bonds and
carry substantially higher risk.
 Debt instruments

 Another increasingly popular form of debt security

within the Australian market is the kangaroo bond. bond
 A kangaroo bond is a long-term debt security issued
in the Australian market by non-residents of
Australia.
 Although the corporate bond market in Australia is
still in its infancy it is growing due to (i) large
companies moving from intermediated sources of
finance to direct sources of finance through capital
markets and (ii) the contraction of the supply of
Commonwealth Government debt.
 Equity instruments

 Although there are many variations in the ways

shares are issued, there are three main types of
shares or equity instruments:
• ordinary shares (fully paid)
• contributing shares or partly paid ordinary shares
• preference shares
 Ordinary shares are the most common form of
equity instrument. All corporations have ordinary
shares on issue and a share is proof of part-
ownership of a company.
 Equity instruments

 Holders of ordinary shares are entitled to dividends

and will be paid on the basis of so many cents per
share, possibly twice per year.
 When two dividend payments are made, the first
payment of the financial year is called an interim
dividend and the latter is a final dividend.
 If the business is a listed company and its shares
are quoted on a stock exchange, then the price of
the shares will be set by the forces of supply and
demand on the day.
 Equity instruments

 Theoretically, the price of the share will be the

present value of the expected future dividends.
 Shares rank behind the claims of all other interested
parties.
 The dividend payable to ordinary shareholders is
variable. Indeed, a corporation is under no obligation
to pay its ordinary shareholders any dividends.
 In the event of winding-up of a company, ordinary
shareholders are the last to receive payment. Quite
often, when a business fails, they receive nothing.
 Equity instruments

 Contributing shares or partly paid shares are

ordinary shares where the full subscription amount
has not yet been paid to the issuing company. This
type of equity is favoured by mining and exploration
companies.
 The rationale for offering partly paid shares stems
mainly from marketing concerns, but also from a
belief that there may not be sufficient funds available
to take up the offer of investment.
 Equity instruments

 Preference shares are hybrid equity instruments

with some characteristics of equity and some of
debt. They normally have a fixed dividend which has
preference over the payment of ordinary dividends.
 In the event of a company’s liquidation, preference
shares rank for repayment after debt but before
ordinary shares.
 Regulators and regulation

 The Australian financial markets are regulated by

three government bodies working closely together
plus another, the Australian Competition and
Consumer Commission (ACCC), which keeps a
watching brief with regard to competition and
consumer welfare.
 The chief government regulators are the:
• Reserve Bank of Australia (RBA)
• Australian Prudential Regulatory Authority (APRA)
• Australian Securities and Investments Commission
(ASIC)
 Regulators and regulation

 In addition, the Australian Stock Exchange (ASX) is

charged with a regulatory role in relation to listed
corporations.
 Regulators and regulation

Reserve Bank of Australia

 The RBA was set up under the Reserve Bank Act

1959 as Australia’s central bank.
 It has the important role in ensuring the stability of
the financial system as a whole.
 The RBA, under its Act, is obliged to manage the
economy to facilitate the stability of prices and full
employment of the economy’s resources.
 To achieve these ends, it controls monetary policy
independently of the government in power.
 Regulators and regulation

Reserve Bank of Australia

 The RBA controls monetary policy via its influence

over the cash rate – the interest rate at which funds
are lent overnight between banks.
 Once the cash rate target is announced, officers of
the RBA conduct open market operations to ensure
that the desired rate is maintained.
 Open market operations are the buying and selling
of Commonwealth Government Securities by the
RBA.
 Regulators and regulation

Australian Prudential Regulatory Authority

 APRA is the regulator of the ADIs.

 APRA generally takes the view that the
management of these ADIs must remain responsible
for sound operations and prudent processes.
 To give ADI management guidance, Australian
authorities adopted the Bank of International
Settlements’ (BIS) capital adequacy guidelines.
 APRA specifies a minimum level of capital to be
held by ADIs.
 Regulators and regulation

Australian Securities and Investments

Commission

 ASIC administers the Corporations Act 2001, which

provides for the federal regulation of companies.
 ASIC is concerned with the management and
maintenance of financial market integrity, consumer
protection and maintenance of confidence by all
stakeholders in the financial system.
 Regulators and regulation

Australian Stock Exchange

 The ASX, through its subsidiary ASX Markets

Supervision, regulates the behaviour of companies
that are listed with it and traded on it with respect to
the handling and release of information about
operations, and results that might be expected to be
market-sensitive.
 Market-sensitive information is information that
could be expected to have an impact on the share
price.
 Regulators and regulation

Australian Stock Exchange

 Issues with the dissemination of price-sensitive

information include timing and scope of distribution.
 The ASX demands that such information be
available to all stakeholders as quickly as possible.
 Insider trading occurs when one or two investors
gain information in advance of the general investing
public and use that information to buy or sell shares
in order to make personal profits before a general
buying or selling movement builds up.
 Regulators and regulation

Australian Stock Exchange

 Insider trading destroys confidence in the system.

 The other issue with regard to information concerns
the briefing of analysts.
 Firms that do not comply with ASX listing
requirements may have trading in their shares
suspended. Similarly, firms that do not respond
appropriately to an ASX query may have trading
suspended.