THE FINANCIAL

ENVIRONMENT
 What is Finance?

Finance can be defined as the art or science of

managing money. Finance is concerned with the
process, institutions, markets and instruments involved
in the transfer of money among individuals, businesses
and governments.

Finance is about decision making related to MONEY!!!!

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 Overview of Financial Management

• Finance Constitutes of three broad areas:

– Securities (GIYF), financial markets and financial institutions (money and
capital markets)
– Investments and investment portfolios
– Corporate financial management and decision-making

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 Corporate financial management

• Corporate financial management

– Every business requires some element of financial management for it to get
established, grow and remain sustainable into the long-term.

The scope of financial management is wide:

 Financial appraisal of business opportunities

 Assessment of the cost effective means of sourcing capital
 Securities evaluation
 Assessment of risk and returns
 Capital and dividend policy strategies

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 Corporate financial management

The goal of financial manager:

Forecasting and planning for the firm’s future.

Undertake investment and financing decisions. Assets must
be acquired, replaced, maintained or hired and funds must be
sourced to achieve these objectives.
Dealing with financial markets in raising funds. A financial
manager needs to understand the workings of both the money
and capital markets.
Risk management. Risk is an integral part of any business
venture, be it from natural disasters or security markets.

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 Corporate financial management

The objectives of the firm (publicly-owned) (GIYF):

Primary Goal: Maximize shareholder wealth i.e. stock price

Corporate Social Responsibility: a firm has a responsibility for the welfare of its
employees, customers and the community at large.
This is an ethical objective that ensures a safe working environment, a pollution
free environment and production of safe products.

Recent Business Trends:

Increased globalization of business

Improvements in Information Technology (IT)
Corporate Governance and Business Ethics

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Flow of Funds…

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 Financial Markets

Financial markets are bodies, structures and systems which, in unison,

create a conducive environment for effective capital formation and
capital transfer from savings surplus units (investors) to savings
deficit units (businesses).

Overall, the role of Financial Markets is to:

• bridge the gap between savings surplus units and savings deficit units (facilitates
an enabling environment)
• ensure effective capital formation (creation of appropriate securities)
• ensure effective capital transfer (regulation, legalities, processes and procedures)

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 Financial Markets

Physical Asset Markets

 trade in tangible products that can be sighted, inspected and physically valued, e.g.
real estate, computers, agricultural produce

Financial Asset Market

 trade in either claims on real assets (shares, bonds, mortgages) or derivative
securities (hedges on stock/economic movements)(GIYF)

Money Markets
 Trade in short-term finance (normally up to 1 year) e.g. treasury bills
 Highly liquid and marketable securities
 Facilitate transactions between savers with temporarily idle funds and businesses
temporarily short of funds (working capital)

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 Financial Markets

Capital Markets
 Trade in long-term finance, e.g. shares, bonds, debentures (GIYF)
 Mechanism through which long-term finance is pooled and made available to
corporations
 Higher in risk and return

Mortgage Markets
 Financial instruments linked to real estate (mortgages) are created by financial
institutions
 These instruments are then traded in the secondary markets

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 Financial Markets

Consumer Credit Markets

• Credit products targeted for personal use and consumption, e.g. credit cards,
personal loans, bank overdraft, auto loans

Primary Market
• The shares/stock are issued directly by the company to investors
• Achieved by either private placement or initial public offering (IPO)(GIYF)
• The company receives the funds and issues share certificates (nowadays not
physical)
• Funds used as start-up or expansion capital
• New capital is formed in the economy
• E.g. BTC listing. What other listing happened recently?

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 Financial Markets

Secondary Market
• Trade in existing or already outstanding securities
• Transaction between security (share) holder and a third party investor

Organised Stock Market

• Also known as physical location exchanges e.g NYSE, BSE, JSE
• Tangible entities where outstanding securities are resold (nowadays done
electronically)
• Limited number of members (brokers) and governed by set rules and regulations
• Account for 62% of the volume of trade (by dollar volume) (Gitman, 2006)

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 Financial Markets

Over the Counter Stock Market

• Intangible markets that trade in securities not listed in the organised exchanges
• Also referred to as Dealer Markets
• Has few dealers, compared to organised exchanges
• Dealers hold security inventories and create markets for them
• Uses an extensive computerised communication network, i.e. Nasdaq, Primary dealer
(banks) trading in Botswana

Spot versus Futures Market

• Spot market is where assets are bought or sold for on-the-spot delivery (normally T+2
for currency, T+3 for bonds and stocks)
• Futures markets are whereby participants agree today to buy or sell an asset at a
specified future date

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 Methods of Capital Transfer

Direct Transfer
• Businesses (savings deficit unit) directly solicit and acquire funds from investors
• Limited capacity to raise finance
• Slow process
• Cuts the involvement and costs of the middleman, i.e. brokers
• i.e. private equity firms like CEDA Venture Capital, unlisted credit lending

BUSINESS SAVERS
Securities (Shares & Bonds)
(INVESTORS)
SAVINGS
DEFICIT Capital (Pula) SAVINGS
UNITS SURPLUS
UNITS
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 Indirect Capital Transfer

Indirect Transfer Through Investment Banks

• The security ‘passes through’ an investment bank to investors
• Investment banks underwrite the issue, an assurance that the issued securities will be fully
subscribed
• Investment banks create conducive conditions for the successful floatation of securities and
transfer of funds between businesses and investors
• In Botswana this service is offered by companies like RMB

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 Indirect Capital Transfer

Indirect Transfer Through Financial Intermediaries

• financial intermediaries directly trade with savings surplus and deficit units
• in the process, Financial Intermediaries can create and float their own securities to savers, and
thereafter invest in other companies’ securities
• Note, two separate security flotations could be necessary before a company finally gets its
capital
• Financial Intermediaries enjoy economies of scale in terms of expertise in analysing
creditworthiness of potential borrowers and minimising the risk of its shareholders through a
diverse pool of investments.
• Eg Unit trusts offered by companies like Stanlib and BIFM, Afinitas.

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 Financial Institutions

Commercial Banks (Barclays, Stanbic, FNB, Capital etc)

• custodians of the savers’ funds, administered through current, savings and fixed deposit
accounts
• offer a wide range of consumer credit products, e.g. credit/debit cards, short/long term
loans, investment packages/advice
• offer corporate financial products
• in recent decades has branched to investment finance, stock brokerage, insurance
Investment Banks (RMB only local company)
• Help corporations design securities with features currently attractive to investors
• They buy these securities and resell them to investors
• also called underwriters since they guarantee that the companies will raise needed capital

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 Financial Institutions

Financial Services Corporations (BIHL, African Alliance etc)

• Large conglomerates that combine many different financial institutions within a
single corporation
• Services include investment banking, brokerage operations, insurance and
commercial banking
• E.g. BIHL (insurance, lending, asset management), African Alliance (broking, asset
management)
Savings and Loan Associations (BSB etc)
• Receive savings from individual (small) savers and in turn lend accumulated funds
to individuals and businesses through short and long term (mortgage) loans
• Advantage: they make professional services on investment and finance readily
available to small savers overlooked by commercial banks, e.g. BBS

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 Financial Institutions

Mutual Savings Banks

• Localised financial institutions that have a depository functionary for individuals and
small scale operators
• The institution creates short and long-term securities for home ownership and other
purposes
Credit Unions (BOPEU owned SACCOS)
• Have well-defined membership
• Operate at a much smaller scale
• Savings accumulated from periodic member contributions
• Pooled funds are lent within the membership at concessionary interest rates
• Credit unions are very common among labour organisations, e.g. Teachers’ Union

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 Financial Institutions

Pension Funds and Life Insurance (Botswana Life, Metropolitan etc)

• A pool of savings in the form of premiums is collected from members
• Employers may contribute to members’ funds
• Appointed fund managers oversee fund investment, creating suitable portfolios
• Rules and regulations govern how the funds ought to be invested
• Members are only entitled to the funds in case of occurrence of an event stipulated
in the policy document or after a defined time lapse, e.g. retirement, disability or
death
• Member borrow short-term against their entitlements

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 Financial Institutions

Mutual Funds (BIFM, Stanlib Unit Trusts etc)

• Create portfolios of securities from a pool of funds invested by savers
• Investors effectively invest in ‘slices’ of created portfolios, rather than individual
shares or securities, i.e. Unit trusts
• Small investors enjoy the benefit of diversification, and thus reduced risk
• Small investors benefit from the economies of scale enjoyed by mutual funds
companies
Exchange Traded Funds (ETFs)
• Similar to mutual funds and often operated by mutual funds companies
• EFTs buy a portfolio of stocks of a certain type (e.g. top 40 companies in JSE) and
then sell their own shares to the public
• ETFs are generally traded in the public market e.g betta beta and Gold ETF in BSE

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 Financial Institutions

Hedge Funds
• Similar to mutual funds in that they accept money from savers and buy various securities
• Unlike mutual funds, hedge funds are largely unregulated as they target high net worth
individuals and institutions
• Used by individuals who want to hedge risks (or economic conditions)

Private Equity Companies (CEDA Venture Capital, CMA Private Equity etc)
• Unlike hedge funds which purchase some of the stocks, private equity firms buy entire firms
• They buy and manage those entire firms
• Most of the money used to buy firms is borrowed

NOTE: With exception to hedge funds and private equity companies, financial institutions are
regulated to protect investors

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 Exercises
a. What are the key aspects involved in corporate financial management?

b. Discuss the responsibilities performed by the Finance Manager or Finance Director of a listed company.

c. Distinguish between: Direct capital transfer and Indirect capital transfer, with relevant hypothetical
examples.

d. Distinguish between: i) Money and Capital markets; ii)Primary and Secondary markets; iii) organised and
over the counter (OTC) stock markets; and iv) spot and futures markets giving relevant hypothetical
examples of each.

e. What would you consider to be a ‘conducive economic environment’ for a business to borrow debt? Use
any three of the factors that determine interest rate to explain your answer.

f. How does the interest rate of short-term securities differ from that of the long-term securities issued by
the Central Bank?

g. A three-month BOB bond carries a nominal interest rate of 6.2%. A comparable (in Liquidity) three-month
bond of a lowly rated company’s carries a nominal interest rate of 7.6%. What is the default risk premium
for the company

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 Interest Rates

Introduction
 Interest Rate is a reflection of the cost of capital, and in particular is the price of
borrowed debt
 Interest rate is a compensation paid by the borrower of funds to the lender
 Interest rate rations available capital funds, thereby allocating funds prudently
among alternative investment opportunities i.e. profitable ventures attract most
capital away from inefficient ones
 It represents the opportunity cost of capital

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 Determinants of Interest Rates

Interest Rate levels in any given economy is influenced by 4 major macro-economic

factors that determine the supply and demand of investment capital:
• Productions Opportunities – competition by way of variety of investment
opportunities available in an economy stimulates a sense of eagerness and
urgency, hence higher interest rates

• Time Preference for Consumption - propensity for high current consumption

starves savings, hence increases the price for lending. Capital formation would be
difficult, supply low, if therefore demand is high, interest rate level would be high

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 Determinants of Interest Rates

• Risk – volatility of the returns, uncertainty about the outcome, instability of the
markets. Increased risk heightens returns (interest rate)

• Rate of Inflation - the percentage amount by which prices increase over time.
Inflation erodes the purchasing power of money and hence an important factor to
be incorporated when considering interest rates (time value of money). The
expected future rate of inflation determines interest rate

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 Other Determinants of Interest Rates

 Foreign Trade Balance - Foreign trade deficit (net-importation) requires

finance and increased borrowing increases interest rates.
Interest rate levels for securities held by foreign investors must remain competitive
with those investors’ comparative domestic rates, otherwise there will be no
economic incentive to hold (invest)

 Business Activity - The general trading conditions and business cycles influence
the general levels of interest rates, i.e. recessions, depressions and booms

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 Determinants of Interest Rates

• Central Bank Policy

– Economic activity, the rate of inflation, and hence interest rates, can be controlled using money
supply
– Increase in money supply increases expected inflation rate, thereby pushing interest rates up
– Reduction in money supply has the opposite effect
– Central bank also has direct control over interest rate
– Short term rates are most adversely impacted by Central Bank intervention. Long-term rates may
remain unchanged, or indicate slight change
– Read BoB 2019 Monetary Policy Statement

 Budget Deficits or Surpluses

– Governments borrow to supplement budgets, thereby increasing the demand (competition) for
money
– Interest rates increase as a direct result
– Debt security buy-backs reduce interest rates

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 Nominal (Quoted) Market Interest Rate (k)

The nominal market interest rate of a security (k) is the actual interest rate that is
quoted for a security as charged by the lender and paid by the borrower

‘k’ will vary across situations, depending largely on the riskiness of both the security
and the borrower

Determinants of nominal interest rate:

k = k* + IP + DRP + LP + MRP Or

k = kRF + DRP + LP + MRP

where: kRF = k* + IP

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 Nominal Market Interest Rate

Real Risk-Free Rate of Interest (k*)

The real compensation (return) an investor demands for foregoing the use of his/her money,
assuming a perfect world:
• The investor is guaranteed a stipulated return, hence risk-free
• Inflation-free economy

Nominal Risk-Free Rate (kRF)

Inflation erodes the purchasing power of money
Inflation lowers the real rate of return on an investment
Inflation Premium (IP) is the (simple) average expected inflation rate over the lifespan of a security,
serves the purpose of protecting returns
• Inflation premium is not necessarily equal to current rate of interest
• kRF is normally equated to a short-term Bank of Botswana bond or Tbill

k* + IP = kRF
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 Nominal Interest Rate

Default risk
• The probability of a borrower becoming unable to service his debt obligations, i.e.
paying principal and interest at agreed intervals
• Default risk is largely influenced by the borrower’s history in debt servicing, hence
rating agencies become important. Debt securities of companies rated highly carry low
DRP
• Central Bank debt securities carry the lowest (near zero) DRP while lowly rated
companies carry the highest DRP

Liquidity Premium
• Securities with weak secondary market tie-up the funds of an investor
• The liquidity premium is levied depending on the marketability or liquidity of the security
• Liquidity is measured by the extent to which a security is easily marketable and
saleable at reasonable price on short notice in the secondary markets
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 Nominal Interest Rate

Maturity Premium
• Investing in long-term securities carries a risk that is associated with unanticipated
adverse economic events that may occur with the passage of time i.e.
economic/political/environmental/social events that may occur with the passage of
time
• To shield the investor’s returns on long-term securities from the possibility of being
disadvantaged from the prospects of some unanticipated occurrence happening
with the passage on time, including Central Bank long-term securities
• The maturity risk premium is charged for risking capital losses due to time passage
as a result of unexpected changes in interest rates,
• Generally, the longer to maturity for a security the higher will be the maturity risk
premium

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 Exercises
i. Gibbs, a UB graduate aged 21, has just been employed and is looking forward to moving out of his parents’ house to
establish himself. Mr Oldie, on the other hand has served the government for 18 years and is starting to think of a retirement
package. From the concept of time preferences for consumption, explain why these two individuals would potentially demand
different interest rates (returns). Who would demand a higher interest rate (return) as a motivation to invest?

ii. Distinguish between ‘real’ and ‘nominal’ risk-free rates.

iii. There is a 5-year security to be offered next-year. You are informed that the expected inflationary levels for the duration of
the security are 5.0%, 5.6%, 4.9%, 7.0% and 7.2%. The current rate of inflation is 3.5%. You are required to compute the
Inflation Premium for the security.

iv. Information drawn from the Central Statistics Office predicts that inflation for the next 6 years as follows; 4.4%, 5.3%, 3.5%,
4.0%, 3.7% and 4.8%. The following data is available with regard to a company’s 6-year security:
Real Risk-free rate 3.75%
Default Risk Premium 1.25%
Liquidity Premium 2.20%
Maturity Risk Premium 1.45%

You are required to compute the Nominal Risk-Free and the Nominal Interest Rates for the company’s security.

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 Exercises

The following data has been compiled for a security with 4 years to
maturity:
Nominal Risk-free rate of return 7.5%
Default Risk Premium 1.75%
Liquidity Premium 2.25%
Maturity Risk Premium 2%
The current rate of inflation is 4.75%, and that expected for the next 5
years is 4.0%, 4.2%, 4.6%, 5.0% and 5.75%.

i) Calculate the security’s inflation premium.

ii) Calculate the security’s interest rate level.

iii) What is the difference in interest rates between a

short-term and long-term government security.

iv) What is the real risk-free rate of return in this

economy

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