PART 2 - CHAPTER 3

FINANCIAL MARKETS AND BANKING

I. FINANCIAL MARKETS

A. Introduction

Financial markets, through various techniques and institutions, collect savings and make these funds available to those who wish to borrow money. Financial institutions have developed to collect, analyze, and disseminate information relevant to the market, thus making the markets efficient.

1. Financial Intermediation: Specialized institutions effect the structure of the transfer process. These institutions include banks, savings and loans, pension funds, insurance companies, and credit unions.

B. Functions of Financial Markets

Financial markets have been established to accomplish three major functions: 1) to transfer funds from savers to users, 2) to provide a method of liquidity for investors, and 3) to provide economic signals to financial managers.

1. Transfer Funds From Savers to Users: As an individual, it would be very difficult to find a buyer for a particular financial security. Financial markets facilitate the transfer of funds from savers to users.

a. Sale of Securities: The issuance of stocks and bonds by corporations are facilitated through investment bankers. They advise the company, bear some of the risk of selling the securities, and actually sell the securities being issued.

b. Sale of Short-Term Debt: Dealers help with the placement of short-term debt securities to be issued by corporations. These dealers act in the same fashion as investment bankers do in the issuance of long-term securities.

2. Provide Liquidity: Investment liquidity represents the ease of which securities can be converted into cash without incurring losses in value. Financial markets give investors an means of converting securities into cash in a short period of time. Stockbrokers are used to buy and sell previously issued securities in the financial markets. This resale market increases the liquidity of investments.

3. Provide Economic Signals: The buying and selling of securities can indicate the future economy. For example, if financial managers feel that a recession is likely, they will sell their investments to increase funds necessary to help them through the recession. They will attempt to do this prior to the start of the recession to avoid losses from sale. The sale of securities can then signal the possibility of changes in the economy.

C. Types of Markets and Exchanges

In order to raise capital, companies often sell new stocks and bonds in the primary securities markets. These markets are regulated by federal and state laws to reduce the possibility of fraud and misrepresentation. After securities have been issued they trade among investors in the secondary market.

1. Primary Market:

a. Investment Banker: Corporations generally receive assistance from investment bankers in the initial sale of their shares.

b. Federal and State Law: Before a company can issue securities in the primary market it must comply with a number of federal and/or state regulations.

1) Federal Regulation: The Securities Act of 1933 requires registration and public disclosure of all relevant information pertaining to the issuance of new securities. Under this act, companies are required to prepare (1) a registration statement (Form S-1) to be filed with the Securities and Exchange Commission (SEC) and (2) a prospectus to be delivered to investors prior to their purchase of the securities. See Chapter 6 for details.

2) State Registration: A sale with both the issuing corporation and all the shareholders in one state is regulated by the security agency of the state government. This is often referred to as a "blue sky" offering. Unlike the disclosure emphasis of the SEC, the State agency may look at the merits of the offering.

2. Secondary Market: The secondary market was established to facilitate on-going trading among investors. Companies register with an exchange and a specialized trader-dealer is appointed. Examples are the New York Stock Exchange or the over-the-counter (OTC) market. The OTC market is computerized and regulated by the National Association of Securities Dealers (NASDAQ).

a. Liquidity Objective: Secondary Markets give liquidity to investments by a means of buying and selling securities with other investors. The Exchange's trader-dealer is charged with maintaining an orderly and stable market in the security.

b. Market Price: The market value placed on a share of stock reflects the evaluation investors place on the financial decisions made by management (investors' expectations of the future profitability of the firm). The prices of individual stocks are also affected by the general price level of the securities markets. The Dow Jones Industrial average and Standard and Poor's 500 Index are two indicators of the behavior in the stock market.

3. Debt and Equity Markets: Financial markets can be classified as either debt securities or equity securities. Transactions dealing with debt, such as bonds, are dealt with in the debt market. Those dealing with the issuance or resale of common stock are done in the equity market. The trading of securities are done on organized exchanges and in the over-the-counter (OTC) markets.

4. Money Market: The capital market deals in securities with maturities greater than one year. The money market is used for trading securities with maturities of one year or less.

a. Importance of the Money Market: The money market is important for the transfer of short-term funds.

1) Raise Funds: It allows companies to sell short-term debt to raise funds.

2) Invest Excess Cash: Companies are able to invest excess cash in short-term money market securities.

b. Characteristics of Money Market Instruments: The money markets trade in debt securities which have short-term maturities, there is minimal risk of default, and the expected rates of return are relatively small.

c. Types of Money Market Instruments: There are several money market instruments including treasury bills, U.S. agency securities, commercial paper, negotiable certificate of deposits, banker's acceptances, and federal funds.

1) Treasury Bills and U.S. Treasury Securities: The market for U.S. treasury securities is the largest part of the money market. These securities have maturities from 13 to 52 weeks. T-bills have almost no default risk and excellent liquidity and therefore carry relatively low returns. Short-term debt securities issued by agencies of the U.S. government (such as the Federal Home Loan Mortgage Corporation and the Federal Land Bank) offer an investment standing similar to T-bills with almost as low a yield.

a) Investment Yield: T-bills are purchased at less than face value (discount) by investors who receive the face value at maturity. The annual investment yield uses 365 days in a year and is calculated as follows:

Discount from Face/Purchase Price or [(Face Value - Purchase Price)/ (Purchase Price)] x (365/ Days to Maturity)

Example: A $10,000 face U.S. Treasury bill trades in the market for $9,790.25 and matures in 85 days. The annual investment yield is calculated as follows:

Yield = [($10,000 - 9,790.25) / 9,720.25] x (365/85) = .0214244 x 4.2941176 = .09199 or 9.2% per year

b) Discount Yield: When dealers buy and sell T-bills, they do so at a discount based on a 360-day year. The calculation of the discount yield is similar to the calculation of the investment yield.

Annual Discount Yield = [(Face Value - Purchase Price) / Face Value] x (360 / Days to Maturity)

Example: A $10,000 face U.S. Treasury bill has 85 days to maturity. The discount yield asked by the dealer is 8.75%. What is the purchase price asked for the security?

Answer: .0875 = [(10,000 - P) / 10,000] x (360/85)

.0875 = [(10,000 - P) / 10,000] x 4.2352941

.0206597 = (10,000 - P) / 10,000

206.59722 = 10,000 - P

P = 10,000 - 206.59722 = 9,793.40

2) Commercial Paper: Commercial paper is short-term promissory notes issued by corporations and is an alternative to borrowing from a bank.

a) Characteristics: Commercial paper is generally issued by finance companies (such as General Motors Acceptance Corporation) and banks. Commercial paper is unsecured and either placed directly with large purchasers or sold through dealers. Maturities on commercial paper generally range from 30 to 270 days and are issued at a discount usually in $100,000 denominations. Because of its higher risk than T-bills, commercial paper requires a higher rate of return. The annual investment yield on commercial paper is calculated the same way as for T-bills. The secondary market for commercial paper is fairly weak.

b) Calculation of Interest Cost: The exam may require the candidate to calculate the annual interest cost of commercial paper or to compare the cost to some other source such as a bank loan.

Cost of commercial paper = (Costs incurred by using commercial paper)/(Net funds available from commercial paper)

Example: Fancy Flow Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be $1,200. The annualized percentage cost of the financing would be:

Answer: [(20,000 + 1,200) / [$1,000,000 - (20,000 + 1,200)]] x 4 = 8.65%

Example: Great Expectations, Inc. will need $4 million over the next year to finance its short-term cash requirements. The company could sell $4 million of 90-day maturity commercial paper every three months at a rate of 7.75%. The dealer's fee to place the issue would be an initial annual 1/8% and will require Great Expectations to maintain a $400,000 compensating balance. Calculate the annual effective cost of this financing alternative for each quarter of the year.

Answer: Cost of commercial paper in the first quarter

Cost of issuing commercial paper:

Interest ($4,000,000 x .0775 x 1/4) $ 77,500
Placement fee ($4,000,000 x .00125) 5,000
Total First quarter cost $ 82,500

Funds available for use:
Funds raised $4,000,000
Less: Compensating balance $400,000
Interest and placement fees 82,500 482,500
Net funds available in first quarter $3,517,500

Cost of commercial paper in the first quarter
= $82,500 / $3,517,500 = 2.345%

Cost of issuing commercial paper for other quarters:
Interest ($4,000,000 x .0775 x 1/4) $ 77,500

Other Three Quarters:
Funds available for use:
Funds raised $4,000,000
Less: Compensating balance $400,000
Interest and Placement fees 77,500 477,500
Net funds available per quarter $3,522,500

Cost of commercial paper for other quarters = $77,500 / $3,522,500 = 2.20%

Total annual effective cost of commercial paper:

Effective cost = 1st quarter cost + 3 (cost of 2nd, 3rd, 4th qtrs.)
= .02345 + 3 (.02200)
= .02345 + .06600 = .08945 = 8.95%

c) Annual Investment Yield: The exam may ask the candidate to calculate the annual yield of commercial paper based upon the investment. The calculation is the same as for T-bills. The formula is

(Discount from Face / Purchase Price) or

[(Face Value - Purchase Price)/Purchase Price] x (365/Days to Maturity)

Example: Pete Moss, financial manager of Golden Gardens, Inc., is planning to buy $100,000 of commercial paper from Primary Finance Company for $96,500, a discount of $3,500. The paper matures in 120 days. What is the annual investment yield on the commercial paper?

Answer: [(100,000 - 96,500) / 96,500] x (365 /120) = 0.0362694 x 3.0416667 = 0.11032 = 11.03%

3) Negotiable Certificate of Deposit: A negotiable certificate of deposit (CD) is a claim against funds that have been deposited in a bank. The bank issues a CD for the amount of the deposit plus interest at a specific rate for the specified period of time. CDs are traded among securities dealers in the secondary market and are generally denominated at $100,000 and above.

4) Banker's Acceptance: A banker's acceptance is a draft drawn on deposits at a bank. This may be issued by an importer's bank to guarantee payment of a foreign exporter's invoice for goods. An acceptance trades in the secondary market at a discount. This is similar to a letter of credit except letters of credit do not have a secondary market.

D. Rating Agencies

1. Types of Agencies: A financial management accountant may consult rating agencies to assist in making investment decisions for listed securities. There are numerous rating services that are available to investors or portfolio managers. These can be classified by the nature of the agency.

a. Brokerage Firm Analysts: Almost all the larger private brokerage firms have their own research department. Such firms often have specialists who focus on and follow particular industries and firms. Free newsletters to clients is the usual way such a firm disseminates information. Brokerage firms receive their revenue from the commissions on their client's trades.

b. Private Stock Analysts: There are also a number of private firms that are not involved in stock transactions. Firms such as Value Line or Fitch Investor Services offer yearly services to investors for a subscription fee. These firms' analysis tends to be more quantitatively oriented. Many argue that their advice is more objective because they do not underwrite offerings or receive commissions resulting from their recommendations.

c. Private Bond Rating Agencies: There are a number of independent rating agencies that focus primarily on debt instruments. Their independence - like the private stock analysts - creates the likelihood of a more objective evaluation.

2. Actual Services: Most serious portfolio managers subscribe to one or more independent services since they may quantify the subjective analysis inherent in the role of a risk-return manager. The most widely known rating agencies are probably Standard & Poor's, Moody's and Duff & Phelps'. These agencies tend to rate all traded bonds using a uniform rating system. There are also numerous rating agencies that specialize in particular industries.

3. Variables: At base, most agencies focus on two variables: quality and default risk.

a. Quality: While return is important to a portfolio manager, the quality grade is almost always inversely related to the risk. Debentures with speculative quality must pay investors a higher return (or interest rate) than high or medium quality issues.

b. Default Risk: The quality-risk rating in descending order is AAA, AA and A, which indicates the best quality, high quality, and upper medium grade respectively. BBB, BB, and B indicate medium grade, speculative issues, and very speculative (with little protection against future default). CCC, CC, and C are issues in poor standing and may be in default. D issues are in default.

4. Portfolio Manager's Use: A corporate treasury function will involve investing excess working capital in marketable securities.

a. Investment Policy: The corporate investment policy will often specify a diversification requirement. It may also dictate a minimum investment grade for each security on an overall average basis. For example, a federally chartered financial institution must now limit the quality of bonds in which they can invest to BBB or above. Similarly corporate decision makers may put such limits on the portfolio managers.

b. Use and Loss Justification: Managers often follow the publications a number of rating agencies as resources in making portfolio decisions. In addition, a security loss may be more easily justified if the purchase was based upon a rating agency's standards and advice rather than a manager's own personal subjective judgment. The more support for the decision, the better.

E. Market Efficiency

1. Two Factors:

a. Efficiency: Markets are efficient when 1) prices respond quickly to new information, 2) successive trades are made at prices close to preceding trades, and 3) the market can absorb large amounts of securities without changing the price significantly. The closer the market adheres to the above three items, the more efficient the market becomes.

b. Liquidity: To be efficient, the market must be liquid (a measure of how quickly a security can be converted into cash). Markets become liquid if continuous trading occurs with a large number of traders. Lower costs of buying and selling enables more people to enter the market.

2. Efficient Capital Markets: In efficient capital markets, expected cash flows and required rates of return are used to determine the intrinsic value of securities and its ultimate price. In large open markets such as the New York Stock Exchange, intrinsic value and market price have been determined to be the same; this is an efficient market. The market becomes efficient because all information available to investors is utilized in the determination of the market value.

a. The Efficient Market Hypothesis: This hypothesis asserts that security prices reflect all know information. Based on various types of information, three versions of the hypothesis have been developed.

1) Strong-Form Efficiency: This hypothesis asserts that all information is reflected in the current market price. This includes even the use of insider information not available to outside investors. This means that corporate officers and other insiders will not be successful in using privately held information to make abnormally higher returns on investments of their own. Most authorities believe this is not realistic for most companies.

2) Semistrong-Form Efficiency: This form assumes the current market price of stocks reflects all publicly available information. This information includes stock prices, dividends, earnings, and data contained in the company's financial statements. Semistrong-form efficiency implies that analysis of publicly available economic and financial factors affecting the corporation will not help an investor since the market has already used that information in determining the stock price. Insider information is excluded.

3) Weak-Form Efficiency: The assumption is that the market price of securities only reflects past price movements and rates of return. Studying stock price trends, such as in technical analysis, will not help in determining undervalued stocks.

b. Probable Actual Market Condition: The most widely accepted hypotheses are the weak-form and semistrong-form of efficiency. This means that there must be publicly available information that if properly researched or used by insiders, will lead to abnormal returns. Abnormal returns exceed the return justified by the riskiness of the investment.

F. Foreign Security Markets

Foreign companies have long sought U.S. security markets. U.S. companies are now considering foreign security markets as a place to list stock and raise capital. The U.S. capital markets in 1997 represent less than 40% of the total world capitalization. This is down from 65% in 1970.

1. Variables: There are three basic variables facing an issuer of securities contemplating an offering on any exchange. Most domestic U.S. markets do not have much variation in these three items. There is much more variation on foreign exchanges. The three factors are flotation costs, necessary yields, and capitalization factor.

a. Flotation Costs: First, is the flotation costs. On large exchanges such as the London, Tokyo or Hong Kong market the cost efficiency is close to the U.S.

b. Necessary Yields: Second, is the expected return or yield investors will demand, which includes dividends on stock or the interest paid on notes and bonds. Unlike the Dow, where the 10 highest-yielding stocks pay below 4%, the highest yielding issues in Hong Kong or the United Kingdom pay better than 5.5%. In contrast, a U.S. corporation may find issuing U.S. dollar denominated bonds outside the country will lower their interest cost.

c. Capitalization Factor: Third, is the market capitalization factor. This is the quality multiple the market places upon a company's earnings. In the U.S., earnings are capitalized at about 15 times; on the Tokyo exchange the rate is nearly double this amount.

2. Objectives: Everything else being equal and disregarding market liquidity or volatility, management should have two objectives in issuing new securities.

a. Lowest Cost: First, is the lowest overall cost of capital. Because the required dividend yield may be higher outside the U.S. this favors enterprises listing on U.S. exchanges.

b. Highest Capitalization: It may be in the stockholders' best interest to own shares on an exchange that has a higher capitalization rate; this favors some foreign exchanges.

3. Examples:

a. American Depository Receipts: ADRs are foreign shares which are bundled together and traded on a U.S. stock exchange. This bundling is done by brokerage firms or banks and is useful to foreign companies interested in lower dividend yields and increased liquidity.

b. Euro or Asia Bonds: These are U.S. dollar designated debentures issued in a foreign country. The advantage is that interest rates may be lower in foreign countries than in the U.S.

II. INTEREST RATES

Interest is the cost of temporary use of funds paid by the borrower to the lender. Various factors play a role in the determination of the actual interest rate to be charged.

A. Term Structure

This is the relationship between long-term and short-term interest rates on debt securities. Yield curves (see Figure 3-2) show a graphically view of the term structure of interest rates.

1. General Rule: Generally lenders will charge a higher rate for long-term financing than for short-term because unknown risks may arise and unknown opportunities may be foregone.

2. Term Structure Theories: Three principle theories exist to explain the shape of the normal yield curve.

a. Liquidity Preference Theory: The upward-sloping yield curve is best explained because short-term bonds return less interest than long-term bonds. The two factors supporting the liquidity preference theory are:

1) Creditor Objective: Lenders want shorter-term liquidity and will thus accept less return.

2) Debtor Objective: Borrowers prefer long-term debt to avoid the risk of costly refunding and will thus pay a higher rate of return than on short-term debt.

b. Market Segmentation Theory: Each lender and borrower has a preferred maturity and this creates two market segments. Merchants want working capital loans for short-term periods while corporations building factories and home buyers want long-term loans. The slope of the curve depends upon the relative demand and supply of funds in these two markets.

c. Expectation Theory: This theory ties interest rates to the expected inflation rate.

1) Inflation Expectancy: This theory would add an inflation premium equal to the average expected inflation rate from the date of issue to the date of maturity. If future rates and/or inflation are expected to be higher than at present, the yield curve will be significantly upward sloping. If the inflation rate is expected to decline, the yield curve would have a flat or downward slope. In December 1997, long-term mortgage rates were lower than short-term loans; many financial analysts credit this phenomenon to the expectation theory.

2) Recession and Interest Rates: When investors expect the economy to slow or contract, long-term drop as inflation fears fade. By contrast short-term interest rates are more anchored to interest rate policies set by the Federal Reserve.

3) Inverted Yield Curve: This is where short-term rates are higher than long-term rates. Every recession since 1960 has been preceded by an inverted yield curve.

4) Computational Problem: The CMA exam has infrequently asked the candidate to compute expected future interest rates. The question often gives associated years-to-maturity and interest rate values from a particular yield curve. This computation is used by investors who are debating whether to buy a two-year bond today or to buy a one-year bond today and reinvest the proceeds in another one-year bond at the beginning of year 2. The formula to compute expected future interest rates is:

Expected Interest Rate in Future Year F from Base Year B = [(1 + Interest rate associated with YF) to YF power / (1 + Interest rate associated with YB) to the YB power] - 1

Where:

YF = number of years in the future that the future year is from today
YB = number of years in the future that the base year is from today

Example: Today, the following yields on a given security are observed:
Yield to Maturity Interest Rate
1 year 4%
2 years 4.5%
3 years 6%

Required: Determine the market's interest rate expectations concerning one-year rates on the security at the beginning of Year 2 (one year from today) and at the beginning of Year 3 (2 years from today).

Answer: One year from today, the one-year rate on the security is expected to be 5.0%, computed as follows:

(1 + .045)squared / (1 + .04) - 1
= (1.092025/1.040) - 1 = 1.050024 - 1
= .050024 = 5.0%

Two years from today, the 4% bond would have to yield a 3-year average of around 6%. The rate in year 1 is 4%, in year 2 it's 5% for a total of 9%. Three years at 6% is 18% so there is a required 9+% in year three. The actual one-year rate on the security is expected to be 9.1%, computed as follows:

[((1 + .06) to the 3rd power) / (1 + .045) squared] - 1
= (1.191016/1.092025) - 1
= 1.090649 - 1
= .090649 = 9.1%

B. Credit or Purchase Discounts

1. Purchase Discounts: Purchases may be subject to discounts to encourage prompt payment. For example, the terms "2/10, net 30" indicate that the purchase is subject to a 2 percent discount if paid for within 10 days, otherwise payment of the full amount is due within 30 days. There are two approaches to accounting for prompt payment purchase discounts: the Gross Price Method (purchases are initially recorded at their gross price) and the Net Price Method (purchases are initially recorded at their net price).

Example: Purchases of $10,000 are made under terms 2/10, net 30. Invoices of $4,000 are paid within the discount period. Invoices of $6,000 are paid after the discount period has passed.

In this example, the purchase should be recorded at the net amount (after the 2% purchase discount), or at a value of $9,800 [10,000 - (10,000 x 2%)]. Since $6,000 is paid after the discount period, $120 of the $200 possible discount will be lost at that point.

2. Trade Discounts: Trade discounts represent adjustments to the list price which are applied sequentially to determine the purchase/sales price. They are taken before the purchase discounts.

Example: Merchandise with a list price of $100,000 is subject to trade discounts of 20%, 10%, and 5%. The net purchase price is calculated as follows:

List price 100,000
Less: 20% discount 20,000
80,000
Less: 10% discount 8,000
72,000
Less: 5% discount 3,600
Net purchase price 68,400

In this instance, the purchase price of the goods becomes $68,400, which would then become the amount subject to any cash discount if the account is paid early.

3. Calculating Credit Discounts: If cash discounts are not taken, there is a substantial cost to the customer. The discount cost should also be offset by the return which could have been earned on the funds if the discount was not taken.

a. Formula: The formula for calculating the annual effective cost for cash discounts is as follows:

[a /(1-a)] x [360 / (c-b)] or [Discount % / (1 - Discount %)] x (360 / Days Money Used)

In the formula, a = the discount percentage for early payment, c = the normal credit terms in number of days until payment is due, and b = the number of days before payment with the discount is due.

b. Examples:

Example 1: 2/10, net 30
[.02 / (1-.02)] x [360 / (30 - 10)]
= (.02 / .98) x (360 / 20) = .367 = 36.7%

Example 2: 3/10, net 45
[.03 / (1 - .03)] x [360 / (45 - 10)]
= (.03 /.97) x (360 / 35) = .318 = 31.8%

Example 3: Slippery Slope, Inc. purchases merchandise from major suppliers all of whom have different credit terms and offer different discounts for prompt payments. Management has had a policy of not taking the discounts but rather paying the invoices on the last day of the credit period to avoid any finance charges for late payment. The company earns 2% on their cash balance. Determine the average effective annual net interest rate associated with their policy of not taking the offered discounts below for each of the suppliers.

Average
Monthly Credit
Supplier Purchases Terms
Acme Co. $450,000 2/10, n/30
Brother Corp. 375,000 1/15, n/30
Charlie Ltd. 525,000 n/30
Dogget & Co. 150,000 5/10, n/120
Total 1,500,000
a. 18.8%
b. 19.5%
c. 16.8%
d. 17.5%

Solution: Step 1 is to calculate the annual percentage cost of each of the four suppliers discount using the above formula.

Acme Co = (.02/.98) x (360/20) = .367

Brother Corp. = (.01/.99) x (360/15)
= .242

Charlie Ltd. = 0 (no discount allowed for early payment)

Dogget & Co. = (.05/.95) x (360/110)
= .172

Step 2 is to weigh the proportion of the total dollars provided by each supplier times its cost.

Annual Weighted
Percentage Cost Weight Average Cost
Supplier (1) (2) (1) x (2)
Acme Co. .367 .30 (450/1500) .110
Brother Corp. .242 .25 (375/1500) .061
Charlie Ltd. - .35 (525/1500) -
Dogget & Co. .172 .10 (150/1500) .017
Total 1.00 .188 = 18.8%

Step 3 is to reduce the discount lost cost of 18.8% by the 2% earned on the cash balances of 2%. The net cost is thus 16.8% and the correct answer is C.

4. Accounts Receivable Financing:

a. Pledging: Accounts receivable can be used as collateral in a borrowing arrangement. Adequate disclosure should be made of the pledged accounts receivable.

b. Assignment: Specific accounts receivable can be assigned to the lender in a borrowing arrangement on a notification or nonnotification basis. Assigned accounts receivable should be segregated in a separate account. Collection of the assigned accounts should be used to satisfy the principal and interest on the borrowing.

c. Factoring: The accounts receivable are sold outright to a purchaser known as a factor. If without recourse, the purchaser assumes the risk of ownership. Remove the accounts receivable and report a loss equal to the fee charged by the factor.

d. Sale With Recourse: If the sale is with recourse, the provisions of SFAS No. 77 apply. The transfer should be treated as a sale if all three of the following conditions are met:

1) Surrender Control: The transferor surrenders control of the future economic benefits of the receivables.

2) Obligation Estimatable: The transferor's obligation under the recourse provisions can be reasonably estimated.

3) No Repurchase: The transferee cannot require the transferor to repurchase the receivables.

If any one of the three conditions is not met, the transaction should be treated as a borrowing arrangement and a liability recorded for the financing provided.

5. Notes Receivable:

a. Short Term: A note receivable is evidenced by a written promissory note wherein the maker agrees to pay a fixed sum of money plus interest on a specified future date. Short-term notes generally pay simple interest. They are recorded at face value. At year end, unpaid interest should be accrued from the date of the note to the end of the accounting period.

b. Discounting Notes Receivable: When notes receivable are discounted, any difference between the net proceeds and carrying value is recorded as interest expense (income).

Maturity Value of Note = (Principal x Annual Interest Rate x Period of the Note) + Principal

Bank Discount = Maturity Value x Bank Discount Rate x Period Held by Bank

Net Proceeds = Maturity Value - Bank Discount

Net Interest Revenue = Net Proceeds - Carrying Value of the Note

Example: Tallent Company received a $30,000, 6-month, 10% interest-bearing note from a customer. After holding the note for two months, Tallent was in need of cash and discounted the note at the United National Bank at a 12% discount rate. The amount of cash received by Tallent from the bank was:
a. $31,260 c. $30,300
b. $30,870 *d. $30,240

Answer:

Maturity Value: ($30,000 x 0.10 x 6/12) + 30,000 = $31,500

Bank Discount: $31,500 x 0.12 x 4/12 = $1,260

Net Proceeds: $31,500 - $1,260 = $30,240

Net Interest Revenue: $30,240 - $30,000 = $240

Since the question asked for the amount of cash received, the correct answer is d, $30,240 net proceeds.

III. INVESTMENT BANKING RELATIONSHIPS

A. Role of Underwriters

The major role of underwriters is to facilitate the sale of securities to the public in the primary market. This is accomplished by investment bankers who give assurances to the issuing company of a specified and guaranteed selling price, thus assuming a form of risk.

1. Underwriting Risk: The risk exists between the time the underwriter purchases the securities from the issuer and the time that the securities are resold to the public. This risk occurs because the securities may be sold for less than the purchase price. The risk is generally divided between a group of investment bankers called an underwriting syndicate.

2. Distribution of Shares: The formation of an underwriting syndicate also helps facilitate the distribution of the securities. Syndicates are generally formed when the size of the security issue is too large for one investment banker to handle. The syndicate members can either sell the shares directly to investors or they can sell to dealers who will then sell to investors.

3. Underwriters' Profit: The difference between the price that a selling corporation receives for an issue of securities (assured by the underwriters) and the price it is sold to the public by the underwriters is called the underwriting spread. This becomes the underwriters' fee for issuing the securities (assuming they are sold for more than the purchase cost).

B. Initial Public Offerings

1. Primary Capital Market: The primary capital market is concerned with new issues of bond and stock securities. Registration of a long-term debt instrument and equity security issue are required under federal or state security laws. Liability for a misstatement or material omission extends to those who substantially participate in the issue. This might easily include a management accountant who participates in soliciting the purchase.

2. Registration Statement: For a federal offering, the issuer must file with the SEC a registration statement and prospectus at least 20 days before any solicitation of potential investors. A federal exemption applies to an intrastate offering which shifts the compliance and reporting to the state security agency and the applicable "blue sky" laws.

3. Organized Exchanges: A company seeking investment capital may list with an organized exchange or use a private offering. Organized exchanges include the New York Stock Exchange and the Over-the-Counter Market (OTC). A private offering will require finding individuals or firms willing to provide capital for the firm (see item C. below).

4. Public Offering: A public security issue is sold to individuals and institutional investors. An investment banker usually buys the securities from the firm at a negotiated price and then resells them to the public. The difference is the underwriting spread. An investment banker may or may not underwrite the risk of adverse price fluctuations. Issuing through an organized exchange will likely lower a firm's cost of capital. Listing will facilitate sales and usually results in lower transaction costs.

C. Private Placements

If a private placement is chosen, a firm approaches one or a small number of investors directly such as insurance companies, venture capitalists, and commercial banks. Common and preferred stocks are usually sold by public offerings whereas debt instruments are more likely sold privately.

1. Advantages of Private Placements: The primary advantages of private placements are their flexibility and the elimination of flotation expenses (which means low transaction costs of bringing the securities to market) and the time-consuming process of SEC registration. A specialized investor may have advantages in multi-round financing. One variety of a private placement is when a corporation sells shares to an Employee Stock Ownership Plan (ESOP) owned by the employees.

2. No Underwriting Required: In a private placement, there is no underwriting involved. Therefore, the investment banker will bring together the buyer and seller to determine a fair price for the securities and complete the transaction. The investment banker earns a fee for this service. A firm will choose between private placement or public sale depending upon which method will yield the lowest borrowing cost (after transaction costs).

3. Firms That Choose Private Placements: Generally, there are two types of firms that use private placements.

a. Small firms: The first is small, lesser known firms of comparatively low credit quality which generally issue small dollar amounts of securities. These firms generally find public sales more expensive than private sales after considering flotation costs.

b. Large, Well Known Firms: The second type of firm using private placements are large, well known firms with a high credit rating. These companies have large issues which allow them to take advantage of economies of scale in flotation costs. Therefore, these companies will substitute between the two markets, selecting the market that provides the lowest expected borrowing cost for a particular offering.

D. Secondary and Subsequent Offerings

The secondary market for corporate stock is the largest in dollar volume and number of trades of any security. The function of secondary markets is to provide liquidity to individuals who acquire securities in the primary market. The primary market would not function well if investors believed they would not be able to resell a security quickly at a fair price in a secondary market. Markets have a dealer(s) who specialize in a security. Dealers are charged with maintaining an orderly and stable market in the security.

1. Organized Exchanges: Organized markets, commonly called security exchanges, provide a meeting place and communication facility for members to complete transactions under specific rules and regulations. Only members of the exchange may use the facilities and only securities listed on the exchange may be traded. The New York Stock Exchange (NYSE), the largest organized exchange in the United States, is an example of an organized exchange. The American Stock Exchange is another large exchange.

2. Over-the-Counter Market (OTC): Securities not sold on an organized exchange are traded in the over-the counter market. Dealers and brokers are connected through an elaborate communications network. In 1971, the National Association of Security Dealers (NASD) introduced an automatic computer-based quotation system which provides continuous bid and ask prices for actively traded OTC stocks. When a quote is needed for a customer, all current bid and ask prices are printed out with the name of the dealer to contact. A customer will place an order with a broker to purchase or sell a security in the OTC. The broker must then secure the best possible price with another broker or dealer who has that particular security for sale.

3. Repurchase of Common Shares: Corporations may repurchase their own common stock on the secondary market. They may accomplish this through a broker, by negotiating with a large investor such as a mutual fund manager, or by a tender offer. This is a use of cash other than for dividends and tends to drive the stock price up, causing a capital gain for the stockholders.

a. Reasons for Repurchase:

1) Change Financial Leverage: Management may want to change the company's financial leverage. By issuing bonds and buying back common stock, the company will become more leveraged, probably in the direction of the optimal level, but will also cause an increase in the company's financial risk.

2) Undervalued: The company may feel that the stock is undervalued, making it a good investment (and at the same time increasing the share price).

3) Resist Takeover: Stock may be repurchased to thwart a hostile takeover attempt. T. Boone Pickens is a well known corporate raider who has attempted several well publicized takeover attempts. However, tactics employed by the targeted companies (for example, Phillips Petroleum), including the repurchase of shares, thwarted Mr. Pickens' attempts.

4) Manipulate Market Price: Management may want to keep the stock price above what the market alone would dictate. A corporation with the necessary cash can place an open buy-order for its stock at a particular price and thus create a short-term floor at that price.

b. Tender Offer: In a repurchase tender offer, the corporation attempts to buy a specific number of shares of their own stock at a set price. A tender offer is made when the board of directors feels that it is an appropriate use of corporate funds that will not be needed for current operations. A tender offer is generally made through an investment banker. (See chapter 4 for a detailed discussion.)

IV. COMMERCIAL BANKING RELATIONSHIPS

A. Introduction

Most corporations strive to build a relationship with one or a few bankers.

1. Banker Characteristics: A firm's banker should understand the business and the competitive environment in which the industry operates. A good banker is smart, imaginative, a good counselor, and has the position, drive and determination to push transactions through loan committees.

2. Good Banking Relations: If your banker is going to be there when you need him, he must be kept informed so he feels a part of the process. The cardinal rule in a banking relationship is to always keep the commitments made to the bank. Another good rule is to not create any surprises. Finally, it's best to borrow money when you don't need it.

B. Creditor's Standard Credit Analysis - 5 Cs

It is important for the management accountant to realize that a creditor may qualify the debtor's credit worthiness using a number of different standards. The evaluation includes both quantitative and qualitative factors. Included are:

1. Condition: A good banker will look at both the macro- and the microeconomic factors effecting your firm. How will the general conditions concerning the firm's position in the industry effect the loan status? Can the firm survive a business downturn or a financial crisis? Is the firm in control of its own destiny, or is it dependent on one or two suppliers or customers?

2. Capacity: Does the entity have the ability to absorb and repay the debt? Will the profits be enough to cover the debt service? This involves more of a cash flow than a net profit analysis. A banker who intends to sell the debt instrument is especially concerned about this factor.

3. Capital: How is the capital injection to be financed? 100% financing is more difficult to place than when a corporation has substantial capital of its own at risk. If you can invest some of your own capital, the outside financing may prove easier to obtain.

4. Collateral: Lenders look to assets of the debtor as a secondary source of repayment. While this is a "just in case" protection, it does reduce the down-side risk. This may be especially important in a marginal loan situation. Recent appraisals can quantify this factor.

5. Character: A deficiency in the borrower's character can override all of the above factors. The loan is ultimately dependent on the trustworthiness and integrity of the promisor. Without this, the financing deal can go wrong even though all the other Cs' technical requirements are met. Honesty, a track record, a commitment to the firm's success and a willingness to put in the necessary time and effort are signs of strength. Note that this is an intangible evaluation that involves judgment.

C. Loans and Interest

Institutional lenders are flexible. Bank loans can be for a fixed term, an unsecured line of credit, or a revolving credit agreement. A revolving credit line is supposed to be paid off regularly. The bank may require collateral to secure the loan. Loans may be made against accounts receivable, inventory or equipment.

1. Required Compensating Balances: A bank may require a compensating cash balance be kept on deposit. This raises the effective borrowing costs of the loan because less money is being used. There may be some flexibility in administering compensating balances.

2. Interest Rate Methods: Interest rates are typically stated as annual percentages, with rate changes sometimes given in terms of basis points. One basis point is 1/100 of one percent. Methods used to calculate the effective interest rate include:

a. Regular: Interest / Borrowed Amount

Example: Sister Corporation borrowed $500,000 at 12.5% with a condition that it keep an average compensating balance in their non-interest bearing account of $150,000. Sister's account balance has ranged from zero to $120,000 and averaged $80,000 over the last two years. Sister's effective interest rates is

Answer: (500,000 x 12.5%)/[500,000 -(150,000 - 80,000)]
= 62,500 / (500,000 - 70,000)
= 62,500 / 430,000 = 14.53%

Note that if the condition was that the $150,000 be Sister's minimum compensating balance, the cost would rise to 17.86%.

b. Discounted: The interest is deducted in advance from the amount the borrower receives.

Interest / ( Borrowed Amount - Interest)

Example: Daughter Corporation borrowed $400,000 from a bank at which it had no compensating balances. The loan will be one year at 12% interest and will require a 5% compensating balance be left in a non-interest bearing account. If this loan is a transaction loan with the interest on a discount basis, the effective interest rate is:

Answer: (400,000 x 12%)/[400,000 - (12% x 400,000) - (5% x 400,000)]
= 48,000/332,000 = 14.46%

c. Add-On Interest: In the few states where it is still allowed, the total calculated interest is added to the funds received to determine the face value of the note. This interest paid is therefore in excess of the amount normally accrued on the amount borrowed.

d. Rule of 78: Add the digits 1 through 12 on a one-year contract to get the denominator. The numerator is the months passed beginning at 12 and descending to 1. The fraction is applied to the total charges. This sum-of-the-period digits method results in higher finance charges to a borrower who pays a loan off early.

e. Floating Interest Rate: This may also be called a variable interest rate.

1) Minimize Creditor's Risk: This feature minimizes the creditor's risk because a bank always earns its "spread" between the cost of and the return earned on funds. Usually the interest charged the customer is the prime rate plus a given percentage. Prime is what large banks charge their most credit-worthy corporate clients.

2) Market Rate Changes: If market rates decline, a floating rate has the advantage of lower interest costs and/or the elimination of the need to refinance. Conversely, the debtor is at a disadvantage if the market rate increases because the interest cost will increase proportionately.

D. Banking Legislation

1. Regulatory Structure: Banks are regulated by one or more of the following agencies.

a. Federal Reserve System
Regulatory Responsibilities include:
1. All State-chartered Federal Reserve member banks
2. All bank holding companies
3. Lender of last resort to all banks

b. Comptroller of Currency
Regulatory Responsibilities include
1. All national banks

c. Federal Deposit Insurance Corporation
Regulatory Responsibilities include:
1. Insures all banks, requiring premium payments to cover depositor's losses up to $100,000
2. Regulates state nonmember banks

d. State Governments
Regulatory Responsibilities include:
1. All state nonmember banks

Source: Federal Reserve Bank of New York, Depository Institutions and Their Regulators (New York, February 1994).

2. The Glass-Steagall Act of 1933:

a. Bank Activities Restrictions: Since l933, this Act has required the separation of commercial and investment banking activities. As a result, banks have been forbidden to underwrite security offerings, sell insurance, and are restricted in brokerage activities.

b. Merchant Banking: Popular in Europe, this term describes commercial banks which do everything from accepting deposits to buying or selling whole companies. Glass-Steagall attempts to stop this. Since the mid-80s, investment banks such as Morgan Stanley have used their own equity to finance takeovers or leveraged buyouts.

c. Liberalization Trend: In the last decade, the Federal Reserve Board has permitted bank affiliates to underwrite debt and equity securities on a limited basis. Treasury Secretary Rubin has proposed further liberalization.

d. Liberalization Effect: Increased competition, lower profit margins and new marketing techniques all seem likely ( as also do increased conflicts of interest when banks serve as both lender and underwriter to the same corporation.

3. Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1993: The essential provisions of the act are divided into two sections.

a. Deregulation: DIDMCA changed the way financial institutions do business.

1) NOW Accounts: Interest bearing checking accounts known as NOW accounts are permitted to be offered by financial institutions.

2) Deposit Rate Ceilings: Maximum interest rate ceilings on deposit accounts were eliminated in favor of a free market determination of rates.

3) Non-bank Lending: Non-bank lenders, such as savings & loans (S & Ls) and credit unions, were given permission to make additional types of loans (credit unions were allowed to make real estate loans) and were permitted higher loan ceilings.

4) Insured Levels: The deposit insurance for commercial banks, savings banks, etc., has been increased from $40,000 to $100,000. All the banks pay premiums to cover the few losses.

5) Restrictions: Commercial banks must meet new capitalization standards, establish stricter internal controls and comply with tighter rules on real estate underwriting, asset growth, loan documentation and interest rate risk exposure. The stiff competition from other financial service providers (including brokerage houses, mutual-fund groups, and computerized banking software systems) continue to drive a wave of bank mega-mergers seeking cost structure reductions and increased market shares.

b. Monetary Control: DIDMCA provided two main provisions as to monetary control.

1) New Reserve Requirements: The new reserve requirements are applied to all depository institutions and all loans. The new reserve requirements were phased in over 8 years and applied to transactions accounts (demand accounts, NOW accounts, share drafts, etc.), nonpersonal time deposits, and eurocurrency reserve requirements.

2) Extended Borrowing From the Fed: Any institution subject to the reserve requirements are now able to borrow at the Fed's discount for temporary sources needed to cover immediate cash or reserve needs. The Fed also established fees for its services, such as checking clearing and wire transfers.

4. Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA): This legislation was passed in 1989 to assist in the rescue of the insolvent savings and loans (S&Ls). The Resolution Trust Corporation was established to liquidate failing thrifts. The law had two functions:

a. Bail Out Failures: One purpose of the Act is to provide funds to bail out failing thrifts or those with negative net worth. The emphasis is on finding healthy institutions to buy out the weak ones.

b. Future Medicine: S&Ls, under the Act, must hold at least 70% of their assets in housing-related loans and are limited to the amount of nontraditional assets that they can own. Each thrift must maintain specific amounts of tangible capital (equity must equal 1.5% of net assets minus goodwill); core capital (equity including "supervisory goodwill" created in a purchase or merger) must equal 3% of tangible assets; risk adjusted capital (equity plus subordinate debt) must equal 7.2% of total assets multiplied by a federally set risk weight. No more than 15% of a S&L's lending exposure can be to any one borrower. The FIRREA set up the Office of Thrift Supervision (OTS) which can declare an S&L insolvent and touch off an FDIC takeover.

E. International Impact

Interest rates are subject to different economic factors in different countries. The inflation premium may vary significantly.

1. Political Factors: Political considerations may create widely varying monetary policy controls in different countries. Some governments feel that low interest rates encourage consumption and consumer debt accumulation which is undesirable. Inflation may create political pressure to raise interest rates.

2. Objective: The objective is to fund projects with the lowest after-tax interest cost. For a multi-national company, borrowing in a lower interest rate country may be an effective way to reduce the cost of capital.

3. Recent History: In the 1990s, the prime interest rate in Japan has averaged 3% while it has been 10% in Europe. The U.S. falls between the extremes. A corporation should borrow in the lowest-rate country.

V. ADMINISTRATION AND COMPLIANCE FOR FINANCING INSTRUMENTS

A. Indentures

1. Definition of a Bond Indenture: A bond indenture is a contract between the issuing corporation and the bondholders. It specifies the features and legal requirements of the bond.

2. Duties of Trustee: A trustee is often required in the indenture to supervise the terms of the indenture. The trustee has three primary duties:

a. Certify Indenture: The trustee certifies that the bond carries the benefits described in the indenture (property pledged, restrictions, etc.).

b. Enforcement: The trustee enforces the terms and protective covenants found in the indenture.

c. Act on Behalf of Bondholders: The trustee can take action on behalf of bondholders in the case where the issuing company does not conform to the indenture agreement. This could lead to accelerated payment of the maturity value of the bonds if the issuer is in default or has violated the terms of the indenture.

B. Protective Covenants and Restrictions

Protective covenants are restrictions a creditor places on a corporation that issues debt securities. A bank may also impose conditions as a condition of a loan.

1. Purpose:

a. Risk of Default: These legal restrictions prevent the issuer from taking a business course of action that would increase the bond's risk of default. This is a major risk that, if present, may override all other considerations.

b. Market Price Depreciation Risk: In addition, the creditor may want to prohibit actions that could adversely affect the market price of the debt security they are holding. For example, a low risk company will issue bonds at a low interest rate. If the company were to then take a course of action with the effect of substantially increasing their overall financial risk, the principal value of the bonds would decrease. This would produce losses for the original purchasers of the bonds if they were to sell them in the secondary market.

2. Types of Covenants: The bond indenture may have covenants that are intended to protect the creditor. Included may be:

a. Limitation: Limits on new ventures or officers' salaries.

b. Ratios: Requirements that specify certain ratios be met, such as the debt ratio not exceeding a particular percentage.

c. Restrictions: Restrictions on the amount of cash dividends on common stock. This may take effect if the current ratio drops below a particular value.

3. Need for Covenants: Protective covenants are attractive to bondholders because of the protection they provide. Risk is more manageable and conditions may be custom made.

4. Disadvantages of Covenants: The exact covenant will affect different borrowers in different ways. Corporations do not usually like covenants since they place restrictions on what courses of action the corporation is able to take.