Revision Part 1

 Finance in Business (Finance Essentials Module

1)
 The financial system (Finance Essentials Module
2)
 Commercial banks operations (Financial Market
s, Institutions and Money Ch. 14)
Week 13
 Nonbank financial institutions (Financial Market
Revision s, Institutions and Money Ch. 15)


2


 Role of financial manager: -Roles of a Financial System

 Three (3) types of financial management ◦ To facilitate the flow of funds
decisions ◦ To provide the mechanism to settle transactions
◦ To generate and disseminate information
◦ Capital budgeting, Financing & Working capital
management ◦ To provide the means to transfer and manage risk
◦ To provide ways of dealing with incentive problems
 Three (3) major forms of business
organization -Benefits of Financial Intermediation
◦ Sole proprietorship, Partnership & Corporation ◦ Denomination divisibility
 Goal of financial management ◦ Currency transformation
◦ Maturity flexibility
◦ Maximize shareholders’ wealth ◦ Credit risk diversification
◦ Liquidity
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Types of FIs -
◦ Commercial Banks, building societies and credit
unions; Foreign bank representatives; Life and General
insurance companies; Finance companies; Investment  Main sources and uses of funds for commercial
funds; Superannuation funds
banks
◦ Sources: deposits, bills acceptance, debt liabilities, foreign
 Types of Financial Markets: currency liabilities, loan capital and shareholders equity
◦ Primary and secondary markets; Exchanges and over- ◦ Uses: Personal and housing finance, Commercial lending,
the-counter; money and capital markets; public and Lending to government
private markets; Futures and options markets; Foreign
exchange markets.
 Liquidity management of commercial banks
 Types of risks: ◦ Asset management - maintaining sufficient cash and
◦ Credit risk; Interest rate risk; Liquidity risk; Foreign noncash assets that can be quickly converted to cash.
exchange risk; Political risk; reputational risk; ◦ liability management - acquiring liquidity from the liability
Environmental risk side of the balance sheet.

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 Importance of banks’ off-balance-sheet Non-bank financial institutions:
business  (1) Building societies
◦ contingent assets or liabilities ◦ ADIs
◦ E.g. . loan commitment, derivatives, letters of ◦ Regulated by APRA
credit, loan brokerage, securitisation ◦ Assets: residential mortgages
◦ Capital: own by members
 Bank capital management:
- BASEL III Capital adequacy requirement
◦ Provides a financial cushion  (2) Credit unions
◦ ADIs
◦ Helps maintain public confidence
◦ Regulated by APRA
◦ Provides some protection to depositors ◦ Assets: loans to members
◦ Serves as a source of funds for expansion ◦ Liabilities: members savings account
◦ Capital: mutual institutions that do not hold
shareholders equity
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 (3) Finance companies Type of Commercial Building Credit Finance

Financial banks Societies Unions Companies
◦ Not ADIs institutions
◦ Regulated by ASIC Regulatory APRA APRA APRA ASIC
◦ Assets: Body
◦ consumer lending – personal loans, real-estate Uses of Households Consumer Short term Higher credit
lending funds and business mortgage loans, risk
loans, loans household Consumer
◦ business lending - Wholesale financing, Retail investment loans loans and
financing, Lease financing business
◦ Liabilities: loans
 Highly leveraged Source of Deposits, deposits deposits Borrowed
funds borrowed funds/parent
 commercial paper, debentures and unsecured notes
funds companies
Ownership shareholders members members shareholders
structure
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Textbook reading 5
Business Finance Ch. 3
Revision Part 2 The Time Value of Money (TVM)
 Time value of money (Business Finance Ch. 3) n
where: FVn  P V (1 i)
 Discounted cash flow and valuation (Business FVn = value of investment at the end of period n
Finance Ch. 4)
PV = original principle (P0) or present value
 Bond Valuations and structure of interest
rates (Business Finance Ch. 6) i = the rate of interest per period
 Share Valuations (Business Finance Ch. 7) n = the number of periods

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 Berry has a windfall of $7500 to invest, and hopes
it will grow to $10,000 in 3 years. If she can earn
5.6% compounded daily, will she have enough?
FV
PV   FV = PV (1+i)n
(1  i ) n  = 7500 (1 + 0.056/365)^3x365
 = 8871.91
or
 Not enough
PV  FV (1 i)n
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Given any 3 of the variables, can solve for

 You would like to buy a new car. You have the 4th
$20,000, but the car costs $38,500. If you can
earn 9% pa, how much do you have to invest  Suppose you are offered an investment that will
today to buy the car in two years? Do you have allow you to triple your money in 3 years. You
have $100 to invest. What is the implied rate of
enough? Assume the price will stay the same. interest?
 Formula:FV = PV (1+i)n  i = (FV / PV)1/n–1
◦ PV=FV/(1+i)n
◦ =38,500/(1.09)^2
◦ =$32,404.68 ◦ i = (300 / 100)^1/3 – 1
◦ You are still short of the required ◦ = 0.44225
amount by $12,404.68. ◦ =44.23%

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 Revenue increased from $2000 to $2500 after 4

years. What is the average annual growth rate in
sales?

n Multiple cash flows:

FVn  PV(1 g) Unequal and or no regular time periods:
 2500 = 2000 (1+g)^4
PV: Discount each cash flow on individual basis
 1.25 = (1+g) 4 and sum
 g = (1.25)^1/4 – 1 FV: Compound each cash flow on individual
 = 1.0574-1 basis and sum
 = 0.0574
 = 5.74%


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  Suppose you plan to deposit $100 into You are offered an investment that will pay:
an account in one year and $300 into the ◦ $200 in year 1;
account in 3 years. How much will be in ◦ Nothing in year 2 &3; and
the account in 5 years if the interest rate ◦ $800 at the end of the 4th year.
is 8%? You can earn 12% on similar investments. What
is the most you should pay for this one? OR
◦ FV = 100(1.08)^4 + 300(1.08)^2 How much is this investment worth?
◦ = 136.05 + 349.92 = $485.97
PV = FV / (1+i)n
$200 / (1.12) + $800 / (1.12)^4
= $686.98

FV = PV(1 + i)n
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 Annuities and perpetuities

You can afford $632 per month towards a
 1  new car. The lending rate is 12% per year for
 1  (1  i ) n  4 years with monthly repayment.
P V A n  C F  
 i  How much can you borrow now?
 
 (1  i ) n
 1 
F V A  C F  
 i 

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1  [1/ (1  i ) n ] 
 CF  
 i 
 1 
1 (1.01)48   Suppose you begin saving for your
PVA  632    23,999.54 retirement by depositing $2,000 per year in
 .01  a superannuation fund. If the interest rate is
  7.5%, how much will you have in 40 years?
Moodle:
 (1  i ) n  1  CF = 2000
FVA  CF   i = 0.075
PVA = 632/0.12/12 [ 1 – 1/(1+0.12/12)^ 4x12]  i  n = 40
= 23,999.54

 (1.075) 40  1 
FVA  $2000    $454,513.04
Therefore, $24 000 is what you can afford to borrow  .075 

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  (1.075) 40  1 
FVA  $2000    $454,513.04  A product promises an initial payment of
 .075  $20,000 at the end of this year and subsequent
payments will thereafter grow at a rate of 3.4%
annually. If you use a 9% discount rate for
 Moodle: investment products, what is the PV of this
 FVA = 2000/0.075 x [ (1+0.075)^40 - 1] growing perpetuity?
CF1
 = $454,513.04 PVA  =
(i - g )
 PVA = 20,000 / (0.09 – 0.034)
 = 357,142.86

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If compounding more often than

 Find the effective annual interest rate of an
annually investment that pays 5.6% compounded daily.
EAR>flat (nominal or stated) rate (APR)

 m
m
EAR  1  APR 1
 
m
EAR  1  APR 1
m  EAR = (1 + 0.056/365)^365 – 1
 = 0.05759
APR= Quoted interest rate = nominal  = 5.76%
interest rate= annual percentage rate

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 The general equation for the price of a bond:

C1 C2 C3 C +F
PB = + + +...+ n n
(1+i)1 (1+i) 2 (1+i) 3 ( 1+i)

Bond valuation  1 
 1- (1 +i )n  F
Bond yields =C  + n 𝐹
1  i  (1 +i) 𝑃𝑉
Interest rate risk 1
1 𝑖  
1 𝑖
𝑃𝑉𝐴 𝐶𝐹
Structure of interest rates 𝑖
PV(coupon) PV(par)

 Bond price = PV(Coupon payments)+ PV

(Principal payments)

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 5% coupon (payments made semi-annually),
$1,000 par value bond, mature in three years.
Required rate of return is 8%.
PB= PV (coupon) + PV (Principal)  Moodle:
  1 
 1- (1+i/2 ) 2 n  F  PB = 50/2 / 0.08/2* [1- 1/(1+0.08/2)^3x2]
PB =C / 2  +
 i/2  (1+i/2 )
2n + 1000/(1+0.08/2)^3x2
   =$921.37
 1 
 1- (1+ 0.08 / 2 ) 2 x3  1000
= 50 / 2  + 2 x3
 0.08 / 2  (1+ 0.08 /2 )
 
 9 2 1.37

 Zero coupon, $1,000 face value, 10-year What happens to bond values if the required
maturity, semi-annual compounding, return is not equal to the coupon rate?
requirement rate of return 12%

Fmn 1000 The bond’s price will differ from its par value
PB  PB 
(1  i / m)mn (1  0.12 / 2) 2 x10
 311.80 i > coupon rate P0 < par value = DISCOUNT

Moodle:

PB = 1000/(1+0.12)^10x2 i < coupon rate P0 > par value = PREMIUM

=$311.80
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Bond Theorems Bond Theorems

 Bond prices are inversely related to interest  For a given change in interest rates, prices
rate movements. of long term bonds will change more than
prices of short-term bonds
 As interest rates decline, prices of bonds  Long-term bonds have greater price volatility
rise; as interest rates rise, prices of than short-term bonds.
bonds decline  All other things being equal, long-term
bonds are more risky than short-term bonds.
 Interest rate risk increases as maturity
increases, but at a decreasing rate.

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Bond Theorems Bond Theorems
 For a given change in interest rates, prices  The lower the bond’s coupon rate, the
of lower-coupon bonds change more than greater the proportion of the bond’s cash
prices of higher-coupon bonds.
flow investors will receive at maturity.

 The lower a bond’s coupon rate, the  All other things being equal, a given
greater its price volatility; hence, lower change in the discount rate interest rates
coupon bonds have greater interest rate will have a greater impact on the price of a
risk. low-coupon bond than a higher-coupon
bond with the same maturity.
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 Ordinary
 Voting rights
 Ordinary shares represent a basic ownership claim in
 Types of secondary markets: a company
◦ Direct search, Broker, dealer, auction  Dividends
 Not a liability of the firm until declared by the BOD
 Not tax deductible
 Types of equity securities:  Taxed as ordinary income for individuals
◦ Ordinary and preference shares
 Preference shares
 no voting rights but a preferential right to dividends
 Dividends
 regardless of firm’s earnings
 stated percentage
 legally classified as perpetuities because they have
no maturity
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Zero growth dividend model  Pay $10 dividend per year (grow rate of zero).
• perpetuity with a constant cash flow. Expect 14% return on investment. What is
price of this share:
• The valuation model for a zero growth share:
D
P0 
R D $10
• P0 = current value D = constant cash dividend
P0    $71.43
R= required return R 0.14

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 Constant growth dividend model  Calculating future share prices
• current price of a share is the next period • The constant-growth dividend model can be
dividend (D1) divided by the difference modified to determine value, or price, of a
between the discount rate and the dividend share at any point in time
growth rate. • Price of a share (P) at time t with growing at
• How to value a constant growth share: the rate of g is therefore:

D1 Dt 1
P0  Pt 
(R  g ) (R  g )
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A company is expected to pay a dividend of A company is expected to pay a dividend of

$3.5 in a year. Dividend is expected to grow at $3.5 in a year. Dividend is expected to grow at
a constant rate of 3% p.a. The expected return a constant rate of 3% p.a. The expected return
of similar share is 15.2%. What is the market of similar share is 15.2%. What is the expected
value of this share in 3 years? (round to 2 d.p.)
value of this share? (round to 2 d.p.)
P3 = $3.5(1+0.03)^3 / (0.152-0.03)
P0 = $3.5 / (0.152-0.03) = $31.35
= $28.69
 The expected value of this share in 3 years is
 The value of this share is $28.69. $31.35

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Revision Part 3
 Consumer credit (Financial Planning 1st ed Advantages of Consumer Credit:
Ch. 9) ◦ Increase current purchasing power
◦ Transact efficiently
 Personal financial planning (Financial Plannin ◦ Indicates good financial standing with
g 2nd ed. Ch. 1) external parties
 Development ◦ Reduces costs of holding cash
◦ Reduces record keeping

Disadvantages of Consumer Credit:

◦ Likelihood of overspending
◦ Reduction in quality of lifestyle if misused
◦ Adverse legal outcomes (court action,
bankruptcy)
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  Types of consumer credit:
◦ Open-ended/ close-ended What is Personal Financial Planning?
◦ Housing loans, Credit cards, HECS/HELP,
personal loans, motor vehicle finance, Revolving  setting in place some personal objectives and
lines of credit, leasing finance, Fully Drawn arranging financial means to satisfy those
Advance, bridging loans objectives
 Has its roots in life cycle theory of consumption
and saving
 Personal financial planning encompasses
different disciplines, including investment,
business structure, insurance, taxation,
superannuation, retirement and estate
management planning
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 (1) gather client information  Part 7.7 of the Act and Regulatory Guides
 (2) establish financial goals and objectives (RG) 175 and (RG) 168 set out the various
 (3) analysing data and identify financial disclosure documents that are required to be
issues provided by a planner.
 (4) prepare and develop the SOA  The three main documents are:
◦ financial services guide (FSG)
 (5) implement the agreed-upon ◦ statement of advice (SOA)
recommendations ◦ product disclosure statement (PDS)
 (6) review and revise the SOA  Ensures retail clients receive appropriate
information and advice, so they can make
informed decisions.
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 Financial services guide (FSG):  Statement of advice (SOA):

◦ Prior to the provision of advice, a FSG must be ◦ Personal advice from a financial planner must be issued
with an SOA in such a way that they are able to make an
provided. informed decision.
◦ Enables a client to decide whether or not to obtain ◦ After advice is provided, the SOA must be provided as
financial services from the financial planner. soon as possible.

◦ An SOA must include:

◦ The FSG must provide the following information:
 the name of the party providing the advice
 who is providing the service  a statement setting out the advice
 what financial services are being offered  the reasoning or basis that led to that advice
 who the service provider is acting for  the remuneration and other benefits received by the provider
of the advice
 details of how the planner is remunerated
 all conflicts of interest that may affect the advice.
 details of any potential conflicts of interest.
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  Product disclosure statement (PDS):
 Statement of advice (SOA): ◦ Must contain sufficient information to enable an
◦ Three main types of advice statements: informed decision about whether to purchase a
 comprehensive advice statement financial product (Pt 7.9 of the Act).
 scaled advice statement (limited scope) ◦ A PDS includes the following information:
 no advice statement (to carry out a transaction, such  fees payable in respect of a financial product
as buying shares).  risks of the financial product
 benefits of the financial product
 significant characteristics of the financial product.

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 Best interest duty and safe harbour

provisions:
◦ The best interest duty mean that a planner has 4
separate duties – a duty to:
 act in the client’s best interests
 provide advice that is appropriate
 provide an advice warning
 prioritise the client’s interests in the event of a
conflict.

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