MONEY MAREKT AND CAPITAL MARKET

Money Market - refers to the network of corporations, financial institutions, investors and governments
which deal with the flow of short-term capital.

Types of Money Market Instruments

Money market securities are short-term instruments with an original maturity of less than one year.

1. Commercial Paper
2. Banker’s Acceptance
3. Treasury Bills
4. Repurchase agreement
5. Government Agency notes
6. Local government notes
7. Interbank loans,
8. Time deposits
9. Paper Issued by international Organization
10. Repos ( Repurchase Agreement )

CAPITAL MARKETS

 Is a financial market in which longer-term debt (original maturity of one year or greater ) and
equity instruments are traded. Capital market securities include bonds, stocks, and mortgages.
 Capital market securities are often held by financial intermediaries such as insurance companies
and pension funds, which have little uncertainty about the amount of funds they will have
available in the future.

Capital Market Participants

The Primary issuers of capital government, and

1) National and local government, and

2) Corporations

The National Government – issues long-term notes and bonds to fund the national debt which local
governments issue notes and bonds to finance capital projects.

Corporations – issue both bonds and stock to finance capital investment expenditures and fund other
investment opportunities.

Capital Market Trading

 Occurs in either the primary market or the secondary market.

The Primary Market – is where new issues of stocks and bonds are introduced. Investment
funds, corporation and individual investors can all purchase securities offered in the primary
market.
 You can think of a primary market transaction as one where the issuer of the security actually
receives the proceeds of the sale.
  When firms sell securities for the very first time, the issue is an INTIAL PUBLIC OFFERING (IPO)
Secondary Market is where the sale of previously issued securities takes place, and it is important
because most investors plan to sell long-term bonds before they reach maturity and eventually
to sell their holdings of stock as well.

2 Type of exchanges in the Secondary Market for Capital Securities:

1. Organized exchanges - has a building where securities ( including stocks, bonds,
options, and features ) trade.
2. Over-the-counter exchanges
* Exchange rules govern trading to ensure the efficient and legal operation of the exchange, and
the exchange’s board constantly reviews these rules to ensure that they result in competitive
trading.

BONDS is a long –term promissory note issued by the firm. A Bond Certificate is the tanginble evidence
of debt issued by a corporation or a government body and represents a loan made by investors to the
issuer.

 Are the most prevalent example of the interest only loan with investors receiving exactly the
same 2 sets of cash flows:
(1) the periodic interest payments
(2) the principal ( par value of face value ) returned at maturity.

TRADING PROCESS FOR COPORATE BONDS

 The initial or primary sale of corporate bond issues occurs either through a public offering, using
an investment bank serving as a security underwriter or through a private placement to a small
group of investors.
 When firm issues bonds to the public, many investment banks are interested in underwriting the
bonds. The bonds can generally be sold in a national market.
 Corporate bonds – are offered publicly through investment banking firms as underwriters.
Normally the investment banks facilitates this transaction using a firm commitment
underwriting.
 Investment bank guarantess the firm a price for newly issued bonds by buying the whole issue at
a fixed price ( the bid price ) from the bon- issuing firm at a discount from par.
 Seeks to resell these securities to investors at a higher price ( the offer price ). As a result,
Investment bank takes a risk that it may not be able to resell the securities to investors at a higher

Sell Bonds Sell Bonds

Pays Bid Price Pays Offer Price

Underwriter
Corporation Investors
( Investment bank )
 price. . This may occur if a firm’s bond value suddenly falls due to an unexpected change in
interest rates or negative information being released about the issuing firm. If this occurs, the
Investment bank takes a loss on its security underwriting. However, bond issuer is protected by
being able to sell the whole issue.

Other Arrangement can be as follows:

1. Competitive Sale
2. Negotiated Sale
3. Best Efforts Underwriting Basis

Advantages of using bonds can be summarized as follows:

1. Long-term debt is generally less expensive than other forms of financing because ( a) investors view
debt as a relatively safe investment alternative and demand a lower rate of return , and (b) interest
expenses are tax deductible.

2. Bondholders do not participate in extraordinary profits; the payments are limited to interest.

3. Bondholders do not have voting rights.

4. Flotation costs of bonds are generally lower than those of ordinary ( common ) equity shares.

Disadvantages:

1. Debt ( other than income bonds ) results in interest payments that, if not met, can force the firm into
bankruptcy.

2. Debt ( other than income bonds ) produces fixed changes, increasing the firm’s financial leverage.
Although this may not be a disadvantage to all firms. It certainly is for some firms with unstable earnings
streams.

3. Debt must be repaid at maturity and thus at some point involves a major cash outflow.

4. The typically restrictive nature of indenture covenants may limit the firm’s future financial flexibility.

Bond Features and Prices – the various features of corporate bonds and some of the terminology
associated with bonds follows:

Par Value – the face value of the bond that is returned to the bondholder at maturity

Coupon Interest Rate – the percentage of the par value of the bond that will be paid out annually in the
form of interest. Formula is: Interest Payment divided the Par value.

Maturity – the length of time until the bond issuer returns the par value to the bondholder and terminates
the bond.
Indenture – the agreement between the firm issuing the bonds and the bond trustee who represents the
bondholders. It provides the specific terms of the loan agreement, including the description of the bonds,
the rights of the bondholders, the rights of the issuing firm and the responsibilities of the trustee.

Current Yield – this refers to the ratio of the annual interest payment to the bond’s market price

Yield to Maturity- this refers to the bond’s internal rate of return. It is the discount rate that equates the
present value of the interest and principal payments with the current market price of the bond.

Formula is: Approximate Yield = Annual Interest Payment + Principal Payment - Price of the Bond
Number of Years to Maturity_____
.6 (Price of the Bond ) + .4 ( Principal Payment )

Illustrative Problem: Determination of Bond Yield to Maturity

Par value of bond: P1,000

Interest rate: 10%
Term: 10 years
Current Price: P900

What is the bond’s approximate yield to maturity

Solution:

Approximate Yield to Maturity = 100 + 1,000 - 900

10_____
. 6 ( 900 ) + .4 ( 1,000)

= 110 or 11.70%
940

CREDIT QUALITY RISK

Credit Quality Risk is the chance that the bond issuer will not be able to make timely payments.

Bond Ratings involve judgment about the future risk potential of the bond provided by rating agencies
such as Moody’s, Standard and Poor’s And Fitch IBCA,Inc. Dominion Bond Rating Services. Bond ratings
are favorably affected by:

(a) A low utilization of financial leverage.

(b) Profitable Operations;
(c) A low variability of past earnings;
(d) Large firm size;
(e) Little use of subordinated debt.
The Poorer the bond rating, the higher the rate of return demanded in the capital markets.

The Bond Credit Ratings agencies assign similar rating based on detailed analyses of issuers’ financial
condition, general economic and credit market conditions, and the economic value of any underlying
collateral. The agencies conduct general economic analyses of companies’ business and analyze firm’s
specific financial situations. A single company for instance may carry several outstanding bond issues and
if these issues feature fundamental differences, then they may have different credit level risk. High
quality corporate bonds are considered investment grade, while higher credit risk bonds are speculative,
also called junk bonds and high-yield bonds.

OTHER TYPES OF BONDS

1. FLOATING RATE OR VARIABLE RATE BONDS

> floating rate bond is one in which the interest payment changes with market conditions. In
period of unstable interest rates this type of debt offering becomes appealing to issuers and investors. To
the issuers like banks and finance companies whose revenues go up when interest rates rise and decline
as interest rats fall, this type of debt eliminates someof therisk andvariability n earnings that accompany
interest rate swings. To the investor, it eliminates major swings in the market value of the debt that
would otherwise have occurred if interest rates had changed.

2. JUNK OR LOW-RATED BOND

> bonds rated BB or below. The major participants of this market are new firs that do not have
and established record of performance, although in recent years junk bonds have been increasingly issued
to finance corporate buyouts.

3. EUROBONDS
> these are bonds payable or denominated in the borrower’s currency, but sold outside the
country of the borrower’s currency, usually by an international syndicate of investment bankers. This
market is denominated by bonds stated in U.S. dollars.

The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold
by companies in Switzerland, Japan, Netherlands, Germany, the United States and Britain, to name the
most popular countries.
Example: might be a bond of a U.S. company payable in dollars and sold in London, Paris, Tokyo or
Frankfurt.

4. TRASURY BONDS – carry the “full-faith-and-credit” basking of the government and investors consider
them among the safest fixed-income investments in the world. The BSP sells Treasury securities through
public auctions usually to finance the government’s budget deficit. When the deficit is large, more bonds
come to auction. In addition, the BSP uses Treasury securities to implement monetary policy.

B. ORDINARY (COMMON) EQUITY SHARES

Ordinary equity shares (traditionally known as ordinary equity share ) is a form of long-term equity that
represents ownership interest of the firm. Ordinary equity shareholders are called residual owners
because their claim to earnings and assets is what remains after satisfying the prior claims of various
creditors and Preferred shareholders. Ordinary ( common ) equity shareholders are the true owners of
the corporation and consequently bear the ultimate risks and rewards of ownership.
Business firms organized as a corporation may choose to issue publicly traded stock (publicly owned
corporation ) or keep ownership only among the original organizers ( closely held corporation). As owners
of the firm ordinary shareholders are considered to be residual domains. This means that ordinary
shareholders have the right to claim any cash flows or value after all other claimants have received what
they are owned. These profits can be used to reinvest in the firm to foster growth, pay out as dividdends
to shareholders or a combination of two.

Shareholders assume a limited liability because their risk of potential loss is limited to their investment in
the corporation’s equity shares.

FEATURS OF ORDINARY EQUITY SHARES

1. PAR VALUE/ NO PAR VALUE

Ordinary equity share may be sold with or without par value. Wheterh or not ordinary equity share has
any par value is stated in the corporatio’s charter. Par value of ordinary equity share is the stated value
attached to a single share at issuance. It has little significance except for accounting and legal purposes.
If ordinary equity share is initially sold for more than its par value, the issue price in excess of par is
recorded as additional paid-in capital, capital surplus, or capital in excess of par. A firm issuing no par
share may either assign a stated value or place it on the books at the price at which the equity share is
sold.

2. AUTHORIZED, ISSUED, AND OUTSTANDING

Authorized shares is the maximum number of shares that a corporation may issue without amending its
charter. Issued shares is the number of authorized shares that have been sold. Outstanding shares are
those shares held by the public. Both the firm’s dividends per share and earnings per share are based on
the outstanding shares. The number of issued shares may be greater than the number of outstanding
shares because shares may be repurchased by the issuing firm. Previously issued shares that atr
reacquired and held by the firm are called treasury shares. Thus, outstanding share is issued share less
treasury share.

3. NO MATURITY

Ordinary equity share has no maturity and is a permanent form of long term financing. Although ordinary
share is neither callable nor convertible, the firm can repurchase its shares in the secondary markets either
through a brokerage firm a tender offer. A tender offer is a formal offer to purchase shares of a
corporation.

4. VOTING RIGHTS
Each share of ordinary equity generally entitles the holder to vote on the selection of directors and in
other matters. Shareholders unable to attend the annual meeting to vote may vote by proxy. A proxy is
a temporary transfer of the right to vote to another party. Proxy voting is done under the rules and
regulations of the Securities and Exchange Commissions, but proxy solicitations are the firm’s
responsibility. Not all ordinary equity shareholders have equal voting power. Some firms have more than
one class of share. Class A ordinary ( common ) equity share typically has limited or no voting rights while
Class B has full voting rights.

There are 2 common systems of voting:

 A. Majority Voting is a voting system that entitles each shareholder to cast one vote for each
share owned. Majority voting is used to indicate the ordinary ( common ) equity shareholders’ approval
or disapproval of most proposed managerial actions on which shareholders may vote. The idrectors
receiving the majority of the votes are elected. IF a group controls over 50 percent of the votes, it can
elect all of the directors and prevent minority shareholders from electing any directors.

B. CUMULATIVE VOTING is a voting system that permits the shareholder to cast multiple votes
for a single director. Cumulative voting assists minority shareholders in electing at least one director.
Cumulative voting is required in some jurisdictions for electing the board of directors.

5. BOOK VALUE PER SHARE

> The accounting value of an ordinary equity share is equal to the ordinary share equity ( ordinary
share plus paid – in capital plus retained earnings ) divided by the number of shares outstanding.

6. NUMEROUS RIGHTS OF STOCKHOLDERS

> Collective and individual rights of ordinary equity shareholders include among others:

A) Right to vote on specific issues as prescribed by the corporate charter such as election of the board of
directors, selecting the firm’s independent auditors, amending the articles of incorporation and bylaws,
increasing the amount of authorized stock, and so forth.

B) Right to receive dividends if declared by the firm’s board of directors.

C) Right to share in the residual assets in the event of liquidation.
D) Right to transfer their ownership in the firm to another party.
E) Right to examine the corporate banks.
F) Right to share proportionally in the purchase of any new issuance of equity shares. This is known as
the pre-emptive rights.

VALUATION
 Ordinarioy or common equity share valuation is complicated by the uncertainty of future returns
and/ or changes in the share’s price.
C. PREFERRED SHARE
> is a class of equity shares which has preference over ordinary ( common ) equity shares in the
payment of dividends and in the distribution of corporation assets in the event of liquidation.

 Means only that the holders of the preferred share must receive a dividend ( in the case of a
going concern firm ) before holder of ordinary ( common ) equity shares are entitled to anything.
Preferred shares generally has no voting privileges but it is a form of equity from a legal and tax
stand point.

The Issuance of Preferred shares is favored when the following conditions prevail:
1. Control problems exist with the issuance of ordinary share.
2. Profit margins are adequate to make of additional leverage attractive.
3. Additional debt poses substantial risk.
4. Interest rates are low lowering the cost of preferred share.
5. The firm has a high debt ratio, suggesting infusion of equity financing is needed.
PREFERRED SHARE FEATURES
The following are the major features of preferred share:

1. Par Value – is the face value that appears on the stock certificate. In some cases, the liquidation value
per share is provided for in the certificate.

2. Dividends – are stated as a percentage of the par value and are commonly fixed and paid quarterly but
are not guaranteed by the issuing firm. Some recent preferred share issues called adjustable rate, variable
rate, or floating rate preferred, do not have a fixed dividend rate but pet dividends to an underlying index
such as one of the Treasury bill rate or other money market rates.

3. Cumulative and Noncumulative dividends- dividends payable to preferred shares are either cumulative
or noncumulative; most are cumulative. If preferred dividends are cumulative are not paid in a particular
year, they will be carried forward as an arrearage. Usually, both accumulated ( past) preferred dividends
and the current preferred dividends must be paid before the ordinary equity shareholders receive
anything. If the preferred dividends are noncumulative, dividends not declared in any particular year are
lost forever and the preferred shareholders cannot claim such anymore.

4. No definite maturity date - Preferred share is usually intended to be a permanent part of a firm’s
equity and has no definite maturity date. However, preferred share sometimes carries special retirement
provisions. Almost all preferred shares have a call feature that gives the issuing firm the option of
purchasing the share directly from its owners, usually at a premium above its par value.

5. Convertible Preferred share – owners of convertible preferred share have the option of exchanging
their preferred share for ordinary ( common ) equity share based on specified terms and conditions.

6. Voting Rights – Preferred Share does not ordinarily carry voting rights. Special voting procedures may
take effect if the issuing firm omits its preferred dividends for a specific time period. Preferred
shareholders are then permitted to elect a certain number of members to the board of directors in order
to represent the preferred shareholder’ interests.

7. Participating features – share entitles its holders to share in profits above and beyond the declared
dividedns, along with ordinary ( common ) equity shareholders. Most preferred share issues are
nonparticipating. Without nonparticipated preferred, the return is limited to the stipulated dividends.

8. Protective features – Preferred share issues often contain covenants to assure the regular payment of
preferred share dividends and to improve the quality of preferred share. For example, covenants may
restrict the amount of common share cash dividends, specify minimum working-capital levels, and limit
the sale of securities senior to preferred share.
Preferred shareholders have priority over ordinary ( common ) equity shareholders with regard to
earnings and assets. Thus, dividends must be paid on preferred share before they can be paid on the
ordinary ( common ) equity share, and in the vent of bankruptcy, the claims of the preferred shareholders
must be satisfied before the ordinary ( common ) equity shareholdrs receive anything. To reinforce these
features, most preferred shares have coverage requirements similar to those on bonds. Thes restrictions
limit the amount of preferred share a company can use, and they also require a minimum level of retained
earnings before common dividends can be paid.
9. Call Provision – gives the issuing corporation the right to call in the preferred share for redemption. As
in the case of bonds, call provisions generally state that the company must pay an amount greater that
the par value of the preferred share, the additional sum being termed a call premium.
For Example: HImalya Corporation’s 12 percent, P100 par value preferred share, issued in 2005,
noncallable for 10 year, but it may be called at a price of P112 after 2015.

10. Maturity - three decades ago, nost preferred share was perpetual – it had no maturity and never
needed to be paid off. However, today most new preferred share has a sinking fund and thus an effective
maturity date.

PREFERRED SHARE VALUATION

Preferred share is share that has a claim against income and assets before ordinary share but after debt.
Often, preferred share considered a hybrid security because it possesses characteristics of both debt and
equity. Generally, preferred share is considered similar to ordinary ( common ) equity share because they
do not have maturity and similar to debt in that both securities have fixed payments, dividends for
preferred share and inter for debt.
Preferred share valuation is relatively simple if the firm pays fixed dividends at the end of each year. If
this condition holds, then the stream of dividend payments can be treated in perpetuity and be discounted
by the investor’s required rate of return on a preferred share issue. A perpetuity is na annuity with an
infinite life span. If the preferred share has high risk, investors normally require a higher rate of return.
This is because creditors have priority over preferred shareholders in their claims to both income and
assets.

Thus, the intrinsic value of a share of preferred share (Po) is the sum of the present values of future
dividends discounted at the investor’s required rate of return. This also can be determined using the
following valuation model

Po= Dp___
Kp

Where: Dp = Per share cash dividend

Kp = Investor’s required rate of return on preferred share

For Example: Federal Electric and Power Company has an issue of preferred share outstanding that pays
a yearly dividend of P10.80. Investors require a 12% return on this preferred share.

Determined the intrinsic value of the preferred value.

Solution:

Po = P10.80 = P90
12%
In the Philippines, the following preferred shares are actively traded in the Philippine Stock Exchange.

First Philippine Holdings – Preferred

San Miguel Purefoods – Preferred
Petron Corporation Perpetual – Preferred
Swift Foods, Inc – Convertible Preferred