L03s Mkts FinStmt IntRates

Lecture 3: Financial Markets and Institutions, Financial Statements, Cash Flow,
and Taxes, and Interest Rates
Learning Objectives
Identify the different types of financial markets and financial
institutions and explain how these markets and institutions
enhance capital allocation
List each of the key financial statements and identify the

information they provide
Understand the difference in tax treatment for dividends and

interest expense
List the various factors that influence the interest rates
Calculate the interest rates on debt instruments
Understand the term structure of interest
Explain what the yield curve is and what determines its shape
1
AB1201:
Financial Management
Lecture 3: Financial Markets and Institutions,

Financial Statements, Cash Flow, and Taxes,
and Interest Rates
By: Chanika Charoenwong

2
Financial markets and institutions > The capital allocation process > Types of financial markets and institutions > LL1 > Financial
statements and taxes > The annual report > Income taxes > LL2 > Interest rates > Four factors affecting interest rates > Nominal/real
rates > Determinants of interest rates > LL3 > The term structure and yield curve > Macroeconomics factors > LL4 > Conclusion
Financial Markets and Institutions
The capital allocation process

Financial markets and financial
institutions
3
The Capital Allocation Process

In a well-functioning economy, capital flows
efficiently from those who supply capital to those
who demand it.
Suppliers of capital individuals and institutions with
excess funds.
These groups are saving money and looking for a rate of
return on their investment.
Demanders or users of capital individuals and
institutions who need to raise funds.
These groups are willing to pay a rate of return on the
capital they borrow.
4
How is capital transferred between

savers and borrowers?
Direct transfer
Securities
Business Dollars
Savers
Investment banks
Securities Investment Securities
Business Banks Savers

Dollars Dollars
5
How is capital transferred between

savers and borrowers?
Financial intermediaries
Business Intermediarys
Securities Securities
Financial
Business Intermediary Savers
Dollars Dollars
6
What is a Market?
A market is a venue where goods and

services are exchanged.
A financial market is a place where individuals
and organisations wanting to borrow funds
are brought together with those having a
surplus of funds.
7
Types of Financial Markets
Physical assets vs. Financial assets

Primary vs. Secondary
Public vs. Private
Please read up more on types
of markets in the textbook
8
Types of Financial Institutions

There are many types of financial institutions:
Commercial banks
Investment banks Read the textbook
Pension funds for more details
Mutual funds
Exchange traded funds (ETFs)
Hedge funds
Private equity companies
9
Lessons Learnt 1
There are three ways to transfer the capital
direct transfer, transfer through investment banks
and financial intermediaries.
Financial markets can be classified based on
different dimensions.
There are many types of financial institutions
such as commercial bank, investment bank,
mutual fund, hedge fund, insurance company,
etc.
10
Financial Statements and Taxes
Key Financial Statements

Balance Sheet
Income Statement
Brief note on taxes
Exclude Free Cash Flows (FCF), MVA and
EVA
11
The Annual Report
Balance
Sheet
Statement Statement
of Cash
Financial of
Flows Statements Stockholders
Equity
Income
Statement
12
The Annual Report
Balance sheet provides a snapshot of a

firms financial position at one point in time.
Income statement summarises a firms
revenues and expenses over a given period
of time.
13
AAA Companys Balance Sheet 31 December 2013

Current Assets Current Liabilities
Cash and equivalents Accrued wages and taxes
Accounts receivables Accounts payable
Inventory Short-term borrowings
Long-Term (Fixed Assets)

Net plant and equipment Long-Term Debt
Other long-term assets
Stockholders Equity
(Common stock + Retained
earnings) must equal Total
assets Total Liabilities
Total assets Total Liabilities and

Equity
14
Balance Sheet: Assets

2014 2013
Cash $208,323 $102,024

Accounts receivable 690,294 824,979
Inventories 942,374 715,414
Total current assets $1,840,991 $1,642,417

Gross fixed assets 317,503 226,674
Less accumulated depreciation 54,045 28,682
Net fixed assets $263,458 $197,992
Total assets $2,104,449 $1,840,409
15
Balance Sheet: Liabilities and Equity

2014 2013
Short-term borrowings $288,798 $296,149
Accounts payable 636,318 414,611
Accruals 106,748 103,362
Total current liabilities $1,031,864 $814,122
Long-term debt 410,769 372,931
Common stock (100,000 shares) 550,000 550,000
Retained earnings 111,816 103,356
Total equity $661,816 $653,356
Total liabilities and equity $2,104,449 $1,840,409
16
Income Statement
2014 2013
Sales $2,325,967 $2,220,607
Cost of goods sold 1,869,326 1,655,827
Other expenses 287,663 273,870
Total operating costs excluding
$2,156,989 $1,929,697
depreciation and amortisation
Depreciation and amortisation 26,341

25,363
EBIT Operating Income $143,615 $264,569
Interest expense 31,422 13,802
EBT $112,193 $250,767

Taxes (40%) 44,877 100,307
Net income $67,316 $150,460
17
Other Data

EPS=
2014 2013
EPS (Earnings per share) $0.67 $1.50
DPS (Dividends per share) $0.5854 $1.42
Book value per share $6.62 $6.53
CC
Stock price $15.60 $21.80
Share outstanding 100,000 100,000
Tax rate 40% 40%

BVPS=

18
Income Tax Systems
Personal Corporate tax

income tax
19
Tax Treatment of Interest and Dividends

Paid by Corporations
Interest paid tax deductible for

corporations (paid out of pre-tax income).
Dividends paid paid out of after-tax
income.
20
Taxes on Dividends and Capital Gains

Received by Investors
Recall: Double
taxation
Dividends received by investors
In the U.S., investors must pay tax on the dividends
received.
In Singapore, dividends received are not taxed.
Capital gains/losses profits/losses from the
sale of shares
In the U.S., capital gains by individuals are taxed
In Singapore, capital gains by individuals are usually not
taxed
21
Lessons Learnt 2
There are four key financial statements.
Balance sheet provides a snapshot of a firms
financial position at one point in time.
Income statement summarises a firms revenues and
expenses over a given period of time.
Interest paid is tax deductible for corporations while
dividends paid is not since they are paid out of
after-tax income.
22
Interest Rates
Determinants of Interest Rates

The Term Structure and Yield Curves
Exclude 7-6 (Pure Expectations Hypothesis)
23
Consider Two Banks
1. Bank ASuper safe

2. Bank BNot so safe
If both banks offer the same

interest rates, which one would
you deposit your money with?
24
What would Make You Want to

Deposit in Bank B?
1. Increase Bank As interest rate

2. Increase Bank Bs interest rate
3. Decrease Bank Bs interest rate
25
What Four Factors Affect the

Level of Interest Rates?
Risk Wants to be compensated for taking on extra risk!
Production opportunities
Expected inflation
Time preferences for consumption
26
Interest Rate: Time preference

for consumption
If you are very hungry and have $10
now, what would you do with it?
1. Lend to Chanika with 1% interest for a

month!
2. Buy a very nice meal!
27
Interest Rate: Time preference for

consumption
If you are not hungry and have $10

now, what would you do with it?
1. Lend to Chanika @ 1% interest for a month

2. Buy a very nice meal!
Time preference for consumption: If savers
are willing to defer consumption and save
for future consumption, interest rates will be
relatively lower
28
Nominal vs. Real rates

r* = represents the real risk-free rate of interest
interest rate on risk-free borrowing when
there is zero expected inflation
r = represents any nominal rate
rRF = represents the rate of interest on
Treasury securities
Borrowings by U.S. government

Considered default-free and very liquid
29

r = r* + IP + DRP + LP + MRP
r, required return on a debt security

nominal interest rate
r*, real risk-free rate of interest
IP, inflation premium
Average expected inflation over life of debt
security
30
r = r* + IP + DRP + LP + MRP
DRP, default risk premium

compensation for possible default
LP, liquidity premium

compensation for possible difficulty selling
debt security quickly at fair market value
31
r= r* + IP + DRP + LP + MRP
MRP, maturity risk premium

Compensation for possible loss in
value due to increase in interest rates
over maturity of debt security
Affects longer term security more
than shorter term
32
Premiums Added to r* for Different Types

of Debt
IP MRP DRP LP
S-T Treasury
L-T Treasury
S-T Corporate
L-T Corporate
33
Lessons Learnt 3
The level of interest rates is affected by risk,

production opportunities, time preference of
consumption and expected inflation rates
The determinants of interest rates on debt
securities:
r= r* + IP + DRP + LP + MRP
34
Yield Curve and the Term Structure of

Interest Rates
Term structure
relationship between
interest rates (or yields)
and maturities.
The yield curve is a graph
of the term structure.
Three Treasury yield curves
are shown at the left.
Singapore yield curve
35
Constructing the Treasury Yield Curve:

Inflation
rRF, t = r* + IPt + MRPt
Step 1 Find the average expected

inflation rate over Years 1 to N:
N
INFL t
IPN t 1
N
36
Constructing the Treasury Yield Curve:

Inflation
Assume inflation is expected to be 5% next year, 6%
the following year, and 8% thereafter.
IP1 5% /1 5.00%
IP10 [5% 6% 8%(8)]/10 7.50%
IP20 [5% 6% 8%(18)]/ 20 7.75%
Must earn these IPs to break even vs. inflation; these
IPs would permit you to earn r* (before taxes).
37
Constructing the Yield Curve:

Maturity Risk
Step 2 Find the appropriate maturity risk premium

(MRP). For this example, the following equation will
be used to find a securitys appropriate maturity risk
premium.
MRPt = 0.1% (t 1)
38
Constructing the Yield Curve:

Maturity Risk
Using the given equation:
MRP1 0.1% (1 1) 0.0%

MRP10 0.1% (10 1) 0.9%
MRP20 0.1% (20 1) 1.9%
Notice that since the equation is linear, the maturity
risk premium is increasing as the time to maturity
increases, as it should be.
39
Add the IPs and MRPs to r* to Find the

Appropriate Nominal Rates
Step 3 Adding the premiums to r*.

Assume r* = 3%,
rRF,1 3% 5.0% 0.0% 8.0%

rRF , 10 3% 7.5% 0.9% 11.4%
rRF , 20 3% 7.75% 1.9% 12.65%
40
Hypothetical Yield Curve

Interest Yield curve is often
Rate (%) upward-sloping.
15 Maturity risk premium
Upward slope due to
an increase in
10 expected inflation and
Inflation premium
increasing maturity risk
premium.
5
Think: When would
Real risk-free rate yield curve slope
Years to down or have
0 Maturity hump-shape?
1 10 20
Graph yield curve was adapted from Figure 7.5 (p.232) in Essentials of Financial Management by
Brigham, Houston, Hsu, Kong, and Bany-Ariffin, 2013, Singapore: Cengage Learning.
41
Relationship Between Treasury Yield

Curve and Yield Curves for Corporate
Issues
Corporate yield curves are higher than that of
Treasury securities, though not necessarily
parallel to the Treasury curve.
DRP and LP
The spread between corporate and Treasury
yield curves widens as the corporate bond
rating decreases. Corporate bond ratings indicate the
likelihood of default by the borrower,
e.g. AAA-rated, BBB-rated. Measures
default risk.
42
Illustrating the Relationship Between

Corporate and Treasury Yield Curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%
Years to
0 Maturity
0 1 5 10 15 20
43
Macroeconomic Factors that Influence

Interest Rate Levels
Federal reserve policy (Monetary policy)

Government budget deficits or surpluses
International factors
Level of business activity
Please read the textbook for details!
44
Lessons Learnt 4
Term structure shows relationship between
interest rates (or yields) and maturities.
The yield curve is a graph of the term structure.
To construct the Treasury yield curve, the IP and
MRP are added to r*.
Corporate yield curves are higher than that of
Treasury securities due to DRP and LP
Macroeconomic factors influence interest rates
45
Where do We Stand?
Financial markets aid in the allocation of funds
Different types of institutions and markets
Balance sheet and income statements
Cost of money or an interest rate is affected by
Production opportunities, time preferences for consumption,
risk, and inflation
Interest rate = r* + IP + DRP + LP + MRP
Term structure of interest rates shows relation between
interest rates and maturity
Yield curve
46
List of Images (1 of 1)
Slide no. Title of image/Source Author/Website License/Terms of use
19 Architettoazienda Vendite Francesco_rollandin/Openclipart https://openclipart.org/ma
https://openclipart.org/detail/25084/Architetto https://openclipart.org/user- y-clipart-be-used-
%20--%20azienda%20Vendite detail/francesco_rollandin comparison
19 People Group Silhouette Clipart Panda http://www.clipartpanda.c

http://www.clipartpanda.com/clipart_images/ http://www.clipartpanda.com/ om/terms
people-group-silhouette-38654030
19 US Capitol Building Gerald_G/Openclipart https://openclipart.org/ma
https://openclipart.org/detail/7869/US%20Capit https://openclipart.org/user- y-clipart-be-used-
ol%20Building detail/Gerald_G comparison
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Lecture 3: Financial Markets and Institutions, Financial Statements, Cash Flow,

and Taxes, and Interest Rates

List each of the key financial statements and identify the

Understand the difference in tax treatment for dividends and

List the various factors that influence the interest rates

Calculate the interest rates on debt instruments

Understand the term structure of interest

Lecture 3: Financial Markets and Institutions,

By: Chanika Charoenwong

Financial Markets and Institutions

The capital allocation process

The Capital Allocation Process

How is capital transferred between

Business Banks Savers

How is capital transferred between

A market is a venue where goods and

Types of Financial Markets

Physical assets vs. Financial assets

Types of Financial Institutions

Financial Statements and Taxes

Key Financial Statements

The Annual Report

The Annual Report

Balance sheet provides a snapshot of a

AAA Companys Balance Sheet 31 December 2013

Long-Term (Fixed Assets)

Total assets Total Liabilities and

Balance Sheet: Assets

Cash $208,323 $102,024

Total current assets $1,840,991 $1,642,417

Balance Sheet: Liabilities and Equity

Depreciation and amortisation 26,341

Interest expense 31,422 13,802

EBT $112,193 $250,767

Income Tax Systems

Personal Corporate tax

Tax Treatment of Interest and Dividends

Interest paid tax deductible for

Taxes on Dividends and Capital Gains

Determinants of Interest Rates

Consider Two Banks

1. Bank ASuper safe

If both banks offer the same

What would Make You Want to

1. Increase Bank As interest rate

What Four Factors Affect the

Time preferences for consumption

Interest Rate: Time preference

1. Lend to Chanika with 1% interest for a

Interest Rate: Time preference for

If you are not hungry and have $10

1. Lend to Chanika @ 1% interest for a month

Nominal vs. Real rates

Borrowings by U.S. government

Determinants of Interest Rates

r, required return on a debt security

Determinants of Interest Rates

DRP, default risk premium

LP, liquidity premium

Determinants of Interest Rates

MRP, maturity risk premium

Premiums Added to r* for Different Types

The level of interest rates is affected by risk,