Introductory Finance - Assignment Example

Introductory Finance Student’s name Course title Instructor’ name Date of submission Question One: In your own words briefly describe and discuss the following markets and the functions and roles played by these markets in the context of a nation’s capital markets: Types of Capital Markets and their functions Equity market Broadly, equity markets give investors an opportunity to buy and sell stocks in publicly traded companies. Shares are issued by the companies and traded through security exchanges or over-the-counter markets (Kaen, 2003). Equity markets serve crucial roles in capital markets worldwide as they avail crucial funds required by companies in order to grow and also allows investors to hold portfolios in various sectors of the economy. The companies access the funds that they need in order to implement various strategies that they require in order to operate in various sectors of national economies such as Australia and across international economies. Equity markets can be divided into primary and secondary markets (Baker & Martin, 2011). The primary market enables issuance of new stocks by a company while the secondary market handles any further trading activities. Equity markets play significant roles in the development of capital markets all over the world. The security exchanges support national and international economies by offering a platform for investors to consolidate funds for investment. As the Australian equity market grow, the capital markets grow by extension leading to the growth of economy. Corporate debt market The corporate debt market involves bonds whereby an investor loans some funds to a corporation for a given period of time at a fixed interest rate. A corporation uses bonds as a tool for raising capital to undertake various projects (Kaen, 2003). The corporation issues bonds and investors buy them. In capital markets, corporate debt markets as a significant source of capital for businesses. They convey information about a company’s credit ability. A company needs to present evidence of consistency in earnings in order to offer bonds to the public for the purpose of raising funds. The corporation reserves a call option that allows them to redeem the bond before the maturity date. The corporate debt market gives some edge to capital market operations by allowing market participants make use of debt financing freely as a financing tool. Government debt market As opposed to the corporate debt market that involves corporations, government debt market involves bonds issued by the government in order to finance certain development projects within the country. The government promises to repay the debts upon the lapse of the maturity period. In the capital markets, government bonds serve as low-risk investment opportunities for various investors since they boast of the government’s backing (Kaen, 2003). As a result, the security of repayment is usually guaranteed. Notable examples of government securities include savings bonds and 90-day Treasury bills issue by the central bank. The government debt market gives some form of vibrancy to the capital markets by offering investors a more secure option to invest. The government debts complement other forms of capital market elements that work together to achieve specific goals. Foreign exchange market The foreign exchange market refers to a market that allows for the buying and selling of national currencies against one another. For example, 100 Australian dollars can be exchanged for a given number of US dollars. Bekaert and Hodrick (2009) observe that “the foreign exchange market is the largest and most perfect of all markets”. The foreign exchange markets, thus, serve critical roles that influence the operation of other capital markets in different ways. Foreign exchange markets allow for the transfer of purchasing power by facilitation conversion of an investor’s funds from one currency to another. As a result, investors can undertake various business transactions within the capital markets. The credit function of forex markets avails critical credit that is required to undertake various operations in capital markets. For example, the Australian capital markets also involve foreign exchange activities that allow for the utilisation of credit to oversee transactions. In addition to the derivatives that assist in managing risks in capital markets, foreign exchange markets serve hedging functions. As a result, capital markets take care of the foreign exchange rates risks that are caused by unforeseen changes in exchange rates. Derivatives market A derivative market makes use of contracts whose price is determined by the market price of an underlying asset (Ayadi, 2014). The derivatives market consists of forwards, futures, options and swaps. Derivatives serve crucial economic roles to ensure efficient operation of capital markets. The roles include risk management, improving market efficiency, price discovery and reduction of transaction costs (Ayadi, 2014). First, derivatives assist in risk management by finding mechanisms to equate the actual level of risk to the desired level of risk. Derivatives allows financial managers to manage risk by coming up with financial contracts that result in financial gains or losses that match gains or losses caused by fluctuations in prices. As a result, derivatives help in increasing profitability by managing the underlying risks facing an asset (Kaen, 2003). Second, derivatives allow for price discovery thus promoting dissemination of information that allows financial managers to make informed decisions (Ayadi, 2014). Specifically, futures help in conveying information about changes in price of a good. Third, derivatives shrink transactions costs in the market thanks to the risk management function they serve in capital markets allowing investors to garner low costs for their positions. Fourth, derivatives help in improving overall efficiency of capital markets by improving the liquidity in these markets (Ayadi, 2014). Liquidity means that more funds are available for investors to undertake various investments in capital markets. The benefits of derivative markets ensures that overall market efficiency prevails allowing for greater gains in capital markets. Question Two Firstly, in your own words identify and briefly explain the various funding alternatives and techniques available to a corporation. Funding alternatives and techniques available to a corporation Corporations typically boast of a number of alternatives to finance various investment projects that they may wish to undertake. As firms look as various funding alternative available to them, they first need to make a decision on whether to use internal or external funding. Managers may approximate external funding needs by subtracting cash dividend payments from their firm’s cash flow operations (Megginson & Smart, 2009). The net cash flow from operations consists of income plus depreciation along with other noncash charges. Using the figures of firm’s internal funding ability against the firm’s financing needs, the external financing requirement can be calculated. However, managers face a difficult decision as they seek a balance between the internal and external financing. The external funds drives attracts higher legal and transactions costs than by retaining internal cash flow (Baker & Martin, 2011). External funding is highly variable leaving corporations in Australia and most developed economies to rely on internal financing. Firms have access two types of financing, namely debt capital and equity capital. Debt capital involves borrowing funds while equity capital involves funds that are invested into the company by investors in exchange for ownership. Businesses utilize equity capital to start and a combination of equity capital and debt capital in order to achieve various growth targets (Baker & Martin, 2011). Moreover, debt capital can be categorised as either short-term or long-term. Short-term debts are usually paid back within a year while long-term debts are paid back over a long period of time exceeding one year. Short-term loans assist companies to cover short-term financial requirements (Megginson & Smart, 2009). For example, the loan may be used to cover for a temporary shortfall in funds required to supply extra units of raw material for a company involved in manufacturing industry. Companies can also make use of an operating line of credit as a short source of credit over cyclical periods. For example, a company requiring more inventory to meet increased demands around the summer and winter holidays. On the other hand, it is also possible to make use of long-term debt instruments such as commercial loans, mortgages, and bonds (Kaen, 2003). Most of the commercial loans are set up such that a borrower makes a constant monthly payment over the duration of the loan until the principal is paid off. Out of each payment, the company manages to pay some portion of the principal and also some portion the interest that vary from time to time. Funding strategies for long-term financing Secondly, describe and discuss in greater detail, two equity funding strategies and one debt funding strategy that may be used by a corporation to fund its long-term financing needs. Equity funding strategies Equity financing aims at mobilizing capital by a firm and involves giving a part of the company to the investors as ownership shares. Equity financing does not stipulate any direct obligations on a corporation to repay the borrowed funds (Graham, Smart & Megginson, 2012). The first strategy that can be used under equity financing is the usage of common stocks and preferred stock. Although this method of financing carries along less risks, it leads to a dilution of ownership in a company. The owners pass on some rights of control to the investors holding varying amounts of stocks. The common stockholders are entitled to vote during the company’s Annual General meeting and they must receive a notice of the meeting (Baker & Martin, 2011). In comparison to debt financing, equity financing leads to higher costs for the company. Common stock and preferred stocks offer corporations a golden opportunity to raise funds for long-term purposes. Another strategy for equity financing lies in the utilization of capital notes. In detail, capital funds refer to securities that can be converted into shares by the holders. The capital notes do not have an attached expiration date or a price at which they can be exercised (Kaen, 2003). Capital notes allows a firm to swap debtors into shareholders of the company such that the company ownership initially remains intact and later changes when debtors get shares of the company. The capital notes can be useful in funding long-term projects conveniently without the threat of disturbance of ownership and control. Debt funding strategy On the other hand, debt financing utilises a corporate bond issued by a corporation as a tool for raising money (Megginson & Smart, 2009). The bond is bought by potential investors expecting a return from their invested funds. The corporate bonds have a given maturity period at a fixed rate of interest. The corporate bonds allows companies to expand business and allow for long-term sustainability. As a result, corporate bonds act as long-term financing options available to corporations. In addition, the corporate bonds have a call option that gives issuers the freedom to redeem them before they mature. Securitization would be a potential alternative to the issue of corporate bonds by corporations. It involves creation of securities funded by some loans or receivables (Baker & Martin, 2011). It also acts as a mechanism for reducing funding costs in general and allow firms with low credit ratings to get access to funds. Two schools of strategic thought exist with regard to long-term debt financing. Aggressive funding strategy dictates that a firm needs to finance its seasonal requirements with short-term debt and its permanent requirements with long-term debt (Graham, Smart & Megginson, 2012). Long-term funds allows a firm to lock in its cost of funds over a period of time and thus avoid the risk of increases in short-term interest rates. In addition, long-term funding ensures that the requisite funds are available to the firm as the need arises. On the other hand, a conservative funding strategy would require a firm to finance both its seasonal and its permanent requirements with long-term debt (Graham, Smart & Megginson, 2012). Either way, long-term debt would not lead to a dilution of ownership as is the case with equity financing. References Top of Form Top of Form Bottom of Form Ayadi, S. (2014). Financial Markets and the Privileged Choice of the Uninformed Traders: The Role of Derivatives. British Journal Of Economics, Management & Trade, 4(9), 1393- 1418. doi:10.9734/bjemt/2014/8003 Baker, H., & Martin, G. (2011). Capital structure & corporate financing decisions. Hoboken, N.J.: John Wiley & Sons. Bekaert, G., & Hodrick, R. (2009). International financial management. Upper Saddle River, N.J.: Pearson Prentice Hall. Graham, J. R., Smart, S. B., & Megginson, W. L. (2012). Introduction to corporate finance. Australia: South-Western/Cengage Learning. Kaen, F. (2003). A blueprint for corporate governance. New York: AMACOM. Megginson, W. L., & Smart, S. B. (2009). Introduction to corporate finance. Mason, Ohio: South-Western Cengage Learning. Read More