Citibank: basic of corporate finance
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ANSWER KEY
14. What percent of Fruit Packing, Inc.'s capital structure is provided by debt?
d) 57.38%
Debt Ratio = (Total Debt) / (Total Assets)
= ($45.1 + $45.1) / ($157.2)
= 57.38%
Include Current Liabilities and Long-term Debt for Total Debt
15. What percentage of each dollar from SALES is available for common shareholders?
b) 9.69%
Profit Margin = (Net Income to Common) / (Sales)
= ($14.6) / ($150.6)
= 9.69%
16. If Fruit Packing, Inc.'s stock price is $15.24 per share and there are 6.5 million shares
outstanding, how much are investors willing to pay for every dollar of reported
profits?
d) 6.78 times
Price / Earnings = (Market price per share) / (Earnings per share)
First we calculate the Earnings per share:
Earnings / Share = (Net Income to Common) / (Number of shares)
= ($14.6) / (6.5 shares)
= $2.2462 per share
Now we can calculate the Price / Earnings Ratio:
Price / Earnings = ($15.24 per share) / ($2.2462 per share)
= 6.78 times
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Unit 2
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UNIT 2: FINANCIAL MARKETS AND INTEREST RATES
INTRODUCTION
In Unit One, we introduced the basic financial operations and general financial structure of
a company. In that context, we discussed the two types of capital that a company can access
for its operations: debt and equity. We will now focus our discussion on the sources of
capital and the process for calculating its value. In this unit, we look at the types of
financial markets and the market participants. We introduce the factors that make up a
quoted interest rate and the characteristics that affect the level of interest rates over time.
UNIT OBJECTIVES
When you complete this unit, you will be able to:
• Recognize the types of participants in the financial markets
• Differentiate between money markets and capital markets
• Differentiate between bond (debt) markets and equity markets
• Identify the factors that influence interest rates
• Understand the term structure of interest rates
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OVERVIEW OF FINANCIAL MARKETS
Market Players
Investors /
lenders and
issuers /
borrowers
As you know, a market is where buyers and sellers meet to exchange
goods, services, money, or anything of value. In a financial market,
the buyers are investors, or lenders: the sellers are issuers, or
borrowers. An investor / lender is an individual, company, government,
or any entity that owns more funds than it can use.
An issuer / borrower is an entity that has a need for capital. Each
investor and issuer is active in a market that meets its needs. Needs
are based on many factors, including a time horizon (short- or long-
term), a cost / return preference, and type of capital (debt or equity).
Brokers and
dealers
The third group of participants in the marketplace includes financial
intermediaries called brokers and dealers. Brokers facilitate the
buying and selling process by matching investors and issuers
according to their needs. Dealers purchase securities from issuers and
sell them to investors. Brokers and dealers may be referred to as
investment bankers. Investment banking firms specialize in the
financial markets.
Security is debt
or equity IOU
Security is a generic term that refers to a debt or equity IOU issued by
a borrower or issuer.
• Debt security or bond – an IOU promising periodic payments
of interest and/or principal from a claim on the issuer's
earnings
• Equity or stock – an IOU promising a share in the ownership
and profits of the issuer
Types of Financial Markets
There are two general classifications of financial markets:
• Money markets
• Capital markets
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Money Markets
Short-term,
liquid securities
Money markets trade short-term, marketable, liquid, low-risk
debt securities. These securities are often called "cash equivalents"
because of their safety and liquidity. The liquidity of a market refers to
the ease with which an investor can sell securities and receive cash. A
market with many active investors and few ownership regulations
usually is a liquid market; a market with relatively few investors, only a
few securities, and many regulations concerning security ownership is
probably less liquid.
Capital Markets
Long-term,
higher risk
securities
Capital markets trade in longer-term, more risky securities. There
are three general subsets of capital markets: bond (or debt) markets,
equity markets, and derivative markets. In this course, we will discuss
debt markets and equity markets in some detail, and we will briefly
introduce the derivative markets.
Bond (debt)
markets
Example
Debt markets specialize in the buying and selling of debt securities. To
illustrate how debt markets look, we will analyze a short example.
Suppose that HT Manufacturing Company needs new equipment for its
operations. Most companies try to match assets and liabilities
according to maturity (time left before the item is no longer useful).
The company expects the new equipment to have a useful life of about
10 years and, therefore, after consulting with its financial advisors, HT
Manufacturing decides to issue 10-year bonds to pay
for the equipment. HT Manufacturing consults with investment bankers
to find out what types of bonds investors are buying and to decide what
interest rate the bonds will pay. The object is to make them attractive
to investors, yet cost-efficient for HT Manufacturing.
After completing all of the details, HT Manufacturing issues the
bonds to investors using two methods.
1) The investment banks use their brokers to find buyers for the
bonds, and HT Manufacturing sells the bonds directly to the
investors.
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2) The investment banks also act as dealers by buying some of the
bonds themselves, then selling them to investors.
Primary and
secondary
markets
The original issue of bonds (or bills, or any other debt security) is
called the primary market issue. A secondary market also exists
where debt securities are bought and sold by investors. For example,
suppose an investor who bought HT Manufacturing bonds one year ago
has a change in investment plans and no longer needs 10-year bonds.
S/he can sell the bonds in the secondary market (usually with the
assistance of a broker) to another investor who wants 10-year bonds.
Because this transaction has no effect on HT Manufacturing's finances
or operations, it is considered a secondary market transaction.
Equity markets
Equity markets, also called stock markets, specialize in the buying and
selling of equity securities (stocks) of companies. As in the debt
markets, the equity markets have a primary and secondary market.
The primary market is where companies originally issue stock in their
companies, a process known as an initial public offering — or "taking
the company public." Investment bankers advise a company on the
process and can also act as brokers and dealers for new stock issues.
The secondary market is where investors buy and sell stocks at prices
that reflect the investors' collective view of the future prospects of
each individual firm.
Derivative
markets
A derivative instrument is a security that derives its value from an
underlying asset, including financial assets such as stocks and bonds
or other assets such as commodities and precious metals. Derivative
instruments include future and forward contracts and options. These
instruments are bought and sold in the market by investors needing to
hedge risk exposure.
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Swaps are also used to hedge risk, but they differ from true derivative
instruments in that they are essentially an exchange of financial
assets. For this reason, they are not really traded among investors, but
they are often included in a discussion of derivatives. We will briefly
introduce options and swaps in Unit 10. For a
more thorough discussion of these instruments and their uses, we
recommend that you refer to the specific workbook covering each
instrument.
INTEREST RATES
Price paid for
use of capital
In a free economy, capital is allocated through the price system.
An interest rate is the price paid by a borrower for the use of an
investor's capital.
Interest rates provide the vehicle for allocating capital among firms. In
a perfect free-market economy, firms with the most profitable
investment opportunities attract capital away from companies with
less inviting investment opportunities arising from problems such as
inefficiency, low demand for products, poor management, etc.
However, a perfect free-market economy doesn't exist. There are
imperfections, usually introduced by governments, that lead to the
allocation of capital to firms that do not necessarily have the most
profitable investment opportunities.
An investor purchasing a debt security, such as a bond, receives an
interest payment for the period that the borrower uses the investor's
capital. In an equity investment, return to the investor takes two forms:
dividend payments and appreciation of the investment, also called a
capital gain.
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Characteristics
affecting the
cost of money
There are two basic investor characteristics that affect interest rates,
or the cost of money:
1) The rate of return investors expect to realize on their
investment opportunities
Those who borrow money are unlikely to pay a higher rate than
the expected return on the investments they plan to make with
the borrowed money.
2) The preference of consumers (those who have money to either
save or spend) to forego current consumption in favor of future
consumption
Those who save will defer consumption if the rates of interest
offered by borrowers are attractive. High offered rates for
savings lead to higher levels of savings and lower levels of
spending.
Let's look at some of the factors that influence the level of interest
rates.
Calculating Interest Rates
Offered rate
of interest
The stated or offered rate of interest (r) reflects three factors:
• Pure rate of interest (r*)
• Premium that reflects expected inflation (IP)
• Premium for risk (RP)
Each of these factors increases the stated interest rate. The resulting
interest rate calculation is:
r = r* + IP + RP
Let's examine the significance of each of these factors.
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Pure Interest Rate
Risk-free
security in non-
inflationary
environment
The pure interest rate (r*) is the rate for a risk-free security when no
inflation is expected. This pure rate is also called the real, risk-free
rate. Most investors consider the interest rate on short-term U.S.
Treasury securities to be a close approximation for the real, risk-free
rate in a non-inflationary environment.
The pure rate constantly changes over time, depending on economic
conditions. The two most important influences on the risk-free rate
are the ones discussed above – the expected rate of return
corporations and other borrowers can earn on their productive
assets (investment opportunities) and the time preference of
consumers for current-versus-future consumption. The real, risk-free
rate is difficult to calculate, but most researchers believe that
in recent years it has fluctuated between 2% and 4%.
Inflation
Erodes
purchasing
power over time
Inflation has a great influence on interest rates because it erodes
the purchasing power of money over time. Investors build in an
inflation premium to compensate for this loss of value. For example,
if the real, risk-free rate is 3%, and 8% inflation is expected for the
next year, the risk-free interest rate on one year U.S. Treasury bills is
11%.
r
T-Bill
= r* + IP
= 3% + 8%
= 11%
Note: The 8% inflation rate is the expected future rate, not the past
inflation rate. It is also important to know that, for longer time
periods, the inflation premium is the expected average rate over that
period. For example, the inflation premium for a ten year security
would be the expected average annual inflation for the next ten years.
As with the risk-free rate, the inflation premium is not constant; it is
always changing based on investors' expectations of the future level of
inflation.
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