19.2 Financial Markets, Long-Term Financing, and Valuation

Financial Markets, Long-Term Financing, and Valuation

This section covers the financial management topics on financial markets, sources of intermediate and long-term financing, basic valuation of bonds and shares, and financial forecasting with additional funds needed (AFN). Valuation questions reuse the same present-value tools as capital budgeting: the value of a security is the present value of the cash flows it promises, discounted at the investor's required return.

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1. Financial Markets and Institutions

Financial intermediaries channel savings to borrowers: universal and commercial banks, thrift and rural banks, investment houses (underwriters), insurance companies, pension funds such as the SSS and GSIS, mutual funds, and bank-managed unit investment trust funds (UITFs).

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2. Money Market Instruments

• Treasury bills: issued by the Bureau of the Treasury in 91-, 182-, and 364-day tenors and sold at a discount from face value; the investor's return is the difference between the purchase price and face value.
• Commercial paper: short-term unsecured promissory notes issued by large, creditworthy corporations.
• Repurchase agreements (repos): a sale of securities with an agreement to buy them back at a higher price, which is effectively a secured short-term loan.
• Certificates of deposit and bankers' acceptances: bank-issued or bank-guaranteed short-term instruments.

Money market instruments are highly liquid and low-risk, which makes them the usual parking place for temporary surplus cash covered under cash management.

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3. Fixed Income Instruments and Bond Valuation

Types: government securities (Treasury bills, fixed-rate Treasury bonds, Retail Treasury Bonds sold to small investors), corporate bonds, zero-coupon bonds (no periodic interest; sold at a deep discount), convertible bonds (exchangeable into common shares), callable bonds (the issuer may redeem early), and asset-backed securities.

$\text{Bond value} = \text{Coupon} \times \text{PVIFA}(k_d, n) + \text{Face value} \times \text{PVIF}(k_d, n)$

Example. A PHP 1,000,000 bond pays a 10% annual coupon and matures in 3 years. The market rate is 12%.

Value = 100,000 x 2.40183 + 1,000,000 x 0.71178 = PHP 951,963 (a discount).

Bond prices move inversely with market interest rates, and longer-maturity bonds are more sensitive to rate changes (interest rate risk). The approximate yield to maturity is [Annual interest + (Face - Price) / n] / [(Face + Price) / 2]. For the example bond bought at PHP 951,963, that gives (100,000 + 16,012) / 975,982 = about 11.9%, close to the exact 12%.

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4. Equity Instruments and Share Valuation

Types: common shares (residual claim, voting rights), preferred shares (fixed dividend with preference; may be cumulative, participating, convertible, or redeemable), and hybrid instruments such as convertible securities, warrants (long-term options to buy shares at a set price, often attached to bonds to lower the coupon), and stock rights offered to existing shareholders.

The Gordon model requires k_e > g. A share is undervalued when its computed intrinsic value exceeds its market price.

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5. Intermediate and Long-Term Financing

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6. Financial Forecasting: Additional Funds Needed (AFN)

When sales grow, spontaneous assets (cash, receivables, inventory, and fixed assets at full capacity) grow with them. Part of the growth is financed by spontaneous liabilities (payables and accruals) and retained earnings; the rest must come from external financing.

$\text{AFN} = \frac{A^*}{S_0}\Delta S - \frac{L^*}{S_0}\Delta S - M \times S_1 \times b$

where A* and L* are assets and liabilities that vary with sales, M is the profit margin, S_1 is next year's sales, and b is the retention ratio (1 - payout ratio).

Example. Sales rise from PHP 10,000,000 to PHP 12,000,000. Spontaneous assets are 60% of sales, spontaneous liabilities 15%, the profit margin is 5%, and the retention ratio is 40%.

AFN = 0.60(2,000,000) - 0.15(2,000,000) - 0.05(12,000,000)(0.40) = 1,200,000 - 300,000 - 240,000 = PHP 660,000

AFN rises with faster growth, higher capital intensity (A*/S_0), and a higher dividend payout, and it falls with a higher profit margin and more spontaneous liabilities. If the firm has excess capacity in fixed assets, only the assets actually needed are included in A*.