Topic: Financial markets

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  • 20 Marks

FM – MAY 2017 – L2 – Q1 – Financial markets

Discuss value for money concepts and compare them with corporate value maximization, and explain various financial markets.

a) Bhim is a not-for-profit non-governmental organization aimed at supporting alleged witches to have an empowered livelihood. The organization is developing a proposal to the Ministry of Gender and Social Protection to secure funding to improve basic healthcare and sanitation at three alleged witches’ camps. They have consulted you to help them develop the section on value for money (VfM) in their proposal.

Required: i) Briefly explain the following value for money concepts:

  • Economy
  • Efficiency
  • Effectiveness
    (6 marks)

ii) Compare and contrast value for money and corporate value maximization.
(4 marks)

b) One of the important sustainability requisites for the accelerated development of an economy is the existence of a dynamic financial market. Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others, like the New York Stock Exchange (NYSE) and the forex markets, trade trillions of dollars daily.

Required:
What is a financial market?
(1 mark)

c) Explain the difference between the following financial markets:
i) Debt market and Equity market.
(3 marks)
ii) Money market and Capital market
(3 marks)
iii) Forex market and Interbank market
(3 marks)

a) i) Value for Money Concepts

  • Economy: This measures the acquisition of inputs at the highest quality, at the lowest cost, and within an acceptable time for achieving a given output.
  • Efficiency: This measures the amount of resources used to achieve a given output and considers the proficiency and appropriateness of the process used for converting inputs into outputs.
  • Effectiveness: This measures the extent to which stated objectives are achieved and to what degree the outputs meet the desired outcomes.

ii) Comparison between Value for Money (VfM) and Corporate Value Maximization

Similarities:

  • Both are corporate objectives used to measure the performance of managers.
  • Both ensure resources are utilized efficiently to yield the best results.
  • Achieving VfM and corporate value maximization has a positive social impact.

Differences:

  • VfM is an objective for not-for-profit entities, while value maximization is emphasized in profit-making entities.
  • VfM considers social welfare at large, whereas value maximization focuses on the interests of shareholders.
  • VfM may sacrifice economic benefit for overall social good, especially for vulnerable groups, but value maximization focuses on economic returns to the owners for every resource utilized.

b) Financial Market: A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies, and derivatives. Financial markets are typically defined by transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade.

c) Differences between Financial Markets

i) Debt Market vs. Equity Market:

  • Debt Market: Involves the trade of bonds and other forms of debt, where investors loan money to an entity (corporate or governmental) for a fixed period at a fixed interest rate.
  • Equity Market: Involves the buying and selling of shares in publicly traded companies, providing companies with access to capital and investors with ownership stakes and potential profits.

ii) Money Market vs. Capital Market:

  • Money Market: Deals in short-term borrowing and lending, typically for periods from several days to just under a year, involving high liquidity instruments like CDs, banker’s acceptances, and treasury bills.
  • Capital Market: Involves the trading of long-term securities such as stocks and bonds, used by companies and governments to raise long-term funds for investment.

iii) Forex Market vs. Interbank Market:

  • Forex Market: The largest market in the world, where currencies are traded globally, involving a wide range of participants including banks, firms, governments, and individuals.
  • Interbank Market: A subset of the forex market where banks and financial institutions trade currencies among themselves, often on behalf of large customers or for their own accounts.
  • 15 Marks

FM – March 2023 – L2 – Q3c – Financial markets

Identify and distinguish between bear and bull markets, and recommend investment strategies for a bull market.

Recently, the major stock indexes like the S&P 500 and DJIA declined in value continuously during the first quarter of 2021 when most economies were battling the devastating effects of the COVID-19 pandemic. A similar situation happened between 2007 and 2009 when the global credit crunch occurred.

Required:
i) State the type of market condition (i.e., a bear or a bull) described in the above preamble. (1 mark)
ii) Distinguish between a bear market and a bull market. (5 marks)
iii) Recommend to a portfolio investor TWO (2) investment strategies that can be employed to take advantage of a bull market. (4 marks)

i) Market Condition:

The market condition described in the preamble is a bear market.
(1 mark)

ii) Distinction between a Bear Market and a Bull Market:

  • Bear Market:
    A bear market refers to a financial market condition where prices of securities are falling or are expected to fall. It is typically characterized by a decline of 20% or more in major stock indexes like the S&P 500 or DJIA over a sustained period. In a bear market, investor sentiment is pessimistic, and there is widespread fear and uncertainty about the future performance of the market.
  • Bull Market:
    A bull market, on the other hand, is a financial market condition where prices of securities are rising or are expected to rise for an extended period. A bull market is characterized by optimism, investor confidence, and expectations that strong performance will continue for a prolonged period. Investors are generally more willing to buy into the market, expecting higher returns.

The principal difference between the two market conditions is that in a bear market, prices are falling, while in a bull market, prices are rising.
(5 marks)

iii) Investment Strategies for a Bull Market:

  1. Buy and Hold Strategy:
    In a bull market, investors can buy securities and hold them for an extended period, expecting that prices will continue to rise. This strategy takes advantage of the general upward trend in the market.
  2. Increased Buy and Hold:
    Investors can increase their investment in securities they believe will perform well as the bull market continues. This involves buying more of the securities that have already shown an upward trend, expecting further gains.
  3. Short Selling:
    Although short selling is more commonly associated with bear markets, in a bull market, an investor can identify overvalued stocks, sell them at a high price, and repurchase them when the price eventually dips, taking advantage of corrections within the overall upward trend.

(Any 2 strategies @ 2 marks each = 4 marks)

  • 20 Marks

FM – NOV 2021 – L2 – Q4 – Financial markets

Explanation of capital investment decisions, NPV calculation for a new project, and differentiation between money and capital markets.

a) Companies spend money in various ways through their annual budgets, which are usually planned. These spending cover both operational and investment-related decisions.

Required:
i) What are Capital Investment decisions? (2 marks)
ii) State THREE (3) areas that will be considered as capital investment spending or decision. (3 marks)

b) Mamaga Ltd manufactures household utensils in Ghana and is considering investing in a new aluminium smelting and moulding plant. This plant will have a useful life of 5 years but will cost GH¢400,000 to acquire and install, with a residual value of GH¢20,000. The plant will produce 100,000 units per year. Other estimates are given below:

  • Selling price: GH¢30 per unit
  • Direct cost: GH¢20 per unit
  • Fixed cost (including depreciation): GH¢160,000 per annum
  • Marketing and promotion cost: GH¢20,000 (Year 1) and GH¢32,000 (Year 2)
  • Investment in debtors and stocks will increase in Year 1 by GH¢30,000 and GH¢40,000, respectively
  • Creditors will also increase by GH¢20,000 in Year 1
  • Debt, stocks, and creditors will be recouped at the end of the machine’s life
  • The cost of capital is 18%
  • Corporate tax is 25% and is paid in the year in which profits are made
  • Depreciation is tax-deductible

Required:
Compute the Net Present Value of this project and advise Mamaga Ltd whether the plant should be acquired. (10 marks)

c) Financial markets provide platforms or mediums through which holders of surplus funds invest their funds. Those with financial deficits could raise funds or capital, enabling both parties to achieve their objectives.

Required:
Distinguish between money markets and capital markets giving an example of financial instruments traded in each type of market. (5 marks)

a)
i) Capital investment decisions involve the deployment of resources, both financial and non-financial, with the expectation of receiving larger sums of money or monetary rewards in the future. The initial financial outlay is significant, and the benefits accrue over several years.
(2 marks)

ii) The following are typical areas of capital investment decisions:

  • Replacement of Equipment or Assets decision
  • Expansion of company activities in the form of new products, branch networks, etc.
  • Undertaking research and development
  • Introduction of new products
  • Purchase of new machinery or equipment
  • Discontinuation of products or closure of units or subsidiaries
    (Any 3 points @ 1 mark each = 3 marks)

b) NPV of Plant (Amounts in GH¢):

Year 0 1 2 3 4 5
Sales 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000
Less: Direct Cost (2,000,000) (2,000,000) (2,000,000) (2,000,000) (2,000,000)
Contribution 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Less: Fixed Cost (84,000) (84,000) (84,000) (84,000) (84,000)
Less: Promotion (20,000) (32,000)
Less: Depreciation (76,000) (76,000) (76,000) (76,000) (76,000)
Net Profit 820,000 808,000 840,000 840,000 840,000
Add: Scrap Value 20,000
Taxable Income 820,000 808,000 840,000 840,000 860,000
Tax @ 25% (205,000) (202,000) (210,000) (210,000) (215,000)
PAT 615,000 606,000 630,000 630,000 645,000
Add: Depreciation 76,000 76,000 76,000 76,000 76,000
Working Capital (400,000) (50,000) 50,000
Net Cash Flow (400,000) 641,000 682,000 706,000 706,000 771,000
DF @ 18% 1 0.847 0.718 0.609 0.516 0.437
Present Value (400,000) 542,927 489,676 429,954 364,296 336,927

NPV = (400,000) + 2,163,780 = GH¢1,763,780

c) Money Markets vs. Capital Markets:

  • Money Markets: Short-term instruments are traded, typically with a tenor within one year. Examples include Treasury bills, commercial papers, certificates of deposit, and overnight deposits.
  • Capital Markets: Long-term securities are traded, with a tenor beyond one year. Examples include government bonds, corporate bonds, and stocks.
  • 8 Marks

FM – MAY 2019 – L2 – Q1b – Financial markets

Explain the different short-term money market instruments such as Bankers’ acceptance, Commercial Paper, Repurchase Agreement, and Term deposit.

Question:
The money market is the arena in which financial institutions make available to a broad range of borrowers and investors the opportunity to buy and sell various forms of short-term securities. The short-term debts and securities sold on the money markets, known as money market instruments, have maturities ranging from one day to one year and are extremely liquid.

Required: Explain the following short-term market instruments:

  1. Bankers’ acceptance (2 marks)
  2. Commercial Paper (2 marks)
  3. Repurchase Agreement (Repo) (2 marks)
  4. Term deposit (2 marks)

(Total: 8 marks)

i) Bankers’ Acceptances
A banker’s acceptance is an instruments produced by a nonfinancial corporation
but in the name of a bank. It is document indicating that such-and-such bank shall
pay the face amount of the instrument at some future time. The bank accepts this
instrument, in effect acting as a guarantor. To be sure the bank does so because it
considers the writer to be credit-worthy. Bankers’ acceptances are generally used
to finance foreign trade, although they also arise when companies purchase goods
on credit or need to finance inventory. The maturity of acceptances ranges from
one to six months.

ii) Commercial Paper
Commercial paper refers to unsecured short-term promissory notes issued by
financial and nonfinancial corporations. Commercial paper has maturities of up to
270 days (the maximum allowed without SEC registration requirement). Dollar
volume for commercial paper exceeds the amount of any money market
instrument other than T-bills. It is typically issued by large, credit-worthy
corporations with unused lines of bank credit and therefore carries low default
risk.
Unlike some other types of money-market instruments, in which banks act as
intermediaries between buyers and sellers, commercial paper is issued directly by
well-established companies, as well as by financial institutions. Banks may act as
agents in the transaction, but they assume no principal position and are in no way
obligated with respect to repayment of the commercial paper. Companies may also
sell commercial paper through dealers who charge a fee and arrange for the
transfer of the funds from the lender to the borrower.

iii) Repos-Repurchase Agreements
Repurchase agreements—also known as repos or buybacks—are Treasury
securities that are purchased from a dealer with the agreement that they will be
sold back at a future date for a higher price. These agreements are the most liquid
of all money market investments, ranging from 24 hours to several months. In fact,
they are very similar to bank deposit accounts, and many corporations arrange for
their banks to transfer excess cash to such funds automatically.

iv) Term deposit
A term deposit is a cash investment held at a financial institution. Your money is
invested for an agreed rate of interest over a fixed amount of time, or term. Term
deposits can be invested into a bank, building society or credit union. When the
money is deposited, the customer understands that the money is there for the predetermined period which usually ranges from 1 month to 5 years and the interest
rate is guaranteed not to change for that nominated period of time. Typically, the
money can only be withdrawn at the end of the period – or earlier with a penalty
attached.
Term deposits are popular with investors who prefer capital security and a set
return as opposed to the fluctuations of, say, the share market. Many investors also
use term deposits as a part of their investment mix.

(4 points well explained @ 2 marks each = 8 marks)

  • 3 Marks

FM – NOV 2015 – L2 – Q4c – Financial markets

State key assumptions of the Random Walk Theory in financial markets.

State TWO (2) key assumptions of the Random Walk Theory. (3 marks)

Random walk theory;
The random walk theory is based on the fact that share prices will reflect every available
information such that prices will alter when new information becomes available. The
assumptions include the following:

  • All information about a company is available to all potential shareholders;
  • The intrinsic value of shares will change to reflect new information available;
  • All investors will act rationally;
  • There will be no insider dealings.
    (1.5mark for each point up to a maximum of 3 marks)
  • 4 Marks

FM – NOV 2015 – L2 – Q1d – Financial markets

Explain the concepts of financial intermediation and financial disintermediation.

Explain the following terms:
i. Financial intermediation (2 marks)
ii. Financial disintermediation (2 marks)

i. Financial Intermediation:
Financial intermediation involves financial institutions such as banks and insurance companies that mobilize funds from savers and lend them to borrowers, facilitating the flow of funds in the economy. (2 marks)

ii. Financial Disintermediation:
Financial disintermediation occurs when borrowers bypass financial intermediaries and directly access the capital markets for funding, often through the issuance of bonds or equity, thus eliminating the traditional role of intermediaries. (2 marks)

  • 6 Marks

FM – NOV 2015 – L2 – Q1c – Financial markets

Discuss government revenue mobilization policies and explain financial intermediation and disintermediation.

The quarterly report of the treasury unit of Buruwa Limited contains a paragraph on government policy targets and progress towards achievement of the targets. The Technical Director has expressed disagreement about the time spent discussing these policies as wasteful because the policies have no relevance to the business activities of the confectionery company.

Required:
As Head of Finance, you have been tasked to discuss SIX (6) points on government revenue mobilization policies to agree or disagree with the Technical Director’s position. (6 marks)

  • Impact on Interest Rates: Government policies can influence interest rates, affecting borrowing costs for businesses. Higher rates might reduce investment and expansion opportunities for companies.
  • Taxation Policies: Government tax policies directly impact business profitability. Changes in tax rates or structures can alter a company’s financial performance and strategic decisions.
  • Public Spending: Increased government spending can lead to greater demand for goods and services, benefiting businesses. Conversely, austerity measures might reduce overall demand.
  • Regulatory Compliance Costs: Policies that require businesses to comply with new regulations can increase operational costs, affecting profitability.
  • Foreign Exchange Policies: Government control over exchange rates can impact the cost of imports and the competitiveness of exports, directly affecting businesses engaged in international trade.
  • Monetary Policy: The central bank’s monetary policies, including inflation control and money supply management, can influence consumer spending and overall economic stability, impacting business operations.

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