Module 2

Sources of
Funds
 Framework
A. Intro to • Funds flow in the economy
financial • Money Markets
• Capital Markets
markets

• Types of business loans

B. Business • The loan process
Loans • The 6C’s of Credit

C. Time • Cash Flow notations

• Simple Interest
Value of • Compound Interest
Money • Present and Future Value
 Framework
A. Intro to • Funds flow in the economy
financial • Money Markets
• Capital Markets
markets

• Types of business loans

B. Business • The loan process
Loans • The 6C’s of Credit

C. Time • Cash Flow notations

• Simple Interest
Value of • Compound Interest
Money • Present and Future Value
 What is an
investment?
 An asset or property right acquired for profit
 Risks:

Liquidity Risk
Market Risk
Inflation Risk
Credit Risk
 General investment
classes
 Savings deposits
 Time deposits
 Life insurance policies
 Bonds
 Money market placements
 Houses, apartments and building ownership
 Land ownership
 Business ownership
 Education and training
 Foreign exchange investments
 Precious tangibles
 Financial
markets
 What is a financial market?
 Offers and sales occur in two distinct ways
 Primary market
 Secondary market
 Financial institutions such as banks act as
intermediaries
 Financial Markets
Money Capital Forex Derivatives
Market Market Market Market
•Tbills •Debt •Spot •Options
•Tnotes •Equity •Forward •Swaps
•CPs •Futures
•BAs •Structured
Products

Money Market vs. Capital Market

•Short-term
•Government bonds
•Large denominations
•Institutional investors
 Money market instruments
-Government raises money by selling notes to the public
Treasury Bills -Investors buy the bills at a discount from the stated maturity
and notes value. At maturity, the investor will get the face value.
- Notes: longer-term and may give periodic interest

- A time deposit
Certificates - May not be withdrawn on demand
of deposit - The bank pays interest and principal at maturity
- Usually insured by government insurance (PDIC)

- Large, well-known companies may issue debt instead of

Commercial borrowing from banks
papers - Usually pays interest and gives back the principal upon
maturity
- Starts with an order to a bank by a bank’s customer to pay a sum of
money at a future date (similar to post-dated check)
Banker’s -When the bank endorses the order for payment as “accepted,” it
assumes responsibility for ultimate payment to the holder of the
acceptance acceptance.
- The acceptance may be traded in secondary markets like any other
claim on the bank.
 Money market instruments

-The dealer sells government securities to an investor on an

overnight basis, with an agreement to buy back those
securities the next day at a slightly higher price.
Repos -The increase in the price is the overnight interest.
-The dealer thus takes out a one-day loan from the investor,
and the securities serve as collateral.
-Reverse repo: mirror image of a repo

- Mechanism used by banks to adjust their daily reserve

Demand loans positions
-Interbank borrowing and lending

Term loans -Loans to banks for a definite period of time

 Types of transactions
Repurchase agreement
Straight sale

- Direct sale to an investor up to - Repurchase (RP) – the

maturity date commercial bank sells to the
central bank using securities as
Ex: A dealer bought a Meralco CP collateral.
on Jan 1 2008 to mature on May 31
2008 with a 15% interest p.a. - Reverse repurchase (RRP) –
Supposing on April 6, a client went the commercial bank lends to the
to the dealer and said he has central bank and the central bank
excess funds up to May 31 (45 gives securities as collateral.
days). The dealer sold the note to
the client at 13% p.a. On the
maturity date, the client received
the principal plus the
corresponding interest. The bank
earned 2% on the transaction.
Capital market instruments
 Features of good
investments

1. Safety of the value of the investment

2. Saleable investments
3. Stability of income
4. Taxes
 Framework
A. Intro to • Funds flow in the economy
financial • Money Markets
• Capital Markets
markets

• Types of business loans

B. Business • The loan process
Loans • The 6C’s of Credit

C. Time • Cash Flow notations

• Simple Interest
Value of • Compound Interest
Money • Present and Future Value
 How are loans made?

Find prospective Evaluate financial

loan customers condition

Evaluate character Assess possible loan

and sincerity of collateral and sign the
purpose loan agreement

Make site visits and Monitor compliance

with loan agreement
evaluate credit and other customer
record service needs
 What makes a good loan?

1 Is the borrower creditworthy?

Can the loan agreement be

2 properly structured and
documented?

Can the lender perfect its

3 claim against the assets or
earnings of the customer?
 1 Is the borrower creditworthy?

6 C’s of Lending
• Well-defined purpose for requesting
CHARACTER credit
• serious intention to repay

• Authority to request the

CAPACITY loan
• Minors, corporations

• Ability to generate enough

CASH cash to repay the loan
 1 Is the borrower creditworthy?

6 C’s of Lending
• Does the borrower have
adequate net worth or own
COLLATERAL enough quality assets to support
the loan?

• Recent trends in borrower’s line of

CONDITIONS industry

• Changes in law and regulation could

adversely affect the borrower
CONTROL • Loan request meets the lenders and
regulatory authorities standard for
loan quality
 Can the loan agreement be properl
2 structured and documented?

 Loan agreement must meet borrower’s

needs for funds with a comfortable
repayment schedule
 Lend less or more money over a longer or
shorter period than requested
 Must protect the lender and those the lender
represents
 Process of recovering lender’s funds must
be carefully spelled out in a loan agreement
 Can the lender perfect its claim against th
3 assets or earnings of the customer?

Reasons for taking collateral

 If the borrower cannot pay, the pledge fo
collateral gives the lender the right to seize
and sell those assets designated as loan
collateral, using the proceeds of the sale to
cover what the borrower didn’t pay back.
 Gives physical advantage over the borrower
(borrower feels more obliged to repay the
loan)
 Can the lender perfect its claim against th
3 assets or earnings of the customer?

Common types of Personal guarantees and pledges

collateral made by the business owners
 Accounts receivables Resources on customer’s B/S
 Factoring Expected profit, income
 Inventory Amount owned
= Loan P+I –
 Real property deposits
 Personal property or cash flow
 Personal guarantees and collateral pledged

or consignors of the loan

Safety zones surrounding loaned

funds

Short-Term Loans
 Self-liquidating inventory
loans
 Working capital loans
 Interim construction
financing
 Security dealer financing
 Retailer and equipment
financing
 Asset-based loans (AR
financing, factoring and
inventory financing)
 Syndicated loans
Types of business
loans
Long-Term Loans
 Term loans to support
the purchase of
equipment, rolling
stock and structures
 Revolving credit
financing
 Project loans
 Loans to support
acquisitions of other
business firms
 What do banks look for in FS?

 Historical analysis
 What are the trends in costs and profit?
 Financial ratio analysis
 Ability to control expenses
 Operating efficiency in using resources to generate
sales
 Marketability of product line
 Coverage that earnings provide over financing costs
 Liquidity position, indicating availability of ready cash
 Track record of profitability
 Financial leverage
 Contingent liabilities
 Comparison with industry performance
 The 4 basic
questions
1. How liquid is the firm?
2. Is management generating adequate
operating profits on the firm’s assets?
3. How is the firm financing its assets?
4. Are the owners (stockholders)
receiving an adequate return on their
investment?
 Framework
A. Intro to • Funds flow in the economy
financial • Money Markets
• Capital Markets
markets

• Types of business loans

B. Business • The loan process
Loans • The 6C’s of Credit

C. Time • Cash Flow notations

• Simple Interest
Value of • Compound Interest
Money • Present and Future Value
 What is the time value of
money?
 A dollar today is worth more than a
dollar in the future.
 WHY?
 Because a dollar can be invested today
and earn interest for the future
 Because a dollar today can be eroded by
inflation
 TVM = Opportunity cost
 Simple Interest
 Suppose you place $100 in a savings
account that pays 6% interest per year. How
much interest will you get at the end of 1
year? How much total money will you get at
the end of 1 year? At the end of 5 years?

Formula Toolbox:
Interest Payment = Principal x Rate x Time
Time = actual no of days /360 days
 Compound
Interest
 Suppose you place $100 in a savings
account that pays 6% interest per year. How
much interest will you get at the end of 1
year? How much total money will you get at
the end of 1 year? At the end of 5 years?

Formula Toolbox:
Future Value (FV) = PV*(1+i)n
Present Value (PV) = FV*(1+i)-n
 Present Value and Future Value
 If we place $1,000 in a savings account paying 5% interest
compounded annually, how much will our account accrue
in 10 years?

 If we invest $500 in a bank where it will earn 8%

compounded annually, how much will it be worth at the end
of 7 years?

 How many years will it take for your initial investment of

$7,753 to grow to $20,000 if it is invested at 9%
compounded annually?

 If you like to buy a new laptop that will cost P20,000 10

years from now, at what rate should you invest your
savings of P11,167?
 Question
 Fred Moreno has found an institution that
will pay him 8% p.a. interest compounded
quarterly on a P10,000 deposit. If he leaves
his money in this account for 24 months,
how much will money will he have at the end
of 1 year? At the end of 2 years?
 How much will he have at the end of 2 years
if the interest rate is 8% p.a. compounded
semi-annually? Compounded monthly?
 Making interest rates comparable

 Future Value (FV) = PV*(1+i/m)n*m

 m = number of times per year that the interest is
compounded
 N = number of years
 Effective annual rate for compounding:
(1+i/m)m - 1
 Continuous compounding: PV x ei*n
 Exercise
 Joseph is a friend of yours. He has plenty of
money but little financial sense. He received a gift
of 12,000 for his recent graduation band is looking
for a bank in which to deposit the funds. BPI is
offering an account with an annual interest rate
compounded 2.85% semi-annually, while PSbank
offers an account with a 2.75% annual interest
compounded monthly. Calculate the value of the
two accounts at the end of one year and
recommend to Joseph which account he should
choose.
 Annuities
 Annuities are equal amounts of payments occurring
for a consecutive time periods (amortization
payments)

Formula Toolbox:

FV 

A (1  i)  1
n
  (1  i)  1
PV  A
n

n 
i  i(1  i) 

 What is the present value of a 10 year $1,000

annuity discounted back to the present at 5%?
 Perpetuities
 A perpetuity is an annuity that continues forever;
that is, for every year from its establishment it
pays the same dollar amount.
 Example: preferred stock that yields a constant
dollar dividend indefinitely

Formula Toolbox:
Where:
PP = constant dollar amount provided by the
PP
PV perpetuity 
perpetuity
i = annual interest or discount rate
i
 Exercise
1. (Comprehensive present value) You are trying to plan for
retirement in 10 years and currently you have $100,000 in
savings account and $300,000 in stocks. In addition, you
plan to add to your savings by depositing $10,000 per year in
your savings account at the end of each of the next five years
and then $20,000 per year at the end of each year for the
final five years until retirement.
a. Assuming your savings account returns 7%
compounded annually and your investment in stocks
will return 12% compounded annually, how much will
you have at the end of 10 years? Ignore taxes.
b. If you expect to live for 20 years after you retire, and at
retirement you deposit all of your savings in a bank
account paying 10%, how much can you withdraw each
year after retirement (20 equal withdrawals beginning
one year after you retire) to end up with a zero balance
at death?
2. How many years would it take for your investment to grow
fourfold if it were invested at 16% compounded semi-
annually?
 Exercise
1. (Comprehensive present value) You found the
woman of your dreams and she agreed to marry
you in 5 years. You currently have Php 150,000
in savings and P15,000 in stocks. You have
deposited your savings in a TD yielding 6.5%
semi-annually, while the expected rate of return
of your stock is 9.75%. To save for the wedding,
you vowed to deposit Php 50,000 per year for
the next five years at a bank deposit yielding
5.25%.
a. How much money can you spend in your
wedding?
b. If your wedding planner told you that the cost
of your dream wedding is php 875,000, how
much should you save each year (in a
deposit yielding 5.25%) to be able to afford