TWINTECH COLLEGE SARAWAK
INTRODUCTION TO FINANCE
Chapter 1: The Financial Environment: Firms, Investors & Markets
1. What is Finance?
 Finance - The processes by which money is transferred among businesses,
individuals, & government
 Financial actions are important not only to the firms involved but also to
both existing & prospective investors in the firm
 Financial decisions influence the value of the firm as reflected in its price,
which affects how much investors earn on their investments in the firm
 Field of finance also involves the conditions of the financial markets in
which firms compete for investors & financing
2. Components of financial environment
a. Financial Managers ( FM )
 A decision maker who invests funds to expand a business & obtains
funds/financing for the business
 The action taken by financial managers to make decisions for their
respective firms are referred to as Financial Management
 FM expected to make financial decisions that will maximise the value of
the firm’s stock price
 In larger firms, FM fit within the firms’ organisational structure & the
financial decisions made by or under the supervision of the Chief
Financial Officer ( CFO ), which will reports to the Chief Executive
Officer ( CEO )
 Investment decisions by FM
- Significantly affect the firm’s degree of success, because
they determine what types of businesses their respective
firms engage in
- Attempts to maintain optimal levels each type of current
asset, such as cash & inventory
- Also decides which fixed assets to invest in & when
existing fixed assets need to modified n etc.
 Financing decisions by FM
- When firms obtain funds, their financing can be classified
as either debt financing or equity financing
- Debt financing – the use of borrowed funds to finance
investments
- Debt securities – certificates representing credit provided
to the firm by the security’s purchaser
- Equity financing – the use of funds obtained in exchange
for ownership in the firm to finance investments
- Equity securities – stock; certificates representing
ownership interest in a firm
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b. Investors
 Individuals or financial institutions that provide funds to firms,
government agencies, or individuals who need funds
 Institutional investors – financial institutions that provide investment
funds
 Debt Financing Provided by Investors
- provided various forms by individual & institutional
investors
- Principal - debt has a specified maturity date at which the
amount borrowed
 Equity Financing Provided by Investors
- obtained when a firm sell shares of stock to investors
- firms’ ownership is represented by its stock – each investor
who purchases stock becomes an owner of the firm
 Return & risk from investing
- Investors’ main interest is the “earning” or “return” on
their investment in exchange for allowing a firm to use
their fund
- Return – the cash flow that would be received if an
investment were purchased at the start of a period & sold
at the end of that period/return is sometimes measured as a
percentage of the amount initially invested
c. Financial Markets
 Represents forums that facilitate the flow of funds among investors, firms,
& government units
 Act as intermediaries
 Equity market – facilitates the sale of enquiry by firms to investors or
between investors
 Debt market – enable firms to obtain debt financing from institutional &
individual investors
3. Integration of Components in the Financial Environment
 FM & investors face similar types of investments decision
 Decide what to invest in, how much to invest, & the length of the
investment period
 The investment decisions of financial managers commonly focus on real
assets; the investment decision of investors focus on financial assets
 The investment decisions made by the firms’ financial managers dictate
how much funds the firm needs to invest in its businesses
 The firms issues financial assets in order to obtain from investors
4. Investor Monitoring of Firms
 Investors attempt to make decisions that will enhance their stream of
expected future cash flows
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 To make decisions about when to buy & to sell any investment, investors
need information
 Using information to value the firm
 Investors monitor the firms in which they are invested or
plan to invest, so that they can properly “value” these firms
to determine whether to buy or sell the firms’ stock
 A firm’s stock price can change continuously throughout
the day even though new information about the firm is not
disclosed that frequently
 This is mainly because the firm’s value is influenced not
only by firm-specific information but also by external
information concerned with economic & political events
that may affect the firm’s cash flows
 How Investors Influence a Firm’s Value
 Investor trading
- investors rely on the information to forecast the future cash
flows of firms in which they invest
- if the future performance, is expected to be weak, investors
may sell their shares of the firm’s stock, which places
downward pressure on the firm’s stock price
 Shareholder Activism
- Shareholders may attempt to influence the decisions of the
firms in which they are invested, in order to align the firm’s
actions more closely with their financial interests
- It is referred to as shareholder activism
- Institutional investors held only about 10% of the total
stock in US ( 1955 ), but today, they hold more than 50%
of the total stock.
 Threat of Takeover
- If a firm’s managers do not act to maximise the value of the
firm, some investors may consider acquiring enough of the
firm’s stock to gain control of it
5. Effects of Asymmetric Information
 Investors monitor firms by reviewing the financial statements that firms
must provide to their shareholders on a periodic basis
 Rely on firm-specific information provided by various third-party
information services
 Monitoring the firm’s action can be difficult for investors, because the
amount of information provided within financial statements is limited
6. The International Finance Environment
 In response to a LOWERING of various international barriers, FM &
investors commonly pursue investment opportunities in foreign countries
 Exporting – shipping products to customers in other countries
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Importing – purchasing products from firms in other countries
Direct foreign investment – the investment of funds in production
facilities in a foreign country in which a firm has substantial sales or from
which it makes substantial purchases of materials
i.
Risks of International Business
- Firms that pursue international business opportunities are
exposed to additional forms of risk that are not normally
considered when the focus is on domestic business
- It can be exposed to exchange rate risk, depreciation &
appreciation
- Exchange rate risk – the risk that cash flows will be
adversely affected by movements in the price of one
currency in relation to another
- Depreciation – the weakening of one currency relative to
another
- Appreciation – the strengthening of one currency relative
to another
ii.
International Finance by Investors
- Firms can attempt to capitalise on foreign business
opportunities by engaging in international business
- The internet & other means of global communication are
making it easier for investors to obtain information about
firms in many other countries
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Chapter 2: Financial Institutions & Markets
Financial Institutions
 FI Serve as intermediaries by channelling the savings of individuals, businesses,
& governments into loans or investments
 FI are the major players in the financial marketplace
 Serve as the main source of funds for businesses & individuals
 Some institutions accept customers’ savings deposits & lend this money to other
customers or to firms
 Many firms rely heavily on loans from institutions for their financial support
i.
Commercial Banks
- FI that accumulate deposits from savers & provide credit to firms,
individuals, & government agencies
- They serve investors who wish to “ invest “ funds in the form of
deposits
- Use the deposited funds to provide commercial loans to firms &
personal loans to individuals & to purchase debt securities issued
by firms or government agencies
- Makes loans directly to borrowers or through the financial markets
 Sources & uses of funds at Commercial Banks
- Obtain most of their funds from investors by
accepting their deposits
- Investors mostly are individuals
- Commercial banks usually use most of their funds
either to provide loans or to purchase debt securities
- They serve as creditors, providing credit to those
borrowers who needs funds
- Provide commercial loans to firms, make personal
loans to individuals, & purchase debt securities
issued by firms or government agencies
- Term loans – funds provided by commercial banks
for a medium-term period ( 4 to 8 years )
- Line of credit – access to a specified amount of
bank funds over a period of time
 Role of Commercial Banks as Financial Intermediaries
 Repackage the deposits received from investors into
loans that are provided to firms
- Small deposits by individual investors can
be consolidate & channelled in the form of
large loans to firms
 Employ credit analysts who have the ability to
assess the creditworthiness
- Investors who deposit funds in commercial
banks are not normally capable of
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
performing this task & would prefer bank
play this role
Diversify loans across several borrowers
- bank will increase their ability to absorb
individual defaulted loans by reducing the
risk that a substantial portion of the loan
portfolio will default
- as the lenders, they accept the risk of default
Serve as financial intermediaries
- Placing the securities that are issued by the
firms
- May facilitate the flow of funds to firms by
finding investors who are willing to
purchase the debt securities issued by firms
ii. Mutual Funds
- financial institutions that sell shares to individuals, pool these
funds, & use the proceeds to invest in securities
- classified into 3 broad types:
a. money market mutual funds pool the proceeds received from
individual investors to invest in money market ( short-term )
securities
b. bond mutual funds pool the proceeds received from individual
investors to invest in the bonds
c. stock mutual funds pool the proceeds received from investors
to invest in the stocks
ii.
Securities Firms
- include investment banks, investment companies, & brokerage
firms
- they serve as intermediaries in various way
- first, they play an investment banking role by placing securities
issued by firms or government agencies
- second, securities firms serve as investment companies by creating,
marketing, & managing investment portfolios
- finally, securities firms play a brokerage role by helping investors
to purchase securities or sell securities that they previously
purchased
iii.
Insurance Companies
- FI that provide various types of insurance for their customers
- They periodically receive payments ( premium ) from their
policyholders, pool the payments, & invest the proceeds until these
funds are needed to pay off claims of policyholders
- They also invest heavily in stocks issued by firms
- This help finance corporate expansion
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iv.
Insurance tend to purchase securities in large blocks, & they
typically have a large stake in several firms
They closely monitor the performance of these firms
Pension Funds
- FI that are receive payments from employees & invest the proceeds
on their behalf
- They typically invest in debt securities issued by firms or
government agencies & in equity securities issued by firms
Overview of Financial Markets
1. Primary vs Secondary Markets
a. Primary Markets
- Debt & securities are issued by firms
- The market that facilitates the issuance of new primary
- The 1st offering of stock to the public is referred to as an Initial
Public Offering ( IPO )
b. Secondary Markets
- Any offering of stock by the firm after that is point is referred to as
secondary offering
- Once securities have been issued, they can be sold by investors to
other investors
- The market that facilitates the trading of existing securities
2. Public Offering vs Private Placement
a. Public Offering
- The nonexclusive sale of securities to the general public
- 1st & secondary markets are also public offering
- Public offering normally conducted with help of a securities firm
that provides investment banking services
- It may even be willing to underwrite the offering, which means
that it guarantees the dollar amount to be received by the issuing
firm
b. Private Placement
- the sale of new securities directly to investors, rather than to the
general public
- Advantage: it avoids fees charged by securities firm
3. Money Markets vs Capital Markets
a. Money Markets ( Pasaran Wang )
- financial markets that facilitates the flow of short-term funds
( maturities of 1 year or less )
- the securities traded in money markets are called money markets
securities
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firms commonly issue money market securities for purchase by
investors in order to obtain funds for a short period of time
firms may also consider purchasing money market securities with
cash available temporarily
investors purchase money market securities with funds that they
may soon need for other investments in the near future
b. Capital Markets ( Pasaran Modal )
- financial markets that facilitate the flow of long-term funds ( with
maturities of more than 1 year )
- the instruments that are traded in capital markets are called
securities. E.g. stock & bonds
- firms commonly issue stocks & bonds to finance their long-term
investments in corporate operations
- institutional & individual investors purchase securities with funds
that they wish to invest for a long time
Key Types of Securities
1. Key Money Market Securities
 Money market tend to have a high degree of liquidity, which means that
they can easily converted into cash without a major loss in their value
 Money market securities most commonly used by firms & investors are Tbills, commercial paper, negotiable certificates of deposit, & foreign
money market securities
a. T-bills
- short term debt securities issued by the government
- accepts the highest competitive bids first & continues accepting
bids until it has obtained the amount of funds desired
b. Commercial Paper
- short-term debt security issued by well-known, creditworthy firms
- it serves the firm as an alternative to an alternative to a short-term
loan from a bank
- commercial paper is not so liquid as T-bills – it does not have an
active secondary market
c. Negotiable Certificates of Deposits
- debt security issued by financial institutions to obtain short-term
funds
- risk – financial institution issuing an NCD will default on its
payment at maturity, investors require a return that is slightly
above the return on T-bills with a similar maturity
d. Foreign Money Market Securities
- firms & investors can also use foreign money markets to borrow or
invest funds for short-term periods
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firms can issue short-term securities such as commercial paper in
foreign markets, assuming that they are perceived as creditworthy
in the those markets
investors may invest in foreign short-term securities because they
have future cash outflows in those currencies
2. Key Capital Market Securities
a. Bonds
- long term debt securities by firms & governments to raise large
amounts of long-term funds
i.
Treasury Bonds
- issued by the U.S. Treasury as a means of obtaining funds for a
long-term period
- maturities: 10 to 30 years
- treasury notes: medium-term debt securities
- T-bonds pay interest on a semi-annual basis to the investors who
hold them
- Earn return in the form of coupon payments & in the difference
between the selling price & purchase price of the bond
ii.
Municipal Bonds
- issued by municipalities to support their expenditures
- classified into 2 categories: general obligation bonds & revenue
bonds
iii. corporate bonds
- issued by corporations to finance their investment in long-term
assets
- a debt instrument indicating that a corporation has borrowed a
certain amount of money & promises to repay it in the future under
clearly defined items
- maturities: 10 to 30 years
iv.
International Bonds
- commonly issued bond in the Eurobond market
- serves issuers & investors in bonds denominated in a variety of
currencies
v.
Stocks
- an equity security that represents ownership interest in the issuing
firm
 Common & preferred stock
 Common stock - units of ownership interest, or equity,
in a corporation
 Preferred stock – a special form of ownership having
a fixed periodic dividend that must be paid prior to
payment of any common stock dividends
 Has priority over common stock when the firms
dividend are disbursed
 International Stocks
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 Issue stock in international equity markets
 Able to sell all of their stock offering more easily by
placing some of the stock in foreign markets
Major Securities Exchanges
 Organisations that provide the marketplace in which firms can raise funds
through the sale of new securities & in which purchasers can resell
securities
 The two key types of securities exchanges : organised exchange & overthe-counter market
a. Organised Securities Exchange
- tangible organizations that act as secondary markets where
outstanding securities are resold
b. Over-the-counter exchange
- intangible market ( not an organisation ) for the purchase & sale of
securities not listed by the organised exchanges
1. Derivative Securities Markets
 Financial contracts whose values are derived from the value of underlying
financial assets
 E..g. stock options & financial futures contracts
 Are used not only to take speculative positions but also to hedge or reduce
exposure to risk
 Some investors use securities to reduce the risk of their investment
portfolio
2. The Foreign Exchange Market
 Allows for the purchase & sale of currencies to facilitate international
purchases of products, services & securities
 Foreign exchange market is not based in one location; it is composed of
large banks around the world that serve as intermediaries between those
firms or investors who wish to purchase a specific currency & those that
wish to sell it
a. Spot Market for Foreign Exchange
- Spot Market: facilitates foreign exchange transactions that involve
the immediate exchange currencies
- Spot Exchange Rate: the prevailing exchange rate at which one
currency can be immediately exchanged for another currency
b. Forward Market for Foreign Exchange
- Forward market – a market that facilitates foreign exchange
transactions that involve the future exchange of currencies
- Forward rate – the rate which one currency can be exchanged for
another currency on a specific future date
- Forward contracts – an agreement that specifies the amount of a
specific currency that will be exchange rate, & the future date at
which a currency exchange will occur
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Chapter 3: Corporate Securities: Bonds & Stocks
General Features of Bond Issue
1. 3 features: conversion feature, call feature & stock purchase warrants
a. Conversion Feature
- a feature of convertible bonds that allows bondholders to change
each bond into a stated number of shares of common stock
- bondholders will convert their bonds into stock only when the
market price of the stock is such that the conversion will provide a
profit for the bondholder
b. Call Feature
- a feature included in most corporate bond issues that gives the
issuer the opportunity to repurchase bonds at a stated call price
prior to maturity
- enables an issuer to call an outstanding bond when IR fall & issue
a new bond at a lower price IR
- when IR rise, the call privilege will not be exercised, except
possibly to meet sinking fund requirement
- call price: the stated price at which a bond may be repurchased, by
use of a call feature, prior to maturity
- sometimes the call features can be exercised only during a certain
period
- as a rule, the call price exceeds the par value of a bond by an
amount equal to 1 year’s interest
- call premium: the amount by which a bond’s call price exceeds its
par value
c. stock purchase warrants
– instruments that give their holders the right to purchase a certain
number of shares of the issuer’s common stock at a specified price
over a certain period of time
- this feature typically allows the issuer to pay a slightly lower
coupon IR than would otherwise be required
2. Bond Rating
 Independent agencies use financial ratio & cash flow analyses to assess
the likely payment of bond interest & principal
 An inverse r/ship exists between the quality of a bond & the rate of return
that it must provide bondholders
 High-quality ( high-rated ) bond provide lower returns than lower-quality
( low-rated ) bonds
 This reflects the lender’s risk-return trade off
 The financial manager must be concerned with the expected ratings of the
bond issue, because these ratings affect salability & cost
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3. Differences between Debt & Equity Capital
 The term capital denotes the long-term funds of a firm
 Debt Capital includes all long-term borrowing incurred by a firm, including
bond
 Equity Capital consists of long-term funds provided by the firm’s owners, the
stockholders
 A firm can obtain equity capital either internally, by retaining earnings rather
than paying them out as dividends to its stockholders, or externally, by selling
common or preferred stock
 Key differences are:
a. Voice in management
- holders of equity capital ( common & preferred stockholders ) are
owners of a firm
- holders of common stock have voting rights that permit them to
select the firm’s directors & to vote on special issues
- debtholders & preferred stockholders may receive voting
privileges only when the firm has violated its stated contractual
obligations to them
b. Claims on income & assets
- Claims on Income - can’t be paid until the claims of creditors have
been satisfied
- After satisfying them, the firm’s board of directors decides whether
to distribute dividends to the owners
- Equity holders’ claims on assets – firm fail, assets are sold, &
proceeds are distributed in following order: employees &
customers; government; creditors; & finally, equity holders
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