Financial Management Topic 3

FINANCIAL MARKETS

QUESTION 1

Explain three functions of the central depository system (CDS) in your country.

•  Functions of central depository system (CDS)

• Immobilisation of securities, that is, elimination of physical movement of securities.
• Dematerialisation, that is, elimination of physical certificate or documents showing entitlement of a security so that ownership exists only as computer words.
• Effective delivery and payment, that is, simultaneous, exchanging or transferring securities.
• Provision of detailed listing of investments according to the type of security held
• Effective delivery of returns, that is, effective distribution of dividends, right issues, interest and bonds issue.

 

QUESTION 2

Discuss four functions of the capital markets regulator in your country.

QUESTION 2

 Functions of a capital markets regulator 

• To remove bottlenecks and create awareness for investment in long term securities.
• To serve as efficient bridge between the public and private sector.
• Create environment which will encourage local companies to go public.
• Grant approvals and licences to brokers.
• To operate a compensation fund to protect investors from financial losses should licensed brokers fail to meet their contractual obligations.
• Act as a watchdog for the entire capital market system.
• Removal of barriers on security transfer.
• Encourage development of institutional investors, for example pension funds, insurance firms. – Provide adequate information to players in the market in order to prevent insider trading.
• Decentralisation of operations.

 

 

QUESTION 3

1.  Explain the following terms as used in capital markets:

• Best efforts offering.
• Pre-emptive rights.
• Green shoe provision.

QUESTION 3

 

• Best efforts offering

This is a system used by investment bankers where they agree to sell as many securities as they can at an established price. They have no responsibility for securities unsold.

• Pre-emptive right

Existing common stockholders have the right to preserve their proportionate ownership in corporation. E.g. rights issue

• Green shoe provision.

Underwrites often obtain the option to purchase additional stock at the offering price.  This option usually last several weeks after the offering.

 

QUESTION 4

•  Explain three measures that developing countries could implement in order to improve their financial markets.

QUESTION 4

• Explain three measures that developing countries could implement in order to improve their financial markets

• Introducing a wide range of financial instruments/ securities

Most financial markets of developing of developing countries have limited financial securities, therefore there is need to introduce a variety of financial assets.

 

• Creation of awareness

This can be done through conferences, seminars so as to create awareness about the functioning and operations of the stock markets.

• Enhancing cross border listing

This is the listing of firms in more than one stock market. This facilitates taping both institutional and retail investors, regionally and globally.

• Formulation of appropriate policies

Sound policies which are geared towards developing all aspects of capital markets will lead to growth and development of any capital markets.

• Automate the stock markets

November 2011 Question Five A

November 2011 Question Five A

 

QUESTION 5

• Briefly explain why companies list their shares on more than one stock exchange.
• Distinguish between “untraded debt” and “floating-rate debt”

QUESTION 5

• Why companies list their shares on more than one stock exchange
  • To raise funds for development purposes
  • To enhance or promote growth and development of stock markets
  • To improve relations between local and other investors regionally and globally.
  • So as to diversify and spread risk thereby creating increasing stability on share prices.
  • It attracts overseas investors and consumers and thus improving product awareness in other potential markets.

So as to increase the trading volumes of shares.

• Distinction between untraded debt and floating rate debt

Untraded debt-refers to debt instruments that are not usually traded or tradable in organized and other financial markets.

Floating rate debt on the other hand are debt instruments which are issued at floating rate of interests i.e. the rate of interest will keep on fluctuating with time. This means that when market rates of interest on loans also increases and vice versa.

 

QUESTION 6

• Outline the factors that contribute to the slow growth of capital markets in many emerging economies.
• Distinguish between “financial gearing” and “operating gearing”.

QUESTION 6

Outline the factors that contribute to slow growth of capital markets in many emerging economies.

• • Lack of sound policies
  • Failure to automate stock markets which are largely manual.
  • Ignorance on the part of potential investors regarding activities of capital markets
  • There is limited number of securities in emerging economies
  • Unfavorable political and legal environment e.g. harsh laws, unfavorable tax policies etc.

 

• Distinction between “financial gearing” and “operating gearing”.

Financial gearing is the use of the financing costs in order to improve the EPS of the company. It shows the percentage change in the EPS as a result of the changes in the EBIT. It’s measured using the degree of financial leverage (DFL).

Operating gearing is the use of the operating costs in order to improve the profitability of the company. It therefore shows the percentage change in the earnings before interest and tax (EBIT) as a result of the changes in the sales. It’s calculated using the degree of operating leverage (DOL).

 

 

QUESTION 7

•  Differentiate between the following sets of terms
• Primary markets and secondary markets ii. Capital markets and money market
•       Brokers and jobbers

QUESTION 7

•  Difference between the following sets of terms
• Primary markets and secondary markets

 Primary markets-

Are those financial markets in which the financial securities are issued for the first time in the stock exchange. Like for companies that are making are initial public offering will sell its securities for the first time in the primary financial markets.

 

Secondary markets-

Are those markets for subsequent selling and purchase of the financial securities i.e. a company which is already listed in the stock exchange will sell its securities in secondary financial markets.

 

Capital markets and money markets Capital markets-

Are those markets for long term sources of finance. Long term loans for development of the country are normally offered through the capital market. The major roles of the capital markets include;

• It provides long term sources of finance which is important for development purposes
• It provides permanent finance which is necessary for strong financial base for going concern.
• It’s a channel through which foreign investments find their way into the country.

Money markets-

It’s a market concerned with short term financial securities. It offers the following  services;- •

It offers a medium through which short term financial securities can be discounted.

• It offers advice to the concerned parties as to which appropriate finance will meet their financial requirements.
• It acts as a source of finance to small businesses which are unable funds in capital markets.
• It is a channel through which government investment such as treasury bills and government bonds are offered to the general public.

 

• Brokers and jobbers

A broker is an agent who buys and sells securities on behalf of his clients on a commission basis. He is a member of the stock exchange who can be suspended in case of mal practice.

He gives advice to the client and sometimes manages the clients’ portfolio.

Jobbers are principals who buy and sell securities on their own name. Since jobbers are experts in the market they are not allowed to deal with the general public and can therefore deal with the brokers or other jobbers. 

 

 

QUESTION 8

Distinguish between the terms “cum div” and “ex – div” as used in financial markets.QUESTION 8

 Cum dividend –means the buyer of the shares will be entitled the next dividend payable on shares

The market price of shares therefore includes the value of dividend.

Ex-dividend –means the buyer of the shares will not be entitled the next dividend payable on shares

The market price of shares therefore will not include the value of dividend

 

QUESTION 9

Explain the main factors behind the rapid development of capital markets in your country.

QUESTION 9

 Factors leading to rapid development of capital market.

• The Capital Market Authority has been educating investors through advertisement and press releases. As a result investors make informed decisions leading to development of capital markets.
• Incentives given by the government to investors e.g. tax incentives
• Political stability

The absence of war and turmoil within the Kenyan borders has led to development of industries.

• Introduction of wider range of financial instruments in the market e.g. futures, warrants, options e.t.c.
• Proper regulation by the CMA ensures that trading is well regulated and investors do not lose funds in the market. This has led to investor confidence in the capital market.
• Encouraging development of institutional investors like insurance funds, pension schemes etc.

 

QUESTION 10

Discuss the role of a capital markets authority in the development of a country’s financial markets

QUESTION 10

•  The role of a capital markets authority in the development of a country’s financial markets:
• It provides long term sources of finance which is important
• It provides permanent finance which is necessary for a strong financial base for a going concern.
• It acts as a channel through which foreign investment find their way into the country  iv) It provides other services in the form of advice to the investors as to which investments are available.

QUESTION 11

•  Describe the benefits to a country of integrating its financial markets with those of other country.QUESTION 11
  • a) Benefits to a country for integrating its financial markets with those of other countries
  • It leads to capital mobility thereby reducing investment risk.
  • Diversified sources of capital are made available at reasonable cost.
  • This can lead to increase in the company’s trading volume of its securities iv) It can lead to mutual understanding between countries.
  • v) Can lead to widening the market for the company’s products to other countries vi) Can lead to mergers and acquisition hence economies of scale.

 

QUESTION 12

• Distinguish between primary and secondary securities market.
• “Despite the large investment in the stock exchange and the various government incentives, only a few companies are listed at the stock exchange of the three East Africa Countries“. This was the opening remark by the guest speaker in a seminar whose theme was “Developing our capital market.”

 

Required:

• The advantage of being listed at the stock exchange.
• Highlight four factors that may hinder companies from being listed at the stock exchange.

QUESTION 12

•  Distinction between Primary and secondary securities market.

The primary financial market are those financial markets in which the financial securities are issued for the first time in the stock exchange i.e. a company making an initial public offering (IPO) will sell its securities for the first time in the primary financial market.

The secondary financial markets on the other hand are those markets for the subsequent selling and purchase of the financial securities i.e. a company which is already listed in the stock exchange will sell its securities in the secondary financial market.

 

 Advantages of being listed at the stock exchange

• Risk diversification i.e. by selling some of their shares to the public the company can be able to diversify its holding hence reducing riskness of its portfolio.
• A listed company can be able to obtain the under writing facilities because it can negotiate with the possible underwriters to purchase its securities which are not subscribed for by the general public.
• A listed company will be perceived by the general public to be credit worth and hence the creditors will be willing to grant credit to the company at favorable terms.
• A listed company can obtain feedback information from the stock exchange concerning its performance over time.
• A listed company is able to compare its performance with other similar companies which are also listed in the stock exchange (cross-sectional analysis).
• A listed company is likely to obtain privileges from the Government i.e tax allowances and protection from the competitors.
• The determination of the value of the firm i.e. the value of the shares of the company is determined by the forces of the market and hence there is no uncertainty.
• Financial management discipline i.e. once the company goes public its finances and its managers will be open for scrutiny by the general public.

 

 

 

 Factors that may hinder companies from being listed

The company will loose confidential information to the public more so to its competitors  2) There are strict rules, regulation and requirements for the company to be listed.

• The existing shareholders may loose control as a result of the incoming shareholders who may come in with new ideas which may disrupt the running of the company.
• A company whose profit records are not good may be deregistered from the stock exchange and their will have a negative impact on the company.
• In case the company profits decrease it will reflect to the general public resulting to reduction in share price and subsequent decrease in goodwill hence making it difficult for the company to raise funds from the general public.
• Listing involves several formalities i.e. getting permission from the capital market and the stock exchange council.

 

 

QUESTION 13

• Briefly explain how the “Dow theory “ views the movement of the market prices of shares traded on a stock exchange.
• Identify and briefly explain the factors that must be taken into account in the design and construction of a market index for shares
• Joseph Kimeu is trying to determine the value of Bidii Ltd’s ordinary shares. The earnings growth rate over his planned six-year holding period is estimated to be 10% and the dividend payout ratio is 60%. The ending price earnings (P/E) ration is expected to be 20 and the current earnings per share are Sh. 4. The required rate of return for this share is 15%.

Required;

Compute the market price of Bidii Ltd’s ordinary share

QUESTION 13

• Dow Theory

The Dow Theory views the movement of market prices occurring in three stages

• Primary movement: This movement is known as bull and bear markets. Bull markets are where prices move in an upward manner for several years whereas in bear markets prices move in a down ward manner row several years or several months.
• Secondary movements: Under secondary movement stock prices move up and down for a few months.

• Daily movements: These are random daily fluctuations in stock prices. Such movements are meaningless and are generally ignored during charting of indices.

 

• Factors to be taken into account in the design and construction of a market index for shares
  • Choice of base year on which to base the price changes
  • The selection of representatives securities / firms
  • Combining the securities/ firms to construct the index
  • Use of suitable weight to be attached to the securities depending on their relative importance c)

If the market is efficient the price of the share will be equal to the present value of all the expected future benefits to be obtained from the share. The benefits to be obtained from the share will be in the form of dividend income and capital gains. The capital gains are normally obtained at the end when the investor sells the share.

 

QUESTION 14

• Briefly describe the three forms of capital markets efficiency. Highlight four factors that may underlie the low rate of listing of companies in a stock exchange you are familiar with.
  • Three forms of capital market efficiency

  The forms of efficiency are defined by the type of information that is released to the market. The three forms of efficiency are:

  • Weak form efficiency

  This is where the share prices fully and instantaneous reflect the past/ historical information that has been released in the market

  • Semi – strong form of efficiency

  This is where the share price fully and instantaneously reflect both past and present information that has been released to the market

  • Strong form of efficiency

  This is where the share price fully and instantaneously reflect both past, present and future information that has been released in the market.

   
  
  

  • Factors that underlie low listing of companies
  • i) Because of the strict rules and regulations governing the listing of companies ii) Because listing of companies will lead to disclosure of some confidential information to the competitors
    • Because most companies in Kenya are family owned and will not agree to the joint ownership hence they cannot be listed
  • There will be greater likelihood of being the subject of a takeover bid and it may be difficult to defend it.
  • High cost of obtaining quotation.

   

 

QUESTION 15

Highlight four advantages and disadvantages to a company of being listed on a stock exchange. (b) In relation to the stock exchange”

• Explain the role of the following members:
  • Floor brokers
  • Market makers
  • Underwriters
• Explain the meaning of the following terms: Bull and bear markets
  • Bid-ask spread.
  • Short selling.QUESTION 15
    • Advantages of being listed
      • New funds may be easily obtained from the stock exchange
      • Easy pricing of shares
      • A better credit standing obtained
      • Easy share per transfer (ownership)
      • Buying other companies is easier
      • Wide ownership of the firm
      • Reduction in perceived risk by shareholders
      • Greater prominence and status given to quoted companies may create goodwill for the company.

     

    Disadvantages

    • Cost of floating
    • Stringent stock exchange regulation
    • Agency problem due to divorce of management and ownership
    • Dilution of control from wider holding of shares
    • Increased chances of forced take over.
    • Extra administrative burdens on management
    • Disclosure requirements

     

    • Floor brokers – act on behalf of individuals
      • Client who are willing to buy or sell some of their shares or debentures through floor/stock brokers:
        • Stock brokers acting on behalf of client will deal with one of the market makers to buy or sell the shares.
        • Market makers may act as shareholders too, dealing directly with individual investors.
        • Stock brokers earn a commission for their service payable by the client.

     

    • Market makers are dealers in the shares of the selected companies whose responsibility is to “make a market” in the shares of those companies. It is noteworthy that a market maker:
      • Must be a member of the stock exchange
      • Must announce which company’s shares they are prepared to market
      • Must undertake to make a two way prices in the securities for which they are registered as market makers under any trading conditions. Must decide the share price
      • Brings “new” companies to the market.
      • Earns a profit being the difference of selling and buying price.

     
    
    

    • Underwriter is an investment banker who performs the insurance function of bearing the risk of adverse price fluctuating during the period in which a new

    issue of security is being distributed.

    • The underwriter underwrites the risk of under-subscription of a company’s shares during a primary issue.
    • He ensures that the company gets the targeted funds sometimes having to take up the shortfall in demand.

     

    • Bull and bear markets

    A bull market is a market characterized by rising prices, encouraging people to buy

    now in the hope of making a profit when they sell later after prices have climbed up. A bear market is characterized by falling prices encouraging bears to sell now in order to avoid future losses when prices would have fallen.

     

    • Bid ask spread

    Is the difference between the offer price and the buying price of a share.

     

    • Short selling
      • Is the act of selling a share which one does not already possess.
    • The dealer could “borrow” the shares, sell them when prices are high and in anticipation of decline in prices, the shares will be bought back at lower prices and refunded to the “lender”

 

QUESTION 16

• What economic advantages are created by the existence of:
•  Primary markets.
  • Secondary markets
  • Portfolio management firms.
• Explain how the Capital Authority can ensure:
  • Faster growth and development of the Nairobi Stock Exchange or Stock Exchange in your country.
  • Development of other stock exchanges in Kenya or in your country.
    • Primary Market

     

    Raising Capital Business

    • mobilizing savings
    • Government can raise capital (sell bonus)
    • Open market operators (control excess liquidity)
    • Vehicle for Foreign Direct Investment

     
    
    

    Secondary Market

    • Investment improvement for companies and small investors.
    • Barometer for Healthy of economy and companies ( as whole)
    • Privatization of parastatals and giving local citizens a chance for ownership of multi-national companies.
    • Realize investments (by disposal in small quantities due to separation of ownership and control.
    • Improves corporate governance
    • Diversification of investments hence reduction of risk – Liquidity of securities improved.

     

    Diversification

    • Professional advice
    • Watchdog for share under/over valuation
    • Enhances market efficiency through information.

     

    •  Protects investors from financial losses
      • Establishes Rules & Regulations for private placement of securities
      • Removal for impendment and creation of incentives for long term investment. of investors.
      • Facilitate National wide system of Brokerage services
      • Creation maintenance and regulation market for securities.
      • Creation for environment which will encourage local companies go public.
      • Removal of Barriers to security transfers
      • Encourage Development of International Investors – eg insurance and premium co’s
      • Introduces wider range of Investments in the market (x) Decentralize operations of market to Rural Areas.

    Provide adequate information to players in market for efficient pricing of securities.