The Financial

Environment And
Sources of Finance
 Understand financial institutions and markets, and
the role they play in financial management.
 Recognise various methods firm can issue securities
to raise funds.
 Understand how issue price is set when firm issues
new securities.
 Recognise various sources of financing and types of
securities.
 Financial markets exist in order to allocate the supply
of savings in the economy to the demanders of those
savings.
 Financial markets are institutions and procedures
that facilitate transactions in all types of financial
claims. A securities market is simply a place where
you can buy and sell securities (Example, New York
Stock Exchange)
Benefits of investing in financial assets
(like stocks) rather than investing in own
business
1. Reduced risk through diversification.
With $200,000 you can perhaps invest in only
one business whereas with $200,000 you can
invest $10,000 each in stocks of 20 Companies.
Such diversification reduces risk as not all
companies will fail at the same time!
2. Low time commitment
3. Limited liability
4. No or low expertise needed
5. Easy to exit/enter
6. Continuous valuation of your wealth
 Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments
into loans or investments.
 The key suppliers and demanders of funds are individuals,
businesses, and governments. In general, individuals are net
suppliers of funds, while businesses and governments are net
demanders of funds.
 Direct Transfer using Private Placement

cash
firm
saver

securities
Indirect Transfer using Investment Banker

funds funds

saver
investment
firm
securities banker securities
Indirect Transfer using Financial
Intermediary

funds funds
saver

financial
intermediary firm
intermediary
securities firm
securities
 Indirect Transfer using an Investment
Banker
 A syndicate of investment bankers buy the entire issue of securities
from the issuing firm. Then sell the firm’s securities at a higher price
to the investing public in the financial markets.
 Firm’s securities just passed through the investment banker, not
transform into a different type of securities.
 Examples of investment banker: Merrill Lynch, Public Merchant
Bankers Berhad, RHB Sakura Merchant Bankers Berhad, Affin
Merchant Bank Berhad.
 A rights issue is a method of raising new share capital by means of an offer to
existing shareholders, inviting them to subscribe cash for new shares in
proportion to their existing holdings.
E.g. ABC Berhad launch a rights issue on a one for four basis at RM2.80 per share.
If you currently own 12,000 shares of ABC Berhad, you are eligible to subscribe
3,000 new shares of ABC Berhad at RM2.80 per share (or RM8,400 in total). If
you subscribed, you will own 15,000 shares after the rights issue.
 Major advantages of a rights issue:
1)Rights issue are cheaper than offers for sale to general public – prospectus not
required, underwriting cost is lower.
2)Rights issue are usually issued at a discount from current market price, and thus
benefit existing shareholders.
3)If existing shareholders take up all the rights (subscribe), then they can maintain
their relative voting rights (percentage of ownership remained the same as
before)
 After the rights issue are actually made, the market price per
share will normally fall because there are more shares in
issue and the new shares were issued at a discount price.
 ‘Cum-rights’ price – the market price of the existing shares
which carry the rights to subscribe to new shares, immediately
just prior to the issue of new shares. Also known as ‘rights-on’
price.
 ‘Ex-rights’ price – the price of the shares immediately after the
issue of new shares.
 Assuming a 1 for N rights issue, the theoretical ex-rights
price, TERP will be:
= [(N x cum-rights price) + (1 x issue price)]
N+1
 Value of rights = Ex-rights price – Issue price
 Value of rights per existing share
= Ex-rights price – Issue price
N
  Angelo Berhad has 1,000,000 ordinary share of RM1.00 par in
issue. The company decides to make a rights issue, and offer the
shareholders the rights to subscribe for one new share at RM1.50
for every four shares they already held. The market price per share
of Angelo Berhad fell to RM1.95 after the announcement of rights
issue, but increased to RM2.00 just prior to the issue being made.
What is the theoretical ex-rights price?

1,000,000 shares cum-rights @ RM2.00 RM 2,000,000

250,000 shares to be issued @ RM1.50 RM 375,000
Theoretical value of 1,250,000 shares RM2,375,000
Theoretical ex-rights price = RM2,375,000 / 1,250,000 = RM1.90 per share
 Solution:
Theoretical ex-rights price
= [(4 x RM2.00) + (1 x RM1.50)]
4+1
= RM1.90 per share
 Value of rights = RM1.90 – RM1.50 = RM0.40

 If an existing shareholder does not have enough money to buy the

new shares, he can sell the rights to subscribe for a new share to
another investor and receive RM0.40 for the sale of rights. The other
investor would have to pay RM1.50 issue price to buy the new share,
and thus the total outlay to buy a new share will be RM0.40+RM1.50
= RM1.90, i.e. the theoretical ex-rights price.
 The possible courses of actions open to existing shareholders are:
(a)To ‘take up’ or ‘exercise’ all the rights, i.e. buy the new shares at
rights issue price. Maintain percentage of holdings in the company’s
total equity.
(b)To sell the rights in the market at value of rights. A shareholder’s
percentage of holdings reduce after the rights issue compared to
before the rights issue.
(c)To sell part of the rights and ‘take up’ the remainder. A shareholder’s
percentage of holdings reduce after the rights issue, but to a lesser
extent than (b) above.
(d)Do nothing.
 Only if the shareholder chooses (a), (b) or (c), his wealth will not be
affected. Choosing (d) will reduce the shareholder’s wealth.
 Example
 Donatello Berhad issued 3,000,000 ordinary shares of RM0.50 each, which are at
present selling for RM4.00 per share in the market. The company plans to issue rights
to purchase one new ordinary share at RM3.20 for every three shares held. An existing
shareholder who owns 900 shares thinks that he will suffer a loss in personal wealth
because the new shares are offered at a price lower than current market price. With the
assumption that the actual market price after the rights issue will be equal to the
theoretical ex-rights price, what will be the effects on the shareholder’s wealth if:
(a) he exercises all the rights
(b) he sells all the rights
(c) do nothing at all
 3 shares @ RM4 cum-rights price 1 RM12.00
new share @ RM3.20 issue price 4 RM 3.20
shares have theoretical value of RM15.20

Theoretical ex-rights price = RM15.20 / 4 = RM3.80 per share

Value of rights per new share = RM3.80 – RM3.20 = RM0.60
(a)
Market value of 1,200 shares ex-rights @RM3.80 RM4,560
Market value of 900 shares cum-rights @RM4.00 RM3,600
Additional investment (300 shares @RM3.20) RM 960
Total wealth before RM4,560
(b)
Sale value of rights (300 rights @RM0.60) RM 180
Market value of 900 shares ex-rights @RM3.80 RM3,420
Total wealth after RM3,600
Market value of 900 shares cum-rights @RM4.00 RM3,600 (= Total wealth before)

(c)
Market value of 900 shares ex-rights @RM3.80 RM3,420 (= Total wealth after)
Market value of 900 shares cum-rights @RM4.00 RM3,600 (= Total wealth before)
 The actual market price of a share after the rights issue may
differ from the theoretical ex-rights price. This will occur when
the expected earnings yield from the new funds raised is
different from the earnings yield from the existing funds in the
business. The market will take a view on how profitable the new
(additional) funds will be invested, and will value the shares
accordingly.
 If the additional funds from rights issue raised are expected to
earn the same rate as existing funds, the actual market price
per share will be equal to the theoretical ex-rights price per
share.
 If the additional funds from rights issue raised are expected to
earn a higher rate than existing funds, the actual market price
per share will be above the theoretical ex-rights price per
share.
 If the additional funds from rights issue raised are expected to
earn a lower rate than existing funds, the actual market price
per share will be below the theoretical ex-rights price per
share.
Indirect Transfer using Investment Banker
 An example of a primary market transaction involving a
money market security is .
a) a new issue of a security with a very short maturity
b) a new issue of a security with a very long maturity
c) the transfer of a previously-issued security with
a very short maturity
d) the transfer of a previously-issued security with
a very long maturity
 An example of a secondary market transaction involving
a capital market security is .
a) A new issue of a security with a very short maturity
b) A new issue of a security with a very long maturity
c) The transfer of a previously-issued security
with a very short maturity
d) The transfer of a previously-issued security with a
very long maturity
 Which of the following relationships is true regarding the
costs of issuing the following securities?
a) common stock > bonds > preferred stock
b) preferred stock > common stock > bonds
c) bonds > common stock > preferred stock
d) common stock > preferred stock > bonds
 Advantages of private placements do not include which
of the following?
a) more financing flexibility
b) lower flotation costs
c) investor protection through extensive regulation
d) funds which are available more quickly than
through a public offering
 Activities of the investment banker include .
a) assuming the risk of selling a security issue
b) selling new securities to the ultimate investors
c) providing advice to firms issuing securities
d) all of the above
 A corporation sells securities to an investment banking
firm on January 1st. The next day an international oil
crisis causes stock prices to drop dramatically. The
corporation is immune from the drop in price of its stock
due to which function of the investment banking firm?
a) hedging
b) distributing
c) reinsurance
d) underwriting
 Spandra Electronics wants to raise money by selling
stock. After talking to several investment banking firms,
Spandra decides to hire Goldman Sachs to sell 5
million shares of its common stock. Goldman sells 4.5
million shares and returns the rest to Spandra. This is
an example of .
a) a privileged subscription with a standby agreement
b) a commission or best-efforts agreement
c) a privileged subscription with a standby agreement
d) a competitive bid purchase
 Reynolds, Inc. needs to raise $5 million by selling
common stock. Reynolds sells 1 million shares of stock
at $5 each to Goldman Sachs, who then is responsible
for selling the shares to investors. This is an example of
a .
a) privileged subscription
b) standby agreement
c) negotiated purchase
d) commission or best-efforts agreement