CHAPTER 8

MONEY MARKETS AND CAPITAL MARKETS

MONEY MARKETS
Introduction

The term “Money Market” refers to the network of corporations, financial institutions, investors
and governments which deal with the flow of short-term capital. When a business needs cash for a
couple of months until a big payments arrives, or when a bank wants to invest money that depositors
may withdraw at any moment, or when a government tries to meet its payroll in the face of big seasonal
fluctuations in tax receipts, the short-term liquidity transactions occur in the money market.

The money markets have expanded significantly in recent years as a result of the general
outflow of money from the banking industry, a process referred to as disintermediation. Until the start
of the 1980s, financial markets in almost all countries were centered on commercial banks. Savers and
investors kept most of their assets on deposit with banks, either as short-term demand deposits, such as
cheque-writing accounts, paying little or no interest, or in the form of certificates of deposits that tied
up the money for years. Drawing on this reliable supply of low-cost money, banks were the main source
of credit for both business and consumers.

How it works

The money market exists to provide the loans that financial institutions and governments need
to carry out their day-to-day operations. For instance, banks may sometimes need to borrow in the
short term to fulfill, their obligations to their customers, and they use the money market to do so.

For example, most deposit accounts have a relatively short notice period and allow customers
access to their money either immediately, or within a few days or weeks. Because of this short notice
period, banks cannot make long-term commitments with all of the money they hold on deposit. They
need to ensure that a proportion of it is liquid (easily accessible) in market terms. Otherwise, if a large
number of customers wish to withdraw their money at the same time, there may be a shortfall between
the money the bank has lent and the cash deposits it needs to return to savers.

Banks may also find that they have greater demand for mortgages or loans than they do for
savings accounts at certain times. This creates a mismatch between the money they have available and
the money they have loaned out, so the bank will need to borrow in order to be able to fulfill the
demand for loans.
 The money markets are the mechanisms that bring these borrowers and investors together
without the comparatively costly intermediation of banks. They make it possible for borrowers to meet
short-run liquidity needs and deal with irregular cash flows without resorting to more costly means of
raising money.

There is an identifiable money market for each currency, because interest rates vary from one
currency to another. These markets are not independent, and both investors and borrowers will shift
from one currency to another depending upon relative interest rates. However, regulations limit the
ability of some money-market investors to hold foreign-currency instruments, and most money-market
investors are concerned to minimize any risk of loss as a result of exchange-rates fluctuations. For these
reasons, most money-market transactions occur in the investor’s home currency.

Who uses the money market?

The primary function of the money market is for banks and other investors with liquid assets to
gain a return on their cash or loans. They provide borrowers such as other banks, brokerages, and hedge
funds with quick access to short-term funding. The money market is dominated by professional
investors, although retail investors with P50,000 can also invest. Smaller deposits can be invested via
money market funds. Banks and companies use the financial instruments traded on money market for
different reasons, and they carry different risks.

Companies Banks Investors

a. When companies need a. If demand for long-term a. Individuals seeking to

to raise money to cover
their payroll or running
costs, they may issue
commercial paper-
short-term, unsecured
loans for P100,000 or
more that mature
within 1-9 months.
loans and mortgages is
not covered by deposits
from savings accounts,
banks may then issue
certificates of deposit,
with asset interest rate
and fixed-term maturity
of up to five years.
invest large sums of
money at relatively low
risk may invest in
financial instruments.
Sums less than P50,000
can be invested in
money market funds.

b. A company that has a

cash surplus may “park”
money for a time in
short-term, debt-based
financial instruments
such as treasury bills and
commercial paper,
certificates of deposit, or
bank deposits.
 The money markets do not exist in a particular place or operate according to a single set of
rules. Nor do they offer a single set of posted prices, with one current interest rate for money. Rather,
they are webs of borrowers and lenders, all linked by telephones and computers. At the centre of each
web is the central bank whose policies determine the short-term interest rates for that currency.
Arrayed around the central bankers are the treasurers of tens of thousands of businesses and
government agencies, whose job is to invest any unneeded cash as safely and profitably as possible and,
when necessary, to borrow at the lowest possible cost. The connections among them are established by
banks and investment companies that trade securities as their main business. The constant soundings
among these diverse players for the best available rate at a particular moment are the forces that keep
the market competitive.

WHAT MONEY MARKETS DO

There is no precise definition of the money markets, but the phrase is usually applied to the
buying and selling of debt instruments maturing in one year or less. The money markets are thus related
to the bond markets, in which corporations and governments borrow and lend based on longer-term
contracts. Similar to bond investors, money-market investors are extending credit, without taking any
ownership in the borrowing entity or any control over management.

Yet the money markets and the bond markets serve different purposes. Bond issuers typically
raise money to finance investments that will generate profits - or, in the case of government issuers,
public benefits - for many years into the future. Issuers of money-market instruments are usually more
concerned with cash management or with financing their portfolios of financial assets.

A well-functioning money market facilitates the development of a market for longer-term

securities. Money markets attach a price to liquidity, the availability of money for immediate
investment. The interest rates for extremely short-term use of money serve as benchmarks for longer-
term financial instruments. If the money markets are active, or "liquid", borrowers and investors always
have the option of engaging in a series of short-term transactions rather than in longer-term
transactions, and this usually holds down longer term rates. In the absence of active money markets to
set short-term, issuers and investors may have less confidence that longer-term rates are reasonable
and greater concern about being able to sell their securities should they so choose. For this reasons,
countries, with less active money markets, on balance, also tend to have less active bond markets.

TYPES OF MONEY-MARKET INSTRUMENTS

Money market securities are short-term instruments with an original maturity of less than one
year.

There are numerous types of money-market instruments. The best known are commercial
papers, bankers' acceptances, treasury bills, repurchase agreement, government agency notes, local
government notes, interbank loans, time deposits, bankers’ acceptance, and papers issued by
international organizations. The amount issued the course of a year is much greater than the amount
outstanding at any one time, as many money-market securities are outstanding for only short periods of
time.

Money market securities are used to "warehouse" funds until needed. The returns earned on
these investments are low due to their low risk and high liquidity.

Money market securities are usually more widely traded than longer-term securities and so tend
to be more liquid.

Commercial paper

Commercial paper is a short-term debt obligation of a private-sector firm or a government-

sponsored corporation. Only companies with good credit ratings issue commercial paper because
investors are reluctant to bring the debt of financially compromised companies. They tend to be issued
by highly rated banks and are traded in a similar way to securities. In most cases, the paper has lifetime,
or maturity, greater than 90 days but less than nine months. This maturity is dictated by regulations. In
the Philippines, most new securities must be registered with the regulator, the Securities and Exchange
Commission. Commercial paper is usually unsecured although a particular commercial paper issue may
be secured by specific asset of the issuer or may be guaranteed by a bank.

Many large companies have continual commercial paper programmes, bringing new short-term
debt on to market every few weeks or months. It is common for issuers to roll over their paper, using
the proceeds of a new issue to repay the principal of a previous issue. In effect, this allows issuers to
borrow money for long periods of time at short-term interest rates, which may be significantly lower
than long-term rates. The short-term nature of the obligation lowers the risk perceived by investors.

These continual borrowing programmes are not riskless. If market conditions or a change in the
firm’s financial circumstances preclude a new commercial paper issue, the borrower faces default if its
lacks the cash to redeem the paper that is maturing.

The use of commercial paper also creates a risk that if interest rates should rise, the total cost of
successive short-term borrowings may be greater than had the firm undertaken longer-tem borrowing
when rates were low.

Bankers' acceptances

Before the 1980s, bankers’ acceptances were the main way for firms to raise short-term funds in
the money market. An acceptance is a promissory note issued by a non-financial firm to a bank in return
for a loan. The bank resells the note in the money market at a discount and guarantees payment.
Acceptances usually have a maturity of less than six months.

Bankers’ acceptances differ from commercial paper in significant ways. They are usually tied to
the sale or storage of specific of specific goods, such as an export order for which the proceeds will be
received in two or three months. They are not issued at all by financial-industry firms. They do not bear
interest; instead, an investor purchases the acceptance at a discount from face value and then redeems
it for face value at maturity. Investors rely on the strength of the guarantor bank, rather than of the
issuing company, for their security.

Treasury bills

Treasury bills, often referred to as T-bills, are securities with a maturity of one year or less,
issued by national governments. Treasury bills issued by a government in its own currency are generally
considered the safest of all possible investments in that currency. Such securities account for a larger
share of money-market trading than any other type of instrument.

Government agency notes

National government agencies and government-sponsored corporations are heavy borrowers in

the money markets in many countries. These include entities such as development banks, housing
finance corporations, education lending agencies and agricultural finance agencies.

Local government notes

Local government notes are issued by, provincial or local governments, and by agencies of these
governments such as schools authorities and transport commissions. The ability of governments at this
level to issue money-market securities varies greatly from country to country. In some cases, the
approval of national authorities is required; in others, local agencies are allowed to borrow only from
banks and cannot enter the money markets.

Interbank loans

Loans extended from one bank to another with which it has no affiliation are called interbank
loans. Many of these loans are across international boundaries and are used by the borrowing
institution to re-lend to its own customers.

Banks lend far greater sums to other institutions in their own country. Overnight loans are short-
term unsecured loans from one bank another. They may be used to help the borrowing bank finance
loans to customers, but often the borrowing bank adds the money to its reserves in order to meet
regulatory requirements and to balance assets and liabilities.

Time deposits

Time deposits, another name for certificates of deposit or CDs, are interest-bearing bank
deposits that cannot be withdrawn without penalty before a specified date. Although time deposits may
last for as long as five years, those with terms of less than one year compete with other money-market
instruments. Time deposits with terms as brief as 30 days are common. Large time deposits are often
used by corporations, governments and money-market funds to invest cash for brief periods. Interest
rates depend on length of maturity, with longer terms getting better rate. The main risks are being
locked into low interest rates if rates rise and early withdrawal penalties.

Repos

Repurchase agreements known as repos, play a critical role in the money markets. They serve to
keep the markets highly liquid, which in turn ensures that there will be a constant supply of buyers for
new money-market instruments.

A repo is a combination of two transactions. In the first, a securities dealer, such as a bank, sells
securities it owns to an investor, agreeing to repurchase the securities at specific higher price at a future
date. In the second transaction, days or months later, the repo is unwound as the dealer buys back the
securities from the investor. The amount the investor lends is less than the market value of the
securities, a difference called the spread or haircut, to ensure that it still has sufficient collateral if the
value of the securities should fall before the dealer repurchases them.

CAPITAL MARKETS
The capital market is a financial market in which longer-term debt (original maturity of one year or
greater) and equity instruments are traded. Capital market securities include bonds, stocks, and
mortgages. Capital market securities are often held by financial intermediaries such as insurance
companies and pension funds, which have little uncertainty about the amount of funds they will have
available in the future.

Capital Market Participants

The primary issuers of capital market securities are the

1. National and local government, and

 2. Corporations

The national government issues long-term notes and bonds to fund the national debt while local
governments issue notes and bonds to finance capital projects.

Corporations issue both bonds and stock to finance capital investment expenditures and fund other
investment opportunities.

Capital Market Trading

Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks bonds are introduced. Investment funds, corporations, and
individual investors can all purchase securities offered in the primary market. You can think of a primary
market transaction as one where the issuer of the security actually receives the proceeds of the sale.
When firms sell securities for the security actually receives the proceeds of the sale. When firms sell
securities for the very first time, the issue is an initial public offering (IPO). Subsequent sales of a firm’s
new stocks or bonds to the public are simply primary market transactions (as opposed to an initial one).

The capital markets have well-developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan to sell
long-term bonds before they reach maturity and eventually to sell their holdings of stock as well. There
are two types of exchanges in the secondary market for capital securities: organized exchanges and
over-the-counter exchanges. Whereas most money market transactions originate over the phone, most
capital market transactions, measured by volume, occur in organized exchanges. An organized exchange
has a building where securities (including stocks, bonds, options, and features) trade. Exchange rules
govern trading to ensure the efficient and legal operation of the exchange, and the exchange's board
constantly reviews these rules to ensure that they result in competitive trading.

A. BONDS

A bond is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan made by
investors to the issuer. Bonds are the most prevalent example of the interest only loan with
investors receiving exactly the same two sets of cash flows; (1) the periodic interest payments, and
(2) the principal (par value or face value) returned at maturity.

Trading Process for Corporate Bonds

The initial or primary sale of corporate bond issues occurs either through a public offering, using
an investment bank serving as a security underwriter or through a private placement to a small group of
investors (often financial institutions). Generally, when a firm issues bonds to the public, many
investment banks are interested in underwriting the bonds. The bonds can generally be sold in a
national market.

Most often, corporate bonds are offered publicly through investment banking firms as
underwriters. Normally, the investment bank facilitates this transaction using a firm commitment
underwriting, illustrated in Figure 9-1. The investment bank guarantees the firm a price for newly issued
bonds by buying the whole issue at a fixed price (the bid price) from the bond-issuing firm at a discount
from par. The investment bank then seeks to resell these securities to investors at a higher price (the
offer price). As a result, the investment bank takes a risk that it may not be able to resell the securities to
investors at a higher price. This may occur if a firm's bond value suddenly falls due to an unexpected
change in interest rates or negative information being released about the issuing firm. If this occurs, the
investment bank takes a loss on its security underwriting. However, the bond issuer is protected by
being able to sell the whole issue.

Figure 8-1. Firm Commitment Underwriting of a Corporate Bond Issue

Other arrangements can be as follows:

1. Competitive Sale

The investment bank can purchase the bonds through competitive bidding against other investment
banks or by directly negotiating with the issuer.

2. Negotiated Sale

With a negotiated sale, a single investment bank obtains the exclusive right to originate, underwrite
and distribute the new bonds through a one-on-one negotiation process. With a negotiated sale, the
investment bank provides the origination and advising services to the issuers.

3. Best Efforts Underwriting Basis

In their arrangement, the underwriter does not guarantee a firm price to the issuer. The investment
bank incurs no risk of mispricing the security since it simply seeks to sell the securities at the best
market price it can get for the issuing firm.
The advantages and disadvantages of using bonds can be summarized as follows:

Advantages

1. Long-term debt is generally less expensive than other forms of financing because (a)
investors view debt as a relatively safe investment alternative and demand a lower rate
of return, and (b) interest expenses are tax deductible.

2. Bondholders do not participate in extraordinary profits; the payments are limited to

interest.

3. Bondholders do not have voting rights.

4. Flotation costs of bonds are generally lower than those of ordinary (common) equity
shares.

Disadvantages

1. Debt (other than income bonds) results in interest payments that, if not met, can force the
firm into bankruptcy.

2. Debt (other than income bonds) produces fixed charges, increasing the firm’s financial
leverage. Although this may not be a disadvantage to all firms, it certainly is for some firms
with unstable earnings streams.

3. Debt must be repaid at maturity and thus at some point involves a major cash outflow.

4. The typically restrictive nature of indenture covenants may limit the firm’s future financial
flexibility.

As of September, 2019, the following are bond issuances by the government, business firms in
the Philippines secured by Bond Funds and part of the Investment Portfolio of Mutual Funds:

ALFM Peso Bonds RCBC Sustainability Bonds

Grepalife Bonds Robinsons Bank
Philam Bonds Fixed Rate Corporate Bonds
Philequity Peso Bonds PH Samurai Bonds
Sun Life Prosperity Bonds Ayala Land Inc. (PH) Bonds

Bond Features and Prices

The various features of corporate bonds and some of the terminology associated with bonds follow:
Par Value

The face value of the bond that is returned to the bondholder at maturity.

Coupon Interest Rate

The percentage of the par value of the bond that will be paid out annually in the form of interest.
Formula is: Stated interest payment divided the Par value.

Maturity

The length of time until the bond issuer returns the par value to the bondholder and terminates the
bond.

Indenture

The agreement between the firm issuing the bonds and the bond trustee who represents the
bondholders. If provides the specific terms of the loan agreement, including the description of the bond
the rights of the bondholders, the rights of the issuing firm and the responsibility of the trustees.

Current Yield

This refers to the ratio of the annual interest payment to the bond's market price.

Yield to Maturity

This refers to the bond's internal rate of return. It is the discount rate that equates the present value of
the interest and principal payments with the current market price of the bond.
Credit Quality Risk

Credit quality risk is the chance that the bond issuer will not be able to make timely payments.

Bond ratings involve a judgment about the future risk potential of the bond provided by rating agencies
such as Moody's, Standard and Poor’s and Fitch IBCA, Inc. Dominion Bond Rating Services. Bond ratings
are favorably affected by:

(a) A low utilization of financial leverage;

(b) Profitable operations;

(c) A low variability of past earnings;

(d) Large firm size;

(e) Little use of subordinated debt.

The poorer the bond rating, the higher the rate of return demanded in the capital markets.

The bond credit ratings agencies assign similar rating based on detailed analyses of issuers’ financial
condition, general economic and credit market conditions, and the economic value of any underlying
collateral. The agencies conduct general economic analyses of companies’ business and analyze firm's
specific financial situations. A single company for instance may carry several outstanding bond issues
and if these issues feature fundamental differences, then they may have different credit level risks. High
quality corporate bonds are considered investment grade, while higher credit risk bonds are speculative,
also called junk bonds and high-yield bonds.
Credit Ratings

For the finance manager, bond ratings are extremely important. They provide an indicator of default risk
that in turn affects the rate of return that must be paid on borrowed funds. An example and description
of these ratings follows:

Credit Risk Credit Rating Description

Investment Grade

Highest quality AAA The obligor’s (issuer’s) capacity

to meet its financial
commitment on the obligation is
extremely strong.

High quality AA The obligor’s capacity to meet its

financial commitment on the
obligation is very strong.

Upper medium grade A The obligor’s capacity to meet its

financial commitment on the
obligation is still strong, though
somewhat susceptible to the
adverse effects of changes in
circumstances and economic
conditions.

Medium grade BBB The obligator exhibits adequate

protection. However, adverse
economic conditions or changing
circumstances are more likely to
meet its financial commitment.

Below Investment Grade

Somewhat speculative BB Faces major ongoing

uncertainties or exposure to
adverse business, financial, or
economic conditions which could
lead to the obligor’s inadequate
capacity to meet its financial
commitment.

Speculative B Averse business, financial, or

economic conditions will likely
 impair the obligor’s capacity or
willingness to meet its financial
commitment.

Highly speculative CCC Currently vulnerable to

nonpayment, and is dependent
upon favorable business,
financial, and economic
conditions for the obligor to
meet its financial commitment.

Most speculative CC Currently high vulnerable to

nonpayment.

Imminent default C Used to cover a situation where

a bankruptcy petition has been
filed or similar action taken, but
payments on this obligation are
being continued.

Default D Obligations are in default or the

filing of a bankruptcy petition
has occurred and payments are
jeopardized.

TYPES OF BONDS

A. Unsecured Long-Term Bonds

Debentures

These are unsecured long-term debt and backed only by the reputation and financial stability of the
corporation. Because these bonds are unsecured, the earning ability of the issuing corporation is of
great concern to the bondholder. To provide some protection to the bondholder, the issuing firm may
be prohibited from issuing future secured long-term debt that would create additional encumbrance of
assets. To the issuing firm, debentures will allow it to incur indebtedness and still preserve some future
borrowing power.

Subordinated Debentures

Claims of bondholders of subordinated debentures are honored only after the claims of secured debt
and unsubordinated debentures have been satisfied.
Income Bonds

An income bond requires interest payments only if earned and non-payment of interest does not lead to
bankruptcy. Usually issued during the reorganization of a firm facing financial difficulties, these bonds
have longer maturity and unpaid interest is generally allowed to accumulate for some period of time
and must be paid prior to the payment of any dividends to stockholders.

B. Secured Long-Term Bonds

Mortgage Bonds

A mortgage bond is a bond secured by a lien on real property. Typically, the market value of the real
property is greater than that of the mortgage bonds issued. This provides the mortgage bondholders
with a margin of safety in the event that the market value of the secured property declines. Should the
issuing firm fail to pay the bonds at maturity; the trustees can foreclose or sell the mortgaged property
and use the proceeds to pay the bondholders.

Mortgage bonds can further be subclassified as follows:

(a) First Mortgage Bonds

The first mortgage bonds have the senior claim on the secured assets if the same property has
been pledged on more than one mortgage bond.

(b) Second Mortgage Bonds

These bonds have the second claim on assets and are paid only after the claims of the first
mortgage bonds have been satisfied.

(c) Blanket or General Mortgage Bonds

All the assets of the firm are used as security for this type of bonds.

(d) Closed-end Mortgage Bonds

The closed-end mortgage bonds forbid the further use of the pledged assets security for other
bonds. This protects the bondholders from dilution of their claims on the assets by any future
mortgage bonds.
(e) Open-end Mortgage Bonds

These bonds allow the issuance of additional mortgage bonds using the same secured assets as
security. However, a restriction may be placed upon the borrower, requiring that additional
assets should be added to the secured property if new debt is issued.

(f) Limited Open-end Mortgage Bonds

These bonds allow the issuance of additional bonds up to a limited amount at the same priority
level using the already mortgaged assets as security.

OTHER TYPES OF BONDS

1. Floating Rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes with market conditions. In periods
of unstable interest rates this type of debt offering becomes appealing to issuers and investors. To
the issuers like banks and finance companies, whose revenues go up when interest rates rise and
decline as interest rates fall, this type of debt eliminates some if the risk and variability in earnings
that accompany interest rate swings. To the investor, it eliminates major swings in the market value
of the debt that would otherwise have occurred if interest rates had changed.

A common feature of all the floating rate bonds is that an attempt is being made lo counter
uncertainty by allowing the interest rate to float [e.g., interest rates may be adjusted quarterly at 3%
above the three-month London Interbank Offered Rate (LIBOR)]. In this way a change in cash inflows
to the firm may be offset by an adjustment in interest payments.

2. Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or below. The major participants of this market are new
firms that do not have an established record of performance, although in recent years junk bonds
have been increasingly issued to finance corporate buyouts. Since junk bonds are of speculative
grade, they carry a coupon rate of between 3 to 5 percent more than AAA grade long-term debt. As
a result, there is now an active market for these new debt instruments. Because of the acceptance
of junk or low-rated bonds, many new firms without established performance records now have a
viable financing alternative to secure financing through a public offering, rather than being forced to
rely on more-costly commercial bank loans.

3. Eurobonds

These are bonds payable or denominated in the borrower’s currency, but sold outside the country
of the borrower, usually by an international syndicate of investment bankers. This market is
denominated by bonds stated in U.S. dollars.
 The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds
sold by companies in Switzerland, Japan, Netherlands, Germany, the United States and Britain, to
name the most popular countries.

An example might be a bond of a U.S. company payable in dollars and sold in London, Paris, Tokyo
or Frankfurt.

Eurobonds are also referred to as bonds issued in Europe by an American company and pay interest
and principal to the lender in U.S. dollars.

The use of Eurobonds by U.S. firms to raise funds has fluctuated dramatically with the relative
interest rates an abundance or lack of funds in the European markets dictating the degree to which
they are used.

4. Treasury Bonds

Treasury bonds carry the "full-faith-and-credit" backing of the government and investors consider
them among the safest fixed-income investments in the world. The BSP sells Treasury securities
through public auctions usually to finance the government's budget deficit. When the deficit is large,
more bonds come to auction. In addition, the BSP uses Treasury securities to implement monetary
policy.

B. ORDINARY (COMMON) EQUITY SHARES

Ordinary equity shares (traditionally known as ordinary equity share) is a form of long-term equity that
represents ownership interest of the firm. Ordinary equity shareholders are called residual owners
because their claim to earnings and assets is what remains after satisfying the prior claims of various
creditors and preferred shareholders. Ordinary (common) equity shareholders are the true owners of
the corporation and consequently bear the ultimate risks and rewards of ownership.

Business firms organized as a corporation may choose to issue publicly traded stock (publicly owned
corporation) or keep ownership only among the original organizers (closely held corporation). As owners
of the firm, ordinary shareholders are considered to be residual domains. This means that ordinary
shareholders have the right to claim any cash flows or value after all other claimants have received what
they are owned. These profits can be used to reinvest in the firm to foster growth, pay out as dividends
to shareholders, or a combination of the two.

Shareholders assume a limited liability because their risk of potential loss is limited to their investment
in the corporation’s equity shares.
FEATURES OF ORDINARY EQUITY SHARES

1. Par value/No par value

Ordinary equity share may be sold with or without par value. Whether or not ordinary equity share has
any par value is stated in the corporation's charter. Par value of ordinary equity share is the stated value
attached to a single share at issuance. It has little significance except for accounting and legal purposes.
If ordinary equity share is initially sold for more than its par value, the issue price in excess of par is
recorded as additional paid-in capital, capital surplus, or capital in excess of par. A firm issuing no par
share may either assign a stated value or place it on the books at the price at which the equity share is
sold.

2. Authorized, issued, and outstanding

Authorized shares is the maximum number of shares that a corporation may issue without amending its
charter. Issued shares is the number of authorized shares that have been sold. Outstanding shares are
those shares held by the public. Both the firm's dividends per share and earnings per share are based on
the outstanding shares. The number of issued shares may be greater than the number of outstanding
shares because shares may be repurchased by the issuing firm. Previously issued shares that are
reacquired and held by the firm are called treasury shares. Thus, outstanding share is issued share less
treasury share.

3. NO maturity

Ordinary equity share has no maturity and is a permanent form of long-term financing. Although
ordinary share is neither callable nor convertible, the firm can repurchase its shares in the secondary
markets either through a brokerage firm a tender otter. A tender offer is a formal offer to purchase
shares of a corporation.

4. Voting rights

Each share of ordinary equity generally entitles the holder to vote on the selection of directors and in
other matters. Shareholders unable to attend the annual meeting to vote may vote by proxy. A proxy is a
temporary transfer of the right to vote to another party. Proxy voting is done under the rules and
regulations of the Securities and Exchange Commissions, but proxy solicitations are the firm's
responsibility. Not all ordinary equity shareholders have equal voting power. Some firms have more than
one class of share. Class A ordinary (common) equity share typically has limited or no voting rights while
Class B has full voting rights.

There are two common systems of voting:

a) Majority voting

Majority voting is a voting system that entitles each shareholder to cast one vote for each share
owned. Majority voting is used to indicate the ordinary (common) equity shareholders’ approval
 or disapproval of most proposed managerial actions on which shareholders may vote. The
directors receiving the majority of the votes are elected. If a group controls over 50 percent or
the votes, it can elect all of the directors and prevent minority shareholders from electing any
directors.

b) Cumulative voting

Cumulative voting is a voting system that permits the shareholder to cast multiple votes for a
single director. Cumulative voting assists minority shareholders in electing at least one director.
Cumulative voting is required in some jurisdictions for electing the board of directors.

5. Book value per share

The accounting value of an ordinary equity share is equal to the ordinary share equity (ordinary share
plus paid-in capital plus retained earnings) divided by the number of shares outstanding.

6. Numerous rights of stockholders

Collective and individual rights of ordinary equity shareholders include among others:

a) Right to vote on specific issues as prescribed by the corporate charter such as election of the
board of directors, selecting the firm's independent auditors, amending the articles of
incorporation and bylaws, increasing the amount of authorized stock, and so forth.

b) Right to receive dividends if declared by the firm’s board of directors.

c) Right to share in the residual assets in the event of liquidation.

d) Right to transfer their ownership in the firm to another party.

e) Right to examine the corporate banks.

f) Right to share proportionally in the purchase of any new issuance of equity shares. This is
known as the pre-emptive right.

VALUATION

Ordinary or common equity share valuation is complicated by the uncertainty of future returns and/ or
changes in the share’s price.

The various valuation models for ordinary or common equity share are discussed in detail in “Financial
Management, 2019 Edition, Chapter 19 page 32S of this book's authors.”

C. PREFERRED SHARE

Preferred share is a class of equity shares which has preference over ordinary (common) equity shares in
the payment of dividends and in the distribution of corporation assets in the event of liquidation.
Preference means only that the holders of the preferred share must receive a dividend (in the case of a
going concern firm) before holder of ordinary (common) equity shares are entitled to anything.
Preferred shares generally has no voting privileges but it is a form of equity from a legal and tax stand
point.

The issuance of preferred shares is favored when the following conditions prevail:

1. Control problems exist with the issuance of ordinary share.

2. Profit margins are adequate to make of additional leverage attractive.

3. Additional debt poses substantial risk.

4. Interest rates are low lowering the cost of preferred share.

5. The firm has a high debt ratio, suggesting infusion of equity financing is needed.

PREFERRED SHARE FEATURES

The following are the major features of preferred share:

1. Par value

Par value is the face value that appears on the stock certificate. In some cases, the liquidation value
per share is provided for in the certificate.

2. Dividends

Dividends are stated as a percentage of the par value and are commonly fixed and paid quarterly but
are not guaranteed by the issuing firm. Some recent preferred share issues called adjustable rate,
variable rate, floating rate preferred, do not have a fixed dividend rate but peg dividends to an
underlying index such as one of the Treasury bill rate or other money market rates.

3. Cumulative and Noncumulative dividends

Dividends payable to preferred shares are either cumulative or noncumulative, most are cumulative.
lf preferred dividends are cumulative are not paid in a particular year, they will be carried forward as
an arrearage. Usually, both accumulated (past) preferred dividends and the current preferred
dividends must be paid before the ordinary equity shareholders receive anything. If the preferred
dividends are noncumulative, dividends not declared in any particular year are lost forever and the
preferred shareholders cannot claim such anymore.
4. No definite maturity date

Preferred share is usually intended to be a permanent part of a firm's equity and has no definite
maturity date. However, preferred share sometimes carries special retirement provisions. Almost all
preferred shares have a call feature that gives the issuing firm the option of purchasing the share
directly from its owners, usually at a premium above its par value. Some preferred shares have a
sinking fund provision that requires the issuer to repurchase and retire the share on a scheduled
basis. Owners of convertible preferred share have the option of exchanging their preferred share for
ordinary (common) equity share based on specified terms and conditions.

5. Convertible preferred share

Owners of convertible preferred share have the option of exchanging their preferred share for
ordinary (common) equity share based on specified terms and conditions.

6. Voting rights

Preferred share does not ordinarily carry voting rights. Special voting procedures may take effect if
the issuing firm omits its preferred dividends for a specific time period. Preferred shareholders are
then permitted to elect a certain number of members to the board of directors in order to represent
the preferred shareholders’ interests.

7. Participating features

Participating preferred share entitles its holders to share in profits above and beyond the declared
dividend, along with ordinary (common) equity shareholders. Most preferred share issues are
nonparticipating. Without non-participated preferred, the return is limited to the stipulated
dividend.

8. Protective features

Preferred share issues often contain covenants to assure the regular payment of preferred share
dividends and to improve the quality of preferred share. For example, covenants may restrict the
amount of common share cash dividends, specify minimum working-capital levels, and limit the sale
of securities senior to preferred share.

Preferred shareholders have priority over ordinary (common) equity shareholders with regard to
earnings and assets. Thus, dividends must be paid on preferred share before they can be paid on the
ordinary (common) equity share, and in the event of bankruptcy, the claims of the preferred
shareholders must be satisfied before the ordinary (common) equity shareholders receive anything.
To reinforce these features, most preferred shares have coverage requirements similar to those on
bonds. These restrictions limit the amount of preferred share a company can use, and they also
require a minimum level of retained earnings before common dividends can be paid.
 9. Call provision

A call provision gives the issuing corporation the right to call in the preferred share for redemption.
As in the case of bonds, call provisions generally state that the company must pay an amount
greater than the par value of the preferred share, the additional sum being termed a call premium.
For example, Himaya Corporation's 12 percent, P100 par value preferred share, issued in 2005, is
non-callable for 10 year, but it may be called at a price of P112 after 2015.

10. Maturity

Three decades ago, most preferred share was perpetual – it had no maturity and never needed to
be paid off. However, today most new preferred share has a sinking fund and thus an effective
maturity date.

PREFERRED SHARE VALUATION

Preferred share is share that has a claim against income and assets before ordinary share but after debt.
Often, preferred share considered a hybrid security because it possesses characteristics of both debt and
equity. Generally, preferred share is considered similar to ordinary (common) equity share because they
do not have maturity and similar to debt in that both securities have fixed payments, dividends for
preferred share and interest for debt.

Preferred share valuation is relatively simple if the firm pays fixed dividends at the end of each year. If
this condition holds, then the stream of dividend payments can be treated in perpetuity and be
discounted by the investor’s required rate of return on a preferred share issue. A perpetuity is an
annuity with an infinite life span. If the preferred share has high risk, investors normally require a higher
rate of return. This is because creditors have priority over preferred shareholders in their claims to both
income and assets.

Thus, the intrinsic value of a share of preferred share (P o) is the sum of the present values of future
dividends discounted at the investor's required rate of return. This also can be determined using the
following valuation model.

For example, Federal Electric and Power (Company has an issue of preferred share outstanding that pays
a yearly dividend of P10.80. Investors require a 12% return on this preferred share.
Determine the intrinsic value of the preferred share.

Solution:

In the Philippines, the following preferred shares are actively traded in the Philippine Stock Exchange:

First Philippine Holding- Preferred

San Miguel Purefoods- Preferred

Petron Corporation Perpetual- Preferred

Swift Foods, Inc. - Convertible Preferred

COMPARATIVE FEATURES OF ORDINARY EQUITY SHARES, PREFERRED SHARES AND BONDS

The characteristics of ordinary shares, preferred shares and bonds are compared in the following table.

Ordinary Equity Shares Preferred Shares Bonds

(a) Ownership and Belongs to ordinary Limited rights when Limited rights under
control of the firm equity shareholders dividends are missed default in interest
through voting right payments
and residual claim to
income

(b) Obligation to None Must receive payment Contractual obligation

provide return before ordinary
shareholder

(c) Claim to assets in Lowest claim of any Bondholders and Highest claim
bankruptcy security holder creditors must be
satisfied first

(d) Cost of distribution Highest Moderate Lowest

(e) Risk-return trade off Highest risk, highest Moderate risk, Lowest risk, moderate
return (at least in moderate return return
 theory)

(f) Tax status of Not deductible Not deductible Tax deductible Cost=
payment by corporation Interest payment x (1 –
Tax rate)

(g) Tax status of A portion of Dividend Same as ordinary shares Government bond
payment to recipient paid to another interest is tax exempt
corporation is tax
exempt