Working Capital

To obtain revenues, the firm strives to provide customers ducts or services. To achieve this,
various inputs are required in need of adequate funding. What is needed is a portion of the capital
which will take care of financing the day-to-day activities of the firm. This funding requirement
is covered by the firm’s working capital.
MEANING AND COMPOSITION OF WORKING CAPITAL
Working capital refers to that part of the capital of the company which is continually circulating.
It is circulating in the sense that the initial cash funds of the firm are converted into inventories,
which in turn are converted into cash or accounts receivable and ultimately into cash again.
Working capital may be described in two ways: (1) gross working capital, which is the total
amount of the firm's current assets; and
(2) working capital, which is the total amount of current assets minus current liabilities.
The gross working capital of the firm is usually composed of the following:
1. cash in the firm's safe;
2. checks to be cashed;
3. balances in the bank accounts;
4. marketable securities (not including stocks in subsidiaries);
5. notes and accounts receivable;
6. supplies;
7. inventories;
8. prepaid expenses; and
9. deferred items.

THE NEED FOR WORNING CAPITAL

Working capital is required for the following purposes:
1. Replenishment of Inventory. A sufficient stock of inventory is required to support the
sales target of the firm. This requirement, however, will depend on the availability of
resources. An unserved portion of demand may mean lost revenues for the firm.
2. Provision for Operating Expenses. To maintain the operations of the firm on a day-to-
day basis, a working capital is required. This will be needed to take care of salaries and
wages, advertising, taxes and licenses, insurance premium, and interest payments.
 3. Support for Credit Sales. At times conditions require that credit sales be extended to the
firm’s clients. This will need sufficient working capital to enable the firm to maintain its
operations until receivables are converted into cash.
4. Provision of a Safety Margin. The firm should have sufficient amount of capital to
provide for unexpected expenditures, delays in the expected inflow of cash, and possible
decline in revenue.
Cash Requirements
The firm needs cash to pay for expenditures that arise from time to time. Even if the anticipated
cash receipts are equal to the anticipated cash expenditures. It is still necessary to maintain a
sufficient cash fund for the firm to meet its cash commitments. This is needed because of the
difficulty in synchronizing cash receipts with cash disbursements. It is therefore, required that a
positive cash balance be maintained so that the firm's obligations are settled as they become due
The amount of cash needed depends upon the following:
1. the amount of the firm's purchases and cash sales:
2. the time period for which the firm receives and grants credit
3. the time period from the dates of purchase of raw materials and payment of wages to the
dates of cash receipts from sales
4. the amount of cash to be used for investment in inventories: and
5. the amount of cash needed for other purposes such as cash dividends
Accounts Receivable Requirements
Since liquidity is a primary concern of sound business tina firms prefer cash sales over credit
sales. Many companies, however, cannot avoid the extension of credit to customers for various
reasons Credit is used to sustain and to promote production distribution and consumption of
goods and services.
The unpaid portion of credit sales is represented by accounts receivable in the firm's records. The
collection of accounts receivable from customers contribute to cash inflow requirements of the
firm.
Credit terms vary according to the degree of competition within individual industries, the
availability of bank credit, and pressures for increased sales in periods of increasing plant
capacities.
Inventory Requirements
The production of large stocks of inventory generate savings as a result of lower production cost.
It will also provide the firm with large quantity of stocks to meet increasing or unusually large
orders from customers. The maintenance of large stocks of inventory, however, may
unnecessarily tie up funds which could have been made available for other uses. Outside
financing may even be required. In addition, storage and warehousing costs may also increase.
The ideal set-up is for the firm to make sales as soon as finished products come out of the
production line, or to acquire raw materials and supplies as soon as they are needed. Since these
are not possible, economists have devised a method of knowing the inventory level that will
optimize results considering both above-mentioned requirements.
MANAGEMENT OF WORKING CAPITAL
Working capital must always be able to cover fund requirements of the company as they are
needed. There are times when unusual pressures on working capital makes the job of the finance
manager very difficult. To overcome this, a system be adapted considering the following
objectives:
1. Working capital must be adequate to cover financial requirements. It must be allocated
am needs in sufficient amounts. The quantity of stocks to be carried and the maximum
allowable of receivables must be decided in advance.
2. The working capital structure must be liquid meet current obligations as they fall due.
Salaries and wages must be paid on time. Raw materials and must be acquired on days
they are needed.
3. Working capital must be conserved through proper allocation and economical use. It
must be protected losses arising out of natural calamities, malversation, or pilferage.
4. Working capital must be used in the attainment of profit objectives of the firm.
Measures to contribute increased profits through avoidance of loss must be instituted.
LIQUIDITY MANAGEMENT
Liquidity refers to the ability of the firm to pay its bills on time or otherwise meet its current
obligations. Activities geared towards is called liquidity achieving the liquidity objectives of the
firm management.
The objective of management is to acquire sufficient amounts of funds to cover the cash
requirements of the firm. The cash inflows of the firm come from various sources which are
briefly described as follows:
1. Cash Sales. The percentages of cash derived from sales vary from company to company and
from industry to industry.
2. Collection of Accounts Receivables. The credit policies and the pattern of company sales
determine the frequency and volume of collections from receivables.
3. Loans. Loans from banks and other creditors may be availed of by management mostly on its
own initiative. The timing and amount of cash receipts derived from depend largely on the
borrowing firm.
4. Sale of Assets. Assets are sometimes sold by the company for various reasons. Obsolescence
is one of those.
5. Ownership Contribution. Additional contributions owners are sometimes tapped to improve
the liquidity posture of the firm.
6. Advances from Customers. Manufacturers, at times, require cash advances from customers
as soon as an o is made and before production is started. This is not unusual especially if the
objects of sale are capital like airplanes and ships. The number of years required the
manufacturing process justifies whatever cash advances are required from customers.
Cash Management
Idle cash earns nothing and even if it is kept in a bank, the interest it earns is minimal. If
sufficient amounts of profits must be attained, cash should be invested. Sufficient cash must be
maintained, however, to cover the firm's cash expenditures. The activity involved in achieving
these two opposite goals is called cash management.
To effectively manage cash, five major approaches are suggested. These are as follows:
1. Exploit techniques of money mobilization to reduce operating requirements for cash;
2. Expend major efforts to increase the precision and reliability of cash flow forecasting;
3. Use maximum efforts to define and quantify the liquidity reserve needs of the firm;
4. Develop explicit alternative sources of liquidity; and
5. Search aggressively for more productive uses of surplus money assets.
Money Mobilization.
Some companies maintain branches and agencies in distant places. Those that serve customers
directly may find that they are also serving customers from far-flung areas. These two conditions
are characterized by remittances which take several
days before they are converted into usable cash balances. Checks payments, for instance, are sent
through the mail. When these are received, they are deposited in the bank. These checks will be
cleared for the company's use after several days. Checks issued by customers from distant areas
require longer clearing period. This time lag stated briefly, consists of two identifiable periods:
(1) the mail traveling time of the check payment; and (2) the check clearing time.
Various solutions are offered to improve the set-up. To shorten the time lag, some companies
open accounts with banks locate the far-flung areas where the company's branches are located.
The banks serve as the collecting arm of the companies. In most ca this improvement reduces to
half the number of days spent between actual payment made by the client and the availability of
system payment for use by the firm.
Improved Cash Flow Forecasting. A cash flow forecast with high degree of precision and
reliability provides the firm with realistic approaches to planning and budgeting. The
disadvantage of cash excess and cash shortages are eliminated if not minimized
The advantages brought by an improved cash flow forecast are the following:
1. Surplus funds are more fully invested;
2. Alternative methods of meeting the outflows can be explored; and
3. The creation of special reserves for major future outlays will be minimized
Defining and Quantifying the Liquidity Reserve Needs of the Firm. Firms are faced with a
number of uncertainties and contingencies which may require cash reserves. To be protected
against the worst possibilities, a very large reserve of cash will be needed. The idea is to avoid
unnecessary losses or expenditures brought about by liquidity problems. The holding of cash
reserves, however, entails cost. The management is left with striking a reasonable balance
between the two requirements. Several steps are necessary to accomplish this objective. These
are the following:
1. Identification of contingencies requiring protection;
2. Assessment of the probabilities of the contingencies occurring:
3. Assessment of the probabilities of the contingencies occurring at the same time; and
4. Assessment of the probable amount of cash required each of the contingencies happens.
If reserves for certain contingencies will not be provided, the amount of possible losses must be
ascertained. If reserves will provided, the cost of carrying the reserves must also be determined
The expected value of the losses and cost must be computed. This may be arrived at by
multiplying the losses or cost with probability estimates of occurrence.
To illustrate, assume that a labor strike happening in the premises of the company will paralyze
operations. Borrowing funds to cover the necessary expenditures of the firm will penalize the
firm with interest charges amounting to one million pesos. It has also been ascertained that if a
reserve fund has to be carried for the contingency, the firm will be penalized with eight thousand
pesos in the form of lost income which could have been otherwise earned by the idle cash
reserve.
If the probability of the strike happening is placed at 50%, the expected values of the options
may be computed as follows:
Option:
No Reserve
With cash reserve
Penalty:
No reserve P1,000,000
With cash reserve P800,000
Probability:
No reserve 50%
With cash reserve 50%
Expected value:
No reserve P500,000
With cash reserve P400,000
Carrying a cash reserve in this case is more economical to the firm because it carries a lower
penalty expected value.
Development of Alternative Sources of Liquidity. Once the liquidity reserve needs of the firm
have been defined and quantified, alternative sources of meeting these needs should be identified
and evaluated.
One possible alternative is the exploitation of the unused borrowing capacity of the firm.
Borrowings, oftentimes, provide the funds necessary for liquidity: Not all companies, however,
may avail this option. During recession, when small companies are unable to borrow money
from lending institutions, interbusiness financing refers to credit flowing from a large business to
small business.
Search for More Productive Uses of Cash Surplus. Cash surplus may be utilized by the firm to
earn higher returns. A gap may exist, however, between the time when cash starts coming in and
the time it is actually made more productive. As various investment opportunities may be
available, it is important sufficient effort is expended in the determination of the alternative.
Planning activities must also be geared to eliminating the unproductive or less productive gap.
Inasmuch as new investment opportunities may be m available from time to time, a continuous
search and evaluation activity must be done.
Accounts Receivable Management
As sales on account cannot be avoided most of the tin management must face the difficulty
squarely and make it work the advantage of the firm. This is important because when accounts
receivables are not properly managed, the financial viability of the firm may be impaired.
Objectives. One of the goals of business finance is to maximize profitability. In this regard, all
activities of the firm must contribute towards the attainment of this objective.
The purpose of credit extension to clients is to maximize sales Thus, if more sales is required by
the firm, more credit is extended. Increased sales, however, is not an end in itself. Any advantage
gained in extending credit to customers may be offset or even surpassed by problems brought
about by bad-debt losses and the consequent tie-up of funds in receivables.
The objective of accounts receivable management is to determine the cost and profitability of
credit sales. There is no point in extending credit to customers if this will cause a lowering of the
firm's return on investment
The second objective of accounts receivable management is the projection of cash flows from
receivables. This will provide an essential input in the preparation of the firm’s financial plan.
The third objective relates to the direction and control of activities involved in the extension of
credit to customers.
Elements of the Cost of Credit. The cost of credit is compos three elements: (1) bad debts cost:
(2) cost of invested run (3) administrative costs.
Bad debts cost refers to accounts receivable uncollected and subsequently written off. The cost
of invested funds refers to the rate at which the firm could borrow funds to finance credit sales.
These include form letter, individually written letters, telephone charges, clerical and
administrative time spent on an account, and credit and investigation expenses.
Functions of the Credit Department. The credit department performs the following functions:
1. gathering and organizing of information necessary for decisions on the granting of credit
to particular customers;
2. assuring that efforts are made to collect receivables when they become due; and
3. determining and carrying out appropriate efforts to collect accounts of customers who
cannot or do not intend to pay.
Sources of Credit Information. A variety of sources may be used to obtain credit information
concerning customers. The sources most commonly used are the following:
1. personal interviews;
2. references;
3. credit bureaus;
4. credit-reporting agencies, and
5. banks.
Personal interviews provide basic information concerning an applicant for credit. The applicant
is usually required to fill up a credit application blank. The credit application contains the
following items:
1. the name of the applicant;
2. residence and former address;
3. occupation or business,
4. business address
5. bank where the applicant maintains an account, and
6. property owned.
More Information is usually required if the credit applicant is at company. References also
provide a valuable source of inform The credit applicant is usually required to u three credit
references. These references, in turn, may pre valuable insights into the character and ability of
the applicant.
Credit bureaus are institutions organized for the exchange ledger information among associated
creditors. Among the service rendered by credit bureaus are the following:
1. reports;
2. bulletins;
3. credit guides, and
4. special services
Credit reporting agencies consist of more specialized forms credit bureaus. Banks constitute a
valuable source of credit information This is largely due to their involvement in lending
activities.
Evaluation of Credit Risk. Before credit is granted, the risk involved is evaluated. This is done
after information regarding the credit risk has been gathered. In the evaluation of a credit risk,
the basic criteria used refer to the following:
1. Capital;
2 Capacity:
3. Character, and
4. Conditions.
Capital refers to the financial resources of the credit applicant. The balance sheet is a very useful
tool in determining the resources of the applicant.
Capacity refers to the ability of the applicant to operate successfully. This is indicated in the
profit and loss statement of the applicant. Character refers to the reputation for honesty and fair
dealing of the applicant or the owners of the firm applying for credit.
Conditions refer to the environment required for the extension of credit.
Inventory Management
Inventory management refers to the activity that keeps track of how many of the procured items
needed to create a product or service are on hand, where each item is, and who has responsibility
for each item.
Inventory management consists of two aspects: liquidity and profitability. The liquidity story
turnover the profitability aspect is measured in a usually measured in terms of tory level at a
given level of sales and profit
A successful inventory management program's main objective to strike a balance among three
key elements as follows:
1. Customer services
2. Inventory investment in terms of pesos of dollars), and
3. Profit
Customer Service. The period between when the order is made and the date of delivery is very
important to the customer. Shorter periods are preferred. If the customers have to wait too long to
get the products, they will get them elsewhere. The company with the shortest lead time, le, the
number of days the customers have to wait, has a better chance of improving its sales.
Inventory Investment. Funds tied up in inventory should ideally be kept to a minimum without
sacrificing customer service. Investments in inventory eat away company profits. These usually
take the form of interests, insurance, taxes, obsolescence, and storage.
Profit. The level of inventory carried by the company most often affects the profitability of the
company. The task of management is to determine the level which would bring the highest return
on equity
Functions of Inventory. Inventories perform certain functions. These are the following
1. They serve to offset errors contained in the forecast of the demand for the company's products;
2. They often permit more economical utilization of equipment, buildings, and manpower when
the nature of the business is such that fluctuations in demand exists, and
3. It permits the company to purchase or man economic lot sizes.
Forms of Inventory. Inventories are composed of forms which are as follows:
1. raw materials:
2. work-in-process; and
3. finished goods.
Raw materials consist of all parts, sub-assembly and components purchased from other firms but
not yet put into the manufacturers own production processes. When raw materials and labor
added into the basic raw material inputs, they are combined and transformed into work-in-
process inventories. They become finished goods when they are composed and stocked.
Methods of Achieving Inventory Goals. Inventory goals may be achieved by using any of the
several devices available. These devices are the following:
1. the ABC method;
2. the economic order quantity method;
3. the safety stock; and
4. the anticipation stock.
The ABC method classifies inventory into three categories: A, B. and C for management and
control purposes. Category A may be classified as those comprising a large proportion of the
inventory value, and in which tight control is applied. Category B comprises those accounting for
a substantial part of the total inventory value, requiring less tight control. Category C items are
those that account only for a small proportion of the total inventory value and as a consequence
is the least controlled.
The economic order quantity (ECO) method is used to determine what quantity to order so as to
minimize total inventory costs. The EOQ method involves two major costs:
1. carrying costs (warehouse storage costs); and
2. ordering costs (filling in purchase requisitions).
These two costs tend to offset each other. One reason is that ordering in large quantities allows
volume discounts, but it also involves higher storage costs. To balance these two factors, an
economic order quantity should be determined. The EOQ formula is as follows:
EOQ = the square root of 2 US/CI
where: EOQ = economic order quantity
U = annual usage
S = restocking or ordering cost
C = cost per unit
I = annual carrying cost (expressed as percentage of inventory value)
Thus, if annual usage is 1,000 units, restocking cost is 1,000 cost per unit is P50,000, and annual
carrying cost is 10%, EOQ is;
EOQ= 500 = the square root of 2 x 1,000 x P1,000/P50,000 x 10%
= 20
When conditions are uncertain, safety stocks are needed. Se stocks are that part of inventory used
to absorb random fluctuations in purchases, production, and sales.
Anticipated stock refers to that portion of the inventory used for expected seasonal, cyclical and
secular changes in inventory
SUMMARY
That portion of the total capital of the firm which finance the day-to-day activities is called
working capital, and it is continually circulating
The gross working capital refers to the firm's total current assets. The networking capital is the
total amount of current assets minus current liabilities.
Working capital is needed for the following purposes: (1) replenishment of inventory: (2)
provision for operating expenses; (3) support for credit sales; and (4) provision of a safety
margin.
Working capital must be: (1) adequate to cover all current financial requirements: (2) liquid
enough to meet current obligations as they fall due; (3) conserved through proper allocation and
economical use; and (4) used in the attainment of the profit objectives.
Management must require sufficient amount of funds to cover the cash requirements of the firm.
Cash inflows come from cash sales, collection of accounts receivable, loans, sale of assets
ownership contribution, and advances from customers.

CHAPTER 4
FINANCIAL MARKETS
Awareness of the environment where the business operates provides a better perspective to the
one making decisions relating to the finance function. An important concern refers to financial
markets which perform a vital role in the operation of the overall financial system including
business finance.

WHAT ARE FINANCIAL MARKETS

There are lots of individuals and firms with surplus funds. This actually means that their current
expenditures are smaller than their current incomes. To many of them, the surplus funds need to
be invested.
At the same time, there are people and firm whose needs for funds are greater than their current
incomes. They need a reliable source of loanable funds.
Individuals and firms who want to borrow money are brought together with those who want to
lend in the financial markets. These markets provide a permanent venue for savers and
borrowers, and which render financial services whenever required by their customers. These
services are made possible by the financial markets through expediting the creation and trading
of financial instruments.
Figure 4 shows an illustration of how funds and financial instruments are channeled to and from
the surplus spending units (SSUS) and the deficit spending units (DSUs) in the financial markets.

BENEFITS OF FINANCIAL MARKETS

The operation of financial markets offer advantages which covers the following:
1. funds are directed to DSUs which can use them most
efficiently; and
2. liquidity is provided to savers.

DIRECT FINANCING
Private placements Brokers Dealers Investment bankers
Direct Credit Market
Primary Securities
Funds
Funds
Primary Securities

SURPLUS SPENDING UNITS

Households Business Firms Government
DEFICIT SPENDING UNITS
Households Business Firms Government
Secondary Securities
Funds
Primary
Securities
Funds

INDIRECT FINANCING BY FINANCIAL INTERMEDIARIES

Commercial banks
Savings and loans Associations
Mutual savings banks
Credit unions
Insurance companies
Pension funds
Finance companies
Mutual funds
Money market funds
Intermediation
Market
Direct Credit
Market
Figure 4. Channels for Funds and Financial
Instruments in the Financial Market

METHODS BY WHICH FINANCIAL MARKETS TRANSFER FUNDS

When firms need funds, the financial markets provide two methods by which funds could be
transferred to them. The methods consist of direct and indirect finance. Direct Finance
Direct finance refers to lending by ultimate borrowers with no intermediary. Under this method,
the SSU gives money to the DSU in exchange for financial claims on the DSU. The claims
issued by the DSU are called direct claims and are typically sold in direct credit markets such as
the money or capital markets.
Direct financing provides SSUs with a venue for savings with expected returns. The DSUs as a
result, are provided with a source of funds for consumption or investment. This arrangement
increases the efficiency of the financial market.
Direct financing, however, has some disadvantages. These are as follows:
1. There are few DSUs which can transact in the direct market
because the denominations of securities sold are very large
(usually millions of pesos).
2. It is difficult to match the requirements of SSUs and DSUS
in terms of denomination, maturity, and other factors. Methods of Direct Financing. There are
various means used in direct financing. These are as follows:
1. private placements;
2. brokers and dealers; and
3. investment brokers.
Private placement refers to the selling of securities by private negotiation directly to insurance
companies, commercial banks, pension funds, large-scale corporate investors, and wealthy
individual investors.
A broker is one who acts as an intermediary between buyers and sellers but does not take title to
the securities traded.
When banks buy Treasury bills (T-bills) from the Bangko Sentral, they do so in consideration of
their clients who buy the T-bills from them and which forms a solid secondary market. Figure 6
shows the flow of funds and securities in the primary and secondary markets. Money Market
The money market is that financial market on which debt securities with an original maturity of
one year or less are traded. Long-term securities may also be traded in the money market if they
have six months or less left to maturity.
Banks like the Land Bank of the Philippines perform money market functions.

PRIMARY MARKET: New Issues

Money Invested
Investment Bankers and
Private Placement
New Funds
New Common Stock and Bond Certificates
New Stock and Bond Certificates
Household
Sector
Money
Business
Sector
Common Stock and Bond Certificates
Common Stock and Bond Certificates
Stock Exchanges and Over-the-counter
Market
Money

SECONDARY MARKETS: Seasoned or Existing Issues

Figure 6. The Flow of Funds and Securities in
Primary and Secondary Markets
Financial markets, just like any market, operate under the influence of the demand and supply of
funds. DSUs that can use borrowed funds in the most productive manner can afford to pay higher
interest rates. Because of this, they have an edge in the bidding for loanable funds. As such,
business firms, big and small, compete for the use of the funds made available by the financial
market. The competition will push interest rates higher and this will motivate savers to save more
so they will have more funds for lending.
An additional benefit provided by financial markets is liquidity. Without the intervention of
financial markets, savers will directly lend to borrowers. This arrangement forces the lender to
wait for the maturity date of the loan before he gets his money back. The lender will be at a great
disadvantage if he finds out later that he needs the loaned amount before maturity. This problem
is eliminated when financial markets are tapped. This happens because financial instruments are
issued to lenders, which in turn, can be converted to cash even before maturity, by endorsement
or sale.
WHY FIRMS INVEST AND BORROW
Firms, at one time or another, are confronted by capital deficiency. This happens when
opportunities for investment come by. Additional investment may bring additional income or
economies in operation. An electronics-retailing firm, for instance, may expand by opening
branches in various places. The immediate advantages that may be derived are as follows:
1. quantity discounts for bulk purchases granted by
suppliers; and
2. additional revenues from sales.
When the owners of the firm cannot provide additional capital, they will resort to borrowing.
This situation happens not only to small firms but to big firms as well.
A system must be able to address that particular economic need. The answer lies in the operation
and maintenance of a financial system, which includes financial markets.

INCRECT FINANCE
FINANCIAL INTERMEDIARIES
Funds
Funds
Funds
Borrowers-Spenders Lender Savers
1 Business Firms
1. Households
FINANCIAL
2. Government
2 Business Firms
MARKETS
3. Government Funds
Funds
3. Households
4. Foreigners
4. Foreigners
DIRECT FINANCE Figure 5.
Transfer of Funds From Lenders to Borrowers
A dealer is one who is in the security business acting as a principal rather than an agent. The
dealer buys for his account and sells to customers from inventory. He makes profits by selling
his inventory of securities at a price higher than the acquisition cost.
The investment banker is a person who provides financial advice and who underwrites and
distributes new investment securities. Indirect Finance
Indirect finance (also called financial intermediation) refers to lending by an ultimate lender to a
financial intermediary that then relends to ultimate borrowers. Financial intermediaries include
commercial banks, mutual savings banks, credit unions, life insurance companies, and pension
funds.
The beneficiaries of direct financing brought to the fore the services of financial intermediaries.
Direct claims with one set of characteristics are purchased from borrowers, then transformed into
indirect claims with a different set of characteristics and then sold to lenders.

CLASSIFICATION OF FINANCIAL MARKETS

Financial markets may be classified as follows:
1. primary market
2 secondary market
3. money market
4. capital market
5. bond market
6. stock market
mortgage market
8. consumer credit market
9. auction market
10. negotiation market
11. organized market
12. over-the-counter market
13. spot market
14. futures market
15. options market
16. foreign exchange market

Primary Market
A financial market in which newly issued primary and secondary securities are traded for the
first time is called primary market. Investors who buy these new issues are supplying funds to
DSUs which issue the securities.
Large corporations needing large amount of funds usually tap the primary market through bond
issuance.
Secondary Market
A secondary market is that financial market through which existing financial securities are
traded. SSUs which bought new securities from the primary market may sell the same to the
secondary market anytime they wish to change their portfolios before maturity dates. As such,
the secondary market provides liquidity to the SSUs with securities held.
Capital Market
The capital market is that portion of the financial market w trading is undertaken for
securities with maturity of more than one year Banks that bid for two year Treasury bonds are
considered part of the capital market
The capital market is subdivided into three parts
1 the bond market:
2 the stock market and
3 the mortgage market.
Bond Market
The market for debt instruments of any kind is called the bord market. It operates through a
system of dealers using a telecommunications network rather than in a single physical location
for trading Dealers include giant banking firms located around the world
Stock Market
The stock market is that financial market where the common and preferred stocles issued
by corporations are traded. It has two components: (1) the organized exchanges and (2) the less
formal over-the-counter markets
There are many organized exchanges throughout the world like the New York and the London
Stock Exchanges in the Philippines stocks are openly traded in the Philippine Stock Exchange.
The companies whose stods are traded in the Philippine Stock Exchange are dassified into the
following categories
1. banks
2 financial service
3 communication
4. power and energy
5. transportation services
6: construction and other related products
7. food, beverages, and tobacco
8 holding firms
9. manufacturing, distribution, and trading
10. hotel, recreation, and other services
11. bonds, preferred stocks, and warrants
12. others
Mortgage Market
The mortgage market is that portion of the financial market which deals with loans on
residential, commercial, and industrial real estate, and on farmland.
Various financial institutions comprise the mortgage market, This may be derived from a
review of advertisements in newspapers where financial institutions are inviting interested
parties to buy foreclosed properties. Aside from banks, the National Home Mortgage Finance
Corporation, the Government Service Insurance System, and the Social Security System grant
mortgage loans, secured by house and lot as collaterals.
Consumer Credit Market
The market involved in loans on autos, appliances, education, travel is referred to as the
consumer credit market. As there are millions of consumers tapping the credit market, it is
expected that there will be a number of financing institutions extending auto, salary, and various
personal loans to consumers.
Auction Market
Negotiation Market When buyers and sellers of securities negotiate with each of regarding
price and volume, either directly or through a broker or dealer, they are engaged in the financial
market called negotiation market. Securities that are not frequently traded and which are in large
volumes may not be readily accommodated in the auction market for lack of time to receive
sufficient orders. This situation is remedied by the negotiation market where the buyers and
sellers are given sufficient time to locate one another and to revise either price or volume in
order to dear the market. Once in a while, the Philippine government negotiates with institutions
like the World Bank for loans intended for various projects.
Organized Market
The organized market is that financial market with fixed trading rules. It is situated at a
central location in the financial district in which trading is generally conducted by auction.
Another name for organized markets are exchanges like the Philippine Stock Exchange and the
Australian Stock Exchange. Common and preferred stocks, bonds, and warrants are sold at the
Philippine Stock Exchange. Stock exchanges have specifically designated members, and have an
elected governing body - the board. Members have seats in the exchange, which are bought and
sold. The seat gives the holder the right to trade on the exchange. The board of governors of the
Philippine Stock Exchange is composed of 15 members.
Over-the-counter Market
The over-the-counter market is that market consisting of large collection of brokers and
dealers, connected electronically by telephones and computers that provide for trading in unlisted
securities. All securities not traded in the stock exchange, for one reason or another, are traded
over the counter. The over-the-counter market consists of facilities, namely:
1. relatively few dealers who hold inventories or over-the counter securities and act as a
securities market;
2. the many brokers who act as agents in bringing these dealers together with investors; and
3. the computers, terminals, and electronic networks the provide a communications link between
dealers and brokers
Spot Market
When securities are traded for immediate delivery and payment, the market type referred to
is the spot market. The sporprice is the feature of the spot market and which is actually the price
paid for a security that will be delivered on the spot immediately The term immediately may
actually mean one or two days to one week depending on the facilities used or the tradition in the
area. The spot market is an alternative to the futures market.
Futures Market
The futures market is that market where contracts are originated and traded that give the
holder the right to buy something in the future at a price specified by the contract For some time
in the past, there was a futures market operating in the Philippines, but it was dissolved because
of some difficulties As its importance cannot be discounted, the Bankers Association of the
Philippines has recommended key reforms in government regulations that will pave the way for
the resumption of futures trading in the country.
Options Market
The options market is one where stock options are traded. A stock option is a contract
giving the owner the right to either buy or sell a fixed number of shares of a stock (usually 100)
at any time before the expiration date at a price specified in the option. Option contracts may
cover items like gold and Treasury bonds. Options are traded in organized securities exchanges
like the Philippine Stock Exchange. One purpose of the options market is to make possible for
investors who wish to reduce the risk of losing money due to price changes in the future. For
instance, an importer purchasing goods to be paid in foreign currency may avoid the risk of a
sharp rise in the foreign exchange rate by buying an options contract.
Foreign Exchange Market
The foreign exchange market is the market where people buy and sell foreign currencies. This
market is composed of the following:
1. banks located throughout the world buying and selling foreign monies, in the form of foreign
currencies are deposits in foreign banks;
2, foreign exchange dealers; and
3. currency exchanges catering mostly to tourists and are found in the downtown areas, airports,
and railroad stations in major tourist centers.
SUMMARY
The financial success of any business firm will depend much on the quality of decisions
made by management regarding the firm's financial activities. The quality of decisions, however,
will depend on how well management understands the environment under which business
finance operates. An important requirement is the clear understanding of financial markets and
how they operate.
When management has sufficient understanding of financial markets, it will be able to tap
resources, which match the firm's needs and capabilities.
Financial markets are useful in two aspects: (1) funds are directed to DSUs which can use
them most efficiently; and (2) liquidity is provided to savers.
Oftentimes, business firms require additional funds for investment purposes. When funds
cannot be sufficiently generated internally, the financial market may come in handy as an
alternative.
Financial markets transfer funds directly or indirectly. The means used in direct financing
consist of private placements, brokers and dealers, and investment bankers. Indirect financing
makes use of financial intermediaries.
Financial markets may be classified as follows: primary market, secondary market, money
market, capital market, bond market, stock market, organized market, over-the-counter market,
spot market, futures market, options market, and foreign exchange market.
KEY TERMS AND CONCEPTS
financial markets surplus spending
units capital market bond market
stock market deficit spending units
direct finance mortgage market
private placements consumer market
brokers auction market
dealers negotiation market
investment bankers organized market
indirect finance over-the-counter mark
financial intermediaries spot market
primary market futures market
secondary market options market
money market foreign exchange mark
QUESTIONS FOR REVIEW AND DISCUSSION
1. Why is knowledge of financial markets an importanrequirement in business finance?
2. How may financial markets be described?
3. What benefits do financial markets offer?
4. Why do firms invest and borrow?
5. What methods do financial markets use to transfer funds? 6. What means are used in direct
financing? In indirect financing?
7. What is a primary market? 8. What is traded in the money market?
9. How does funds and securities flow in primary and secondary markets? 10. What situation is
remedied by the negotiation market?
SUGGESTED ITEM FOR RESEARCH Prepare a list of financial intermediaries in your area
providing indirect financing
Capital Budgeting
Management is originally hired to take control of the funds of the owners of the business.
In most cases, it involves themaximization of the earning power of these funds. The planningand
control of capital expenditures is, therefore, a basic executive function. As such, the budgeting of
funds for capital expenditures is a very important activity of management.
In this chapter, capital budgeting as an important segment of business finance is presented.
Among those included are the relevant concepts pertaining to investment, valuation, risk, and
uncertainty.
BASIC TERMS IN CAPITAL BUDGETING
For a better understanding of capital budgeting concepts, the following terms are defined
and explained: capital expenditures, capital budgeting, valuation, and investments.

Capital Expenditures
The term capital expenditure refers to substantial outlay offunds the purpose of which is to
lower costs and increase net income for several years in the future. It includes expenditures that
tie up
capital inflexibility for long periods. It fixed assets but also expenditures for major research on
new
covers not only outlays for products and methods and for advertising that has cumulative effects.
Classes of Capital Expenditures.
Capital expenditures may be classified into the following:
1. replacement investments - this refers to investments onreplacement of worn-out or
obsolete facilities;
2. expansion investments – this provide additional facilities totype of expenditure will and/or
distribution capabilities of the firm; the production increase
3. product-line or new market investments expenditures on new products or new markets, and
on
improvement of old products with the combined features of replacement and expansion
investments. are expenditures necessary to comply with government
4. investments in safety and/or environmental projectsorders, labor agreements, or
insurance
policy terms. These are sometimes called mandatory investments or non-revenue.producing
projects.
5. strategic investments - these are investments accomplish the overall objectives of the
firm. buildings, parking lots, executive aircraft.
6. other investments this catch-all term includes office

Capital Budgeting
as capital budgeting. This activity is essential because it Theplanning and control of capital
expenditures is referred tosystematic evaluation of the firm's alternatives. It helps management
provides a in choosing an alternative that will provide the best yield for the
Valuation
Management is, at times, confronted with the problem ofevaluating a proposal. When the
proposal's real worth to the firm is determined, the process is called valuation.
Investment
An investment is made when a firm spends some of its funds for the establishment of a project.
By doing so, the opportunity touse the same funds in other possible projects is lost. Investments
take two forms:
1) initial; and (2) later.
Initial investment refers to the amount that has been devoted to a project until it generates
cash inflows from operations. Expenditures made after the first cash inflow is called later
investments.
OBJECTIVES OF CAPITAL BUDGETING
The objectives of capital budgeting are the following:
1.establishing priorities;
2.cash planning;
3.construction planning;
4.eliminating duplication; and
5.revising plans.
Establishing Priorities
The resources of the firm is said to be limited. The total number of opportunities available for
investment cannot all be accommodated by the firm. Capital budgeting will help to solve this
difficulty. This is possible because investment priorities are established in capital budgeting.
Cash Planning
The objective of the cash planning activities of the firm is ensure the availability of funds that
will be sufficient to meet its cash requirements, including those concerning the acquisition
ofcapital assets. A periodic cash expenditures estimate included inthe capital budget helps to
attain such objective.
Construction Planning
The objective of construction planning is to minimize the periodexpended for the construction or
acquisition of a capital asset. The construction plan, a requirement for capital budgeting, will
be presented before the capital budget is prepared. This requirement ensures the preparation of
such plans.
Eliminating Duplication
A centralized capital budgeting activity will help identify effortsundertaken at various levels in
a decentralized organization. Theduplication of efforts, as a result, will be minimized if
not totallyeliminated.
Revising Plans
revisions in the Changes in the environmental factors may require appropriate authorization of
investment projects which include expected profitability, construction cost, and the timing of
start-up, where coordination with related activities isessential. Such requirements will be made
obvious by A timely response to such problems, then becomes a possibility. good capital
budgeting system.
THE CAPITAL BUDGETING SYSTEM
The capital budgeting system is composed of the following:
1.preparation and submission of budget requests;
2.approval of budget;
3.request for appropriation;
4.submission of progress reports; and
5. post approval reviews.
Budget Requests
budget capital projects which are felt to be desirable by those in the those made to include in
the Budget requests are corporatelower organizational levels.
The budget request contains the following:
1. project title;
2. cost, including estimates on:
a. fixed capital
b. working capital
C. non-operating outlays
d. others, including opportunity cost;
3. priority rating of the project;
4. profitability of the project;
5. timing or the ability to adhere to a construction schedule;
6. financing method;
7. project classification; and
8. project narrative.
Approval of the Budget
The approval of the budget is a process which requires thefollowing steps:
1. budget requests are forwarded to top management;
2. topmanagement decides which projects to recommend to the board of directors;
3. top management sends recommendations to the board ofdirectors;
4. the board of directors approves or recommendations; and
5. top management informs projects sponsors of the action taken on their projects.

Request for Appropriation

After the approval of the budget, the next step undertaken isgetting an appropriations request
approved. managers of a corporation are usually given the authority to
approveappropriations requests up to certain established limits.
The appropriations request usually contains the following:
1. the request and authority section - this serves to identify theoriginator and the project;
2. the narrative section - this details the requesting entity'sjustification for undertaking the
proposal. This section normally includes the following:
a. proposal.
b. objectives;
C. conceptual framework;
d. alternatives; and
e. sensitivity and risk.
3. supporting documentation section - estimates and the results of market studies and
financial this contains cost analysis.
Submission of Progress Reports
Progress reports are submitted at regular intervals for thefollowing purposes:
1. to review the accuracy of the expenditures forecasts;
2. to provide updated expenditures forecasts; and
3. to verify the assumptions and acceptance of individual projects. economics underlying the
Post Approval Reviews
Post approval reviews are required to satisfy the following objectives
1. to provide management with a standard method of evaluating the abilities and judgment of
project sponsors/
2. to identify errors or patterns of error in judgment whichavoided in future similar situations;
and
3. to help ensure that the quality and accuracy of informationattains the highest feasible
standards.
EVALUATION OF PROPOSED CAPITAL EXPENDITURES
Proposed capital expenditures should be scrutinized since theyinvolve large outlays of funds. A
number of primary factorsshould be considered by management. These are the following:
1. Urgency. Decisions should be made as quickly as possible for requirements that are urgent.
2. Repairs. Management should consider the availability of spare parts and maintenance experts.
When these are critical and they are not available, the concerned proposal should be ruled out.
3. Credit. This factor should be considered in the sense thatsome credit terms may be highly
favorable to the company.
4. Non -Economic Factors. These refer to social considerations,and other non-economic
persuasions and preferences.
5. Investment Worth. This refers to the economic evaluation of a certain proposal.
6. Risk Involved. This refers to the uncertainty of an expectedreturn.

METHODS OF ECONOMIC EVALUATION

Since the primary objective of the firm is to make profits, everybusiness activity should be
directed towards achieving this end.are not exempted from this
requirement. Capital investmentstherefore, a requirement that investment proposals
shouldanalyzed and a determination of their economic value to the firmshould be made.
There are three basic methods of evaluating proposals. These are composed of the following: (1)
the payback method; (2) theaverage rate of return methods; and (3) methods. These methods will
be discussed in succeeding pages using data indicated in Exhibit 3.
The Payback Method
The payback method determines the number of years required to recover the cash investment
made on a project. The recovery ofcash comes from the cash inflows generated from the
project. Theformula used is as follows:
The cost of the machinery is expected to be recovered in fullafter 4.2 years. When the firm does
not favor exposure of its own The payback method is investments for longer periods, the
proposal is rejected. This decision can be made quickly with the use of the payback method.
The payback method, however, has some disadvantages.
1. it does not consider the time value of money;
2. the accept-reject criterion is stated in terms of years ratherthan at a discount rate;
3. the firm's attention is focused on cash flow rather than on rate of return;
4. careful projection of the timing of the investment outlays and the year-by-year projection of
cash inflows over the entire life of the proposal are not encouraged; and
5.the salvage value of the proposal is not considered.
The Average Rate of Return Methods
The average rate of return methods consists of the following:
(1) the average return on investment; and
(2) the average return on average investment.
Average Return on Investment.
This method is simple andeasy to compute. It shows the ratio of the average cash inflow to the
investment. The advantageof this method is that it is very easy to compute and the available
accounting data may be readilyused. Its main disadvantage, however, is that it does not take into
account the time value ofmoney.
Average Return on Average Investment.
This method issimilar to the average return on
investment method except that the effect of the depreciation charge on the investment is taken
into consideration.
Discounted Cash Flow Methods
The time value of money is recognized under the discountedcash flow methods. There are two
approaches available: (1) the net present value method; and (2) the internal rate of return
method. discounted and compared to the values of other proposals. The Under these approaches,
all future values of a proposal are discounting factor makes these two methods preferred by users
in evaluating capital expenditure proposals.
Net Present Value Method. Under this method, a desired rate of return is used for discounting
purposes. The term discounting is synonymous to the calculation of the present worth of a future
value as presented in Chapter 3. The present value concept is applied to the cash flows of a
proposal and are discounted at the desired rate of return for the periods involved. The sum of the
present values of the outflows (i.e., the cost of the machine in Exhibit 3) is compared with the
sum of the present values of the inflows (i.e., net income plus depreciation). If the discounted
cash inflows are larger than the discounted cash outflows, the project will earn more than the
desired rate of return. The proposal is accepted. Conversely, if the discounted cash outflows are
larger than the discounted cash inflows, the project will not be able to generate the desired
minimum rate of return. The proposal is, then, rejected. To illustrate, the following formula and
computation are presented as follows:
NPV = PVCI-PVCO
where NPV = net present value (also the net value derived after deducting the discounted cash
outflow from the discounted cash inflow)
PVCI discounted value of the anticipated cash inflows
PVCO discounted value of the anticipated cash outflows
The formula for finding the present value of an expected cash inflow is as follows:
PV= A/ (1+R) n
Where:
A = expected cash inflow
R = desired rate of return
n = number of years the cash inflow is expected
If the desired rate of return in Exhibit 3 is 25%, the cash inflows for the ten-year period may be
computed to determine the present value for each year. For example, the present value of the
cash inflow for the second year is computed as follows:
PV of cash inflow, year 2
= P 2, 380, 000/ (1+.25)2 = P 2, 380, 000/ (1.25)2
+ P 1, 523, 200

To find out the net present value of the proposal presented in Exhibit 3, the formula earlier stated
is applied as follows:
NPV = PVCI-PVCO
=P8,508,490 - P10,000,000
= (P1,491,510)
The computation shows a negative net present value indicating that the sum of the discounted
cash outflow is greater than the sum of the discounted cash inflows. On this basis, the proposal is
rejected. Internal Rate of Return Method. This method and the net present value method use the
discount rate as a factor. The difference, however, is that under the internal rate of return method,
the discount rate is not given. Rather, it becomes the object of computation. The discount rate
which will yield a net present value of zero or one approximating zero is the correct discount
rate. This means that the present value of the cash inflows is equal to the present value of the
cash outflows. The correct discount rate may be determined by trial and error. The acceptability
of the proposal will depend on the prevailing interest rates as compared with the computed
correct discount rate. If the prevailing rate is higher, the proposal is rejected, and conversely, if it
is lower, the proposal is accepted. In our computation of the preceding method, a negative net
present value of P1, 491, 510 was shown. Since the discount rate of 25% was used, an attempt to
find the correct discount rate will be made using one which is lower than 25%. Computations
using various discount rates applicable to the example shown in the preceding method are shown
below.

The net present values at different discount rates may now be computed as follows:
NPV at 22% discount rate = PVCI-PVCO
= P9,350, 800-P10,000,000 = - (P649,200)
NPV at 21% discount rate = PVCI-PVCO
= P9,603,520-P10,000,000 = - (P396,480)
NPV at 20% discount rate = PVCI-PVCO
= P9,994,080-P10,000,000 = - (P5,920)
The results of the computation show net present values at different discount rates. Obviously, the
discount rate which yields the net present value nearest to zero is 20%. If the standard interest
rate is below 20%, the proposal is acceptable.
RISK, UNCERTAINTY, AND SENSITIVITY Among the primary factors considered in the
evaluation of proposed capital expenditures, the uncertainty of expected returns pose a challenge
to one who manages the firm's finances. In the preceding discussion of the methods of economic
evaluation, it is assumed that the returns are certain. This is misleading because one can never be
fully certain about the results that will be obtained from an investment.
Meaning of Risk, Uncertainty, and Sensitivity Risk is defined in Chapter 3 as the uncertainty
concerning loss. Uncertainty, as a term is synonymous to risk, and as such, they will be used
interchangeably in the discussions that will follow. At this point, however, it is worth mentioning
their similarity and difference. Uncertainty and risk both refer to variations of actual values from
average or expected values. They differ, however, in the cause of the variations. The variations
referred to in risks is caused by chance, while the variations referred to in uncertainty is caused
by errors in estimating.

Sensitivity refers to the effect on investment of changes in some factors, which were not
previously determined with certainty.
Factors Affecting Risk Sensitivity refers to the effect on investment of changes in some factors,
which were not previously determined with certainty. There are four primary factors involved in
the evaluation of risks pertaining to capital expenditures. These are the following: (1) possible
inaccuracy of the figures used in the evaluation; (2) type of business involved; (3) type of
physical plant and equipment involved; and (4) the length of time that must pass before all the
conditions of the evaluation become fulfilled. Estimates could be wrong or inaccurate at times.
Accuracy, however, depends on how the figures were obtained. Estimates can be made either by
scientific methods or by plain guesswork. A certain degree of reliability can be assigned to the
former and none to the latter method. Every type of business has its own degree of risk that is
peculiar to itself. One line may be more stable in terms of demand than the others. The demand
for food, for instance, is more stable than the demand for specialized consumer items like hair
dyes. Also, more risk is involved in the operations of a new venture than a business with a
successful record of past performance. Physical plants and equipment are also subject to risks.
Some may become obsolete before their economic life expires. The demand for special
equipment, like that for DVD players, may diminish without warning. Finally, estimates
involving longer periods are usually more prone to inaccuracies than those involving shorter
periods. This is true because, most often, changes in the environment happen sooner than
expected.
Sensitivity Analysis The expected returns on investment may change as changes in some
relevant factors happen. Capacity utilization at various levels, for instance, may yield various
rates of return on investment. As the availability of raw materials, it is important that an analysis
of capacity utilization depends mostly on some relevant factors like actually finding the
sensitivity of an investment to various changes.
Sensitivity analysis is applicable to capital expenditures involving the purchase or construction
of a plant. It is useful for management to know the expected returns that will be generated by the
various capacity utilization in the operation of the plant Consider the following example:
Effect of Various Capacity Operation on Rate of Return Pertaining to a Plant
Capacity
Operation
Capacity
Operation
Capacity
Operation
100% 75% 50%
Annual Revenue P 10, 000, 000 P 7, 500, 00 P 5, 000, 000
Annual Expenses 7, 000, 000 5, 500, 000 4, 000, 000
Net Income 3, 000, 000 2, 000, 000 1, 000, 000
Rate of Return 43% 36% 25%
The example cited above indicates that by using the plant at full capacity, the return will be at its
highest level, which is 43%. However, if because of some factors, this is not possible, the
expected return will still be 36% at 75% capacity operation, and 25% at 50% capacity operation.
If the prevailing interest rate is below 25%, the proposal should be accepted.

SUMMARY
Capital budgeting is an important segment of business finance. It includes relevant aspects of
investment, valuation, risk, and uncertainty. The substantial outlay of funds for the purpose of
lowering costs and increasing net income for several years in the future is called capital
expenditure. The planning and control of capital expenditure is called capital budgeting. When
the real worth to the firm of any proposal for capital expenditure is determined, the process is
called valuation. An investment happens when the firm spends some of its funds for the
establishment of a project.

Capital budgeting is done for the following purposes: (1) establishing priorities; (2) cash
planning; (3) construction planning; (4) eliminating duplication; and (5) revising plans.
The capital budgeting system consists of the following steps: (1) preparation and submission of
budget requests; (2) approval of budget; (3) request for appropriation; (4) submission of progress
reports; and (5) post approval reviews.

The primary factors considered in evaluating proposed capital expenditures are: urgency, repairs,
credit, non-economic factors, investment worth, and risk involved.
The economic evaluation of proposals consists of three basic methods: (1) the payback method;
(2) the average rate of return method; and (3) the discounted cash flow methods.