MONEY It refers to any asset, token or good which is generally acceptable I the exchange of goods and services as a medium of exchange in the settlement of debts and obligations. Nature of money Essential characteristics of the functions of money Medium of exchange Unit of account Store of value An object has these characteristics and it has kept primarily to store value for future use or trade. It is important however that such an object be liquid, i.e. be easily converted into form that gives instant value (cash) and without any cost and without any loss of capital or interest. No good or token is money unless it can satisfy all these criteria e.g. while property of houses are good store of value especially inflationary economies, they are not Principles of banking Page 1 liquid and they are definitely not units of account or medium of exchange. Desirable features of money Acceptability Portability Durability Recognizability Divisibility Uniformity or homogeneity Scarcity Stable purchasing power Difficult to counterfeit Types of money Private currency Commodity money Fiduciary money Credit money Principles of banking Page 2 Coinage money Representative money Primitive money Commodity money Is a form of money whose value comes from the particular commodity out of which it is made? The first instances of money were commodities or objects which were useful in their intrinsic value e.g. animal. As such it’s almost impossible to define money in terms of its physical form or properties since these are so diverse. Therefore any definition must be based on its function. Any important point to note about the commodity money is that while it have a physical form, It doesn’t have a physical value that can be universally accepted. Its value is localized or socially determined to a larger extend e.g. gold. Standard coinage The discovery of the touch stone made it possible to have metal based coins. A touch stone is a small tablet of dark stone used for testing the content (quality and quantity) of precious metals in any alloy. With this Principles of banking Page 3 instrument, coins and notes could now be made and it would be easy to determine the amount of any precious metal in every coin. This also insures that no one could use fodged coins as they would fail in touch stone test. Representative money The system of commodity money continues to evolve this time representative money. Representative money refers to a form money that consists of a ticket or certificate that can be exchanged for fixed amount of a commodity such as gold, silver or even water. In this monetary system, the material that constituted money itself had very little intrinsic value but worthless achieved significant market value through being scarce as an artfeet. The term British Pound originated in this system. It was a unit of money backed by a tower pound of sterling silver hence the currency pound sterling. For most of the 19th century and 20th century many currencies were based on representative money through use of Gold standard. Fiat money Principles of banking Page 4 Refers to the money that is not backed by resource of another commodity. The money itself is given value by the government i.e. by a decree or by enforcing legal tender laws (forced) whereby debtors are legally relieved of debt if they pay it of in the government money. Throughout history government have often switched forms of fiat money it terms of war and crisis. In 1971, the United States switched to fiat money indefinitely. At this point in time many of the economically developed countries were fixed to the US dollar and this single step meant that most of these currencies became fiat money based e.g. Euro Credit money Refers to the money that is backed by a promise to pay made by someone other than state e.g. credit card loans and bank deposits. Most of the western world money is credit money. Credit money tends to arise as the byproduct of banking and borrowing money. Private currency This is a system where virtually anyone and everyone could issue their own paper money. The advantage Principles of banking Page 5 with this system is that the issuer goes bankrupt, close etc the note will be worthless. On top of this unscrupulous organization emerged who issued these currencies but failed to guarantee the money realisibility as they as there was no real value to back them. As such, the issue of any private money has been severely restricted by law. Despite the measure to curb practice, they are still several party issued digital currencies in circulation in the western world that function as money. Their use however restricted compared to government or credit money Primitive money These used the barter system and various commodities ranging from animals to minerals were used to determine the rate of exchange of various goods. While these systems worked during their time, they are worthless and have some disadvantages. 1. There was need of double coincidence of wants events and raised some complications ο· Time constraint this meant that the exchange of goods was impossible e.g. if one wishes to exchange fruit for some maize, one would only Principles of banking Page 6 do this when the fruit and maize were both available at the same time and place. That scenario will only be possible for a very brief period or never. ο· Liquidity constraint to go round, the problem of timing constraint a immediate commodity would be needed that one would sell their fruit and keep it until the maize is ripe and then exchange it for maize. However there were still problems in finding a commodity or item that would have properties comparable to today’s money. ο· Emergence of several key goods comparable to today’s money: in trying to solve the timing constraint by looking for a liquid good or token further problem arose as people could not agree on particular item. As such different people even in the same location had different definitions of the most tradable or liquid item of exchange. 2. Lack of desirable feature of money. The commodities that were used in the barter trade system did not posses what could be described as desirable features of money. They didn’t have a stable value. Some Principles of banking Page 7 could be counterfeited. Most were not easily divisible or transportable and they do not fungible (similar) Measurement of money Money is one of the central topics studied in economics and it forms its most logical links to findings. The amount of money in the economy directly affects inflation and interest rates and because of this, money supply has a profound effect on the economy Because of this fluctuations in money supply, can lead to a monetary crisis and this can have very significant economic threats especially if it leads to monetary failure and adoption of much less efficient barter system. An example of this is what happened in Russia in 1990s when prices would go up many times whilst in the queue to buy a commodity until the monetary system crushed. Modern economy also faces problem in deciding what exactly money is such that the economist has grouped the money into different categories or stock composition and have come up with different defections of these compositions. Principles of banking Page 8 The stock or supply of money is decided by the monetary authorities. The growth or decline in the stock of money should be published on a monthly basis by such authorities. The money is measured in numbers with each composed of various forms of money. The measures may vary from country to country. In Zimbabwe the RBZ defines money in these categories; I. π΄π : Consists of notes and coins in circulation. II. π΄π : Consists of π0 + demand deposits. These are notes and coins in circulation with the general public. It also constitutes demand deposits with the banking sector i.e. mainly commercial banks. ππ is also referred to as narrow money because it includes other forms of money. III. π΄π : Consists of ππ + savings deposits which are 30 day and below with the banking sector and under 30 day deposits with other banking institutions, discount houses and merchant banks deposits. ππ is also referred to as retail Principles of banking Page 9 money. Other banking institutions include Building societies and Finance houses. IV. π΄π : Comprises of π2 + over 30 day deposits with the banking system and over 30 day time deposits with other banking institutions. ππ is also referred to as broad money because it includes all forms of money. The above definitions all exclude the following; a. Holdings of money by the central bank, local authorities and all nationalized Institutes and Public Corporations. b. Holding of notes and coins and bank deposits with themselves (Banks) and Building societies with banks. NB The above measures are not permanent in definition and compositions. They are often changed and redefined as the authorities see it fit. Seignoirage is the difference between nominal value or face value if note or coin and the value or cost of producing the note or coin. Principles of banking Page 10 Seignoirage is the greatest or highest as the face or the note increases. The higher the face value of the note, the high the seigneur age (is the difference between the value of money and the cost to produce and distribute it). Seigneur age is the greatest with e-money. THE GOLD STANDARD It refers to a system of maintaining gold reserves by the countries. The gold standard exists when most countries are using on gold coins as primary means of exchange. Fixed exchange rate between an of gold and its currency. When countries have an unrestricted gold flow in and out of the country. Domestic money has to rise and fall in line with gold stock. The gold standard has to have the following features; I. No restrictions in trade of gold. II. Fixed exchange rates: each currency was paid in terms of gold and the rates would be maintained for long period of time as revenues to devalue and revalue were slim. Principles of banking Page 11 III. The private sector could issue, sale or buy stocks of gold due to capital mobility, free capital flows in adjustments of interest rates. The rules of the game This is an important term associated with gold standards These were a set of rules of conducts which participating members were supposed to follow. In the case of classical gold standard, the participating countries were required to observe the following rules; ο Gold parity: each country should declare a fixed value ratio between gold and domestic currency and form those gold parties. Countries could determine exchange rate. ο Convertibility to gold: All proper money issued must be exchanged freely to gold at debated old party if the bearer brings it to the bank. During those days the currency was converted to gold but nowadays it means convertibility to international currency. ο Interest rate policy: If a country began to love gold. It was expected to raise short term interest rates to Principles of banking Page 12 attract back the gold by so doing the monetary policy could assist the international adjustment. On the other hand if it gaining gold short term interest rates must be lowered to repel gold inflow. ο Free international gold trade: There should be no restrictions on the exportation or importation of gold as a commodity as well as a payment method. This generated the mobility in demand supply conditions. Advantages of maintaining a gold standard 1. Current monetary system increases inefficiency and wasteful expenditure by government because they know that they can print money whenever they want to in order reduce their fiscal deficit which is not possible under gold standard. 2. This system puts brakes on government abilities to print unlimited amount of money we all have seen how from the past few years central banks work. Disadvantages of maintaining a gold standard 1. The system ties the hands of the central bank and government to tackle any economic catastrophe and Principles of banking Page 13 therefore whenever such things happen it can lead to of the whole exchange system. 2. Sometimes money supply is needed to push economic activities as money can be force multiplier for economic growth which is not possible under this system. 3. Since gold is not divided equally it can lead to imbalances as countries having it as a neutral resource can exploit countries that have less gold. The demand for money The demand for money is the amount of money the public wishes to hold as notes and coins and as bank deposits. It tells us how many the public wishes to hold which is not necessarily the amount that succeed in holding. In contrast the realized holding of money is the amount the public actually ends up holding. Within the demand for money balances is less than the supply on attempt is made to spend excess on the purchase of the current output. In other words the aggregate desired expenditure curve shifts upwards. Principles of banking Page 14 I n Y c o AE1 m e AE0 Because Y is fixed at, the upward shift in the A2 curve creates excess demand if output and the price level rise. The price level keeps on rising until all excess money balances are wiped away. Within the demand for money balances is greater than the available demand, the public will attempt to add its balances by reducing its purchase of current output. The AE2 curve shifts downwards when the price level goes down. Opportunity costs of holding money balances Liquidity Preference Theory Principles of banking Page 15 The opportunity cost of holding money balances is the interest foregone that is the return that could have been earned if the money had been used to purchase an income earning asset (invested). The reason for not holding money in the form of assets but in its pure form has been stated by Keynes as liquidity preference which is made up of 3 elements i.e. I. The transaction motive II. The precautionary motive III. The speculative motive The transaction motive Money held to meet day to day expenditures; the demand for money arises because it is not possible to obtain a perfect synchronization between the receipt of income and spending that income frequently of income payments and spending habits of the community. The longer a person’s income, the more we will hold for transaction purposes. Precautionary motive In addition to the money held day to day expenses, household for firms extend to hold additional sums as Principles of banking Page 16 means of insurance against unforeseen categories. The balances are held to deal with sudden misfortune, to take advantage of unexpected bargains or in case of expenses prove to be higher than budgeted for. This demand upon the state of people expectations i.e. if they are pessimistic. The Precautionary balances are also known as active balances as they are hold for the purpose of spending on goods and services Speculative motive Holdings of money over and above what is required to meet the transaction and precautionary demand. Households and firms hold such balances when they fear if the capital losses on other assets. It is that money which is held in hope of making a speculative gain to avoid possible loss as a result of the change in interest rates and their price of financial assets e.g. if interests are low people would speculate by holding cash anticipating that interest rates would rise and hence the price of financial assets will fall. The price for bonds and the interest rates are inversely proportional to each other. Consider a fixed income bond which yields an income of $5 per year. If the net rate of Principles of banking Page 17 interest is 10% the price of the bond will be $50. This is because the rate of interest on the bond must be equal to what savers could earn by investing their money elsewhere. If the market rate of interests were to fall by 2.5% the price of the bond would rise to $200. What determines the demand for money I. The rate of change of price If everyone believes prices are going to rise they have an incentive to reduce money balances and purchases commodities or assets whose money value might be expected to rise in line with the price level. II. The level of real income The higher the level of income, the greater the amount of money demanded for transactions and precautionary purposes. III. The absolute level of prices This influences demand for money because it determines how much money is needed to carry transactions. IV. The rate of interest It is the price which has to be paid to persuade people to forego the advantages of holding money. Principles of banking Page 18 The higher the interest, the lower the demand for money and the vice versa. The value of money Money has no intrinsic value, that derives a value and it is acceptable in exchange for goods and services. The value of money is therefore determined by the price of goods and services purchased by money. Conversely i.e. all prices in the economy falls, the value of money will rise and if the value of money decreases, its purchase power falls. The quantity theory of money This was an attempt to explain the causes of changes in the value of money. It is based on the equation of exchange: MVy = PY where; M = total money stock or quantity of money Vy = Income velocity of circulation the number of times each unit of currency is used to purchase final output in any given period of time P = is the average price of final output Principles of banking Page 19 Y = Total volume of real output produced in given period of time. Since P is the average price of the final product or output and Y is the total volume of total output, PY is simply another way of expressing the Gross National Product (GNP). The equation of exchange tell us that the quantity of money multiplied by its velocity of circulation must be identical to the money value of National Income e.g. given that the money National Income is $2million calculate the velocity of equation The classic theory of money Only recognizes the transaction demand to hold money balances and assuming this demand function as well as the level of national income to be given. It predicts that any given change in the quantity of money will cause an equal percentage change on the price level. ο That is any change in M will cause a change in P and there cannot be a change in P independent of a change in M. Principles of banking Page 20 ο The quantity theory of money states that “the amount of money in the system X the velocity circulation must be identical to the number of transactions and their price”. ο The velocity of circulation is the measure of speed at which money circulate in the economy and is determined by the following; 1. Length of time for which money is held – The greater the value of money stock held as assets (wealth form) the lower the overall velocity of circulation. 2. The rate at which money is passed from one person to another. This is in turn primarily determined by payment practices e.g. weekly payments and monthly payments of wages. Ways of controlling the demand for money 1. Interest rate Setting of a higher fixed rate may reduce demand for bank loan. 2. Control of inflation Principles of banking Page 21 The higher the inflation rate, the higher the demand for money and individuals need to offset the reduction in the purchasing power caused by inflation. 3. Technological innovations in the financial markets E.g. E-banking has resulted in demand for money. 4. Investing depositor confidence in the market More money is banked. Theories of banking The currency school of banking This school of thought viewed the proper role of bank as the store of the community gold and silver money. Community banks were expected to be only depositors of the public money, holding deposits for their customers and making payments but creating additional money. The currency school of banking required no monetary policy at all and advocate that a nation’s money supply would depend at all times on its supply of gold and silver. The banking school They regarded banks having a proper role of creating additional money. Banks would create in the form of new Principles of banking Page 22 loans equal to the community’ s giving ability to produce real goods and services to ensure that the quantity of spending power would be enough for stable noninflationary growth and full employment. To accomplish the desired rate of growth of credit money banks were expected to follow a principle called real bills doctrine where loans would be made only for real productive purposes. Normally loans would be short term commercial industry or agricultural loans. Short term commercial and industrial loans were supposed to be self-liquidating and self-regulating. Self-liquidating means the borrowed money would be used to earn funds to pay off or liquidate the loan. There was no danger of the inability to pay (self-liquidating). Self-regulating means the quantity of money would be precisely equal to the value of new production. Loans could not be made for speculative purposes as these would cause excess spending and stimulate inflation. There was no lending for real estate or for long term capital investments. Principles of banking Page 23 Weaknesses of the theory ο· In a more complex economy with money stages of processing in short term commercial loans might not be self-liquidating. ο· The optimism and pessimism of banks also affect whether loans are self-regulating. ο· The doctrine considered consumer loans as unproductive. To liquidate one commercial or industrial loan may require a series of a new consumer loan. ο· Whatever the process policy makes have devised for restricting the amounts of credit, some lenders and borrowers have found ways to get around it e.g. new type of instruments making loans on top of loans etc. The monetarist school of thought Monetarist theory says that the government proper economic role is to control the rate of inflation by controlling the amount of money in circulation. It is the view within monetary economics that variations in the money supply has major influences on national output in the short term run and the price level over the longer Principles of banking Page 24 periods and that objections of monetary policy are best by targeting the growth rate of money supply. The founding father of monetarism is the economists Milton Friedman. Organization and structures of commercial banks The organization and structure of commercial banks differ from country to country. The two principle banking systems are the unit banking and branch banking Unit banking ο Are independent, one office banks. ο Their operations are confined in general to a one single office. ο The usually operate in small towns and cities and country banks and city banks respectively. Advantages ο Efficient working i.e. they provide prompt services to its customers. ο Personal relations- since it organizes and other staffs are generally local people, they have personal Principles of banking Page 25 relations which help in mobilizing large resources for the bank. ο Local utilization of deposits i.e. local deposits are utilized by a unit or local bank on the development of the same locality and they are not transferred to other towns as is done under branch banking. Disadvantages ο Failure to spread risks i.e. failure of one big party to repay the loan in time may bring disaster to the bank. ο Limited resources. ο No economies of large operations. ο No diversified services. Branch Banking The most prevalent banking system in the majority of the countries. Under this system a big bank has a number of branches in different parts of the country even many branches will be in a cosmopolitan city like Harare or Bulawayo Advantages ο Spreading of risks. Principles of banking Page 26 ο Diversified services. ο Large investment (due to large deposit base). ο Economies of scale. ο Customers can access in any one of the branches. Disadvantages ο Supervision problem i.e. it is difficult to manage supervise them efficiently and s a result clients suffer. ο Transfer of funds i.e. may be used for financing business and industry in other areas. ο They may not meet local needs (because they have to operate under the rules set by the head office). ο Bureaucracy- management of all branches and decision making is under control of the head office. ο No or weak banker or client relationship as that in a unit banking system. Group banking Is a type of multiple office banking consisting of 2 or more banks under the control of a holding company which itself may or may not be a bank. The holding company is called the parent company and the banks are called operating companies. Principles of banking Page 27 ο The parent company controls and manages. ο This system is most prevalent in the US banking system. Advantages ο Pooling of resources. ο Don’t need large cash reserves because they can simply transfer funds to each other when need arises. ο Economies of large operations. ο Increase in efficiency i.e. when the parent company provides such specialized services as research, advice on investments and legal matters to all bank in the group. Disadvantages ο Monopoly banking- is not healthy from an economic point of view. ο Chain reaction – if business of one member declines it may adversely affect the business of other members of the group. Chain Banking Principles of banking Page 28 A banking system where the same or individual or group individuals control two or more banks as against control by a holding company under group banking. It’s done by stock ownership in two or more banks. Shareholders directly or through their nominees exercise control of competing banks. Money Supply It is defined as currency with the public and demand deposits in commercial banks i.e. M=C+D. Professor Friedman defines money supply at any moment in time as “the number of money people are carrying around in their pockets, number of money they have to their credit at banks or money they have to their credit at banks in the form of document deposits”. Structure of money supply in Zimbabwe Currently the Zimbabwean economy is experiencing low liquidity level in the money market. There are a limited number of surplus unit to lend to the deficit unit. Lending from Excess Reserves Excess reserves are any legal (total) reserves over and above those required by regulators. These are reserves Principles of banking Page 29 (vault cash and bank deposits) that banks have over and above what they are required by the government to keep to the backup deposits. Excess reserves can also e termed free reserves and their primary use is for making loans to consumers and businesses. This makes them exceeding important to the banking industry. Because these reserves do not generate interest, revenue or profit, banks are inclined to keep as few reserves as possible. Excess reserves make it possible for banks to function as financial intermediaries because banks act as conduit deposits and loans. They bring deposits to the bank, keep a few reserve lend out the rest. Therefore the excess reserves are the key to this lending. Determinants of changes in money supply Money supply refers to the amount of money that is in the circulation and the amount of is deposited with the banking sector. π΄π =C+D Simple model of money determination In this model, money supply is either high power charged (H) or Dx deposits with the financial sector. The Principles of banking Page 30 parameters which affect the level of money supply including the Cash Reserve Ratio required by the nonbanking private sector and total reserves with the banking sector. π π = F(c,r) where; r is the ratio of reserve s to total deposits c is the ratio of total cash held by the non-banking private sector in relation to total deposits. C= πππ β πππππ ππ‘π π = where; π C is the total cash held by the non-banking private sector. D is total deposits. NB CD=C Therefore π π = C+D = CD+C = D(C+1) (i) π r = where R= total reserves π· Principles of banking Page 31 r +c = π π· + πΆ π· 1 = (R + C) π· D = π +πΆ (ii) π+π From equation (i) π π = DC(C+1) = ππ = | (π +πΆ )(πΆ+1) π+π πΆ+1 π+π |(H) (iii) Where H is money held by the whole economy, money supply is therefore a function of total amount of high powered money in the economy. The required reserve ratio (r) and the desired liquidity ratio (c) by the non-banking private sector. Money supply is dependent on H and the level of the money multiplier. When small r rises, money supply decreases (π π ). When c rises π π also falls. (H) Is the base for expansion of bank deposits and creation of money. Principles of banking Page 32 The supply of money (π π ) varies directly with the change in the monetary base. Reserve Ratio A higher (r) results in smaller bank multiplier and reduces money supply. When r is determined by the bank, its size will to a large extend depend on the marginal cost of money to the banks. The desired cash ratio An increase in c results in an increase in leakage of cash reserves from the banking sector to the non-banking private sector. This reduces cash reserve upon which banking sector can create and π π is therefore restricted. The level of high money (H) An increase in H increases the level of π π even if the money multiplier remains unchanged. H = f (money growth rate, B.O.P, inflation) Criticism of money supply model 1. Its too mechanistic: assumes that small c and r are constant in the real world situation these change Principles of banking Page 33 with the changes in behaviour of banks and individual perceptions. 2. It’s assumed to be exogenously determined by the government or bank. This is unrealistic in the sense that the level of (H) can be driven affected by the public sector borrowing requirement on the position of the balance of payment. Public sector borrowing requirement refers to that part of government expenditure not financed by either tax revenue or sale of government debt to the nonbanking private sector. A higher public sector borrowing requirement either increases π π and cause inflation or rises interest rates and crowds out of investment Determinants of the reserve ratio Bank size The larger the size of the bank, the larger the amount of reserves it has to keep to the backup its deposits. Safety reasons Principles of banking Page 34 To ascertain greater safety, a bank has to keep more reserves to backup its deposits. Interest foregone by holding reserves The higher the interest rate, the lower the amount of money kept in reserves and the vice versa. Uncertainty of deposit flow The higher the uncertainty, the higher the amount kept in reserve Credit creation of commercial banks It is the actual money creation by the monetary authority. It is created by commercial banks through loans. Coins and notes in circulation are called (H) money or the monetary base because it can create more money. How banks create money They create credit money through loaning after receiving some deposits from surplus reserve. For example, deposit creation in a single bank system with a 10% cash ration. Initial Deposits liabilities 10000 Principles of banking or Loans or Asset or cash advances retained 9000 1000 Page 35 deposits 1π π‘ Re- 9000 deposits 2ππ Re- 8100 deposits 3ππ Re- 7290 deposits 4π‘β Redeposits 5π‘β Redeposits 100000(liabilities) 8100 900 7290 810 6561 729 90000 10000(deposits will be equal to initial deposit) The bank multiplier The limit to credit creation is the cash ratio which is 10%. The maximum amount of credit possible is π given by the formula D = × c where, π D = the amount bank deposits r = the cash ratio C = cash held by banks D= π ππ Principles of banking × πππ πππ = ππππ0 Page 36 1 The value of is known as the bank or cash creation π multiplier. It shows the relationship between cash, reserve, asset and the total amount of liabilities. The effect of any additional deposits of cash into the system upon the level of the deposits can be given by the π formula D = ×πc Where πD is the effect upon total π deposits as a result of a π₯ ππ πππ β πππππ ππ‘π π. π. π₯π. To what extend do banks create money? I. As long as they are borrowers willingly to borrow because they cannot be creation without loaning out. II. As long as there are cash deposits banks cannot create money. III. The extend to which the economy is monetarized. This is the degree to which the economy uses money as medium of exchange, the extend to which it uses banks, financial institutes rather than in hidden economy. IV. The level of cash reserves required by law to be kept in precautionary measures through Principles of banking Page 37 withdrawals. The smaller the cash ratio, the greater the ability to create money and the vice versa. V. The level of special reserves required by the central bank. Limitations to credit creation While it is time that banks will always create credit as long as they receive deposits from customers, there are limitations to credit creation. 1. Prudence consideration: Banks may deliberately reduce the amount of loans they will give to customers as a result of risk consideration. 2. Cash leakages: They may occur in 2 ways, the bank customers may receive a payment of $9000 as in the previous example and may not necessarily deposit the whole amount into the bank especially where he receives the payment in cash. Secondly the customer can change his money into other convertible currency and take it outside the country. 3. Demand for loans and interest rates: A low demands for loans by both cooperate and customers will lead to low deposits and this will Principles of banking Page 38 mean that there will be less credit created. Factors that lead to a low demand for loans include recession and high interests rates because these two lead to low economic activity. 4. Government intervention and regulation: May be done through the reserve ratio or through manipulating interests rates or by direct instruction to the banks for them to stop making advances for a given period. Normally the later happens when the authorities fear that credit creation is exceedingly the desired level. Profitability Vs Safety in Credit Creation In creating credit and therefore making profits banks have something to worry about i.e. the safety of loans they give and like all commercial enterprises, banks need to make profits so that they can pay shareholders and as such their aim is that of profit maximization among others. Maximizing profits requires that and in theory that banks should on-lend all the deposits they receive because the highest possible interest rate and they may mean lending to the riskiest borrowers for the largest time period. Principles of banking Page 39 However in practice banks cant blindly seek to maximize profits without regard to the safety of the customer deposit and the shareholder’s equity. Therefore a fine balance should be reached which will both maximize profits and safety for the deposits. Banks normally resolve this dilemma by maintaining prudent, liquidity cushions in the form of each in their safe (within the limit and policies of the central bank, operational or reserve requirements with the central bank, investments in money markets on a call or short notice basis, holding first class commercial bills, government short dared bills and CDs issued by other banks. After putting in place the fine balance in the form of a liquidity cushion portfolio, the bank can then lend as this is its major activity and source of revenue. Principles of banking Page 40 Central Banking Monetary Control The central bank has the main responsibility to control the supply of money in the economy through a monetary policy. Monetary policy refers to a set of resources enacted by the central bank to control the cost if credit and therefore of money in circulation i.e. π π . In coming up with its monetary policy, the central bank aim is to influence rate of growth on π π (π3 )r which is its intermediate target in order to achieve the ultimate target of low and stable prices. A stable level of the prices helps to achieve full employment, economic growth and better living standards. The RBZ ultimate target is consistent with its mission to maintain the internal and external value of the country’s currency. Instruments used in monetary control To implement monetary policy the RBZ uses several instruments which include the following; ο OMO Principles of banking Page 41 ο RRR ο Moral Suasion ο Rediscount rate ο Interest rate ο Funding ο Special deposits or Special reserves ο Direct controls on lending Reserve Requirement Ratio These are tools of monetary policy which are computed as a percentage of deposits that banks must hold as vault cash or on deposits at the central bank rather than lend out to the public. They represent a cost to the bank in that while the banks are required to pay interest to the depositors, the banks are not getting a market return on the same. As a tool of monetary policy, they are one way of influencing the country’s financial behavior, borrowing interests rates by affecting the potential of banking system to create transaction deposits (current account and other account that can be used directly as cash without withdrawal limits or restrictions. Principles of banking Page 42 They are the only bank deposits that require the bank to keep reserves at the central bank. In the real world the connection the reserve requirement and money or credit creation is not too simplified as in the previous example. This is because reserve requirement only apply to transaction deposits which are composed of π1 or narrow money. Deposits which are components of π2 πππ π3 (ππ’π‘ πππ‘ π1 ) such as savings accounts and time deposits are not subject to reserve requirement and therefore they can expand without regard to reserve levels. Furthermore Central banks may allow to acquire the reserves they need to meet their requirements from the money market or interbank market as long as the banks are willing to pay the prevailing price Open Market Operation They are a means by which the central bank control the liquidity of the national currency by buying and selling government securities. They are the foundation of a monetary policy. The process involves the use of national currency to buy in the open market some Increase π π Principles of banking The RBZ buys financial assets from the market The RBZ gives out money have increases Page 43 money supply financial assets typically gold, foreign currency or government bonds. Alternatively, it may involve the selling in the open Market a financial asset in order to redeem back national currency. These operations directly affect the liquidity and the value of the national currency by increasing or decreasing the supply of cash in circulation. Reduce π π Te RBZ will sell financial assets to the market The market buys the financial assets through cheques e.t.c. thus reduces money circulation Moral Suasion Consists of recommendations and positive advisory services to commercial banks to behave in a certain way. However, the tool is not binding but depend on the bank credibility in the eyes of the bankers. Funding Principles of banking Page 44 Involve the conversion of the maturity structure of government debt for example, to reduce liquidity in the economy, short term government debt may be converted into long term government debt and vice versa. However, this policy tool is not widely used in Zimbabwe. The Rediscount Rate or Discount Rate Is set by the central bank in line with its monetary policy objectives and it’s on indicator of the banks view of inflation as well as the base rate for most short term interest rates. The Central bank extends short term loans secure by government bond to financial institutions and the discount rate changed on such loans is an important factor in the control of money supply. In order to increase the π π the central bank reduces the discount rate to enable bank to borrow more at cheaper costs and the opposite is true. When the Central Bank lends to the financial institutions, the funds so loaned represents on expansion in the π π or monetary base. Special Deposits A call for special deposits is the most direct means available to the Central Bank for reducing the liquidity Principles of banking Page 45 position of banks and licensed deposit takers and is therefore the most direct means of controlling their lending. As the stock of liquid assets falls, banks are forced to cut their lending. Special deposits can be released when the bank wishes to see the expansion ofπ π . NB The difference between the reserve requirement and the special deposit is that the reserve requirement is given as a percentage of the actual deposits made into the bank by individuals e.g. 5% of whereas special deposits is an absolute figure e.eg. $20000 Reserve requirement does not earn interest whereas special deposits can earn interest when held by central bank Interest rate policy A rise in interest rate charged by commercial banks will lead to a reduced demand for bank credit and the vice versa STOCK EXCHANGE It is a platform or an arena on which listed securities are sold and bought. Principles of banking Page 46 Functions of stock exchange a. Established for the purpose of assisting, regulating and controlling the business of buying, selling and dealing in securities. b. Provide a market for the trading of securities to individuals and organizations seeking to invest their savings of excess funds through the purchase of securities. c. Provision of liquidity to investors. d. Offers possibility of diversifying portfolio e. Mobilize and efficiently allocate resources for country’s economic development. f. Establishes rules for fair trading practices and regulates the trading activities of its members according to those rules. g. It offers a fair, efficient, transparent and secure price discovery mechanism in a well regulated environment. Benefits of listing on the stock exchange 1) Visibility- It offers the company free publicity 2) Enhances investor confidence. 3) Increased demand for products and services. Principles of banking Page 47 4) Overall increase in profitability. 5) Market support is enhanced. Desirable characteristics of stock exchange 1) Liquidity- someone should be able to sell an asset quickly at a fair price and low transaction cost. 2) Information should be readily available to every investor and it has to be cheap enough to acquire and should be available at same time. 3) Narrow price spread and difference between the bid and ask prices should be reasonable’ 4) Small price fluctuations. 5) Prices should react to new information quickly. 6) Investors must perceive the market to be inefficient and so believe they can outperform market expectations. Functions of the central bank RBZ RESEARCH ON LIMITATIONS OF THE MONETARY POLICY TOOLS 1. Issue of notes and coins 2. Formulates and implements monetary policy: monetary policy contains a set of policies designed to Principles of banking Page 48 influence the supply of demand for and the price of money. 3. The banker to the government: The central bank keeps the central government accounts and it also acts as an advisor to the government. 4. Supervises the banking system: the bank has the responsibility under the RBZ Act and Banking Act for the supervision of the banking system. It must try to ensure that individual banks retain sufficient liquidity and do not undertake projects which are risky. 5. The lender of last resort: The bank will provide funds for banks that are short of cash. 6. The bankers’ bank: Every commercial bank maintains an account with the central bank. 7. Management of the exchange of equalization account: This account represents the deposits of the nation’s gold and foreign currency reserves. It is used to stabilize the exchange value of the dollar (exchange rate) against other currency. 8. Manager of the country’s national debt: The central bank administers the repayment of government debt when these debts reach their maturity. Principles of banking Page 49 Bank regulation and supervision This subjects financial system to certain requirements restrictions and guidelines aimed at maintaining integrity of the financial system handled by either government or any independent agent. In other countries regulation does not only focuses safety and soundless of the sector but also looks into privacy, disclosure requirements, fraud prevention, anti money laundering as well as prompting lending to the lower income segment or key economic sectors. Aims of regulation ο· To minimize financial loss of depositors ο· To enforce applicable laws (the banking Act and the RBZ Act) ο· To prosecute cases of market misconduct such as insider trading or money laundering. ο· To protect clients and provide a vehicle for the investigation of customer complaints. ο· To license providers of financial services. Bank Supervision Principles of banking Page 50 It entails the upholding of bank rulers as set cut in the regulatory framework and conformity of procedures. This is done through on site of offsite inspection as well as analysis of bank performance through submitted reports. Bank supervision aims at the following ο· To ensure that capital allocation is more and sensitive. ο· Separating operational risk from credit risk and quantifying both. ο· Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. NB Arbitrage is an art of profit making by taking advantage of different prices of the same item affected in different markets e.g. US$1 : 15ZAR in market A and US$1 : 10ZAR in market B. Therefore one can go and purchase US$1 in market B and sell them in market A and gain profit of 1ZAR whereas speculation is anticipating a change in prices of items and try taking the grasp of such advantage. ο· To eliminate fraud in the banking sector. Principles of banking Page 51 ο· To build confidence in the commercial banking. Capital reserve requirement Sets the minimum capital reserve each bank must hold in position of their customer deposits for notes holding. The purpose of this is to put a limit on how much the supply of deposits can grow and also work as a cushion in case of a severe recession that leads to bankruptcy. It sets framework on how banks and depository institutions must handle their capital in relation to their assets. The international bank of settlements (the Basel Committee) Influences each country’s capital requirement internationally. In 1988 the Committee decided to introduce the capital measurement system referred to as the Basel Capital Accord and the latest one being Basel II. NB Recess : negative growth or sustained negative growth I the economy. Controls imposed by the Banking Act ο· To ensure that the banks do not conduct their business to the determinant of their clients. Principles of banking Page 52 ο· Each commercial bank is required to maintain a certain level of liquidity to meet customer demands and other related issues. ο· Each commercial bank shall publish its name including its class of business on the entrance of its business premises and in all communication memos. ο· Each bank is required to maintain a main administration office in Zimbabwe even if it is an international bank. ο· Banking Act: The bank shall not alter its Memorandum or Articles of Association without the consent of the registry of Banks. ο· Every bank is required to publish its annual and semiannual accounts in a manner which is clear both to customers and regulators. These accounts are published in a government gazette. ο· Obliged to maintain a minimum capital requirement set out by the regulatory authorities. Financial Markets Is where individuals, firms and other organizations raise money by issuing securities or certificates in pieces of paper in return for the money. Its role is to Principles of banking Page 53 facilitate the transfer of funds from surplus units to deficit units. Securities are financial instruments issued by investors (surplus units) by firms, government and other institutions (deficit units). The security will specify the nature of the investment, the benefits that the investor will enjoy in return for investing his money. These securities are represented by documents that act as evidence that the holder of the document has a financial stake in the organization that issued the certificate. After being issued some of the securities can be transferred or negotiated from one person or organization to another except where there are restrictions to such transferability. Primary and Secondary Markets Financial markets can be divided into 2 parts i.e. primary and secondary markets. The primary market is where the initial issue of securities occurs. The transaction is therefore between the initial investors and the initial borrower although intermediaries can be used. In other words the money that is exchanged for securities goes direct to the borrower. Primary market is not Principles of banking Page 54 necessarily an organized market or a physical place but whenever a deficit unit raise funds from the public and issues on security as opposed to transferring the one that was initially issued sometime ago, the transaction is said to happen in the primary market. A Secondary market is a market where securities already in existence are traded i.e. bought and sold by investors as long as they are transferable. It should be noted that the purchase and sale of securities is between investors and as such the funds generated by the transaction in this market do not flow to the issuer of the security but flow between the traders or investors in the secondary sense (secondary market). Money and Capital Markets in Zimbabwe The markets are part of a broader market called the financial market which is not only made up of money and capital market but also the foreign exchange market and the derivatives markets. Money Markets Refers to the markets which financial intermediaries and other participants trade in various financial Principles of banking Page 55 instruments, enter into contracts such as repurchase agreements. The market normally trade in securities which maturity is up to 1 year and as such the money market provides short term financial securities. Functions of money markets (3 basic functions) ο· To provide short term capital to the government, corporate world, financial institutions, organizations and individuals requiring short term finance. ο· To act as barometer of liquidity in the economy. Many of the strategies to increase or curb liquidity by the Central Bank are done through the market. ο· To provide a market for short term investors to invest funds in securities that have short maturities, highly liquid and low risk. ο· The money market is the main determinant of interest rates in the economy. ο· The demand and surplus of funds in the money market will determine the interest rates levels. Instruments used in the Money Market Certificate of Deposit Principles of banking Page 56 ο· It is a time deposit is a specific maturity date shown on a certificate. ο· If the certificate can be maturity it’s called a NCD. ο· Large denomination CDS are the ones usually negotiable. ο· A certificate of Deposit is an interest bearing instrument i.e. interest is added to the principal amount. Commercial Paper ο· It is an insecure promissory note or debt instrument with fixed maturity. ο· It is usually sold at discount from face value i.e. the purchase or surplus unit pays an amount less than the face value written on the “paper” but receives the face value on maturity. Treasury bills ο· Are issued by the government through Central of Bank and the government debt financing instruments. ο· They are very liquid but usually earn a low return because of low risk. Principles of banking Page 57 ο· They are sold at discount of the face or nominal per value of maturities ranging from 30 day, 91 days to 182 days. ο· They are sold periodically and because they are issued by the government, many participants in the money market consider them to be risk free. ο· They can be traded in the secondary markets on an annualized percentage yield to maturity. Bankers Acceptance “Bas” ο· Is a draft bill or Bill of Exchange drawn on and accepted by the bank. It’s an instrument of high quality and can be negotiated in ease in a developed secondary market that exists for such paper. They were created to avoid the technical problems arising from the physical disturbances between buyers and seller. In other words it starts an order by a banks customer for bank to pay a sum of money at a future date to a given recipient. ο· If the bank agrees and endorses the order for payment by writing the word accepted on the face Principles of banking Page 58 of the bill, the bank then assumes responsibility for the ultimate payment to the holder of the acceptance. Repurchase Agreements ο· Are short term loans normally for less than 2 weeks and frequently for one day arranged by selling securities to an investor in an agreement to repurchase the securities at a fixed price on a fixed date. ο· They are suitable for corporation of access fund that they were to invest for very short periods. Euro Dollar deposits ο· Foreign currency deposits in a locally owned bank branch or a foreign bank located outside the country. They owe interest bearing. Deposit held by the Central Bank ο· Include interest bearing deposits held by banks and other depository institutions at the Central Bank. These are immediately available funds that institutions borrow usually on an overnight basis. Principles of banking Page 59 Participant in the Money Market ο· Money market is not a physical place but network of institution and individual who trade in short term security. ο· Major participants are of discount house, Merchant Bank, Finance houses, Building societies, RBZ individuals, Government and other companies. ο· The financial institutions mentioned above make money market, invest in money market securities. ο· However the main investors in the money market in Zimbabwe are companies that excess funds, for example Insurance and Pensions funds companies. The Capital Market Question; Outline the role of the securities and exchange commission of Zimbabwe in the Capital Market. ο· The capital market includes the stock or equity market whose secondary market is the Zimbabwe Stock Exchange and also includes the Bond or Debt Market for raising long term debt. ο· These markets are also divided into primary and secondary market, and most trading in this market is Principles of banking Page 60 normally found in the secondary market between investors willing to buy and those willing to sell them after having brought them in either primary market secondary market itself. ο· In Zimbabwe the primary market are made up of mainly the investment banks, Merchant banks and Stock banking firms who underwrite and structure deal for their clients for a fee. ο· The other market where securities can be traded in the secondary market is called the over counter market “OTC” although not yet very developed in Zimbabwe Trading of Securities in the Capital Market ο· Trading in Zimbabwe is restricted to the Zimbabwe securities and is only done through stock broker who are member of the stock exchange. ο· An investor wishing to buy or selling the security has to go through stock brokers. ο· Investors place their order or instruction either to buy or sell to the stocks. ο· Broker specifying the name of the security, the amount of securities and the indication price at the Principles of banking Page 61 transaction has to be conducted among other thing. The broking firm will collect all this information from various investors willing to trade and then pass it on to its brokers who are allowed to transact on the stock exchange. ο· For example investors A want to buy Econet share and investor B want to sell Econet shares. Investor B Bulawayo Investor A Harare . Kingdom Bank Kingdom Bank DEALERS . Principles of banking Page 62 Stock Exchange NB: kingdom is the brokerage firm for seller B and buyer A The work for a brokerage firm and are so called because the investors pay commission to the brokering firm for the securities that they render. The investor who is selling will have to complete a security transfer form also deliver the share certificate to the broker before he receives payment. The buyer also has to complete the security transfer form soon after receiving the share certificate as an acknowledgement of receiving the certificate. However before receiving the certificate and signing the form he should have paid for the shares endued + commission. The Zimbabwe Stock Exchange does not operate on a continuous basis but it uses what is called a call over system where brokers meet thrice a day and make bid and ask prices and seek to reach an agreeable Principles of banking Page 63 price for the trade. The price at which the deal takes place will depend on the number of shares offered for sale for the number of shares willing to be purchased i.e. Demand and Supply. In planning orders, investors have 3 general or broad types of orders they can use i.e. The market order, The limit order and The stop order. In a Market Order, an investor instructs the broker to buy or sell at the best price obtainable on the market. In a Limit Order, an investor specifies the price at which the shares should be purchased or sold. A Stop Order is only executed if certain conditions occur e.g. selling or buying after a certain drop or raise in the price. The ZSE provides on a daily basis quotation and indices basis on the previous day’s transaction. Quotation given includes bid, ask and deal prices. The bid is the price at which those who want to buy are prepared to buy the shares whilst the ask price is the price at which those who are selling would Principles of banking Page 64 demand in order to part with their shares whereas the deal price is the price at which transactions actually took place. The stock index provides a measure of the overall performance of securities, equities traded on the exchange on any particular day. The ZSE calculate 2 indices daily that the industrial and moving index which are value weighted i.e. calculated by multiplying the deal price (middle price) of each share by the number of shares in issue for each counter trade. Aggregate is calculated is then divided by a reference figure called the base figure (usually 100). Common Stock These are known as ordinary shares or equity securities because the investors who purchase such shares in the company became part owners or shareholders of the company. The level of ownership will depend on number of shares purchased compared will depend on the number of shares that that has been issued by the company. Investors in Principles of banking Page 65 ordinary shares can control the company through their ability to vote. Debentures or Bonds A Bond is an interest bearing security that is used by a company or government and any other organization when it borrows long term capital. It’s a long term promissory note and the debenture or certificate provides evidence of borrowing and outline the terms and conditions thereof. The important features of the bond are as follows 1. Coupon Rate 2. Face Value 3. Maturity Value 4. Yield Preferred Stock Are hybrid securities i.e. they have features of both common stock and debentures or bonds. They are similar bonds in that the dividend rate is usually fixed and that they have a priority claim over ordinary shares in both the distribution of dividends and in case of liquidation. Principles of banking Page 66 They are similar to common stock in that the dividend can be skipped in times where profits are negative. FINANCIAL INTERMEDIATION A financial intermediary is an institution which links lenders and borrowers by obtaining deposits from lenders and relending them to borrowers. Lenders are persons or organizations in the economy with excess money and they are sometimes referred to as surplus units. Borrowers are persons or organizations in the economy with the shortage of money and are also called the deficit units. Financial intermediation exists to make easier the process of money moving from surplus units to deficit units. Financial intermediation can be subdivided into banking and non banking. Examples of non banking intermediaries ο· ο· ο· ο· ο· Insurance Company Pension Funds Unit Trust Company Finance Houses Investment Trust Company Principles of banking Page 67 ο· Building Societies Examples of banking intermediaries ο· Commercial Banks ο· Merchant Banks ο· Discount Houses Roles or Functions of Financial Intermediaries Mobilizing and Allocation of resources They receive deposits from surplus units and lend those in deficit units Risk Management Through findings other projects and assessing their relevance for funding. Asset Transformation Through taking many small deposits and aggregating them into a big amount to fund larger projects. Information Services They give information to clients and the economy as a whole. Principles of banking Page 68 Liquidity Services They provide finding and cash to the public to enable transactions for day to day activities. Monetary Policy Transmissions The central bank implements its monetary policy through commercial banks and discount houses. Reduction of Transaction cost Is brought about through employment for specialist for certain respective areas or services Payment Services E.g. The use of ATMs, cheques and Point Of Sale facilities (POSF). Market Efficiency It is a term used to describe the degree that stock prices are a representative of all data that is collected with a given market place. The efficiency of the market is usually identified in degrees with a strong market efficiency indicating that the prices are firmly and an accurate reflection of what is happening in the market. If a stock price does not appear to be related very strongly to Principles of banking Page 69 prevailing market conditions that is expressed as a weak market. An efficient market is one where the market price is an unbiased estimate of the time value of the investment. Market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased i.e. prices can be greater than or less than the true value as long as these deviations are random. The fact that deviations from the true value are random implies that there is an equal chance that stocks are under or over valued at any point in time and these deviations are not correlated with any observable variable and this follows that no group of investors should be able to consistently fund under or overvalued stock using any investment strategy. Classification Of The Equity Market Hypothesis The equity market hypothesis was created by Eugene Fama and this hypothesis suggests that any given time price fully reflect all available information at a particular share or the market in general. It can be classified into 3 forms that are weak form, semi strong and strong form. Weak form Principles of banking Page 70 Under weak form efficiency of the current price reflects information contained in all past prices suggesting that charts and technical analysis that use past prices alone would not be useful in finding under or overvalued stocks. Semi strong form Under semi-strong efficiency, the current prices reflects the information not only in past prices but all public information and no approach that was benchmark on using this information would e useful in finding over valued stocks. Strong form Under strong form efficiency, the current price reflects all information, public as well as private and no investors will be able to consistently find undervalued stocks. In Reality 1. There are investors who have beaten the market consistently such as Warren Buffet (a very successful investor) put it, “I would be a bam in the street with a cup tin if the markets were efficient.” 2. There are consistent patterns present in the market and the most obvious is the January effect and Principles of banking Page 71 weekend effect. In January it’s a tradition that higher returns tend to be earned and prices tend to be higher over the weekend. 3. In behavioral finance, it is revealed that there are predictable patterns to be found on the stock market as it currently operates, investors buy undervalued shares and sell over valued shares. As it has been suggested that short term investors buy and sell latest stocks the result of which is distortion in market price. This demonstrates the prices that prices are actually altered by investors’ actions. However the theory of Equity Market Hypothesis counters this because it does not actually dismiss the possibilities of anomalies that can lead to the generation of abnormal profits. Investing in a market in which people believe in efficiency is like playing poker against those who believe it does not pay to look at the cards. E.g. An investor pays $9500 for a year treasury bill and will obtain $10000 for that treasury bill at maturity. Calculate the discount rate. π· 365 π 4 Discount Rate = × Principles of banking Page 72 Discount Rate = 500 10000 × 365 365 × 100 Discount Rate = 5% Represents the difference between the sale price and the original purchase price 21463.95 – 20000 = 1453.95 20000 × 365 88 × 100 = 30.6% Treasury Bills They are issued by the government for short periods as a way of financing the government expenditure. They are referred to as risk free money market instruments. They are sol at discount of the face value. If you buy a 91 day treasury bill with a yield of 25% and a face of 100 million calculate the cost of the bill. Value Treasury bill = face value – [ππππ π£πππ’π × πππ¦π π‘π πππ‘π’πππ‘π¦ πππ π π¦πππ Principles of banking × π¦ππππ] Page 73 Value Treasury bill = 100 000 000 − [100 000 000 × 91 365 × 25⁄100] Value Treasury bill = 100 000 000 – 6232786.71 Value Treasury bill = $93 767 123.29 Discount rates on Discount instruments DR = π· π × 365⁄π» Where D = amount of discount in dollars P = is the value of the discount instrument e.g. Treasury bill H = the number of days remaining until maturity Formula 1) Purchase price =Face value × (πππ’πππ ×ππππππππ ππππ )×π΅ ×100 (πππ ×πππ¦ ππππ’ππππ) +π΅ ×100 WHERE YTM = Yield to maturity i.e. rate required In secondary market trading or the current rate. B = our daily base Coupon = interest rate payable or original deposit. Principles of banking Page 74 2) Purchase price = π π· π΅ [1+ ( ×π)] WHERE f = principal + interest D = days to maturity B = base year number of days Y = yield for a CD holder Calculate the value of CD which was issued in the previous example but now with 10 days to maturity and a yield of 25% Purchase price = = = π π· π΅ [1 + ( ×π)] 20000 +1610.96 10 25 × )] 365 100 [1 + ( 21610.96 1.006849312 = $21 463.95 Calculate the amount to be invested so that an amount of $10 000 can be realized after 2 years at 135 per annum. PV = ( 10000 1 +0.31)2 = 10000 1.716 Principles of banking Page 75 = $5827.17 Money Market Products Certificate of deposit A certificate of deposit is a record which shows that an investor has placed some funds with some (usually a financial institution). It records and shows the rate of deposit. E.g. A bank issues a certificate of deposit for $20 000 at rate of 30% for period of 98 days. Calculate the interest payable of the certificate of deposit. I = 20 000 × 0.3 × 98 365 = $ 1610.96 Secondary Market Pricing for a Certificate of Deposit The value of a certificate of deposit in the secondary market is determined by 2 periods. 1) The period for which the CD has run 2) The period left to run Calculate Effective annual yield, this formula is used where compounding is being done more than once a year Principles of banking Page 76 π π Effective yield = [(1 + ) − 1] × 100 π An investment pay 15% semi annually. Calculate the effective annual yield. Effective yield = [(1 + 0.15 2 2 ) − 2] × 100 = 1+0.0752 − 1 = 15.5625% Annual yield is higher than semi-annual because one investment pays 15% and the other pays interest on investment. Discounting Is the reverse of compounding, in this case the investors wants the amount which should be invested now in order to realize some specified amount at a given rate for a given period of time. πΉππ 1+π )π Formula PV = ( r = 45 2000×0.041 r = 48.67 Principles of banking Page 77 Compound interest Compounding refers to investments which are placed in banks for fixed period within a year. The interest received is not paid out but reinvested so that the investor ends up realizing interest on the principal and interest on the added interest as well. πΉππ = π(1 + π)π WHERE πΉππ = future value p = Principal n = number of compounding periods Calculate the future value for $200 investment made for 60 days attracting 25% interest and maintained for 365 days. πΉππ = 200(1 + 25%)1 = 200(1 + 0.25)6 = 200(1.25)6 = 762.94 A customer places $100 for 3 years at an annual yield and 40%. Calculate the future value assuming annual compounding. Principles of banking Page 78 πΉππ=100(1+0.4)3 = 100(1.04)3 = 274.4 Issue and Dealing Mathematics Basic Arithmetic and Interest rates Financial institution deal in 2 types of securities 1) Interest bearing securities 2) Discount instruments Those securities differ in the manner in which yield rates are calculated Calculation of simple interest SI is calculated as a percentage of the principal I = π × π × π where; I = Simple interest amount P = Principal amount R = Rate per annum T = Time expressed in years QUESTION A customer places $1000 in a bank for a period of 135 days. The customer receives 39% per annum. Calculate Principles of banking Page 79 his interest based on the information given above, assuming no withdrawal ax is charged. I = 1000 × 39 100 × 135 365 = 144.246 Calculate the rate given to a customer who places 2000 in a bank account for 15 days and receives $45 as his interest amount. 45 =2000 × π × 15 365 45 = 82R R= 45 82 × 100 R = 54.9% By taking weighted average we can see how much interest the company has to pay for every demand it finances E.g. the expected return on the market is 13% with a risk free market rate of 7% along its corporate tax of 35%. Horizon financial services have a beta of 1.29 and a debt to equity ratio of 1.What is Horizon cost of equity and the Principles of banking Page 80 weighted average cost of capital when the firm has a before tax cost of debt of 7%. = π π + π΅(π π − π π ) = 7 + 1.29(13% − 7%) = 14.74 The firm has a debt at market value of $60 000 000. The firm pays a 50% rate of interest on its new debt and has a beta of 1.41, assume that the risk premium of the market is 8.5% and the TB rate is 11% Required I. Compute Weighted Average Cost of Capital for the firm II. Calculate the price of a TB if par value is $1000, maturity is 3 months and discount is 7.5% It is a calculation of firm’s cost of capital in which each category of capital is proportionally weighed. Weighted Average cost of capital of a firm increases as the beta and rate of return on equity increases. Weighted Average Cost of Capital equation is the cost of each capital Principles of banking Page 81 component multiplied by its proportional weigh and then summed up. π¬ π« π½ π½ Formula: × πΉπ + × πΉπ × (π − π»π) WHERE: Re = Cost of equity Rd = Cost of debt E = Market value if the firm’s equity D = Market value of the firm’s debt V=πΈ+π· π· π πΈ π = Percent of financing that is debt = Percent of financing that is equity Tc = Corporate tax value Free rate is 7%, what is the appropriate discount rate for the new project assuming a market risk of 8.5%? Ε = π π + π΅(Επ − π π) = 7 + (1.3)(8.5) = 18.05 Cost of debt Principles of banking Page 82 Refers to the effective rate that a company pays on its current debt. This can be measured in either before or after tax returns. A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to all the overall rate being paid by the company to use debt financing. This measure can also give investors an idea as to riskiness of the company compared to other companies. Riskier companies generally have a high cost of debt. To get the after tax rate, simply multiply the before tax rate by 1 minus the marginal tax rate i.e. after tax rate =ππππππ πππ ππππ × (π − ππππππππ πππ ππππ). If a company’s only debt were a single bond in which if paid 5%, the before tax cost of debt would be simply 5%. If however the company’s marginal tax rate were 40% the company’s after tax cost of debt would only be 3% = 5% × (1 − 40%) Weighted Average Cost Of Capital When firm finances with both debt and equity, the discount rate to use is the project’s overall cost of capital. The overall cost of capital is the weighted average cost of debt and the cost of equity. Principles of banking Page 83 Cost of Equity Capital Whenever a firm has extra cash, it can take one of two actions I. It can pay out the cash immediately as dividends. OR II. It can invest the extra cash in a project, paying out the future cash flows of the project as dividends. From a firm’s perspective, the expected return is the cost of equity capital Using The capital asset pricing model Ε = Rf+π© × (Επ − πΉπ) WHERE: Εm−Rf = Market risk premium B = the company Beta R = Expected return Rf = Risk free market E.g. suppose the stock of Mutare Poly has a beta of 1.5 the firm is 100% equity financed. Mutare Poly is considering a number of capital budgeting projects are similar to Mutare Poly’s existing ones, the average beat Principles of banking Page 84 on the new projects is assumed to be equal to its existing beta. The risk the highest returns in compensation. Debt finance Long term debt finance carries less risk for investors than equity finance and this is reflected in its lower required rate of return. Debt can be engineered to suit the requirements of the companies and investors e.g. a new issue of debt securities can be made attractive to investors by attaching warrants to it. These give the holder the subscribe for ordinary shares at an attractive price (exercise price in future). Leasing Is a form of short to medium term financing which in essence refers to hire an asset under an agreed contract. The company hiring the asset is called the lessee and the company owning the asset is called the lesser. It’s a source of financing where the lessee obtains use of an asset for a period of time while legal title of the asset remains with the lesser. Advantages of leasing ο· It’s an off balance sheet source of finance. Principles of banking Page 85 ο· Allows small company access to expensive assets. ο· Allows a company to avoid obsolescence to some assets. ο· It can be a source of finance if a company is short of liquidity. Economy Pi condition Xi(%) [π₯π 2 Piπ₯π − ∑(π₯π ) − ∑(π₯π )] Horrid 0.15 10 Bad 0.25 20 Average 0.50 25 Good 0.10 30 144(10 − 22)2 4(20 − 22)2 9(25 − 22)2 64(30 − 22)2 216(144 × 0.15) 1(4 × 0.25) 4.5(9 × 0.50) 6.4(64 × 0.10) ∑ 33.5 Sources of Business Finance Internal finance Principles of banking Page 86 It emanates from the cash generated by the company we be not needed to operating costs, interest payment, tax liabilities, cash dividend or fixed assets replacements. This surplus cash is called retained earnings. Another source of internal finance is saving that can be generated by more efficient management of working capital. External Finance Can be split into debt or equity finance. It can also be classified account to whether its short terms (less than one year, medium term (1 to 5 years) or long term (+5) account to whether it’s traded (for examples ordinary share s or untraded (bank loans). Equity finance Is raised through the sale of ordinary shares to investors. This sale may be through the stock market or through a right issue. Ordinary shareholders are the ultimate bearers of the risk associated in the business activities of the company they own. Since ordinary shareholders earn the greatest risk of any of the providers of long term finance, they expect the return on an asset. Principles of banking Page 87 Economic Condition Horrid Bad Average Good Pi Xi (%) 0.15 0.25 0.50 0.10 10 20 25 30 Calculate the expected Return =10(0.15) + 20 (0.25) +25 (0.50) + 30 (0.10) =22% Risk of a Single Asset ο· Is measured using variance and standard deviation. ο· Variance; is the average of the mean squared error term. ο· Mean to Error: Is the square of the difference between a given return (Xi) and the average of all return is the E(R). ο· formula: [π₯π − πΈ (π₯π )]2 i =1 Variance is the expectation of the mean squared error terms and therefore it’s given as Variance (0−2 ) =∑ ππ [π₯π − (π₯π )] Principles of banking Page 88 Standard Deviation =√π£πππππππ . Calculate from previous example, the variance (0−2 ) 0−2 =∑ ππ [π₯π − (π₯π )]2 i=1 Return and Risk Analysis for A Single Asset Risk Is the volatility of a security’s return? Expected Return Due to, it may be difficult to know the except return on a particular financial investment. However possible outcomes or returns may be determined depending on different situations that may prevail in future. Expected return is a return that an individual expects a stock to earn in the next period. Because it is an expectation it maybe either higher or lower than the actual return. It may simply be the mean or average return per period of a security has earned in Principles of banking Page 89 the past. The expected return or mean return is the probability of observing each rate of return multiplied by rate of return and then sunned up across all possible returns. Formula = ∑ππ=1 ππ × π Expected Return of a single asset Mathematically the Expected Return of a single asset is defined as ∑ππ=1 ππ × π WHERE n = number of possible outcomes Pi = probability of observing the π π‘β rate of return Xi = is the π π‘β rate of return Where probabilities are not given, assume equal chance for all outcomes Project/ Investment Appraisal/ Capital Budgeting The basic objective of investment spending is to meet firm’s objectives of which the central objective is taken to be profitable in the long run. It is expressed as the maximization of shareholders wealth. Principles of banking Page 90 For this reason, the starting point for any discussion of investment appraisal is the assumption that the ultimate objective of investment is to maximize the value of the firm. First an investment schedule is necessary to replace the existing equipment . Secondly investment maybe needed in support of expansion. Thirdly investment maybe required for reasons of compliance with government regulations. Whatever the immediate objective of investment, the fundamental purpose is to enhance the value of the firm. Certain techniques are available to appraise each project and may essentially be the same across projects. Investment appraisal may have or may aim at 3 basic objectives; 1) Deciding to accept or reject the project 2) To rank different projects 3) To choose between mutually exclusive alternatives Methods Of Investment Appraisal The following are some of the methods used to analyze long term investments. Principles of banking Page 91 1) Payback Period Method 2) Account Rate Of Return (ARR) 3) Net Present Value (NPV) 4) Internal Rate Of Return (IRR) 5) Modified Internal Rate Of Return (MIRR) 6) Discounted Payback Period (DPP) 7) Profitability Index (PI) Payback Period Method Is the time an investment takes to recover the Initial Outlay (Io). For an annuity, payback = πΌπππ‘πππ ππ’π‘πππ¦ πππ’ππ πππ β ππππ€π For a unequal cash flows, payback = πΌπ−πΆπ‘ πΆπΉπ‘+1 Where t = last full year in which cumulative cash flows are less than the initial outlay πΆπΉπ‘+1 = is the cash flow in the year t + 1 Ct = cumulative cash flow in year t. The aim is to accept or reject projects which exceed the cutoff period. If the aim is to rank projects, those with the shortest payback period rank higher. If the aim is to make Principles of banking Page 92 initially exclusive projects, one with shortest payback period will be chosen. For independent projects, all projects with a payback period below a given hurdle must be taken subject to availability of funds. Advantages of Payback Period ο· Easy to calculate and understand. ο· It measures the risk of the project. Disadvantages O f Payback Period ο· ο· ο· ο· It is biased towards short term projects. It does not consider cash flow variability. Does not cash flow after payback period. It ignores the time value of money Discounted Payback Period Instead of using the whole cash flows, it applies cash flows but uses the same concept as payback period. πΆπ‘ (1+π)π‘ π‘+πΌπ− Formula = πΆπΉπ‘ ⁄( 1+π )1+1 Net Present Value Method Principles of banking Page 93 Is the essence of investment appraisal lays in comparing values of outlays and returns which occur on different times, the principle of discounting provides a solution to the basing problem. Returns occurring over the life time of the project may be reduced to a single figure representing the present value of those steams of cash flows which is called NPV. NPV is defined as the surplus or deficit of the present values of incremental cash flows over the initial outlay. ππΆπΉ1 1+π )1 NPV = Io +( ππΆπΉ2 1+π )2 +( ππΆπΉ3 ππΆπΉπ β― (1+π )π 1+π )3 +( Where NCF = Net cash flows arising in different years R = The opportunity cost of capital For initially exclusive projects, the one with highest positive NPV should be chosen. For those independent projects, all those with positive NPV should be chosen subject to availability of funds. Advantages Of NPV ο· Takes into account the time value of money because it discounts future cash flows into present value Principles of banking Page 94 ο· It takes into account all possible cash flow of the project Disadvantages Of NPV ο· Does not take into account the time taken to recoup the initial outlay. ο· The concept of value added may not be easily appreciated as a measure of return because people are more comfortable with percentage returns. Internal Rate Of Return (IRR) Is the discount rate which leads to an NPV of zero i.e. the present value of future cash flows should result in zero. IRR = π1+[ π1 ]×(π2 −π1 ) π1 +π2 Where π1=πππ πππ’ππ‘ πππ‘π π‘βππ‘ πππ£ππ π πππ ππ‘ππ£π πππ π2=πππ πππ’ππ‘ πππ‘π π‘βππ‘ πππ£ππ π πππππ‘ππ£π πππ π1=πππ π€ππ‘β π1 ππ πππ πππ’ππ‘ πππ‘π π2=πππ π€ππ‘β π2 ππ πππ πππ’ππ‘ πππ‘π Principles of banking Page 95 This method is based on trial and error. The decision rule is that accept the project if the IRR exceeds the opportunity cost of capital. If the IRR is less than the opportunity cost of capital, the project should be rejected. For mutually exclusive projects take the one with highest IRR above the cost of capital. For independent projects accepts all projects with IRR above the cost of capital subject to the availability of funds. Advantages Of IRR ο· Considers the time value of money. ο· It uses the opportunity cost of capital. ο· It considers all possible cash flows. Disadvantages Of IRR ο· Time consuming as it is based on trial and error. ο· It assumes that opportunity cost remains constant and therefore can’t be used where opportunity cost is expected to change along the investment horizon. Accounting Rate Of Return May take a use of different forms but consists essentially of estimating net profits occurring over the project’s life Principles of banking Page 96 cycle. It calculates the average profits as a percentage of initial outlay to give an estimated rate of return. Formula = ππ£πππππ ππππππ‘ ππ£πππππ πππ£ππ π‘ππππ‘ × 100 ο· If the rate of return exceeds the firm’s minimum requirement then the project is accepted. Projects are ranked by minimum rate of return. Advantages Of ARR ο· Simple to calculate. ο· It shows return on investment as a percentage Disadvantages Of ARR ο· Does not take into account the time value of money. ο· It only shows the accounting profits and does not show whether cash flow occur or not in the accounting period. It does not take into account cash flow risk. Profitability Index (PI) PI = ππππ πππ‘ π£πππ’π ππ πππ β ππππ€ ππππ πππ‘ π£πππ’π ππ πΌπ Principles of banking Page 97 PI = πΆπΌπΉπ‘ (1+π)π‘ πΆππΉπ‘ ∑π π‘=0(1+π)π‘ ∑π π‘=0 Where πΆπΌπΉπ‘ = πππ β ππππππ€ ππ‘ π‘πππ π‘ πΆππΉπ‘= πππ β ππ’π‘ππππ€ ππ‘ π‘πππ π‘ The PI shows the relative profitability of any project. The project is acceptable if PI is greater than initial outlay. In other words cash inflows are greater than cash outflows. The higher the PI, the higher the projects ranking. PRACTICAL 2 You have been contracted by an indigenous business to start up a company to advice on the decision to select either of the two mutually exclusive projects i.e. Goat rearing and Bee keeping. After a thorough research on the projects you have come with the following information; The cost of capital is 10% The cash flows are as below Goat Rearing Year Cash flow 0 (25000) Principles of banking Bee keeping Year 0 Cash flow (14000) Page 98 1 2 3 4 7000 10000 16000 15000 1 2 3 4 2500 5000 9000 12000 Advise the company on which of the two projects to implement using; a. Payback period [4] b. The discounted payback method [6] c. Net Present Value [6] d. The Profitability Index [6] e. Accounting Rate of Return [4] f. The Internal Rate Of Return [8] Define and explain capital budgeting [6] Returns and Risk Analysis For A Single Asset Risk is the volatizing of a security’s return. Expected Return [E(R)] Due to risk, it may be difficult to know the exact return on a particular financial investment. However possible outcomes or returns may be determined depending on different estimations that may prevail in the future. Expected return is a return that Principles of banking Page 99 an individual expects a stock to earn in the next period because it is an expectation, it may be either higher or lower than the actual outcome. It may simply be the mean or average return per period a security has earned in the past. The E(R) or mean return is the probability of observing each rate in return and then summed up across all possible returns. Formula = ∑ππ=1 ππππ Expected return of a single asset Mathematically the E(R) of a single asset is defined as ∑ππ=1 ππππ N = number of possible outcomes Pi = probability of observing the π π‘β rate of return Xi = is the π π‘β rate of return Where probabilities are not given, assume equal chance for all outcomes Economic condition Horrid Bad Principles of banking Pi Xi% 0.15 0.25 10 20 Page 100 Average 0.50 good 0.10 Calculate the expected return 25 30 Answer =10(0.15) + 20(0.25) + 25(0.50) + 30(0.10) = 22% Risk of a single asset Is measured using variance and Sd Variance: is the average of the mean squared error terms π΄ππππ : is the square of the difference between a given return Xi and the average of all the returns i.e. E(R) ππππ2 πππππ = [ππ − πΈ (ππ )]2 Variance is the expectation of the mean squared error terms and therefore it is given as; Formula π=2 ∑π 2 π=π ππ [ππ−πΈ (ππ )] Standard deviation (Sd) Formula = √π£πππππππ Calculate from the previous example, the variance and standard deviation Principles of banking Page 101 π 2 π 2= ∑π=1 ππ[ππ−πΈ(ππ)] Economic condition Horrid Bad Average good total Pi Xi 0.15 0.25 0.50 0.10 10 20 25 30 [ππ − πΈ (ππ )]2 144 4 9 64 ππππ − πΈ (ππ )2 21.6 1.5 4.5 6.4 33.5 Management Of Working Capital Long term investment and financing decision give rise to future C.F which can be discounted by an appropriate cost of capital, determine market value of a company. However, such a long term decision will only result in the expected benefits for a company if attention is also paid to short term decisions regarding to current assets and current liabilities. Current assets and current liabilities need to be managed carefully. Net working capital is the term given to the difference between current assets and current liabilities. Principles of banking Page 102 The level of current assets is a key factor in a company’s liquidity position. A company must have or be able to generate enough cash to meet its short term needs if it’s to continue in business. Without the ‘oil’ of working capital, the ‘engine’ of fixed assets will not function. Objectives of working capital management Two main objectives of working capital are; 1. To increase profitability of a company. 2. To ensure that the company has sufficient liquidity to meet short term obligation as thye fall due and so as to continue in business. These positive goals of profitability and liquidity will often conflict since liquid assets give the lowest returns. Working Capital Policies A company should have working capital policies on the management of stock, debtors, cash and short term investments in order to minimize the probability of managers to make decisions which are not in the best interests of the company. E.g. suboptimal decisions like giving credit to customers who are unlikely to pay and ordering stocks of raw materials. Working capital policies Principles of banking Page 103 need to consider the nature of a company’s business since different business will have different working capital requirements. Cash Management Cash consists of the firm’s holdings of currency and demand deposits. There are three motives of holding cash; 1. Transactional motive 2. Precautionary motive 3. Speculative motive However, sound working capital management requires maintenance of an ample amount of cash for several other specific reasons; Reason 1: it’s essential that the firm has sufficient cash to take advantage of trade discounts. Reason 2: since the current and the acid test ratio are key items in credit analysis, it’s essential that the firm needs to maintain credit standing, meet the standards of the line of business in which it is engaged. A credit standing enables the firm to purchase goods from trade suppliers Principles of banking Page 104 on favorable terms and to maintain its line of credit with banks and other sources of credit. Reason 3: ample cash is useful for taking advantage of favorable business opportunity that may come along from time to time. Reason 4: the firm should have sufficient liquidity to meet emergencies like strikes, fires or marketing campaign of competitors. Financial managers may be able to improve the inflowoutflow pattern through better synchronization of flow, expediting collections and cheque clearing, showing disbursements and through using float (the leg between the time the cheque is written until the time, the bank receives it) Optimum Cash Levels The optimum amount of cash held will depend on the following factors; 1. Foams of the future cash inflows and outflows. 2. The efficiency with which the cash flows of the company are managed. Principles of banking Page 105 3. The availability of liquid assets of the company – anything you can dispose at a lesser cost. 4. The borrowing capability of the company. 5. The company’s tolerance capacity of risks The Investment of surplus cash Cash which is surplus to immediate needs should earn by being on a short term basis without risk of capital loss. Factors which should be considered when choosing an appropriate investment method for short term cash surplus are; 1. The size of surplus as some investments methods have minimum amounts. 2. The cash with an investment can be realized. 3. When the investment is expected to mature. 4. The risk and yield of a investment 5. Any penalties which may be incurred for any liquidity. Management Of Debtors Key variables affecting the level of debtors include the terms of sales which are prevalent in the company’s area of business and the ability of the company to match and Principles of banking Page 106 service comparable terms of sales. There is a relationship between the level of debtors and company’s pricing policy. The effectiveness of debtor follow up procedures will also influence the level of debtor and the likelihood of bad debtors arising. The debtor management policy decided upon by senior managers should also take into account the administrative cost of debt collection. In order to operate its debtors policy a company needs to set up a credit analysis, a credit control system and a debtor collection system. 1) Credit Analysis System The risk of bad debts can be minimized if the credit worthiness of new customers is carefully assessed before credit is granted and if the credit worthiness of customers is revealed on a regular basis. Sources Of Information In Credit Analysis Bank references: these indicate the financial standing of the potential borrower. Trade references: these give an incite into satisfying conduct of business affairs. Credit references agency: a credit agency report includes a company profile, recent Principles of banking Page 107 accounts, financial ratios and industry companies, analysis of trade industry, type of borrowing, credit limits and previous financial position. 2) Credit Control System Customer account should be kept within the agreed audit limit and credit granted should be revealed periodically to ensure that it remains appropriate. Invoices and receipts should be carefully checked to ensure there is accuracy and dispatched quickly. Under no circumstances should customers who exceed agreed credit limits be able to obtain goods. Insurance Against Bad Debts Whole turnover requirements cover any debt below the agreed amount against the risk of payments. Specific accounts insurance allows the company to ensure key accounts against defaults and maybe useful for major customers. Discounts For early payments Cash discount s may encourage early payments, but the cost of such discounts must be less than the total financing savings resulting from lower debtors’ balances, Principles of banking Page 108 any administrative of financing savings owing from shorter debtor collection periods, and any benefits from lower bad debts. Factoring Factoring companies offer a range of services in the area of sales admin and the collection of amounts due from debtors. A factor can offer cash in advance against the security of debtors allowing a company ready access to cash as soon as the credits are made. The factor usually does not have resource to the company for the compensation in the event of non-payment and this is termed as non-resource factoring. There is however a reduction in admin costs and the company will have access to the factor experties in credit analysis and control. Advantages offered to the company through factoring ο· Prompt payments of supplies. ο· Reduction in the amount of working capital tied up in debtors. ο· Financing growth through sales. ο· Savings on admin costs. Principles of banking Page 109 ο· Benefits occurring to the company from the factor experience in credit analysis and control. Management Of Stock Significant amounts of working capital can be invested in stocks of raw materials work in progress and finished goods. Stocks of raw materials and work in progress come out as a buffer between different stages of the production process and so ensure its smooth separation. A stock of finished goods allows the sales department to satisfy customer demand without unreasonable delay and potential loss of sales. Benefits of holding stock must be weighted against any cost incurred. Costs which may be incurred include; 1) Holding costs such as insurance, rentals, power e.tc 2) Replacement costs which include the cost of obsolete stock. 3) The opportunity cost of cash tied up in the stock The Economic Order Quantity (EOQ) This model establishes an optimum level of stock by balancing the cost of holding stock against the cost of Principles of banking Page 110 ordering fresh supplies. It then uses optimal level of stock as the basis of a minimum cost procurement policy. The model assumes that for the period under considerations, cost and activity are constant and known with certainty. The EOQ occurs where total cost which is the sum of the annual holding cost and the annual ordering cost is at a minimum. Total annual cost = annual holding cost + annual ordering cost π ππΆ = π×π» 2 + π×πΉ 2 Where Q = order quantity in units. H = holding cost per unit per year. S = annual demand in units per year. F = ordering cost per order. The minimum total cost is when holding cost and ordering cost are equal. Putting holding cost equal to ordering cost and rearranging gives Q = √ Principles of banking 2×π×πΉ π» Page 111 Q is now the EOQ. That is the order quantity that minimizes the sum of holding cost and ordering cost. E.g. a company sells soap which it buys in boxes of 1000 bars with ordering cost of $5 per year and holding cost of 50cents per year per 1000 bars. What is EOQ and the average stock level for this stock. 2×π×πΉ EOQ (Q) = √ π» 2×200000×5 0.50⁄ 1000 =√ 400000×5 = √ 0.50 ⁄1000 =√ 2000000 0.0005 = √4000000000 = 63245.55 bars Average stock = = πΈππ 2 63245.55 2 = 31622.775 bars Principles of banking Page 112 Overtrading (undercapitalization) How do increase in turnover cause overtrading Occurs if a company is trying to support too large a volume of trade from too to small working capital base. It means the demand for funds is greater than the supply for funds to the company. Even if a company is spending at a profit overtrading can result in a liquidity crisis with the company unable meet its debt as they fall due because cash has been absorbed by growth in fixed assets, stock and debtors. Overtrading can be caused by a rapid increase in turnover, perhaps as a result of a successful marketing campaign where provisions for the necessary associated investments in fixed assets and current assets was not met. Overtrading can also result in the early years of new business if it starts off with insufficient capital. This may be due to a mistaken belief that sufficient capital could be generated from trading profits and ploughed back into business. Overtrading may be due to erosion of company’s capital base due to non replacement of long term loan financing their repayment. Indications of overtrading Principles of banking Page 113 ο· Rapid growth in sales over a relatively short period. ο· Rapid growth in the amount of current assets. ο· Deteriorating stock days and debtor days ratios. ο· Increasing use of trade credit to finance growth in current assets (increasing creditors days). ο· Declining liquidity indicated by falling quick ratio. ο· Declining profitability, perhaps due to using discounts to increase sales. ο· A lack of cash and liquid investments. Strategies to deal with overtrading ο· Introduction of new capital most preferably equity capital. ο· Improved working capital management. ο· Reducing business activity. Questions 1. Discuss the possible reasons why a company might experience cash flow problems and suggest ways in which such problems might be alienated. 2. Suggest ways in which companies can exercise control over their level of working capital. Principles of banking Page 114 Principles of banking Page 115
