ACC08/FMS01 LECTURES

Financial Management Part 1

Gems

Economic Foundation of Financial Management

Topical Objectives
At the end of this section, you are expected to : 1. Review relevant microeconomic concepts; 2. Review relevant macroeconomic concepts; and 3. Identify the Green regulations affecting doing business.

I am not
afraid of storms, for I am learning how to sail my ship

-Louisa May Alcott (1832-1888)

Why study microeconomics?

Understanding these concepts enables analysts to differentiate among various companies on an individual level, and to determine their attractiveness for an investor ECONOMICS

Elasticity
-a concept related to the equilibrium between demand and supply -measures the dependency between demand and supply and the impact of changes in either on the equilibrium price level.

comes from the combined Greek words oikos (house) and nomos (custom or law)

Law of Supply and Demand

Demand curve is downward sloping to the right: the quantity demanded is increasing as price is decreasing Supply curve is upward sloping to the right: the quantity supplied is increasing as price is increasing Differentiate between movement along the curve and shifting curve

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Factors that increase (decrease) demand for goods

Increase the Demand for Goods A rise in the number of consumers in the market A rise in consumer income A rise in the price or decline in availability the substitute A fall in the price of a complementary good A rise in the expected future price of the good Changes in consumer preferences Changes in distribution of consumer income Decrease the Demand for Goods A fall in the number of consumers in the market A fall in consumer income A fall in the price or increase in availability the substitute A rise in the price of a complementary good A fall in the expected future price of the good Changes in consumer preferences Changes in distribution of consumer income

Factors that increase (decrease) supply of goods

Increase the Supply for Goods A fall in the resource price used in producing the good A technological change allowing cheaper production Favorable weather, political factors, etc. A reduction the taxes Decrease the Supply for Goods A rise in the resource price used in producing the good A technological change allowing cheaper production Unfavorable weather, political factors, etc. An increase in the taxes

Short- vs. long-run equilibrium

Short-run Equilibrium Short run is a time period where the decision makers could not fully adjust to market changes ; one can alter only the labor and raw materials, but with existing plant and equipment Short-run equilibrium: a balance between amount supplied and amount demanded Long-run Equilibrium Long run is a time period of sufficient length to enable decision makers to adjust fully to market changes

Long-run equilibrium: a balance between amount supplied and amount demanded + opportunity cost of producing the product must equal to the market price

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Price elasticity of demand

Total expenditures and Price Elasticity of Demand

Downward sloping demand curve means that the quantity demanded will be lower if the price increases Total expenditures/revenue = Price x Quantity ? = x ? = x
Demand is Expenses change as Price changes Revenues change as Price changes

Inelastic (0 -> 1) Elastic ( > 1) Unitary ( = 1)

Same direction Opposite Direction Constant

Same direction Opposite Direction Constant

Price Elasticity of Supply Same concept as demand elasticity Marginal Benefit vs. Marginal Cost
Definitions Marginal Benefit Benefit that an individual gets from consuming an additional unit of good or service. However each additional unit consumed results in smaller marginal benefit and results in diminishing returns. Marginal Benefit Cost of producing an additional unit of output; also referred to as opportunity cost. Important concepts 1. Demand measures the benefit from consuming an additional good (benefit measured as the willingness to pay for the extra good). 2. Demand measures the marginal benefit. ECONOMIC FOUNDATIONS OF FINANCE11

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3. Supply measures the cost of producing an additional good. 4. Supply measures the marginal cost. 5. We want an activity to continue to take place as long as the marginal benefit is higher than the marginal cost.

Consumer surplus
Consumer Surplus is the difference between total value consumers place on a good produced less the amount paid

Producer surplus
Producer Surplus is the difference between the price received for each good produced and the opportunity cost of producing the good.

Price Takers Vs. Price Searchers

Price takers must take the market price in selling their product, because each price takers output is small relative to total market Price searchers have a downward sloping demand curve for their product. The amount they are able to sell is inversely related to the price they charge

Market Structures

The market environment influences the price a firm can demand for its goods or services. Among the most important of these market forms are monopoly and perfect competition, although monopolistic competition and oligopoly are also covered. Price Taker Market Characteristics All firms are producing an identical product A large number of firms exist in the market Each firm supplies only a very small portion of total amount supplied to the market No barriers limit the entry or exit of firms in the market

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ACC08FINANCIAL MANAGEMENT PART 1 Monopolies Characterized by one seller of a specific, well-defined product that has no good substitutes. For a firm to maintain its monopoly position it must be the case that barriers to entry to the market are high. Legal Barriers Natural Barriers: there are large economies of scale, it means that the average cost of production decreases as a single firm produces greater and greater output. Monopoly Price-Setting Strategies Single price Price discrimination. Price, Marginal Revenue, And Elasticity For A Monopoly The profit maximizing output for a monopolist is where MR = MC. Monopolists want to maximize profits, not price. Monopolists are price searchers and have imperfect information regarding market demand. They must experiment with different prices to find the one that maximizes profit.

Monopolistic Competition A large number of independent sellers: Each firm has a relatively small market share, so no individual firm has any significant power over price. Firms need only pay attention to average market price, not the price of individual competitors. There are too many firms in the industry for collusion (price fixing) to be possible. Each seller produces a differentiated product. Firms compete on price, quality, and marketing Quality is a significant product differentiating characteristic. Marketing is a must in order to inform the market about a product's (differentiating) characteristics. Low barriers to entry. Their demand curves are highly elastic because competing products are perceived by consumers as close substitutes. Oligopoly markets It is competition among the few Oligopoly There are two conflicting tendencies: A small number of sellers. Strong incentive to collude among them to Interdependence among competitors maximize the joint profit, but also strong incentive to cheat secretly on the Significant barriers to entry which often collusive agreement in order to increase its share include large economies of scale. of the joint profit Products may be similar or differentiated. Oligopolists are highly dependent upon the actions of their rivals when making business decisions. Cartel: an organization of sellers designed to coordinate supply decisions so that the joint profits of the members will be maximized (e.g.: OPEC)

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ACC08FINANCIAL MANAGEMENT PART 1 Monopolistic Competition MR= MC, but due to low barriers to entry, competitors will enter the market in pursuit of these economic profits. After new firms have entered the market, the demand curve faced by each individual firm down to the point where price equals average total such that economic profit is zero. Efficiency of monopolistic competition is unclear increased information vs. increased costs

Macroeconomics Concepts
Macroeconomic concepts that have an impact on all firms in the same environment, be it a country, a group of related countries, or a particular industry. Topics covered concepts about the business cycle, and how to forecast changes in the business cycle and the impact on, among other things, price levels and profitability.

The Business Cycle

In the past, ups and downs have often characterized aggregate business activity. Despite these fluctuations, there has been an upward trend in real GDP in the United States and other industrial nations.

What is Inflation?
The Rate of Inflation is calculated as: Inflation = Last years price index - This years price index * 100 rate Last years price index Inflation is an increase in the general level of prices. High rates of inflation are almost always associated with substantial year-to-year swings in the inflation rate, making them difficult to forecast accurately.

Aggregate Demand for Goods & Services

Aggregate demand (AD) curve: indicates the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels . The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.

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Short-Run Aggregate Supply (SRAS)

SRAS indicates the various quantities of goods and services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market. SRAS curve slopes upward to the right. The upward slope reflects the fact that in the short run an unanticipated increase in the price level will improve the profitability of firms. Firms respond to this increase in the price level with an expansion in output. In the short-run, firms will expand output as the price level increases because higher prices improve profit margins since many components of costs will be temporarily fixed as the result of prior long-term commitments. The SRAS shows the relationship between the price level and the quantity supplied of goods & services

An increase in the price level will increase the quantity supplied in the short run.

Long-Run Aggregate Supply (LRAS)

LRAS indicates the relationship between the price level and quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible. The LRAS curve is vertical. LRAS is related to the economy's production possibilities constraint. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements. In the long-run, a higher price level will not expand an economys rate of output. Once people have time to adjust their long-term commitments, resource markets (and costs) will adjust to the higher levels of prices and thereby remove the incentive of firms to continue to supply a larger output.

Change in price level does not affect quantity supplied in the long run.

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ACC08FINANCIAL MANAGEMENT PART 1 An economys full employment rate of output (YF), the maximum output rate that is sustainable, is determined by the supply of resources, level of technology, and the structure of the institutions, factors that are insensitive to changes in the price level. Hence the vertical LRAS curve.

Aggregate Demand Curve

Other things constant, a lower price level will increase the wealth of people holding the fixed quantity of money, lead to lower interest rates, and make domestically produced goods cheaper relative to foreign goods.

A reduction in the price level will increase the quantity of goods & services demanded.

Monetary sector of an economy

It examines the functions of money and how it is created, highlighting the special role of the central bank within an economy. Supply and demand for resources, such as labor and capital, and goods are strongly interrelated. Describes circumstances when this may lead to inflation and the transmission mechanisms between the monetary sector and the real part of the economy.

Four Main Economic Functions of Depository Institutions

Create liquidity - using the funds from (short-term) deposits to make (longer-term) loans. Be a financial intermediary - lower the cost of funds for borrowers. Monitor the risk of loans. Pool the default risks of individual loans.

Money Creation And The Multiplier Effect

A bank is only required to hold a fraction of its deposits in reserve. Deposits in excess of the required reserve (excess reserves) may be loaned. The required reserve ratio is used to measure the, reserve requirement. Multiplier effect - process of re-lending, re-spending, and depositing.

Goals of Reserve
Inflation targeting - Keep inflation low by managing the money supply. ECONOMIC FOUNDATIONS OF FINANCE16

ACC08FINANCIAL MANAGEMENT PART 1 Promote economic growth and full employment.

The 3 Tools the Monetary Board Uses to Control the Money Supply
1. Reserve requirements: a percent of a specified liability category (for example transaction accounts) that banking institutions are required to hold as reserves against that type of liability. When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply. Raising the reserve requirements has the opposite effect. 2. Open Market Operations: the buying and selling of securities (national debt in the form of bonds) by the BSP. This is the primary tool used by the BSP. BSP buys bonds the money supply expands: bond buyers acquire money bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans. BSP sells bonds the money supply contracts: bond buyers give up money for securities bank reserves decline, causing them to extend fewer loans. 3. Discount Rate: the interest rate the Fed charges banking institutions for borrowed funds. An increase in the discount rate decreases the money supply (restrictive) because it discourages banks from borrowing from the Reserve to extend new loans. A reduction in the discount rate increases the money supply (expansionary) because it makes borrowing from the Reserve less costly. Households either consume (spend) or save their incomes. Demand for money is largely determined by interest rates. The opportunity cost of holding money (cash balances) is the interest rate. Supply of money - determined by the central bank Is independent of the interest rate. This accounts for the vertical (perfectly inelastic) supply curve. Real money supply - the money supply in terms of constant purchasing power.

Interest Rate Determination

To decrease (increase) short-term interest rates the Central Bank can do so by buying (selling) securities in the open market. The cash paid (received) for the securities increases (decreases) the real money supply and bank reserves, which leads to a further increase (decrease) in the real money supply as banks make loans based on the increase (decrease) in excess reserves. This shifts the real money supply curve to the right (left).

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ACC08FINANCIAL MANAGEMENT PART 1 There is now excess (less) supply of money balances. To reduce (increase) their money holdings, firms and households buy (sell) securities, increasing (decreasing) securities prices and decreasing (increasing) interest rates until the new equilibrium interest rate is achieved.

Inflation And Prices

Inflation is a persistent increase in the price level over time. Erodes the purchasing power of a currency. Unchecked, inflation ultimately can destroy a country's monetary system, forcing individuals and businesses to adopt foreign money or revert to bartering physical goods. If inflation is present, the prices of almost all goods and services are increasing.

Demand-pull vs. Cost-push Inflation Demand-pull inflation - results from an increase in aggregate demand; can result from an increase in the money supply, increased government spending, or any other cause that increases aggregate demand. Cost-push inflation - results from a decrease in aggregate supply; can also result from an initial decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as wages or energy. If the decline in GDP brings a policy response that stimulates aggregate demand so output returns to its long-run potential, the result would be a further increase in the price level. Fiscal Policy, Budget Deficits, And Budget Surpluses
Fiscal policy - refers to the federal government's use of spending and taxation to meet macroeconomic goals. The federal budget is said to be balanced when tax revenues equal federal government expenditures. A budget surplus occurs when government tax revenues exceed expenditures, and a budget deficit occurs when government expenditures exceed tax revenues. Taxes are increased and/or government spending reduced during inflationary periods, and taxes are decreased and/or government spending increased during recessionary periods.

Multiplier Effect
Changes in government spending, taxation, or both have magnified effects on aggregate demand. The multiplier effect applies equally to increases and decreases in government spending and increases and decreases in taxes. The government purchases multiplier is greater than the tax multiplier making the balanced budget multiplier positive. An increase (decrease) in government spending coupled with an equal increase (decrease) in taxes will tend to increase (decrease) aggregate demand. ECONOMIC FOUNDATIONS OF FINANCE18

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Environmental (green) policies and their implications for the management of the economy and the firm
The Materials Balances Model
Using the materials balance model adapted from Kneese, Ayresand DArge (1970) (Thomas, 2010) (Figure 1.0), the relationship between the natural environment and the economic decision making activities of the firm can be seen1:
Natural resources drawn from Nature Residuals from Consumption Households Recovery, recycling, reuse Factor market Figure 1.0 Nature and the Market Nature Residuals from Production Output market Firms

Production and consumption produce residuals that can damage the environment from which resources are drawn. It appears that not only desirable goods are provided in the free market. But the existence of environmental pollution (residuals production) causes market failures such as externalities and public goods. The externality theory suggests that environmental problems cause market failure since they are caused outside the market process. Recall that one of the barriers cited for the investor is the failure to internalize environmental costs and benefits into the market model. On the other hand,
1

Market Failure by Externalities -Civil /class action -Making it punishable by law -Education -Taxes or Subsidies Tragedy of Commons -limitation of amount of common good available for use (use of P _ _ _ _ _S) -user cooperation -conversion of common good to _ _ _ _ _ _ E good

(Trivia: United Nations Moon Treaty, Outer Space Treaty) The figures in bold typesetting are the components in the market where the main activities are production and consumption.The relationships among them were no longer included in the diagram.

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ACC08FINANCIAL MANAGEMENT PART 1 environmental quality is considered a public good because of its non-rivalness and nonexcludability characteristics. The failure rests on the difficulty of identifying the market demand which is represented by the willingness to pay of consumers. This difficulty is caused by the fact that consumers preferences for environmental quality provision are unrevealed.

The Philippine Experience Legal Basis 1. P.D. 1151 Philippine Environmental Policy (1977)
2. Renewable Energy Act (2008) In December of 2008, then President Gloria M. Arroyo signed into law the Republic Act 9513 Renewable Energy (RE) Act of 2008-an act promoting the development, utilization, and commercialization of renewable energy resources and for other purposes. Its targets were, for the Philippines, (Perez, 2009): to be the No.1 geothermal producer in the world to be the No.1 wind power producer in the Southeast Asia to double its hydro capacity by 2013 to expand contribution of biomass, solar, and ocean energy by 250 MW

The Philippines has an abounding potential for generating energy from renewable resources (Perez, 2009): Geothermal resource: 1,200 MW Wind: 700 MW Solar: no potential estimate which depends on solar panels put up (but currently the largest solar manufacturing hub in Southeast Asia producing 400 MW) Hydro: 1,784 MW from 888 sites Biomass (bagasse): 235 MMBFOE

Amidst the so-called abundance of this Philippine potential for renewable energy, about 50% of its power generation still comes from non-renewable sources (i.e. coal (26%) and oil (23%)) (Department of Trade and Industry, 2009). DTI has forecasted that with growing industrial demand, the country will still require 4,000 to 4,350 MW for sustainability (Department of Trade and Industry, 2009). In economic theory, when there is potential demand, entrants will soon be attracted to the market to provide supply.

3. Other Environmental Laws in the Philippines

Republic Act No. 7394 The Consumer Act of the Philippines Republic Act No. 6713 Code of Conduct and Ethical Standards for Public Officials and Employees. Republic Act No. 387 Petroleum Act of 1949 Presidential Decree No. 972 Coal Development Act of 1976 Republic Act No. 5207 Atomic Energy Regulatory and Liability Act of 1968

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Executive Order No. 15 Created the Philippine Council for Sustainable Development DENR Administrative Order No. 91-24 Shift in Logging from the Old Growth (Virgin) Forests to the Second Growth (Residual) Forests. Presidential Decree No. 1219 Provides for the exploration, exploitation, utilization and conservation of coral resources. REPUBLIC ACT NO. 9147 Wildlife Resources Conservation and Protection Act. Republic Act No. 9003 The Ecological Solid Waste Management Act

Republic Act No. 7638 Department of Energy Act of 1992 Republic Act No. 7611 Strategic Environmental Plan (SEP) for Palawan Act Republic Act No. 3195 Grants a franchise for an electricity system for the Municipality of Tumauini, Isabela. Republic Act No. 8749 Philippine Clean Air Act of 1999 Republic Act 8550 The Philippine Fisheries Code of 1998 Republic Act No. 8041 An Act to Address the National Water Crisis Presidential Decree No. 825 Provides penalties for improper disposal of garbage and other forms of uncleanliness. Presidential Decree No. 601 The Revised Coast Guard Law of 1974 Presidential Decree No. 2001 Established a program phasing-out tetraethyl lead (TEL) in gasoline. Presidential Decree No. 1899 Establishes small-scale mining as a new dimension in mineral development Presidential Decree No. 1775 Amends section eighty of the Revised Philippine Forestry Code (PD 705) Presidential Decree No. 1160 Gives authority to Barangay Captains to enforce Pollution and Environmental Control Laws DENR Memorandum Circular No. 06, June 4, 1992 Covers the implementation of Project CARE Activities After Species Adoption by Each Barangay, Municipality, City and Province

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The Philippine Experience the sad truth legally speaking

Read: An excerpt from LEGAL MARKETING OF ENVIRONMENTAL LAW: THE PHILIPPINES EXPERIENCE by OPOSA,
ANTONIO A. JR delivered in the FOURTH INTERNATIONAL CONFERENCE ON ENVIRONMENTAL COMPLIANCE AND ENFORCEMENT

2 PRINCIPLES OF EFFECTIVE ENVIRONMENTAL LAW IMPLEMENTATION If one carefully examines the innumerable provisions of formal and informal laws (i.e. statutory and traditional or customary laws), the potential for creativity to make sustainable development work effectively is contained in or in-between the very lines of the Law. Voluntary compliance is more socially desirable than coerced compliance. Put a little differently, the best form of law enforcement is that where the law does not need to be enforced. In the course of years of environmental law practice, both in the public interest and private sectors, the author has identified several principles of effective environmental law implementation. First, recall that a law is an agreement of minds, a social contract. As an agreement, the participants must fully understand and appreciate the reason behind . and the need for . the law. In legal language, this is the Ratio Legis, the reason for the law. In sociological terms, this is the .social product. and the .common good. which the law seeks to promote. And voluntary compliance is possible only when those whose conduct is sought to be regulated or modified fully understand the reason for the law and appreciate its value. If their understanding is secured that the social product and policy are desirable, then their mental and emotional .agreement. is reached. In addition, the body politic must also participate in the making of the law. When the social policy is generally agreed upon, there is consensus, a characteristic mode of reaching an agreement in Asian societies. Then, the law is nothing more than the informal agreement formally crystallized into words. Second, legal marketing, or selling the law, may be used to promote voluntary compliance. The legitimacy and effectiveness of a law is in large part dependent on publicizing the law. As ordinary marketing sells a product; law sells a mode of conduct. Thus, in like manner that active marketing, advertising and promotions are techniques used to sell a consumer product, so must creative marketing use proactive methods to .sell. the social good and the mode of conduct desired. Third, the manner of implementing the law must be socio-culturally sensitive. It must take into account the social and cultural characteristics of the people who are the target market of the law. This is particularly true in situations and countries and regions that may have some commonalties in their socio-cultural traits such as Asia. Fourth, the law must contain an aspect of punishment in order to modify behavior and serve as a deterrent. That is, people must be aware that deviating from the conduct which promotes social good carries a penalty. Penal law must, however, be reserved only for the hard-headed. And it is effective as a deterrent if, and only if, its application is swift, painful and public. Human conduct is such that it responds to the stimuli of pleasure and pain. To promote behavior, therefore, it must promise a pleasure, and to discourage it, it must present the possibility of extreme pain. Technically, the term used is .incentives-and-disincentives.. It is also called the .carrot and- stick. market-based incentives (MBIs). For this discussion, however, a more graphic term shall be used: .candies-and-needles.. Candies are so irresistible that unless one has severe dietary restrictions, it is generally accepted, taken and ingested. On the other hand, the prospect of a sharp and long needle being pierced into ones flesh is so squirmingly painful by its mere appearance that one would generally not want to tangle with it. The following will illustrate some approaches and examples by which the candies-and needles technique may be applied to address environmental law non-compliance. 3 CANDIES AND NEEDLES APPLIED In the application of this approach, care must be taken to consider the socio-cultural characteristics of the target market. Among Filipinos, as among many Asians, the following cultural attributes are significant: Highly personal. Filipinos are a highly personal people. They would rather .talk things over. than issue or receive written orders. When people have problems with one another, they are more inclined to approach the person concerned. Debt-of-gratitude. One value the people hold dear is the debt-of-gratitude. When a favor is owed, it is the source of great shame when one will refuse to requite it. Face value sanction. .Loss of face. is a sanction of the highest order, higher than ordinary legal sanction. A man can pay a big fine quietly and be done with it. But even a small fine if well-publicized will inflict much greater pain. And the pain extends not only to one.s self but also to his family. Thus, the sanction is imposed also on the strongest social tie and ultimate psychological crutch of the wrongdoer. It is so painful, one would not even want to think of it.

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Samples of Environmental Policy Statement http://www.environcorp.com/img/media/ISOpreview.pdf

http://www.environmentalpolicy.org.uk/statement.html http://www.adb.org/documents/policies/environment/default.asp?p=policies The Board of Directors' approved the Environment Policy R-Paper on 8 November 2002. The Environment Policy represents the culmination of two years of extensive consultations with internal and external stakeholders, including a Board seminar, country workshops, and several rounds of inter-departmental review. It also incorporates comments and suggestions made by Board members during the Board discussion of the Environment Policy working paper in April 2002. The Environment Policy has been prepared to address five main challenges: 1. the need for environmental interventions to reduce poverty 2. the need to mainstream environmental considerations into economic growth and development planning 3. the need to maintain regional and global life support systems 4. the need to work in partnership with others 5. the need to further strengthen the processes and procedures for addressing environmental concerns in ADB's own operations The Policy highlights a number of areas that require attention in ADB's environmental assessment process. It addresses the need for more upstream environmental assessment at the level of country programming, the need for more structured consultation in the conduct of environmental assessments, the need for greater emphasis on monitoring and compliance with environmental requirements during project implementation, and finally the need to view environmental assessment as an ongoing process rather than a one-time event.

References
Varian, Hal, Intermediate Microeconomics, 3rd ed., 1993, W.W. Norton and Company, Inc. Dornbusch, Rudiger and Fisher, Stanley, Macroeconomics, 7th ed., 1998, Mcgraw-Hill Publishing Company (earlier editions are also acceptable) CFA institute materials

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