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7RSLF X Financial

Environment

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1.

Explain the importance of financial market;

2.

Differentiate between money market and capital market;

3.

Elaborate the factors influencing interest rate; and

4.

Analyse the effects of the change in interest rate on the profit of the
firm.

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Financial environment can affect a financial managers decisions and actions. It is
important that a financial manager understands the firms financial environment. In
this topic, the endeavour to understand financial environment will cover discussion
on money market and capital market as well as the institutions in these markets.
Also, this topic will introduce interest rate and the factors influencing it and the
effect of interest rates on a firms profits.



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Individuals, business organisations and the government need sufficient capital

to undertake a business or project. If there is insufficient capital, they will need
financing from outside sources. The financial market is an important source of
capital financing.
Financial market is an intermediary between those who have surplus funds with
those who are in need of funds. It facilitates savings and loan transactions. Those
with surplus funds can deposit them in the financial institutions from which those
in need can have access to them. Therefore, a financial market is an intermediary
that can disburse funds more efficiently in the economy.

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There are two types of financial markets:

(a)

Money market; and

(b) Capital market.

The two types of financial market can be summarised as in Figure 2.1.

Figure 2.1: Types of financial markets

(a)

Money Market
Money market is a market which manages the buying and selling of shortterm securities that have a maturity period of less than one year. The role
of the money market is important for the banking and business sectors,
the government, as well as the economy as a whole. A developing and
progressive money market facilitates allocation of short-term funds through
which those with surplus funds can invest and from which those in need
of short-term funds can borrow. As such, money market can be regarded as
an intermediary between surplus units and deficit units. Those with surplus
funds have the opportunity to invest in the money market to attain returns.
If excess money is deposited in a safe or in a bank current account, they will
not yield any return. On the other hand, those who are in need of short-term
funds can access them from the money market.
Apart from its role as a financial intermediary, a money market can also play
an important role in the implementation of government financial policy to
achieve its macroeconomics objectives such as stabilising the state of the
economy.

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Have you ever had any instrument in the capital market? Explain.

(i)

Treasury Bills
Treasury bills are short-term securities which are issued by the
government, which have maturity periods of either 3 months, 6
months, 9 months or 12 months. When the government issues treasury
bills, this means that the government intends to borrow money from
those who buy the treasury bills. In short, treasury bills are government
debts to the buyers of the bills. The objective of the government in
issuing treasury bills is to have funds to finance its operations. The
selling of treasury bills is done through tenders whereby interested
buyers state the price they are willing to pay for those treasury bills
which have a specific nominal value. For example, an investor is
willing to pay RM950 to get a one-year treasury bill which has a
nominal value of RM1,000. This means that the bill is sold at a discount
and the rate of return gained by the investor is known as discount rate,
that is 50/950 = 5.26%. This transaction is called discounting.

(ii) Commercial Paper

Commercial papers refers to notes which have been issued by a wellknown, creditworthy company which has a strong financial standing
for the purpose of borrowing money from investors for a short period
of time. This is a kind of short-term financial source for a large firm.
(iii) Negotiable Certificates of Deposit
Although it has similarities to the fixed deposit in a bank, it differs from
the latter as it can be bought and sold in the money market whereas
ordinary fixed deposits cannot be traded. Since this certificate can be
traded, it is an alternative short-term investment for a large firm which
has short-term surplus fund. For example, a company which saves
money to pay off its taxes can make use of the opportunity to attain
returns by investing in the negotiable certificate of deposit till the
payment date of the taxes is due.

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Match the correct answers.
1. Short-term financing resource for
a large firm.

Money market

2. Alternative investment for large

firms which have surplus fund.

Commercial paper

3. The government issues them to

finance its deposit operational
expenditures.

Negotiable certificates of
deposit

4. The market which manages the

trading of short-term securities.

Treasury bills

(b) Capital Market

A capital market is a market for securities which have maturity periods
of more than one year. Examples of instruments in this market are bonds,
preference shares and ordinary shares. These securities are traded in two
types of markets:
(i)

Primary Market
A primary market is a market where a company sells new securities to
get capital. Trade is done directly between investors and the company
that issues those securities. A company wishing to offer its stocks
in public can publish a prospectus, which is a document that gives
information on the company to investors to enable them to make a
decision whether to buy or not to buy the companys stocks.

(ii) Secondary Market

It is a market for stocks which had been issued and are traded between
investors. An example of a secondary market is Bursa Saham Kuala
Lumpur (BSKL) which was established in 1964 as Bursa Saham
Malaysia. In 1973, it was transferred to a new BSKL company. Presently,
the BSKL is known as Bursa Malaysia.
The main reason why a company is listed in the stock exchange is to
gather funds more effectively. Companies which are listed in the
stock exchange can attain large sums for capital more easily because
investors have more confidence in listed companies. This is so because
listed companies in the stock exchange have a higher profile and the
stocks can be traded with ease, thus increasing liquidity of these types
of investments.



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Companies wishing to be listed in the stock exchange must follow

certain procedures like making application to the Securities
Commission, getting the permission of Bursa Malaysia, etc. There
are two listing boards in Bursa Malaysia, i.e. the Main Board and
the Second Board. Companies going for listing must observe listing
requirements of that particular board, for example the sum of
minimum paid-up capital, the sum of public share holdings, the history
of profit achievement, etc.
A stock exchange is regarded as a secondary market because
companies shares issued in it are traded between investors. Although
the trading of shares in the stock market do not result in either the inflow or out-flow of the companies funds, financial managers must still
give attention to the trading of shares because the price of the stocks,
which are determined by the market, influences the value of a limited
company.

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Form a schedule to differentiate each of the following terms:
(a)

Money market and capital market; and

(b) Primary market and secondary market.



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What do you understand about interest rate?
Interest rate is the price for the capital which had been borrowed. In a free
enterprise economic system, capital such as goods and services are allocated
through a price system determined by the forces of demand and supply.
Explanations regarding this matter are as below:
Demand for capital is influenced by existing opportunities of investment
and the expected rate of return to be gained from the capital invested. The
higher the rate of return, the higher is the interest rate willingly offered by
the debtor to the party offering the fund.

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The supply of capital is influenced by the consumers priorities towards current

and future consumption. If you have surplus funds but need the money now,
you will not use the funds for investments. On the other hand, if you currently
do not need the money, you will use it for investments. Hence, capital is offered
even though the interest rate may not be attractive.

Government
policy

Inflation rate

Factors which
Influence Interest Rate

Rate of risk

Figure 2.2: Factors which influence interest rate

Apart from the demand supply and for capital, interest rate is also influenced by
factors such as shown in Figure 2.2. Explanations regarding these factors are as
follows:
(a)

Inflation Rate
Inflation is related to the increase of the price of goods and services. The
higher the expected rate of inflation, the higher the demanded rate of
returns. Hence, the capital provider must be offered a higher interest rate to
encourage him to provide loans.

(b) Rate of Risk

Risk happens due to the existence of the elements of uncertainty. The higher
the rate of risk, the higher the demanded rate of returns. Increased risk will
lead to increased interest rate.
(c)

Government Policy
To influence aggregate demand and economic activities, the government can
use monetary policy and a suitable budgetary policy for a specific economic
condition.



(i)

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Monetary Policy
This policy controls the levels of aggregate demand through the
financial system. The Central Bank controls total credit and the usage
of various types of credits through interest rate. For example, in an
inflationary situation, the Central Bank can adopt a tight monetary
policy which will cause the interest rate to rise in the economy and
reduce aggregate demand.
On the other hand, if there is an economic recession, the Central Bank
will adopt an accommodative monetary policy which will result in the
decrease of interest rate in the market.

(ii) Budgetary Policy

Budgetary policy is also known as fiscal policy. This policy uses the tax
system and government spending to achieve price stabilisation, high
employment and economic growth. If there is an economic recession,
the government can adopt a deficit budget policy where spending
exceed returns. When this happens, the government will need to
borrow to make up for the spending deficit. The demand for funds will
increase and in turn, will cause interest rates to rise.

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Give other factors which will increase the interest rate in the economy.



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Describe the effect of interest rate on the profits gained by a firm.

Interest rate is the cost a firm has to pay on capital borrowed. For this reason,
interest rate can have several effects to the profit of a firm. Two of the affects are:
(a)

Interest rate is a cost to a firm. For this reason, a high interest rate will result
in the rise of the cost for the firm and jeopardise its profit.

(b) Interest rate can influence economic activity and in turn, influence profit
of firms. If interest rate increases, sales will decrease because buyers will
be more careful in their spending especially for expensive goods such

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as electrical utensils and housing. This will result in the cost of debts to
increase due to the increase in interest rates.
In making a financial decision, a financial manager must opt for either short-term
or long-term methods of financing. Changes in interest rate will affect the cost of
a project and if a financial manager wrongly decides on the type of financing for
the project, this will jeopardise the performance of the firm and its profits. For this
reason, a financial manager must use a combination of both short-term and longterm methods of financing which exist in the monetary policy to ensure that the
firm is able to solve any financial difficulty which may crop up due to changes in
the interest rate.

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Discuss the effect on the profit of a firm if interest rate goes up or down.



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Multiple-Choice Questions
1.

Which of the following is not an example of a money market?

A. Treasury bills issued by the government.
B. Government bonds which has a maturity period of 10 years.
C. Commercials paper issued by an established company.

2.

Primary market encompasses___________________.

A. companies which sell new securities through a prospectus
B. companies listed in Bursa Malaysia
C. companies whose stocks are traded by investors

3.

When interest rate goes up_____________________.

A. capital becomes cheap
B. the demand for capital rises
C. the cost of capital rises

4.

Monetary and budgetary policies are used for_____________________.

A. influencing aggregate demand
B. encouraging more people to borrow capital
C. decreasing interest rates

5.

The profits of firms are affected whenever interest rates goes up

because _______________________.
A. the cost of debts becomes high
B. firms are more careful in sales
C. firms have insufficient capital



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The financial market is an intermediary for those who have surplus funds and those
who are in need of funds. This plays an important role in the distribution of funds
in the economy.
A financial market consists of money market, capital market, primary market and
secondary market.

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A money market is a market that manages the buying and selling of short-term
securities which have maturity periods of less than a year. The instruments which
exist in a money market are:
(a)

Treasury bills;

(b) Commercial paper; and

(c)

Negotiable certificates of deposit.

A capital market is a market for securities which have a maturity period of more
than one year. The instruments which exist in the capital market are:
(a)

Bonds;

(b) Preference shares; and

(c)

Ordinary shares.

A primary market is a market which manages the sales of new securities.

A secondary market is a market for securities which have been issued and can be
traded between investors. Example: Bursa Malaysia.
Interest rate is the price for capital which had been loaned and it can be determined
by the demand and supply of capital. Other factors which can influence interest
rate include:
(a)

Rate of inflation;

(b) Rate of risk; and

(c)

Government policy monetary and budgetary policies.

The effects of interest rate on the profits of a firm are:

(a)

Interest rate can influence the cost of a firm and this affects the firms profits.

(b) Interest rate can influence economic activities such as the sales and the
profits of a firm.
Financial managers must give attention to the movement and change of interest
rates because this can affect the decision regarding project financing as well as the
performance of a firm.
Financial managers should combine short-term and long-term methods of financing
to avoid financial problems which may crop up due to the change of interest rate.



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A money market manages the buying and selling of short-term securities,

whereas a capital market manages securities which have a period of more than
one year.

Interest rate is an important factor in a financial environment.

Capital market
Financial market
Interest rate

Money market
Primary market
Secondary market