ACST252 Finance and Financial Reporting

Topic 1 Overview: Context of the Economy and the Financial Markets,

The Corporation and Its Objectives

Reading

Introduction

This topic covers the overview of finance and how the financial concepts apply in practice. We
cover the definition of finance, its relationship with the field of economics, the global economy
and financial markets, the discussion of the theoretical objectives of shareholder value
maximisation and its limitations in practice and the difference between price and value. We will
explore the current global economy and market conditions, as this is the context in which our unit
materials will be placed. Finally, you will get information about where to look for some of the
economic and market data online. The aim is to not only study finance from a purely theoretical
perspective, but to place it into our current environment. This will hopefully allow you to
appreciate the financial concepts and keep you up to date with what is occurring in the current
economy.

Note that this reading is quite voluminous and contains much material to digest. This material
do not need to be understood immediately, and you should revise this regularly over the semester
as you cover different topics. Gradually, you will see the context in which you are applying the
concepts that are covered in this unit.

What is Finance?

Finance and economics are related, though they are two distinct disciplines. Economics looks into
the scarcity of resources and how to best allocate resources given this scarcity. Finance looks into
how to individuals or institutions allocate resources with the aim of maximising wealth,
delivering goods and services to generate value and to deploy capital in an efficient manner.
Financial decisions are made in context of the economy by considering the interaction between
participants in the market, the characteristics of different assets and the regulatory environment.

The three key areas of finance and what they cover are given below:

Corporate Finance Looks into how institutions raise capital (financing decisions), deploy capital
(investing decisions) and then distribute the profits and earnings to their stakeholders (dividend
decisions) with the aim to maximise shareholder wealth.

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Asset Pricing Explores financial models used to project future cash flows and calculate its value.
This value can be compared against the prevailing market price, so if the value of the asset is
greater than the price, then buying this asset will allow one to make a profit when the market
realises its true worth and the price is adjusted to reflect this value.

Behavioural Finance Explores the behaviour of individuals and institutions and hence
understand their interactions in the economy and markets. This may affect decision-making
relating to resource allocation and deployment, taking into account the prevailing environment.

This unit covers mainly the first two key areas, with a little coverage of the third area.

Overview of the Dynamics of the Economy

The economy can be viewed as containing four key participant groups households, institutions,
governments and the external sector. The first three groups are domestic, and they interact with
each other. The external sector is a collective group that contains the first three groups outside of
ones country. These groups trade with each other broadly by doing the following:

Households. Households provide labour to institutions and governments in return for

salaries and wages. They also invest their financial capital with institutions by lending to
them or becoming shareholders. They pay their taxes and duties to governments. They
similarly interact with the external sector through international activities.
Institutions. Institutions offer goods and services to the other sectors as they conduct their
business. They also pay dividends and interest to their capital providers, and taxes to the
government for their profits. Institutions also engage externally through international trade.
Governments. Governments provide services to the public including administration, military
defence, public infrastructure (electricity, water, public transport, other utilities), health
services and education. In return, they collect taxes and duties. Governments may also
borrow from the other sectors by selling them government bonds, paying interest and
principal back to them.
External sector. The external sector can be considered as foreign nations with their
governments, institutions and households. Cross-border trade and activities occur between
the external sector and the previous three groups. With increasing globalisation, some
households and institutions are multinational entities that are simultaneously conducting
activities domestically and internationally.

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The Goals of Finance

Most financial textbooks state that the goal of institutions is to maximise shareholder wealth, and
their decision-making has that as the end product. However, in more recent times, people have
come to realise that value maximisation cannot be the sole goal for mankind. The cycle of booms
and busts with the cycle becoming more severe in magnitude, as evidenced by the fallout of the
subprime crisis that began in mid-2007, has brought to light deep wealth inequality, social
destabilisation and capital misallocation.

In addition to pursuing value maximisation, the importance of ethical and sustainable business
practices cannot be ignored. Financial decisions should be made to take into consideration the
welfare of shareholders, governments, the general public and the environment.

Price and Value Making Wise Investment Decisions

A common problem plaguing the financial markets is the inability to discern price and value
when evaluating investment assets. This misunderstanding is a major reason for market bubbles
and also has led to many becoming bankrupt. Thus, we will gain much to investigate this aspect
more closely.

An asset is defined as an instrument that pays cash flows in the future. Such an asset may be
categorised as bonds, stocks, properties, etc. However, they should be evaluated the same way
even if their structure differs. Basically, assets can be evaluated by considering the following three
characteristics:

Size of cash flows.

Timing of cash flows
Uncertainty of size and timing of cash flows.

The theoretical price of an asset is the present value of the future cash flows expected, discounted
back to today using a rate that reflects the prevailing interest rate plus a premium for the risk of
the asset. The future cash flows are payments of interest, dividends, rent or some form of return
that is paid to the investor. These payments may be known for some assets, such as fixed interest
securities including bonds and debentures, while for other assets, such as equities, these
payments may be variable. Thus, pricing certain assets may be more complicated since one has
to estimate the future expected cash flows based on the issuing entitys ability and willingness to
make such payments as well as consider the pricing of risk.

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In the market, price is determined by supply and demand. The seller of an asset puts their asset
into the market for a price and if a buyer is willing to pay that price, a transaction. The market
price actually reflects the price of the last transaction. This price also reflects the subjective view
of the buyer and seller of the future expected returns of the asset. Note this is a subjective view
and the intrinsic value of the asset, what is its true worth based on future cash flows and the price
of risk, may be different. In fact, assets can be overpriced or underpriced because the market has
incorrectly evaluated the assets future earning potential or risk profile. A prolonged mispricing
of assets may present itself as both an opportunity and a threat, depending on the position you
take. This is how fundamental analysts, those who evaluate a companys earnings potential and
exploit mispricing for profit, make their long-term investment decision.

The dynamics of price and value can be best summarised by Warren Buffetts statement that
price is what you pay, value is what you get. If you pay more than what you will end up
receiving in the form of cash flows, you have made a bad investment decision!

The Context of the Global Economy

From this point onward, our unit will take a slightly different direction from the typical finance
textbook by considering the current context of the economy. The reason is that the current
economic conditions may well have been a result of decisions made by governments, central
banks, institutions and individuals using financial theory that may have exacerbated the problem.
The decisions that were made appeared to have arose from the following views on economics
and finance:

The fallacy that economic growth, regardless of the driver for growth including debt-driven
growth, is an indicator of social progress. Thus, as long as an economy generates growth, it
does not matter if it comes from borrowings either from institutions or future earnings.
The belief that economic cycles can be eliminated by human effort. Thus, governments and
central banks are able to implement policies that prevent a boom/bust cycle. The actual result
is more correctly described as a more pronounced boom/bust cycle.
A flawed understanding of price vs value that distorts capital investment. Many investors
have allocated their capital into expensive assets that have risen in price beyond their future
earning potential. As a result, capital is being wasted since one is paying much more for the
future returns rather than investing in assets that are priced to better reflect the future returns.

We will explore the modern financial system to understand how it was established and the
implications it had to the current times.

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A Brief Overview of the Modern Financial System

We live presently in a petrodollar economy, whereby the US dollar is the reserve currency,
meaning that other currencies around the world is valued in relation to the dollar by considering
the relative strengths of these nations economies to the US economy. The US dollar is used as the
default currency in the exchange of petrol, which is the predominant source of energy that drives
our global economy.

This system came into place on 15th August 1971 when the US President Richard Nixon signed an
order that closed the exchange of notes and coins into gold (and silver). Prior to this, a nations
economy and wealth is reflected by their gold reserves. A nation with higher gold reserves would
be wealthier. A nations currency supply would also be regulated by their gold reserves, until the
change in 1971, when we moved effectively from a gold-backed monetary system to a fiat
currency system.

To further understand the role of gold and the current fiat currency system, please watch
Episode 1 of Mike Maloneys The Hidden Secrets of Money. You can find this on YouTube.

The move towards a petrodollar economy coincides with the increasing importance of the role of
central banks and their monetary policy. However, we also experience an increasing reliance on
debt. This is discussed next.

Central Banks and Monetary Policy

Theoretically, the role of central banks is to provide financial stability to an economy by

implementing monetary policy, monitor the economy and also to act as a lender of last resort to
governments and banks should there be a crisis. Central banks implement monetary policy by
setting the economic rate of interest or manage currency reserves to strike a balance between
controlling inflation, productivity and their exchange rates with foreign currencies.

In the balance of inflation, unemployment and the foreign exchange rates, central banks can only
control two of the three variables. Thus, central banks seek to harmonise these three variables.
This approach can be delicate, as can be seen in more recent times as seen by the troubles that the
key central banks including the US Federal Reserve, the European Central Banks, the Bank of
Japan, The Peoples Bank of China, face with addressing the issues of weakening global economic
growth, rising debt levels, lower consumer confidence and weak or negative jobs growth.

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The current economic theories that dominates central bank policies appears to be a mix of
Monetarist and Keynesian economics. These theories rests primarily on the Income-Expenditure
Model, whereby the economic level of income is a multiplier of expenditures by the various
participants, and the relationship between monetary supply and price levels. Therefore, as long
as participants spend, the economy will generate income and growth. Furthermore, the supply
of money or currency can motivate productivity or stoke inflation. Thus, as long as there is
circulation of money or currency in the economy, participants will spend and this will generate
economic growth.

However, the longstanding belief of these theories has reached a stage where asset markets and
the goods and services markets have been distorted. The existence of asset bubbles, meaning
assets are trading at prices well above their future earning potential, reflects the misallocation of
resources. These are exacerbated by debt-driven investing, with participants borrowing to
continue to invest in such assets due to the momentum of rising prices, believing that rising prices
beget rising future investment potential.

The figures below show how the equity markets, using the Dow Jones Industrial Average Index
as an illustration, have become increasingly volatile over time, especially since the move towards
a truly fiat currency system from 1971 onwards:

Dow Jones Industrial Average Dow Jones Industrial Average

1951-1972 1972-1990
500 350
450 300
400
350 250
300 200
250
200 150
150 100
100 50
50
0 0
1/01/1973
1/01/1974
1/01/1975
1/01/1976
1/01/1977
1/01/1978
1/01/1979
1/01/1980
1/01/1981
1/01/1982
1/01/1983
1/01/1984
1/01/1985
1/01/1986
1/01/1987
1/01/1988
1/01/1989
1/01/1990

Dow Jones Industrial Average Dow Jones Industrial Average

1991-2016 1951-2016
800 20000
700 18000
16000
600
14000
500 12000
400 10000
300 8000
6000
200 4000
100 2000
0 0
1/01/1951

1/01/1955

1/01/1959

1/01/1963

1/01/1967

1/01/1971

1/01/1975

1/01/1979

1/01/1983

1/01/1987

1/01/1991

1/01/1995

1/01/1999

1/01/2003

1/01/2007

1/01/2011

1/01/2015

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Understanding Economic and Market Variables

Government agencies, regulatory bodies and private institutions may collect and release data
relating to the state of the global or domestic economy. These data reports may often drive market
movements as they are analysed and interpreted by governments, institutions and individuals
alike in their decision making. Knowing where to find such data, interpreting such data and
understanding the limitations of such data are valuable skills.

Monetary Policy and Interest Rate Data

Central banks around the world set the overnight lending rate that is regarded as the baseline
risk-free interest rate used for pricing and risk management. Furthermore, the interest rates and
the strength of the economy of one nation relative to another determines the exchange rates of
their currencies.

The US Federal Reserve is the most important central bank in the world. Their monetary policy
is usually set in the third week of each month, except for February, and is closely followed by the
world. The current Federal Reserve Funds rate is approximately 0.4%. You can find information
about when they will set the interest rate in the following address:

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

The history of the US Federal Reserve Funds rate is given below (you can get the data at
http://www.federalreserve.gov/releases/h15/data.htm):

US Federal Reserve Funds Rate (% p.a.)

1954-2016
25

20

15

10

0
1/07/1954
1/07/1957
1/07/1960
1/07/1963
1/07/1966
1/07/1969
1/07/1972
1/07/1975
1/07/1978
1/07/1981
1/07/1984
1/07/1987
1/07/1990
1/07/1993
1/07/1996
1/07/1999
1/07/2002
1/07/2005
1/07/2008
1/07/2011
1/07/2014

The Reserve Bank of Australia is the central bank of Australia. They set their monetary policy on
the first Tuesday of each month, except for January. The current RBA 24 hour cash rate is 1.75%.
You can find information about when they will set the interest rate in the following address:

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http://www.rba.gov.au/schedules-events/calendar-2016-text.html

The history of the RBA 24 hour cash rate is given below (you can get the data at
http://www.rba.gov.au/statistics/tables/#interest-rates):

RBA 24 Hour Cash Rate History

January 2000 to July 2016
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
04-Jan-2000
04-Jul-2000
04-Jan-2001
04-Jul-2001
04-Jan-2002
04-Jul-2002
04-Jan-2003
04-Jul-2003
04-Jan-2004
04-Jul-2004
04-Jan-2005
04-Jul-2005
04-Jan-2006
04-Jul-2006
04-Jan-2007
04-Jul-2007
04-Jan-2008
04-Jul-2008
04-Jan-2009
04-Jul-2009
04-Jan-2010
04-Jul-2010
04-Jan-2011
04-Jul-2011
04-Jan-2012
04-Jul-2012
04-Jan-2013
04-Jul-2013
04-Jan-2014
04-Jul-2014
04-Jan-2015
04-Jul-2015
04-Jan-2016
04-Jul-2016
Inflation and the Consumer Price Index

The monetary policy is set with respect to the economic rate of inflation, among other things.
Inflation is, strictly speaking, the increase in supply of currency relative to supply of goods and
services. This is observable by price increases in the economy.

Inflation is measured using a basket of goods and services and tracking the price over time. This
measure is captured by the Consumer Price Index (CPI). You can find this information for
Australia in the Reserve Bank of Australia website.

Purchasing Power and Average Weekly Earnings

The purchasing power reflects how much an individual can purchase in the economy. The
purchasing power is the relative difference between an individuals income and the cost of goods
and services in the economy. A high purchasing power will reflect a higher standard of living
and wealth, as individuals can afford to buy more with their income.

Average Weekly Earnings (AWE) indicate the average income earned by individuals in a city or
country. The relative growth of this to the CPI shows how purchasing power improves or
deteriorates over time. You can find this information in the Australian Bureau of Statistics website.

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Jobs Data and Unemployment Rate

A strong economy is one where the population is gainfully employed and being paid adequately
to support their daily living needs. Governments understand the importance of jobs growth as
they know the general public will evaluate their effectiveness in terms of how well they are
accommodate for this.

In the US, the Bureau of Labour Statistics (BLS) releases the non-farm payrolls data on the first
Friday of each month. The most important statistics in that report (though given far too much
media attention) are the number of jobs that are created over the month and the resultant
unemployment rate.

Unfortunately, the unemployment rate that is reported by government agencies around the world
is misleading. Since the late 1980s, the calculation of unemployment rate has been changed to
deliver a more flattering figure. Prior to the changes, an individual who can work but is not
working is counted as unemployed. However, nowadays, an individual is counted as
unemployed if they are not working but they are still seeking work. If an individual has stopped
seeking work, they are no longer counted. As a result, the headline unemployment rate in the US
of 4.9% in June 2016, as reported by the BLS, is very significantly understated. The actual
unemployment rate, using the 1980s definition, can be found in www.shadowstats.com and it
stands currently at around 22.9%!

Stock/Equity Markets

The stock markets around the world show the price levels of stocks of listed companies that are
being traded. Oftentimes, the stock market indices are used as one of the number of key indicators
of economic well-being and wealth. This is because companies, managed funds and sovereign
wealth funds trade on these stock markets and hold substantial shareholdings of major
companies and institutions. Thus, growth the equity markets is often considered a positive sign
of a healthy growing economy

The key stock markets include:

The US. Dow Jones Industrial Average (30 large US listed companies across diverse sectors),
S&P 500 (500 largest US listed companies across diverse sectors) and NASDAQ (Large
technology and software companies).
The European Union and Great Britain. Euro 50 (50 large EU companies), FTSE 100 (100
largest UK listed companies), DAX 100 (100 largest German listed companies)

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 Asia. Nikkei 225 (225 largest Japanese listed companies across diverse sectors), Hangseng
Index (a selection of the largest Hong Kong listed companies) and ASX 200 (200 largest
Australian listed companies across diverse sectors)

Bond Markets

Governments can borrow from the public by issuing bonds that pay regular interest and a final
principal upon maturity. The bond price is determined with reference to the interest rate set by
the central banks. Interestingly, the yields of bonds with different terms to maturity may help
indicate potential changes in the monetary policy.

In Australia, you can buy and sell bonds on the Australian Stock Exchange. You can find bond
yield information on the RBA website.

Commodity Prices Oil, Gold, Silver and Precious Metals (Among many!)

Commodities are used for production and storing wealth. In a petrodollar economy, the oil price
is a major driver of wealth creation, inflation and unemployment. A high oil price increases the
cost of input and production, thus will reduce the standard of living and economic growth.
Similarly, a lower oil price usually allows for more disposable income and thus encourage
spending.

The price of commodities also reflects the state of the economy as it shows the relative supply
and demand for these materials used for production. A sharply falling commodity market
suggests global economic slowdown as there is a decline in demand relative to supply. This has
occurred in late 2008 and recently in late 2014.

You can find commodity price information on www.kitco.com.

Reflection

This introductory topic provides an overview into key financial theory, how markets operate and
the challenges faced by the global economy and financial markets. The key points include:

1. Finance is a discipline that considers the allocation of resources to maximise shareholder

value, but also needs to consider as well sustainability and social welfare.
2. Institutions need to consider where they can source their capital, deploy their capital to
generate returns and then to consider how to distribute their profits either to reward those
who contributed capital to them or to reinvest and expand.
3. When investing, consider the price one pays to purchase the asset and the value that they
receive in the form of future returns and cashflows.

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4. The current global economy is in a delicate position as a result of policies implemented by
governments and central banks that may be theoretically sound but practically, it may
achieve an opposite effect due to their misunderstanding of theory and practice.
5. Studying finance requires one to take into account the context of the current economy and
financial markets, as reflected by key market variables. Note that some of these variables may
not be fully accurate so some caution in interpretation is needed.

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