CHAPTER 2:

THE FINANCIAL MANAGEMENT ENVIRONMENT

1. THE ECONOMICS ENVIRONMENT FOR BUSINESS
2. THE NATURE AND ROLE OF FINANCIAL MARKETS AND INSTITUTIONS
 TOPIC LEARNING OBJECTIVES
At the end of the chapter, you should able to:
• Define and discuss the role of fiscal, monetary, interest rate and exchange rate
policies in achieving macroeconomic policy targets.
• Explain how government policy interacts with planning and decision making in
business.
• Explain the need for, and the interaction with planning and decision-making in
business of: (i) competition policy; (ii) government assistance for business; (iii)
green policies; and (iv) corporate governance regulation.
• Explain the role of financial intermediaries.
• Explain the functions of a stock market and a corporate bond market.
Economic Growth Control Inflation
- ↑ national - Stable prices
income
Economic
Policies &
Objectives
Balance of Full Employment
Payments - Low
Stability unemployment
 Influence monetary
Monetary variables to achieve
target
Using government
Policies
Fiscal spending to influence
aggregate demand
Exchange rate
management to
Exchange Rate
influence currency’s
strength
Stimulate exports Vs
External Trade Protection for domestic
industries
 Objectives
1. Achieve
sustained
Economic Policy

Fiscal Policy growth

2. Full
employment
3. Control rate
Monetary Policy
of inflation
 Government
Spending

Financed by Financed by
taxation borrowing

Indirect Issuing Savings & Issuing

Income of Profits of
taxation e.g. Government Investment Government
Individual Companies
GST Long-term Schemes Short-term
Bonds Bonds
 Fiscal Policy & Business
Affect
Other tax
business Affect
charges can
decisions e.g. customers’
Minimize tax affect the rate
tax relief, spending
liability e.g. of growth e.g.
pioneer status, habits e.g.
moving to low increase
tax increase GST
tax countries personal
allowances from 6% to
income tax
for capital 7%
rate
investment
 TUTORIAL QUESTION 2.1
Governments have a number of economic targets as part of their fiscal policy. Which of
the following targets relate predominantly to fiscal policy?
i. Increasing tax revenue
ii. Controlling the growth in the size of the money supply
iii. Reducing public expenditure
iv. Keeping interest rates low
• (i) only
• (i) and (iii) only
• (ii) and (iv) only
Answer: B
• (ii), (iii) and (iv) only
 TUTORIAL QUESTION 2.1
Governments have a number of economic targets as part of their fiscal policy. Which of
the following targets relate predominantly to fiscal policy?
i. Increasing tax revenue
ii. Controlling the growth in the size of the money supply
iii. Reducing public expenditure
iv. Keeping interest rates low
• (i) only
• (i) and (iii) only
• (ii) and (iv) only
Answer: B
• (ii), (iii) and (iv) only
 TUTORIAL QUESTION 2.2
If Malaysian government intends to borrow money to build infrastructure by issuing
10-year bonds, illustrate the possible effects on the following parties:
(i) Individuals
(ii) Companies

Answer Tutorial 2.2

i. If the government borrows by issuing 10-years bonds, individuals will be attracted by the risk-
free nature of investing in the bonds.
ii. Government borrowing might affect borrowing by companies. If companies also want to
borrow by issuing bonds, they will need to offer a higher rate of interest to investors in order to
persuade them to invest in relatively high risk corporate bonds.
 TUTORIAL QUESTION 2.2
If Malaysian government intends to borrow money to build infrastructure by issuing
10-year bonds, illustrate the possible effects on the following parties:
(i) Individuals
(ii) Companies

Answer Tutorial 2.2

i. If the government borrows by issuing 10-years bonds, individuals will be attracted by the risk-
free nature of investing in the bonds.
ii. Government borrowing might affect borrowing by companies. If companies also want to
borrow by issuing bonds, they will need to offer a higher rate of interest to investors in order to
persuade them to invest in relatively high risk corporate bonds.
 Target of monetary policy

Rate of inflation Growth in

the size of The level of
Monetary

money interest rates

Policy

Interest rates
supply

The exchange rate for

domestic currency The volume
against foreign The volume of
currencies of credit or expenditure
growth in the
e.g. MYR Vs USD economy
INTEREST RATE POLICY & BUSINESS

• Interestrate changes brought about by government policy affect the

borrowing costs of business as the following diagram:

Deter companies from

expanding
- Fewer investment with
+ve return

Difficult to issue
new shares ↑ Decrease in
interest consumer
~ Low share demand
price rate
 TUTORIAL QUESTION 2.3

Outline the effects of aggregate expenditure in the economy of a policy of

high interest rates to dampen demand and inflation.
Solution Tutorial 2.3
An increase in interest rates is thought to reduce the money supply in the economy and
thereby to reduce the level of effective demand which will, in turn, decrease inflation
Aggregate expenditure in the economy will decrease, for various reasons.
a. A higher interest rate encourages savings at the expense of consumer expenditure.
b. Higher interest rates will increase mortgage payments and will thus reduce the amount of
disposable income in the hands of home buyers for discretionary spending
c. The higher cost of consumer credit will deter borrowing and spending on consumer
durables
d. Higher prices of goods due to higher borrowing costs for industry will also reduce some
consumer expenditure in the economy
 TUTORIAL QUESTION 2.3

Outline the effects of aggregate expenditure in the economy of a policy of

high interest rates to dampen demand and inflation.
Solution Tutorial 2.3
An increase in interest rates is thought to reduce the money supply in the economy and
thereby to reduce the level of effective demand which will, in turn, decrease inflation
Aggregate expenditure in the economy will decrease, for various reasons.
a. A higher interest rate encourages savings at the expense of consumer expenditure.
b. Higher interest rates will increase mortgage payments and will thus reduce the amount of
disposable income in the hands of home buyers for discretionary spending
c. The higher cost of consumer credit will deter borrowing and spending on consumer
durables
d. Higher prices of goods due to higher borrowing costs for industry will also reduce some
consumer expenditure in the economy
 OTHER INFLUENCES OF GOVERNMENT ON BUSINESS
Government Corporate
Competition
Assistant for Green Policies Governance
Policy
Business Regulations
Cash grants ‘Externalities
Preventing ’ – Cost
in specific Regulate financial
‘monopolies’ created by
region mismanagement
companies
due to
Competition pollution
SCORE
Act 2010
Promotion of
sustainable
Malaysia business
Competition
Commission
 Short-term facilities e.g.
Financial Institutions overdraft
Source of finance for company

e.g. banks
Medium to long-term loan

Primary Market
- Issuing new financial
Capital Market instruments e.g. shares /
bonds
Financial market - Equity & Bond
- Bring together - Maturity period more than Secondary market
organizations & individual 1 year
- To sell/buy financial
- for purpose of obtaining Money Market products that are already
financing & investment - Maturity period of 1 year issued
or shorter
 WHO IS
FINANCIAL
INTERMEDIARIES?

Functions of Banks as Intermediary

Provide
Pooling of
maturity
funds
transformation Provide risk
~ accept
~ short-term transformation
deposits for savers
deposit vs
from
long-term
customers
loans
 FUNCTIONS OF STOCK MARKET
• Provide a system in which shares can be traded.
• Enforce rules of business conduct on market participants, ensuring fair
dealing.
• Ensure that there is an efficient system for providing latest financial
information about companies to investors.
• Provide a system for recording information about share prices
 TUTORIAL QUESTION 2.4
Which of the following are advantages to a company of being listed on the stock exchange?
(i) It will lead to a better perception of the firm by potential investors.
(ii) It will be more difficult for the firm to raise capital.
(iii) Listing may well lower the cost of equity of the firm as investors will see it as a safer investment
and thus accept a lower return.
(iv) The company may be required to disclose more information about it’s operations.
A. (i) and (ii) only
B. (ii) and (iii) only
C. (ii) and (iv) only
D. (i) and (iii) only Answer: D
 TUTORIAL QUESTION 2.4
Which of the following are advantages to a company of being listed on the stock exchange?
(i) It will lead to a better perception of the firm by potential investors.
(ii) It will be more difficult for the firm to raise capital.
(iii) Listing may well lower the cost of equity of the firm as investors will see it as a safer investment
and thus accept a lower return.
(iv) The company may be required to disclose more information about it’s operations.
A. (i) and (ii) only
B. (ii) and (iii) only
C. (ii) and (iv) only
D. (i) and (iii) only Answer: D
BOND MARKET

• Debt instruments
• Issued by governments, government agencies, international organisations &
companies.
• Issued for a fixed period of time (maturity) and redeemed at face value
• The issuer pays the bondholders fixed rate of interest during the period of time.
MONEY MARKETS
• Trading in financial instruments with the maturity not longer than one year
• Examples:
The interbank market
Treasury bills
Certificate of Deposit (CDs)
The repo market