Financial Institutions and Markets
If a corporation needs to borrow from the
bank or issue new securities, then its financial manager had better understand
how financial markets work. Perhaps
less obviously, the capital budgeting decision also requires an understanding
of financial markets. We have said that a successful investment is one that increases firm value. But how do investors
value a firm? The answer to this question requires a theory of how the firm`s stock is priced in financial markets.
Of course, theory is not the end of it. The financial
manager is in day-by-day sometimes minute-by-minute contact with financial
markets and must understand their
institutions, regulations, and operating practices. We can give you a flavor
for these issues by considering briefly some of the ways that firms interact with financial markets and institutions.
FINANCIAL INSTITUTIONS
Most firms are too small to raise funds by selling
stocks or bonds directly to investors. When these companies need to raise funds
to help pay for a capital investment,
the only choice is to borrow money from a financial intermediary like a bank or insurance company. The financial intermediary, in turn, raises funds, often
in small amounts, from individual households. For example, a bank raises funds
when customers deposit money into their
bank accounts. The bank can then lend this money to borrowers.
The bank saves borrowers and lenders from finding and
negotiating with each other directly. For example, a firm that wishes to borrow
$2.5 million could in principle try to
arrange loans from many individuals:
However, it is far more convenient and efficient for a
bank, which has ongoing relations with thousands of depositors, to raise the
funds from them, and then lend the
money to the company:
The bank provides a service. To cover the costs of
this service, it charges borrowers a higher interest rate than it pays its
depositors.
Banks and their immediate relatives, such as savings
and loan companies, are the most familiar financial intermediaries. But there
are many others, such as insurance
companies.
In the United States, insurance companies are more
important than banks for the long-term financing of
business. They are massive investors in
corporate stocks and bonds, and they often make long-term loans directly
to corporations. Suppose a company needs a loan for 9 years, not 9 months. It could issue a bond directly to
investors, or it could negotiate a 9-year loan with an insurance company:
The money to make the loan comes mainly from the sale
of insurance policies. Say you buy a fire insurance policy on your home. You
pay cash to the insurance company and
get a financial asset (the policy) in exchange. You receive no interest
payments on this financial asset, but if a fire does strike, the company is obliged to cover the damages up to
the policy limit. This is the return on your investment.
The company will issue not just one policy, but
thousands. Normally the incidence of fires ¬averages out, leaving the company
with a predictable obligation to its
policyholders as a group. Of course the insurance company must charge enough
for its policies to cover selling and
administrative costs, pay policyholders` claims, and generate a profit
for its stockholders.
Why is a financial intermediary different from a
manufacturing corporation? First, it may raise money differently, for example,
by taking deposits or selling insurance
policies. Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to
businesses or individuals. The
manufacturing company`s main investments are in plant, equipment, and other real assets.
FINANCIAL INTERMEDIARY
Firm that raises money from many small investors and
provides financing to businesses or other organizations by investing in
their securities.
Category: Corporate finance
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