Finance, a term applied to the purchase and sale of legal instruments that give owners specified rights to a series of future cash flows. These legal instruments, known as financial assets or securities, are issued by private concerns, such as companies and corporations, and government bodies, and include bonds, stocks, and shares.
The original issuer of a security is in effect borrowing money that the purchaser is lending. Borrowers have an immediate need for cash, whereas lenders have an excess of cash. When the borrower issues a security such as a bond to the lender, both parties benefit; the borrower obtains the current use of cash and the lender obtains a claim to future cash flows that involve repayment of the initial loan as well as the payment of interest. In the case of equities (the ordinary shares of a company), the provider of finance (the lender) hopes to realize an increase in the value of the capital acquired as well as to receive share dividends, though neither is guaranteed.
II FINANCIAL MARKETS
Transactions between an initial borrower and lender are called primary market transactions. Many financial assets created in the primary market may be sold by the original lender to other people in what are known as secondary markets. The trading of marketable securities in secondary markets has no impact on the original borrower; only the legal owner of the security changes. Examples of formally incorporated secondary markets are stock exchanges such as the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange. Secondary market transactions that do not take place on incorporated exchanges are referred to as over-the-counter transactions.
III TYPES OF SECURITIES
Most securities traded in the secondary markets belong to one of two broad classifications: bonds or stocks (shares). Bonds are credit instruments redeemable for a given sum and yielding a fixed return. Important characteristics of bonds include face (or par) value, maturity date, and coupon rate. Face value represents the total amount of cash payable to the owner at the bond’s maturity date, which can range from 3 months to 30 years. Prior to maturity, yearly coupon payments equal to the coupon rate times the face value are paid. These payments are the bond owner’s profit. Once set in the initial primary market sale, the coupon rate on a given issue will not change in response to changing interest rates in the economy. Instead, the market price of the bond changes. When a bond’s coupon rate is equal to the general level of interest rates prevailing in the economy, the bond’s market price will be equal to its face value. When the coupon rate is higher than prevailing interest rates, the bond will sell for more than its face value. When the coupon rate is lower than prevailing interest rates, the bond will sell at less than its face value. Interest on bonds constitutes a legal obligation, and failure to pay it may result in bankruptcy.
Preference shares are similar to bonds in that they have stated face values and a specified dividend payment (similar to a bond’s coupon). They differ from bonds because they do not have a scheduled maturity date and because yearly dividends may remain unpaid for a few years without forcing the issuer into bankruptcy. Common stocks (ordinary shares) have no specified yearly cash payments or maturity date. These securities have an infinite life on which a cash return will be earned only if the issuer has satisfactory profits. They, therefore, carry a higher level of risk than other securities, their attraction to the holder being larger expected a (if not guaranteed) return. Because the cash returns on bonds are in general the most certain, they are viewed as the least risky investment and provide a lower expected return. However, junk bonds issued by companies with low credit ratings offer higher rates of return because of the higher risk that the bond issuer will default. Preference shares are viewed as riskier than bonds and less risky than ordinary shares.
Security issuers are classified as either private or public. Private issuers consist of individuals, partnerships, and corporations. Public issuers are various governmental bodies.
IV FINANCE IN THE PRIVATE SECTOR
Many businesses issue financial securities to pay for various assets they wish to purchase. Because companies represent the dominant financial force in the private sector, this section focuses on corporate finance. Companies acquire new capital by the sale of stocks and bonds, or they may finance their temporary needs by borrowing money from banks.
Asset-investment decisions are based on two criteria: the expected rate of return and the risk. In order to estimate the expected return on a project, detailed forecasts are made of the costs and revenues that might result from a given investment. The level of risk involved depends on how much control the firm has over factors that affect such matters. Having arrived at a judgement that assesses the return and weighs up the risk, it is the board of directors that has the final decision in a company on how the acquisition of costly assets should be financed.
Their decision will largely be determined by the cost of finance. This is basically the effective rate of interest that the company will have to pay to borrow the money.
A Short-Term Financing
Debt financing is classified as short term or long term. Short-term debt issues must be repaid within five years. Loans obtained from commercial banks are a common form of short-term debt. Bank lines of credit allow a firm to borrow up to a specified maximum but generally require that the loan balance be zero for one or more months during a year. Lines of credit are typically not backed by collateral. Banks will also provide two- to three-year loans, but these are often secured by a claim to inventories or accounts receivable if they are not repaid on time.
Three other major types of short-term financing include commercial paper, pledging, and factoring. Commercial paper is a debt of the firm that has a maturity of one year or less. It is sold only by large, financially sound firms and its financing cost is slightly less than the prime rate given to lowest-risk bank loans. Factoring and pledging are used by smaller, less stable companies. Factoring is when a business sells to a factor (often a bank or a bank subsidiary) the right to collect the money it is owed (its receivables); in return for providing the business with cash in advance of the time payment is due the factor takes a percentage of the invoice value and may provide cover for bad debts. Pledging is a loan secured by the firm’s receivables due from customers. Because of their increased risk, the financing cost to a business of pledging and factoring is higher than if it issued commercial paper.
Before the mid-1960s virtually all debt issues were sold within the country in which the issuing corporation resided. Since then international financing has increased dramatically. Much of this international financing is short term and takes place in what is referred to as the Eurobond market, the major centre for which is London. The Eurobond market allows companies to raise finance in foreign currency (often United States dollars) and avoid the regulations and restrictions of their domestic financial markets. The proceeds of such bond issues are frequently converted into the companies’ domestic currency at the time of the issue. The Eurobond market is used for raising both short-term and long-term finance. In recent years bonds with up to 50-year maturities have been issued.
B Long-Term Financing
Long-term debt frequently takes the form of a bond issue or lease financing. Bonds that have no claim to specific assets if the firm defaults are referred to as debentures. Because of their risk, debentures carry a higher interest rate than secured bond issues. Leases are similar to debt issues except that the legal title to the asset being financed does not pass to the firm doing the leasing. Lease financing has been used increasingly in recent years owing to various taxation advantages not found in debt or equity financing.
Occasionally, long-term bond issues are sold that provide the buyer with a claim to purchase ordinary shares of the issuing firm. Convertible bonds allow the owner to convert the bond into a specified number of shares. Bonds with warrants attached allow the holder to purchase shares at a favourable price. From the corporation’s viewpoint, convertible bonds will eventually become new shares, whereas bonds with warrants will remain debt but will (or should) also provide new equity money in the future.
Preference shares are in many ways similar to bonds. They are sold at a specified face value or par; pay a stated amount each year; and, in the event of a company bankruptcy, carry a claim to a share in the liquidation of assets before that of ordinary shares. They also have certain features of ordinary shares: dividends need not be paid unless the firm has cash available for this purpose, and they will often be allowed to increase as profits of the firm increase. Straight bonds, on the other hand, pay a guaranteed and specified coupon rate each year.
The true owners of a corporation are the holders of its ordinary shares; they receive any profits from asset investments after all debt interest and preference share dividends are paid. These profits are distributed in two ways: as cash from the corporation to the shareholder in the form of dividends and as capital gains realized when the shares are sold at a price higher than was paid for them. Increases (or decreases) in common stock prices are caused by two things. (1) The retention of profits to provide for growth and other corporate goals increases the total asset value of the firm and thus increases the value of the stock. If for example, a given figure in earnings per common share is retained within the firm, the value per share should increase by that figure. (2) Changes in the opinions of shareholders about the future profit potential of the firm will cause share prices to rise or fall. The actual rate of return earned by ordinary shareholders is determined by the actual cash dividend received plus or minus any price gain or loss on the shares.
C Financial Intermediaries
Institutions that obtain financial resources from a lender and supply them to a borrower are known as financial intermediaries. A commercial bank, for example, obtains money from demand deposits, savings accounts, and bond sales. This money is then lent to private individuals, corporations, or governments. Other types of financial intermediaries are building societies, mutual funds, insurance companies, and pension funds. These institutions allow savers with small amounts of capital to pool their funds in order to diversify across a large number of investments. In addition, the financial expertise of the institutions’ managers can provide a high return for the savers on their investment.
V FINANCE IN THE PUBLIC SECTOR
Through public expenditure, a nation carries out the functions required of it by its citizens. During the past century, the public sector has expanded greatly in virtually every country, regardless of its political system.
Public expenditure falls into three main categories: defence, public works, and social welfare programmes. Public works include such services as roads and housing, public utilities, and, in many countries, the postal, railway, telephone, and telecommunications systems, as well as other services such as public service broadcasting. Social welfare programmes involve expenditure on public health services, education, and unemployment benefit. In some states, such as France or China, state financial support of industry or agriculture also accounts for a sizeable share of public expenditure.
Public expenditure is financed chiefly by taxation. This takes various forms, such as excise duties, income tax, value added tax, and other revenue-raising mechanisms.
B Financing Deficits
When government expenditure exceeds revenues from taxation and other sources (such as privatization of public assets), the resulting deficit must be financed by borrowing money. At the national level, a treasury department is usually empowered to sell both short- and long-term securities. In Great Britain, treasury bills have a maturity of three months or more; government bonds have maturities ranging from 1 year to around 20 years. Government bonds are normally regarded as especially safe forms of security.
State and local debt issues have increased rapidly in many countries. Such issues are similar in many respects to government securities but have a larger risk of default. They, therefore, tend to carry higher yields than government issues with a similar maturity. In some countries, they may also offer tax advantages.
C Money Creation
The final way in which government expenditures are financed is by the creation of new money. This source of financing is available only to national governments, and although it is widely discredited as a tool in macroeconomic management because it inevitably creates inflation, governments have historically resorted to it, often for political rather than economic reasons. If a national government wishes to spend a set amount on various projects, for instance, it can pay for them by printing that figure in new money. In practice, however, the process is more complex; usually, it is conducted by a central bank. In Great Britain, this central bank is the Bank of England, which is responsible for controlling the money supply available to the country. Where the central bank has less power to resist the demands of central government, the manipulation of the money supply for budgetary ends may be greater, and it is often international financial markets that exercise greater restraint on the state’s tendency to print money. The supply of money is often manipulated to aid the central government in financing deficits, controlling interest rates, controlling inflation, and increasing employment. Unfortunately, the procedures used to meet many of these goals conflicts. For example, attempts to keep interest rates low at one point in time often lead to higher interest rates and inflation in the long run.
VI INTERNATIONAL FINANCE
Capital movements between countries are classified either as current account or capital account movements. Current account movements refer to payments for imports and exports, as well as the payment of interest and dividends. During any year, a given country will have either a surplus or a deficit of current account transactions. Capital account movements refer to the purchase or sale of securities in one country by citizens of another country. Such transactions will also result in a net surplus or deficit for a given country. When the capital and current account are added together, the result is the overall balance of payments position of a country. A net balance of payments deficit means that more financial resources have flowed out of a country than into it; a net surplus means the opposite.
Each country will demand payment for net surpluses in the currency it uses. The United Kingdom, for example, uses the pound sterling, while the United States uses the dollar. The value of one currency relative to another depends on which country has a net deficit to the other. If the United States, for instance, has a net deficit to the United Kingdom, the value of the British pound will rise relative to the dollar. This relative value is indicated by the exchange rate, which represents the cost of one unit of a given currency in terms of another. The rise in the value of the British pound will make British exports to the United States more expensive, and US exports to the United Kingdom cheaper. As a result, the deficit should tend to correct itself. The exchange rate is, therefore, important because of its role in restoring a balance between deficits and surpluses in different countries.
Capital movements have become more important as a result of financial liberalization reforms during the 1980s and 1990s and the lifting of exchange controls. As a result, currency speculators and investors, aided by advanced communication technology, can shift enormous sums of money around the world with tremendous speed. The power of this international financial system was demonstrated in 1992, when concerted speculative pressure forced Britain and Italy to withdraw from the Exchange Rate Mechanism of the European Union, and again in early 1995, when the financial markets lost confidence in Mexico, instigating domestic panic and a vast US government financial aid package.
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