Basics of Finance: III - Borrowing, Lending & Financial Markets

~Continuation and expansion of the previous article:

Assume that you once again are going to borrow money for an ice cream machine (or any other real asset) - then you (or a financial manager, etc.) better know how the financial market works. In other words, the capital budgeting decision mentioned in the previous article, requires you to understand the financial market. 

So, what’s the goal of your firm? Well, one would say earning money. That’s correct; but that is a consequence of the actual goal - maximizing firm value. And in order to do that, we need to define how you valuate/how to price a stock/how it’s priced. All of this is essential when selling securities and taking the loan for the ice cream machine.

So far I’ve assumed that your lemonade stand is big. Big enough to sell those securities and raise money and capital. But, it is more likely, especially with a small lemonade stand, that you cannot do so. Then, what are you going to do? Actually, the “only” choice is to borrow money from a financial intermediary (-bank or insurance company)

Now this is the topic of this article. Understanding the concept of “loaning and borrowing” and understanding the process of it. Something many companies experience at least (more often than not a company borrows money more than once) and in turn you have to understand what is happening. This is essential when you own your own firm.

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A bank lends money and the bank raise funds (in small amounts) from households. For instance, you deposit $100’000 in the bank, now the bank raises funds and are now able to lend this money to borrowers. Does that mean that if you borrow $100’000, that you borrow money from many individuals? Yes. That’s the principle of borrowing. You could, theoretically borrow money from many individuals and it would branch down to almost the same principle. It is however more practical to borrow directly from the bank.

Let’s combine earlier knowledge with that principle. A good example is an insurance. First off you need to raise the cash, the question how to do this, is as you should know by now a financing decision. Once done, you might “buy” a fire insurance for the raised cash. (What to invest in, etc. is the capital budgeting decision). What you get back is a financial asset (the policy or the insurance). Now, if a fire strike, the insurance company pays you back - the return of your investment. Obviously, the company won’t sell insurances for you merely because that’s a higher risk. Instead, the company will sell to thousands of clients so that the cash outflow (the cash being paid in this case) averages out with the cash inflow (the cash individuals pay for the policy/insurance).

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However, once or when your lemonade stand grows, your need for expansion of capital does too. At this point, your firm might raise funds directly from investors. As you know by now, you sell financial assets in forms of shares to the public. The first time you do it, is denoted as an initial public offering or IPO. Your lemonade stand was privately held as now, it went public. You might ask how you do it. Do you press a button and you’ve sold some securities? Well, usually firms like Goldman Sachs or Merrill Lynch does this. An IPO is however not the only occasion where you sell newly issued stocks to the public. 

Example:

Assume that your lemonade stand is big enough to sell stocks and that you’ve done it once already. Now, you need to renovate your lemonade stand, but you know that you do not have the money for it. Now, what you can do is to make a banking firm to raise funds. So, assume that you sell stocks for investors for a value of $50’000. Some of those buying them will be people like you and me, but also companies such as insurance companies. Now, this is called a primary issue and is done is in the primary market. Now, once an investors do not want the stock(s) the investor probably sell it and someone else might buy it. In other words, someone else now owns a part of the business. This takes place in the secondary market.

However, the example of borrowing money and some other examples have no secondary market. When you borrow money, the bank gives an IOU and does not sell it to another bank. 

—- As a conclusion: Financial managers really need to understand - not only the process - but the market and how it works. Not only national markets, but global (international) markets.

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So, what’s the advantages of having markets?

   - The Payment Mechanism

      Even though you might know that it exist, you might not have thought of the great advantages that comes along with a good working “payment mechanism.” Assume that you want to invest $10’000 in a company xyz. Now, assume that the payment mechanism we have today would not exist. That would mean that you would have to send all the money and someone would have to ship all the money to an address instead of using your credit card, checking account, etc.

   

   - Borrowing & Lending

     You can save/“pay” for the future. Assume that you have some money left at the end of the month, you can save it for a rainy day when you lack money. However, if you want to buy a new place to have your lemonade stand, you can simply lend money from the bank —> both gets happier than spending all the money now. 

   - Pooling Risk

     By diversifying your portfolio (for instance by buying mutual funds, stocks in different companies) then you’re better off (?) because if one stock goes down, some of the others might go up, and you’ll still make a profit. In order to lose money, the majority of your stocks has to lose value.

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This pretty much summarizes what I wanted to discuss today. Hopefully you understand what I’m writing and if you don’t, let me hear and feel free to leave a comment.

Next time, I'll continue with the “financial manager” and I’ll discuss who the financial manager is and what careers you can chose from. 

Take care. 

Basics of Finance: II - The Role of the Financial Manager.

Whenever we mention a concept in any given topic, we often forget the definition of that concept. For instance, what really is an asset? Well, we would agree that the following things are assets:

   -Business entity (startups, etc.)

   -Patents and R&D

   -Reputation and Knowledge

Well, the list can be made very long and yet, not one hundred percent correct. Because when I mention the word asset later on, I will relate to a given, general definition that most economists agree with. You need to know what it means in order to minimise the risk of misconception. 

The definition of an asset is simply "a sequence of cash flow relative to time." Where a cash flow is the movement (the flow) of cash. So, when you hear a friend saying: "company xyz has great assets," you now know that's economically incorrect. Because an asset is always relative to time, so it should be "xyz has great assets right now." But, is there only one type of assets then? Well, let's go back to the lemonade stand in order to understand it better.

Assume that you took a loan for an ice cream machine instead of the fridge, which now allows you to start making delicious ice cream. So, if you keep on doing this for a while, you start realising that this machine indirectly produces money, right? That's called a real asset. In fact, the ice cream machine is a tangible (real) asset. Concisely written, tangible assets are real assets that you can touch; for example offices and machineries. As you might be wondering, there must be intangible assets as well?! Yes. Intangible (real) assets are assets you cannot touch. For instance, trademarks, patents and technical expertises are intangible (real) assets.

At this point we know that our lemonade stand obtains a lot of real assets. You've got an ice cream machine, maybe you've got an office and you might even have a small factory where you produce you own lemonade. However, the money that the real assets are generating, should be called something as well? What's the outcome of a real asset?

The money generated from your ice cream machine is called a financial asset.

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So which one comes first in a company, the real asset or the financial asset? In order to answer that question, you really need to grasp the two definitions. Real assets (indirectly) produce money, whereas you need money to buy them. And the financial assets are the one you (for example) buy real assets with. So the answer would be financial assets.

Now, if your company needs money for the real assets, you might choose to sell financial assets (securities) in order to get cash. The following picture explains the process:

In the lemonade stand you might choose to sell financial assets to get some cash (1). Once you got the cash needed, you decide to buy the ice cream machine (2). If the ice cream machine does well, you might expect more money to be generated than in the first place (3). At this point you might choose to reinvest in your lemonade stand (4) but you might actually pay the investors back because they were the one providing the money at the beginning.

The bright reader might realise by looking at the illustration, that the financial manager faces a few problems. One could be: how much money should you invest in the stand and in what should you invest in? (In this case the ice cream machine). That's an investment decision, or CAPITAL BUDGETING DECISION. The second, rather commonly asked question is, how are we going get the cash? That is called the FINANCING DECISION.

The capital budgeting decision is vital to a company's success. Almost always when you hear about a company having economical problems, it branches down to a failure linked to capital budgeting decision. Some of you might recall the construction of Disney Land Paris Theme Park at a cost of approximately $2B in the 1980's. They opened in 1992 and recorded a loss of nearly $200M in 1994. Whether to invest in the park or not is a capital budgeting decision. 

So, the example of the ice cream machine in the lemonade stand and the theme park are both physical examples of capital budgeting decisions. However, not all capital budgeting decisions need to be physical ones. You might as well advertise for your lemonade stand or advertise for the park. 

But in order to construct the them park, buy the ice cream machine or advertise, you need to raise the money needed. The cash won't simply pop up from nowhere even though you wish they would. A company might offer you to buy shares and in turn share the company's profits and/or offer you a fixed payment (for instance, dividend), etc. in this case you become a shareholder and in turn, as I mentioned earlier, a part-owner of the company. Long term financing in this context is often called capital structure decision and the market for this long term financing is called capital markets. In this case, the financial manager needs to be assured of that there's no big risks in these long term decisions. Examples of that might be a rapid change in dollar value, oil price, etc. I'll later on discuss how to find these risks.

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BASICS OF FINANCE: I - Organizing a Business

Students who attend the corporate finance class often gets very surprised about the course. First off, they don't grasp why understanding different businesses and their purposes and economical processes are important. All they want to do is to start valuating bonds, stocks, etc. and become a "smart and rich" economist. Isn't that all there is to finance? Valuating things all day long and get rich?

That sort of questions always get asked. Not merely in finance. Why know algebra? Why know how it works? Why should a doctor know anatomy if the doctor can study diseases and learn the symptoms? By understanding the very basics of how firms work together with some other important concepts in finance, you'll learn the anatomy of finance, allowing you to start interpreting things in new ways - being a "smart" economist. Sure, you'll learn how to valuate things without this sort of knowledge, but the framework I discussed in my previous article is highly related to this knowledge. Which also, is the purpose of this blog. Letting you understand what is happening out there. Now, let's get started.

 

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Assume that you one day decide to establish a small lemonade stand in your neighborhood on your own. Meaning that you'll provide the materials and products needed. You'll pay rent and if everything goes well, you'll also pay taxes. When you decide to establish this type of business, we call it a sole proprietorship. That simply means that one person owns and manages the firm. 

Now, your lemonade stand is going very well and one day you decide to start selling ice cream as well. But you have a problem - you have no fridge to store the ice cream in. Now, you don't have the money on hand needed to buy a fridge either, so you decide to borrow the money from the bank. What happens if you cannot pay back the loan? Will the lemonade stand be responsible? The answer is no. In a so-called sole proprietorship everything will be on the individual, owning the business, including debts. In other words, you can be personally responsible for not paying back the loan - we say that the sole proprietor has an ulimited liability. 

As a conclusion. A sole proprietorship is when one person (the sole proprietor) owns and manage a business. Where all things that happens will be personally handled (including taxes, loans, etc.).

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Anyways, let's go back to the founding of this lemonade stand. Assume that you instead realises that you'll need some help with providing products and materials and/or some other kind of help managing it. You call some friends up and you decide to run it together. In this case, you form a so-called partnership. Theoretically, the partnership and the sole proprietorship are similar to each other. The partners are still personally responsible for any problems/opportunities that occurs. You still have an unlimited liability and there's no distinction between management and owning (other than now you and some friends manage and own it). 

However, what you'll have to do, is a partnership agreement. Simply explained, it says how decisions are supposed to be managed and the proportion of the profits to which each partner is entitled. 

As you might be thinking, there's many well-known businesses today that started out as a partnership. For instance, Merril Lynch, Morgan Stanley, Salomon, Goldman Sachs, Smith Barney, Apple and Microsoft all started as a partnership.

The message of a partnership is basically: Know thy Partner.

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As capital grows, so does the need of employees and more products and materials - your firm (lemonade stand) starts to expand/grow. When your firm (lemonade stand)reaches a certain point in its expansion, you might decide to incorporate your firm (lemonade stand). Now, there's an obvious, theoretical distinction between this and the two aforementioned types of businesses. A corporation is based on something called articles of incorporation and can be seen as equivalent to a partnership agreement. 

In the articles of incorporation, the purpose of the business, the amount of shares that can be issued and the numbers of directors to be appointed is described. From this point of view, you might relate the articles of incorporation with the general view of corporations: "a corporation is a resident of its state." That means, that a business can do pretty much anything within the laws except for voting. For example, it can borrow and lend money. Sue and get sued. 

As I wrote earlier the sole proprietor/the partners, both own and manage the business. I certainly claimed that there is no distinction between the two. Now it is. Once incorporated we form a distinction where the shareholders own the business. 

So let's say you are a shareholder of the lemonade stand and that the lemonade stand can't repay the loan for the fridge. Will you be personally responsible for that? The answer(s) is: "indirectly you will be affected" and "directly you won't be responsible." Because if the business can't repay its loan, it will probably stop being profitable and start to lose money. When that happens, you lose money that you invested in the company. However, the bank won't call you up and claim that you should pay the bank. This is called limited liability.

Now we know that there is a distinction between ownership and management. Yet, we don't know who manages the corporation. Usually a board of directors is elected and appointed. They represent the shareholders and in turn, they should act in their best interest. This distinction, once again, is one very important feature for a corporation. It gives the corporation more flexibility and permanence than, for example a partnership. 

As the shareholders own a part of the business, we can look at shareholders as voters. If an investor owns one share, worth a few dollars, that share can be viewed as one vote for that company. If you own a few shares you're only entitled to a small amount of the profit compared to an investor that owns many shares. So, the number of votes is directly linked to the proportion of profit of which the shareholders are entitled. 

Why aren't all business organized like this? Why not form a corporation straight away? Assume that a few partners decide to incorporate immediately. Is that good or bad? Well, with the fact given above, it should be good. However, there's a drawback to this. All corporations have to pay twice as much in taxes. When we looked at sole proprietorship, we said that all things are personally handled, we said that taxation are personally paid. The corporation pays taxes and also the shareholders. 

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What if your lemonade stand doesn't seem to fit any of these? When businesses do not fit into these neat categories, we call them hybrids. One you might have seen already is limited partnership. In this case, partners are either classified as general or limited partners. General partners manage the business and an unlimited liability. The limited partners can lose all the money they put in but not more, whereas their management are restricted.

For all of you who live in the United States, you might have seen LLC  (limited liability company) and LLP (limited liability partnership). In this case the partners have limited liability and the tax advantage (lower taxes) but still, there's no distinction between management and ownership which is (almost) vital to big companies. 

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The following "table" summarises the tree categories mentioned:

 

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That's all for now. If you have any questions and/or think I should keep this up, please leave a comment. Take care.

The Purpose of This Page

I would like to begin by looking at some of the problems/opportunities the United States faces today. Oil price crashed not so long ago (and now, oil prices are fluctuating), Dow Jones Industrial Average together with NASDAQ peaked at levels not seen for almost ten years - peaks resulting in stocks (in general) being overpriced. All of this resulting in greater cash inflows and a greater economy for the United States in general, right...?

The aforementioned handful examples are being discussed all over the United States and we always see a new article on the news regarding the oil price and/or that the Dow Jones is peaking. Yet, a lot of people discussing these topics cannot understand the underlying causes/consequences of it. In other words: why is it so interesting? Why care that the Dow Jones peaked? Why care that the FEDS raised taxes? Why would that affect my investing? 

These questions lie at the heart of finance and the all of you who are studying corporate finance might already have an answer to these sorts of questions. But still. The purpose of this page is to help and guide you to form the framework in finance needed to understand the news and more important the market. 

So, finally. Welcome to  my page – Corporate Finance. This will be a page tutoring all of you the fundamental principles of corporate finance and furthermore touch up the knowledge some of you might already have in Corporate Finance. I'm looking forward to this journey and where it might lead me/us.