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.