Financing

Financing is the generic term often used to describe the process of raising money to accomplish a business purpose. Although countless variations, modifications and extensions exist, the two basic building blocks for financing are debt and equity. Debt financing involves the use of another's resources (money) with an explicit promise to return those resources along with some prescribed payment for their temporary use. Equity financing involves the transfer of fractional ownership of a venture to a willing party in exchange for funds. Normally that transfer is relatively permanent with no promise of repayment. Managers and aspiring managers need to understand the ramifications of these tools and their related elements to best realize their benefits. The two important considerations of financing are its risk and required return. Normally, a positive relationship is associated with risk and return. That is, higher risk opportunities are perceived to offer higher returns. A further dimension closely intertwined with risk and return is time. The sooner a return is realized, the more beneficial it is to a recipient. The trade-off in value between quantities of money at different points in time involves an analysis of the time value of money.

The venue through which individuals and organizations needing resources meet with individuals or organizations having surplus resources that they wish to share is the financial market. The financial market can be segmented in a variety of ways. One common distinction is the time until an agreed relationship is terminated. For agreements that persist more than one year and perhaps perpetually, the segment is known as the capital market. Conversely, short-term agreements that mature within one year and have minimal risk are said to be within the money market.

Liquidity

An important dimension of financial instruments is the ease of translating them into cash. Those instruments readily convertible into cash are said to be liquid. Assets that cannot be easily converted into cash are called illiquid.

Organizations that function primarily within the capital market or money market are known as financial institutions. Many financial institutions operate directly between other parties in the financial markets and are thereby known as financial intermediaries. Other organizations function primarily within other areas such as manufacturing, service, or extraction and deal with financial institutions as needed.

Security offerings

The sale of securities from issuing firms to others involves some elaborate procedures and constraints. Some of the earliest regulations were issued by state governments and known as "Blue Sky Laws." The name derived from a Kansas legislator who proudly exclaimed after helping to pass some early regulations that investors would have something more than the blue sky to protect them. The most stringent legislation imposed on security issuers today is the body of regulations administered by the Securities and Exchange Commission. The SEC was formed during the Great Depression of the Roosevelt era to administer the laws passed in Securities Exchange Act. The ostensible purpose of these regulations was to protect the public from unscrupulous activities. The regulation's primary focus is insuring full disclosure rather than suitability for investment. Furthermore, most attention is directed toward securities offered to the public at large rather than transactions among small groups.

The overwhelming majority of firms engage is some practice other than placing securities in the hands of new investors. Most companies are in business to provide some good or service. However, occasionally nearly all firms need to raise funds. Consequently, when they wish to sell securities to investors in order to raise necessary funds, they rely on the services of investment bankers. Investment banking organizations concentrate their efforts explicitly on the process of placing securities into the hands of investors. This process of finding buyers for newly issued securities is commonly known as underwriting.

Regulation

In the United States most security transactions are regulated by the Securities Exchange Commission. This organization was established during the 1930s to administer the Securities Exchange Act.

Underwriting

The term underwriting comes from early days of investment banking, insurance and other financial activities. Parties willing to participate in a new venture would sign their names under an agreement. Thereby, they were engaging in "underwriting." When a business enterprise wishes to engage an underwriter two alternative selection processes are available. One approach is to directly negotiate with prospective investment bank underwriters and select the preferred alternative. This approach is relatively simple, but it offers little guarantee that the lowest cost or best alternative has been selected. The second approach is to competitively select the investment banker offering the best terms. This approach is more complicated and time consuming. First the provisions of the offering must be determined. Then prospective investment banks must be invited to participate in the competition. Often an investment bank is initially invited to develop the proposal and is disqualified from the competition. Presumably, competitive selection offers the best chance of making the best selection. In practice most investment bankers are selected through private negotiation.

Public offerings

When a company sells a security to the public for the first time it is known as an initial public offering (IPO). Elaborate procedures for conducting public offerings have been developed in various countries. Primary emphasis here is directed toward procedures used in the United States. Two procedures for placing securities for issuing firms are firm underwriting and best efforts underwriting. With firm underwriting the risk of selling the securities for the expected price is borne by the investment banker. With a best efforts procedure, the issuing firm bears all the risk of not selling all securities for the expected price.

Private offerings

When a company offers to sell a security to a select group of potential buyers, that situation is known as a private offering. Typically, relatively few people are included in the target group; and logically they are wealthy individuals able to buy a substantial block of the new offering. It would make little sense to make small sales to someone when you are limited to relatively few participants.

Rights offerings

Selling new shares to existing shareholders at a preferential price can be done in accordance with the preemptive right. The notion of a preemptive right stems from old English common law which interpreted the sale of new shares at less than the market price as a misappropriation of the existing shareholder's property. When rights offerings are used various relevant values can be calculated.

Financial institutions

Some business organizations engage in activities that are purely financial in nature. Rather than producing a product such as a widgit or providing a service such as dry cleaning, these organizations offer purely financial products. Such organizations are known as financial institutions. The assortment of financial institutions includes commercial banks, savings banks, investment banks, insurance companies, trust funds, credit unions, small loan companies, and other similar organizations. Some of these organizations directly collect funds form others, depositors for example, and repackage these funds into loans, etc. for customers. These financial institutions are known as financial intermediaries. That is they intermediate or go between those with funds and others needing funds. The rational for intermediaries existence is that they employ economies of scale and techniques of specialization allowing them to transfer resources from those with extra resources to those in need of resources more efficiently than could be done directly. Occasionally, something happens to this process and there is a shift from using intermediaries to direct investment. This process is known as dis-intermediation.

Financial institutions tend to be located in large cities. New York, London and Tokyo are the most important financial centers of the world. Due to the size of the American market, New York tends to have the largest institutions. However, on an international scale, London is the site of most international trading of stocks, bonds and currencies. That situation is supported by the physical location of the London market with respect to time zones. Traders in London are able to deal with people in all financial centers throughout their trading day. That luxury does not exist for many other locations.

Investment banks

The organizations primarily involved with placement of new securities are investment banks. These organizations also engage in a practice known as proprietary trading. In that activity trading is conducted to generate direct profits for the firm.

Financial instruments

A vast assortment of contractual relationships including debt, equity, derivatives, forwards, futures, options and other components comprise what are known as financial instruments. These are the basic building blocks for financial transactions. We will explore a number of them to understand their use, valuation, and risks. Furthermore, many regulations are specifically targeted at financial instruments, so those regulations will also be explored.

Debt

One of the most popular sources of funds is debt or borrowed money. By definition debt must be repaid at maturity. During the lifetime of debt, its owners are compensated for the use of those funds by a firm in the form of interest. Such interest payments are considered a cost of doing business, and consequently are paid from before tax income earned by the firm.

Equity

The basic form of corporate ownership is common stock which is commonly known as equity. Holders of a firm's equity are entitled to share in its profitability. The sharing is distributed according to fractional ownership typically in the form of common stock shares. Each individual share represents an equal fraction of ownership. Share owners receive benefits in the form of dividends, price appreciation and control. Dividends represent a distribution of profits and consequently are paid from after tax earnings.

Due diligence

Before investors buy debt or equity they need to examine the character of the instrument they are buying. A full and proper analysis for such a purchase is known as due diligence.

EURO markets

Starting near the middle of the 20th century a major new market emerged known initially as the EURO dollar market. The initiation of this market is widely attributed to Russian financial practices. During the Cold War, Russia was regularly at odds with the U.S. For international trade Russians needed U.S. dollars. The Russian ruble was a soft or inconvertible currency. That is, people were not permitted to take rubles out of Russia. Furthermore, if somebody did get rubles outside of Russia, they were not permitted to use them to buy anything from Russians. The U.S. dollar in contrast was the reserve currency of the world. People would accept it anywhere and could use it anywhere. Initially Russians kept their dollars in U.S. banks for convenient trading. Russian fears mounted as they considered the potential for the U.S. government to freeze those assets. Specifically, U.S. banks would logically be subservient to the U.S. government's request that dollars on deposit from Russia not be spent as directed. To protect themselves, the Russians withdrew their U.S. dollars from U.S. banks and deposited them into French and British banks. The Russians stipulated that the deposits be sustained in dollars as that was how their deposits would be spent. Having these large U.S. dollar deposits encouraged those banks to make loans denominated in U.S. dollars. Despite the bank's locations in London and Paris, they made dollar loans. The telex call symbol for the Paris bank, Banque Commerciale pour l’Europe du Nord, identified on the Telex report for transactions was EURO. Hence, when transactions it made denominated in dollars were reported on the telex, they came to be known as EURO dollars. Eventually, the name applied to any currency being loaned outside the borders of its issuing country. Finally, the name has been modified to EURO currency to accommodate for yen, pounds and other currencies being used in similar ways.

Euros

Another use of the term euro emerged in 2000. The European Union decided to form a common currency to take advantage of scale economies and trading efficiency. The name adopted for the currency they chose to issue was euro. Consequently, one must be careful to distinguish between the notion of a EURO currency and a euro which itself is a currency. The European Union organized a new central bank to manage that new currency and conduct other financial activities. After considerable study and controversy it was decided to locate the new European Central Bank (ECB) in Frankfurt, Germany. Perhaps a major factor in that city's selection was the presence of the Bundesbank, Germany's central bank in that city. The Bundesbank had an impressive reputation for managing a strong currency and perhaps the proximity would add to the perception of the euro.

Recent trends

Over the 20th century a dramatic shift in thinking occurred. During early years there was considerable enthusiasm for central control of economies. As communication improved and business organizations expanded the perception that government should similarly expand evolved. The concept of a limited government as existed during the founding years of the United States was largely replaced with the concept of extensive central control. Critics of a free economic system as advocated by Adam Smith emerged with strong advocacy of centralization. Leaders of some countries such as V. I. Lenin and Joseph Stalin implemented stringent programs of collectivization following the Russian Revolution of 1917. Adolph Hitler led the movement toward national socialism in Germany with his NAZI party. Other countries such as the United Kingdom and the United States continued to largely embrace free economic systems, but incorporated some dimensions of central control. A number of industries were nationalized and extensive regulation was imposed on others. The Bank of England, a free sector institution since its founding in 1694 was nationalized in 1946.

During the 1970's the attitude and effects of central control and regulation seemed to reach a peak. It became increasingly apparent that despite its expansion the central control system was failing. The Labor government in the U.K. imposed controls on the transfer of currency abroad for investments in a feeble attempt to rejuvenate a failing economy. Among other things, this led to the creation of a new market for swap agreements. The notion of stagflation emerged in the U.S. and in his famous speech of despair, President Carter declared that "a malaise has settled upon the land." He seemed oblivious of any way to resolve the problem. The Soviet Union had embraced central control to a much greater extent than most other countries of the world. Joseph Stalin imposed forced collectivization upon Soviet citizens throughout his life to insure that socialism had an opportunity to evolve. From the early days of his rule citizens often chose to leave the country and not return. Eventually, the Soviet Union had isolated itself and few outsiders appreciated what a deplorable state of affairs existed there. Central planners in the Soviet Union continued to profess success and by directing a massive fraction of the economy's resources toward military preparation managed to control not only their own country's system, but that of other countries within the so called "Eastern Block." Firm central control and force sustained the Soviet Union as its leaders professed openness and superiority of their system.

These conditions led to the emergence of a new attitude toward government control. Margaret Thatcher of the U.K. became prime minister and started a major revolution. She aggressively dismantled much of the British government's involvement with the economic system. This led to the reversal of nationalization, a process often misnamed, "privatization." In fact many organizations that had been taken from the free sector of the economy and placed in the coercive sector of the economy through the nationalization process were returned to the free sector. Along with this restructuring of ownership came a restructuring of regulation. In the U.S. many of the regulatory constraints imposed on the economy during the Roosevelt Depression were eliminated during the 1980s and afterward. This dramatic shift from protectionism and control toward open and free markets has contributed to considerable economic growth.

Securitization

A practice that emerged in recent decades and grew rapidly involved the repackaging of financial instruments into trade-able instruments.

Sample financing problems