Finance

I

Introduction

Finance, 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 (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 more risky 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.