Roles of Financial Markets and Institutions

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that require the application of concepts learned within the chapter, as related to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family.

It was initially financed with an equity investment by the Carson family and ten other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period.

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It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional funds either through loans or by issuing bonds.

It is also considering the issuance of stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

a.In what way is Carson a surplus unit?

Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuer of those securities.

b.In what way is Carson a deficit unit?

Carson has borrowed funds from financial institutions.

c.How might finance companies facilitate Carson’s expansion?

Finance companies can provide loans to Carson so that Carson can expand its operations.

d.How might commercial banks facilitate Carson’s expansion?

Commercial banks can provide loans to Carson so that Carson can expand its operations.

e.Why might Carson have limited access to additional debt financing during its growth phase?

Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to lend more funds to Carson if it has too much debt.

f.How might securities firms facilitate Carson’s expansion?

First, securities firms could advise Carson on its acquisitions. In addition, they could underwrite a stock offering or a bond offering by Carson.

g.How might Carson use the primary market to facilitate its expansion?

It could issue new stock or bonds to obtain funds.

h.How might it use the secondary market?

It could sell its holdings of Treasury securities in the secondary market.

i.If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

It would have been able to obtain loans directly from surplus units. It would have been able to assess potential targets for acquisitions without the advice of investment securities firms. It would be able to engage in a new issuance of stock or bonds without the help of a securities firm.

j.The loans that Carson has obtained from commercial banks stipulate that Carson must receive the banks’ approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?

The purpose is to prevent Carson from using the funds in a manner that would be very risky, as Carson may default on its loans if it takes excessive risk when using the funds to expand its business. The owners of the firm may prefer to take more risk than the lenders will allow, because the owners would benefit directly from risky ventures that generate large returns. Conversely, the lenders simply hope to receive the repayments on the loan that they provided, and do not receive a share in the profits. They would prefer that the funds be used in a conservative manner so that Carson will definitely generate sufficient cash flows to repay the loan.

Chapter Two Flow of Funds Exercise

How the Flow of Funds Affects Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, its cost of obtaining funds is sensitive to interest rate movements. Given its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to pay for this growth, and it plans to borrow additional funds either through loans or by issuing bonds. The company is considering the issuance of stock to raise funds in the next year.

a.Explain why Carson should be very interested in future interest rate movements.

The future interest rate movements affect Carson’s cost of obtaining funds, and therefore may affect the value of its stock.

b.Given Carson’s expectations, do you think that the company anticipates that interest rates will increase or decrease in the future? Explain.

Carson expects the U.S. economy to strengthen, and therefore should expect that interest rates will increase (assuming other things held constant).

c.If Carson’s expectations of future interest rates are correct, how would this affect its cost of borrowing on its existing loans and on future loans?

Carson’s cost of borrowing will increase, because the interest rate on prevailing and future loans would be tied to market interest rates.

d.Explain why Carson’s expectations about future interest rates may affect its decision about when to borrow funds and whether to obtain floating-rate or fixed-rate loans.

If Carson expects rising interest rates, it may prefer to lock in today’s interest rate for a period that reflects the length of time that it will need funds. In this way, the cost of funds borrowed would be insulated from the changes in market interest rates.

Chapter Three Flow of Funds Exercise

Influence of the Structure of Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to the six-month Treasury bill rate (and includes a risk premium) and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. Because of its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to finance its growth, and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year.

a.Assume that the market’s expectations for the economy are similar to those of Carson. Also assume that the yield curve is primarily influenced by interest rate expectations. Would the yield curve be upward sloping or downward sloping? Why?

The yield curve would be upward sloping to reflect the expectations or rising interest rates along with a liquidity premium for debt securities with longer maturities.

b.If Carson could obtain more debt financing for 10-year projects, would it prefer to obtain credit at a long-term fixed interest rate, or at a floating rate. Why?

The prevailing interest rate would be lower on loans than on the bonds, but the interest rate on loans would increase over time if market interest rates rise. Therefore, Carson may be willing to lock in the cost of debt by issuing bonds rather than be subjected to the uncertainty if it obtains floating-rate loans.

c.If Carson attempts to obtain funds by issuing 10-year bonds, explain what information would help to estimate the yield it would have to pay on 10-year bonds. That is, what are the key factors that would influence the rate it would pay on the 10-year bonds?

The key factors are the risk-free rate on 10-year bonds, the risk premium, and any special provisions on the bond. The yield to be offered is equal to a risk-free rate on ten-year bonds plus a risk premium to reflect the possibility of Carson’s default, plus an adjustment for any special features of the bond.

d.If Carson attempts to obtain funds by issuing loans with floating interest rates every six months, explain what information would help to estimate the yield it would have to pay over the next ten years. That is, what are the key factors that would influence the rate it would pay over the 10-year period?

The key factors are the risk-free rate on six-month T-bills, and the risk premium. The cost of debt in this case changes over time, and is dependent on how T-bill rates move over time. e.An upward-sloping yield curve suggests that the initial rate that financial institutions could charge on a long-term loan to Carson would be higher than the initial rate that they could charge on a loan that floats in accordance with short-term interest rates. Does this imply that creditors should prefer to provide a fixed-rate loan rather than a floating-rate loan to Carson? Explain why Carson’s expectations of future interest rates are not necessarily the same as those of some financial institutions.