Chapter 14 An Overview of Corporate Financing 373
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such as a bank, to link up the borrower and lender. For example, banks are equipped to check
out the would-be borrower’s creditworthiness and to monitor the use of cash lent out.^28
Pooling Risk
Financial markets and institutions allow firms and individuals to pool their risks. For instance,
insurance companies make it possible to share the risk of an automobile accident or a house-
hold fire. Here is another example. Suppose that you have only a small sum to invest. You
could buy the stock of a single company, but then you would be wiped out if that company
went belly-up. It is generally better to buy shares in a mutual fund that invests in a diversified
portfolio of common stocks or other securities. In this case you are exposed only to the risk
that security prices as a whole will fall.
Information Provided by Financial Markets
In well-functioning financial markets, you can see what securities and commodities are worth,
and you can see—or at least estimate—the rates of return that investors can expect on their
savings. The information financial markets provide is often essential to a financial manager’s
job. Consider these scenarios.
In December, Catalytic Concepts, a manufacturer of catalytic converters, is planning pro-
duction for the next July. The converters include platinum, which is traded on the New York
Mercantile Exchange. How much per ounce should the company budget for purchases of
platinum in July? Easy: The company’s CFO looks up the market price of platinum on the
New York Mercantile Exchange—$1,230 per ounce for delivery in July (this was the price for
platinum in November 2014, for delivery the following July). The CFO can lock in that price
if she wishes. We explain how in Chapter 26.
Now suppose the CFO of Catalytic Concepts needs to raise $400 million in new financing.
She considers an issue of 30-year bonds. If the company’s bonds are rated Baa, what interest
rate will it have to pay on the new issue? The CFO sees that existing Baa bonds yield 4.70%.
The company should be able to sell its new bonds at a similar rate.
Finally, stock prices and company values summarize investors’ collective assessment of
how well a company is doing, both its current performance and its future prospects. Thus an
increase in stock price sends a positive signal from investors to managers.^29 That is why top
management’s compensation is linked to stock prices. A manager who owns shares in his or
her company will be motivated to increase the company’s market value. This reduces agency
costs by aligning the interests of managers and stockholders. This is one important advantage
of going public. A private company can’t use its stock price as a measure of performance. It can
still compensate managers with shares, but the shares will not be valued in a financial market.
The basic functions of financial markets are the same the world over. So it is not surpris-
ing that similar institutions have emerged to perform these functions. In almost every country
you will find banks accepting deposits, making loans, and looking after the payments system.
You will also encounter insurance companies offering life insurance and protection against
accident. If the country is relatively prosperous, other institutions, such as pension funds and
(^28) However, in the past decade a number of peer-to-peer lending firms (P2PLs), such as Prosper and Lending Club, have been estab-
lished. These firms receive applications for loans from individuals or small businesses and then advertise on the Web for interested
lenders. Lenders do not know the identity of the borrower, but the peer-to-peer intermediary does provide a credit score and its own
credit assessment of the borrower, which is reflected in the interest rate being offered. The P2PL provides a market place that links
borrowers and lenders. In addition, it offers credit information, and collects payments from borrowers and forwards them to the lend-
ers. By contrast a bank owns its portfolio of loans and offers its depositors instant access to their money.
(^29) We can’t claim that investors’ assessments of value are always correct. Finance can be a risky and dangerous business—danger-
ous for your wealth, that is. With hindsight we see horrible mistakes by investors—for example, the gross overvaluation of Internet
and telecom companies in 2000. On average, however, it appears that financial markets collect and assess information quickly and
accurately.