Fundamentals of Financial Management (Concise 6th Edition)

PART 2 Fundamental Concepts in Financial Management

2-1 THE CAPITAL ALLOCATION PROCESS

Businesses, individuals, and governments often need to raise capital. For example,

Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity

in North and South Carolina, so it will build a new power plant to meet those

needs. Because CP&L’s bank account does not contain the $1 billion necessary to

pay for the plant, the company must raise this capital in the! nancial markets. Simi-

larly, Mr. Fong, the proprietor of a San Francisco hardware store, wants to expand

into appliances. Where will he get the money to buy the initial inventory of TV sets,

washers, and freezers? Or suppose the Johnson family wants to buy a home that

costs $200,000, but they have only $50,000 in savings. Where will they get the addi-

tional $150,000? The city of New York needs $200 million to build a new sewer

plant. Where can it obtain this money? Finally, the federal government needs more

money than it receives from taxes. Where will the extra money come from?

On the other hand, some individuals and! rms have incomes that exceed

their current expenditures, in which case they have funds available to invest. For

example, Carol Hawk has an income of $36,000, but her expenses are only $30,000.

That leaves her with $6,000 to invest. Similarly, Microsoft has accumulated

roughly $23.5 billion of cash. What can Microsoft do with this money until it is

needed in the business?

People and organizations with surplus funds are saving today in order to ac-

cumulate funds for some future use. Members of a household might save to pay

for their children’s education and the parents’ retirement, while a business might

save to fund future investments. Those with surplus funds expect to earn a return

on their investments, while people and organizations that need capital understand

that they must pay interest to those who provide that capital.

In a well-functioning economy, capital " ows ef! ciently from those with sur-

plus capital to those who need it. This transfer can take place in the three ways de-

scribed in Figure 2-1.

1. Direct transfers of money and securities, as shown in the top section, occur when
   a business sells its stocks or bonds directly to savers, without going through

Business

Business

Business

1. Direct Transfers


2. Indirect Transfers through Investment Bankers


3. Indirect Transfers through a Financial Intermediary

Savers

Savers

IntermediaryFinancial Savers

Investment Banks

Securities (Stocks or Bonds)

Dollars

Securities

Dollars

Securities

Dollars

Intermediary’s

Securities

Dollars

Business’

Securities

Dollars

Diagram of the Capital Formation Process

F I G U R E 2! 1