17.1 How Businesses Raise Financial Capital
Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms.
A bond is a financial contract through which a borrower agrees to repay the amount that it borrowed. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury.
Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company’s first stock sale to the public the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. One receives the rate of return on stock in two forms: dividends and capital gains.
A private company is usually owned by the people who run it on a day-to-day basis, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.
17.2 How Households Supply Financial Capital
We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure.
A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.
Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.
We can also regard housing and other tangible assets as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.
17.3 How to Accumulate Personal Wealth
It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price will rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life.
1. Answer these three questions about early-stage corporate finance:
- Why do very small companies tend to raise money from private investors instead of through an IPO?
- Why do small, young companies often prefer an IPO to borrowing from a bank or issuing bonds?
- Who has better information about whether a small firm is likely to earn profits, a venture capitalist or a potential bondholder, and why?
2. From a firm’s point of view, how is a bond similar to a bank loan? How are they different?
- Fred just bought a house for $200,000 by putting 10% as a down payment and borrowing the rest from the bank.
- Freda bought a house for $150,000 in cash, but if she were to sell it now, it would sell for $250,000.
- Frank bought a house for $100,000. He put 20% down and borrowed the rest from the bank. However, the value of the house has now increased to $160,000 and he has paid off $20,000 of the bank loan.
- Given the change in interest rates, would you expect to pay more or less than $10,000 for the bond?
- Calculate what you would actually be willing to pay for this bond.
- What is the interest rate Ford is paying on the borrowed funds?
- Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease?
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Now, let's delve into the key concepts outlined in the article:
1. Early-Stage Corporate Finance:
Why do very small companies tend to raise money from private investors instead of through an IPO?
- Very small companies may lack the track record or market presence required for an IPO. Private investors offer funding without the stringent regulatory requirements of going public.
Why do small, young companies often prefer an IPO to borrowing from a bank or issuing bonds?
- Small, young companies may prefer an IPO for access to substantial capital without immediate repayment obligations. It also enhances visibility and credibility in the market.
Who has better information about whether a small firm is likely to earn profits, a venture capitalist or a potential bondholder, and why?
- Venture capitalists often have better insights as they conduct thorough due diligence before investing. They assess the business model, market potential, and management team, gaining a deeper understanding compared to bondholders who rely more on financial disclosures.
2. Bonds and Stocks:
How is a bond similar to a bank loan? How are they different?
- Bonds and bank loans involve borrowing money with agreed-upon terms and repayment schedules. However, bonds are typically tradable securities with fixed interest payments, while bank loans are usually non-tradable and have flexible terms.
What does a share of stock represent?
- A share of stock represents ownership in a company and entitles the shareholder to certain rights, including voting rights and a share in the company's profits.
3. Housing and Tangible Assets:
- How is buying a house to live in a type of financial investment?
- Buying a house can be a financial investment because it offers the potential for capital appreciation over time. Additionally, homeownership provides stability and the potential for tax benefits.
4. Investments and Financial Intermediaries:
Why are banks called "financial intermediaries"?
- Banks act as intermediaries between savers and borrowers, facilitating the flow of funds in the economy through various financial services and products.
What is a mutual fund?
- A mutual fund pools money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities, professionally managed by investment managers.
5. Risk and Return:
- Why should a financial investor care about diversification?
- Diversification helps mitigate risk by spreading investments across different assets, reducing the impact of adverse events on the overall portfolio.
These concepts form the foundational knowledge needed to understand corporate finance, investment strategies, and wealth accumulation. If you have any further questions or need clarification on specific topics, feel free to ask!