Raising Funds and Cost of Capital

Raising Funds and Cost of Capital

1. What are the three primary roles of financial markets? Explain.

Financial markets serve three major functions.

• Channel funds. Financial markets help channel funds from suppliers to demanders. Within an economy, some have a surplus of funds while others have a shortage of funds. Financial markets provide a mechanism to help move funds from those who have a surplus (suppliers) to those who have a shortage (demanders). Business firms are net users of funds.

• Provide a resale market. Financial markets provide a resale market. Such markets provide liquidity by enabling the holder to convert an asset into cash with ease. If investors believe that liquidating the investment would be difficult or costly, they would be reluctant to commit funds.

• Establish market prices and rates of return. Financial markets establish market prices and rates of return. Setting prices is difficult but occurs through the interaction of suppliers and demanders. Factors contributing to markets efficiently pricing securities include high volume, standardization of securities, and a concentration of traders.

2. What is the major difference between capital markets and money markets? Give two examples of securities in each market.

A money market is a financial market for short-term debt instruments. Money markets have several distinguishing features. First, the original maturity of money market securities is one year or less from their original issue date. Second, money market securities do not trade in a physical location but through a network of wires, telephones, and computers connecting banks and dealers. Third, money market instruments typically have an active secondary market. Fourth, the securities trade in large denominations. Examples of money market instruments include Treasury bills, negotiable certificates of deposit, Eurodollar market time deposits, commercial paper, repurchase agreements, and bankers’ acceptances.

A capital market is a financial market for long-term securities. That is, the original maturities of capital funds are greater than one year. Examples of capital market securities include notes and bonds (government, agency, municipal, and corporate), preferred and common stock, and mortgages.

3. When would a corporation use the primary market and the secondary market?

A primary market is the market for new issues of securities. Thus, corporations use the primary market to raise new capital (debt and equity) because the proceeds of the issue go to the seller. A corporation could raise capital in the primary market by selling securities through public offerings and private placements.

A secondary market is the market for buying and selling securities subsequent to original issuance. Because secondary markets are resale markets, firms do not use secondary markets to raise new capital. The proceeds of secondary market sales accrue to the selling dealers and investors, not to the firms originally issuing the securities. Corporations are interested in the secondary market on which their securities trade because a healthy secondary market may help to entice investors to buy their new stocks or bonds. In addition, corporations use the secondary market to repurchase their securities or buy securities in other companies.

4. How do primary markets differ from secondary markets?

A primary market is a financial market for the original sale of new securities, whereas a secondary market is a market for trading existing securities among investors. In the primary market, the issuer receives the funds raised by the initial sale. The original issuer does not receive the proceeds of a secondary market sale.

1. What are the major functions of financial intermediaries? Explain.

The major function of financial intermediaries is to facilitate the transfer of financial assets and obligations between various market participants. The main market participants are savers (suppliers) and users (demanders) of funds. Other functions of intermediaries depend on their classification – depository institutions and nondepository institutions. Depository institutions accept depositions that customers can redeem on demand. Two major types of depository institutions are commercial banks and thrift institutions such as savings and loan associations, mutual savings associations, and credit unions. For example, some activities of banks include extending credit, servicing loans, offering