CASH FLOWS TO AND FROM THE FIRM

The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The arrows in Figure 1.2trace the passage of cash from the financial markets to the firm and from the firm back to the financial markets.

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed assets (B). These assets generate cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F).

A financial market, like any market, is just a way of bringing buyers and sellers together. In financial markets, it is debt and equity securities that are bought and sold. Financial markets differ in detail, however. The most important differences concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of these differences are discussed next.

PRIMARY VERSUS SECONDARY MARKETS

Financial markets function as both primary and secondary markets for debt and equity securities. The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. In the discussion that follows, we focus on corporate securities only.

Primary Markets In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer.

FIGURE 1.2 Cash Flows between the Firm and the Financial Markets

 

Page 15By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable.

 

To learn more about the SEC, visit  www.sec.gov .

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).

Secondary Markets A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. Although a corporation is directly involved only in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired.

Dealer versus Auction Markets There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses.

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically.

Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

Trading in Corporate Securities The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE). There is also a large OTC market for stocks. In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (which originally stood for NASD Automated Quotation system and is pronounced “naz-dak”). NASDAQ-listed companies tend to be smaller and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is much less than the total value of NYSE stocks.

 

To learn more about the exchanges, visit  www.nyse.com  and  www.nasdaq.com .

There are many large and important financial markets outside the United States, of course, and U.S. corporations are increasingly looking to these markets to raise cash. The Tokyo Stock Exchange and the London Stock Exchange (TSE and LSE, respectively) are two well-known examples. The fact that OTC markets have no physical location means that Page 16national borders do not present a great barrier, and there is now a huge international OTC debt market. Because of globalization, financial markets have reached the point where trading in many investments never stops; it just travels around the world.

Listing Stocks that trade on an organized exchange are said to be listed on that exchange. To be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ from one exchange to another.

The NYSE has the most stringent requirements of the exchanges in the United States. For example, to be listed on the NYSE, a company is expected to have a market value for its publicly held shares of at least $100 million. There are additional minimums on earnings, assets, and number of shares outstanding.

Concept Questions

1.5a   What is a dealer market? How do dealer and auction markets differ?

1.5b   What does OTC stand for? What is the large OTC market for stocks called?

1.5c   What is the largest auction market in the United States?

 

1.6   Summary and Conclusions

This chapter introduced you to some of the basic ideas in corporate finance:

1.  Corporate finance has three main areas of concern:

a.  Capital budgeting: What long-term investments should the firm take?

b.  Capital structure: Where will the firm get the long-term financing to pay for its investments? In other words, what mixture of debt and equity should the firm use to fund operations?

c.  Working capital management: How should the firm manage its everyday financial activities?

2.  The goal of financial management in a for-profit business is to make decisions that increase the value of the stock or, more generally, increase the market value of the equity.

3.  The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation.

4.  There is the possibility of conflicts between stockholders and management in a large corporation. We called these conflicts agency problems and discussed how they might be controlled and reduced.

5.  The advantages of the corporate form are enhanced by the existence of financial markets. Financial markets function as both primary and secondary markets for corporate securities and can be organized as either dealer or auction markets.

Of the topics we’ve discussed thus far, the most important is the goal of financial management: maximizing the value of the stock. Throughout the text, we will be analyzing many different financial decisions, but we will always ask the same question: How does the decision under consideration affect the value of the stock?

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CONNECT TO FINANCE

 

Connect Finance offers you plenty of opportunities to practice mastering these concepts. Log on to connect.mheducation.com to learn more. If you like what you see, ask your professor about using Connect Finance!

Can you answer the following Connect Quiz questions?

Section 1.1	Deciding which fixed assets should be purchased is an example of what type of decision?
Section 1.2	What form of ownership is easiest to transfer?
Section 1.3	What best describes the goal of financial management?
Section 1.4	In a corporation, the primary agency conflict arises between which two parties?