Financial Markets and Institutions

11th Edition
by Jeff Madura

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 22 Finance Company Operations
Chapter Objectives

■ describe the main types of finance companies

■ identify the main sources and uses of finance company
funds
■ describe how finance companies are exposed to various
forms of risk
■ identify the factors that determine the values of finance
companies
■ explain how finance companies interact with other
financial institutions
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2
 Types of Finance Companies

Consumer Finance Companies

 Provide financing for customers of retail stores or
wholesalers.
 Provide personal loans directly to individuals to finance
purchases of large household items.
 Provide mortgage loans.

Business Finance Companies

 Offer loans to small businesses.
 Provide financing in the form of credit cards that are used
by a business’s employees for travel or for making
purchases on behalf of the business.

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 Types of Finance Companies

Captive Finance Subsidiaries

A wholly owned subsidiary whose primary purpose is to
finance sales of the parent company’s products and services,
provide wholesale financing to distributors of the parent
company’s products, and purchase receivables of the parent
company.
 Advantages of Captive Finance Subsidiaries:
 Can be used to finance distributor or dealer inventories until a
sale occurs, making production less cyclical for manufacturers.
 Can serve as an effective marketing tool by providing retail
financing. It can also be used to finance products leased to others
 Allows a corporation to clearly separate its manufacturing and
retailing activities from its financing activities.
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 Sources and Uses of Funds

Sources of Funds
 Loans from Banks – Finance companies borrow from
commercial banks and can renew the loans over time.
 Commercial Paper – Finance companies continually roll over
their issues to create a permanent source of funds.
 Deposits - Some states allow finance companies to attract
funds by offering customer deposits.
 Bonds - Finance companies in need of long-term funds can
issue bonds.
 Capital - Finance companies can build their capital base by
retaining earnings or by issuing stock.

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 Sources and Uses of Funds

Uses of Finance Company Funds

 Consumer Loans - Finance companies extend consumer loans
in the form of personal loans.
 Business Loans and Leasing - In addition to consumer loans,
finance companies also provide business (commercial) loans.
 Real Estate Loans - Finance companies offer real estate loans
in the form of mortgages on commercial real estate and second
mortgages on residential real estate.
 Summary of Uses of Funds – The uses of funds depends on
whether the finance company is focused on business or
consumer lending. (Exhibit 22.1)

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 Exhibit 22.1 How Finance Companies Finance
Economic Growth

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 Sources and Uses of Funds

Interaction with Other Financial Institutions

 When finance companies obtain or use funds, they interact
with other financial institutions. (Exhibit 22.2)
 Finance companies compete with commercial banks, savings
institutions, and credit unions.
 Finance companies utilize various financial markets to manage
their operations. (Exhibit 22.3)

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 Exhibit 22.2 Interaction between Finance Companies
and Other Financial Institutions

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 Exhibit 22.3 Participation of Finance Companies in
Financial Markets

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 Valuation of a Finance Company

Factors That Affect Cash Flows

V  f (E (CF ), k )
 Economic Growth
 Can enhance a finance company’s cash flows by increasing
household demand for consumer loans, thereby allowing the
finance company to provide more loans.
 Change in the Risk-Free Interest Rates
 Cash flows may be inversely related to interest rate
movements.
 Finance companies rely heavily on short-term funds

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 Valuation of a Finance Company

Factors that Affect Cash Flows (Cont.)

 Change in Industry Conditions
Conditions include regulatory constraints, technology, and
competition within the industry.
 Change in Management Abilities
Managers attempt to make internal decisions that will
capitalize on external forces (economic growth, interest
rates, regulatory constraints).

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 Valuation of a Finance Company

Factors That Affect the Required Rate of Return

k  f (R f , RP)

 The risk-free rate is positively related to inflation, economic

growth, and the budget deficit level, but inversely related to
money supply growth (assuming it does not cause inflation)
(Exhibit 22.4)
 The risk premium is inversely related to economic growth and
the company’s management skill.

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 Exhibit 22.4 Framework for Valuing a Finance
Company

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 Exposure of Finance Companies to Risk

Liquidity Risk
Finance companies generally do not hold assets that could
be easily sold in the secondary market. However, their
balance sheet structure does not call for much liquidity.
Interest Rate Risk
Both liability and asset maturities of finance companies are
short or intermediate term. Therefore, they are not as
susceptible to increasing interest rates as savings institutions
are.
Credit Risk
Credit risk is a major concern because the majority of funds
are allocated as loans to consumers and businesses.
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 Multinational Finance Companies

 Some finance companies are large multinational

corporations with subsidiaries in several countries.
 For example, GE money provides consumer finance
services in 55 countries and serves more than 130
million customers around the world.

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 SUMMARY

 Finance companies are classified by type. A consumer finance

company provides financing for customers of retail stores or
wholesalers, while a business finance company offers loans to
small businesses. A captive finance subsidiary (CFS) is a
wholly owned subsidiary whose primary purpose is to finance
sales of the parent company’s products and services, provide
wholesale financing to distributors of the parent company’s
products, and purchase receivables of the parent company.
 The main sources of finance company funds are loans from
banks, sales of commercial paper, bonds, and capital. The main
uses of finance company funds are consumer loans, business
loans, leasing, and real estate loans.

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 SUMMARY (Cont.)

 Finance companies are exposed to credit risk as a result of

their consumer loans, business loans, and real estate loans.
They are also exposed to liquidity risk because their assets are
not very marketable in the secondary market. They may also
be exposed to interest rate risk.
 Finance companies are valued as the present value of their
expected cash flows. Their valuation is highly dependent on
economic conditions because there are more requests for loans
by qualified borrowers when economic conditions are
favorable. In addition, the amount of loan defaults is normally
lower when the economy is strong.

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 SUMMARY (Cont.)

 Finance companies compete with depository institutions (such

as commercial banks, savings institutions, and credit unions)
that provide loans to consumers and businesses. Many finance
companies have insurance subsidiaries that compete directly
with other insurance subsidiaries.

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