Chapter 22
Finance Company Operations
Outline
Types of Finance Companies
Consumer Finance Companies
Business Finance Companies
Captive Finance Companies
Regulation of Finance Companies
Sources and Uses of Finance Company Funds
Sources of Finance Company Funds
Uses of Finance Company Funds
Interaction with Other Financial Institutions
Participation in Financial Markets
Valuation of a Finance Company
Factors That Affect Cash Flows
Factors That Affect the Required Rate of Return
Exposure of Finance Companies to Risk
Liquidity Risk
Interest Rate Risk
Credit Risk
Multinational Finance Companies
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Key Concepts
1. Describe the types of finance companies.
2. Describe the finance company’s sources and uses of funds.
3. Discuss the participation of finance companies in financial markets.
POINT/COUNTER-POINT:
Will Finance Companies be Replaced by Banks?
WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue
and then formulate your own opinion.
ANSWER: Finance companies tend to provide credit to borrowers that exhibit higher risk. They can
Questions
1. Exposure to Interest Rate Risk. Is the cost of funds obtained by finance companies very sensitive to
market interest rate movements? Explain.
2. Issuance of Commercial Paper. How are small and medium-sized finance companies able to issue
commercial paper? Why do some well-known finance companies directly place their commercial
paper?
3. Finance Company Affiliations. Explain why some finance companies are associated with
automobile manufacturers. Why do some of these finance companies offer below-market rates on
loans?
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4. Uses of Funds. Describe the major uses of funds by finance companies.
5. Credit Card Services. Explain how finance companies benefit from offering consumers a credit
card.
6. Leasing Services. Explain how finance companies provide financing through leasing.
7. Regulation of Finance Companies. Describe the kinds of regulations that are imposed on finance
companies.
8. Liquidity Position. Explain how the liquidity position of finance companies differs from that of
depository institutions such as commercial banks.
9. Exposure to Interest Rate Risk. Explain how the interest rate risk of finance companies differs from
that of savings institutions.
10. Exposure to Credit Risk. Explain how the credit risk of finance companies differs from that of other
lending financial institutions.
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CRITICAL THINKING QUESTION
The Future of Finance Company Operations Write a short essay on the future of finance company
operations? Should they be merged into the banking industry, or should they remain distinctly different
from commercial banks?
ANSWER
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “During a credit crunch, finance companies tend to generate a large amount of business.”
b. “Some finance companies took a huge hit as a result of the last recession because they opened
their wallets too wide before the recession occurred.”
c. “During periods of strong economic growth, finance companies generate unusually high returns
without any hint of excessive risk; but their returns are at the mercy of the economy.”
Managing in Financial Markets
As a manager of a finance company, you are attempting to increase the spread between the rate earned on
your assets and the rate paid on your liabilities.
a. Assume that you expect interest rates decline over time. Should you issue bonds or commercial
paper in order to obtain funds?
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b. If you expect interest rates decline, will you benefit more from providing medium-term, fixed-
rate loans to consumers or floating-rate loans to businesses?
c. Why would you still maintain some balance between medium-term, fixed-rate loans and floating-
rate loans to businesses, even if you anticipate that one type of loan will be more profitable under
a cycle of declining interest rates?
Flow of Funds Exercise
How Finance Companies Facilitate the Flow of Funds
Carson Company has sometimes relied on debt financing from Fente Finance Company. Fente has been
willing to lend money even when most commercial banks were not. Fente obtains funding from issuing
commercial paper and focuses mostly on channeling the funds to borrowers.
a. Explain how finance companies are unique by comparing Fente’s net interest income, noninterest
income, noninterest expenses, and loan losses to those of commercial banks.
Fente’s net interest income is higher than that of banks because it provides riskier loans and can
b. Explain why Fente performs better than commercial banks in some periods.
Fente performs better than banks in some periods when the economy is strong, because its loan
c. Describe the flow of funds channeled through finance companies to firms such as Carson
Company. What is the original source of the money that is channeled to firms or households that
borrow from finance companies?
