Chapter 22
Finance Company Operations
Outline
Types of Finance Companies
Sources and Uses of Finance Company Funds
Valuation of a Finance Company
Factors That Affect Cash Flows
Factors That Affect the Required Rate of Return
Exposure of Finance Companies to Risk
Multinational Finance Companies
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Key Concepts
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?
POINT: Yes. Commercial banks specialize in loans and can provide the services that are provided by
finance companies. The two types of financial institutions will ultimately merge into a single category.
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.
ANSWER: The interest expenses on short-term funds obtained by issuing commercial paper and
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?
ANSWER: They can issue secured commercial paper, so that the debt is backed by assets. Even
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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ANSWER: Some finance companies specialize in providing financing for customers of automobile
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.
ANSWER: Finance companies finance the purchase by the consumer, charging an interest rate that
6. Leasing Services. Explain how finance companies provide financing through leasing.
ANSWER: Finance companies purchase machinery or equipment for the purpose of leasing it to
7. Regulation of Finance Companies. Describe the kinds of regulations that are imposed on finance
companies.
ANSWER: Finance companies that act as or are owned by bank holding companies are federally
8. Liquidity Position. Explain how the liquidity position of finance companies differs from that of
depository institutions such as commercial banks.
ANSWER: Reliance on deposits by depository institutions can cause liquidity problems, because the
9. Exposure to Interest Rate Risk. Explain how the interest rate risk of finance companies differs from
that of savings institutions.
ANSWER: Since finance company assets and liabilities share somewhat similar interest rate-
10. Exposure to Credit Risk. Explain how the credit risk of finance companies differs from that of other
lending financial institutions.
ANSWER: Finance companies focus on consumer loans and on commercial loans that have moderate
risk. Their concentrated loan portfolio exposes them to a relatively high degree of credit risk.
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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 finance companies be merged into the banking industry, or should they remain
distinctly different from commercial banks?
ANSWER
Finance companies are distinguished from commercial banks in that they specialize in providing
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.”
When commercial banks cut back on the amount of loans that they provide, some potential
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.”
Some finance companies were too liberal in providing loans; a high percentage of the borrowers
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.”
When the economy is strong, the default rate on loans by finance companies is low. Given the
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 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?
The medium-term loans may be more desirable, because the rate will stay fixed even if interest
rates decline.
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?
There may not be sufficient demand for consumer loans to simply focus on consumer loans. Also,
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 by 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?
The original source of money is buyers of commercial paper that is issued by finance companies.
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