Module 8: Loanable Funds

How do you Obtain Funds?

• If you are profitable, reinvest the profits back into your firm

• Take on a partner

• Borrow from a bank, government or friends/family

What are the Sources of Borrowing/

• Indirect Finance

• Direct Finance

What is Indirect Finance?

A flow of funds from savers to borrowers through financial intermediaries such as banks

What is Direct Finance?

A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange (stocks and bonds)

What is the Financial System?

The system of financial markets and financial intermediaries through which firms acquire funds from households

What are Financial Markets?

Markets where financial securities, such as stocks and bonds, are bought and sold

What are Financial Intermediaries?

Firms, such as banks, mutual funds, pension funds, and insurance companies, that borrow funds from savers and lend them to borowers

What is a bond?

A certificate of indebtedness that specifies obligations of the borrower to the holder of the bond

What kind of financing method is the Bond Market?

Direct Finance

What does issuing bonds allow?

Borrowing directly from the public

What does the saver or lender do in the bond market?

Buys a bond

What does the borrower do in the bond market?

Issues a bond

Who is usually the borrower?

Usually governments and corporations

What does it mean to issue a bond?

To create a bond

What is a Coupon payment?

A payment on a bond

What is the Interest Rate for Issuer or the Coupon Rate?

The cost of borrowing funds, usually expressed as a percentage of the amount borrowed

How do you find the coupon rate of a bond?

Coupon Payment / Price of Bond

What are the characteristics for Interest Rate Determination?

• Length of time until the bond matures

• Probability that the borrower will fail to pay some of the interest or principal

What are the important parts of the Bond Market?

• Repayment Time

• Amount of Loan

• Risk of Borrower Default (not paid back on time)

What do Longer Loans mean?

Higher Interest Rates

What does More Expensive Loans mean?

Higher Interest Rates

What does a Good Credit History mean?

Lower Interest Rate

What does it mean the riskier a bond?

The higher the interest rate

What is a Stock?

Represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes

What are Dividends?

Payments by a corporation to its shareholders

What is the sale of stock to raise money called?

Equity Financing

What do stocks offer compared to bonds?

Higher risk and potentially higher returns

What kind of financing method is the stock market?

Direct Finance

What are the most important stock exchanges in the United States?

• New York Stock Exchange

• American Stock Exchange

• NASDAQ

What do the stock and bond markets provide?

Capital and information

What do stock prices indicate?

Confidence in a company’s future

What do bond prices indicate?

The cost of borrowing

What is the correlation between bond prices and interest rates?

Negatively correlated

What are Mutual Funds?

An institution that sells shares to the public and uses the proceeds to buy a portfolio, of a various types of stocks, bonds, or both

What do mutual funds allow for?

Allow people with small amounts of money to easily diversify

What are Banks?

Take deposits from people who want to save and use the deposits to make loans to people who want to borrow

What type of financing method are banks?

Indirect Finance

How do banks take deposits and make loans?

By collecting information

What do banks pay depositors?

Interest on their deposits

What do banks charge borrowers?

Slightly higher interest on their loans

What is GDP?

Both total income in an economy and total expenditure on the economy’s output of goods and services

What is the equation for GDP?

Y = C + I + G + NX

What is a closed economy?

One that does not engage in international trade (NX=0)

What is the equation for a closed economy?

Y = C + I + G

What is National Saving?

The total income in the economy that remains after paying for consumption and government purchases

What is Private Saving?

The amount of income that households have after receiving transfers from the government (TR), after paying taxes (T), and after paying for consumption

What is the equation for Private Saving?

Private Saving = Y + TR - T - C

What is Public Saving?

The amount of tax revenue (T) that the government has left after paying for its spending and its transfers (TR)

What is the Equation for Public Saving?

Public Saving = T - G - TR

What is the Equation for Budget Surplus?

Budget Surplus = T - G - TR

What is Public Saving the same as?

The budget surplus

What is the equation to find G for government purchases?

G = T - TR - Budget Surplus

What does a Budget Surplus mean?

Positive public saving

What does a Budget Deficit Mean?

Negative public saving

What is the equation for Budget Deficit?

Budget Deficit = G + TR - T

What is the equation for National Saving or Saving?

S = Y - C - G

What do financial markets coordinate?

The economy’s saving and investment

What does the Market for Loanable Funds include?

• Supply from savers (public and private)

• Demand from borrowers (majority businesses)

What does the equilibrium of the supply and demand for loanable funds determine?

The real interest rate

What does the Real Interest Rate in the Loanable Funds Market impact?

• Price of loans

• Reward for saving

What are the Supply Shifters for the Loanable Funds Market?

• Government Spending (incr. → shift supply left)

• Expectations of future income and price levels (incr. → shift supply right)

• Income (incr. → shift supply right)

What are the Demand Shifters for the Loanable Funds Market?

• Expectations of future profitability (incr. → shift demand right)

• Productive technology (incr. → shift demand right)

• Business taxes (decr. → shift demand right)

• Cash flow (incr. → shift demand right)

What does an increase in demand do to the loanable funds market?

Increases the equilibrium real interest rate and the equilibrium quantity of loanable funds (saving and investment)

What does an increase in supply do to the loanable funds market?

Decreases the equilibrium real interest rate and increases the equilibrium quantity of loanable funds (saving and investment)

What does the market for Loanable funds predict?

The effects on saving, investment, and interest rates from investment tax credit, crowding out, consumption tax

What is Crowding Out?

A decline in private expenditures as a result of an increase in government purchases via deficits (G > T)

What is the effect of an Investment Tax Credit on the Loanable Fund Market?

• Increases the demand for loanable funds

• Interest rate increases

• S & I increases

What is the effect of a Deficit on the Loanable Fund Market?

• Decreases the supply of loanable funds

• Interest rate increases

• S & I decreases

What is the effect of a Tax on Consumption on the Loanable Fund Market?

• Increases the supply of loanable funds

• Interest rates decrease

• S & I increases

What is the effect of Pessimistic Businesses on the Loanable Fund Market?

• Decreases the demand of loanable funds

• Interest rates decrease

• S & I decreases

What is Present Value?

The amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money

What is preferred according to the present value method?

Receiving a given sum of money in the present is preferred to receiving the same sum in the future

What do you need to do to compare values at different points in time?

Compare their present values

When do firms undertake investment projects?

If the present value of the project exceeds the cost

What is the Present Value formula for one (lump sum) future payment?

Future Value / (1+r)^N

What is the Present Value formula for future payments over time (bond or stock prices)?

PV = FV₁/(1+r)¹ + … + FV_N/(1+r)^N

What is the process of finding a present value of a future sum of money called?

Discounting

What do you do the longer the time or the lower the expected rate of return?

Take the structured payment

What do you do the shorter the time or the higher the expected rate of return?

Take the lump sum now