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8.5 The Bigger Picture

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Explain how financial markets and institutions fit into financial decision making.
  2. Discuss ethical implications of financial institutions and markets.

All companies need access to capital: growing companies need to purchase assets to expand, distressed companies need to maintain liquidity while “righting the ship”, and established companies may need to fund existing projects. Financial institutions and markets provide this access. During financial crises, when aquiring more capital can be more costly or difficult, companies may have to scale back on new projects. Good relationships with financial institutions need to be maintained if a company wants to be certain of having the necessary cash without paying an exhorbitant cost.

Managers must be able to “think like an investor” when necessary, as these stakeholders are able to choke off access to capital if they are unhappy. Additionally, financial managers need to pay attention to what is happening in the markets, as during a financial crisis might not be the best time to embark on a large expansion project. In upcoming chapters, we will examine how investors value the financial assets that companies issue to raise cash, and also consider how we factor in this valuation to enable us to make capital budgeting decisions.

Ethical Considerations

Unfortuantely, some managers view meeting the bare minimum the regulations require as sufficient for fulfilling the obligations to investors. A few even go so far as trying to mislead investors with the information presented when applying for loans, issuing stock or bonds, and the like.

On the other side of the coin, financial institutions have much influence over companies’ actions because of their control of capital access. In recent years, financial institutions have been criticized for taking on extra risk with the intention of increasing profits. This extra risk might result in increased capital access: for example, issuing mortgages or business loans to higher risk individuals. This added risk might be one of the factors leading to more extreme financial crises in recent years.

Though markets are made up of hopefully ethical individuals, there is no guarantee that aggregate results will reflect a concrete opinion of management’s actions. Often, managers will justify an unethical course of action by the market’s positive response; in reality, the market participants could be reacting to any number of pieces of information, such as expected return, risk, or a number of other factors. This is especially true when material information has not yet been made public. In such situations, management must do what is right for the stakeholders using their own judgment, since they might be the only ones with the relevant knowledge.

Key Takeaways

  • Management needs to be able to “think like an investor”.
  • Keeping the markets happy is important, but not if it means misleading statements or unethical behavior.

Exercise

  1. A bank manager is considering relaxing certain restrictions on the types of mortgages that the bank can issue. By lowering standards, 50 more families will qualify for mortgages to purchase their first homes. Since these mortgages will come with a higher interest rate attached, bank profits will be affected positively if the mortgages are repaid, but if the mortgages aren’t repaid, then the bank’s finances will be in trouble. What are some ethical considerations the manager should include in making this decision?