Ch 1 - 4 Answer Key

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Chapter One Flow of Funds Exercise

Roles of Financial Markets and Institutions

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that require the application of concepts learned within the chapter, as related to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and ten other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

a.In what way is Carson a surplus unit?

Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuer of those securities.

b.In what way is Carson a deficit unit?

Carson has borrowed funds from financial institutions.

c.How might finance companies facilitate Carson’s expansion?

Finance companies can provide loans to Carson so that Carson can expand its operations.

d.How might commercial banks facilitate Carson’s expansion?

Commercial banks can provide loans to Carson so that Carson can expand its operations.

e.Why might Carson have limited access to additional debt financing during its growth phase?

Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to lend more funds to Carson if it has too much debt.

f.How might securities firms facilitate Carson’s expansion?

First, securities firms could advise Carson on its acquisitions. In addition, they could underwrite a stock offering or a bond offering by Carson.

g.How might Carson use the primary market to facilitate its expansion?

It could issue new stock or bonds to obtain funds.

h.How might it use the secondary market?

It could sell its holdings of Treasury securities in the secondary market.

i.If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

It would have been able to obtain loans directly from surplus units. It would have been able to assess potential targets for acquisitions without the advice of investment securities firms. It would be able to engage in a new issuance of stock or bonds without the help of a securities firm.

j.The loans that Carson has obtained from commercial banks stipulate that Carson must receive the banks’ approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?

The purpose is to prevent Carson from using the funds in a manner that would be very risky, as Carson may default on...
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