THE CAPITAL ALLOCATION PROCESS

Businesses, individuals, and governments often need to raise capital. For example,
Carolina Power & Light (CP&L) forecasts an increase in the demand for electricity
in North and South Carolina, so it will build a new power plant to meet those
needs. Because CP&L’s bank account does not contain the $1 billion necessary to
pay for the plant, the company must raise this capital in the financial markets.
Similarly, Mr. Fong, the proprietor of a San Francisco hardware store, wants to
expand into appliances. Where will he get the money to buy the initial inventory
of TV sets, washers, and freezers? Or suppose the Johnson family wants to buy a
home that costs $200,000, but they have only $50,000 in savings. Where will they
get the additional $150,000? The city of New York needs $200 million to build a
new sewer plant. Where can it obtain this money? Finally, the federal government
needs more money than it receives from taxes. Where will the extra money come
from?
On the other hand, some individuals and firms have incomes that exceed their
current expenditures, in which case they have funds available to invest. For
example, Carol Hawk has an income of $36,000, but her expenses are only $30,000.
That leaves her with $6,000 to invest. Similarly, Microsoft has accumulated
roughly $23.5 billion of cash. What can Microsoft do with this money until it is
needed in the business?
People and organizations with surplus funds are saving today in order to
accumulate funds for some future use. Members of a household might save to pay
for their children’s education and the parents’ retirement, while a business might
save to fund future investments. Those with surplus funds expect to earn a return
on their investments, while people and organizations that need capital understand
that they must pay interest to those who provide that capital.
In a well-functioning economy, capital flows efficiently from those with surplus
capital to those who need it. This transfer can take place in the three ways
described in Figure 2-1.
1. Direct transfers of money and securities, as shown in the top section, occur
when a business sells its stocks or bonds directly to savers, without going
through any type of financial institution. The business delivers its securities
to savers, who, in turn, give the firm the money it needs. This procedure is
used mainly by small firms, and relatively little capital is raised by direct
transfers.
2. As shown in the middle section, transfers may also go through an investment
bank (iBank) such as Citigroup, which underwrites the issue. An underwriter
serves as a middleman and facilitates the issuance of securities. The company
sells its stocks or bonds to the investment bank, which then sells these same
securities to savers. The businesses’ securities and the savers’ money merely
“pass through” the investment bank. However, because the investment bank
buys and holds the securities for a period of time, it is taking a risk—it may
not be able to resell the securities to savers for as much as it paid. Because new
securities are involved and the corporation receives the proceeds of the sale,
this transaction is called a primary market transaction.
3. Transfers can also be made through a financial intermediary such as a bank, an
insurance company, or a mutual fund. Here the intermediary obtains funds
from savers in exchange for its securities. The intermediary uses this money to
buy and hold businesses’ securities, while the savers hold the intermediary’s
securities. For example, a saver deposits dollars in a bank, receiving a certificate
of deposit; then the bank lends the money to a business in the form of a
mortgage loan. Thus, intermediaries literally create new forms of capital—in
this case, certificates of deposit, which are safer and more liquid than mortgages
and thus are better for most savers to hold. The existence of intermediaries
greatly increases the efficiency of money and capital markets.
Often the entity needing capital is a business (and specifically a corporation); but it
is easy to visualize the demander of capital being a home purchaser, a small
business, or a government unit. For example, if your uncle lends you money to
help you fund a new business, a direct transfer of funds will occur. Alternatively,
if you borrow money to purchase a home, you will probably raise the funds
through a financial intermediary such as your local commercial bank or mortgage
banker. That banker could sell your mortgage to an investment bank, which then
might use it as collateral for a bond that is bought by a pension fund.
In a global context, economic development is highly correlated with the level
and efficiency of financial markets and institutions.1 It is difficult, if not impossible,
for an economy to reach its full potential if it doesn’t have access to a wellfunctioning
financial system. In a well-developed economy like that of the United
States, an extensive set of markets and institutions has evolved over time to
facilitate the efficient allocation of capital. To raise capital efficiently, managers
must understand how these markets and institutions work; and individuals need
to know how the markets and institutions work to get high rates of returns on
their savings.