The Financial Environment | The Capital Allocation Process

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The Financial Environment | The Capital Allocation Process

The Financial Environment

The financial environment consists of financial markets, financial intermediaries, and savings surplus, and savings deficit units. Savings surplus units could be business organizations or individuals, whose savings exceed their investment in real assets and thus own the financial assets with an available surplus. On the other hand, savings deficit units are the individuals and business organizations whose savings are less than their investment in real assets. They incur financial liabilities to meet the deficiency in savings. A financial manager has to work in a complex financial environment because the savings and investment functions in any economy are performed by these different economic units.

The Financial Environment | The Capital Allocation Process

The transfer of funds from savings surplus units to savings deficit units takes place in the financial markets. In other words, financial markets are comprised of all trades that result in the creation of financial assets and financial liabilities. On the other hand, financial intermediaries bring together, through transactions in the financial markets, the savings surplus units, and savings deficit units to facilitate the redistribution of savings into the most productive uses. The financial intermediaries are the specialized business organizations whose activities include the creation of financial assets and financial liabilities. All these components of the financial environment are dealt with in the following sections in detail.

The Capital Allocation Process

Individuals, business organizations, and governments frequently need funds to finance different activities. For example, suppose you need Rs 5 million to build a new house. You have Rs 3 million in your personal savings generated over the years. Where will you get the additional Rs 2 million to finance your new house? Similarly, banks and financial institutions in Nepal are required to increase their paid-up capital by fiscal year-end 2073/2074 B.S. They can satisfy some portion of the required capital increment through retained earnings. Where will they get the rest of the additional capital? Finally, the government also needs funds to finance the general administrative and developmental activities. It can satisfy these financing needs through tax revenues to some extent. Where will the government get extra funds? Note that, in all these examples, individuals, business organizations, and government must rely on financial markets to raise required funds.

On the other hand, some individuals and business organizations may have incomes in excess of their expenditures. For example, suppose you earn Rs 100,000 monthly, Your expenses for food, clothes, shelter, children’s education, and for other purposes come around only Rs 70,000 per month. So, you have an excess of Rs 30,000 in monthly income over your monthly expenditure. What. will you do with this excess monthly income? Similarly, a business organization might have surplus cash in any year. What will it do with the surplus cash until it is needed for reinvestment in the business? In these examples, the individuals and business organizations with surplus cash also need financial markets for savings and investments.

Thus, in a financial market, individuals and business organizations with surplus funds invest for a rate of return. On the other hand, individuals and business organizations with deficit funds demand and use the surpluses generated by others and pay a cost, in terms of interest, for it. In a well-functioning financial system, savings generated by surplus units are transferred to the deficit units for investment. Financial markets and institutions facilitate bringing together savers and users of funds. They accept savings from different individuals and institutional savers. In turn, they make loans and investments to the businesses, corporate sectors. and governments who demand funds. The figure shows how transfers of funds take place between savers and those who need capital.

The Financial Environment | The Capital Allocation Process

Direct transfers

As shown in Figure, direct transfer of funds takes place when a business firm sells its securities directly to the savers. In turn, the savers provide their surplus funds by investing in the securities offered by businesses.

Indirect transfers through investment bankers

Funds also transfer from savers to users through investment bankers. Investment bankers are specialized institutions whose primary job is selling securities issued by businesses to investing public. If the issue of securities has to cover the huge mass of investors scattered across wide geographical areas, direct transfers are not possible. In this case, the issuing firm has to employ the service of investment bankers. The investment bankers generally work in two conditions: first, on the basis of best effort selling, and second, on the basis of the underwriting agreement. They try their best to sell entire securities on behalf of issuing firm when they work on best effort selling. In this case, they simply work as the distributors of securities on a commission basis. They do not take any responsibility if the entire issue could not be sold off. Alternatively, they also work as the underwriter. As an underwriter, they guarantee the sale of entire issues. If the entire issue could not be sold off, they assume otherwise may occur to the issuer. When worked as investment bankers purchase an entire lot of securities from the issuer and then sells them to the investing public at the best possible time and at the right price. 

Indirect transfers through a financial intermediary

Funds are supplied from the surplus units to the deficit units also through financial intermediaries such as banks, insurance companies, and mutual funds. The surplus units deposit their funds or make other kinds of investments to these financial intermediaries. In turn, the financial intermediaries provide funds to the users in the form of loans. Primarily, financial intermediaries raise funds from savers by selling their own securities and provide funds to business organizations by purchasing the securities issued by the businesses. If businesses sell their securities to a small group of investors, normally to financial intermediaries, it is called a private placement. A private placement is the way of financing that directly occurs between financial intermediaries and businesses demanding funds. Besides, financial intermediaries also provide funds to government and businesses by investing in stocks, bonds, and other financial instruments in the financial markets.

Savers could invest directly in securities issued by the government or corporations through public offerings. However, financial intermediaries are important in this process for two reasons. First, they gather and process required information more efficiently and are able to provide a better risk-return combination than individual lenders and savers could do. Thus, amateur investors could take the help of financial intermediaries to form their efficient portfolio of investment. Second, the financial intermediaries, such as commercial banks, also provide credit to the individual investors to participate in public offerings.

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