Module 6.2

Question 1

Types of Finance Companies (1 of 2)

Answer 1

Consumer Finance Companies  Provide financing for customers of retail stores or wholesalers.  Provide personal loans directly to individuals to finance purchases of large household items.  Provide mortgage loans. Business Finance Companies  Offer loans to small businesses.  Provide financing in the form of credit cards that are used by a business’s employees for travel or for making purchases on behalf of the business.

Question 2

Captive Finance Subsidiaries

Answer 2

A wholly owned subsidiary whose primary purpose is to finance sales of the parent company’s products and services, provide wholesale financing to distributors of the parent company’s products, and purchase receivables of the parent company.

Question 3

Advantages of Captive Finance Subsidiaries

Answer 3

Can be used to finance distributor or dealer inventories until a sale occurs, making production less cyclical for manufacturers.  Can serve as an effective marketing tool by providing retail financing; it can also be used to finance products leased to others.  Allows a corporation to clearly separate its manufacturing and retailing activities from its financing activities.

Question 4

Sources of Funds

Answer 4

Loans from Banks Finance companies borrow from commercial banks and can renew the loans over time.  Commercial Paper Finance companies continually roll over their issues to create a permanent source of funds.  Deposits Some states allow finance companies to attract funds by offering customer deposits.  Bonds Finance companies in need of long term funds can issue bonds.  Capital Finance companies can build their capital base by retaining earnings or by issuing stock.

Question 5

Uses of Finance Company Funds

Answer 5

Consumer Loans Finance companies extend consumer loans in the form of personal loans.  Business Loans and Leasing In addition to consumer loans, finance companies also provide business (commercial) loans.  Real Estate Loans Finance companies offer real estate loans in the form of mortgages on commercial real estate and second mortgages on residential real estate.  Summary of Uses of Funds The uses of funds depends on whether the finance company is focused on business or consumer lending. (Exhibit 22.1)

Question 6

How Finance Companies Finance
Economic Growth

Answer 6

Question 7

Interaction with Other Financial Institutions

Answer 7

When finance companies obtain or use funds, they
interact with other financial institutions. (Exhibit 22.2)

Finance companies compete with commercial banks,
savings institutions, and credit unions.

Finance companies utilize various financial markets to
manage their operations. (Exhibit 22.3)

Question 8

Interaction between Finance Companies
and Other Financial Institutions

Answer 8

Question 9

Participation of Finance Companies in
Financial Markets

Answer 9

Question 10

Valuation of a Finance Company (1 of 3)

Answer 10

Factors That Affect Cash Flows

Economic Growth

Can enhance a finance company’s cash flows by increasing
household demand for consumer loans, thereby allowing the
finance company to provide more loans.

Change in the Risk Free Interest Rates

Cash flows may be inversely related to interest rate
movements.

Finance companies rely heavily on short term funds

Question 11

Factors that Affect Cash Flows

Answer 11

Change in Industry Conditions
Conditions include regulatory constraints, technology, and
competition within the industry.

Change in Management Abilities
Managers attempt to make internal decisions that will
capitalize on external forces (economic growth, interest
rates, regulatory constraints).

Question 12

Factors That Affect the Required Rate of Return

Answer 12

The risk free rate is positively related to inflation,
economic growth, and the budget deficit level, but
inversely related to money supply growth (assuming it
does not cause inflation). (Exhibit 22.4)

The risk premium is inversely related to economic growth
and the company’s management skill.

Question 13

Framework for Valuing a Finance
Company

Answer 13

Question 14

Exposure of Finance Companies to Risk

Answer 14

Liquidity Risk
Finance companies generally do not hold assets that could
be easily sold in the secondary market. However, their
balance sheet structure does not call for much liquidity.
Interest Rate Risk
Both liability and asset maturities of finance companies are
short or intermediate term. Therefore, they are not as
susceptible to increasing interest rates as savings institutions
are.
Credit Risk
Credit risk is a major concern because the majority of funds
are allocated as loans to consumers and businesses.

Question 15

Multinational Finance Companies

Answer 15

Some finance companies are large multinational
corporations with subsidiaries in several
countries.
■
For example, GM Financial provides consumer
finance services in auto loan services in 20
countries in North America, Latin America,
Europe, and Asia.

Question 16

SUMMARY (1 of 2)

Answer 16

Finance companies are classified by type. A consumer
finance company provides financing for customers of
retail stores or wholesalers, while a business finance
company offers loans to small businesses. A captive
finance subsidiary (CFS) is a wholly owned subsidiary
whose primary purpose is to finance sales of the parent
company’s products and services, provide wholesale
financing to distributors of the parent company’s
products, and purchase receivables of the parent
company.

The main sources of finance company funds are loans
from banks, sales of commercial paper, bonds, and
capital. The main uses of finance company funds are
consumer loans, business loans, leasing, and real estate
loans.

Question 17

SUMMARY (2 of 2)

Answer 17

Finance companies compete with depository institutions
(such as commercial banks, savings institutions, and
credit unions) that provide loans to consumers and
businesses. Many finance companies have insurance
subsidiaries that compete directly with other insurance
subsidiaries.

Finance companies are exposed to credit risk as a result
of their consumer loans, business loans, and real estate
loans. They are also exposed to liquidity risk because
their assets are not very marketable in the secondary
market. They may also be exposed to interest rate risk.