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CHAPTER 23 Consumer Finance Operations. Chapter Objectives n Identify the main sources and uses of finance company funds n Describe the risk exposure.

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Presentation on theme: "CHAPTER 23 Consumer Finance Operations. Chapter Objectives n Identify the main sources and uses of finance company funds n Describe the risk exposure."— Presentation transcript:

1 CHAPTER 23 Consumer Finance Operations

2 Chapter Objectives n Identify the main sources and uses of finance company funds n Describe the risk exposure of finance companies n Explain how finance companies interact with other financial institutions

3 Types of Finance Companies Finance Companies Consumer Sales Commercial

4 Types of Finance Companies n Consumer finance companies make direct loans to consumers n Sales finance companies concentrate on purchasing credit contracts from retailers n Commercial finance companies provide loans to medium and higher risk companies n Captive finance companies, subsidiaries of manufacturers, lend to support sales of their parent company and other areas

5 Sources of Finance Company Financing Bank Loans Commercial Paper Deposits and Capital Market Financing Capital

6 Sources of Finance Company Funds n Finance companies use bank loans as a source of funds and consistently renew the loans over time n Commercial paper l A short-term money market source but finance companies roll over their issues to create a permanent source of funds l Secured commercial paper allows smaller and medium-sized firms access to the market l Well-known firms use direct placement

7 Sources of Finance Company Funds n Some states allow finance companies to accept customer deposits n Bonds are used as a long-term source of funds and the use of this source depends on l Expectations about future interest rates l The balance sheet structure l May be subordinated to bank loans n Capital comes from retained earnings or issuing stock and serves as a base for leveraging

8 Exhibit 23.2 Finance Company Lending Areas Business Loans $335.1 Billion 33% Consumer Loans $254.9 Billion 25% Real Estate Loans $98.5 Billion 10% Other $313.7 Billion 31%

9 Uses of Finance Company Funds n Finance companies make many kinds of consumer loans in the form of personal loans l Auto loans/leases offered by a finance company owned by the manufacturer: direct or sales financed l Home improvement (second mortgage), mobile home and other kinds of personal loans: direct or sales financed l Credit cards which can be used at a variety of retail stores u Company logo cards operated by finance company

10 Uses of Finance Company Funds n Credit card loans in which a retailer sells a credit contract to a finance company l Customers make payments to the finance company l Support “Ninety-days Same As Cash” loans l Gives the finance company access to new customers

11 Uses of Finance Company Funds n Business loans and leasing are used to finance the cash cycle of companies l Cash cycle is the amount of time it takes between when inventory is purchased, the product is sold and customers pay l This financing is often backed by accounts receivable or inventory n Leveraged buy-out loans n Factoring of accounts receivable

12 Uses of Finance Company Funds n Leasing l Finance company purchases equipment l Leases it to businesses n Real estate loans l Mortgages on commercial real estate l Second mortgages on residential real estate

13 Regulation of Finance Companies n Federal regulations apply if finance companies are acting as bank holding companies or are subsidiaries of bank holding companies n State regulations apply otherwise n Subject to interest rate ceilings and a maximum term or amount for the loan in some states

14 Risks Faced by Finance Companies n Liquidity risk l Finance companies do not hold assets that can be easily sold in the secondary market u May securitize loans u Depend on liability liquidity l Maintaining access to money and capital market is the primary liquidity management focus l Balance sheet structure does not call for much liquidity because of little deposit outflow

15 Risks Faced by Finance Companies n Interest rate risk is less for depository institutions because the maturity of assets and liabilities may be matched closely n Assets are typically not as rate sensitive as liabilities n Can use adjustable rates and shorter maturities on their loans to manage risk n Derivative contracts are used to manage interest rate risk

16 Risks Faced by Finance Companies n Credit risk l The major risk faced by finance companies l Loan delinquency rates are typically higher than for other kinds of institutions l Charge a higher interest rate to compensate for the risk l High return, high risk nature of loans makes performance sensitive to prevailing economic conditions

17 Captive Finance Subsidiaries n Captive finance subsidiaries (CFS) have several characteristics l They are a wholly owned subsidiary with the primary purpose to finance sales of the parent company’s products and services l Provide financing to distributors of the parent company’s products l Purchase receivables of the parent company l May diversify into other lending/leasing operations

18 Captive Finance Subsidiaries n Motives for creating a captive finance subsidiary shown by the example from the auto industry l Can finance distributor and dealer inventories l Makes production less cyclical for manufacturer l An effective tool in retail marketing n Growth in the industry occurred between 1946 and 1960 l More liberalized credit policies l The need to finance growing inventories

19 Captive Finance Subsidiaries n Advantages of captive finance subsidiaries l Corporations can separate manufacturing and retailing from financing l Makes it easier and less expensive to analyze each segment of the parent l Captive establishes credit rating separate from parent n Comparison with other financial institutions l No reserve requirement l No restrictions on how to obtain funds l Competitive advantage in retail sales

20 Valuation of a Finance Company n Value of a savings institution depends on its expected cash flows and required rate of return  V = f [  E(CF),  k]  V = Change in value of the institution  k = Change in required rate or return Where:  E(CF) = Change in expected cash flows +

21 Valuation of a Finance Company n Factors that affect cash flows E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions Where:  E(CF)= f (  ECON,  R f,  INDUS,  MANAB) ECON = Economic growth MANAB = The ability of the institution’s management ++

22 Valuation of a Finance Company n Economic growth l Positive affect because it enhances household demand for consumer goods l Economic growth reduces defaults n Change in the risk-free rates l Cash flows inversely related to interest rate movement l Short term sources of funds means their rates change as do those of other interest rates

23 Valuation of a Finance Company n Change in industry conditions which include regulatory constraints, technology and competition n Change in management abilities

24 Valuation of a Savings Institution n Investors required rate of return  k = f(  R f,  RP) ++ R f = Risk free interest rate Where: RP = Risk premium

25 Interaction with Other Financial Institutions n Interact in various ways with other financial institutions n Concentration in commercial lending means they are closely related to commercial banks, savings institutions and credit unions n Compete with savings institutions and increase market share when their competitors have problems

26 Participation in Financial Markets n Participate in a wide range of financial markets l Money markets l Bond markets l Mortgage markets l Stock markets l Futures markets l Options markets l Swap markets

27 Multinational Finance Companies n Large multinational companies with subsidiaries in many countries n Reasons why finance companies go global l Enter new markets l Reduce exposure to the U.S. economy

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