Corporate Finance I - Financial Markets and the Corporation

Financial markets play a crucial role in connecting corporations with investors and facilitating the flow of funds between those who have excess capital and those who need it for various purposes. Understanding how financial markets work and how they interact with corporations is essential for effective capital allocation and financial decision-making.

Cash Flows to and from the Firm

Financial markets enable corporations to raise capital through the issuance of various financial instruments. These instruments represent claims on the company's future cash flows. There are two main types of cash flows to and from the firm in the context of financial markets:

Cash Inflows (Financing Activities): Corporations raise capital by issuing financial instruments such as stocks and bonds. Investors purchase these instruments, providing the company with the necessary funds. The cash raised can be used for various purposes, including funding expansion projects, research and development, and working capital needs.

Cash Outflows (Investing Activities): Once a corporation has raised funds from investors, it undertakes various investment activities aimed at generating future cash flows. These activities can include capital expenditures, acquisitions, research initiatives, and other investments that contribute to the company's growth and profitability.

Primary versus Secondary Markets

Financial markets are divided into primary and secondary markets, each serving distinct functions in the interaction between corporations and investors.

Primary Markets: In the primary market, new securities (stocks, bonds, etc.) are issued by corporations and sold to investors for the first time. This is where corporations raise initial capital to fund their operations or projects. The primary market involves the company working with investment banks to underwrite and facilitate the issuance of these securities.

Secondary Markets: The secondary market, also known as the stock market or securities exchange, is where previously issued securities are bought and sold between investors without direct involvement from the issuing corporation. Secondary markets provide liquidity to investors, allowing them to buy or sell securities they already own. The price of securities in the secondary market reflects supply and demand dynamics and can impact the company's perceived value.

Example: Imagine a technology company called TechCo that wants to raise funds to develop a new product. TechCo decides to issue new shares of stock to the public. In the primary market, investment banks help TechCo determine the price of the shares and facilitate the sale of these shares to individual and institutional investors. The cash raised from the sale of these shares will be used to fund the development of the new product.

Once the shares are publicly traded, they can be bought and sold by investors on a stock exchange in the secondary market. If the company performs well and investors expect strong future cash flows, the demand for TechCo's shares in the secondary market might increase, causing the share price to rise. Conversely, poor performance or negative news might lead to a decrease in share price.

Hence, financial markets enable corporations to raise capital and invest in growth opportunities, with cash flows originating from financing activities (issuing securities) and being utilized in investing activities (capital expenditures, acquisitions, etc.). The primary market facilitates the initial issuance of securities, while the secondary market provides liquidity for trading existing securities. Understanding these dynamics is crucial for corporations and investors alike.