Corporate Finance For Dummies. Michael Taillard

of stock to raise money for the company to become a corporation.

      Funds

      During the early days of the Christian church and then again in the United States in the 1960s, groups often pooled all their assets together and allowed them to be managed for the good of the group. Funds are basically the free-market-investor version of this collective idea. Individuals pool their money together in a fund, that money is managed as a single investment portfolio, and the individuals who contributed to that portfolio (the fund) receive returns on their investments proportional to their ownership in the returns generated by the entire portfolio.

      

The point of pooling assets is to make professional investments and investing strategies available to people who otherwise wouldn’t have the resources on their own to pursue such investments. Funds are popular options for corporations to provide for the retirement funds of their employees, but corporations themselves also frequently trust their investment management to a fund. Generally speaking, each fund has its own investing strategy, so investors choosing between funds must pick one that has a strategy they believe will most benefit them.

Funds come in two types — hedge funds and mutual funds — and although they both have the same fundamental principles, each type has some unique traits, processes, regulations, and variations. Table 2-1 gives you a quick look at the main differences.

TABLE 2-1 Differences between Hedge Funds and Mutual Funds

	Hedge Funds	Mutual Funds
Strategy	Managers have more freedom in their use of investment tools and an ability to change strategy as they see fit.	Managers must adhere strictly to the strategy described when the fund was established and must choose from a rather limited range of investment types.
Fees	Hedge funds typically charge a fee based on the performance of the fund; the better the fund performs in the market, the more the investors pay in fees.	Mutual funds are highly regulated in terms of the amount they can charge in fees and the types of fees they can charge. (For instance, 12b-1 fees are those related to the administrative functions of the fund and are capped by the Securities and Exchange Commission.)
Shares	Hedge funds pool the assets of the investors collectively and invest them.	Mutual funds sell shares of a pool, which is either indefinite, meaning that there are no restrictions on the number of shares issued and that the fund buys back shares as they are sold by investors, or traded like stocks, depending on whether the mutual fund is open-end or closed-end, respectively.

      Financing institutions

      Financing institutions are kind of like banks in that they lend money, but they’re a bit different, too. First of all, they tend to give different types of loans than banks do. Secondly, they get their funding by borrowing it themselves instead of through deposits. They earn a profit by charging you higher interest rates than they’re paying on their own loans.

      Sales financing institutions

      If you’ve been to a car dealership, furniture store, jewelry store, or some other retailer that deals in expensive merchandise, odds are you’ve been offered a loan that you can use to purchase an item immediately and then pay off the loan in installments. The store itself isn’t offering you the loan; a type of financing institution called a sales financing institution works with the store to give you the loan. Sales financing institutions work with both individuals and companies making large purchases.

      Personal credit institutions

      Personal credit institutions are companies that offer small personal loans and credit cards to individuals. Because they don’t have much to do with corporate finance — unless the personal credit institution itself is a corporation or you’re using your personal line of credit to invest in a corporation (in which case, as long as your returns exceed the interest you’re paying, then good for you) — I don’t cover this topic in detail here or elsewhere in this book.

      Business credit institutions

      Did you know that corporations can get credit cards and credit loans just as you can? Well, they can, and those credit loans come from a type of financing institution called a business credit institution. Business credit loans differ from standard business loans in that they’re a running line of credit in the same way that your credit card is a running line of credit. These loans can be freely increased or gradually paid off within certain limits as long as the corporation makes periodic minimum payments on the balance.

      

A special type of business credit institution, called a captive financing company, is a company that’s owned by another organization and that handles the financing and credit only for that organization rather than for any applicants. For example, GMAC, the financing arm of General Motors, which changed its name to Ally Bank, is the captive credit financing company for the corporation General Motors.

      Loan sharks and subprime lenders

      All the lending I talk about in this chapter has been at the prime rate, which is the interest rate charged to customers who are considered to be of little or no risk of defaulting. In the United States, the prime rate is about 3 percent above the interest rate that banks charge each other, called the federal funds rate. (Some nations use LIBOR, which is the London Interbank Offered Rate.) For those corporations and people who are considered higher risk, they will often qualify for only loans considered subprime, which are offered at interest rates higher than the prime rate.

      

Another form of high-interest loan is called the payday loan. The payday loan basically makes loan sharks legal (organizations that offer loans at rates above the legal level and who often have heavy-handed tactics). The payday loan gives you money for a short period, usually only one to two weeks, and charges several hundred percent in annual percentage rate, in addition to fees and penalties. Rather than breaking your knees, as the stereotype suggests, these lenders simply annihilate your credit score and financial well-being. As a result, many states have outlawed these lenders.

      For a period between the 1980s and 1990s, subprime mortgage lenders were also very common. In fact, they contributed to the 2007 financial collapse, when many commercial banks were venturing into the subprime market with little or inappropriate risk management. Bottom line: Avoid loan sharks and subprime lenders at all costs, or they’ll ruin your finances and the greater economy at large.

      Exchanges

      Exchanges such as the NASDAQ, NYSE, Nikkei, and others are globally renowned for being open forums for ferocious trading. In both stock and commodities exchanges, the most recognized space is called the pit, or trading floor, and it’s where large