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Definitions
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Dictionary > Definitions > Economy > Financial Institution
Financial Institution
Definition
In financial economics, a financial institution acts as an agent that provides financial services for its clients or members. Financial institutions generally fall under financial regulation from a government authority. Common types of financial instituti
Description
Financial institutions provide a service as intermediaries of the capital and
debt markets. They are responsible for transferring funds from investors to
companies, in need of those funds. The presence of financial institutions
facilitate the flow of monies through the economy. To do so, savings accounts
are pooled to mitigate the risk brought by individual account holders (see
adverse selection) in order to provide funds for loans. Such is the primary
means for depository institutions to develop revenue. Should the yield curve
become inverse, firms in this arena will offer additional fee-generating
services including securities underwriting, and prime brokerage.
Use Equity Multiples (as opposed to Enterprise Multiples). In order to consider
how valuing a Financial Institution's balance sheet is different from a
non-Financial firm. Consider how an industrials firm wields capital machinery
(asset) and the loans (liabilities) it used to finance that asset. The line is
blurred in Financial Institutions, which must hold deposit accounts
(liabilities) to fuel the issuance of loans (assets). The same accounts are
considered loans as they are held in ownership not of the bank, but of the
individual client.
You'll need the FCFE (Free Cash Flow for Equity), which is the amount of money
that is returned to shareholders. Calculate an FCFF (Free Cash Flow to the
Firm): EBIT (1-tax rate) -Capital Expenditures+ (Depreciation & Amortization) -
(Net increase in working capital)= FCFF
FCFF-Debt+Cash=FCFE
Use the Capital Asset Pricing Model, not the Weighted Average Cost of Capital
(for the same reasons one uses Equity Multiples in relative valuation) to
determine the cost of equity (the return required by shareholders in order to
make the decision to invest in a financial institutions)
Author
Aziz
Author Email
azizjipsbd@yahoo.com
References
Definitions to be consulted