What is Finance
Almost every day we hear news reports about economic conditions, unemployment, price changes, interest rates, stock prices, government expenditures and taxes, and monetary policy.
Many of us are often overwhelmed trying to understand and interpret developments and inter-actions among these topics. We begin this textbook by defining fi nance and describing the financial environment and the three areas of finance.
Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other fi nancial assets. Understanding fi nance is important to all students regardless of the discipline or area of study, because nearly all business and economic decisions have fi nancial implications. The decision to spend or consume now (for new clothes or dinner at a fancy restaurant) rather than save or invest (for spending or consuming more in the future) is an everyday decision that we all face.
The financial environment encompasses the financial system, institutions or interme-diaries (we will use these terms interchangeably throughout this text), fi nancial markets, business fi rms, individuals, and global interactions that contribute to an effi ciently operating economy. depicts the three areas of finance—institutions and markets, investments, and financial management—within the financial environment. Note that while we identify three distinct fi nance areas, these areas do not operate in isolation but rather interact or inter-sect with each other. Our focus in this book is to provide the reader with exposure to all three areas, as well as to show how they are integrated. Of course, students pursuing a major or area of emphasis in finance will take multiple courses in one or more of these areas.
Financial institutions are organizations or intermediaries that help the fi nancial system operate effi ciently and transfer funds from savers and investors to individuals, businesses, and governments that seek to spend or invest the funds in physical assets (inventories, buildings, and equipment). Financial markets are physical locations or electronic forums that facilit-ate the flow of funds amon investors,businesses, and governments. The investments area involves the sale or marketing of securities, the analysis of securities, and the management of investment risk through portfolio diversification. Financial management involves financial planning, asset management, and fund-raising decisions to enhance the value of businesses.
Finance has its origins in economics and accounting. Economists use a supply-and-demand framework to explain how the prices and quantities of goods and services are determ-ined in a free-market economic system. Accountants provide the record-keeping mechanism for showing ownership of the fi nancial instruments used in the fl ow of fi nancial funds between savers and borrowers. Accountants also record revenues, expenses, and profi tability of organ-izations that produce and exchange goods and services.
cient methods of production and specialization of labor can exist only if there is an eff ective means of paying for raw materials and fi nal products. Businesses can obtain the
money needed to buy capital goods, such as machinery and equipment, only if a mechanism has been established for making savings available for investment. Similarly, federal and other governmental units, such as state and local governments and tax districts, can carry out their wide range of activities only if effi cient means exist for raising money, for making payments, and for borrowing.
Financial institutions, financial markets, and investment and fi nancial management are crucial elements of the financial environment and well-developed fi nancial systems. Financial
institutions are intermediaries, such as banks, insurance companies, and investment companies that engage in fi nancial activities to aid the fl ow of funds from savers to borrowers or investors.
Financial markets provide the mechanism for allocating financial resources or funds from savers to borrowers. Individuals make decisions as investors and fi nancial managers. Investors include savers and lenders as well as equity investors.
While we focus on fi nancial managers in this book, we recognize that individuals also must be continuously involved in managing their personal finances. Investment management involves making decisions relating to issuing and investing in stocks and bonds. Financialmanagement in business involves making decisions relating to the effi cient use of financial resources in the production and sale of goods and services. The goal of the fi nancial manager in a profi t-seeking organization should be to maximize the owners’ wealth. This is accom-plished through eff ective fi nancial planning and analysis, asset management, and the acquis-ition of fi nancial capital. Financial managers in not-for-profi t organizations aim to providea desired level of services at acceptable costs and perform the same financial managementfunctions as their for-profit counterparts.
Six Principles of Finance
FINANCE Finance is founded on six important principles. The first fi ve relate to the economic behavior of individuals, and the sixth focuses on ethical behavior. Knowing about these prin-ciples will help us understand how managers, investors, and others incorporate time and riskinto their decisions, as well as why the desire to earn excess returns leads to information-effi cient financial markets in which prices refl ect available information. Unfortunately, sometimes greed associated with the desire to earn excess returns causes individuals to risk losing their reputations by engaging in questionable ethical behavior and even unethical behavior in the form of fraud or other illegal activities. The bottom line is, “Reputation matters!” The follow-ing are the six principles that serve as the foundation of fi nance:
• Money has a time value.
• Higher returns are expected for taking on more risk.
• Diversifi cation of investments can reduce risk.
• Financial markets are efficient in pricing securities.
• Manager and stockholder objectives may diff er.
• Reputation matters.
Time Value of Money
Let’s look at these principles one by one. Money in hand today is worth more than the promise of receiving the same amount in the future. The “time value” of money exists because a sum of money today could be invested and grow over time. For example, assume that you have $1,000 today and that it could earn $60 (6 percent) interest over the next year. Thus, $1,000 today would be worth $1,060 at the end of one year (i.e., $1,000 plus $60). As a result, a dollar today is worth more than a dollar received a year from now. The time-value-of-money principle helps us to understand the economic behavior of individuals and the economic decisions of the institutions and businesses that they run. This fi nance principle pillar is apparent in many of our day-to-day activities, and knowledge of it will help us better understand the implica-tions of time-varying money decisions. We explore the details of the time value of money but this fi rst principle of fi nance will be apparent throughout this book.
Risk Versus Return
A trade-off exists between risk and expected return in all types of investments—both assets and securities. Risk is the uncertainty about the outcome or payoff of an investment in thefuture. For example, you might invest $1,000 in a business venture today. After one year, the firm might be bankrupt and you would lose your total investment. On the other hand, after
one year your investment might be worth $2,400. This variability in possible outcomes is your risk.
Instead, you might invest your $1,000 in a U.S. government security, where after oneyear the value may be $950 or $1,100. Rational investors would consider the business ventureinvestment to be riskier and would choose this investment only if they feel the expected return is high enough to justify the greater risk. Investors make these trade-off decisions every day.
Business managers make similar trade-off decisions when they choose between diff er-ent projects in which they could invest.
Understanding the risk/return trade-off principle also helps us understand how individuals make economic decisions. While we specifi cally explore the trade-off between risk and expected return in greater detail in Part 2,this second principle of finance is involved in many financial decisions throughout this text.
Diversification of Risk
While higher returns are expected for taking on more risk, all investment risk is not the same. In fact, some risk can be removed or diversifi ed by investing in several differentassets or securities. Let’s return to the example involving a $1,000 investment in a business venture, where after one year the investment could provide a return of either zero dollarsor $2,400. Now let’s assume that there also is an opportunity to invest $1,000 isecond,unrelated business venture in which the outcomes would be zero dollars or $2,400. Let’s further assume that we will put one-half of our $1,000 investment funds in each investment opportunity such that the individual outcomes for each $500 investment would be zero dollarsor $1,200.
While it is possible that both investments could lose everything (i.e., return zero dollars)or return $1,200 each (a total of $2,400), it is also possible that one investment would go broke
and the other would return $1,200. So, four outcomes are now possible:
If each outcome has an equal, one-fourth (25 percent), chance of occurring, most of uswould prefer this diversifi ed investment. While it is true that our combined investment of$1,000 ($500 in each investment) at the extremes could still return zero dollars or $2,400, it is true that we have a 50 percent chance of getting $1,200 back for our $1,000 investment.
As a result, most of us would prefer investing in the combined or diversifi ed investment rather
than in either of the two investments separately. We will explore the benefi ts of investment diversification in Part 2 of this text.
Financial Markets Are Efficient
A fourth fi nance-related aspect of economic behavior is that individuals seek to find under-valued and overvalued investment opportunities involving both real and fi nancial assets.
It is human nature, economically speaking, to search for investment opportunities thatwill provide returns higher than those expected for undertaking a specifi ed level of risk.
This attempt by many to earn excess returns, or to “beat the market,” leads to information-efficient fi nancial markets. However, at the same time it becomes almost impossible toconsistently earn returns higher than those expected in a risk/return trade-off framework.
Rather than looking at this third pillar of fi nance as a negative consequence of humaneconomic behavior, we prefer to couch it positively in that it leads to information-effi cient financial markets.
A fi nancial market is said to be information effi cient if at any point the prices of securit-ies refl ect all information available to the public. When new information becomes available,prices quickly change to refl ect that information. For example, let’s assume that a fi rm’s stock is currently trading at $20 per share. If the market is effi cient, both potential buyers and sellers of the stock know that $20 per share is a fair price. Trades should be at $20, or near to it, if the demand (potential buyers) and supply (potential sellers) are in reasonable balance. Now, let’s assume that the fi rm announces the production of a new product that is expected to substan- tially increase sales and profi ts. Investors might react by bidding up the price to, say, $25 per share to refl ect this new information. Assuming this new information is assessed properly, the new fair price becomes $25 per share. This informational effi ciency of fi nancial markets exists because a large number of professionals are continually searching for mispriced securities. Of course, as soon as new information is discovered, it is immediately refl ected in the price of the associated security. Information-effi cient fi nancial markets play an important role in the marketing and transferring of fi nancial assets between investors by providing liquidity and fair prices. The importance of information-effi cient fi nancial markets is examined throughout this.