PART One
Background
CHAPTER 1
What is Finance?
Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty. Investors allocate their funds among financial assets in order to accomplish their objectives, and businesses and governments raise funds by issuing claims against themselves that are invested. Finance provides the framework for making decisions as to how those funds should be obtained and then invested. It is the financial system that provides the platform by which funds are transferred from those entities that have funds to invest to those entities that need funds to invest.
The theoretical foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics . The tools used in financial decision-making, however, draw from many areas outside of economics: financial accounting, mathematics, probability theory, statistical theory, and psychology. In Chapters 2 and 3, we cover the mathematics of finance as well as the basics of financial analysis that we use throughout this book. We need to understand the former topic in order to determine the value of an investment, the yield on an investment, and the cost of funds. The key concept is the time value of money, a simple mathematical concept that allows financial decision-makers to translate future cash flows to a value in the present, translate a value today into a value at some future point in time, and calculate the yield on an investment. The time-value-of-money mathematics allows an evaluation and comparison of investments and financing arrangements. Financial analysis involves the selection, evaluation, and interpretation of financial data and other pertinent information to assist in evaluating the operating performance and financial condition of a company. These tools include financial ratio analysis, cash flow analysis, and quantitative analysis.
It is generally agreed that the field of finance has three specialty areas:
ā¢ Capital markets and capital market theory
ā¢ Financial management
ā¢ Investment management
We cover these three areas in this book in Parts Two, Three, and Four of this book. In this chapter, we provide an overview of these three specialty areas and a description of the coverage of the chapters in the three parts of the book.
CAPITAL MARKETS AND CAPITAL MARKET THEORY
The specialty field of capital markets and capital market theory focuses on the study of the financial system, the structure of interest rates, and the pricing of risky assets.
The financial system of an economy consists of three components: (1) financial markets; (2) financial intermediaries; and (3) financial regulators. For this reason, we refer to this specialty area as financial markets and institutions. In Chapter 4, we discuss the three components of the financial system and the role that each plays. We begin the chapter by defining financial assets, their economic function, and the difference between debt and equity financial instruments. We then explain the different ways to classify financial markets: internal versus external markets, capital markets versus money markets, cash versus derivative markets, primary versus secondary markets, private placement versus public markets, order driven versus quote driven markets, and exchange-traded versus over-the-counter markets. We also explain what is meant by market efficiency and the different forms of market efficiency (weak, semi-strong, and strong forms). In the discussion of financial regulators, we discuss changes in the regulatory system in response to the problems in the credit markets in 2008. We discuss the major market players (that is, households, governments, nonfinancial corporations, depository institutions, insurance companies, asset management firms, investment banks, nonprofit organizations, and foreign investors), as well as the importance of financial intermediaries.
We describe the level and structure of interest rates in Chapter 5. We begin this chapter with two economic theories that each seek to explain the determination of the level of interest rates: the loanable funds theory and the liquidity preference theory. We then review the Federal Reserve System and the role of monetary policy. As we point out, there is not one interest rate in an economy; rather, there is a structure of interest rates. We explain that the factors that affect interest rates in different sectors of the debt market, with a major focus on the term structure of interest rates (i.e., the relationship between interest rate and the maturity of debt instrument of the same credit quality).
As we explain in Chapter 6, derivative instruments play an important role in finance because they offer financial managers and investors the opportunity to cost effectively control their exposure to different types of risk. The two basic derivative contracts are futures/forward contracts and options contracts. As we demonstrate, swaps and caps/floors are economically equivalent to a package of these two basic contracts. In this chapter, we explain the basic features of derivative instruments and how they are priced. We detail the well-known Black-Scholes option pricing model in the appendix of this chapter. We wait until later chapters, however, to describe how they are employed in financial management and investment management.
Valuation is the process of determining the fair value of a financial asset. We explain the basics of valuation and illustrate these through examples in Chapter 7. The fundamental principle of valuation is that the value of any financial asset is the present value of the expected cash flows. Thus, the valuation of a financial asset involves (1) estimating the expected cash flows; (2) determining the appropriate interest rate or interest rates that should be used to discount the cash flows; and (3) calculating the present value of the expected cash flows using the interest rate or interest rates. In this chapter, we apply many of the financial mathematics principles that we explained in Chapter 2. We apply the valuation process to the valuation of common stocks and bonds in Chapter 7 given an assumed discount rate.
In Chapter 8, we discuss asset pricing models. The purpose of such models is to provide the appropriate discount rate or required interest rate that should be used in valuation. We present two asset pricing models in this chapter: the capital asset pricing models and the arbitrage pricing theory.
FINANCIAL MANAGEMENT
Financial management, sometimes called business finance, is the specialty area of finance concerned with financial decision-making within a business entity. Often, we refer to financial management as corporate finance. However, the principles of financial management also apply to other forms of business and to government entities. Moreover, not all non-government business enterprises are corporations. Financial managers are primarily concerned with investment decisions and financing decisions within business organizations, whether that organization is a sole proprietorship, a partnership, a limited liability company, a corporation, or a governmental entity.
In Chapter 9, we provide an overview of financial management. Investment decisions are concerned with the use of fundsāthe buying, holding, or selling of all types of assets: Should a business purchase a new machine? Should a business introduce a new product line? Sell the old production facility? Acquire another business? Build a manufacturing plan? Maintain a higher level of inventory? Financing decisions are concerned with the procuring of funds that can be used for long-term investing and financing day-to-day operations. Should financial managers use profits raised through the firmsā revenues or distribute those profits to the owners? Shoul...