Introducing Finance

Defining Finance

Finance is the study of fund management and asset allocation over time.

Learning Objectives

Explain the importance of time to the discipline of finance

Key Takeaways

Key Points

  • The two main drivers of finance are the time value of money and risk.
  • Since the value of assets changes over time, finance seeks to ensure the change is beneficial for the organization or individual.
  • Financial professionals generally operate in an environment of uncertainty where they must make forecasts about future events.

Key Terms

  • investment: A placement of capital in expectation of deriving income or profit from its use.
  • asset: Something or someone of any value; any portion of one’s property or effects so considered.
  • debtor: A person or firm that owes money, one in debt, or one who owes a debt.

Overview

Finance is the study of fund management and asset allocation over time. Funds consist of money and other assets. There are many different types of finance, but all are fundamentally concerned with studying how best to allocate assets in different conditions over time.

Importance of Time

The underlying driver behind all of finance is time. There are two reasons why time is so important to finance:

  1. Time value of money: For a number of reasons, money today is worth more than the same amount of money in the future. For example, you would rather have $100 today than $100 in 10 years – the money is worth more to you now than it would be in the distant future. We will explore this concept in greater depth later on.
  2. Risk: Making an investment does not guarantee a return. When a bank makes a loan, they’re not sure the debtor will pay it back. There is a risk that the person will just take the money and run, the debtor will file for bankruptcy, or, for dozens of other reasons, the bank will not get the money they lent back.

The field of finance, however, embraces time. Finance says, “Since I know assets change value over time, how do I use that to cause my assets to change value in the direction I want? How do I manage assets so that they’re worth more in the future than they are today? ”

Challenges in Finance

Figuring out what to do with assets is sometimes easy: all of the variables are known, and there is clearly an option that is better than all the others. However, most of the time, this is not the case. Finance generally operates with a lot of uncertainty. As a result, companies hire entire departments of people to help them figure out which option is best.

image

Walmart CFO: Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.

Comparing the Fields of Finance, Economics, and Accounting

Finance, economics, and accounting are business subjects with many similarities and differences; each is a distinct field of study.

Learning Objectives

Recognize how finance, economics and accounting overlap.

Key Takeaways

Key Points

  • Finance is the study of how to optimally allocate assets. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.
  • Economics is the social science that analyzes the production, distribution, and consumption of goods and services.
  • Accounting is the process of communicating financial information about a business. Accounting is fundamentally a backward-looking field.

Key Terms

  • return: Gain or loss from an investment.

Finance, economics, and accounting are business subjects with many similarities and differences. While they influence each other, each is a distinct field of study.

Finance

Finance is the study of how to optimally allocate assets—how individuals and organizations should invest assets in order to get the highest possible return given changing conditions over time. Finance is fundamentally a forward looking field, concerned with what an asset will be worth in the future.

Economics

Economics is a social science that analyzes the production, distribution, and consumption of goods and services. It focuses on how economic agents (people, businesses, and government) interact and make decisions. Economics is fundamentally the study of cause and effect. It tries to figure out how one variable affects economic agents or the economy as a whole.

Accounting

Accounting focuses on communicating a businesses’ financial information. Accounting is fundamentally a backward-looking field, concerned with what has already happened financially and what position that leaves the company in today.

If accounting is called the language of business, then the financial statements that accountants prepare are the words. Statements are created under a standardized set of accounting laws, which allows one to easily compare and contrast companies. This indicates how financially healthy a company is.

image

Balance Sheet: The balance sheet is one of the three main financial statements. The other two are the cash flow statement and the income statement.

Overlap

Finance, economics, and accounting overlap in a lot of areas. For example, an investor will use accounting to see whether a company has shown past financial success and to predict what the company will look like in the future. Part of that prediction incorporates economics. The investor wants to know what the overall economy will look like in the future and wants to know how the company will interact with its competitors. The investor can use finance to figure out what his or her investment will be worth in the future.

There are few strong delineators between finance, economics and accounting. All three fields intermingle and influence one another. It is almost impossible to have a strong grasp of one without at least a basic understanding of the other two.

Role of Finance in an Organization

The primary role of corporate finance is to determine how best to maximize shareholder value.

Learning Objectives

Define the role of finance in an organization

Key Takeaways

Key Points

  • Maximizing shareholder value can be done over the long-term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to contradict each other.
  • The finance department is devoted to the task of figuring out how to allocate assets for the overarching goal of maximizing shareholder value. They must ensure that the right assets are in the right place at the right time.
  • The finance department must also manage the company’s liabilities so that all projects are financed in an optimal way without taking on too much risk.

Key Terms

  • shareholder: One who owns shares of stock.
  • asset: Something or someone of any value; any portion of one’s property or effects so considered.
  • liability: An obligation, debt or responsibility owed to someone.

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make. When finance is talked about in the context of business decisions, it is called corporate finance (technically, corporate finance deals only with corporations, while managerial finance deals with all types of companies, but we will use the terms interchangeably). There are other branches of finance such as personal finance (individuals taking care of their money) and public finance (the finances of the government).

The primary goal of corporate finance is to maximize shareholder value. Maximizing shareholder value can be done over the long-term or the short-term, so the job of the finance department is to determine how best to do both. Sometimes, the goals may appear to be in competition with one another. For example, a company can choose to pay dividends (a small payment to each person who owns a stock of a company), which increases short-term shareholder wealth. However, paying dividends means that the money is not being invested in long-term investments, which may cause the stock price to increase more in the future, and thereby increasing long-term shareholder wealth.

The technique behind maximizing shareholder value is the management of assets. This means that the finance department figures out how to best invest its money.

For example, a company could have two proposals from the R&D department to develop different products, but only enough money to fund one. The finance department will project out the future revenues and costs of each product and figure out which one, if either, is worth the money.

image

iPod Touch: Apple used financial analysis to decide to fund the development of the iPod. The money allocated development could not be used for another project, but the finance department determined the iPod was the best option.

Also, the finance department will determine when a company should take on a liability. For example, suppose both projects are absolute home-runs, but the company still only has enough money to fund one. The finance department will figure out if the company should borrow money so that it can fund both.

The role of finance in an organization is to make sure that money is at the right place at the right time. A company wants to have enough money to pay its bills, but also wants to invest so that it can grow in the future. The finance department is devoted to the task of figuring out how to allocate assets to do so, for the overarching goal of maximizing shareholder value.

Types of Financial Decisions: Investment and Financing

Investment and financing decisions boil down to how to spend money and how to borrow money.

Learning Objectives

Identify the criteria a corporation must use when making a financial decision

Key Takeaways

Key Points

  • The primary goal of both investment and financing decisions is to maximize shareholder value.
  • Investment decisions revolve around how to best allocate capital to maximize their value.
  • Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sell equity.

Key Terms

  • expected return: Considering the magnitude and likelihood of exogenous events, the yield that an investor predicts s/he will earn on average.
  • financing: A transaction that provides funds for a business.
  • equity: Ownership, especially in terms of net monetary value, of a business.

There are two fundamental types of financial decisions that the finance team needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.

Investment

An investment decision revolves around spending capital on assets that will yield the highest return for the company over a desired time period. In other words, the decision is about what to buy so that the company will gain the most value.

To do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn’t investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn’t hold enough cash, it can’t pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.

The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine an expected return . This return is not guaranteed, but is the average return on an investment if it were to be made many times.

The investments must meet three main criteria:

  1. It must maximize the value of the firm, after considering the amount of risk the company is comfortable with (risk aversion).
  2. It must be financed appropriately (we will talk more about this shortly).
  3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.

Financing

All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.

There are two ways to finance an investment: using a company’s own money or by raising money from external funders. Each has its advantages and disadvantages.

There are two ways to raise money from external funders: by taking on debt or selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing. Selling equity is essentially selling part of your company. When a company goes public, for example, they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.

image

NYSE: If a company chooses to finance an investment by selling equity, they may issue stocks on an exchange like the New York Stock Exchange

Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.

Functions of Corporate Finance

Corporate finance utilizes tools and analysis to make sound financial business decisions.

Learning Objectives

Describe the role of finance in corporation

Key Takeaways

Key Points

  • The finance group is in charge of budgeting. It will look for the optimal allocation of assets across all business functions.
  • Corporate finance decides how best to finance projects. The department can either use existing internal funds, borrow money, or sell equity.
  • The finance group must balance both short- and long-term company goals, though the overarching goal is to maximize shareholder value.

Key Terms

  • finance: To provide or obtain funding for a transaction or undertaking; to back; to support.
  • investment: A placement of capital in expectation of deriving income or profit from its use.

Corporate finance deals with monetary decisions that business enterprises make and the tools and analysis utilized to make the decisions. Corporate finance is concerned primarily with making investment and financing decisions; that is, making sure that money is being used in the best way.

The corporate finance department of a company is in charge of budgeting. Management must allocate limited resources between competing opportunities; since a dollar cannot be used for more than one project at once, it is a challenge to determine how much money should be allocated to each part of the business.

In determining how to allocate money, the finance group must also figure out where the money will be best utilized. This requires valuing projects and business functions. A large element of finance is deciding how exactly to value a project. There are a number of variables – inflation, expected revenues, expected costs, length of time required – that are all incorporated into the valuation process. Finding the true value of a project is often wrought with uncertainty, but without an accurate valuation, a company may allocate its resources sub-optimally.

The corporate finance department must also determine how to finance projects. A company can finance a project by using either internal funds (money the company already has), borrowing, or selling equity. Each option carries a certain cost that can be quantified. It is the job of the finance department to make sure that the overall cost isn’t too high and that the company has an optimal mix of all three strategies.

One public job function of corporate finance is determining whether or not the company pays a dividend, and if so, how much. The company has a responsibility to maximize shareholder value, but that can be achieved in multiple ways. Paying a dividend puts cash directly in the hands of shareholders, increasing shareholder value. However, paying a dividend means that money is not being reinvested in the company. If a company doesn’t pay a dividend and instead chooses to reinvest the money, the value of the company will presumably increase, in turn increasing shareholder value. The finance department determines which option maximizes shareholder value.

Lastly, the finance department must also ensure that there is a good balance between long- and short-term goals. The company must have enough assets to cover short-term costs, referred to as working capital management, and enough invested to ensure the company has long-term growth.

image

Factory: Purchasing new machinery requires a valuation of all equipment, an accurate idea of the total cost over time, and a way to finance the purchase while leaving enough cash for other upcoming costs.

Overview of the Role of Financial Manager

The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.

Learning Objectives

Describe the role and skills of a financial manager

Key Takeaways

Key Points

  • The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product.
  • The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.
  • The financial manager must not just be an expert at financial projections; s/he also must have a grasp of the accounting systems in place and the strategy of the business over the coming years.
  • The head of the financial department is the chief financial officer (CFO) who is responsible for all financial decisions and reporting done in the company.

Key Terms

  • capital: Money and wealth; the means to acquire goods and services, especially in a non-barter system.

The Role of the Financial Manager

The role of a financial manager is a complex one, requiring both an understanding of how the business functions as a whole and specialized financial knowledge. The head of the financial operations is called the chief financial officer (CFO).

The structure of the company varies, but a financial manager is responsible for the same general things across the board. The manager is responsible for managing the budget. This involves allocating money to different projects and segments so that the business can continue operating, but the best projects get the necessary funding.

The manager is responsible for figuring out the financial projections for the business. The development of a new product, for example, requires an investment of capital over time. The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product. This is a lot tougher than it sounds because there is no accurate financial data for the future. The finance manager will use data analyses and educated guesses to approximate the value, but it’s extremely rare that s/he can be 100% sure of the future cash flows.

image

Collaboration: The finance manager must collaborate across business functions in order to determine how to best allocate and manage assets.

Figuring out the value of an operation is one thing, but it is another thing to figure out if it’s worth financing. There is a cost to investing money, either the opportunity cost of not investing it elsewhere, the cost of borrowing money, or the cost of selling equity. The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

At the same time that this is going on, the financial manager must also ensure that the business has enough cash to pay upcoming financial obligations without hoarding assets that could otherwise be invested. This is a delicate dance between short-term and long-term responsibilities.

The CFO is the head of the financial department and is responsible for all of the same things as his/her subordinates, but is also the person who has to sign off that all of the company’s financial statements are accurate. S/he is also responsible for financial planning and record-keeping, as well as financial reporting to higher management.

The financial manager is not just an expert at financial projections, s/he must also have a grasp of the accounting systems in place and the strategy of the business over the coming years.

Reasons to Study Finance

Finance is relevant to all business functions, the macroeconomy, and personal finances.

Learning Objectives

List the reasons why a person would want to study finance

Key Takeaways

Key Points

  • Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance.
  • Like companies, individuals are faced with investment and financing decisions. Having a firm grasp of finance will help individuals make those decisions.
  • All businesses functions deal with finance because they need to be able to make the financial argument for the funding of their projects and to manage their budgets.

Key Terms

  • leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

The study of finance often feels a lot narrower than it really is. There is a lot of talk of issuing bonds or pricing projects which belies how relevant finance is to everyday life, regardless of whether or not you have any desire of working in finance.

Understanding the Economic Environment

Finance plays an involved role in the health of the overall economy, which impacts everyone, regardless of whether or not they have studied finance. The field of finance explains why the 2008 recession occurred; it is the reason why people care about how the stock market is doing each day; and it articulates why businesses and governments make some of the decisions they do.

image

Random Walk: Stock market cannot be predicted.

Finance plays a role in many of the stories in the news every day, which means that those who understand finance have a better grasp on how the events of the world affect them.

Personal Finances

Each person will also have to manage his or her own personal finances. Like corporations, individuals are faced with investment and financing decisions. In order to invest, individuals must be able to do the same projections and valuations as companies in order to determine the best investment for their needs. Individuals cannot sell equity like corporations, but they can choose to either dip into their savings or take out loans. Many take on debt in the form of student loans, mortgages, or through their credit cards; being able to properly compare options to leverage is just as important for individuals as it is for companies.

Application to Business

Of course, finance is an important field of study for those who have a desire of working in finance or accounting. Finance is heavily used in jobs ranging from investment banker to CFO to venture capitalist.

However, finance is not segmented from the other functions in business. Every job from marketing to engineering has to be able to manage a budget and make a business case that it should get funding for a project.

This is especially true higher up in the organizational hierarchy: managers, directors, and vice presidents need to be able to articulate why their departments should get financial support from the company.

Finance is a field of both hard analytical skill and personal judgement. There are set processes and theories for determining which financial option is best, but in the real world, it is rare to have all of the information needed to be absolutely certain about what to do. Finance develops strong analytical skills, but also the degree of finesse required to operate in an environment of uncertainty.

image

Silver Bid Chart: Finance helps explain what trends in silver bids mean, but more importantly, why people care about them (even those not trading silver).