1.1 What Is Finance?

Definition of Finance

Finance is the study of the management, movement, and raising of money. The word finance can be used as a verb, such as when the First National Bank agrees to finance your home mortgage loan. It can also be used as a noun referring to an entire industry. At its essence, the study of finance is about understanding the uses and sources of cash, as well as the concept of risk-reward trade-off. Finance is also a tool that can help us be better decision makers.

Basic Areas in Finance

Finance is divided into three primary areas in the domestic market: business finance, investments, and financial markets and institutions (see Figure 1.2). We look at each here in turn.

Figure 1.2 The Three Basic Areas of Study in Finance

Business Finance

Business finance looks at how managers can apply financial principles to maximize the value of a firm in a risky environment. Businesses have many stakeholders. In the case of corporations, the shareholders own the company, and they hire managers to run the company with the intent to maximize shareholder wealth. Consequently, all management decisions should run through the filter of these questions: “How does this decision impact the wealth of the shareholders?” and “Is this the best decision to be made for shareholders?”

In business finance, managers focus on three broad areas (see Figure 1.3).

1. Working capital management (WCM) is the study and management of short-term assets and liabilities. The chief financial officer (CFO) and the finance team are responsible for establishing company policy for how to manage WCM. The finance department determines credit policy, establishes minimum criteria for the extension of credit to clients, terms of lending, when to extend, and when to take advantage of short-term creditor financing. The accounting department basically implements the finance department’s policies. In many firms, the accounting and finance functions operate in the same department; in others, they are separate.
2. Capital budgeting is the process of determining which long-term or fixed assets to acquire in an effort to maximize shareholder value. Capital budgeting decisions add the greatest value to a firm. As such, capital budgeting is thought to be one of the most important financial functions within a firm. The capital budgeting process consists of estimating the value of potential investments by forecasting the size, timing, and risk of cash flows associated with the investments. The finance department develops and compiles cash flow estimates with input from the marketing, operations, accounting, human resources, and economics departments to develop a portfolio of investment projects that collectively maximize the value of the firm.
3. Capital structure is the process by which managers focus more specifically on long-term debt and increasing shareholder wealth. Capital structure questions require financial managers to work with economists, lenders, underwriters, investment bankers, and other sources of external financial information and financial capital. When Bacon Signs developed its financial plan, the executives included each of these three aspects of business finance into the plan.

Figure 1.3 How Corporate Finance Decision-Making Activities Relate to the Balance Sheet

Figure 1.3 demonstrates how the three essential decision-making activities of the financial manager are related to a balance sheet. Working capital management focuses on short-term assets and liabilities, capital budgeting is focused on long-term assets, and capital structure is concerned with the mix of long-term debt and equity financing.

Why We Study Finance

Finance is the lubricant that keeps our economy running smoothly. Issuing a mortgage can be profitable for a bank, but it also allows people to live in their own homes and to pay for them over time. Do MasterCard, Venmo, and PayPal make money when you use their product? Sure, but think how much more convenient and safer it is to carry a card or use an app instead of cash. In addition, these services allow you to easily track where and how you spend your money. A well-regulated and independent financial system is important to capital-based economies. Our smoothly functioning financial system has removed us from the days of strictly bartering to our system today, where transactions are as simple as a tap on your mobile phone.

There are any number of professional and personal reasons to study finance. A search of the internet provides a long list of finance-related professions. Interviews with senior managers reveal that an understanding of financial tools and concepts is an important consideration in hiring new employees. Financial skills are among the most important tools for advancement toward greater responsibility and remuneration. Government and work-guaranteed pension benefits are growing less common and less generous, meaning individuals must take greater responsibility for their personal financial well-being now and at retirement. Let’s take a closer look at some of the reasons why we study finance.

There are many career opportunities in the fields of finance. A single course in finance such as this one may pique your interest and encourage you to study more finance-related topics. These studies in turn may qualify you for engaging and high-paying finance careers. We take a closer look at financial career opportunities in Careers in Finance.

A career in finance is just one reason to study finance. Finance is an excellent decision-making tool; it requires analytical thinking. Further, it provides a framework for estimating value through an assessment of the timing, magnitude, and risk of cash flows for long-term projects. Finance is important for more immediate activities as well, such as the development of budgets to assure timely distribution of cash flows such as dividends or paychecks.

An understanding of finance and financial markets opens a broader world of available financial investment opportunities. At one time, commercial bank deposits and the occasional investment in stocks, bonds, real estate, or gold may have provided sufficient coverage of investment opportunities, portfolio diversification, and adequate returns. However, in today’s market of financial technology, derivative securities, and cryptocurrencies, an understanding of available financial products and categories is key for taking advantage of both new and old financial products.

Risk and Return in Finance

Finance tells us that an increase in risk results in an increase in expected return. The study of historical financial markets demonstrates that this relationship generally holds true and that riskier investments over time have provided greater returns. Of course, this is not true all the time and under all conditions; otherwise, where’s the risk?

At its most basic level, risk is uncertainty. The study of finance attempts to quantify risk in a way that helps individuals and organizations assess an appropriate trade-off for risk. Risk-return tradeoffs are all around us in our everyday decision-making. When we consider walking across the street in the middle of a city block or walking down to the marked intersection, we are assessing the trade-off between convenience and safety. Should you buy the required text for your class or instead rely on the professor’s notes and the internet? Should you buy that new-to-you used car sight unseen, or should you spend the money for a mechanic to assess the vehicle before you buy? Should you accept your first job offer at graduation or hold out for the offer you really want? A better understanding of finance makes these types of decisions easier and can provide you, as the decision maker, with statistics instead of just intuition.

Return is compensation for making an investment and waiting for the benefit (see Figure 1.4). Return could be the interest earned on an investment in a bond or the dividend from the purchase of stock. Return could be the higher income received and the greater job satisfaction realized from investing in a college education. Individuals tend to be risk averse. This means that for investors to take greater risks, they must have the expectation of greater returns. Investors would not be satisfied if the average return on stocks and bonds were the same as that for a risk-free savings account. Stocks and bonds have greater risk than a savings account, and that means investors expect a greater average return.

The study of finance provides us with the tools to make better and more consistent assessments of the risk-return trade-offs in all decision-making, but especially in financial decision-making. Finance has many different definitions and measurements for risk. Portfolios of investment securities tend to demonstrate the characteristics of a normal return distribution, or the familiar “bell-shaped” curve you studied in your statistics classes. Understanding a security’s average and variability of returns can help us estimate the range and likelihood of higher- or lower-than-expected outcomes. This assessment in turn helps determine appropriate prices that satisfy investors’ required return premiums based on quantifiable expectations about risk or uncertainty. In other words, finance attempts to measure with numbers what we already “know.”

Figure 1.4 Risk and Expected Return This describes the trade-off that invested money can bring higher profits if the investor is willing to accept the risk of possible loss.

The overall uncertainty of returns has several components.

• Default risk on a financial security is the chance that the issuer will fail to make the required payment. For example, a homeowner may fail to make a monthly mortgage payment, or a corporation may default on required semiannual interest payments on a bond.
• Inflation risk occurs when investors have less purchasing power from the realized cash flows from an investment due to rising prices or inflation.
• Diversifiable risk, also known as unsystematic risk, occurs when investors hold individual securities or smallish portfolios and bear the risk that a larger, more well-rounded portfolio could eliminate. In these situations, investors carry additional risk or uncertainty without additional compensation.
• Non-diversifiable risk, or systematic risk, is what remains after portfolio diversification has eliminated unnecessary diversifiable risk. We measure non-diversifiable risk with a statistical term called beta. Subsequent chapters on risk and return provide a more in-depth discussion of beta.
• Political risk is associated with macroeconomic issues beyond the control of a company or its managers. This is the risk of local, state, or national governments “changing the rules” and disrupting firm cash flows. Political risk could come about due to zoning changes, product liability decisions, taxation, or even nationalization of a firm or industry.