What is finance
Money has a time value
- A dollar received today is worth more than a dollar received in the future. -Since we can earn interest on money received today, it is better to receive money sooner rather than later. -Since we can earn interest on money kept today, it is better to pay money later rather than sooner.
Cash flow is what matters
- Accounting profits are not equal to cash flows. - It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books. - Cash flow, and not profits, drive the value of a business. - We must determine incremental or marginal cash flows when making financial decisions.
Finance definition
-"... the science or study of the management of money" -The science that describes the management, creation and study of money, banking, credit, investments, assets and liabilities." -A study of allocating funds across different entities and across different periods of time
Principle 1:
Cash flow is what matters
Incremental cash flows
Incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.
Principle 4
Market prices are generally right
Principle 3
Risk requires a reward
Principle 2
: Money has a time value
Classifications of finance
-personal finance (importance of financial literacy!), -corporate finance (focus of our attention), -government finance (also called public finance), -international finance
Financial system
-Comprises financial institutions, instruments and markets -Facilitates the flow of funds between deficit units and surplus unit through the interaction of its three components
Risk requires a reward
-Investors will not take on additional risk unless they expect to be compensated with additional reward or return. -Investors expect to be compensated for "delaying consumption" and "taking on risk." -Thus, investors expect a return when they deposit their savings in a bank (ex. delayed consumption) and they expect to earn a relatively higher rate of return on stocks compared to a bank savings account (ex. taking on risk).
Deficit units
-borrow from others -run down their net assets -issue financial claims /take on financial obligations
Surplus units
-lend to other -increase their net assets -Purchase (hold) financial claims
Principle 5
Conflicts of Interest cause agency problems
Market prices are generally right
§In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully reflect all available information at any instant in time. §Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes in expected future cash flows. Good decisions will tend to increase in stock price and vice versa. §Note there are inefficiencies in the market that may distort the market prices from value of assets. Such inefficiencies are often caused by behavioral biases.
Deficit and Surplus Units
§Income - Consumption expenditure = Saving •Saving - Investment expenditure (e.g. home purchase) = Surplus (or Deficit) −Investment refers to the acquisition of new physical assets −Saving means the change in a unit or sector's net worth −Dissaving occurs when consumption exceeds income
Conflicts of Interest cause agency problems
§The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth. -Agency conflict is reduced through monitoring (ex. annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. takeovers)
