"Finance" Bodie and Merton
OUTLINE
1. Defining Finance
2. Five core principles of finance
3. Financial Decisions - Households
Chapter 1:
Introduction to Finance
4. Financial Decisions - Firms
5. The Financial System
Introduction
1. Defining Finance
I’m saving for retirement. Should I
Finance is the study of how people allocate scarce resources
over time (Bodie and Merton)
deposit into bank, mutual fund, direct stock market investment?
I want a new motorbike. Should I use
saved cash, borrow money?
I’m thinking about starting a new business
Is it worth doing? How much money do I need to start? Where can
I get money?
"Finance" Bodie and Merton
Financial Transaction
Real Assets versus Financial Assets
• Spread out through space and over time
Asset: any possession that has value in an exchange
• Risk – Return trade off
A real asset is used to produce goods and services and thereby
generate cash flow
• Assets used for the transactions is either cash or
E.g: machine, building, equipment, land/real estate
financial assets
A financial asset is a claim against a firm, government or
individual for future expected cash flows.
E.g: bonds, preferred stocks and common stocks.
The Liquidity Spectrum
Financial assets
Main properties:
Rate of Return : expected return
Risk: credit risk, market risk
Liquidity: Easy convertibility into cash with little or no
loss of value
•2-8
"Finance" Bodie and Merton
Financial Assets
2. Five Core Principles of Finance
Three broad types of financial assets:
- Time has value
Fixed-income securities
- Risk requires compensation
Equity securities
- Information is the basis for decisions
Derivative securities
- Markets determine prices and allocate resources
- Stability improves welfare
3 Financial Decisions of Households
Consumption and savings decisions
How to allocate wealth over time?
Investment decisions
How to grow wealth?
How should they invest to get benefit?
Financing decisions
How to finance consumption and investment?
Risk management decisions
How to reduce financial uncertainties and when should increase
risk?
Cash flow and financial decisions of
households
Cash raised by selling financial assets
Cash invested in real assets
Cash consumed
Cash invested in financial assets
"Finance" Bodie and Merton
4. Financial Decisions of Firms
Forms of business organization
Business Firms
Three major forms in the U.S
entities whose primary function is to produce goods and
services
they vary widely in size from part-time businesses run from a
spare room, to giant corporations (e.g. Mitsubishi or General
Motors) with hundreds of thousands of employees, and an even
larger ownership
1. Sole proprietorship
2. Partnership
3. Corporation
Financial Decisions of Firms
Financial decisions
When you start your own business, what financial decisions
do you have to take?
Investment decision – how much to invest and in what assets?
1. What long-term investments should we take on?
2. What are the sources of long-term financing?
(equity, loans)
3. How should we manage everyday financial
activities – managing working capital? (collecting
receivables, paying suppliers etc.)
Financing decision – where is money from in order to finance
long-term investments?
Working capital decision
"Finance" Bodie and Merton
Financial Decisions of Firms
Financial Decisions of Firms
The Capital Budgeting Process – Investment Decision
The Financing Process
The preparation of a plan for acquiring factories, machinery,
research laboratories, show rooms, warehouses, and human
assets to implement the strategic plan
The basic unit of analysis is the investment project. Investment
projects are identified, triaged, and implemented in the capital
budgeting process
Financial Decisions of Firms
Once a new set of approved projects has been identified, it must
be financed with retained earnings, stock, bonds, et cetera
Capital structure is the amount of the firm’s market value
allocated to each category of issued securities. It determines
ownership and risk level of the firms future cash flows
Capital structure’s unit of analysis is the firm as a whole (not an
investment project )
5. The Financial System
FIGURE
Working Capital
all firms (including highly profitable ones) that do not pay
sufficient attention to working capital management may be
seriously damaged by the resulting
loss of investor and creditor confidence
delayed in investment schedules
sub-optimal temporary finance
unscheduled sale of the firms assets
"Finance" Bodie and Merton
5.1. What is the Financial System?
A Financial System is comprised of
markets, intermediaries, service firms and other institutions
used to carry out the financial decisions of households,
business firms, and governments
The household is the primary provider of funds to businesses and
government.
Households must accumulate financial resources throughout their
working life times to have enough savings (pension) to live on in their
retirement years
Financial intermediaries transform the nature of the securities
they issue and invest in
Banks, trust companies, credit unions, insurance firms, mutual funds
Market intermediaries simply help make markets work
Investment dealers
Brokers
The Financial System
Financial Intermediaries: a firm whose primary business
is to provide financial services and financial products
Spending Sectors
Household
- Banks and other deposit-taking institutions: checking accounts,
loans, CDs …
Business Firms
- Insurance companies: term life insurance...
Government
- Pension Funds
Foreign Sector
- Mutual Funds
•
SURPLUS SPENDING
UNITS
•
DEFICIT SPENDING
UNITS
"Finance" Bodie and Merton
Surplus Spending Unit (1)
Has more cash income flow than expenditure on
consumption and real investments in a period of time. The
surplus is then allocated to the financial sector.
Other terms for surplus unit are saver, lender, buyer
of financial assets, financial investor, supplier of loanable
funds, buyer of securities.
Deficit Spending Unit (1)
Has more expenditures on consumption and real
goods (investment) in the real sector than income during a
period of time
The deficit unit must participate (borrow) in the
financial sector to balance cash inflows with outflows
Surplus Spending Unit (2)
The surplus unit may buy financial assets, hold more
money, or pay off financial liabilities issued earlier when in a
deficit situation
sector
The household and foreign sectors are usually a surplus
Deficit Spending Unit (2)
Other terms for deficit expending unit are borrower,
demander of loanable funds, and seller of securities.
The deficit spending unit may issue financial
liabilities, reduce money balances, and sell financial assets
acquired previously when in a surplus situation
"Finance" Bodie and Merton
THE FLOW OF FUNDS DIAGRAM
5.2 The Flow of Funds
Funds may flow from the surplus unit to the deficit unit
in three ways:
Funds
Funds
Directly meet
Through market intermediaries (or markets)
Surplus Spending
Unit (SSU)
Through intermediaries
•Deficit Spending
Unit (DSU)
•
Financial Assets
= Financial Claims
The Flow of Funds Diagram
The Flow of Funds Diagram
We shall examine various pathways from the surplus unit
to the deficit unit
Markets
Surplus Units
Deficit Units
Intermediaries
"Finance" Bodie and Merton
Fund Flows via Markets
Fund Flows via Markets
A household with surplus funds invests them in
government bonds
Markets
Surplus Units
Deficit Units
Intermediaries
Fund Flows via Intermediaries
Fund Flows via Intermediaries
Holders of surplus funds may use an intermediary, such as a
bank, to invest them. The bank receives the surplus funds, say
as 90-day deposits, and adds them to the bank’s assets (creating
a bank liability). Money is fungible, so the corresponding loan
can not be identified
Markets
Surplus Units
Deficit Units
Intermediaries
"Finance" Bodie and Merton
Fund Flows via Intermediaries and Markets
Fund Flows via Intermediaries and Markets
Sometimes the intermediary itself has surplus funds, and invests
them in the market or another intermediary
Markets
A bank that borrows and invests in the money market can
increase its flexibility, reduce its risks, and turn a profit
Eventually, the surplus funds are consumed by a deficit unit
Surplus Units
Deficit Units
Intermediaries
Fund Flow via Markets and Intermediaries
Funds Flow via Markets and Intermediaries
Intermediaries such as General Motors Acceptance
Corporation issue commercial paper to finance car loans and
leases made to households needing a car
In this case, the paper has a shorter maturity than the
loan, leading to a risk
Markets
Surplus Units
Deficit Units
Intermediaries