Chapter 1:
Introduction to Finance
OUTLINE
1. Defining Finance
2. Five core principles of finance
3. Financial Decisions - Households
4. Financial Decisions - Firms
5. The Financial System
1. Defining Finance
Finance is the study of how people allocate scarce resources
over time (Bodie and Merton)
2. The Financial System
2.1. 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
Market Participants
Spending Sectors
Household
•
SURPLUS SPENDING
UNITS
•
DEFICIT SPENDING
UNITS
Business Firms
Government
Foreign Sector
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
a. Surplus Spending Unit
• 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.
a. Surplus Spending Unit
• The surplus unit may buy financial assets, hold more money,
or pay off financial liabilities issued earlier when in a deficit
situation
• The household and foreign sectors are usually a surplus
sector
b. Deficit Spending Unit
• 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
b. Deficit Spending Unit
• 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
c. Other Participants
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
2.2 Financial Transaction
• Spread out through space and over time
• Risk – Return trade off
• Assets used for the transactions is either cash or
financial assets
Real Assets versus Financial Assets
Asset: any possession that has value in an exchange
A real asset is used to produce goods and services and thereby
generate cash flow
E.g: machine, building, equipment, land/real estate
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.
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
The Liquidity Spectrum
•2-15
Financial Assets
Three broad types of financial assets:
Fixed-income securities
Equity securities
Derivative securities
2.3 The Flow of Funds
Funds may flow from the surplus unit to the deficit unit
in three ways:
Directly meet
Through market intermediaries (or markets)
Through intermediaries
The Flow of Funds Diagram
Markets
Surplus Units
Deficit Units
Intermediaries
The Flow of Funds Diagram
We shall examine various pathways from the surplus unit
to the deficit unit
Direct Meet
Funds
Funds
•Deficit Spending
Unit (DSU)
Surplus Spending
Unit (SSU)
•
Financial Claims
Fund Flows via Markets
Markets
Surplus Units
Deficit Units
Intermediaries
Fund Flows via Markets
A household with surplus funds invests them in
government bonds
Fund Flows via Intermediaries
Markets
Surplus Units
Deficit Units
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
Fund Flows via Intermediaries and Markets
Markets
Surplus Units
Deficit Units
Intermediaries
Fund Flows via Intermediaries and Markets
Sometimes the intermediary itself has surplus funds, and invests
them in the market or another intermediary
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
Fund 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
Funds Flow via Markets and Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
3. Five Core Principles of Finance
- Time has value
- Risk requires compensation
- Information is the basis for decisions
- Markets determine prices and allocate resources
- Stability improves welfare
4. 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
5. Financial Decisions of Firms
Business Firms
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
Forms of business organization
Three major forms in the U.S
1. Sole proprietorship
2. Partnership
3. Corporation
Financial Decisions of Firms
When you start your own business, what financial decisions
do you have to take?
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.)
Financial decisions
Investment decision – how much to invest and in what assets?
Financing decision – where is money from in order to finance
long-term investments?
Working capital decision
Financial Decisions of Firms
The Capital Budgeting Process – Investment Decision
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
The Financing Process
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 )
Financial Decisions of Firms
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