Table of Contents

Title Page

Copyright Page

Dedication

Preface

CHAPTER 1 - What Is Finance?

CAPITAL MARKETS AND CAPITAL MARKET THEORY

FINANCIAL MANAGEMENT

INVESTMENT MANAGEMENT

ORGANIZATION OF THIS BOOK

THE BOTTOM LINE

QUESTIONS

PART One - The Financial System

CHAPTER 2 - Financial Instruments, Markets, and Intermediaries

THE FINANCIAL SYSTEM

THE ROLE OF FINANCIAL MARKETS

THE ROLE OF FINANCIAL INTERMEDIARIES

TYPES OF FINANCIAL MARKETS

THE BOTTOM LINE

QUESTIONS

CHAPTER 3 - The Financial System’s Cast of Characters

DOMESTIC NONFINANCIAL SECTORS

NONFINANCIAL BUSINESSES

DOMESTIC FINANCIAL SECTORS

FOREIGN INVESTORS

THE BOTTOM LINE

QUESTIONS

PART Two - Financial Management

CHAPTER 4 - Financial Statements

ACCOUNTING PRINCIPLES: WHAT ARE THEY?

THE BASIC FINANCIAL STATEMENTS

HOW ARETHE STATEMENTS RELATED?

WHY BOTHER ABOUT THEFOOTNOTES?

ACCOUNTING FLEXIBILITY

U.S. ACCOUNTING VS. OUTSIDE OF THE U.S.

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 5 - Business Finance

FORMS OF BUSINESS ENTERPRISE

THE OBJECTIVE OF FINANCIAL MANAGEMENT

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 6 - Financial Strategy and Financial Planning

STRATEGY AND VALUE

THE BUDGETING PROCESS

BUDGETING

PERFORMANCE EVALUATION

STRATEGY AND VALUE CREATION

THE BOTTOM LINE

QUESTIONS

CHAPTER 7 - Dividend and Dividend Policies

DIVIDENDS

STOCK DISTRIBUTIONS

DIVIDEND POLICIES

STOCK REPURCHASES

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 8 - The Corporate Financing Decision

DEBT VS. EQUITY

FINANCIAL LEVERAGE AND RISK

FINANCIAL DISTRESS

THE COST OF CAPITAL

OPTIMAL CAPITAL STRUCTURE: THEORY AND PRACTICE

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 9 - Financial Risk Management

THE DEFINITION OF RISK

ENTERPRISE RISK MANAGEMENT

MANAGING RISKS

THE BOTTOM LINE

QUESTIONS

PART Three - Valuation and Analytical Tools

CHAPTER 10 - The Math of Finance

WHY THE TIME VALUE OF MONEY?

CALCULATING THE FUTURE VALUE

CALCULATING A PRESENT VALUE

DETERMINING THE UNKNOWN INTEREST RATE

THE TIME VALUE OF A SERIES OF CASH FLOWS

ANNUITIES

LOAN AMORTIZATION

INTEREST RATES AND YIELDS

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 11 - Financial Ratio Analysis

CLASSIFYING FINANCIAL RATIOS

LIQUIDITY

PROFITABILITY RATIOS

ACTIVITY RATIOS

FINANCIAL LEVERAGE

RETURN ON INVESTMENT

THE DUPONT SYSTEM

COMMON-SIZE ANALYSIS

USING FINANCIAL RATIO ANALYSIS

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 12 - Cash Flow Analysis

DIFFICULTIES WITH MEASURING CASH FLOW

FREE CASH FLOW

USEFULNESS OF CASH FLOWS ANALYSIS

RATIO ANALYSIS

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 13 - Capital Budgeting

INVESTMENT DECISIONS AND OWNERS’ WEALTH

THE CAPITAL BUDGETING PROCESS

DETERMINING CASH FLOWS FROM INVESTMENTS

CAPITAL BUDGETING TECHNIQUES

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 14 - Derivatives for Controlling Risk

FUTURES AND FORWARD CONTRACTS

OPTIONS

SWAPS

THE BOTTOM LINE

APPENDIX: BLACK- SCHOLES OPTION PRICING MODEL

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

PART Four - Investment Management

CHAPTER 15 - Investment Management

SETTING INVESTMENT OBJECTIVES

ESTABLISHING AN INVESTMENT POLICY

CONSTRUCTING AND MONITORING A PORTFOLIO

MEASURING AND EVALUATING PERFORMANCE

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 16 - The Theory of Portfolio Selection

SOME BASIC CONCEPTS

ESTIMATING A PORTFOLIO’S EXPECTED RETURN

MEASURING PORTFOLIO RISK

PORTFOLIO DIVERSIFICATION

CHOOSING A PORTFOLIO OF RISKY ASSETS

ISSUES IN THE THEORY OF PORTFOLIO SELECTION

BEHAVIORAL FINANCE AND PORTFOLIO THEORY

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 17 - Asset Pricing Theory

CHARACTERISTICS OF AN ASSET PRICING MODEL

THE CAPITAL ASSET PRICING MODEL

THE ARBITRAGE PRICING THEORY MODEL

SOME PRINCIPLES TO TAKE AWAY

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 18 - The Structure of Interest Rates

THE BASE INTEREST RATE

THE TERM STRUCTURE OF INTEREST RATES

TERM STRUCTURE OF INTEREST RATES THEORIES

SWAP RATE YIELD CURVE

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 19 - Valuing Common Stock

DISCOUNTED CASH FLOW MODELS

RELATIVE VALUATION METHODS

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

CHAPTER 20 - Valuing Bonds

VALUING A BOND

CONVENTIONAL YIELD MEASURES

VALUING BONDS THAT HAVE EMBEDDED OPTIONS

THE BOTTOM LINE

SOLUTIONS TO TRY IT! PROBLEMS

QUESTIONS

Glossary

About the Authors

Index

APPENDIX - Solutions to End of Chapter Questions

The Frank J. Fabozzi Series

Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz
Foundations of Economic Value Added, Second Edition by James L. Grant
Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson

Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi
The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry
The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry
The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi
Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy
Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann
Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi

Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm

Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet

Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi

Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi

Handbook of Alternative Assets, Second Edition by Mark J. P. Anson
Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry
Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic

Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning

Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi

Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi

How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross

Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi
The Handbook of Commodity Investing by Frank J. Fabozzi, Roland Füss, and Dieter G. Kaiser
The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi

Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas, Thomas A Zimmerman, and Frank J. Fabozzi

Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari
Structured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi
Handbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J. Fabozzi
Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. Fabozzi
Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by Frank J. Fabozzi

Finance: Capital Markets, Financial Management, and Investment Management by Frank J. Fabozzi and Pamela Peterson Drake

Active Private Equity Real Estate Strategy edited by David J. Lynn
Foundations and Applications of the Time Value of Money by Pamela Peterson Drake and Frank J. Fabozzi

Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives by Stephen Antczak, Douglas Lucas, and Frank J. Fabozzi

Modern Financial Systems: Theory and Applications by Edwin Neave
Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications by Frank J. Fabozzi
Quantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, Sergio M. Focardi, Petter N. Kolm

Basics of Finance: An Introduction to Financial Markets, Business Finance, and Portfolio Management by Frank J. Fabozzi and Pamela Peterson Drake

Simulation and Optimization in Finance: Modeling with MATLAB, @Risk, or VBA by Dessislava Pachamanova and Frank J. Fabozzi

Copyright © 2010 by John Wiley & Sons. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Fabozzi, Frank J.

The basics of finance : an introduction to financial markets, business finance, and portfolio management / Frank J. Fabozzi, Pamela Peterson Drake.

p. cm. - (Frank J. Fabozzi series ; 192)

Includes index.

ISBN 978-0-470-60971-2 (cloth); 978-0-470-87743-2 (ebk); 978-0-470-87771-5 (ebk); 978-0-470-87772-2 (ebk)

1. Finance. I. Peterson Drake, Pamela, 1954- II. Title.

HG173.F25 2010

332-dc22 2010010863

To my husband, Randy, and my children, Ken and Erica

—P.P.D.

To my wife, Donna, and my children, Francesco, Patricia, and Karly

—F.J.F.

Preface

An investment in knowledge pays the best interest.

—Benjamin Franklin

The purpose of this book is to provide an introduction to financial decision-making, and the framework in which these decisions are made. The Basics of Finance is an accessible book for those who want to gain a better understanding of this field, but lack a strong business background. In this book, we cover the essential concepts, tools, methods, and strategies in finance without delving too far into theory.

In Basics of Finance, we discuss financial instruments and markets, portfolio management techniques, understanding and analyzing financial statements, and corporate financial strategy, planning, and policy. We explain concepts in various areas of finance without getting too complicated.

We explore, in a basic way, topics such as cash flow analysis, asset valuation, capital budgeting, and derivatives. We also provide a solid foundation in the field of finance, which you can quickly build upon.

Along the way, we provide sample problems—Try it! problems—so that you can try out any math that we demonstrate in the chapter. We also provide end-of-chapter questions—with solutions easily accessible on our web site—that test your knowledge of the basic terms and concepts that we discuss in the chapter. Solutions to end-of-chapter problems can be downloaded by visiting www.wiley.com/go/petersonbasics. Please log in to the web site using this password: Petersonbasics123.

The Basics of Finance offers essential guidance on financial markets and institutions, business finance, portfolio management, risk management, and much more. If you’re looking to learn more about finance, this is the place to start.

We thank Glen Larsen, Professor of Finance at the Kelley School of Business, Indiana University, for coauthoring with us the section on relative valuation in Chapter 19.

PAMELA PETERSON DRAKE
FRANK J. FABOZZI
May 2010

CHAPTER 1

What Is Finance?

A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.

—Warren Buffett, Letter to Shareholders of Berkshire
Hathaway, February 2008

Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty. In other words, in finance we worry about money and we worry about the future. Investors allocate their funds among financial assets in order to accomplish their objectives, and businesses and governments raise funds by issuing claims against themselves and then use those funds for operations.

Finance provides the framework for making decisions as to how to get funds and what we should do with them once we have them. It is the financial system that provides the platform by which funds are transferred from those entities that have funds to those entities that need funds.

The foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics. For example, as you saw with the quote by Warren Buffett at the beginning of this chapter, competition is important in the valuation of a company. The ability to keep competitors at bay is valuable because it ensures that the company can continue to earn economic profits.¹

EXHIBIT 1.1 Finance and Its Relation to Other Fields

FINANCE IS . . .

• analytical, using statistical, probability, and mathematics to solve problems.

• based on economic principles.

• uses accounting information as inputs to decision-making.

• global in perspective.

• the study of how to raise money and invest it productively.

The tools used in financial decision-making, however, draw from many areas outside of economics: financial accounting, mathematics, probability theory, statistical theory, and psychology, as we show in Exhibit 1.1.

We can think of the field of finance as comprised of three areas: capital markets and capital market theory, financial management, and investment management, as we illustrate in Exhibit 1.2. And, as this exhibit illustrates, the three areas are all intertwined, based on a common set of theories and principles. In the balance of this chapter, we discuss each of these specialty areas.

EXHIBIT 1.2 The Three Areas within the Field of Finance

CAPITAL MARKETS AND CAPITAL MARKET THEORY

The field of capital markets and capital market theory focuses on the study of the financial system, the structure of interest rates, and the pricing of risky assets. The financial system of an economy consists of three components: (1) financial markets; (2) financial intermediaries; and (3) financial regulators. For this reason, we often refer to this area as financial markets and institutions.

Several important topics included in this specialty area of finance are the pricing efficiency of financial markets, the role and investment behavior of the players in financial markets, the best way to design and regulate financial markets, the measurement of risk, and the theory of asset pricing. The pricing efficiency of the financial markets is critical because it deals with whether investors can “beat the market.” If a market is highly price efficient, it is extremely difficult for investors to earn returns that are greater than those expected for the investment’s level of risk—that is, it is difficult for investors to beat the market. An investor who pursues an investment strategy that seeks to “beat the market” must believe that the sector of the financial market to which the strategy is applied is not highly price efficient. Such a strategy seeking to “beat the market” is called an active strategy. Financial theory tells us that if a capital market is efficient, the optimal strategy is not an active strategy, but rather is a passive strategy that seeks to match the performance of the market.

In finance, beating the market means outperforming the market by generating a return on investment beyond what is expected after adjusting for risk and transaction costs. To be able to quantitatively determine what is “expected” from an investment after adjusting for risk, it is necessary to formulate and empirically test theories about how assets are priced or, equivalently, valuing an asset to determine its fair value.

A cow for her milk
A hen for her eggs,
And a stock, by heck,
For her dividends.

An orchard for fruit,
Bees for their honey,
And stocks, besides,
For their dividends.

—John Burr Williams “Evaluation of the Rule of Present Worth,” Theory of Investment Value, 1937

The fundamental principle of valuation is that the value of any financial asset is the present value of the expected cash flows. Thus, the valuation of a financial asset involves (1) estimating the expected cash flows; (2) determining the appropriate interest rate or interest rates that should be used to discount the cash flows; and (3) calculating the present value of the expected cash flows. For example, in valuing a stock, we often estimate future dividends and gauge how uncertain are these dividends. We use basic mathematics of finance to compute the present value or discounted value of cash flows. In the process of this calculation of the present value or discounted value, we must use a suitable interest rate, which we will refer to as a discount rate. Capital market theory provides theories that guide investors in selecting the appropriate interest rate or interest rates.

FINANCIAL MANAGEMENT

Financial management, sometimes called business finance or corporate finance, is the specialty area of finance concerned with financial decision-making within a business entity. Although financial management is often referred to as corporate finance, the principles of financial management also apply to other forms of business and to government entities. Financial managers are primarily concerned with investment decisions and financing decisions within organizations, whether that organization is a sole proprietorship, a partnership, a limited liability company, a corporation, or a governmental entity.

Regarding investment decisions, we are concerned with the use of funds—the buying, holding, or selling of all types of assets: Should a business purchase a new machine? Should a business introduce a new product line? Sell the old production facility? Acquire another business? Build a manufacturing plant? Maintain a higher level of inventory?

Financing decisions are concerned with the procuring of funds that can be used for long-term investing and financing day-to-day operations. Should financial managers use profits raised through the company’s revenues or distribute those profits to the owners? Should financial managers seek money from outside of the business? A company’s operations and investments can be financed from outside the business by incurring debt—such as through bank loans or the sale of bonds—or by selling ownership interests. Because each method of financing obligates the business in different ways, financing decisions are extremely important. The financing decision also involves the dividend decision, which involves how much of a company’s profit should be retained and how much to distribute to owners.

A company’s financial strategic plan is a framework of achieving its goal of maximizing owner’s wealth. Implementing the strategic plan requires both long-term and short-term financial planning that brings together forecasts of the company’s sales with financing and investment decision-making. Budgets are employed to manage the information used in this planning; performance measures are used to evaluate progress toward the strategic goals.

The capital structure of a company is the mixture of debt and equity that management elects to raise to finance the assets of the company. There are several economic theories about how the company should be financed and whether an optimal capital structure (that is, one that maximizes a company’s value) exists.

Investment decisions made by the financial manager involve the long-term commitment of a company’s scarce resources in long-term investments. We refer to these decisions as capital budgeting decisions. These decisions play a prominent role in determining the success of a business enterprise. Although there are capital budgeting decisions that are routine and, hence, do not alter the course or risk of a company, there are also strategic capital budgeting decisions that either affect a company’s future market position in its current product lines or permit it to expand into new product lines in the future.

A financial manager must also make decisions about a company’s current assets. Current assets are those assets that could reasonably be converted into cash within one operating cycle or one year, whichever takes longer. Current assets include cash, marketable securities, accounts receivable, and inventories, and support the long-term investment decisions of a company.

Another critical task in financial management is the risk management of a company. The process of risk management involves determining which risks to accept, which to neutralize, and which to transfer. The four key processes in risk management are risk:

1. Identification

2. Assessment

3. Mitigation

4. Transference

The traditional process of risk management focuses on managing the risks of only parts of the business (products, departments, or divisions), ignoring the implications for the value of the company. Today, some form of enterprise risk management is followed by large corporations, which is risk management applied to the company as a whole. Enterprise risk management allows management to align the risk appetite and strategies across the company, improve the quality of the company’s risk response decisions, identify the risks across the company, and manage the risks across the company.

The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that substitutes deliberate ignorance for thoughtful planning.

—Charles Tremper

INVESTMENT MANAGEMENT

Investment management is the specialty area within finance dealing with the management of individual or institutional funds. Other terms commonly used to describe this area of finance are asset management, portfolio management , money management, and wealth management. In industry jargon, an asset manager “runs money.”

EXHIBIT 1.3 Investment Management Activities

Investment management involves five primary activities, as we detail in Exhibit 1.3. Setting investment objectives starts with a thorough analysis of what the entity or client wants to accomplish. Given the investment objectives, the investment manager develops policy guidelines, taking into consideration any client-imposed investment constraints, legal/regulatory constraints, and tax restrictions. This task begins with the decision of how to allocate assets in the portfolio (i.e., how the funds are to be allocated among the major asset classes). The portfolio is simply the set of investments that are managed for the benefit of the client or clients. Next, the investment manager must select a portfolio strategy that is consistent with the investment objectives and investment policy guidelines.

In general, portfolio strategies are classified as either active or passive. Selecting the specific financial assets to include in the portfolio, which is referred to as the portfolio selection problem, is the next step. The theory of portfolio selection was formulated by Harry Markowitz in 1952.² This theory proposes how investors can construct portfolios based on two parameters: mean return and standard deviation of returns. The latter parameter is a measure of risk. An important task is the evaluation of the performance of the asset manager. This task allows a client to determine answers to questions such as: How did the asset manager perform after adjusting for the risks associated with the active strategy employed? And, how did the asset manager achieve the reported return?

ORGANIZATION OF THIS BOOK

We have organized this book in parts to enable you to see how all the pieces in finance come together. In Part One, we provide the basic framework of the financial system and the players in this system. In Part Two, we focus on financial management, and discuss financial statements, financial decision-making within a business enterprise, strategy, and decisions including dividends, financing, and investment management.

In Part Three, we focus more on the analytical part of finance, which involves valuing assets, making investment decisions, and analyzing performance. In Part Four, we introduce you to investments, which include derivatives and risk management, as well as portfolio management. In this part, we also explain the basic methods that are used to value stocks and bonds, and some of the theories behind these valuations.

THE BOTTOM LINE

• Finance blends together economics, psychology, accounting, statistics, mathematics, and probability theory to make decisions that involve future outcomes.

• We often characterize finance as comprised of three related areas: capital markets and capital market theory, financial management, and investment management.

• Capital markets and capital market theory focus on the financial system that includes markets, intermediaries, and regulators.

• Financial management focuses on the decision-making of a business enterprise, which includes decisions related to investing in long-lived assets and financing these investments.

• Investment management deals with managing the investments of individuals and institutions.

QUESTIONS

1. What distinguishes investment management from financial management?

2. What is the role of a discount rate in decision-making?

3. What is the responsibility of the investment manager with respect to the investment portfolio?

4. Distinguish between capital budgeting and capital structure.

5. What are current assets?

6. If a market is price efficient, a. Can an investor “beat the market”? b. Which type of portfolio management—active or passive—is best?

7. What does the financing decision of a firm involve?

8. List the general steps in the risk management of a company.

9. What is enterprise risk management?

10. List the five activities of an investment manager.

PART One

The Financial System

CHAPTER 2

Financial Instruments, Markets, and Intermediaries

A strong financial system is vitally important—not for Wall Street, not for bankers, but for working Americans. When our markets work, people throughout our economy benefit—Americans seeking to buy a car or buy a home, families borrowing to pay for college, innovators borrowing on the strength of a good idea for a new product or technology, and businesses financing investments that create new jobs. And when our financial system is under stress, millions of working Americans bear the consequences. Government has a responsibility to make sure our financial system is regulated effectively. And in this area, we can do a better job. In sum, the ultimate beneficiaries from improved financial regulation are America’s workers, families, and businesses—both large and small.

—Henry M. Paulson, Jr., then Secretary of the U.S. Department
of the Treasury, March 31, 2008

THE FINANCIAL SYSTEM

A country’s financial system consists of entities that help facilitate the flow of funds from those that have funds to invest to those who need funds to invest. Consider if you had to finance a purchase of a home by rounding up enough folks willing to lend to you. This would be challenging—and a bit awkward. In addition, this would require careful planning—and lots of paperwork—to keep track of the loan contracts, and how much you must repay and to whom. And what about the folks you borrow from? How are they going to evaluate whether they should lend to you and what interest rate they should charge you for the use of their funds?

In lending and investing situations, there is not only the awkwardness of dealing directly with the other party or parties, but there is the problem that one party has a different information set than the other. In other words, there is information asymmetry.

A financial system makes possible a more efficient transfer of funds by mitigating the information asymmetry problem between those with funds to invest and those needing funds. In addition to the lenders and the borrowers, the financial system has three components: (1) financial markets, where transactions take place; (2) financial intermediaries, who facilitate the transactions; and (3) regulators of financial activities, who try to make sure that everyone is playing fair. In this chapter, we look at each of these components and the motivation for their existence. Before we discuss the participants, we need to first discuss financial assets, which represent the borrowings or investments.

Financial Assets

An asset is any resource that we expect to provide future benefits and, hence, has economic value. We can categorize assets into two types: tangible assets and intangible assets. The value of a tangible asset depends on its physical properties. Buildings, aircraft, land, and machinery are examples of tangible assets, which we often refer to as fixed assets.

An intangible asset represents a legal claim to some future economic benefit or benefits. Examples of intangible assets include patents, copyrights, and trademarks. The value of an intangible asset bears no relation to the form, physical or otherwise, in which the claims are recorded. , such as stocks and bonds, are also intangible assets because the future benefits come in the form of a claim to future cash flows. Another term we use for a financial asset is We often refer to certain types of financial instruments as , which include stocks and bonds.

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!