Module 1 Flashcards
Defining Finance
Finance is the study of fund management and asset allocation over time. There are many different types of finance, but all are fundamentally concerned with studying how best to allocate assets in different conditions over time.
Walmart CFO: Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.
Funds consist of
money and other assets.
The underlying driver behind all of finance is
time
investment:
asset:
debtor:
return:
shareholder:
asset:
liability:
investment: A placement of capital in expectation of deriving income or profit from its use.
asset: Something or someone of any value; any portion of one’s property or effects so considered.
debtor: A person or firm that owes money, one in debt, or one who owes a debt.
return: Gain or loss from an investment
shareholder: One who owns shares of stock.
asset: Something or someone of any value; any portion of one’s property or effects so considered.
liability: An obligation, debt or responsibility owed to someone.
There are two reasons why time is so important to finance:
- Time value of money: For a number of reasons, money today is worth more than the same amount of money in the future. For example, you would rather have $100 today than $100 in 10 years – the money is worth more to you now than it would be in the distant future. We will explore this concept in greater depth later on.
- Risk: Making an investment does not guarantee a return. When a bank makes a loan, they’re not sure the debtor will pay it back. There is a risk that the person will just take the money and run, the debtor will file for bankruptcy, or, for dozens of other reasons, the bank will not get the money they lent back.
The field of finance, however, embraces time. Finance says,
“Since I know assets change value over time, how do use that to cause my assets to change the value in the direction I want? How do I manage assets so that they’re worth more in the future than they are today? ”
Challenges in Finance
Figuring out what to do with assets is sometimes easy: all of the variables are known, and there is clearly an option that is better than all the others. However, most of the time, this is not the case. Finance generally operates with a lot of uncertainty. As a result, companies hire entire departments of people to help them figure out which option is best.
Finance, economics, and accounting are
business subjects with many similarities and differences. While they influence each other, each is a distinct field of study.
Finance is
the study of how to optimally allocate assets—how individuals and organizations should invest assets in order to get the highest possible return given changing conditions over time. Finance is fundamentally a forward-looking field, concerned with what an asset will be worth in the future.
Economics is
a social science that analyzes the production, distribution, and consumption of goods and services. It focuses on how economic agents (people, businesses, and government) interact and make decisions. Economics is fundamentally the study of cause and effect. It tries to figure out how one variable affects economic agents or the economy as a whole.
Accounting focuses on
communicating a businesses’ financial information. Accounting is fundamentally a backward-looking field, concerned with what has already happened financially and what position that leaves the company in today.
If accounting is called the language of business, then the financial statements that accountants prepare
are the words. Statements are created under a standardized set of accounting laws, which allows one to easily compare and contrast companies. This indicates how financially healthy a company is
Explain how finance, economics, and accounting overlap in a lot of areas.
For example, an investor will use accounting to see whether a company has shown past financial success and to predict what the company will look like in the future. Part of that prediction incorporates economics. The investor wants to know what the overall economy will look like in the future and wants to know how the company will interact with its competitors. The investor can use finance to figure out what his or her investment will be worth in the future.
There are few strong delineators between finance, economics and accounting. All three fields intermingle and influence one another. It is almost impossible to have a strong grasp of one without at least a basic understanding of the other two.
The primary role of corporate finance is
to determine how best to maximize shareholder value
Corporate finance is
the area of finance dealing with monetary decisions that business enterprises make.
When finance is talked about in the context of business decisions, it is called corporate finance (technically, corporate finance deals only with corporations, while managerial finance deals with all types of companies, but we will use the terms interchangeably). There are other branches of finance such as personal finance (individuals taking care of their money) and public finance (the finances of the government).
The primary goal of corporate finance is
to maximize shareholder value. Maximizing shareholder value can be done over the long-term or the short-term, so the job of the finance department is to determine how best to do both.
Sometimes, the goals of long term and short term may appear to be in competition with one another. For example,
a company can choose to pay dividends (a small payment to each person who owns a stock of a company), which increases short-term shareholder wealth. However, paying dividends means that the money is not being invested in long-term investments, which may cause the stock price to increase more in the future, and thereby increasing long-term shareholder wealth.
The technique behind maximizing shareholder value is the management of assets. This means that the finance department figures out how to best invest its money.
The technique behind maximizing shareholder value is the management of assets. This means that the finance department figures out how to best invest its money.
