Defining Finance

Finance is the study of fund management and asset allocation over time.

Learning Objective

 Explain the importance of time to the discipline of finance

Key Points

 The two main drivers of finance are the time value of money and risk.
 Since the value of assets changes over time, finance seeks to ensure
the change is beneficial for the organization or individual.
 Financial professionals generally operate in an environment of
uncertainty where they must make forecasts about future events.

Terms

 debtor

A person or firm that owes money, one in debt, or one who owes a debt.

 asset

Something or someone of any value; any portion of one's property or effects so

considered.

 investment

A placement of capital in expectation of deriving income or profit from its use.

Overview

Finance is the study of fund management and asset allocation over time. Funds
consist of money and other assets. There are many different types of finance,
but all are fundamentally concerned with studying how best to allocate assets in
different conditions over time.

Importance of Time
The underlying driver behind all of finance is time. 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 than100todaythan100 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 I use that to cause my assets to change 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.
1.2 Comparing the Fields of Finance, Economics, and Accounting

Finance, economics, and accounting are business subjects with many similarities
and differences; each is a distinct field of study.

Learning Objective

 Recognize how finance, economics, and accounting overlap.

Key Points

 Finance is the study of how to optimally allocate assets. Finance is

fundamentally a forward looking field, concerned with what an asset
will be worth in the future.
 Economics is the social science that analyzes the production,
distribution, and consumption of goods and services.
 Accounting is the process of communicating financial information
about a business. Accounting is fundamentally a backward-looking
field.

Terms

 return

Gain or loss from an investment.

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

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

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

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.

Overlap

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.
1.3Role of Finance in an Organization

The primary role of corporate finance is to determine how best to maximize

shareholder value.

Learning Objective

 Define the role of finance in an organization

Key Points

 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 may appear to contradict each
other.
 The finance department is devoted to the task of figuring out how
to allocate assets for the overarching goal of maximizing shareholder
value. They must ensure that the right assets are in the right place at
the right time.
 The finance department must also manage the
company's liabilities so that all projects are financed in an optimal
way without taking on too much risk.

Terms

 liability

An obligation, debt, or responsibility owed to someone.

 asset

Something or someone of any value; any portion of one's property or

effects so considered.

 shareholder
 One who owns shares of stock.

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 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.

For example, a company could have two proposals from the R&D department to
develop different products, but only enough money to fund one. The finance
department will project out the future revenues and costs of each product and
figure out which one, if either, is worth the money.

iPod Touch
Apple used financial analysis to decide to fund the development of the iPod. The
money allocated for development could not be used for another project, but the
finance department determined the iPod was the best option.

Also, the finance department will determine when a company should take on a
liability. For example, suppose both projects are absolute home runs, but the
company still only has enough money to fund one. The finance department will
figure out if the company should borrow money so that it can fund both.

The role of finance in an organization is to make sure that money is at the right
place at the right time. A company wants to have enough money to pay its bills,
but also wants to invest so that it can grow in the future. The finance department
is devoted to the task of figuring out how to allocate assets to do so, for the
overarching goal of maximizing shareholder value.