Chapter 1 – Introduction to Finance

Finance

The study of concepts, applications, and systems that affect the value of individuals, companies, and countries over time

Main focus of finance

Risk and return, and how to make decisions that maximize value

Finance ≠ Money

Finance is about managing and allocating money effectively, not just holding or using it

Main areas of finance

Business finance, investments, and financial markets and institutions

Business finance

How companies raise and manage money to maximize shareholder value

Working capital management

Managing short-term assets and liabilities to ensure liquidity

Capital budgeting

Deciding which long-term projects a company should invest in

Capital structure

Determining the mix of debt and equity financing used by a company

Investments

How individuals and institutions allocate money to assets (like stocks or bonds) for future gain

Financial markets and institutions

Systems that enable the flow of money between savers and borrowers through intermediaries and regulations

Money – Forms

Cash and cashless (cards, transfers, crypto, etc)

Money – Functions

Medium of exchange, unit of account, and store of value

Medium of exchange

Used to buy and sell goods or services

Unit of account

Provides a common measure of value for goods and services

Store of value

Maintains purchasing power over time

Economic system – main entities

Households, firms, government, and foreign sector

Households

Provide labor and savings to the economy

Firms

Produce goods and demand capital for investment

Government

Regulates, redistributes income, and influences the economy

Foreign sector

Engages in international trade and capital flows

Surplus Spending Units (SSU)

Have more income than expenditure; also called savers or lenders

Deficit Spending Units (DSU)

Have more expenditure than income; also called borrowers or demanders of funds

Financial system

A network of institutions, markets, and instruments that allow capital transfer between savers and borrowers

Functions of the financial system

Money transferring, risk sharing, clearing and settlement, aggregation and disaggregation, shifting financial resources, providing information, and managing uncertainty

Market-based system

Relies mainly on securities markets (example: USA)

Bank-based system

Relies mainly on financial institutions (example: Germany)

Financial intermediaries

Institutions that channel funds between savers and borrowers (like banks and insurance companies)

Maturity transformation

Matching short-term deposits with long-term loans

Risk transformation

Reducing or spreading risk among participants

Convenience denomination

Pooling funds from many small investors

Advantages of financial intermediaries

Lower costs, risk spreading, reconciling lender-borrower needs, and ensuring market stability

Microeconomics

Studies decisions of individuals and firms (like supply, demand, and pricing)

Macroeconomics

Studies overall economy variables such as inflation, GDP, and unemployment

Role of finance in organizations

Planning and forecasting cash flows, selecting investment projects, and communicating with stakeholders

Time and value concept

Finance studies trade-offs between present and future consumption using compounding and discounting

Compounding

Process of earning interest on both the principal and previously earned interest

Discounting

Process of finding the present value of future money

Risk vs Return principle

Higher risk leads to higher potential returns, but not guaranteed