Chapter 1 – Introduction to Finance

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38 Terms

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Finance
The study of concepts, applications, and systems that affect the value of individuals, companies, and countries over time
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Main focus of finance
Risk and return, and how to make decisions that maximize value
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Finance ≠ Money
Finance is about managing and allocating money effectively, not just holding or using it
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Main areas of finance
Business finance, investments, and financial markets and institutions
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Business finance
How companies raise and manage money to maximize shareholder value
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Working capital management
Managing short-term assets and liabilities to ensure liquidity
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Capital budgeting
Deciding which long-term projects a company should invest in
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Capital structure
Determining the mix of debt and equity financing used by a company
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Investments
How individuals and institutions allocate money to assets (like stocks or bonds) for future gain
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Financial markets and institutions
Systems that enable the flow of money between savers and borrowers through intermediaries and regulations
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Money – Forms

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

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Money – Functions
Medium of exchange, unit of account, and store of value
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Medium of exchange
Used to buy and sell goods or services
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Unit of account
Provides a common measure of value for goods and services
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Store of value
Maintains purchasing power over time
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Economic system – main entities
Households, firms, government, and foreign sector
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Households
Provide labor and savings to the economy
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Firms
Produce goods and demand capital for investment
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Government
Regulates, redistributes income, and influences the economy
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Foreign sector
Engages in international trade and capital flows
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Surplus Spending Units (SSU)
Have more income than expenditure; also called savers or lenders
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Deficit Spending Units (DSU)
Have more expenditure than income; also called borrowers or demanders of funds
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Financial system
A network of institutions, markets, and instruments that allow capital transfer between savers and borrowers
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Functions of the financial system
Money transferring, risk sharing, clearing and settlement, aggregation and disaggregation, shifting financial resources, providing information, and managing uncertainty
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Market-based system
Relies mainly on securities markets (example: USA)
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Bank-based system
Relies mainly on financial institutions (example: Germany)
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Financial intermediaries
Institutions that channel funds between savers and borrowers (like banks and insurance companies)
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Maturity transformation
Matching short-term deposits with long-term loans
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Risk transformation
Reducing or spreading risk among participants
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Convenience denomination
Pooling funds from many small investors
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Advantages of financial intermediaries
Lower costs, risk spreading, reconciling lender-borrower needs, and ensuring market stability
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Microeconomics
Studies decisions of individuals and firms (like supply, demand, and pricing)
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Macroeconomics
Studies overall economy variables such as inflation, GDP, and unemployment
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Role of finance in organizations
Planning and forecasting cash flows, selecting investment projects, and communicating with stakeholders
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Time and value concept
Finance studies trade-offs between present and future consumption using compounding and discounting
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Compounding
Process of earning interest on both the principal and previously earned interest
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Discounting
Process of finding the present value of future money
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Risk vs Return principle

Higher risk leads to higher potential returns, but not guaranteed