CHAPTER1

WHATISFINANCE?

Objectives

Definefinance.

Explainwhyfinanceisworthstudying.

Introducethemainplayersintheworldoffinance—householdsandfirms—andthekindsoffinancialdecisionstheymake.

Outline

tc"Outline"

1.1 DefiningFinance

1.2 WhyStudyFinance?

1.3 FinancialDecisionsofHouseholds

1.4 FinancialDecisionsofFirms

1.5 FormsofBusinessOrganization

1.6 SeparationofOwnershipandManagement

1.7 TheGoalofManagement

1.8 MarketDiscipline:Takeovers

1.9 TheRoleoftheFinanceSpecialistinaCorporation

Summary

tc"Summary"

Financeisthestudyofhowtoallocatescarceresourcesovertime.Thetwofeaturesthatdistinguishfinancearethatthecostsandbenefitsoffinancialdecisionsarespreadoutovertimeandareusuallynotknownwithcertaintyinadvancebyeitherthedecision-makeroranybodyelse.

Abasictenetoffinanceisthattheultimatefunctionofthesystemistosatisfypeople’sconsumptionpreferences.Economicorganizationssuchasfirmsandgovernmentsexistinordertofacilitatetheachievementofthatultimatefunction.Manyfinancialdecisionscanbemadestrictlyonthebasisofimprovingthetradeoffsavailabletopeoplewithoutknowledgeoftheirconsumptionpreferences.

Thereareatleastfivegoodreasonstostudyfinance:

Tomanageyourpersonalresources.

Todealwiththeworldofbusiness.

Topursueinterestingandrewardingcareeropportunities.

Tomakeinformedpublicchoicesasacitizen.

Toexpandyourmind.

Theplayersinfinancetheoryarehouseholdsandbusinessfirms.Householdsoccupyaspecialplaceinthetheorybecausetheultimatefunctionofthesystemistosatisfythepreferencesofpeople,andthetheorytreatsthosepreferencesasgiven.Financetheoryexplainshouseholdbehaviorasanattempttosatisfythosepreferences.Thebehavioroffirmsisviewedfromtheperspectiveofhowitaffectsthewelfareofhouseholds.

Householdsfacefourbasictypesoffinancialdecisions:

Savingdecisions:Howmuchoftheircurrentincomeshouldtheysaveforthefuture?

Investmentdecisions:Howshouldtheyinvestthemoneytheyhavesaved?

Financingdecisions:Whenandhowshouldtheyuseotherpeople’smoneytosatisfytheirwantsandneeds?

Riskmanagementdecisions:Howandonwhattermsshouldtheyseektoreducetheeconomicuncertaintiestheyfaceortotakecalculatedrisks?

Therearethreemainareasoffinancialdecision-makinginabusiness:capitalbudgeting,capitalstructure,andworkingcapitalmanagement.

Therearefivereasonsforseparatingthemanagementfromtheownershipofabusinessenterprise:

Professionalmanagersmaybefoundwhohaveasuperiorabilitytorunthebusiness.

Toachievetheefficientscaleofabusinesstheresourcesofmanyhouseholdsmayhavetobepooled.

Inanuncertaineconomicenvironment,ownerswillwanttodiversifytheirrisksacrossmanyfirms.Suchefficientdiversificationisdifficulttoachievewithoutseparationofownershipandmanagement.

Savingsinthecostsofgatheringinformation.

The“l(fā)earningcurve”or“goingconcern”effect.Whentheownerisalsothemanager,thenewownerhastolearnthebusinessfromtheoldownerinordertomanageitefficiently.Iftheownerisnotthemanager,thenwhenthebusinessissold,themanagercontinuesinplaceandworksforthenewowner.

Thecorporateformisespeciallywellsuitedtotheseparationofownershipandmanagementoffirmsbecauseitallowsrelativelyfrequentchangesinownersbysharetransferwithoutaffectingtheoperationsofthefirm.

Theprimarygoalofcorporatemanagementistomaximizeshareholderwealth.Itleadsmanagerstomakethesameinvestmentdecisionsthateachoftheindividualownerswouldhavemadehadtheymadethedecisionsthemselves.

Acompetitivestockmarketimposesastrongdisciplineonmanagerstotakeactionstomaximizethemarketvalueofthefirm’sshares.

SolutionstoProblemsatEndofChapter

1. Whatareyourmaingoalsinlife?Howdoesfinanceplayapartinachievingthosegoals?Whatarethemajortrade-offsyouface?

SAMPLEANSWER:

Finishschool

GetgoodpayingjobwhichIlike

Getmarriedandhavechildren

Ownmyownhome

Provideforfamily

Payforchildren’seducation

Retire

HowFinancePlaysaRole:

SAMPLEANSWER:

Financehelpsmepayforundergraduateandgraduateeducationandhelpsmedecidewhetherspendingthemoneyongraduateeducationwillbeagoodinvestmentdecisionornot.

HighereducationshouldenhancemyearningpowerandabilitytoobtainajobIlike.

OnceIammarriedandhavechildrenIwillhaveadditionalfinancialresponsibilities(dependents)andIwillhavetolearnhowtoallocateresourcesamongindividualsinthehouseholdandlearnhowtosetasideenoughmoneytopayforemergencies,education,vacationsetc.Financealsohelpsmeunderstandhowtomanageriskssuchasfordisability,lifeandhealth.

FinancehelpsmedeterminewhetherthehomeIwanttobuyisagoodvalueornot.Thestudyoffinancealsohelpsmedeterminethecheapestsourceoffinancingforthepurchaseofthathome.

FinancehelpsmedeterminehowmuchmoneyIwillhavetosaveinordertopayformychildren’seducationaswellasmyownretirement.

MajorTrade-Offs:

SAMPLEANSWER

Spendmoneynowbygoingtocollege(andpossiblygraduateschool)butpresumablymakemoremoneyonceIgraduateduetomyhighereducation.

ConsumenowandhavelessmoneysavedforfutureexpendituressuchasforahouseorcarORsavemoremoneynowbutconsumelessthansomeofmyfriends.

2. Whatisyournetworth?Whathaveyouincludedamongyourassetsandyourliabilities?Whathaveyouexcludedthatyoumighthaveincluded?

SAMPLEANSWER:

$____________(verypossiblynegativeatthispoint)

Assets:

Checkingaccountbalance

Savingsaccountbalance

Furniture/Jewelry(watch)

Car(possibly)

Liabilities:

Studentloans

Creditcardbalance

Ifrenting,remainderofrentalagreement(unlesssublettingisapossibility)

Carpayments(possibly)

Studentstypicallyexcludethehighvalueoftheirpotentiallifetimeearningpowerwhencalculatingtheirnetworth.

3. Howarethefinancialdecisionsfacedbyasinglepersonlivingalonedifferentfromthosefacedbytheheadofahouseholdwithresponsibilityforseveralchildrenofschoolage?Arethetradeoffstheyhavetomakedifferent,orwilltheyevaluatethetradeoffsdifferently?

Asinglepersonneedsonlytosupporthimselfandthereforecanmakeeveryfinancialdecisiononhisown.Ifhedoesnotwanthealthinsurance(andiswillingtobearthefinancialrisksassociatedwiththatdecision)thennoonewillbeaffectedbythatdecisionotherthanthatsingleperson.Inaddition,thispersonneedstomakenodecisionsaboutallocatingincomeamongdependents.Asinglepersonisverymobileandcanchoosetolivealmostanywhere.Thetradeoffsthisindividualmakesgenerallyconcernissuesofconsuming(orspending)todayversussavingforconsumptiontomorrow.Sincethispersonissupportingonlyhimself,theneedtosavenowislessimportantthanfortheheadofhouseholddiscussednext.

Theheadofhouseholdwithseveralchildrenmustshareresources(income)amongdependents.Thisindividualmustbepreparedtodealwithriskmanagementissuessuchashowtobepreparedforpotentialfinancialemergencies(suchasaserioushealthproblemexperiencedbyamemberofthefamilyorhomeownersinsuranceincaseofafireorothermishap).Becausetherearemorepeopleinthishouseholdthanwithasingleperson,therearegreaterrisksthatsomeonewillgetsickorinjured.Andbecausetherearedependents,thewageearner(s)shouldthinkcarefullyaboutlifeanddisabilityinsurance.Inaddition,thefamilyisnotasmobileasthesingleindividual.Becauseoftheschoolagechildren,thefamilymightwanttolivenear“goodschools”thinkingthatastrongereducationwilleventuallyhelpthosechildren’sfuturewellbeingandfinancialsituation.Thus,thetradeoffsfortheheadofhouseholdaremorecomplex:moremoneyisneededtoconsumetoday(heorsheneedstosupportmoredependents),butalotmoremoneyisalsoneededtosaveforfutureexpensessuchaseducationandhousingandmoremoneyisneededforriskmanagementsuchaslifeanddisabilityinsurance.

4. FamilyAandfamilyBbothconsistofafather,motherandtwochildrenofschoolage.InfamilyAbothspouseshavejobsoutsidethehomeandearnacombinedincomeof$100,000peryear.InfamilyB,onlyonespouseworksoutsidethehomeandearns$100,000peryear.Howdothefinancialcircumstancesanddecisionsfacedbythetwofamiliesdiffer?

Withtwowageearners,thereislessriskofatotallossoffamilyincomeduetounemploymentordisabilitythanthereisinasinglewageearninghousehold.Thesinglewageearningfamilywillprobablywantmoredisabilityandlifeinsurancethanthetwowageearningfamily.Ontheflipside,however,thetwowageearningfamilymayneedtospendextramoneyonchildcareexpensesiftheyneedtopaysomeonetowatchthechildrenafterschool.

5. Atwhatageshouldchildrenbeexpectedtobecomefinanciallyindependent?

Studentswillhavedifferingresponsestothisquestiondependingupontheirspecificexperiencesandopinions.Mostwillprobablysayindependenceshouldcomeafterfinishingtheireducation,andtheyhaveadecentpayingjob.

6. Youarethinkingofbuyingacar.Analyzethedecisionbyaddressingthefollowingissues:

Arethereotherwaystosatisfyyourtransportationrequirementsbesidesbuyingacar?Makealistofallthealternativesandwritedowntheprosandcons.

TransportationMode

Pros

Cons

Walking

Takesyoudirectlywhereyouwanttogo

Free

Convenient

Takesalongtime

Destinationmaybetoofar

Bicycle

Takesyoudirectlytowhereyouwanttogo

Free

Convenient

Requiresphysicalstrengthandendurance

Destinationmaybetoofar

Bus

Inexpensive

Reachesdistantdestinations

Maynottakeyoudirectlywhereyouwanttogo togo

Manystops,notefficient

Subway

Inexpensive

Fast

Maynottakeyoudirectlywhereyouwanttogo

Localdestinationsonly

Train

Reachesdistantdestinations

Maynottakeyoudirectlywhereyouwanttogo

Airplane

Reachesdistantdestinations

Fast

Expensive

Whatarethedifferentwaysyoucanfinancethepurchaseofacar?

Financethroughabankloanorlease,financethroughacardealerwithaloanoraleaseorfinancethecaroutofyourownsavings.

Obtaininformationfromatleastthreedifferentprovidersofautomobilefinancingonthetermstheyoffer.

Whatcriteriashouldyouuseinmakingyourdecision?

Yourdecisionwillbetoselectthefinancingalternativethathasthelowestcosttoyou.

Whenanalyzingtheinformation,youshouldconsiderthefollowing:

Doyouhavethecashsavedtomakeanoutrightpurchase?Whatinterestratewouldyoubegivinguptomakethatpurchase?Doyoupayadifferentpriceforthecarifyoupaycashratherthanfinance?

Fordifferingloanplans,whatisthedownpaymenttoday?Whatarethemonthlypayments?Forhowlong?Whatistherelevantinterestrateyouwillbepaying?Doesthewholeloangetpaidthroughmonthlypaymentsoristhereaballoonpaymentattheend?Aretaxesand/orinsurancepaymentsincludedinthemonthlypayments?

Fordifferingleaseplans,whatisthedownpaymenttoday?Whatarethemonthlypayments?Forhowlong?Doyouownthecarattheendofthelease?Ifnot,whatdoesitcosttobuythecar?Doyouhavetobuythecarattheendoftheleaseorisitanoption?Isthereachargeifyoudecidenottobuythecar?Whatrelevantinterestratewillyoubepaying?Aretaxesand/orinsurancepaymentsincludedinthemonthlypayments?Aretheremileagerestrictions?

7. Youarethinkingofstartingyourownbusiness,buthavenomoney.

Thinkofabusinessthatyoucouldstartwithouthavingtoborrowanymoney.

Anybusinesswhichinvolvesastudent’sownpersonalservicewouldbecheaptostartup.Forinstanceheorshecouldstartabusinessrunningerrandsforothers,walkingtheirdogs,shoppingetc.Alongthosesamelinestheycouldstartsomekindofconsultingbusiness.Bothofthesebusinessescouldberunoutoftheirdormroomortheirownhomeandcouldbestartedwithverylittlecapital.Iftheywantedtohireadditionalworkers,theywouldhavetobepaidonacommissionbasistolimitupfrontexpenses.

Nowthinkofabusinessthatyouwouldwanttostartifyoucouldborrowanyamountofmoneyatthegoingmarketinterestrate.

Certainlytherearemanyinterestingbusinesseswhichcouldbestartedifonecouldfinance100%ofthebusinesswithborrowedcapitalandnoequity.Sinceyouwillbeabletoborrow100%ofthefinancing,youwillbewillingtotakealotgreaterriskthanifyouwereinvestingyourownmoney.

Whataretherisksyouwouldfaceinthisbusiness?

[Answeris,ofcourse,dependentonanswertoquestion“b.”]

Wherecanyougetfinancingforyournewbusiness?

Dependinguponthesizeofthefinancingneeded,studentsshouldbelookingforbothdebtandequityfinancing.Thesourcesofthisfinancingranges