30 1 • Introduction to Finance
Average Annual Rate of Return = 10%
Assumptions Scenario 1 Scenario 2 Scenario 3 Scenario 4
Annual investment $5,000 $5,000 $5,000 $5,000
Total investment amount $175,000 $35,000 $25,000 $25,000
Value at age 60 $1,490,634 $1,466,369 $1,838,858 $2,961,500
Table 1.2 Four Investment Scenarios: Assumptions and Expected Outcomes
Definition of Economic Value
Value is a term used frequently in business and especially in economics, accounting, and finance. Accountants
track, record, and display value in the form of financial statements and footnotes. The numbers they present
are “book values” and represent what has occurred. Financial people like to speak in terms of “market values.”
Market values are calculated using expected future cash flows discounted to today. Market values are the
prices that consumers pay for a product. Economic value is what we believe consumers are actually willing to
pay for a product, service, or experience. For example, the price of a movie ticket may be $10, but there are
individuals who are willing to pay far more for the experience of watching a movie on the big screen.
Generally, the economic value is at least as great as the market value or current price of an asset. When Bacon
Signs planned for the future, the firm attempted to determine the economic value of its products when
creating an optimal mix of price and quantity sold. Firms that produce unique products for clients may have
multiple prices based on the estimated economic value of their good or service to the client. One way to think
about the difference between market value and economic value is that market value is what you have to pay,
while economic value is what you are willing to pay.
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1 • Summary 31
Summary
1.1 What Is Finance?
Finance is the study of the trade-off between risk and expected return. There are three broad areas of finance:
business finance, investments, and financial markets and institutions.
1.2 The Role of Finance in an Organization
The accounting department creates financial statements, and the finance department implements the firm’s
policy objectives, monitors results, and responds to necessary strategic and tactical changes. Finance is
responsible for budgeting and forecasting. Finance aids in establishing firm objectives and is responsible for
meeting with creditors, lenders, owners, regulators, and other stakeholders that provide capital to the firm or
have a claim against firm assets.
1.3 Importance of Data and Technology
Much of the data used in business today has been available for many years. However, data today is more
attainable than ever due to technological advancements facilitating a user’s ability to gather, evaluate, and
store information faster and more cost effectively than ever. Information is continually available, so the
quicker and less expensively firms can adjust to the arrival of new information, the more valuable they become
for their stakeholders.
1.4 Careers in Finance
Careers in finance are plentiful, fulfilling, and well compensated. Introductory positions are available in areas
such as data collection and data entry. More skill and experience is required for roles such as data analysis and
forecasting. Eventually, executive-level positions such as CFO present themselves to the most qualified.
Finance careers are not limited to financial firms, as understanding finance is an important skill in government
regulatory positions, nonprofit management, and all types of commercial business—from real estate, to retail,
to manufacturing, to education.
1.5 Markets and Participants
Financial markets are where buyers and sellers of financial securities come together to trade. The trading of
securities allows markets to value assets and signal value as new information arrives. Brokers operate to bring
buyers and sellers together and receive commissions. Dealers trade from their own portfolios and are often
willing to make markets for specific securities by agreeing to buy or sell at the current bid and ask prices.
Financial intermediaries actually change or create new financial products.
1.6 Microeconomic and Macroeconomic Matters
Economics is the study of the allocation of scarce resources. Economists attempt to understand the how and
why of human, physical, and financial capital allocation. Microeconomics is the study of factors affecting an
individual’s consumption, and macroeconomics is the study of all the aggregate factors affecting an economy.
Economics is important in finance due to the number of economic variables critical to good financial
forecasting.
1.7 Financial Instruments
Maturity is one method to differentiate among financial instruments. Using this methodology, we have money
markets and capital markets. Money markets consist of short-term marketable securities, and capital markets
focus on longer-term securities such as bonds and stocks.
1.8 Concepts of Time and Value
The concepts of time and value involve the resolution of conflict between consumption now versus
consumption later. Time and value represent the trade-off between risk and expected return. Many financial
32 1 • Key Terms
exercises examine the relationships among time, interest rates, risk, cash flows now, and cash flows in the
future. You can expect to solve several “time value of money” problems before you complete this book.
Key Terms
brokers individuals or a firm that brings together potential buyers and sellers of a product and receives a
commission at transaction
business finance the study and application of how managers can apply financial principles to maximize the
value of a firm in a risky environment
capital budgeting the process of determining which long-term or fixed assets to acquire in an effort to
maximize shareholder value
capital market market for longer-term financial instruments, such as stocks and bonds, used to finance
long-term projects for organizations
capital structure the mix of financing, usually debt and equity, used by a firm
chief financial officer (CFO) an executive-level officer who sets policy for working capital management,
determines optimal capital structure for the firm, and makes the final decision in matters of capital
budgeting
commercial paper (CP) short-term, unsecured financial obligations issued by firms as a means of short-term
financing for items such as inventory or payables
comptroller also referred to as controller, individual in charge of financial reporting and the oversight of the
accounting activities necessary to develop financial reports
dealers facilitate a market and the trading of securities by holding a portfolio of the underlying asset for easy
purchase and sale; earn money on the spread between ask and bid prices for the asset
default risk the risk that the issuer of a financial security will be unable to make payments as specified in the
terms of a financial contract
diversifiable risk also called unsystematic risk, a risk that can be eliminated without the loss of expected
return by holding a portfolio of securities
economic value the amount a consumer is willing to pay for a particular asset or service, usually greater
than or equal to the current market price or present value of the asset
federal funds rate the rate targeted by the Federal Reserve in the implementation of monetary policy
financial industry regulatory authority (FINRA) an independent, nongovernmental organization that
writes and enforces the rules governing registered brokers and broker-dealer firms in the United States
financial intermediary a commercial bank or a mutual fund investment company that serves as an
intermediary to enable easier and more efficient exchanges among transacting parties, often accepting one
form of financial asset from which they create another, such as taking demand deposits to create mortgage
loans
financial markets and institutions one of the three main areas of the field of finance; firms and regulatory
agencies that oversee our financial system
inflation risk the risk of reduced purchasing power of goods and services due to rising prices
investments one of the three main areas of finance; products and processes used to create individual and
institutional portfolios with the intent of growing wealth
money market the market for short-term, low-risk, highly liquid, homogeneous financial securities; common
money market securities include T-bills, NCDs, and commercial paper
money market mutual funds created by investment companies to pool the money of many investors to
purchase and then manage short-term, low-risk, liquid financial portfolios of securities
municipal bonds (munis) long-term debt obligations issued by state or local governments that often have
important tax advantages relative to corporate bonds
negotiable certificate of deposit very large CDs issued by financial institutions, redeemable only at maturity
but can and often do trade prior to maturity in a broad secondary market; also called jumbo CDs because
they sell in increments of $100,000 or more
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