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Essential Concepts
Time Value of Money
Evaluating Cash Flows
Risk and Return

PreMBA Analytical Methods
Essential Concepts

Finance is the science of allocating monetary assets. Put more simply, finance is a collection of concepts and tools that measures the value of things and explores how to best allocate resources to maximize value. These concepts and tools derive from a combination of many disciplines, especially those of accounting, economics, mathematics, and statistics.

In the business world, you make investments now that have uncertain paybacks in the future. The key functional disciplines of finance enable you to decide which investments will likely produce the highest returns, to manage the risk of those predicted returns.

Time Value of Money

If you have the choice of making one of two investments, each of which requires $1,000 to begin, which would you choose? Suppose project A returns $2,000 in three years whereas project B returns $3,000 in three years. All else being equal, you might choose project B. But what if project B required ten years—now which would you prefer? What if project B would return $1,000 in three years and an additional $2,000 in five years? The analysis of cash flows of different sizes and different timing is a fundamental area of finance known as the time value of money. In this section of the course, you will use mathematical formulas for computing an investment's present value and future value.

Evaluating Cash Flows

Some financial instruments have features that make it easy to measure what appear to be complex sets of cash flows. For example, a mortgage loan is designed so that the borrower pays a given rate of interest each month on the outstanding balance. The payment is a fixed dollar amount each month for a stated number of months, and will fully amortize the entire amount borrowed in that stated time period. The portion of the payment that is interest declines over time, while the portion that pays off the principal balance increases. Mathematics provides a relatively simple formula for calculating a series of equal payments within equal time intervals, known as an annuity. The annuity formula enables you to compute the payments for any given loan amount, interest rate, and number of payments, so long as the payments are equal in amount and occur at equally spaced time intervals.

An annuity that goes on forever—a perpetuity—is another useful tool in finance. Although true perpetuities are rare, finance values the cash dividends paid by companies as perpetuities. The simple perpetuity formula can value a perpetuity that grows at a constant rate over time. These formulas provide a simple approach to evaluate the price of common stocks.

This section will show you how these formulas are developed and used, as well as the basic tools used to evaluate the returns of projects. Net present value is a method of calculating the amount that a project is expected to return, adjusting for the timing of the cash flows. The internal rate of return is the interest rate at which an investment grows over the life of a project. Being able to compare the return on a series of uneven cash flows to a constant rate of interest is a great achievement of finance, and one not easy to calculate without computers.

Risk and Return

"Don't count your chickens before they hatch." "Don't put all of your eggs in one basket." "A bird in the hand is worth two in the bush." Many sayings in American folklore reflect the risky nature of future cash flows. Finance provides some basic methods to measure risky outcomes and to deal with those risks. This section shows the formulas for computing expected returns and variance (risk) in the returns of common stocks. By spreading an investment over several stocks, you can move towards the same level of expected return while reducing some of your risk.

Who Uses Finance and How?

The three chief groups who use finance are

  • financial managers in companies
  • those who work in financial markets, where investors buy and sell financial instruments
  • those who work for financial intermediaries, such as banks and mutual funds

All of these groups use the key concept presented in this course, the time value of money.

Financial departments
A company's financial manager uses financial tools to make decisions about where to invest funds and how to raise funds. For example, a company may undertake a project or improvement that requires a large investment to start, and then provides cash inflows over time. In practice, the company's financial manager must show how those cash inflows, or returns, are sufficient to pay any obligations and still provide a return to the stockholders sufficient to induce them to invest. Companies must deal with real assets, such as buildings, factories, and inventories, as well as financial assets, such as stocks, bonds, and loans.

Financial markets
Financial market participants include the investors, the investment bankers who help companies (and governments) issue instruments, and brokers who help investors trade instruments. The study of financial markets also concerns the instruments, such as stocks, bonds, and options, that the participants trade. The largest financial markets include the stock markets and the bond markets. The bond markets include corporate bonds, U.S. Treasury bonds, and city and state bonds.

How do the stock markets and bond markets work?

Financial intermediaries
Investors who do not want the risk of investing directly in corporate debt or stock have two alternatives: commercial banks and mutual funds.

How do banks and mutual funds act as financial intermediaries?

The World of Finance

Now that you have an idea of who uses finance, and what they use finance for, you can begin reviewing the tools and concepts that they all share in the sections "Time Value of Money," "Evaluating Cash Flows," and "Risk and Return." For current news examples about how finance works, which will give you a context for what you are learning, read the articles linked in the margin. Welcome to the world of finance.

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