What is Finance? What are the Strategy of Finance Management?

What is Finance? What are the Strategy of Finance Management? 

Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty. In other words, in finance we worry about money and we worry about the future. Investors allocate their funds among financial assets in order to accomplish their objectives, and businesses and governments raise funds by issuing claims against themselves and then use those funds for operations.

Finance provides the framework for making decisions as to how to get funds and what we should do with them once we have them. It is the financial system that provides the platform by which funds are transferred from those entities that have funds to those entities that need funds. The foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics. For example, as you saw with the quote by Warren Buffett at the beginning of this chapter, competition is important in the valuation of a company. The ability to keep competitors at bay is valuable because it ensures that the company can continue to earn economic profits.

FINANCE IS . . .

·        analytical, using statistical, probability, and mathematics to solve problems. ·        based on economic principles. ·        uses accounting information as inputs to decision-making. ·        global in perspective. ·        the study of how to raise money and invest it productively.

The tools used in financial decision-making, however, draw from many areas outside of economics: financial accounting, mathematics, probability theory, statistical theory, and psychology, as we show in Exhibit 1.1. We can think of the field of finance as comprised of three areas: capital markets and capital market theory, financial management, and investment management, as we illustrate in Exhibit 1.2. And, as this exhibit illustrates, the three areas are all intertwined, based on a common set of theories and principles. In the balance of this chapter, we discuss each of these specialty areas.

CAPITAL MARKETS AND CAPITAL MARKET THEORY

The field of capital markets and capital market theory focuses on the study of the financial system, the structure of interest rates, and the pricing of risky assets. The financial system of an economy consists of three components:

1.Financial markets

2. Financial intermediaries

3.Financial regulators

For this reason, we often refer to this area as financial markets and institutions.

Several important topics included in this specialty area of finance are the pricing efficiency of financial markets, the role and investment behaviour of the players in financial markets, the best way to design and regulate financial markets, the measurement of risk, and the theory of asset pricing.

The pricing efficiency of the financial markets is critical because it deals with whether investors can “beat the market.” If a market is highly price efficient, it is extremely difficult for investors to earn returns that are greater than those expected for the investment’s level of risk—that is, it is difficult for investors to beat the market. An investor who pursues an investment strategy that seeks to “beat the market” must believe that the sector of the financial market to which the strategy is applied is not highly price efficient.

Such a strategy seeking to “beat the market” is called an active strategy. Financial theory tells us that if a capital market is efficient, the optimal strategy is not an active strategy, but rather is a passive strategy that seeks to match the performance of the market. In finance, beating the market means outperforming the market by generating a return on investment beyond what is expected after adjusting for risk and transaction costs. To be able to quantitatively determine what is “expected” from an investment after adjusting for risk, it is necessary to formulate and empirically test theories about how assets are priced or, equivalently, valuing an asset to determine its fair value.

The fundamental principle of valuation is that the value of any financial asset is the present value of the expected cash flows. Thus, the valuation of a financial asset involves (1) estimating the expected cash flows; (2) determining the appropriate interest rate or interest rates that should be used to discount the cash flows; and (3) calculating the present value of the expected cash flows. For example, in valuing a stock, we often estimate future dividends and gauge how uncertain are these dividends. We use basic mathematics of finance to compute the present value or discounted value of cash lows. In the process of this calculation of the present value or discounted value, we must use a suitable interest rate, which we will refer to as a discount rate. Capital market theory provides theories that guide investors in selecting the appropriate interest rate or interest rates.

FINANCIAL MANAGEMENT

Financial management, sometimes called business finance or corporate finance, is the specialty area of finance concerned with financial decision making within a business entity. Although financial management is often referred to as corporate finance, the principles of financial management also apply to other forms of business and to government entities. Financial managers are primarily concerned with investment decisions and financing decisions within organizations, whether that organization is a sole proprietorship, a partnership, a limited liability company, a corporation, or a governmental entity.

 Financing decisions are concerned with the procuring of funds that can be used for long-term investing and financing day-to-day operations. Should financial managers use profits raised through the company’s revenues or distribute those profits to the owners? Should financial managers seek money from outside of the business? A company’s operations and investments can be financed from outside the business by incurring debt—such as through bank loans or the sale of bonds—or by selling ownership interests.

Because each method of financing obligates the business in different ways, financing decisions are extremely important. The financing decision also involves the dividend decision, which involves how much of a company’s profit should be retained and how much to distribute to owners. A company’s financial strategic plan is a framework of achieving its goal of maximizing owner’s wealth. Implementing the strategic plan requires both long-term and short-term financial planning that brings together forecasts of the company’s sales with financing and investment decision-making. Budgets are employed to manage the information used in this planning; performance measures are used to evaluate progress toward the strategic goals.

Another critical task in financial management is the risk management of a company. The process of risk management involves determining which risks to accept, which to neutralize, and which to transfer. The four key processes in risk management are risk:

1. Identification
2. Assessment
3. Mitigation
4. Transference

INVESTMENT MANAGEMENT

Investment management is the specialty area within finance dealing with the management of individual or institutional funds. Other terms commonly used to describe this area of finance are asset management, portfolio management, money management, and wealth management. In industry jargon, an asset manager “runs money.” Setting investment objectives Establishing an investment policy Selecting specific assets Selecting an investment strategy Measuring and evaluating investment performance.

Investment Management Activities

Investment management involves five primary activities, as we detail in Setting investment objectives starts with a thorough analysis of what the entity or client wants to accomplish. Given the investment objectives, the investment manager develops policy guidelines, taking into consideration any client-imposed investment constraints, legal/regulatory constraints, and tax restrictions. This task begins with the decision of how to allocate assets in the portfolio (i.e., how the funds are to be allocated among the major asset classes). The portfolio is simply the set of investments that are managed for the benefit of the client or clients. Next, the investment manager must select a portfolio strategy that is consistent with the investment objectives and investment policy guidelines.

Financial Assets

An asset is any resource that we expect to provide future benefits and, hence, has economic value. We can categorize assets into two types: tangible assets and intangible assets. The value of a tangible asset depends on its physical properties. Buildings, aircraft, land, and machinery are examples of tangible assets, which we often refer to as fixed assets.

Why Do We Need Financial Assets?

Financial assets serve two principal functions:

1. They allow the transference of funds from those entities that have surplus funds to invest to those who need funds to invest in tangible assets.

2. They permit the transference of funds in such a way as to redistribute the unavoidable risk associated with the tangible assets’ cash flow among those seeking and those providing the funds. 

However, the claims held by the final wealth holders generally differ from the liabilities issued by those entities because of the activity of entities operating in financial systems—the financial intermediaries—who transform the final liabilities into different financial assets preferred by
investors. We discuss financial intermediaries in more detail later.

Regulating Financial Activities
Most governments throughout the world regulate various aspects of financial activities because they recognize the vital role played by a country’s financial system. Although the degree of regulation varies from country to country,

Regulation takes one of four forms:

1. Disclosure regulation.
2. Financial activity regulation.
3. Regulation of financial institutions.
4. Regulation of foreign participants.

Disclosure regulation requires that any publicly traded company provide financial information and nonfinancial information on a timely basis that would be expected to affect the value of its security to actual and potential investors. Governments justify disclosure regulation by pointing out that the issuer has access to better information about the economic well-being of the entity than those who own or are contemplating ownership of the securities.

Economists refer to this uneven access or uneven possession of information as asymmetric information. In the United States, disclosure regulation is embedded in various securities acts that delegate to the Securities and Exchange Commission (SEC) the responsibility for gathering and publicizing relevant information, and for punishing those issuers who supply fraudulent or misleading data. However, disclosure regulation does not attempt to prevent the issuance of risky assets. Rather, the SEC’s sole motivation is to assure that issuers supply diligent and intelligent investors with the information needed for a fair evaluation of the securities.