WHAT IS FINANCE?

It’s hard to define finance—the term has many facets, which makes it difficult to
provide a clear and concise definition. The discussion in this section will give you
an idea of what finance people do and what you might do if you enter the finance
field after you graduate.
1-1a Finance versus Economics and Accounting
Finance as we know it today grew out of economics and accounting. Economists
developed the notion that an asset’s value is based on the future cash flows the
asset will provide, and accountants provided information regarding the likely size
of those cash flows. Finance then grew out of and lies between economics and
accounting, so people who work in finance need knowledge of those two fields.
Also, as discussed next, in the modern corporation, the accounting department
falls under the control of the chief financial officer (CFO).
1-1b Finance within an Organization
Most businesses and not-for-profit organizations have an organization chart
similar to the one shown in Figure 1-1.
The board of directors is the top governing body, and the chairperson of the
board is generally the highest-ranking individual. The CEO comes next, but note
that the chairperson of the board often serves as the CEO as well. Below the CEO
comes the chief operating officer (COO), who is often also designated as a firm’s
president. The COO directs the firm’s operations, which include marketing,
manufacturing, sales, and other operating departments. The CFO, who is generally
a senior vice president and the third ranking officer, is in charge of accounting,financing, credit policy, decisions regarding asset acquisitions, and investor relations,
which involves communications with stockholders and the press.
If the firm is publicly owned, the CEO and the CFO must both certify to the
Securities and Exchange Commission (SEC) that reports released to stockholders,
and especially the annual report, are accurate. If inaccuracies later emerge, the
CEO and the CFO could be fined or even jailed. This requirement was instituted in
2002 as a part of the Sarbanes-Oxley Act. The Act was passed by Congress in the
wake of a series of corporate scandals involving now-defunct companies such as
Enron and WorldCom, where investors, workers, and suppliers lost billions of
dollars due to false information released by those companies.
1-1c Corporate Finance, Capital Markets,
and Investments
Finance as taught in universities is generally divided into three areas: (1) financial
management, (2) capital markets, and (3) investments.
Financial management, also called corporate finance, focuses on decisions
relating to how much and what types of assets to acquire, how to raise the
capital needed to buy assets, and how to run the firm so as to maximize its
value. The same principles apply to both for-profit and not-for-profit organizations;
and as the title suggests, much of this book is concerned with financial
management.
Capital markets relate to the markets where interest rates, along with stock and
bond prices, are determined. Also studied here are the financial institutions that
supply capital to businesses. Banks, investment banks, stockbrokers, mutual
funds, insurance companies, and the like bring together “savers” who have money
to invest and businesses, individuals, and other entities that need capital for
various purposes. Governmental organizations such as the Federal Reserve System,
which regulates banks and controls the supply of money, and the SEC, which
regulates the trading of stocks and bonds in public markets, are also studied as
part of capital markets.
Investments relate to decisions concerning stocks and bonds and include a
number of activities: (1) Security analysis deals with finding the proper values of
individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the best
way to structure portfolios, or “baskets,” of stocks and bonds. Rational investors
want to hold diversified portfolios in order to limit risks, so choosing a properly
balanced portfolio is an important issue for any investor. (3) Market analysis deals
with the issue of whether stock and bond markets at any given time are “too
high,” “too low,” or “about right.” Behavioral finance, where investor psychology is
examined in an effort to determine if stock prices have been bid up to unreasonable
heights in a speculative bubble or driven down to unreasonable lows in a
fit of irrational pessimism, is a part of market analysis.
Although we separate these three areas, they are closely interconnected.
Banking is studied under capital markets, but a bank lending officer evaluating a
business’ loan request must understand corporate finance to make a sound decision.
Similarly, a corporate treasurer negotiating with a banker must understand
banking if the treasurer is to borrow on “reasonable” terms. Moreover, a security
analyst trying to determine a stock’s true value must understand corporate finance
and capital markets to do his or her job. In addition, financial decisions of all types
depend on the level of interest rates; so all people in corporate finance, investments,
and banking must know something about interest rates and the way they
are determined. Because of these interdependencies, we cover all three areas in
this book.