Chapter One – Terms and Questions

List of Terms

1. Finance - Involves the management of money.

2. Corporate Finance - The management of money/capital within a corporation. The major
monetary decisions facing a corporation concern working capital management, capital
budgeting and the capital structure decision.
3. Capital Markets - Financial markets (such as the NYSE, NASDAQ, OTC, CBOT)
where issuers and investors buy and sell long-term (<1 year) financial instruments.
4. Debt - A financial asset (obligation) that typically has “fixed” cash inflows (outflows).
Examples include bonds, loans and revolving credit facilities.
5. Stocks - Financial asset that represents equity ownership in a company. It is characterized
by having junior status to the claims of creditors and preferred stockholders in the event
of liquidation.
6. Market Efficiency - The stock market is brutally efficient, current prices reflect all
publicly available information and prices react completely, correctly and almost
instantaneously to incorporate the receipt of new information.
7. Asset Allocation - The process of dividing a portfolio among major asset categories such
as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying
the portfolio.
8. Diversification - A risk management technique that mixes a wide variety of investments
within a portfolio. It is designed to minimize the impact of any one security on overall
portfolio performance.
9. Risk - The chance that an investment's actual return will be different than expected. This
includes the possibility of losing some or all of the original investment. It is usually
measured by calculating the standard deviation of the historical returns or average
returns of a specific investment. The greater the amount of risk an investor is willing to
take, the greater potential return they expect.
10. Markets - Where shares are issued and traded either through exchanges or over-the-
counter markets. Also known as the equity market, it is one of the most vital areas of a
market economy as it provides companies with access to capital and investors with
ownership in the company and the exposure to potential gains based on the
company's future performance.
11. Financial Intermediaries - When a financial intermediary borrows fund from savers or
investors by issuing a claim, and uses those funds to make loans or to purchase higher
yielding securities. Financial institutions act as middlemen, linking lenders and
borrowers through intermediation.
12. Investment Decision - Investing the funds of the company in working capital, tangible
and intangible assets to buy or build projects and investment that will be worth more than
they cost.
13. Financing Decision - Raising money for the company from institutional and individual
investors through the sale of debt and equity claims to finance the investment projects of
the firm.
14. Net Present Value - The present value of the expected future cash flows minus the initial
cost/investment
15. Cost of Capital - The required return for a capital budgeting project as measured by the
return offered by equivalent-risk investments. It is the cost of raising debt and equity for
the company.
16. Primary Markets – Capital markets in which governments, agencies and municipal
entities issue debt securities and corporations issue stocks and bonds to investors, and the
issuer of the securities receives the proceeds from the sale of securities.
 17. Secondary Markets - Where stocks and bongs are traded after their initial issuance. The
issuing corporation receives no proceeds from the sale.
18. Liquidity - The ease with which an owner of a security can sell an investment to another
investor or trade it in the securities markets.
19. Direct Finance - The process in which issuers receive funds directly from the purchasers
of stocks and bonds in the markets.
20. Indirect Finance - The process of funds moving from investors through financial
intermediaries to borrowers.

Questions
1. What is finance?
Finance is the process of managing money. In a corporation, the major financial decisions
concern working capital management, capital budgeting and the capital structure
decision.
2. Broadly speaking, who is affected by finance? Are you? Why? Explain where you fit
into the “big picture.”
Everyone is affected by finance as it is the study of managing money. While everyone
may not work with finance in a corporation, they still need to budget their expenses,
make investments and decide how to finance the purchase of cars and houses.
3. How has the growing importance of capital markets affected the role of finance in
organizations?
The growing importance of capital markets throughout the world has forced companies to
become more focused on their global scope of operations. The role of finance has truly
become international as corporations face decisions of managing funds (working capital
management), investing (capital budgeting) and financing (capital structure decision) in
different countries.
4. How has the financial landscape changed in the past decade?
Over the past twenty years, a wave of international deregulation has swept over the
financial markets thereby opening new sources of capital for companies throughout the
world. The recent breakdown in accounting and corporate governance at Enron,
WorldCom and Adelphia has shown that regulation and oversight are necessary to reduce
corruption and fraud in the financial markets.
5. What are the three major areas of the study of finance?
The three major areas of the study of finance are: (1) working capital management, (2)
capital budgeting, and (3) the capital structure decision.
6. Describe the basic steps involved in the process of investment valuation.
The decisions to make an investment should be based upon three cash related criteria: a
projection of the amount of the money that you expect to receive on the investments, the
probable timing of the money that you expect to receive and a reasonable assessment of
the probability or risk associated with receiving the money. Once you estimate the
amount, timing and risk of cash flows, you use financial techniques to determine the true
value of a project through the NPV calculation.
7. Describe the basic function of finance in a business firm.
Finance functions to support the corporation’s operating units in creating value for its
shareholders.
8. Explain how the five primary business functions interrelate: finance, marketing,
management, logistics, and accounting.
Finance focuses on managing money. Marketing is involved with advertising and
understanding the marketplace for the corporation’s products. Management focuses on
managing the human capital within the firm. Logistics is concerned with determining the
 most efficient ways of transporting the corporation’s products. Accounting is engaged in
measuring and monitoring a company’s operations. All five business functions most
dynamically support each other for a corporation to be successful.
9. Briefly define the four pillars of corporate finance.
 Creating Shareholder Value: The goal of a company is to increase the value of
the corporation.
 Time Value of Money: A dollar now is worth more than a dollar in the future.
This pillar is very important when planning long term projects.
 Risk and Return: As the risk (or likelihood of failure) of a project increases, a
higher return will be demanded by shareholders to invest in the project.
 Market Efficiency: A concept that focuses on the amount and accuracy of all
information processing in a financial market. U.S. markets tend to be very
efficient.
10. Describe the differences between the capital budgeting decisions and the capital
structure divisions that face corporate managers.
Capital budgeting is the valuation, planning and managing of corporate investments for a
firm. Capital structure is minimizing the cost of capital by using the right mix of debt
and equity.
11. Explain the concept of risk and return. Why is it important when investing in a
project?
As the risk of a project increases, the investors of the project (whether debt or equity) will
demand a higher return. Investors will look to maximize their return and minimize their
risk. Thus they will look to invest in projects that offer the highest return with the least
risk of losing their investment.
12. What three cash criteria should an investment decision be based upon?
The three cash related criteria are: a projection of the amount of the money that you
expect to receive on the investments, the probable timing of the money that you expect to
receive and a reasonable assessment of the probability or risk associated with receiving
the money.
13. What determines short-term security price? Long-term prices?
Short-term security prices are affected by news such as earning announcements. Long-
term prices are determined by the long-run strategies of the company’s management and
its financial performance..
14. What are the three basic decisions that corporate financial managers face?
Financial managers face the following decisions:
 The Investment Decision: Investing funds in working capital or assets to buy or
build projects and investments that will be worth more than they cost
 The Financing Decision: Raising money through the sale of debt and equity
claims to finance the investment projects of the firm
 The Dividend Decision: Deciding how much of the company’s cash from
operations should be reinvested in the business and how much should be returned
to the company’s shareholders in the form of dividends
15. How does the principle of asset allocation differ from the principle diversification?
Asset allocation is when an investor diversifies her holdings over an array asset classes.
The most basic classes are cash and short maturity deposits or securities, fixed income
securities and bonds and common stock. Wall Street recommends an asset allocation
breakdown of 55% stocks, 35% bonds and 10% cash. Diversification reduces the
unsystematic risk of a portfolio, and unsystematic risk is specific to a company.
16. Why would one expect to receive a higher yield from a corporate bond than from a
government security?
 A corporate bond has the risk of the corporation that issues it. Obviously, a corporation
has more risk of not paying back the bond than the U.S. government, thus investors are
willing to accept a smaller return on government securities because there is less risk of
repayment.
17. Why are financial markets and financial intermediaries vital to our economy?
Financial markets and financial intermediaries exist so that excess monies from investors
or surplus units can be transferred cheaply and efficiently to businesses, governments,
individuals and other entities, or deficit units, who have a shortage of funds.
18. What are the elements of the financial toolbox?
The major elements of the financial toolbox are the following: (1) Financial Statements
and Ratios, (2) Present Value Concepts, (3) Models of Risk and Return , and (4)
Spreadsheet Modeling Methods.
19. List and briefly describe the three primary financial statements.
 The Income Statement: A financial report that - by summarizing revenues and
expenses, and showing the net profit or loss in a specified accounting period -
depicts a business entity’s financial performance due to operations as well as
other activities rendering gains or losses. Also known as the "profit and loss
statement" or "statement of revenue and expense".
 The Balance Sheet: A financial statement that summarizes a company's assets,
liabilities and shareholders' equity at a specific point in time. These three balance
sheet segments give investors an idea as to what the company owns and owes, as
well as the amount invested by the shareholders. The balance sheet must follow
the following formula:
Assets = Liabilities + Shareholders' Equity
 The Statement of Changes in Cash Flows: Provides information on the
changes in the cash position of a company over the accounting period. The
statement is a bridge between accrual and cash accounting by breaking down the
inflows and disbursements of every cash transaction. There are three parts to this
statement: operating cash flows, investing cash flows and financing cash flows.