1.1 The Subspecialties within Finance

There are three primary areas in the world of finance. These so-called mainline finance disciplines are (1) corporate finance, (2) investments, and (3) institutions. Although these areas sometimes overlap, they are considered to be the standard subfields within finance. Within the three areas of finance, there are various fields or specialties. Some examples of these fields include insurance, personal finance, financial planning, asset management, financial engineering, real estate, and entrepreneurial finance.

Corporate Finance

Corporate finance is also known as managerial finance, financial management, and business finance. The goal of a financial manager (and firm) is to maximize shareholder wealth for publicly traded firms or to maximize owner wealth for privately held companies.

The financial manager works toward this goal by managing the investing and financing functions of a firm. Here is an example. Suppose you and your brother-in-law decide to start your own lawn care business. Because you’re enrolled in this class, you volunteer to serve as the financial manager. Your first analysis will be on what equipment you must purchase to run your business. After some careful research, you decide on a John Deere riding lawn mower, a gas-operated weed eater, and a gas-operated blower. You will also need a trailer to transport the equipment and a truck to pull the trailer. Your brother-in-law has a pickup truck, so you won’t have to buy that, but you’ll have to buy a trailer. After carefully shopping around, you determine you will need $6,000 to invest in the equipment for your company.

Now that you know how much you need to invest, you must determine how to finance the investment. If the funds are available, you and your brother-in-law could each give $3,000 and have enough to cover the cost. However, you may be able to borrow the money from a local bank. As the financial manager, you are the one to determine which is the best form of financing. We have simplified this example by assuming you will buy the equipment. However, you would also have the option to lease (rent) the equipment. As the financial manager, you would need to decide which option—purchasing or leasing—would be better. You would also need to conduct a capital budgeting analysis to see if starting the business in the first place is even a good idea financially.

Remember, investing and financing decisions are the heart of corporate finance. There are other issues as well, which we will cover in this course. As you work through this class, you will learn the methods needed to analyze and decide whether you should buy or lease in situations like the lawn care business described above. You will also learn whether you should finance your firm with your own money (equity) or the bank’s money (debt).

If you’ve ever taken an accounting class, you may remember talking a lot about equity and about short- and long-term assets and liabilities. The chart below (known as a balance sheet) provides a visual of how assets, liabilities, and equity look in the corporate finance arena.

In corporate finance, the left side of the balance sheet deals with your investment decisions, such as what assets the firm should acquire. The right side of the balance sheet deals with your financing decisions, such as how the firm should finance the assets desired. As the financial manager, you would conduct the necessary analyses to make these choices.

Investments

Investments contain several subdisciplines within finance. Perhaps the most common responsibility within the investments field is that of an asset manager. An asset manager is someone who invests funds in an attempt to earn positive returns. Asset managers can invest in publicly traded companies through their stocks (mutual funds), in real estate (real estate investment trusts), in private companies (venture capital), and in many other types of assets. The term asset manager has been coined within the past few years. If you are speaking with someone who graduated more than a few years ago, they will most likely use the term money manager.

Another major subdiscipline of investments is asset pricing. One of the challenges of finance is trying to place a dollar value on an asset. You can’t know exactly how much an asset is worth until it is purchased. Once the purchase price is observed, then the current market value is known. Asset pricers attempt to use quantitative methods to estimate the value of an asset prior to selling or buying it. This field can get very technical, and many finance professors focus their careers on researching asset pricing methods.

The main objective of someone who works within the investments arena is to identify assets that are mispriced. These professionals use asset pricing models and other methods to estimate what an asset is worth. They then compare this estimated amount to the current market value. If there is a big enough difference between the estimated price and the current market price, the investor will either buy the asset (if the analysis indicates the asset is underpriced) or sell the asset (if it is overpriced). We will get into the technicalities of longing (buying) and shorting (selling) assets later in the text.

Within the financial services sector is the field of personal financial investments. This field covers individuals (like you and us) who want to invest their own money as well as professionals who make their living investing their clients’ money. Often, personal finance does not involve searching for mispriced assets. Rather, it consists of a more passive investment strategy, where the investors buy assets that they feel are fairly priced but that will provide a fair return over the life of the investment. One passive technique is known as dollar-cost averaging, where the investor invests a set amount each month in a no-load mutual (or index) fund. Often, employees have the investment deducted automatically from their paycheck, and they invest in a tax-sheltered plan, such as a 401(k) or Roth IRA.

Institutions

The field of institutions is sometimes referred to as banking, although this can be a misnomer. When most of us think of a bank, we think of our personal bank down on the corner. When we have a check, we drive to the window and cash or deposit it. When we need some cash, we swing by the ATM at the local branch. These types of banks are known as consumer banks. Most individuals and small businesses use consumer banks. Commercial banks, on the other hand, deal with companies. Typically, large commercial banks will only deal with big firms. The size of the loans can be very large.

Both consumer and commercial banking are included under the institutions umbrella. Insurance companies and pension companies are typically included as part of institutions as well. Here you can see how some of the fields intermix. For example, a life insurance company is considered a financial institution, but many of the professionals who work for the life insurance company will specialize in the investments discipline. When consumers buy insurance policies, professional investors who work for the insurance company invest that money so the insurance benefits can be paid out in the future (and so the insurance company makes a profit). Likewise, pension companies are considered institutions, but the pension funds they run are typically considered an investment. In a pension setting, professional investors invest the pension fund so beneficiaries will have retirement checks to collect in the future.