1.1 What Is Finance?

A commonly used definition of economics is the study of management or the allocation of scarce resources. Like most business disciplines, finance is a subfield within economics. Here, finance is the study of the management or allocation of capital. Capital is broadly defined, but for a working definition, we will assume that capital is a financial asset or the value of an asset. Examples of capital might range from cash to machinery or equipment used by a business. As a student, your main learning objective throughout this course will be to understand the costs and the benefits associated with investing in capital. For the most part, our discussion will be focused on a firm’s investment in new capital. For example, a firm might want to invest in new machinery to improve the efficiency of production. Another firm might be looking to invest in labor—perhaps a larger sales force—in order to increase firm revenue. While our focus will be from the firm’s perspective, perhaps this course will be most applicable to those who are looking to invest their own resources into stocks, bonds, or other financial instruments.

Before we get started, let’s discuss three important areas in finance:

1. Corporate finance: The first area is corporate finance, which focuses on financial decision-making by a firm’s management.

2. Investments: The second area is investments. This area is devoted to understanding the various types of financial instruments—such as stocks and bonds—and how to value these instruments.

3. Financial institutions (banking): The third area is banking. Almost everyone taking this course will have already visited a bank and will understand that banks make money by paying depositors a smaller interest rate than the interest rate they charge to borrowers.

Hopefully, we will understand that the management or allocation of capital is important in each of these three areas. In this course, we will explore financial markets and discuss the differences between bonds and stocks. We will learn methods to value stocks and bonds. From the corporation’s perspective, we will understand the trade-off between using debt (bonds) or equity (stocks) to finance, or pay for, some investment. We will also learn about capital budgeting, which is the planning of a firm’s long-term investments. Finally, we will conclude by introducing methods that will allow us to determine the value of an entire firm. Are you ready?