1.1 What is Finance?
Finance is study of the valuation and management of risk. There are two components
to risk.
1. The time of its revelation.
2. The nature of its randomness. We start with the "timing" problem by considering
valuation and management of risk free cash flows at different points in time. The
second problem is more tricky. How can one distinguish between different classes, or
categories, of risky cash flows? We all know how to distinguish between apples and
pears, but what is the equivalent for risky cash flows?
1.2 Corporate Finance
This book is about financial issues connected with corporations. Typical definitions of
corporations deal with the legalities of defining the ownership and control. But we
will largely abstract from these. From a finance point of view, the corporation is a
bundle of risky cash flows. To value a corporation, we disentangle 3 4 Finance the
components of the risky cash flows (including the date of revelation), value these
separately, and, finally, apply value additive to sum all the components. For our
purposes, managing a company is largely playing around with the bundling of the
risky components of the corporation. For example, reshuffling of cash flows in time to
postpone tax payments, or understanding how bundling creates incentives for
participants, such as management, bondholders and equity owners.
1.3 Financial Markets
For our purposes, financial markets can be thought of as supermarkets for risky cash
flows. Unlike regular supermarkets where you shop among products on the shelves,
financial supermarkets work as organized exchanges, where financial securities are
bought and sold in continuous auctions. Financial securities are best though of as
packages of cash flows, and they come in all sorts. Let us look at some examples.
Most governments need to finance their deficits. To do so they issue government debt.
The debt can be short term, in which case we call it a Treasury Bill, which will
promise a given cash flow sometime within the next year. A treasury bill is the typical
example of a risk free security, there is no uncertainty about the future payments. If
government debt is long term, over a year, it is typically issued as government bonds,
with annual payments of coupons and a repayment of the face value at the bond
maturity. Since governments can always print money, there is no uncertainty about
whether you get your money back when you hold a long term government bond. But
Finance is study of the valuation and management of risk. There are two components
to risk.
1. The time of its revelation.
2. The nature of its randomness. We start with the "timing" problem by considering
valuation and management of risk free cash flows at different points in time. The
second problem is more tricky. How can one distinguish between different classes, or
categories, of risky cash flows? We all know how to distinguish between apples and
pears, but what is the equivalent for risky cash flows?
1.2 Corporate Finance
This book is about financial issues connected with corporations. Typical definitions of
corporations deal with the legalities of defining the ownership and control. But we
will largely abstract from these. From a finance point of view, the corporation is a
bundle of risky cash flows. To value a corporation, we disentangle 3 4 Finance the
components of the risky cash flows (including the date of revelation), value these
separately, and, finally, apply value additive to sum all the components. For our
purposes, managing a company is largely playing around with the bundling of the
risky components of the corporation. For example, reshuffling of cash flows in time to
postpone tax payments, or understanding how bundling creates incentives for
participants, such as management, bondholders and equity owners.
1.3 Financial Markets
For our purposes, financial markets can be thought of as supermarkets for risky cash
flows. Unlike regular supermarkets where you shop among products on the shelves,
financial supermarkets work as organized exchanges, where financial securities are
bought and sold in continuous auctions. Financial securities are best though of as
packages of cash flows, and they come in all sorts. Let us look at some examples.
Most governments need to finance their deficits. To do so they issue government debt.
The debt can be short term, in which case we call it a Treasury Bill, which will
promise a given cash flow sometime within the next year. A treasury bill is the typical
example of a risk free security, there is no uncertainty about the future payments. If
government debt is long term, over a year, it is typically issued as government bonds,
with annual payments of coupons and a repayment of the face value at the bond
maturity. Since governments can always print money, there is no uncertainty about
whether you get your money back when you hold a long term government bond. But
