"Finance" Bodie and Merton

OUTLINE

1. Defining Finance

2. Five core principles of finance

3. Financial Decisions - Households

4. Financial Decisions - Firms

Chapter 1: 5. The Financial System
Introduction to Finance

Introduction 1. Defining Finance

I’m saving for retirement. Should I Finance is the study of how people allocate scarce resources
deposit into bank, mutual fund, direct stock market investment? over time (Bodie and Merton)

I want a new motorbike. Should I use

saved cash, borrow money?

I’m thinking about starting a new business

Is it worth doing? How much money do I need to start? Where can
I get money?
"Finance" Bodie and Merton

Financial Transaction Real Assets versus Financial Assets

• Spread out through space and over time Asset: any possession that has value in an exchange

• Risk – Return trade off A real asset is used to produce goods and services and thereby
generate cash flow
• Assets used for the transactions is either cash or
financial assets E.g: machine, building, equipment, land/real estate

A financial asset is a claim against a firm, government or

individual for future expected cash flows.

E.g: bonds, preferred stocks and common stocks.

Financial assets The Liquidity Spectrum

Main properties:
Rate of Return : expected return

Risk: credit risk, market risk

Liquidity: Easy convertibility into cash with little or no

loss of value

•2-8
"Finance" Bodie and Merton

Financial Assets 2. Five Core Principles of Finance

Three broad types of financial assets: - Time has value

Fixed-income securities - Risk requires compensation

Equity securities - Information is the basis for decisions

Derivative securities - Markets determine prices and allocate resources

- Stability improves welfare

Cash flow and financial decisions of

3 Financial Decisions of Households households

Consumption and savings decisions Cash raised by selling financial assets

How to allocate wealth over time? Cash invested in real assets
Cash consumed
Investment decisions
Cash invested in financial assets
How to grow wealth?
How should they invest to get benefit?

Financing decisions
How to finance consumption and investment?

Risk management decisions

How to reduce financial uncertainties and when should increase
risk?
"Finance" Bodie and Merton

4. Financial Decisions of Firms Forms of business organization

Business Firms Three major forms in the U.S

entities whose primary function is to produce goods and
1. Sole proprietorship
services
they vary widely in size from part-time businesses run from a 2. Partnership
spare room, to giant corporations (e.g. Mitsubishi or General
Motors) with hundreds of thousands of employees, and an even 3. Corporation
larger ownership

Financial Decisions of Firms Financial decisions

When you start your own business, what financial decisions Investment decision – how much to invest and in what assets?
do you have to take? Financing decision – where is money from in order to finance
long-term investments?
1. What long-term investments should we take on? Working capital decision
2. What are the sources of long-term financing?
(equity, loans)
3. How should we manage everyday financial
activities – managing working capital? (collecting
receivables, paying suppliers etc.)
"Finance" Bodie and Merton

Financial Decisions of Firms Financial Decisions of Firms

The Capital Budgeting Process – Investment Decision The Financing Process

The preparation of a plan for acquiring factories, machinery,
research laboratories, show rooms, warehouses, and human
assets to implement the strategic plan
The basic unit of analysis is the investment project. Investment
projects are identified, triaged, and implemented in the capital
budgeting process
Once a new set of approved projects has been identified, it must
be financed with retained earnings, stock, bonds, et cetera
Capital structure is the amount of the firm’s market value
allocated to each category of issued securities. It determines
ownership and risk level of the firms future cash flows
Capital structure’s unit of analysis is the firm as a whole (not an
investment project )

Financial Decisions of Firms 5. The Financial System

FIGURE

Working Capital
all firms (including highly profitable ones) that do not pay
sufficient attention to working capital management may be
seriously damaged by the resulting
loss of investor and creditor confidence
delayed in investment schedules
sub-optimal temporary finance
unscheduled sale of the firms assets
"Finance" Bodie and Merton

5.1. What is the Financial System?

A Financial System is comprised of
markets, intermediaries, service firms and other institutions
used to carry out the financial decisions of households,
business firms, and governments
The household is the primary provider of funds to businesses and
government.
Households must accumulate financial resources throughout their
working life times to have enough savings (pension) to live on in their
retirement years

Financial intermediaries transform the nature of the securities

they issue and invest in
Banks, trust companies, credit unions, insurance firms, mutual funds

Market intermediaries simply help make markets work

Investment dealers
Brokers

The Financial System Spending Sectors

Financial Intermediaries: a firm whose primary business

is to provide financial services and financial products
Household
- Banks and other deposit-taking institutions: checking accounts, • SURPLUS SPENDING
loans, CDs … Business Firms UNITS
- Insurance companies: term life insurance... Government

Foreign Sector
• DEFICIT SPENDING
- Pension Funds
UNITS
- Mutual Funds
"Finance" Bodie and Merton
Surplus Spending Unit (1)
Has more cash income flow than expenditure on
consumption and real investments in a period of time. The
surplus is then allocated to the financial sector.
Other terms for surplus unit are saver, lender, buyer
of financial assets, financial investor, supplier of loanable
funds, buyer of securities.
Deficit Spending Unit (1)
Has more expenditures on consumption and real
goods (investment) in the real sector than income during a
period of time
The deficit unit must participate (borrow) in the
financial sector to balance cash inflows with outflows
Surplus Spending Unit (2)
The surplus unit may buy financial assets, hold more
money, or pay off financial liabilities issued earlier when in a
deficit situation
The household and foreign sectors are usually a surplus
sector
Deficit Spending Unit (2)
Other terms for deficit expending unit are borrower,
demander of loanable funds, and seller of securities.
The deficit spending unit may issue financial
liabilities, reduce money balances, and sell financial assets
acquired previously when in a surplus situation
"Finance" Bodie and Merton

THE FLOW OF FUNDS DIAGRAM

5.2 The Flow of Funds

Funds may flow from the surplus unit to the deficit unit
in three ways: Funds Funds
Directly meet
Through market intermediaries (or markets) •Deficit Spending
Surplus Spending
Through intermediaries Unit (DSU)
Unit (SSU)

•
Financial Assets = Financial Claims

The Flow of Funds Diagram The Flow of Funds Diagram

We shall examine various pathways from the surplus unit

Markets to the deficit unit

Surplus Units Deficit Units

Intermediaries
"Finance" Bodie and Merton

Fund Flows via Markets Fund Flows via Markets

A household with surplus funds invests them in

government bonds Markets

Surplus Units Deficit Units

Intermediaries

Fund Flows via Intermediaries Fund Flows via Intermediaries

Holders of surplus funds may use an intermediary, such as a

bank, to invest them. The bank receives the surplus funds, say Markets
as 90-day deposits, and adds them to the bank’s assets (creating
a bank liability). Money is fungible, so the corresponding loan
can not be identified
Surplus Units Deficit Units

Intermediaries
"Finance" Bodie and Merton

Fund Flows via Intermediaries and Markets Fund Flows via Intermediaries and Markets

Sometimes the intermediary itself has surplus funds, and invests

them in the market or another intermediary Markets

A bank that borrows and invests in the money market can

increase its flexibility, reduce its risks, and turn a profit

Eventually, the surplus funds are consumed by a deficit unit Surplus Units Deficit Units

Intermediaries

Fund Flow via Markets and Intermediaries Funds Flow via Markets and Intermediaries

Intermediaries such as General Motors Acceptance

Corporation issue commercial paper to finance car loans and Markets
leases made to households needing a car

In this case, the paper has a shorter maturity than the

loan, leading to a risk
Surplus Units Deficit Units

Intermediaries