CHAPTER 1: OVERVIEW OF

FINANCE

Sources:
• Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc.
•Timothy J.G (2013), Financial Management: Principle and
practices, 6th ed, Freeload Press Publishers.

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 LEARNING OBJECTIVES
After reading this chapter, you should be
able to:
• Describe finance and main areas
• Differentiate financial decisions with
other scarce resources allocation decision
• Understand financial decisions of main
actors in economy

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Chapter 1: Overview of finance

DEFINITION OF FINANCE

FINANCIAL DECISIONS

MAIN AREAS OF FINANCE

FINANCIAL FUNCTIONS

FINANCIAL SYSTEM,
FINANCIAL INFRASTRUCTURE AND REGULATIONS,
FINANCIAL CRISIS
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 DEFINITION OF FINANCE

• Finance is the study of how to allocate

scarce resources over time under conditions
of uncertainty.
(Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc)

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 Definition of finance
• Finance is the science and art of managing
money.
(Lawrence J. Gitman)

• Finance is the processes by which money is

transferred (financing and investing) among
businesses, individuals, and governments.
(Lawrence J. Gitman, Jeff Mandura (2001) Introduction to finance)

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 Financial theory
• Finance theory consists of:
A set of concepts that help to organize one’s
thinking about how to allocate resources over
time.
A set of quantitative models to help evaluate
alternatives, make decisions and implement
them.
• The same basic concepts and quantitative
models apply at all levels and scales of
decision making.

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Financial theory

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Financial theory

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 Why study finance?
• To manage your personal resources
• To deal with the world of business
• To find a good career
• To be informed and updated about public
choices as a citizen of modern society
• To expand your mind

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 Career opportunities in finance
• Careers in finance typically fall into one of two
broad categories:
– (1) financial services and
– (2) managerial finance
• Workers in both areas rely on a common
analytical “tool kit,” but the types of problems
to which that tool kit is applied vary a great
deal from one career path to the other.

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 Main players in finance
• Household
• Firms
• Government

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 FINANCIAL DECISIONS
• Financial decisions of households
• Financial decisions of firms
• Financial decisions of governments

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Financial decisions of households
• Household may be from extended family to
single person living alone.
• Financial decisions of households include:
– Consumption and saving decisions
– Investment decisions
– Financing decisions
– Risk-management decisions

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 Financial decisions of firms
• Business firms – or simply firms – are entities
whose primary function is to produce goods
and services; vary from part-time business
run to giant corporations.
• The branch of finance dealing with financial
decisions of firms is called business finance or
corporate finance.

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 Financial decisions of firms
• Financial decisions of firms include:
– Strategic planning
– Capital budgeting process
– Financing process
– Working capital management

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 Financial decisions of firms
• Strategic planning: decide what businesses
they are in.
– The firm’s business may be defined in terms of a
group of products, technologies or customers
– A firm will have a core business, defined by its main
product line, and may branch out into other
business, often related lines of business.
– A firms’ strategic goals may change over time.

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 Financial decisions of firms
• Capital budgeting process: prepare plan for
acquiring long-lived assets and personnel to
implement the strategic plan.
– The basic unit of analysis in capital budgeting is an
investment project.
– The process of capital budgeting consists of
identifying ideas for new investment projects,
evaluating them
deciding which one to undertake and
implementing them.

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 Financial decisions of firms
• Financing process: after deciding what
project to undertake, the firm must figure out
how to finance them (capital structure).
– The unit of analysis in capital structure decisions
is not the individual investment project but the
firm as a whole.
– The firm must firstly
• define a feasible financing plan, then
• determine the optimal financing mix: issuing
securities or making bank loans…
– Deciding which financial instruments to call for
capital is important as it determines who controls
the firm under different contingencies.
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 Financial decisions of firms
• Working capital management: deals with
day-to-day financial affairs of the business.
– Managers must pay attention to the firm’s cash
flows in and out, which may not match up
exactly in time.
– Managers should ensure that
operating cash flow deficits are financed and
cash flow surpluses are efficiently invested to earn a
good return.

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Financial decisions of governments
• Financial decisions of governments
include:
– Identify expenditure required for running its
bodies
– Sources of revenue
– The budgeting process
– Debt issuances for public projects

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 THE FIELD OF FINANCE
• Personal finance
• Corporate finance
• Public finance
• Financial Markets and Institutions
• Investments

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 The field of finance
The field of Function
finance
Corporate -Manage the finance of a business firm.
finance -A combination of accounting and economics.
Financial -Facilitate the flow of funds in the economy.
Markets and -Analyze the impact of interest rates on that flow
of funds
Institutions
Investments - Locate, select and manage cash producing assets
for individuals and groups
- Analyze money manager performance
- Create new investment vehicles

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 Personal finance
• Personal finance is the application of the
principles of finance to the monetary
decisions of an individual or family unit. 
• It addresses the ways in which individuals or
families obtain, budget, save and spend
monetary resources over time, taking into
account various financial risks and future life
events. 

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 Personal finance
• Areas of focus
– Financial position
– Adequate protection
– Tax planning
– Investment and accumulation goals
– Retirement planning
– Estate planning

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 Corporate finance
• The financial activities related to running a
corporation.
• A division or department that oversees the financial
activities of a company. Corporate finance is
primarily concerned with maximizing shareholder
value through long-term and short-term financial
planning and the implementation of various
strategies. Everything from capital investment
decisions to investment banking falls under the
domain of corporate finance.
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 Corporate finance
• What corporate finance includes?
– Planning the finance
– Raising the finance
– Investing the finance
– Monitoring the finance

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 Corporate finance
• Forms of business organization
• Separation of ownership and management
• The duties of financial managers
• The basic goal of financial management
• Focus of financial professionals
• Legal/ ethical challenges for financial
managers
• ….

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 Public finance
• Public finance is the study of the income and
expenditure of the State.
• It deals only with the finances of the
Government.
• Scope of Public finance consists in the study of
the collection of funds and their allocation
between various branches of state activities
which are regarded as essential duties or
functions of the State.
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 Public finance
• Public finance may be divided into following
three parts:
– Public expenditure
– Public revenue
– Public debt

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Financial markets and institutions

• Financial markets
• Financial institutions/ Financial
intermediaries
• Topics related

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 Topics related
• How interest rate levels are determined
• How the central bank controls the money
supply
• Relationships between macroeconomic
variables such as inflation, interest rates,
money supply and DDP
• …

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 Investment
• Stockholders vs bondholders
• Risk-return tradeoff
• Cost of funds
• …

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 Stockholders vs bondholders
• Financial analysis from the perspective of
the investor:
– Stockholders are owners of the firm
– Bondholders are creditors of the firm

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 Risk-return tradeoff
• Investors prefer high returns to low returns
and low risk to high risk.
– As investment risk increase, investors will
require higher returns to compensate them for
the additional risk.
– To earn higher returns, investors must take on
more investment risk.

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 Cost of funds
• From the firm’s perspective the investor’s
rate of return represents a cost of funds to
the firm.

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 FINANCIAL FUNCTIONS
• Transferring resources across time and
space
• Managing risk
• Clearing and settling payments
• Pooling resources and subdividing shares
• Providing information
• Dealing with incentive problems

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Transferring resources across time and
space

• A financial system provide ways to

transfer economic resources through
time, across geographic regions and
among industries.

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Transferring resources across time and
space

– A French household now has excess funds

that they will need to use in 5 years.
– A Vietnamese business now wants to
implement a profitable investment plan but
lack of capital.
• Financial markets make this match.

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 Managing risks
• A financial system provides ways to manage
risk.
– Both funds and risks are transferred (bundled
together, unbundled or repackaged) through
financial systems.
– Risks may be transferred from safety lovers to
risks lovers by ways of using portfolios, financial
derivatives and guarantees.
– Many financial contracts target risks rather than
funds.

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 Managing risks
• A fund manager may increases risk (and
expected returns) of a fund by issuing
bonds secured against the funds assets,
writing put options, buying call options,
and going “long” market index futures
• Another fund manager may decrease risk
by investing in the money market, put
options, and short index futures

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Clearing and settling payments
• A financial system provides ways of
clearing and settling payments to
facilitate the exchange of goods, services
and assets.

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Clearing and settling payments
• Ways that have been used:
– Barter (Levi jeans, old stamps & coins)
– Gold (requires purity assay, heavy)
– Paper money (restricted geographically)
– Checks, credit card (not everywhere accepted)
– Electronic fund transfer

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Pooling resources and subdividing shares

• A financial system provides a mechanism

for the pooling of funds to undertake
large-scale indivisible enterprise or for
the subdividing of shares in large
enterprises with many owners.

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Pooling resources and subdiving shares

• The financial system provides a variety of

mechanism (like stock markets or
intermediation) to pool or aggregate the
wealth of households (smaller and
decentralized amount) into larger masses of
capital (centralized and bigger lump sums of
money) for use by business firms.
• Financial system then subdivide the pool of
funds into “pieces” (shares) to meet the
demands of various investors.
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Pooling resources and subdiving shares

• If you only have USD 10,000, you cannot

open a firm with the scope of USD 100,000
to implement investment plan in media as
you wish.
• However, by dividing the firm’s value into
“pieces” (shares) and distributing the
shares to the investors like you, you can
make your wish come true by buying the
shares and owning 1/10 the firm.

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 Providing information
• A financial system provides price information
that helps coordinate decentralized decision
making in various sectors of the economy.

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 Providing information
• Market prices are useful to evaluate similar
assets which are not quoted.
• Asset prices and interest rates provide
critical signals for managers of firms to
make financial decisions.
• Standardized option contracts provide
quantitative information about the riskiness
of economic and financial variables, so it’s
useful for making risk-management
decisions.

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Dealing with incentive problems
• A financial system provides ways to deal
with the incentive problems when one
party to a financial transaction has
information that the other party does
not, or when one party is an agent that
makes decision for another.

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Dealing with incentive problems
• Incentive problems may be:
– Information asymmetry:
• Adverse selection
• Moral hazard
– Principal-agent problem

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 Asymmetric information
• Asymmetric information is a situation
that arises when one party’s insufficient
knowledge about the other party
involved in a transaction makes it
impossible to make accurate decisions
when conducting the transaction.
• In fact, “asymmetric” refers to:
– Not everyone has the same information
– Everyone has less than perfect information
– Some parties to a transaction have “inside”
information which is not made available to
both sides of the transaction.
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 Asymmetric information
Asymmetric information

Adverse Moral
selection Before the After the hazard
transaction transaction
occur occur

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 FINANCIAL SYSTEMS
• What is financial system?
• Financial instruments
• Financial markets
• Financial intermediaries
• The flow of funds
• The international financial system

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What is financial system?

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The flows of funds through the financial system
 What is financial system?
• The purpose of the financial system is to bring economic
units that generate and spend funds together
– Surplus economic units have funds left over after spending all they
wish to spend
– Deficit economic units need to acquire additional funds to sustain
their operations
• To enable funds to move through the financial system, funds
are exchanged for securities.
– Securities are documents that represents the right to receive funds
in the future.
• Securities are traded in financial markets.
• Financial intermediaries often help to facilitate this process

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INTERNATIONALIZATION OF FINANCE
• The globalization of financial markets has accelerated
at a rapid pace in recent years; financial markets have
become increasingly integrated throughout the world.
• Ex:
– American companies often borrow in foreign financial
markets and foreign companies borrow in U.S. financial
markets;
– Banks have become increasingly international, with
operations in many countries throughout the world.
• The tremendous increase in capital flows among
countries heightens the international financial
system’s impact on domestic economies.

What should we care when finance goes internationalized?

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 FINANCIAL INNOVATION AND THE
“INVISIBLE HAND”
• “Every individual endeavors to employ his capital
so that its produce may be of greatest value. He
generally neither intends to promote the public
interest, nor knows how much he is promoting it.
He intends only his own security, only his own
gain. And he is in this led by an invisible hand to
promote an end which was no part of his
intention. By pursuing his own interest he
frequently promotes that of society more
effectually than when he really intends to
promote it.”
(Adam Smith, The Wealth of Nations (Chicago: University of Chicago Press, 1977),
p.408)
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 Financial innovation and the “invisible
hand”

• Financial innovation occurs spontaneously

from the individual actions of
entrepreneurs and firms, and not from the
actions of a central authority.
• Example: Credit cards

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FINANCIAL CRISIS

? Financial
crisis ?

?
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 FINANCIAL CRISIS
• A financial crisis occurs when an increase
in asymmetric information from a
disruption in the financial system causes
severe adverse selection and moral hazard
problems that render financial markets
incapable of channeling funds efficiently
from savers to households and firms with
productive investment opportunities.
When financial markets fail to function
efficiently, economic activity contracts
sharply.
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 Financial crisis
• “Wall Street firms and commercial banks
suffered hundreds of billions of dollars of
losses. Households and businesses found they
had to pay higher rates on their borrowing –
and it was much harder to get credit. All over
the world, stock markets crashed, with the U.S.
market failing by 40% from its peak. Many
financial firms, including commercial banks,
investment banks, and insurance companies,
went belly up.”
(Mishkin, F.S. (2010), The Economics of Money, Banking and Financial
markets, 9th ed, The Addison – Wesley Series in Economics, p.199 –
Describing the “once-in-a-century credit tsunami” – the subprime
financial crisis in the U.S. in 2007-2008)
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 FINANCIAL INFRASTRUCTURE AND
REGULATIONS
• The financial infrastructure consists of
– Rules for Trading
– Accounting Systems
– Organization of trading and clearing facilities
– Regulatory structures that govern the relations
among the users of the financial system.
• These laws may differ from country to
country and change over time.
• Changes in the law are sometimes a
response to changing needs for the
operation of the financial system.
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 Rules for trading
• Serve the function of standardizing
procedures so that the costs of
transacting are kept to a minimum.

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 Accounting systems
• To be useful, financial information must be
presented in a standard format.
• The discipline that studies the reporting of
financial information is called accounting.
• The development of double-entry
bookkeeping – a major leap forward in
accounting systems – occurred in Renaissance
Italy in response to the need to keep track of
the complex financial transactions arising from
trade and banking
• Accounting systems are perhaps the most
important part of the infrastructure of the
financial system.
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 Government and Quasi-Government
Organizations

• Central banks
• Special Purpose Intermediaries
• Regional and World Organizations

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 Financial regulations
• Financial system is among the most heavily
regulated sectors.
• Two main reasons for this regulating:
– To increase the information available to
investors
– To ensure the soundness of the financial
system.

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 Financial regulations
Example: Principal Regulatory Agencies of the U.S. Financial system
Regulatory Agency Subject of Regulation Nature of Regulation
Securities and Exchange Organized exchanges Requires disclosure of
Commission (SEC) and financial markets information, restricts insider
trading
Commodities Futures Futures market Regulates procedures for
Trading Commission exchanges trading in future markets
(CFTC)
Office of the Comptroller Federally chartered Charters and examines the
of the Currency commercial banks books of federally chartered
commercial banks and
imposes restrictions on assets
they can hold
National Credit Union Federally chartered Charters and examines the
Administration (NCUA) credit unions book s of federally chartered
credit unions and imposes
restrictions on assets they can
hold

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 Financial regulations
Example: Principal Regulatory Agencies of the U.S. Financial system
Regulatory Agency Subject of Regulation Nature of Regulation
State banking and State-chartered Charters and examines the books of
insurance depository state-chartered banks and insurance
commissions institutions companies and imposes restrictions
on assets they can hold and impose
Federal Deposit Commercial banks, Provides insurance of up to $100,000
Insurance mutual savings banks, (temporally $250,000) for each
Corporation (FDIC) savings and loan depositor at a bank, examines the
associations books of insured banks, and imposes
restrictions on assets they can hold
Federal Reserve All depository Examines the books of commercial
System institutions banks that are members of the
system, sets reserve requirements
for all banks
Office of Thrift Savings and Loan Examines the books of S&L, imposes
Supervision associations restrictions on assets they can hold

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 Summary
• Definition of finance
• Financial decisions
• Fields of finance
• Financial functions
– Asymmetric information
• Others:
– Financial system
– Financial innovation
– Financial infrastructure and regulation
– Financial crisis

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 ASSIGNMENT OF CHAPTER 1
1. SELF-TEST
2. REVIEW QUESTIONS
3. PROBLEMS

 DO IT BY YOURSELF FIRST
 ASK IN LATER CLASS IF YOU COULD NOT FINISH

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 PREPARE FOR CHAPTER 2
1. What is interest rate? What kinds of interest
rate do you know? What determines interest
rates? Explore!
2. Why “cash received sooner being better than
cash received later” (same as “it’s better to pay
out cash later rather than sooner”) – all other
factors being equal.
3. Prepare your own calculator.

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