Finance

Contents

1 Main article 11.1 Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1.1 Areas of nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.1.2 Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.1.3 Financial theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.1.4 Professional qualications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61.1.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 The main techniques and sectors of the nancial industry 72.1 Financial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.1.1 The history of nancial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72.1.2 Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72.1.3 Foreign exchange services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.1.4 Investment services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.1.5 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.1.6 Other nancial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.1.7 Financial crime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.1.8 Market share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.1.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92.1.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102.1.11 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102.1.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

3 Personal nance 113.1 Personal nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3.1.1 Personal nancial planning process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.1.2 Areas of focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.1.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.1.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.1.5 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.1.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

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4 Corporate nance 134.1 Corporate nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

4.1.1 Outline of corporate nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134.1.2 Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144.1.3 Investment and project valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154.1.4 Dividend policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174.1.5 Working capital management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174.1.6 Relationship with other areas in nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184.1.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194.1.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194.1.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204.1.10 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4.2 Financial capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214.2.1 Three concepts of capital maintenance authorized in IFRS . . . . . . . . . . . . . . . . . . 214.2.2 Sources of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224.2.3 Dierences between shares and debentures . . . . . . . . . . . . . . . . . . . . . . . . . . 224.2.4 Fixed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224.2.5 Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224.2.6 Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234.2.7 Own and borrowed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234.2.8 Issuing and trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234.2.9 Broadening the notion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.10 Marxian perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.11 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.12 Economic role . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.13 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.14 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244.2.15 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

4.3 Cornering the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254.3.1 Historical examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254.3.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

4.4 Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274.4.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274.4.2 Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294.4.3 Societal eects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304.4.4 Insurers business model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314.4.5 Types of insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324.4.6 Insurance companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394.4.7 Across the world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414.4.8 Controversies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424.4.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

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4.4.10 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454.4.11 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474.4.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

5 Risk Management 485.1 Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

5.1.1 Collateralised debt obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485.1.2 Credit default swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485.1.3 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.1.4 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.1.5 Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505.1.6 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505.1.7 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515.1.8 Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515.1.9 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525.1.10 Size of market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525.1.11 Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535.1.12 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545.1.13 Economic function of the derivative market . . . . . . . . . . . . . . . . . . . . . . . . . 555.1.14 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565.1.15 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565.1.16 Financial Reform and Government Regulation . . . . . . . . . . . . . . . . . . . . . . . . 575.1.17 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595.1.18 Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605.1.19 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605.1.20 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605.1.21 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635.1.22 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

6 Finance of states 646.1 Public nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

6.1.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646.1.2 Public nance management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646.1.3 Government expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 656.1.4 Financing of government expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 656.1.5 Government Finance Statistics and Methodology . . . . . . . . . . . . . . . . . . . . . . . 676.1.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696.1.7 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696.1.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696.1.9 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

7 Financial economics 71

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7.1 Financial economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 717.1.1 Underlying economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 717.1.2 Resultant models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727.1.3 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747.1.4 Challenges and criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 767.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 767.1.7 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 767.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

8 Financial mathematics 808.1 Financial mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

8.1.1 History: Q versus P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 808.1.2 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 818.1.3 Mathematical nance articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 828.1.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 828.1.5 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 828.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

9 Experimental nance 839.1 Experimental nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

9.1.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839.1.2 Scientic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839.1.3 Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839.1.4 Types of experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 849.1.5 Main ndings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 849.1.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 859.1.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 859.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

10 Behavioral nance 8610.1 Behavioral nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

10.1.1 Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8610.1.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8810.1.3 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9010.1.4 Notable theorists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9110.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9210.1.6 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9210.1.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9410.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

11 Intangible asset nance 9611.1 Intangible asset nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

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11.1.1 Basic principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9611.1.2 Business models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9611.1.3 Signicant transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9711.1.4 Government, societies, think tanks, and other non-prots . . . . . . . . . . . . . . . . . . 9711.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9711.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9711.1.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

12 Text and image sources, contributors, and licenses 9812.1 Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9812.2 Images . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10312.3 Content license . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Chapter 1

Main article

1.1 FinanceFor the board game, see Finance (game).Financial redirects here. For the Caucasian newspaper,see FINANCIAL.

Finance is a eld that deals with the allocation of assetsand liabilities over time under conditions of certainty anduncertainty. Finance can also be dened as the science ofmoney management. A key point in nance is the timevalue of money, which states that purchasing power ofone unit of currency can vary over time. Finance aims toprice assets based on their risk level and their expectedrate of return. Finance can be broken into three dier-ent sub-categories: public nance, corporate nance andpersonal nance.

1.1.1 Areas of nance

Wall Street, the center of American nance.

Personal nance

Main article: Personal nance

Questions in personal nance revolve around:

Protection against unforeseen personal events, aswell as events in the wider economy

Transference of family across generations (bequestsand inheritance)

Eects of tax policies (tax subsidies and/or penal-ties) on management of personal nances

Eects of credit on individual nancial standing Development of a savings plan or nancing for largepurchases (auto, education, home)

Planning a secure nancial future in an environmentof economic instability

Personal nance may involve paying for education, -nancing durable goods such as real estate and cars, buyinginsurance, e.g. health and property insurance, investingand saving for retirement.Personal nance may also involve paying for a loan, ordebt obligations. The six key areas of personal nancialplanning, as suggested by the Financial Planning Stan-dards Board, are:[1]

1. Financial position: is concerned with understand-ing the personal resources available by examiningnet worth and household cash ow. Net worth is apersons balance sheet, calculated by adding up allassets under that persons control, minus all liabili-ties of the household, at one point in time. House-hold cash ow totals up all the expected sources ofincome within a year, minus all expected expenseswithin the same year. From this analysis, the nan-cial planner can determine to what degree and inwhat time the personal goals can be accomplished.

2. Adequate protection: the analysis of how to pro-tect a household from unforeseen risks. These riskscan be divided into liability, property, death, dis-ability, health and long term care. Some of theserisks may be self-insurable, while most will requirethe purchase of an insurance contract. Determininghowmuch insurance to get, at the most cost eectiveterms requires knowledge of the market for personalinsurance. Business owners, professionals, athletes

1

2 CHAPTER 1. MAIN ARTICLE

and entertainers require specialized insurance pro-fessionals to adequately protect themselves. Sinceinsurance also enjoys some tax benets, utilizing in-surance investment products may be a critical pieceof the overall investment planning.

3. Tax planning: typically the income tax is the singlelargest expense in a household. Managing taxes isnot a question of if you will pay taxes, but when andhow much. Government gives many incentives inthe form of tax deductions and credits, which can beused to reduce the lifetime tax burden. Most mod-ern governments use a progressive tax. Typically,as ones income grows, a higher marginal rate of taxmust be paid. Understanding how to take advan-tage of the myriad tax breaks when planning onespersonal nances can make a signicant impact inwhich it can later save you money in the long term.

4. Investment and accumulation goals: planninghow to accumulate enough money - for large pur-chases and life events - is what most people con-sider to be nancial planning. Major reasons to ac-cumulate assets include, purchasing a house or car,starting a business, paying for education expenses,and saving for retirement. Achieving these goalsrequires projecting what they will cost, and whenyou need to withdraw funds that will be necessaryto be able to achieve these goals. A major risk tothe household in achieving their accumulation goalis the rate of price increases over time, or ination.Using net present value calculators, the nancialplanner will suggest a combination of asset earmark-ing and regular savings to be invested in a variety ofinvestments. In order to overcome the rate of in-ation, the investment portfolio has to get a higherrate of return, which typically will subject the port-folio to a number of risks. Managing these portfoliorisks is most often accomplished using asset alloca-tion, which seeks to diversify investment risk andopportunity. This asset allocation will prescribe apercentage allocation to be invested in stocks (ei-ther preferred stock and/or common stock), bonds(for example mutual bonds or government bods, orcorporate bonds), cash and alternative investments.The allocation should also take into considerationthe personal risk prole of every investor, since riskattitudes vary from person to person.

5. Retirement planning is the process of understand-ing howmuch it costs to live at retirement, and com-ing up with a plan to distribute assets to meet any in-come shortfall. Methods for retirement plan includetaking advantage of government allowed structuresto manage tax liability including: individual (IRA)structures, or employer sponsored retirement plans.

6. Estate planning involves planning for the dispo-sition of ones assets after death. Typically, thereis a tax due to the state or federal government at

ones death. Avoiding these taxes means that moreof ones assets will be distributed to ones heirs. Onecan leave ones assets to family, friends or charitablegroups.

Corporate nance

Main article: Corporate nance

Corporate nance deals with the sources of funding andthe capital structure of corporations and the actions thatmanagers take to increase the value of the rm to theshareholders, as well as the tools and analysis used to al-locate nancial resources. Although it is in principle dif-ferent from managerial nance which studies the nan-cial management of all rms, rather than corporationsalone, the main concepts in the study of corporate -nance are applicable to the nancial problems of all kindsof rms. Corporate nance generally involves balancingrisk and protability, while attempting to maximize anentitys wealth and the value of its stock, and genericallyentails three primary areas of capital resource allocation.In the rst, capital budgeting, management must choosewhich projects (if any) to undertake. The discipline ofcapital budgeting may employ standard business valua-tion techniques or even extend to real options valuation;see Financial modeling. The second, sources of capitalrelates to how these investments are to be funded: invest-ment capital can be provided through dierent sources,such as by shareholders, in the form of equity (privately orvia an initial public oering), creditors, often in the formof bonds, and the rms operations (cash ow). Short-term funding or working capital is mostly provided bybanks extending a line of credit. The balance betweenthese elements forms the companys capital structure.The third, the dividend policy, requires managementto determine whether any unappropriated prot (excesscash) is to be retained for future investment / operationalrequirements, or instead to be distributed to shareholders,and if so in what form. Short term nancial managementis often termed "working capital management", and re-lates to cash-, inventory- and debtors management.Corporate nance also includes within its scope businessvaluation, stock investing, or investment management.An investment is an acquisition of an asset in the hope thatit will maintain or increase its value over time that willin hope give back a higher rate of return when it comesto disbursing dividends. In investment management inchoosing a portfolio one has to use nancial analysis todetermine what, how much and when to invest. To dothis, a company must:

Identify relevant objectives and constraints: institu-tion or individual goals, time horizon, risk aversionand tax considerations;

Identify the appropriate strategy: active versus pas-

1.1. FINANCE 3

sive hedging strategy Measure the portfolio performance

Financial management overlaps with the nancial func-tion of the Accounting profession. However, nancial ac-counting is the reporting of historical nancial informa-tion, while nancial management is concerned with theallocation of capital resources to increase a rms valueto the shareholders and increase their rate of return onthe investments.Financial risk management, an element of corporate -nance, is the practice of creating and protecting economicvalue in a rm by using nancial instruments to man-age exposure to risk, particularly credit risk and marketrisk. (Other risk types include Foreign exchange, Shape,Volatility, Sector, liquidity, Ination risks, etc.) It focuseson when and how to hedge using nancial instruments;in this sense it overlaps with nancial engineering. Sim-ilar to general risk management, nancial risk manage-ment requires identifying its sources, measuring it (see:Risk measure: Well known risk measures), and formu-lating plans to address these, and can be qualitative andquantitative. In the banking sector worldwide, the BaselAccords are generally adopted by internationally activebanks for tracking, reporting and exposing operational,credit and market risks.

Financial services Main article: Financial services

An entity whose income exceeds its expenditure can lendor invest the excess income to help that excess incomeproduce more income in the future. Though on the otherhand, an entity whose income is less than its expenditurecan raise capital by borrowing or selling equity claims,decreasing its expenses, or increasing its income. Thelender can nd a borrower--a nancial intermediary suchas a bank--or buy notes or bonds (corporate bonds, gov-ernment bonds, ormutual bonds) in the bondmarket. Thelender receives interest, the borrower pays a higher inter-est than the lender receives, and the nancial intermediaryearns the dierence for arranging the loan.A bank aggregates the activities of many borrowers andlenders. A bank accepts deposits from lenders, on whichit pays interest. The bank then lends these deposits to bor-rowers. Banks allow borrowers and lenders, of dierentsizes, to coordinate their activity.Finance is used by individuals (personal nance), by gov-ernments (public nance), by businesses (corporate -nance) and by a wide variety of other organizations suchas including schools and non-prot organizations. In gen-eral, the goals of each of the above activities are achievedthrough the use of appropriate nancial instruments andmethodologies, with consideration to their institutionalsetting.Finance is one of the most important aspects of business

management and includes analysis related to the use andacquisition of funds for the enterprise.In corporate nance, a companys capital structure is thetotal mix of nancing methods it uses to raise funds. Onemethod is debt nancing, which includes bank loans andbond sales. Another method is equity nancing - the saleof stock by a company to investors, the original share-holders (they own a portion of the business) of a share.Ownership of a share gives the shareholder certain con-tractual rights and powers, which typically include theright to receive declared dividends and to vote the proxyon important matters (e.g., board elections). The own-ers of both bonds (either government bonds or corporatebonds) and stock (whether its preferred stock or commonstock), may be institutional investors - nancial institu-tions such as investment banks and pension funds or pri-vate individuals, called private investors or retail investors.

Public nance

Main article: Public nance

Public nance describes nance as related to sovereignstates and sub-national entities (states/provinces, coun-ties, municipalities, etc.) and related public entities (e.g.school districts) or agencies. It is concerned with:

Identication of required expenditure of a publicsector entity

Source(s) of that entitys revenue The budgeting process Debt issuance (municipal bonds) for public worksprojects

Central banks, such as the Federal Reserve System banksin the United States and Bank of England in the UnitedKingdom, are strong players in public nance, acting aslenders of last resort as well as strong inuences on mon-etary and credit conditions in the economy.[2]

1.1.2 CapitalMain article: Financial capital

Capital, in the nancial sense, is the money that gives thebusiness the power to buy goods to be used in the pro-duction of other goods or the oering of a service. (Thecapital has two types of resources, Equity and Debt).The deployment of capital is decided by the budget. Thismay include the objective of business, targets set, and re-sults in nancial terms, e.g., the target set for sale, re-sulting cost, growth, required investment to achieve theplanned sales, and nancing source for the investment.

4 CHAPTER 1. MAIN ARTICLE

A budget may be long term or short term. Long termbudgets have a time horizon of 510 years giving a visionto the company; short term is an annual budget which isdrawn to control and operate in that particular year.Budgets will include proposed xed asset requirementsand how these expenditures will be nanced. Capitalbudgets are often adjusted annually (done every year) andshould be part of a longer-term Capital ImprovementsPlan.A cash budget is also required. The working capital re-quirements of a business are monitored at all times to en-sure that there are sucient funds available to meet short-term expenses.The cash budget is basically a detailed plan that showsall expected sources and uses of cash when it comes tospending it appropriately. The cash budget has the fol-lowing six main sections:

1. Beginning Cash Balance - contains the last pe-riods closing cash balance, in other words, the re-maining cash from last years earnings.

2. Cash collections - includes all expected cash re-ceipts (all sources of cash for the period considered,mainly sales)

3. Cash disbursements - lists all planned cash out-ows for the period such as dividend, excluding in-terest payments on short-term loans, which appearin the nancing section. All expenses that do notaect cash ow are excluded from this list (e.g. de-preciation, amortization, etc.)

4. Cash excess or deciency - a function of the cashneeds and cash available. Cash needs are deter-mined by the total cash disbursements plus the min-imum cash balance required by company policy. Iftotal cash available is less than cash needs, a de-ciency exists.

5. Financing - discloses the planned borrowings andrepayments of those planned borrowings, includinginterest.

1.1.3 Financial theoryFinancial economics

Main article: Financial economics

Financial economics is the branch of economics study-ing the interrelation of nancial variables, such as prices,interest rates and shares, as opposed to goods and ser-vices. Financial economics concentrates on inuences ofreal economic variables on nancial ones, in contrast topure nance. It centres on managing risk in the contextof the nancial markets, and the resultant economic and

nancial models. It essentially explores how rational in-vestors would apply risk and return to the problem ofan investment policy. Here, the twin assumptions ofrationality and market eciency lead to modern portfo-lio theory (the CAPM), and to the BlackScholes the-ory for option valuation; it further studies phenomena andmodels where these assumptions do not hold, or are ex-tended. Financial economics, at least formally, alsoconsiders investment under "certainty" (Fisher separa-tion theorem, theory of investment value, Modigliani-Miller theorem) and hence also contributes to corporatenance theory. Financial econometrics is the branch ofnancial economics that uses econometric techniques toparameterize the relationships suggested.Although closely related, the disciplines of economicsand nance are distinctive. The economy is a socialinstitution that organizes a societys production, distri-bution, and consumption of goods and services, all ofwhich must be nanced.Economists make a number of abstract assumptions forpurposes of their analyses and predictions. They gener-ally regard nancial markets that function for the nan-cial system as an ecient mechanism (Ecient-markethypothesis). Instead, nancial markets are subject to hu-man error and emotion.[3] New research discloses themischaracterization of investment safety and measures ofnancial products and markets so complex that their ef-fects, especially under conditions of uncertainty, are im-possible to predict. The study of nance is subsumedunder economics as nancial economics, but the scope,speed, power relations and practices of the nancial sys-tem can uplift or cripple whole economies and the well-being of households, businesses and governing bodieswithin themsometimes in a single day.

Financial mathematics

Main article: Financial mathematics

Financial mathematics is a eld of applied mathemat-ics, concerned with nancial markets. The subject hasa close relationship with the discipline of nancial eco-nomics, which is concerned with much of the underlyingtheory that is involved in nancial mathematics. Gen-erally, mathematical nance will derive, and extend, themathematical or numerical models suggested by nancialeconomics. In terms of practice, mathematical nancealso overlaps heavily with the eld of computational -nance (also known as nancial engineering). Arguably,these are largely synonymous, although the latter focuseson application, while the former focuses on modeling andderivation (see: Quantitative analyst). The eld is largelyfocused on the modelling of derivatives, although otherimportant subelds include insurance mathematics andquantitative portfolio problems. See Outline of nance:Mathematical tools; Outline of nance: Derivatives pric-

1.1. FINANCE 5

ing.

Experimental nance

Main article: Experimental nance

Experimental nance aims to establish dierent mar-ket settings and environments to observe experimentallyand provide a lens through which science can analyzeagents behavior and the resulting characteristics of trad-ing ows, information diusion and aggregation, pricesetting mechanisms, and returns processes. Researchersin experimental nance can study to what extent existingnancial economics theory makes valid predictions andtherefore prove them, and attempt to discover new prin-ciples on which such theory can be extended and be ap-plied to future nancial decisions. Research may proceedby conducting trading simulations or by establishing andstudying the behavior, and the way that these people actor react, of people in articial competitive market-likesettings.

Behavioral nance

Main article: Behavioral economics

Behavioral nance studies how the psychology of in-vestors or managers aects nancial decisions and mar-kets when making a decision that can impact either neg-atively or positive one of there areas. Behavioral nancehas grown over the last few decades to become centraland very important to nance.Behavioral nance includes such topics as:

1. Empirical studies that demonstrate signicant devi-ations from classical theories.

2. Models of how psychology aects and impacts trad-ing and prices

3. Forecasting based on these methods.

4. Studies of experimental asset markets and use ofmodels to forecast experiments.

A strand of behavioral nance has been dubbed Quanti-tative Behavioral Finance, which uses mathematical andstatistical methodology to understand behavioral biasesin conjunction with valuation. Some of this endeavor hasbeen led by Gunduz Caginalp (Professor of Mathematicsand Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002Nobel Laureate in Economics), David Porter, Don Balen-ovich, Vladimira Ilieva, Ahmet Duran). Studies by JeMadura, Ray Sturm and others have demonstrated sig-nicant behavioral eects in stocks and exchange traded

funds. Among other topics, quantitative behavioral -nance studies behavioral eects together with the non-classical assumption of the niteness of assets.

Intangible asset nance

Main article: Intangible asset nance

Intangible asset nance is the area of nance that dealswith intangible assets such as patents, trademarks, good-will, reputation, etc.

1.1.4 Professional qualicationsThere are several related professional qualications, thatcan lead to the eld:

Generalist Finance qualications: Degrees: Master of Science in Finance(MSF), Master of Finance (M.Fin), Master ofFinancial Economics, Master of Applied Fi-nance

Certications: Chartered Financial Analyst(CFA), Certied Treasury Professional (CTP),Certied Valuation Analyst (CVA), CertiedPatent Valuation Analyst (CPVA), CharteredBusiness Valuator (CBV), Certied Interna-tional Investment Analyst (CIIA), FinancialRisk Manager (FRM), Professional RiskManager (PRM), Association of CorporateTreasurers (ACT), Certied Market Analyst(CMA/FAD) Dual Designation, Corporate Fi-nance Qualication (CF), Chartered Alterna-tive Investment Analyst (CAIA), CharteredInvestment Manager (CIM)

Quantitative Finance qualications: Master ofFinancial Engineering (MSFE), Master of Quan-titative Finance (MQF), Master of ComputationalFinance (MCF), Master of Financial Mathematics(MFM), Certicate in Quantitative Finance (CQF).

Accountancy qualications: Qualied accountant: Chartered Accountant(The Institute of Chartered Accountant ofPakistan - ICAP), Chartered Accountant (TheInstitute of Chartered Accountants of India- ICAI), Chartered Accountant (ACA - UKcertication / CA - certication in Common-wealth countries), Chartered Certied Ac-countant (ACCA, UK certication), CertiedPublic Accountant (CPA, US certication),ACMA/FCMA (Associate/Fellow CharteredManagement Accountant) from Chartered In-stitute of Management Accountant (CIMA),UK.

6 CHAPTER 1. MAIN ARTICLE

Non-statutory qualications: Chartered CostAccountant CCA Designation from AAFM

Business qualications: Master of Business Ad-ministration (MBA),Master ofManagement (MM),Master of Commerce (M.Comm), Master of Sci-ence in Management (MSM), Doctor of BusinessAdministration (DBA)

1.1.5 See also Outline of nance Financial crisis of 20072010

1.1.6 References[1] Financial Planning Curriculum Framework. Financial

Planning Standards Board. 2011. Retrieved 7 April 2012.

[2] Board of Governors of Federal Reserve System of theUnited States. Mission of the Federal Reserve System.Federalreserve.gov Accessed: 2010-01-16. (Archived byWebCite at Webcitation.org)

[3] Berezin, M. (2005). Emotions and the Economy inSmelser, N.J. and R. Swedberg (eds.) The Handbook ofEconomic Sociology, Second Edition. Princeton Univer-sity Press: Princeton, NJ

1.1.7 External links Learn Finance Step by step with infographics tools OECD work on nancial markets Observation ofUK Finance Market

Wharton Finance Knowledge Project - aimed to of-fer free access to nance knowledge for students,teachers, and self-learners.

Professor Aswath Damodaran (New York Univer-sity Stern School of Business) - provides resourcescovering three areas in nance: corporate nance,valuation and investment management and syndicatenance.

Chapter 2

The main techniques and sectors of thenancial industry

2.1 Financial services

Financial services are the economic services providedby the nance industry, which encompasses a broadrange of businesses that manage money, including creditunions, banks, credit card companies, insurance compa-nies, accountancy companies, consumer nance compa-nies, stock brokerages, investment funds, real estate fundsand some government sponsored enterprises.As of 2004, the nancial services industry represented20% of the market capitalization of the S&P 500 in theUnited States. The U.S. nance industry comprised only10% of total non-farm business prots in 1947, but itgrew to 50% by 2010. Over the same period, nanceindustry income as a proportion of GDP rose from 2.5%to 7.5%, and the nance industrys proportion of all cor-porate income rose from 10% to 20%.

2.1.1 The history of nancial services

The term nancial services became more prevalent inthe United States partly as a result of the Gramm-Leach-Bliley Act of the late 1990s, which enabled dierenttypes of companies operating in the U.S. nancial ser-vices industry at that time to merge.[1]

Companies usually have two distinct approaches to thisnew type of business. One approach would be abank which simply buys an insurance company or aninvestment bank, keeps the original brands of the ac-quired rm, and adds the acquisition to its holding com-pany simply to diversify its earnings. Outside the U.S.(e.g., in Japan), non-nancial services companies are per-mitted within the holding company. In this scenario, eachcompany still looks independent, and has its own cus-tomers, etc. In the other style, a bank would simply createits own brokerage division or insurance division and at-tempt to sell those products to its own existing customers,with incentives for combining all things with one com-pany.

2.1.2 BanksMain article: Bank

Commercial banking services

A "commercial bank" is what is commonly referred to assimply a bank. The term "commercial" is used to dis-tinguish it from an "investment bank, a type of nancialservices entity which, instead of lending money directlyto a business, helps businesses raise money from otherrms in the form of bonds (debt) or stock (equity).The primary operations of banks include:

Keepingmoney safe while also allowing withdrawalswhen needed

Issuance of chequebooks so that bills can be paid andother kinds of payments can be delivered by post

Provide personal loans, commercial loans, andmortgage loans (typically loans to purchase a home,property or business)

Issuance of credit cards and processing of creditcard transactions and billing

Issuance of debit cards for use as a substitute forcheques

Allow nancial transactions at branches or by usingAutomatic Teller Machines (ATMs)

Provide wire transfers of funds and Electronic fundtransfers between banks

Facilitation of standing orders and direct debits, sopayments for bills can be made automatically

Provide overdraft agreements for the temporaryadvancement of the banks own money to meetmonthly spending commitments of a customer intheir current account.

7

8 CHAPTER 2. THE MAIN TECHNIQUES AND SECTORS OF THE FINANCIAL INDUSTRY

Provide internet banking system to facilitate the cus-tomers to view and operate their respective accountsthrough internet.

Provide charge card advances of the banks ownmoney for customers wishing to settle credit ad-vances monthly.

Provide a check guaranteed by the bank itself andprepaid by the customer, such as a cashiers checkor certied check.

Notary service for nancial and other documents Accepting the deposits from customer and providethe credit facilities to them.

Sell investment products like mutual funds etc.

Investment banking services

Capital markets services - underwriting debt andequity, assist company deals (advisory services, un-derwriting, mergers and acquisitions and advisoryfees), and restructure debt into structured nanceproducts.

Private banking - Private banks provide bankingservices exclusively to high-net-worth individuals.Many nancial services rms require a person orfamily to have a certain minimum net worth to qual-ify for private banking services.[2] Private banks of-ten provide more personal services, such as wealthmanagement and tax planning, than normal retailbanks.[3]

Brokerage services - facilitating the buying and sell-ing of nancial securities between a buyer and aseller. In todays (2014) stock brokers, brokeragesservices are oered online to self trading investorsthroughout the world who have the option of trad-ing with 'tied' online trading platforms oered by abanking institution or with online trading platformssometimes oered in a group by so-called onlinetrading portals.

2.1.3 Foreign exchange servicesForeign exchange services are provided by many banksand specialist foreign exchange brokers around the world.Foreign exchange services include:

Currency exchange - where clients can purchase andsell foreign currency banknotes.

Wire transfer - where clients can send funds to in-ternational banks abroad.

Remittance - where clients that are migrant workerssend money back to their home country.

2.1.4 Investment services

Asset management - the term usually given to de-scribe companies which run collective investmentfunds. Also refers to services provided by oth-ers, generally registered with the Securities and Ex-change Commission as Registered Investment Ad-visors. Investment banking nancial services focuson creating capital through client investments.

Hedge fund management - Hedge funds often em-ploy the services of "prime brokerage" divisions atmajor investment banks to execute their trades.

Custody services - the safe-keeping and processingof the worlds securities trades and servicing theassociated portfolios. Assets under custody in theworld are approximately US$100 trillion.[4]

2.1.5 Insurance

Main article: Insurance

Insurance brokerage - Insurance brokers shop for in-surance (generally corporate property and casualtyinsurance) on behalf of customers. Recently a num-ber of websites have been created to give consumersbasic price comparisons for services such as insur-ance, causing controversy within the industry.[5]

Insurance underwriting - Personal lines insuranceunderwriters actually underwrite insurance for in-dividuals, a service still oered primarily throughagents, insurance brokers, and stock brokers. Un-derwriters may also oer similar commercial linesof coverage for businesses. Activities include insur-ance and annuities, life insurance, retirement insur-ance, health insurance, and property & casualty in-surance.

F&I - Finance & Insurance, a service still oeredprimarily at asset dealerships. The F&I managerencompasses the nancing and insuring of the as-set which is sold by the dealer. F&I is often calledthe second gross in dealerships who have adoptedthe model

Reinsurance - Reinsurance is insurance sold to in-surers themselves, to protect them from catastrophiclosses.

2.1.6 Other nancial services

Bank cards - include both credit cards and debitcards.According to the Nilson Report, Bank OfAmerica is the largest issuer of bank cards.

2.1. FINANCIAL SERVICES 9

Credit card machine services and networks - Com-panies which provide credit card machine andpayment networks call themselves merchant cardproviders.

Intermediation or advisory services - These servicesinvolve stock brokers (private client services) anddiscount brokers. Stock brokers assist investors inbuying or selling shares. Primarily internet-basedcompanies are often referred to as discount broker-ages, although many now have branch oces to as-sist clients. These brokerages primarily target indi-vidual investors. Full service and private client rmsprimarily assist and execute trades for clients withlarge amounts of capital to invest, such as large com-panies, wealthy individuals, and investment man-agement funds.

Private equity - Private equity funds are typicallyclosed-end funds, which usually take controlling eq-uity stakes in businesses that are either private, ortaken private once acquired. Private equity fundsoften use leveraged buyouts (LBOs) to acquire therms in which they invest. The most successful pri-vate equity funds can generate returns signicantlyhigher than provided by the equity markets

Venture capital is a type of private equity capitaltypically provided by professional, outside investorsto new, high-growth-potential companies in the in-terest of taking the company to an IPO or trade saleof the business.

Angel investment - An angel investor or angel(known as a business angel or informal investor inEurope), is an auent individual who provides cap-ital for a business start-up, usually in exchange forconvertible debt or ownership equity. A small butincreasing number of angel investors organize them-selves into angel groups or angel networks to shareresources and pool their investment capital.

Conglomerates - A nancial services company, suchas a universal bank, that is active in more than onesector of the nancial services market e.g. life in-surance, general insurance, health insurance, assetmanagement, retail banking, wholesale banking, in-vestment banking, etc. A key rationale for the exis-tence of such businesses is the existence of diversi-cation benets that are present when dierent typesof businesses are aggregated i.e. bad things don't al-ways happen at the same time. As a consequence,economic capital for a conglomerate is usually sub-stantially less than economic capital is for the sumof its parts.

Financial market utilities - Organisations that arepart of the infrastructure of nancial services, suchas stock exchanges, clearing houses, derivative andcommodity exchanges and payment systems such as

real-time gross settlement systems or interbank net-works.

Debt resolution is a consumer service that assists in-dividuals that have too much debt to pay o as re-quested, but do not want to le bankruptcy and wishto pay o their debts owed. This debt can be ac-crued in various ways including but not limited topersonal loans, credit cards or in some cases mer-chant accounts.

2.1.7 Financial crime

UK

Fraud within the nancial industry costs the UK (reg-ulated by the FSA) an estimated 14bn a year andit is believed a further 25bn is laundered by Britishinstitutions.[6]

2.1.8 Market share

US

The U.S. nance industry comprised only 10% of totalnon-farm business prots in 1947, but it grew to 50%by 2010. Over the same period, nance industry incomeas a proportion of GDP rose from 2.5% to 7.5%, andthe nance industrys proportion of all corporate incomerose from 10% to 20%. The mean earnings per employeehour in nance relative to all other sectors has closelymirrored the share of total U.S. income earned by thetop 1% income earners since 1930. The mean salary inNew York Citys nance industry rose from $80,000 in1981 to $360,000 in 2011, while average New York Citysalaries rose from $40,000 to $70,000. In 1988, therewere about 12,500 U.S. banks with less than $300 mil-lion in deposits, and about 900 with more deposits, butby 2012, there were only 4,200 banks with less than $300million in deposits in the U.S., and over 1,801 with more.The nancial services industry constitutes the largestgroup of companies in the world in terms of earnings andequity market capitalization. However it is not the largestcategory in terms of revenue or number of employees.It is also a slow growing and extremely fragmented in-dustry, with the largest company (Citigroup), only havinga 3% US market share.[7] In contrast, the largest homeimprovement store in the US, Home Depot, has a 30%market share, and the largest coee house Starbucks hasa market share of 32% .

2.1.9 See also

List of largest nancial services companies by rev-enue

10 CHAPTER 2. THE MAIN TECHNIQUES AND SECTORS OF THE FINANCIAL INDUSTRY

Alternative nancial services Financial analyst Financial data vendors Financial markets Financial technology Financialization International Monetary Fund Investment management List of banks List of investment banks

2.1.10 References[1] Bill Summary & Status 106th Congress (1999 - 2000)

S.900 CRS Summary - Thomas (Library of Congress)".Retrieved 2011-02-08.

[2] Private Banking denition. Investor Words.com. Re-trieved 2009-02-06.

[3] How Swiss Bank Accounts Work. How Stu Works.Retrieved 2009-02-06.

[4] Prudential: Securities Processing Primer

[5] Price comparison sites face probe. BBC News. 2008-01-22. Retrieved 2009-02-06.

[6] Watchdog warns of criminal gangs inside banks. TheGuardian (London). 2005-11-16. Retrieved 2007-11-30.

[7] The Opportunity: Small Global Market Share, Page 11,from the Sanford C. Bernstein & Co. Strategic DecisionsConference 6/02/04

2.1.11 Further reading Porteous, Bruce T.; Pradip Tapadar (December2005). Economic Capital and Financial Risk Man-agement for Financial Services Firms and Conglom-erates. Palgrave Macmillan. ISBN 1-4039-3608-0.

2.1.12 External links The role of the nancial Services Sector in Expand-ing Economic Opportunity | A report by Christo-pher N. Sutton and Beth Jenkins | John F. KennedySchool of Government | Harvard University

Chapter 3

Personal nance

3.1 Personal nancePersonal nance is the nancial management which anindividual or a family unit is required to do to obtain,budget, save, and spend monetary resources over time,taking into account various nancial risks and future lifeevents.[1] When planning personal nances the individ-ual would consider the suitability to his or her needs of arange of banking products (checking, savings accounts,credit cards and consumer loans) or investment (stockmarket, bonds, mutual funds) and insurance (life insur-ance, health insurance, disability insurance) products orparticipation and monitoring of individual- or employer-sponsored retirement plans, social security benets, andincome tax management.

3.1.1 Personal nancial planning processThe key component of personal nance is nancial plan-ning, which is a dynamic process that requires regularmonitoring and reevaluation. In general, it involves vesteps:[2]

1. Assessment: A persons nancial situation is as-sessed by compiling simplied versions of nan-cial statements including balance sheets and incomestatements. A personal balance sheet lists the valuesof personal assets (e.g., car, house, clothes, stocks,bank account), along with personal liabilities (e.g.,credit card debt, bank loan, mortgage). A per-sonal income statement lists personal income andexpenses.

2. Goal setting: Having multiple goals is common, in-cluding a mix of short-term and long-term goals.For example, a long-term goal would be to retireat age 65 with a personal net worth of $1,000,000,while a short-term goal would be to save up for anew computer in the next month. Setting nancialgoals helps to direct nancial planning. Goal settingis done with an objective to meet certain nancialrequirements.

3. Creating a plan: The nancial plan details how toaccomplish the goals. It could include, for example,

reducing unnecessary expenses, increasing the em-ployment income, or investing in the stock market.

4. Execution: Execution of a nancial plan oftenrequires discipline and perseverance. Many peo-ple obtain assistance from professionals such asaccountants, nancial planners, investment advisers,and lawyers.

5. Monitoring and reassessment: As time passes,the nancial plan must be monitored for possible ad-justments or reassessments.

Typical goals most adults and young adults have are pay-ing o credit card and/or student loan debt, investing forretirement, investing for college costs for children, payingmedical expenses, and planning for passing on their prop-erty to their heirs (which is known as estate planning).

3.1.2 Areas of focusThe six key areas of personal nancial planning, as sug-gested by the Financial Planning Standards Board, are:[3]

1. Financial position: is concerned with understand-ing the personal resources available by examiningnet worth and household cash ow. Net worth is apersons balance sheet, calculated by adding up allassets under that persons control, minus all liabili-ties of the household, at one point in time. House-hold cash ow totals up all the expected sources ofincome within a year, minus all expected expenseswithin the same year. From this analysis, the nan-cial planner can determine to what degree and inwhat time the personal goals can be accomplished.

2. Adequate protection: the analysis of how to pro-tect a household from unforeseen risks. These riskscan be divided into liability, property, death, dis-ability, health and long-term care. Some of theserisks may be self-insurable, while most will requirethe purchase of an insurance contract. Determininghowmuch insurance to get, at the most cost eectiveterms requires knowledge of the market for personalinsurance. Business owners, professionals, athletes

11

12 CHAPTER 3. PERSONAL FINANCE

and entertainers require specialized insurance pro-fessionals to adequately protect themselves. Sinceinsurance also enjoys some tax benets, utilizing in-surance investment products may be a critical pieceof the overall investment planning.

3. Tax planning: typically the income tax is the singlelargest expense in a household. Managing taxes isnot a question of if you will pay taxes, but when andhow much. Government gives many incentives inthe form of tax deductions and credits, which can beused to reduce the lifetime tax burden. Most mod-ern governments use a progressive tax. Typically,as ones income grows, a higher marginal rate of taxmust be paid. Understanding how to take advantageof the myriad tax breaks when planning ones per-sonal nances can make a signicant impact.

4. Investment and accumulation goals: planninghow to accumulate enough money for large pur-chases, and life events is what most people considerto be nancial planning. Major reasons to accumu-late assets include, purchasing a house or car, start-ing a business, paying for education expenses, andsaving for retirement.

Achieving these goals requires project-ing what they will cost, and when youneed to withdraw funds. A major riskto the household in achieving their ac-cumulation goal is the rate of price in-creases over time, or ination. Usingnet present value calculators, the nan-cial planner will suggest a combinationof asset earmarking and regular savingsto be invested in a variety of investments.In order to overcome the rate of ina-tion, the investment portfolio has to geta higher rate of return, which typicallywill subject the portfolio to a number ofrisks. Managing these portfolio risks ismost often accomplished using asset al-location, which seeks to diversify invest-ment risk and opportunity. This asset al-location will prescribe a percentage al-location to be invested in stocks, bonds,cash and alternative investments. The al-location should also take into considera-tion the personal risk prole of every in-vestor, since risk attitudes vary from per-son to person.

5. Retirement planning is the process of understand-ing howmuch it costs to live at retirement, and com-ing up with a plan to distribute assets to meet any in-come shortfall. Methods for retirement plan includetaking advantage of government allowed structuresto manage tax liability including: individual (IRA)structures, or employer sponsored retirement plans.

6. Estate planning involves planning for the dispo-sition of ones assets after death. Typically, thereis a tax due to the state or federal government atyour death. Avoiding these taxes means that moreof your assets will be distributed to your heirs. Youcan leave your assets to family, friends or charitablegroups.

3.1.3 See also Accounting software Asset allocation Asset location Corporate nance Debt consolidation Equity investment Family planning Personal budget Personal nances of professional American athletes Separately managed account Wealth management Comparison of accounting software

3.1.4 References[1] Personal Finance. Investopedia. Retrieved 7 April

2012.

[2] What is Personal Finance?". Practical Financial Tips.Retrieved 7 April 2012.

[3] Financial Planning Curriculum Framework. FinancialPlanning Standards Board. 2011. Retrieved 7 April 2012.

3.1.5 Further reading Kwok, H., Milevsky, M., and Robinson, C. (1994)Asset Allocation, Life Expectancy, and Shortfall,Financial Services Review, 1994, vol 3(2), pg. 109-126.

3.1.6 External links Free Journal of Financial Counseling and Planningarticles

Chapter 4

Corporate nance

4.1 Corporate nance

Corporate nance is the area of nance dealing with thesources of funding and the capital structure of corpora-tions and the actions that managers take to increase thevalue of the rm to the shareholders, as well as the toolsand analysis used to allocate nancial resources. The pri-mary goal of corporate nance is to maximize or increaseshareholder value.[1] Although it is in principle dierentfrom managerial nance which studies the nancial man-agement of all rms, rather than corporations alone, themain concepts in the study of corporate nance are ap-plicable to the nancial problems of all kinds of rms.Investment analysis (or capital budgeting) is concernedwith the setting of criteria about which value-addingprojects should receive investment funding, and whetherto nance that investment with equity or debt capital.Working capital management is the management of thecompanys monetary funds that deal with the short-termoperating balance of current assets and current liabilities;the focus here is onmanaging cash, inventories, and short-term borrowing and lending (such as the terms on creditextended to customers).The terms corporate nance and corporate nancier arealso associated with investment banking. The typical roleof an investment bank is to evaluate the companys -nancial needs and raise the appropriate type of capitalthat best ts those needs. Thus, the terms corporate -nance and corporate nancier may be associated withtransactions in which capital is raised in order to create,develop, grow or acquire businesses. Recent legal andregulatory developments in the U.S. will likely alter themakeup of the group of arrangers and nanciers willingto arrange and provide nancing for certain highly lever-aged transactions.[2]

Financial management overlaps with the nancial func-tion of the Accounting profession. However, nancial ac-counting is the reporting of historical nancial informa-tion, while nancial management is concerned with theallocation of capital resources to increase a rms valueto the shareholders.

4.1.1 Outline of corporate nance

The primary goal of nancial management is to maxi-mize or to continually increase shareholder value. Maxi-mizing shareholder value requires managers to be able tobalance capital funding between investments in projectsthat increase the rms long term protability and sus-tainability, along with paying excess cash in the form ofdividends to shareholders. Managers of growth compa-nies (i.e. rms that earn high rates of return on investedcapital) will use most of the rms capital resources andsurplus cash on investments and projects so the companycan continue to expand its business operations into the fu-ture. When companies reach maturity levels within theirindustry (i.e. companies that earn approximately averageor lower returns on invested capital), managers of thesecompanies will use surplus cash to payout dividends toshareholders. Managers must do an analysis to determinethe appropriate allocation of the rms capital resourcesand cash surplus between projects and payouts of divi-dends to shareholders, as well as paying back creditor re-lated debt.Choosing between investment projects will be based uponseveral inter-related criteria. (1) Corporate managementseeks to maximize the value of the rm by investing inprojects which yield a positive net present value when val-ued using an appropriate discount rate in consideration ofrisk. (2) These projects must also be nanced appropri-ately. (3) If no growth is possible by the company andexcess cash surplus is not needed to the rm, then nan-cial theory suggests that management should return someor all of the excess cash to shareholders (i.e., distributionvia dividends).This "capital budgeting" is the planning of value-adding,long-term corporate nancial projects relating to invest-ments funded through and aecting the rms capitalstructure. Management must allocate the rms limitedresources between competing opportunities (projects).[3]

Capital budgeting is also concerned with the setting ofcriteria about which projects should receive investmentfunding to increase the value of the rm, and whether tonance that investment with equity or debt capital. In-vestments should be made on the basis of value-addedto the future of the corporation. Projects that increase a

13

14 CHAPTER 4. CORPORATE FINANCE

rms value may include a wide variety of dierent typesof investments, including but not limited to, expansionpolicies, or mergers and acquisitions. When no growthor expansion is possible by a corporation and excess cashsurplus exists and is not needed, then management is ex-pected to pay out some or all of those surplus earningsin the form of cash dividends or to repurchase the com-panys stock through a share buyback program.

4.1.2 Capital structureCapitalization structure

Domestic credit to private sector in 2005.

Main article: Capital structureFurther information: Security (nance)

Achieving the goals of corporate nance requires thatany corporate investment be nanced appropriately.[4]The sources of nancing are, generically, capital self-generated by the rm and capital from external funders,obtained by issuing new debt and equity (and hybrid- orconvertible securities). As above, since both hurdle rateand cash ows (and hence the riskiness of the rm) willbe aected, the nancing mix will impact the valuation ofthe rm. There are two interrelated considerations here:

Management must identify the optimal mix of -nancing the capital structure that results in maxi-mum rm value,[5] (See Balance sheet, WACC) butmust also take other factors into account (see trade-o theory below). Financing a project through debtresults in a liability or obligation that must be ser-viced, thus entailing cash ow implications indepen-dent of the projects degree of success. Equity -nancing is less risky with respect to cash ow com-mitments, but results in a dilution of share owner-ship, control and earnings. The cost of equity (seeCAPM and APT) is also typically higher than thecost of debt - which is, additionally, a deductible ex-pense and so equity nancing may result in an in-creased hurdle rate which may oset any reductionin cash ow risk.[6]

Management must attempt to match the long-termnancing mix to the assets being nanced as closelyas possible, in terms of both timing and cash

ows. Managing any potential asset liability mis-match or duration gap entails matching the as-sets and liabilities respectively according to ma-turity pattern ("Cashow matching") or duration("immunization"); managing this relationship in theshort-term is a major function of working capitalmanagement, as discussed below. Other techniques,such as securitization, or hedging using interest rate-or credit derivatives, are also common. See Asset li-ability management; Treasury management; Creditrisk; Interest rate risk.

Much of the theory here, falls under the umbrella of theTrade-O Theory in which rms are assumed to trade-o the tax benets of debt with the bankruptcy costs ofdebt when choosing how to allocate the companys re-sources. However economists have developed a set ofalternative theories about how managers allocate a cor-porations nances. One of the main alternative theoriesof how rms manage their capital funds is the PeckingOrder Theory (Stewart Myers), which suggests that rmsavoid external nancing while they have internal nancingavailable and avoid new equity nancing while they canengage in new debt nancing at reasonably low interestrates. Also, Capital structure substitution theory hypoth-esizes that management manipulates the capital struc-ture such that earnings per share (EPS) are maximized.An emerging area in nance theory is right-nancingwhereby investment banks and corporations can enhanceinvestment return and company value over time by de-termining the right investment objectives, policy frame-work, institutional structure, source of nancing (debt orequity) and expenditure framework within a given econ-omy and under given market conditions. One of the morerecent innovations in this area from a theoretical pointof view is the Market timing hypothesis. This hypothe-sis, inspired in the behavioral nance literature, states thatrms look for the cheaper type of nancing regardless oftheir current levels of internal resources, debt and equity.

Sources of capital

Further information: Security (nance)

Debt capital Further information: Bankruptcy andFinancial distress

Corporations may rely on borrowed funds (debt capital orcredit) as sources of investment to sustain ongoing busi-ness operations or to fund future growth. Debt comes inseveral forms, such as through bank loans, notes payable,or bonds issued to the public. Bonds require the cor-porations to make regular interest payments (interest ex-penses) on the borrowed capital until the debt reaches itsmaturity date, therein the rm must pay back the obliga-tion in full. Debt payments can also be made in the form

4.1. CORPORATE FINANCE 15

of sinking fund provisions, whereby the corporation paysannual installments of the borrowed debt above regularinterest charges. Corporations that issue callable bondsare entitled to pay back the obligation in full wheneverthe company feels it is in their best interest to pay othe debt payments. If interest expenses cannot be madeby the corporation through cash payments, the rm mayalso use collateral assets as a form of repaying their debtobligations (or through the process of liquidation).

Equity capital Corporations can alternatively sellshares of the company to investors to raise capital. In-vestors, or shareholders, expect that there will be an up-ward trend in value of the company (or appreciate invalue) over time to make their investment a protablepurchase. Shareholder value is increased when corpora-tions invest equity capital and other funds into projects(or investments) that earn a positive rate of return for theowners. Investors prefer to buy shares of stock into com-panies that will consistently earn a positive rate of returnon capital in the future, thus increasing the market valueof the stock of that corporation. Shareholder value mayalso be increased when corporations payout excess cashsurplus (funds from retained earnings that are not neededfor business) in the form of dividends.

Preferred stock Preferred stock is an equity securitywhich may have any combination of features not pos-sessed by common stock including properties of both anequity and a debt instruments, and is generally considereda hybrid instrument. Preferreds are senior (i.e. higherranking) to common stock, but subordinate to bonds interms of claim (or rights to their share of the assets of thecompany).[7]

Preferred stock usually carries no voting rights,[8] butmaycarry a dividend and may have priority over commonstock in the payment of dividends and upon liquidation.Terms of the preferred stock are stated in a Certicateof Designation.Similar to bonds, preferred stocks are rated by the ma-jor credit-rating companies. The rating for preferreds isgenerally lower, since preferred dividends do not carrythe same guarantees as interest payments from bonds andthey are junior to all creditors.[9]

Preferred stock is a special class of shares whichmay haveany combination of features not possessed by commonstock. The following features are usually associated withpreferred stock:[10]

Preference in dividends Preference in assets, in the event of liquidation Convertibility to common stock. Callability, at the option of the corporation Nonvoting

4.1.3 Investment and project valuation

Further information: Business valuation, stock valuationand fundamental analysis

In general,[11] each projects value will be estimated usinga discounted cash ow (DCF) valuation, and the oppor-tunity with the highest value, as measured by the resul-tant net present value (NPV) will be selected (applied toCorporate Finance by Joel Dean in 1951). This requiresestimating the size and timing of all of the incrementalcash ows resulting from the project. Such future cashows are then discounted to determine their present value(see Time value of money). These present values are thensummed, and this sum net of the initial investment outlayis the NPV. See Financial modeling.The NPV is greatly aected by the discount rate. Thus,identifying the proper discount rate often termed, theproject hurdle rate[12] is critical to choosing goodprojects and investments for the rm. The hurdle rate isthe minimum acceptable return on an investment i.e.,the project appropriate discount rate. The hurdle rateshould reect the riskiness of the investment, typicallymeasured by volatility of cash ows, and must take intoaccount the project-relevant nancing mix.[13] Managersuse models such as the CAPM or the APT to estimate adiscount rate appropriate for a particular project, and usethe weighted average cost of capital (WACC) to reect thenancing mix selected. (A common error in choosing adiscount rate for a project is to apply aWACC that appliesto the entire rm. Such an approach may not be appropri-ate where the risk of a particular project diers markedlyfrom that of the rms existing portfolio of assets.)In conjunction with NPV, there are several other mea-sures used as (secondary) selection criteria in corpo-rate nance. These are visible from the DCF and in-clude discounted payback period, IRR, Modied IRR,equivalent annuity, capital eciency, and ROI. Alter-natives (complements) to NPV include Residual IncomeValuation, MVA / EVA (Joel Stern, Stern Stewart & Co)and APV (Stewart Myers). See list of valuation topics.

Valuing exibility

Main articles: Real options analysis and decision tree

In many cases, for example R&D projects, a project mayopen (or close) various paths of action to the company,but this reality will not (typically) be captured in a strictNPV approach.[14] Some analysts account for this uncer-tainty by adjusting the discount rate (e.g. by increas-ing the cost of capital) or the cash ows (using certaintyequivalents, or applying (subjective) haircuts to theforecast numbers).[15][16] Even when employed, however,these latter methods do not normally properly accountfor changes in risk over the projects lifecycle and hence

16 CHAPTER 4. CORPORATE FINANCE

fail to appropriately adapt the risk adjustment.[17] Man-agement will therefore (sometimes) employ tools whichplace an explicit value on these options. So, whereas ina DCF valuation the most likely or average or scenariospecic cash ows are discounted, here the exible andstaged nature of the investment is modelled, and henceall potential payos are considered. See further un-der Real options valuation. The dierence between thetwo valuations is the value of exibility inherent in theproject.The two most common tools are Decision Tree Analysis(DTA)[18][19] and Real options valuation (ROV);[20] theymay often be used interchangeably:

DTA values exibility by incorporating possibleevents (or states) and consequent management deci-sions. (For example, a company would build a fac-tory given that demand for its product exceeded acertain level during the pilot-phase, and outsourceproduction otherwise. In turn, given further de-mand, it would similarly expand the factory, andmaintain it otherwise. In a DCF model, by con-trast, there is no branching each scenario mustbe modelled separately.) In the decision tree, eachmanagement decision in response to an event gen-erates a branch or path which the company couldfollow; the probabilities of each event are deter-mined or specied by management. Once the treeis constructed: (1) all possible events and their re-sultant paths are visible to management; (2) giventhis knowledge of the events that could follow, andassuming rational decision making, managementchooses the branches (i.e. actions) corresponding tothe highest value path probability weighted; (3) thispath is then taken as representative of project value.See Decision theory#Choice under uncertainty.

ROV is usually used when the value of a projectis contingent on the value of some other asset orunderlying variable. (For example, the viability ofa mining project is contingent on the price of gold;if the price is too low, management will abandonthe mining rights, if suciently high, managementwill develop the ore body. Again, a DCF valuationwould capture only one of these outcomes.) Here:(1) using nancial option theory as a framework, thedecision to be taken is identied as corresponding toeither a call option or a put option; (2) an appropri-ate valuation technique is then employed usuallya variant on the Binomial options model or a be-spoke simulation model, while Black Scholes typeformulae are used less often; see Contingent claimvaluation. (3) The true value of the project is thenthe NPV of the most likely scenario plus the op-tion value. (Real options in corporate nance wererst discussed by Stewart Myers in 1977; viewingcorporate strategy as a series of options was origi-nally per Timothy Luehrman, in the late 1990s.) See

also Option pricing approaches under Business val-uation.

Quantifying uncertainty

Further information: Sensitivity analysis, Scenarioplanning and Monte Carlo methods in nance

Given the uncertainty inherent in project forecasting andvaluation,[19][21] analysts will wish to assess the sensitivityof project NPV to the various inputs (i.e. assumptions)to the DCF model. In a typical sensitivity analysis theanalyst will vary one key factor while holding all other in-puts constant, ceteris paribus. The sensitivity of NPV to achange in that factor is then observed, and is calculated asa slope": NPV / factor. For example, the analyst willdetermine NPV at various growth rates in annual revenueas specied (usually at set increments, e.g. 10%,5%,0%, 5%....), and then determine the sensitivity using thisformula. Often, several variables may be of interest, andtheir various combinations produce a value-surface",[22](or even a value-space",) where NPV is then a functionof several variables. See also Stress testing.Using a related technique, analysts also run scenariobased forecasts of NPV. Here, a scenario comprises aparticular outcome for economy-wide, global factors(demand for the product, exchange rates, commodityprices, etc...) as well as for company-specic factors (unitcosts, etc...). As an example, the analyst may specifyvarious revenue growth scenarios (e.g. 0% for WorstCase, 10% for Likely Case and 20% for Best Case),where all key inputs are adjusted so as to be consistentwith the growth assumptions, and calculate the NPV foreach. Note that for scenario based analysis, the variouscombinations of inputs must be internally consistent (seediscussion at Financial modeling), whereas for the sen-sitivity approach these need not be so. An applicationof this methodology is to determine an "unbiased" NPV,where management determines a (subjective) probabil-ity for each scenario the NPV for the project is thenthe probability-weighted average of the various scenarios;see First Chicago Method. (See also rNPV, where cashows, as opposed to scenarios, are probability-weighted.)A further advancement which overcomes the limita-tions of sensitivity and scenario analyses by examin-ing the eects of all possible combinations of variablesand their realizations [23] is to construct stochastic[24]or probabilistic nancial models as opposed to thetraditional static and deterministic models as above.[21]For this purpose, the most common method is to useMonte Carlo simulation to analyze the projects NPV.This method was introduced to nance by David B. Hertzin 1964, although it has only recently become com-mon: today analysts are even able to run simulations inspreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here,

4.1. CORPORATE FINANCE 17

the cash ow components that are (heavily) impactedby uncertainty are simulated, mathematically reectingtheir random characteristics. In contrast to the scenarioapproach above, the simulation produces several thou-sand random but possible outcomes, or trials, coveringall conceivable real world contingencies in proportion totheir likelihood;" [25] see Monte Carlo Simulation versusWhat If Scenarios. The output is then a histogram ofproject NPV, and the average NPV of the potential in-vestment as well as its volatility and other sensitivities is then observed. This histogram provides informationnot visible from the static DCF: for example, it allowsfor an estimate of the probability that a project has a netpresent value greater than zero (or any other value).Continuing the above example: instead of assigning threediscrete values to revenue growth, and to the other rel-evant variables, the analyst would assign an appropri-ate probability distribution to each variable (commonlytriangular or beta), and, where possible, specify the ob-served or supposed correlation between the variables.These distributions would then be sampled repeatedly incorporating this correlation so as to generate sev-eral thousand random but possible scenarios, with corre-sponding valuations, which are then used to generate theNPV histogram. The resultant statistics (average NPVand standard deviation of NPV) will be a more accu-rate mirror of the projects randomness than the vari-ance observed under the scenario based approach. Theseare often used as estimates of the underlying "spot price"and volatility for the real option valuation as above; seeReal options valuation: Valuation inputs. A more ro-bust Monte Carlo model would include the possible oc-currence of risk events (e.g., a credit crunch) that drivevariations in one or more of the DCF model inputs.

4.1.4 Dividend policy

Main article: Dividend policy

Dividend policy is concerned with nancial policies re-garding the payment of a cash dividend in the present orpaying an increased dividend at a later stage. Whetherto issue dividends,[26] and what amount, is determinedmainly on the basis of the companys unappropriatedprot (excess cash) and inuenced by the companys long-term earning power. When cash surplus exists and isnot needed by the rm, then management is expected topay out some or all of those surplus earnings in the formof cash dividends or to repurchase the companys stockthrough a share buyback program.If there are no NPV positive opportunities, i.e. projectswhere returns exceed the hurdle rate, and excess cash sur-plus is not needed, then nance theory suggests man-agement should return some or all of the excess cash toshareholders as dividends. This is the general case, how-ever there are exceptions. For example, shareholders of a

"growth stock", expect that the company will, almost bydenition, retain most of the excess cash surplus so as tofund future projects internally to help increase the valueof the rm.Management must also choose the form of the dividenddistribution, generally as cash dividends or via a sharebuyback. Various factors may be taken into considera-tion: where shareholders must pay tax on dividends, rmsmay elect to retain earnings or to perform a stock buy-back, in both cases increasing the value of shares out-standing. Alternatively, some companies will pay div-idends from stock rather than in cash; see Corporateaction. Financial theory suggests that the dividend pol-icy should be set based upon the type of company andwhat management determines is the best use of those div-idend resources for the rm to its shareholders. As a gen-eral rule, shareholders of growth companies would prefermanagers to retain earnings and pay no dividends (useexcess cash to reinvest into the companys operations),whereas shareholders of value or secondary stocks wouldprefer the management of these companies to payout sur-plus earnings in the form of cash dividends when a posi-tive return cannot be earned through the reinvestment ofundistributed earnings. A share buyback program maybe accepted when the value of the stock is greater thanthe returns to be realized from the reinvestment of undis-tributed prots. In all instances, the appropriate dividendpolicy is usually directed by that which maximizes long-term shareholder value.

4.1.5 Working capital management

Main article: Working capital

Managing the corporations working capital position tosustain ongoing business operations is referred to aswork-ing capital management.[27][28] These involve managingthe relationship between a rms short-term assets and itsshort-term liabilities. In general this is as follows: Asabove, the goal of Corporate Finance is the maximiza-tion of rm value. In the context of long term, capitalbudgeting, rm value is enhanced through appropriatelyselecting and funding NPV positive investments. Theseinvestments, in turn, have implications in terms of cashow and cost of capital. The goal ofWorking Capital (i.e.short term) management is therefore to ensure that therm is able to operate, and that it has sucient cash owto service long term debt, and to satisfy both maturingshort-term debt and upcoming operational expenses. Inso doing, rm value is enhanced when, and if, the returnon capital exceeds the cost of capital; See Economic valueadded (EVA).Managing short term nance and long termnance is one task of a modern CFO.

18 CHAPTER 4. CORPORATE FINANCE

Working capital

Working capital is the amount of funds which are nec-essary to an organization to continue its ongoing busi-ness operations, until the rm is reimbursed through pay-ments for the goods or services it has delivered to itscustomers.[29] Working capital is measured through thedierence between resources in cash or readily convert-ible into cash (Current Assets), and cash requirements(Current Liabilities). As a result, capital resource al-locations relating to working capital are always current,i.e. short term. In addition to time horizon, work-ing capital management diers from capital budgetingin terms of discounting and protability considerations;they are also reversible to some extent. (Considerationsas to Risk appetite and return targets remain identical, al-though some constraints such as those imposed by loancovenants may be more relevant here).The (short term) goals of working capital are therefore notapproached on the same basis as (long term) protability,and working capital management applies dierent criteriain allocating resources: the main considerations are (1)cash ow / liquidity and (2) protability / return on capital(of which cash ow is probably the most important).

Themost widely usedmeasure of cash ow is the netoperating cycle, or cash conversion cycle. This rep-resents the time dierence between cash paymentfor raw materials and cash collection for sales. Thecash conversion cycle indicates the rms ability toconvert its resources into cash. Because this num-ber eectively corresponds to the time that the rmscash is tied up in operations and unavailable for otheractivities, management generally aims at a low netcount. (Another measure is gross operating cyclewhich is the same as net operating cycle except thatit does not take into account the creditors deferralperiod.)

In this context, the most useful measure of prof-itability is Return on capital (ROC). The result isshown as a percentage, determined by dividing rele-vant income for the 12 months by capital employed;Return on equity (ROE) shows this result for therms shareholders. As above, rm value is en-hanced when, and if, the return on capital exceedsthe cost of capital.

Management of working capital

Guided by the above criteria, management will use a com-bination of policies and techniques for the managementof working capital.[30] These policies aim at managingthe current assets (generally cash and cash equivalents,inventories and debtors) and the short term nancing,such that cash ows and returns are acceptable.[28]

Cash management. Identify the cash balance

which allows for the business to meet day to day ex-penses, but reduces cash holding costs.

Inventory management. Identify the level of in-ventory which allows for uninterrupted productionbut reduces the investment in raw materials andminimizes reordering costs and hence increasescash ow. Note that inventory is usually the realmof operations management: given the potential im-pact on cash ow, and on the balance sheet in gen-eral, nance typically gets involved in an oversightor poli