1.1 What Is Finance?
1.1 What Is Finance?
1.1 What Is Finance?
Chapter 1
Finance
Contents
1.1 What is Finance? . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Corporate Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
the components of the risky cash flows (including the date of revelation), value
these separately, and, finally, apply value additivity to sum all the components.
For our purposes, managing a company is largely playing around with the
bundling of the risky components of the corporation. For example, reshuing
of cash flows in time to postpone tax payments, or understanding how bundling
creates incentives for participants, such as management, bondholders and equity
owners.
We usually make a distinction between the primary and the secondary mar-
ket. The primary market is at the issue of a security. Treasury securities are
often issued to the general public by an auction where anybody can send in bids.
This is then the primary market for treasury securities. When a corporation is-
sues equities for the first time, the Initial Public Oering, this is the primary
market for equities.
When securities are traded after they have been issued (in the primary mar-
ket), they are said to be traded in the secondary market. In terms of volume and
value, the secondary market dwarfs the primary market. Many do not understand
why secondary markets are important, because they only seem to be zero sum
games. (If somebody makes a gain buying a stock the seller must be a loser.)
These people miss some important services that financial markets provide:
Relative to the amounts being bought and sold in financial markets, the costs
of transacting are small. (Hey, all you are doing is shuing paper around.) The
costs are not zero (How do you think stockbrokers survive?), but they are closer to
the economists definition of a perfect market than most other markets. It is this
that makes it justifiable for us to make an assumption of perfect capital markets,
markets where it is costless to transact. Their existence would in practice lead to
extreme investment strategies, like: Never realize any capital gains until you die,
realize losses as soon as they occur, shield dividends from taxation by borrowing
money. When we use them in our models, they are best thought of as reasonable
approximations to the true market.