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Finance


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Contents

Articles

Introduction 1

Main article 2

Finance 2

The main techniques and sectors of the financial industry 11

Financial services 11

Personal finance 15

Personal finance 15

Corporate finance 18


Financial capital 25

Cornering the market 30

Insurance 32

Risk Management 51

Derivative 51

Finance of states 60

Public finance 60

Financial economics 68

Financial economics 68

Financial mathematics 71

Financial mathematics 71

Experimental finance 75

Experimental finance 75

Behavioral finance 76

Behavioral finance 76

Intangible asset finance 85

Intangible asset finance 85


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References

Article Sources and Contributors 88

Image Sources, Licenses and Contributors 90

Article Licenses

License 91


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Introduction 1

Introduction

Note. This book is based on the Wikipedia article, "Finance." The supporting articles are those referenced as major

expansions of selected sections.


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2

Main article

FinanceFinance is the science of funds management.

[1]The general areas of finance arebusiness finance,personal finance,

andpublic finance.[2]

Finance includes saving money and often includes lending money. The field of finance deals

with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and

budgeted.

One aspect of finance is through individuals and business organizations, which deposit money in a bank. The bank

then lends the money out to other individuals or corporations for consumption or investment, and charges interest on

the loans.

Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or

directly from a corporation. Bonds are debt instruments sold to investors for organisations such as companies,

governments or charities.[3]

The investor can then hold the debt and collect the interest or sell the debt on a

secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity,

mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt.

Financial assets, known as investments, are financially managed with careful attention to financial risk management

to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities

exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly traded corporations.

Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United

Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on

monetary and credit conditions in the economy.[4]

The main techniques and sectors of the financial industry

An entity whose income exceeds their expenditure can lend or invest the excess income. On the other hand, an entity

whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its

expenses, or increasing its income. The lender can find a borrower, a financial intermediary such as a bank, or buy

notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender

receives, and the financial intermediary pockets the difference.

A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it

pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes,

to coordinate their activity. Banks are thus compensators of money flows in space.

A specific example of corporate finance is the sale of stock by a company to institutional investors like investment

banks, who may sell it on to private investors, or other financial institutions such as pension funds. The stock give

part ownership in that company in proportion to shares owned.

In return for the stock, the company receives cash, which it may use to expand its business; ("equity financing"), to

reduce its debt.[5]

Equity financing mixed with the sale of bonds (or any other debt financing) is called the company's

capital structure.

Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate

finance), as well as by a wide variety of organizations including schools and non-profit organizations. In general, the

goals of each of the above activities are achieved through the use of appropriate financial instruments and

methodologies, with consideration to their institutional setting.
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Finance 3

Finance is one of the most important aspects of business management. Without proper financial planning a new

enterprise is unlikely to be successful. Managing money (a liquid asset) is essential to ensure a secure future, both for

the individual and an organization.

Personal finance

Questions in personal finance revolve around

How much money will be needed by an individual (or by a family), and when?

Where will this money come from, and how?

How can people protect themselves against unforeseen personal events, as well as those in the external economy?

How can family assets best be transferred across generations (bequests and inheritance)?

How does tax policy (tax subsidies or penalties) affect personal financial decisions?

How does credit affect an individual's financial standing?

How can one plan for a secure financial future in an environment of economic instability?

Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars,

buying insurance, e.g. health and property insurance, investing and saving for retirement.

Personal financial decisions may also involve paying for a loan, or debt obligations.

Corporate finance

Managerial or corporate finance is the task of providing the funds for a corporation's activities. For small business,

this is referred to as SME finance (Small and Medium Enterprises). It generally involves balancing risk and

profitability, while attempting to maximize an entity's wealth and the value of its stock.

Long term funds are provided by ownership equity and long-term credit, often in the form of bonds. The balance

between these elements forms the company's capital structure. Short-term funding or working capital is mostly

provided by banks extending a line of credit.

Another business decision concerning finance is investment, or fund management. An investment is an acquisition of

an asset in the hope that it will maintain or increase its value. In investment managementin choosing a portfolio

one has to decide what, how much and when to invest. To do this, a company must:

Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax

considerations;

Identify the appropriate strategy: active v. passivehedging strategy

Measure the portfolio performance

Financial management is duplicate with the financial function of the Accounting profession. However, financial

accounting is more concerned with the reporting of historical financial information, while the financial decision is

directed toward the future of the firm.

Capital

Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the

production of other goods or the offering of a service.

The desirability of budgeting

Budget is a document which documents the plan of the business. This may include the objective of business, targets

set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve

the planned sales, and financing source for the investment. Also budget may be long term or short term. Long termbudgets have a time horizon of 510 years giving a vision to the company; short term is an annual budget which is
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Finance 4

drawn to control and operate in that particular year.

Capital budget

This concerns proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are

often adjusted annually and should be part of a longer-term Capital Improvements Plan.

Cash budget

Working capital requirements of a business should be monitored at all times to ensure that there are sufficient funds

available to meet short-term expenses.

The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The cash budget has

the following six main sections:

1. Beginning Cash Balance - contains the last period's closing cash balance.

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

3. Cash disbursements - lists all planned cash outflows for the period, excluding interest payments on short-term

loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list

(e.g. depreciation, amortization, etc.)

4. Cash excess or deficiency - a function of the cash needs and cash available. Cash needs are determined by the

total cash disbursements plus the minimum cash balance required by company policy. If total cash available is

less than cash needs, a deficiency exists.

5. Financing - discloses the planned borrowings and repayments, including interest.

6. Ending Cash balance - simply reveals the planned ending cash balance.

Management of current assets

Credit policy

Credit gives the consumer the opportunity to buy, purchase or acquire goods and services, and pay for them at a laterdate. This has its advantages and disadvantages as follows:

Advantages of credit trade

Usually results in more customers than cash trade.

Can charge more for goods to cover the risk of bad debt.

Gain goodwill and loyalty of customers.

People can buy goods and pay for them at a later date.

Farmers can buy seeds and implements, and pay for them only after the harvest.

Stimulates agricultural and industrial production and commerce.

Can be used as a promotional tool.

Increase the sales.

Modest rates to be filled.

can be a marketing tool


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Finance 5

Disadvantages of credit trade

Risk of bad debt.

High administration expenses.

People can buy more than they can afford.

More working capital needed.

Risk of Bankruptcy. May lose peace of mind.

Forms of credit

Suppliers credit:

Credit on ordinary open account

Installment sales

Bills of exchange

Credit cards

Contractor's credit

Factoring of debtors Cash credit

Cpf credits

Exchange of product

Factors which influence credit conditions

Nature of the business's activities

Financial position

Product durability

Length of production process

Competition and competitors' credit conditions Country's economic position

Conditions at financial institutions

Discount for early payment

Debtor's type of business and financial position

Credit collection

Overdue accounts

Attach a notice of overdue account to statement.

Send a letter asking for settlement of debt. Send a second or third letter if first is ineffectual.

Threaten legal action.

Effective credit control

Increases sales

Reduces bad debts

Increases profits

Builds customer loyalty

Builds confidence of financial industry

Increase company capitalisation Increase the customer relationship


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Finance 6

Sources of information on creditworthiness

Business references

Bank references

Credit agencies

Chambers of commerce

Employers Credit application forms

Duties of the credit department

Legal action

Taking necessary steps to ensure settlement of account

Knowing the credit policy and procedures for credit control

Setting credit limits

Ensuring that statements of account are sent out

Ensuring that thorough checks are carried out on credit customers

Keeping records of all amounts owing Ensuring that debts are settled promptly

Timely reporting to the upper level of management for better management.

Stock

Purpose of stock control

Ensures that enough stock is on hand to satisfy demand.

Protects and monitors theft.

Safeguards against having to stockpile.

Allows for control over selling and cost price.

Stockpiling

This refers to the purchase of stock at the right time, at the right price and in the right quantities.

There are several advantages to the stockpiling, the following are some of the examples:

Losses due to price fluctuations and stock loss kept to a minimum

Ensures that goods reach customers timeously; better service

Saves space and storage cost

Investment of working capital kept to minimum

No loss in production due to delays

There are several disadvantages to the stockpiling, the following are some of the examples:

Obsolescence

Danger of fire and theft

Initial working capital investment is very large

Losses due to price fluctuation

Rate of stock turnover

This refers to the number of times per year that the average level of stock is sold. It may be worked out by dividing

the cost price of goods sold by the cost price of the average stock level.

Determining optimum stock levels

Maximum stock level refers to the maximum stock level that may be maintained to ensure cost effectiveness.

Minimum stock level refers to the point below which the stock level may not go.

Standard order refers to the amount of stock generally ordered.


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Finance 7

Order level refers to the stock level which calls for an order to be made.

Cash

Reasons for keeping cash

Cash is usually referred to as the "king" in finance, as it is the most liquid asset.

The transaction motive refers to the money kept available to pay expenses.

The precautionary motive refers to the money kept aside for unforeseen expenses.

The speculative motive refers to the money kept aside to take advantage of suddenly arising opportunities.

Advantages of sufficient cash

Current liabilities may be catered for meeting the current obligations of the company

Cash discounts are given for cash payments.

Production is kept moving

Surplus cash may be invested on a short-term basis.

The business is able to pay its accounts in a timely manner, allowing for easily obtained credit.

Liquidity

Quick upfront payments.

Management of fixed assets

Depreciation

Depreciation is the allocation of the cost of an asset over its useful life as determined at the time of purchase. It is

calculated yearly to enforce the matching principle.

Insurance

Insurance is the undertaking of one party to indemnify another, in exchange for a premium, against a certain

eventuality.

Uninsured risks

Bad debt

Changes in fashion

Time lapses between ordering and delivery

New machinery or technology

Different prices at different places

Requirements of an insurance contract

Insurable interest

The insured must derive a real financial gain from that which he is insuring, or stand to lose if it is destroyed or

lost.

The item must belong to the insured.

One person may take out insurance on the life of another if the second party owes the first money.

Must be some person or item which can, legally, be insured.

The insured must have a legal claim to that which he is insuring.

Good faith

Uberrimae fidei refers to absolute honesty and must characterise the dealings of both the insurer and the

insured.
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Finance 8

Shared Services

There is currently a move towards converging and consolidating Finance provisions into shared services within an

organization. Rather than an organization having a number of separate Finance departments performing the same

tasks from different locations a more centralized version can be created.

Finance of states

Country, state, county, city or municipality finance is called public finance. It is concerned with

Identification of required expenditure of a public sector entity

Source(s) of that entity's revenue

The budgeting process

Debt issuance (municipal bonds) for public works projects

Financial economics

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,

interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on

influences of real economic variables on financial ones, in contrast to pure finance.

It studies:

Valuation - Determination of the fair value of an asset

How risky is the asset? (identification of the asset-appropriate discount rate)

What cash flows will it produce? (discounting of relevant cash flows)

How does the market price compare to similar assets? (relative valuation)

Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)

Financial markets and instruments

Commodities - topics

Stocks - topics

Bonds - topics

Money market instruments- topics

Derivatives - topics

Financial institutions and regulation

Financial Econometrics is the branch of Financial Economics that uses econometric techniques to parameterise the

relationships.

Financial mathematics

Financial mathematics is a main branch of applied mathematics concerned with the financial markets. Financial

mathematics is the study of financial data with the tools of mathematics, mainly statistics. Such data can be

movements of securitiesstocks and bonds etc.and their relations. Another large subfield is insurance

mathematics. This is also known as quantitative finance, practitioners as Quantitative analysts.

Experimental finance

Experimental finance aims to establish different market settings and environments to observe experimentally and

provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows,

information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental

finance can study to what extent existing financial economics theory makes valid predictions, and attempt to
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Finance 9

discover new principles on which such theory can be extended. Research may proceed by conducting trading

simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.

Behavioral finance

Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets.

Behavioral finance has grown over the last few decades to become central to finance.

Behavioral finance includes such topics as:

1. Empirical studies that demonstrate significant deviations from classical theories.

2. Models of how psychology affects trading and prices

3. Forecasting based on these methods.

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

A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and

statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has

been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during

2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, DonBalenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated

significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral

finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

Intangible Asset Finance

Intangible asset finance is the area of finance that deals with intangible assets such as patents, trademarks, goodwill,

reputation, etc.

Related professional qualificationsThere are several related professional qualifications in finance, that can lead to the field:

Accountancy:

Qualified accountant: Chartered Accountant (ACA - UK certification / CA - certification in Commonwealth

countries), Chartered Certified Accountant (ACCA, UK certification), Certified Public Accountant (CPA, US

certification)

Non-statutory qualifications: Chartered Cost Accountant CCA Designation from AAFM

Business qualifications: Master of Business Administration (MBA), Bachelor of Business Management (BBM),

Master of Commerce (M.Comm), Master of Science in Management (MSM), Doctor of Business Administration

(DBA)

Generalist Finance qualifications:

Degrees: Masters degree in Finance (MSF), Master of Financial Economics, Master of Finance & Control

(MFC), Master Financial Manager (MFM), Master of Financial Administration (MFA)

Certifications: Chartered Financial Analyst (CFA), Certified International Investment Analyst (CIIA),

Association of Corporate Treasurers (ACT), Certified Market Analyst (CMA/FAD) Dual Designation,

Corporate Finance Qualification (CF)

Quantitative Finance qualifications: Master of Science in Financial Engineering (MSFE), Master of

Quantitative Finance (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM),

Certificate in Quantitative Finance (CQF).
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Finance 10

See also

Financial crisis of 20072010

Local Government Finance in Kerala

External links

OECD work on financial markets[6]

Wharton Finance Knowledge Project[7]

- aimed to offer free access to finance knowledge for students, teachers,

and self-learners.

Professor Aswath Damodaran[8]

(New York University Stern School of Business) - provides resources covering

three areas in finance: corporate finance, valuation and investment management and syndicate finance.

References

[1] Gove, P. et al. 1961.Finance. Webster's Third New International Dictionary of the English Language Unabridged. Springfield,

Massachusetts: G. & C. Merriam Company.

[2] finance. (2009). In Encyclopdia Britannica. Retrieved June 23, 2009, from Encyclopdia Britannica Online: Finance (http://www.britannica.com/EBchecked/topic/207147/finance)

[3] Charitytimes.com (http://www.charitytimes.com/pages/ct_news/news archive/July_06_news/030706_wellcome_trust_charity_bond.

htm)

[4] Board of Governors of Federal Reserve System of the United States. Mission of the Federal Reserve System. Federalreserve.gov (http://

www.federalreserve.gov/aboutthefed/mission.htm) Accessed: 2010-01-16. (Archived by WebCite at Webcitation.org (http://www.

webcitation.org/5mpS52OAl))

[5] Business.timesonline.co.uk (http://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article5602963.ece)

[6] http://www.oecd.org/finance

[7] http://knowledge.wharton.upenn.edu/category.cfm?cid=1

[8] http://pages.stern.nyu. edu/~adamodar/
http://pages.stern.nyu.edu/~adamodar/http://knowledge.wharton.upenn.edu/category.cfm?cid=1http://www.oecd.org/financehttp://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article5602963.ecehttp://www.webcitation.org/5mpS52OAlhttp://www.webcitation.org/5mpS52OAlhttp://www.federalreserve.gov/aboutthefed/mission.htmhttp://www.federalreserve.gov/aboutthefed/mission.htmhttp://www.charitytimes.com/pages/ct_news/news%20archive/July_06_news/030706_wellcome_trust_charity_bond.htmhttp://www.charitytimes.com/pages/ct_news/news%20archive/July_06_news/030706_wellcome_trust_charity_bond.htmhttp://www.britannica.com/EBchecked/topic/207147/financehttp://www.britannica.com/EBchecked/topic/207147/financehttp://en.wikipedia.org/w/index.php?title=New_York_University_Stern_School_of_Businesshttp://pages.stern.nyu.edu/~adamodar/http://knowledge.wharton.upenn.edu/category.cfm?cid=1http://www.oecd.org/financehttp://en.wikipedia.org/w/index.php?title=Local_Government_Finance_in_Keralahttp://en.wikipedia.org/w/index.php?title=Financial_crisis_of_2007%E2%80%932010


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11

The main techniques and sectors of thefinancial industry

Financial services

Financial services refer to services provided by the finance industry. The finance industry encompasses a broad

range of organizations that deal with the management of money. Among these organizations are banks, credit card

companies, insurance companies, consumer finance companies, stock brokerages, investment funds and some

government sponsored enterprises. As of 2004, the financial services industry represented 20% of the market

capitalization of the S&P 500 in the United States.[1]

History of financial services

In the United States

The term "financial services" became more prevalent in the United States partly as a result of the

Gramm-Leach-Bliley Act of the late 1990s, which enabled different types of companies operating in the U.S.

financial services industry at that time to merge. Companies usually have two distinct approaches to this new type of

business. One approach would be a bank which simply buys an insurance company or an investment bank, keeps the

original brands of the acquired firm, and adds the acquisition to its holding company simply to diversify its earnings.

Outside the U.S. (e.g., in Japan), non-financial services companies are permitted within the holding company. In this

scenario, each company still looks independent, and has its own customers, etc. In the other style, a bank would

simply create its own brokerage division or insurance division and attempt to sell those products to its own existing

customers, with incentives for combining all things with one company.

Banks

A "commercial bank" is what is commonly referred to as simply a "bank". The term "commercial" is used to

distinguish it from an "investment bank", a type of financial services entity which, instead of lending money directly

to a business, helps businesses raise money from other firms in the form of bonds (debt) or stock (equity).

Banking services

The primary operations of banks include:

Keeping money safe while also allowing withdrawals when needed

Issuance of checkbooks so that bills can be paid and other kinds of payments can be delivered by post

Provide personal loans, commercial loans, and mortgage loans (typically loans to purchase a home, property or

business)

Issuance of credit cards and processing of credit card transactions and billing

Issuance of debit cards for use as a substitute for checks

Allow financial transactions at branches or by using Automatic Teller Machines (ATMs)

Provide wire transfers of funds and Electronic fund transfers between banks

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

Provide overdraft agreements for the temporary advancement of the Bank's own money to meet monthly spending

commitments of a customer in their current account.
http://en.wikipedia.org/w/index.php?title=Electronic_fund_transferhttp://en.wikipedia.org/w/index.php?title=Debithttp://en.wikipedia.org/w/index.php?title=Overdrafthttp://en.wikipedia.org/w/index.php?title=Overdrafthttp://en.wikipedia.org/w/index.php?title=Debithttp://en.wikipedia.org/w/index.php?title=Electronic_fund_transferhttp://en.wikipedia.org/w/index.php?title=Automatic_Teller_Machinehttp://en.wikipedia.org/w/index.php?title=Debit_cardshttp://en.wikipedia.org/w/index.php?title=Credit_cardshttp://en.wikipedia.org/w/index.php?title=Mortgage_loanhttp://en.wikipedia.org/w/index.php?title=Loanhttp://en.wikipedia.org/w/index.php?title=Unsecured_loanhttp://en.wikipedia.org/w/index.php?title=Checkbookhttp://en.wikipedia.org/w/index.php?title=Withdrawalhttp://en.wikipedia.org/w/index.php?title=Safehttp://en.wikipedia.org/w/index.php?title=Stockhttp://en.wikipedia.org/w/index.php?title=Bond_%28finance%29http://en.wikipedia.org/w/index.php?title=Investment_bankhttp://en.wikipedia.org/w/index.php?title=Commercehttp://en.wikipedia.org/w/index.php?title=Commercial_bankhttp://en.wikipedia.org/w/index.php?title=Holding_companyhttp://en.wikipedia.org/w/index.php?title=Japanhttp://en.wikipedia.org/w/index.php?title=Earningshttp://en.wikipedia.org/w/index.php?title=Takeoverhttp://en.wikipedia.org/w/index.php?title=Brandhttp://en.wikipedia.org/w/index.php?title=Investment_bankhttp://en.wikipedia.org/w/index.php?title=Gramm-Leach-Bliley_Acthttp://en.wikipedia.org/w/index.php?title=United_Stateshttp://en.wikipedia.org/w/index.php?title=United_Stateshttp://en.wikipedia.org/w/index.php?title=S%26P_500http://en.wikipedia.org/w/index.php?title=Market_capitalizationhttp://en.wikipedia.org/w/index.php?title=Market_capitalizationhttp://en.wikipedia.org/w/index.php?title=Government_sponsored_enterprisehttp://en.wikipedia.org/w/index.php?title=Investment_managementhttp://en.wikipedia.org/w/index.php?title=Stock_brokerhttp://en.wikipedia.org/w/index.php?title=Consumer_financehttp://en.wikipedia.org/w/index.php?title=Credit_cardhttp://en.wikipedia.org/w/index.php?title=Bankhttp://en.wikipedia.org/w/index.php?title=Service_%28economics%29


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Provide Charge card advances of the Bank's own money for customers wishing to settle credit advances monthly.

Provide a check guaranteed by the Bank itself and prepaid by the customer, such as a cashier's check or certified

check.

Notary service for financial and other documents

Other types of bank services Private banking - Private banks provide banking services exclusively to high net worth individuals. Many

financial services firms require a person or family to have a certain minimum net worth to qualify for private

banking services.[2]

Private banks often provide more personal services, such as wealth management and tax

planning, than normal retail banks.[3]

Capital market bank - bank that underwrite debt and equity, assist company deals (advisory services, underwriting

and advisory fees), and restructure debt into structured finance products.

Bank cards - include both credit cards and debit cards. Bank Of America is the largest issuer of bank cards.

Credit card machine services and networks - Companies which provide credit card machine and payment

networks call themselves "merchant card providers".

Foreign exchange services

Foreign exchange services are provided by many banks around the world. Foreign exchange services include:

Currency Exchange - where clients can purchase and sell foreign currency banknotes.

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

Foreign Currency Banking - banking transactions are done in foreign currency.

Investment services

Asset management - the term usually given to describe companies which run collective investment funds.

Hedge fund management - Hedge funds often employ the services of "prime brokerage" divisions at major

investment banks to execute their trades.

Custody services - the safe-keeping and processing of the world's securities trades and servicing the associated

portfolios. Assets under custody in the world are approximately $100 trillion.[4]

Insurance

Insurance brokerage - Insurance brokers shop for insurance (generally corporate property and casualty insurance)

on behalf of customers. Recently a number of websites have been created to give consumers basic price

comparisons for services such as insurance, causing controversy within the industry.[5]

Insurance underwriting - Personal lines insurance underwriters actually underwrite insurance for individuals, aservice still offered primarily through agents, insurance brokers, and stock brokers. Underwriters may also offer

similar commercial lines of coverage for businesses. Activities include insurance and annuities, life insurance,

retirement insurance, health insurance, and property & casualty insurance.

Reinsurance - Reinsurance is insurance sold to insurers themselves, to protect them from catastrophic losses.
http://en.wikipedia.org/w/index.php?title=Reinsurancehttp://en.wikipedia.org/w/index.php?title=Property_%26_casualty_insurancehttp://en.wikipedia.org/w/index.php?title=Health_insurancehttp://en.wikipedia.org/w/index.php?title=Life_insurancehttp://en.wikipedia.org/w/index.php?title=Annuity_%28financial_contracts%29http://en.wikipedia.org/w/index.php?title=Stock_brokerhttp://en.wikipedia.org/w/index.php?title=Insurance_brokerhttp://en.wikipedia.org/w/index.php?title=Underwriterhttp://en.wikipedia.org/w/index.php?title=Insurance_brokerhttp://en.wikipedia.org/w/index.php?title=Hedge_fundhttp://en.wikipedia.org/w/index.php?title=Collective_investment_fundhttp://en.wikipedia.org/w/index.php?title=Investment_managementhttp://en.wikipedia.org/w/index.php?title=Foreign_Currency_Bankinghttp://en.wikipedia.org/w/index.php?title=Wire_transferhttp://en.wikipedia.org/w/index.php?title=Currency_Exchangehttp://en.wikipedia.org/w/index.php?title=Debit_cardhttp://en.wikipedia.org/w/index.php?title=Credit_cardhttp://en.wikipedia.org/w/index.php?title=Structured_financehttp://en.wikipedia.org/w/index.php?title=Stockhttp://en.wikipedia.org/w/index.php?title=Underwritehttp://en.wikipedia.org/w/index.php?title=High_net_worth_individualshttp://en.wikipedia.org/w/index.php?title=Private_bankinghttp://en.wikipedia.org/w/index.php?title=Notaryhttp://en.wikipedia.org/w/index.php?title=Certified_checkhttp://en.wikipedia.org/w/index.php?title=Certified_checkhttp://en.wikipedia.org/w/index.php?title=Cashier%27s_check


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Other financial services

Intermediation or advisory services - These services involve stock brokers (private client services) and discount

brokers. Stock brokers assist investors in buying or selling shares. Primarily internet-based companies are often

referred to as discount brokerages, although many now have branch offices to assist clients. These brokerages

primarily target individual investors. Full service and private client firms primarily assist and execute trades for

clients with large amounts of capital to invest, such as large companies, wealthy individuals, and investmentmanagement funds.

Private equity - Private equity funds are typically closed-end funds, which usually take controlling equity stakes

in businesses that are either private, or taken private once acquired. Private equity funds often use leveraged

buyouts (LBOs) to acquire the firms in which they invest. The most successful private equity funds can generate

returns significantly higher than provided by the equity markets

Venture capital is a type of private equity capital typically provided by professional, outside investors to new,

high-potential-growth companies in the interest of taking the company to an IPO or trade sale of the business.

Angel investment - An angel investor or angel (known as a business angel or informal investor in Europe), is an

affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or

ownership equity. A small but increasing number of angel investors organize themselves into angel groups or

angel networks to share research and pool their investment capital.

Conglomerates - A financial services conglomerate is a financial services firm that is active in more than one

sector of the financial services market e.g. life insurance, general insurance, health insurance, asset management,

retail banking, wholesale banking, investment banking, etc. A key rationale for the existence of such businesses is

the existence of diversification benefits that are present when different types of businesses are aggregated i.e. bad

things don't always happen at the same time. As a consequence, economic capital for a conglomerate is usually

substantially less than economic capital is for the sum of its parts.

Financial crime

UK

Fraud within the financial industry costs the UK an estimated 14bn a year and it is believed a further 25bn is

laundered by British institutions.[6]

Market share

The financial services industry constitutes the largest group of companies in the world in terms of earnings and

equity market cap. However it is not the largest category in terms of revenue or number of employees. It is also a

slow growing and extremely fragmented industry, with the largest company (Citigroup), only having a 3 % US

market share.[7] In contrast, the largest home improvement store in the US, Home Depot, has a 30 % market share,

and the largest coffee house Starbucks has a 32 % market share.
http://en.wikipedia.org/w/index.php?title=Starbuckshttp://en.wikipedia.org/w/index.php?title=Home_Depothttp://en.wikipedia.org/w/index.php?title=Market_sharehttp://en.wikipedia.org/w/index.php?title=Citigrouphttp://en.wikipedia.org/w/index.php?title=British_institutionhttp://en.wikipedia.org/w/index.php?title=Money_launderinghttp://en.wikipedia.org/w/index.php?title=Fraudhttp://en.wikipedia.org/w/index.php?title=Economic_capitalhttp://en.wikipedia.org/w/index.php?title=Economic_capitalhttp://en.wikipedia.org/w/index.php?title=Retail_bankinghttp://en.wikipedia.org/w/index.php?title=Conglomerate_%28company%29http://en.wikipedia.org/w/index.php?title=Angel_investorhttp://en.wikipedia.org/w/index.php?title=Venture_capitalhttp://en.wikipedia.org/w/index.php?title=Private_equity


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See also

Accounting scandals

BFSI

European Financial Services Roundtable

Financial analyst

Financial data vendors Financial markets

Financialization

Financial transaction tax

Government sponsored enterprise

Institutional customers

International Monetary Fund

Investment management

List of banks

List of investment banks

Misleading financial analysis

Thomson Financial League Tables

References

[1] "The Mistakes Of Our Grandparents?" (http://www.contraryinvestor.com/2004archives/mofeb04.htm). Contrary Investor.com. February

2004. . Retrieved 2009-02-06.

[2] "Private Banking definition" (http://www. investorwords.com/5946/private_banking.html). Investor Words.com. . Retrieved 2009-02-06.

[3] "How Swiss Bank Accounts Work" (http://money.howstuffworks.com/personal-finance/banking/swiss-bank-account.htm). How Stuff

Works. . Retrieved 2009-02-06.

[4] http://www.globalcustody.net/no_cookie/custody_assets_worldwide/GlobalCustody.net Asset Table

[5] "Price comparison sites face probe" (http://news.bbc.co.uk/1/hi/business/7201345.stm). BBC News. 2008-01-22. . Retrieved

2009-02-06.

[6] "Watchdog warns of criminal gangs inside banks" (http://money.guardian.co.uk/news_/story/0,1456,1643860,00.html). The Guardian

(London). 2005-11-16. . Retrieved 2007-11-30.

[7] The Opportunity: Small Global Market Share (http://www.citigroup.com/citigroup/fin/data/p040602.pdf), Page 11, from the Sanford C.

Bernstein & Co. Strategic Decisions Conference - 6/02/04

Porteous, Bruce T.; Pradip Tapadar (December 2005).Economic Capital and Financial Risk Management for

Financial Services Firms and Conglomerates. Palgrave Macmillan. ISBN 1-4039-3608-0.

Schoppmann, Henning (Edit.); Julien Ernoult, Walburga Hemetsberger, Christoph Wengler (September 2008).

European Banking and Financial Services Law - Third Edition . Larcier. ISBN 2-8044-3180-0.
http://en.wikipedia.org/w/index.php?title=Sanford_C._Bernstein_%26_Co.http://en.wikipedia.org/w/index.php?title=Sanford_C._Bernstein_%26_Co.http://www.citigroup.com/citigroup/fin/data/p040602.pdfhttp://en.wikipedia.org/w/index.php?title=The_Guardianhttp://money.guardian.co.uk/news_/story/0,1456,1643860,00.htmlhttp://news.bbc.co.uk/1/hi/business/7201345.stmhttp://www.globalcustody.net/no_cookie/custody_assets_worldwide/http://money.howstuffworks.com/personal-finance/banking/swiss-bank-account.htmhttp://www.investorwords.com/5946/private_banking.htmlhttp://www.contraryinvestor.com/2004archives/mofeb04.htmhttp://en.wikipedia.org/w/index.php?title=Thomson_Financial_League_Tableshttp://en.wikipedia.org/w/index.php?title=Misleading_financial_analysishttp://en.wikipedia.org/w/index.php?title=List_of_investment_bankshttp://en.wikipedia.org/w/index.php?title=List_of_bankshttp://en.wikipedia.org/w/index.php?title=Investment_managementhttp://en.wikipedia.org/w/index.php?title=International_Monetary_Fundhttp://en.wikipedia.org/w/index.php?title=Institutional_customershttp://en.wikipedia.org/w/index.php?title=Government_sponsored_enterprisehttp://en.wikipedia.org/w/index.php?title=Financial_transaction_taxhttp://en.wikipedia.org/w/index.php?title=Financializationhttp://en.wikipedia.org/w/index.php?title=Financial_marketshttp://en.wikipedia.org/w/index.php?title=Financial_data_vendorshttp://en.wikipedia.org/w/index.php?title=Financial_analysthttp://en.wikipedia.org/w/index.php?title=European_Financial_Services_Roundtablehttp://en.wikipedia.org/w/index.php?title=BFSIhttp://en.wikipedia.org/w/index.php?title=Accounting_scandals


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15

Personal finance

Personal financePersonal 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. Components of personal finance might

include checking and savings accounts, credit cards and consumer loans, investments in the stock market, retirement

plans, social security benefits, insurance policies, and income tax management.

Personal financial planning

A key component of personal finance is financial planning, a dynamic process that requires regular monitoring and

reevaluation. In general, it has five steps:

1. Assessment: One's personal financial situation can be assessed by compiling simplified versions of financial

balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car,

house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage).

A personal income statement lists personal income and expenses.

2. Setting goals: Two examples are "retire at age 65 with a personal net worth of $1,000,000" and "buy a house in 3

years paying a monthly mortgage servicing cost that is no more than 25% of my gross income". It is not

uncommon to have several goals, some short term and some long term. Setting financial goals helps direct

financial planning.

3. Creating a plan: The financial plan details how to accomplish your goals. It could include, for example,reducing unnecessary expenses, increasing one's employment income, or investing in the stock market.

4. Execution: Execution of one's personal financial plan often requires discipline and perseverance. Many people

obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.

5. Monitoring and reassessment: As time passes, one's personal financial plan must be monitored for possible

adjustments or reassessments.

Typical goals most adults have are paying off credit card and or student loan debt, retirement, college costs for

children, medical expenses, and estate planning.

The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:

1 - Financial Position: this area is concerned with understanding the personal resources available by examining net

worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that

person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the

expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the

financial planner can determine to what degree and in what time the personal goals can be accomplished.

2 - Adequate Protection: the analysis of how to protect a household from unforeseen risks. These risks can be

divided into liability, property, death, disability, health and long term care. Some of these risks may be

self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to

get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners,

professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves.

Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of theoverall investment planning.
http://en.wikipedia.org/w/index.php?title=Expenseshttp://en.wikipedia.org/w/index.php?title=Incomehttp://en.wikipedia.org/w/index.php?title=Income_statementhttp://en.wikipedia.org/w/index.php?title=Liability_%28financial_accounting%29http://en.wikipedia.org/w/index.php?title=Assethttp://en.wikipedia.org/w/index.php?title=Income_statementhttp://en.wikipedia.org/w/index.php?title=Balance_sheethttp://en.wikipedia.org/w/index.php?title=Income_taxhttp://en.wikipedia.org/w/index.php?title=Social_securityhttp://en.wikipedia.org/w/index.php?title=Retirement_planhttp://en.wikipedia.org/w/index.php?title=Retirement_planhttp://en.wikipedia.org/w/index.php?title=Stock_markethttp://en.wikipedia.org/w/index.php?title=Loanhttp://en.wikipedia.org/w/index.php?title=Credit_cardhttp://en.wikipedia.org/w/index.php?title=Savings_accounthttp://en.wikipedia.org/w/index.php?title=Checking_accounthttp://en.wikipedia.org/w/index.php?title=Personal_budget


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Personal finance 16

3 - Tax Planning: typically the income tax is the single largest expense in a household. Managing taxes is not a

question of if you will pay taxes, but when and how much. Government gives many incentives in the form of tax

deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a

progressive tax. Typically, as your income grows, you pay a higher marginal rate of tax. Understanding how to take

advantage of the myriad tax breaks when planning your personal finances can make a significant impact upon your

success.

4 - Investment and Accumulation Goals: planning how to accumulate enough money to acquire items with a high

price is what most people consider to be financial planning. The major reasons to accumulate assets is for the

following: a - purchasing a house b - purchasing a car c - starting a business d - paying for education expenses e -

accumulating money for retirement, to generate a stream of income to cover lifestyle expenses.

Achieving these goals requires projecting what they will cost, and when you need to withdraw funds. A major risk to

the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net

present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to

be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get

a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks

is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This

asset allocation will prescribe a percentage allocation to be invested in stocks, bonds, cash and alternative

investments. The allocation should also take into consideration the personal risk profile of every investor, since risk

attitudes vary from person to person.

5 - Retirement Planning: retirement planning is the process of understanding how much it costs to live at retirement,

and coming up with a plan to distribute assets to meet any income shortfall.

6 - Estate Planning: involves planning for the disposition of your asset when you die. Typically, there is a tax due to

the state or federal government at your death. Avoiding these taxes means that more of your assets will be distributed

to your heirs. You can leave your assets to family, friends or charitable groups.

See also

Accounting software

Corporate finance

Credit card debt

Debt consolidation

Equity investment

Financial literacy

Financial Literacy Month

Family planning

Insurance

Investment

List of personal finance related articles

Mortgage loan

Payday loan

Pension

Personal budget

Personal financial management

Separately managed account

Settlement (finance)

Wealth

Wealth management
http://en.wikipedia.org/w/index.php?title=Wealth_managementhttp://en.wikipedia.org/w/index.php?title=Separately_managed_accounthttp://en.wikipedia.org/w/index.php?title=Settlement_%28finance%29http://en.wikipedia.org/w/index.php?title=Wealthhttp://en.wikipedia.org/w/index.php?title=Wealth_managementhttp://en.wikipedia.org/w/index.php?title=Wealth_managementhttp://en.wikipedia.org/w/index.php?title=Wealthhttp://en.wikipedia.org/w/index.php?title=Settlement_%28finance%29http://en.wikipedia.org/w/index.php?title=Separately_managed_accounthttp://en.wikipedia.org/w/index.php?title=Personal_financial_managementhttp://en.wikipedia.org/w/index.php?title=Personal_budgethttp://en.wikipedia.org/w/index.php?title=Pensionhttp://en.wikipedia.org/w/index.php?title=Payday_loanhttp://en.wikipedia.org/w/index.php?title=Mortgage_loanhttp://en.wikipedia.org/w/index.php?title=List_of_finance_topics%23Personal_financehttp://en.wikipedia.org/w/index.php?title=Investmenthttp://en.wikipedia.org/w/index.php?title=Family_planninghttp://en.wikipedia.org/w/index.php?title=Financial_Literacy_Monthhttp://en.wikipedia.org/w/index.php?title=Financial_literacyhttp://en.wikipedia.org/w/index.php?title=Equity_investmenthttp://en.wikipedia.org/w/index.php?title=Debt_consolidationhttp://en.wikipedia.org/w/index.php?title=Credit_card_debthttp://en.wikipedia.org/w/index.php?title=Accounting_software


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Personal finance 17

References

Kwok, H., Milevsky, M., and Robinson, C. (1994) Asset Allocation, Life Expectancy, and Shortfall,Financial

Services Review, 1994, vol 3(2), pg. 109-126.

External links

FreeJournal of Financial Counseling and Planning articles[1]

.

References

[1] http://www.afcpe.org/publications/journal-articles.php
http://www.afcpe.org/publications/journal-articles.phphttp://www.afcpe.org/publications/journal-articles.php


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18

Corporate finance

Corporate finance

Domestic credit to private sector in 2005

Corporate finance is an area of finance dealing with financial

decisions business enterprises make and the tools and analysis used to

make these decisions. The primary goal of corporate finance is to

maximize corporate value[1]

while managing the firm's financial risks.

Although it is in principle different from managerial finance which

studies the financial decisions of all firms, rather than corporations

alone, the main concepts in the study of corporate finance are

applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions

are long-term choices about which projects receive investment, whether to finance that investment with equity or

debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be

grouped under the heading "Working capital management". This subject deals with the short-term balance of current

assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending

(such as the terms on credit extended to customers).

The terms corporate finance and corporate financier are also associated with investment banking. The typical role

of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best

fits those needs.

Capital investment decisions

Capital investment decisions[2]

are long-term corporate finance decisions relating to fixed assets and capital

structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the

value of the firm by investing in projects which yield a positive net present value when valued using an appropriate

discount rate. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing

shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends).

Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

The investment decision

Management must allocate limited resources between competing opportunities (projects) in a process known as

capital budgeting[3]

. Making this capital allocation decision requires estimating the value of each opportunity or

project, which is a function of the size, timing and predictability of future cash flows.

Project valuation

In general[4]

, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the

opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to

Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: theory). This

requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future

cash flows are then discounted to determine their present value (see Time value of money). These present values arethen summed, and this sum net of the initial investment outlay is the NPV.
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The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate - often termed, the

project "hurdle rate"[5]

- is critical to making an appropriate decision. The hurdle rate is the minimum acceptable

return on an investmenti.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the

investment, typically measured by volatility of cash flows, and must take into account the financing mix. Managers

use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the

weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a

discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be

appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance.

These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity,

capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Stern Stewart & Co) and

APV (Stewart Myers). See list of valuation topics.

Valuing flexibility

In many cases, for example R&D projects, a project may open (or close) paths of action to the company, but this

reality will not typically be captured in a strict NPV approach.[6]

Management will therefore (sometimes) employtools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or

scenario specific cash flows are discounted, here the flexibile and staged nature of the investment is modelled, and

hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility"

inherent in the project.

The two most common tools are Decision Tree Analysis (DTA)[7]

and Real options analysis (ROA)[8]

; they may

often be used interchangeably:

DTA values flexibility by incorporatingpossible events (or states) and consequent management decisions. (For

example, a company would build a factory given that demand for its product exceeded a certain level during the

pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the

factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" - each scenario must be

modelled separately.) In the decision tree, each management decision in response to an "event" generates a

"branch" or "path" which the company could follow; the probabilities of each event are determined or specified

by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to

management; (2) given this knowledge of the events that could follow, management chooses the actions

corresponding to the highest value path probability weighted; (3) then, assuming rational decision making, this

path is taken as representative of project value. See Decision theory: Choice under uncertainty.

ROA is usually used when the value of a project is contingenton the value of some other asset or underlying

variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low,

management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, aDCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a

framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an

appropriate valuation technique is then employed - usually a variant on the Binomial options model or a bespoke

simulation model, while Black Scholes type formulae are used less often - see Contingent claim valuation. (3)

The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options

in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of

options was originally per Timothy Luehrman, in the late 1990s.)
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Quantifying uncertainty

Given the uncertainty inherent in project forecasting and valuation,[9]

analysts will wish to assess the sensitivity of

project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst

will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change

in that factor is then observed, and is calculated as a "slope": NPV / factor. For example, the analyst will

determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%,0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and

their various combinations produce a "value-surface" (or even a "value-space"), where NPV is then a function of

several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts ofNPV. Here, a scenario comprises a particular

outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as

well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue

growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs

are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for

scenario based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity

approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where

management determines a (subjective) probability for each scenario the NPV for the project is then the

probability-weighted average of the various scenarios.

A further advancement is to construct stochastic or probabilistic financial models as opposed to the traditional

static and deterministic models as above.[10]

For this purpose, the most common method is to use Monte Carlo

simulation to analyze the projects NPV. This method was introduced to finance by David B. Hertz in 1964, although

has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF

models, typically using an add-in, such as Crystal Ball. Using simulation, the cash flow components that are

(heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". Here, in

contrast to the scenario approach above, the simulation produces several thousandrandom but possible outcomes, or

"trials"; see Monte Carlo Simulation versus What If Scenarios. The output is then a histogram of project NPV, and

the average NPV of the potential investmentas well as its volatility and other sensitivitiesis then observed. This

histogram provides information not visible from the static DCF: for example, it allows for an estimate of the

probability that a project has a net present value greater than zero (or any other value).

Continuing the above example: instead ofassigning three discrete values to revenue growth, and to the other relevant

variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or

beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions

would then be "sampled" repeatedly - incorporating this correlation - so as to generate several thousand scenarios,

with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average

NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the varianceobserved under the scenario based approach. (These are often used as estimates of the underlying "spot price" and

volatility for the real option valuation as above; see Real options analysis: Model inputs.)

The financing decision

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately[11]

. As

above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix

can impact the valuation. Management must therefore identify the "optimal mix" of financingthe capital structure

that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the

Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity financing. Financing a

project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications
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independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments,

but results in a dilution of ownership, control and earnings. The cost of equity is also typically higher than the cost of

debt(see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any

reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms

of both timing and cash flows.One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests

that firms avoid external financing while they have internal financing available and avoid new equity financing while

they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off

Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when

making their decisions. An emerging area in finance theory is right-financing whereby investment banks and

corporations can enhance investment return and company value over time by determining the right investment

objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework

within a given economy and under given market conditions. One last theory about this decision is the Market timing

hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal

resources, debt and equity.

The dividend decision

Whether to issue dividends,[12]

and what amount, is calculated mainly on the basis of the company's unappropriated

profit and its earning prospects for the coming year. If there are no NPV positive opportunities, i.e. projects where

returns exceed the hurdle rate, then management must return excess cash to investors. These free cash flows

comprise cash remaining after all business expenses have been met.

This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the

company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an

opportunity is currently NPV negative, management may consider investment flexibility / potential payoffs and

decide to retain cash flows; see above and Real options.

Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share

buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may

elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.

Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Today, it is

generally accepted that dividend policy is value neutral (see Modigliani-Miller theorem).

Working capital management

Decisions relating to working capital and short term financing are referred to as working capital management[13]

.

These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital

investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments.

These investments, in turn, have implications in terms of cash flow and cost of capital.

The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has

sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational

expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See

Economic value added (EVA).
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