Principles of Finance

Principles of Finance is a concise guide to the essential concepts that drive the financial world. From the basics of money and markets to valuing investments and managing risk, this booklet provides a clear foundation for understanding how financial decisions are made. Designed for easy learning, it equips readers with the tools to navigate the science of finance with confidence.

Table of Contents

Go to 👉 Chapter 1: The Basics

• An Overview on Money: A refresher on the nature, functions, and forms of money, building on its role as a medium of exchange, unit of account, and store of value.
• Principle of Relative Valuation: Introducing the idea that the value of any asset is determined by comparing it to the value of similar, benchmark assets.
• Role of a CFO and Finance Managers: Outlining the key responsibilities of financial leaders within an organization, from financial planning and raising capital to making investment decisions.
• Is Accounting and Finance One and the Same?: Clarifying the crucial distinction between accounting (recording past financial events) and finance (making decisions about the future).

Go to 👉 Chapter 2: Financial Markets and Institutions

• Stock Markets: What they are, how they function (primary vs. secondary markets), and their role in allowing companies to raise equity capital.
• Bond Markets: An introduction to the markets where debt securities are issued and traded, including government and corporate bonds.
• Money Markets: A look at the market for short-term, highly liquid debt instruments, used for borrowing and lending in the short term.
• Derivatives Markets: A brief overview of markets for financial instruments whose value is "derived" from an underlying asset (e.g., futures, options).
• Foreign Exchange Markets: An introduction to the global marketplace for trading national currencies against one another.
• Determinants of Interest Rates: Exploring the fundamental factors that influence interest rates, including inflation, risk, and central bank policy.
• The Federal Reserve System: An overview of the structure and functions of the U.S. central bank, the "lender of last resort."
• Commercial Banks: The role of commercial banks as financial intermediaries, taking deposits and making loans.
• Regulation of Commercial Banks: A brief look at why banks are heavily regulated and the key objectives of banking regulation (stability, consumer protection).

Chapter 3: The Time Value of Money

• Introduction to Time Value of Money: The foundational concept that a dollar today is worth more than a dollar tomorrow, due to its earning potential.
• The Concept of Returns: Defining return as the financial reward for investing, expressed as a percentage of the initial amount.
• The Present Value of Money, Net Present Value and Discounting: Explaining how to calculate the current worth of a future cash flow (Present Value) and how to sum the present values of all cash flows from a project to determine its Net Present Value (NPV).
• The Opportunity Cost of Capital: Defining the cost of capital as the return foregone by not investing in the next best alternative of comparable risk.
• The Effect of Compounding and Future Value: Demonstrating how money grows over time when returns are reinvested, and how to calculate its value at a future date.
• Summary: A concise recap of the key formulas and concepts from the chapter.

Chapter 4: Applications of Time Value of Money

• How to make Investment Decisions?: Applying the NPV rule to decide whether to accept or reject a project.
• All about Perpetuities: Valuing a stream of cash flows that continues forever.
• Annuity: Valuing a stream of equal cash flows that continues for a fixed number of periods.
• Summary: A review of the practical applications of TVM in valuing financial instruments.

Section 2: Investments and Returns

This section applies the foundational concepts to specific asset classes and introduces the critical element of risk. It covers bonds, the nature of risk, and the core principles of corporate finance.

Chapter 5: Bonds

• Rate of Returns: Varying and Annualized: Distinguishing between different measures of return, including the holding period return and the annualized return.
• The Yield Curve: Explaining the relationship between bond yields and their maturities, and what its shape (normal, inverted, flat) tells us about the economy.
• Valuing Bonds: Applying present value techniques to calculate the fair price of a bond, based on its coupon payments and principal repayment.
• The Yield to Market Curve: How bond yields move with market conditions and what drives these changes.
• Advanced Concepts of Bonds: A brief introduction to more complex bond topics, such as duration, convexity, and callable bonds.
• Summary: A recap of bond valuation and the key factors influencing bond prices.

Chapter 6: Risk and Return

• What is Risk?: Defining risk in finance as the measurable uncertainty surrounding future returns.
• Types of Risk: Distinguishing between systematic (market-wide) and unsystematic (specific) risk, and between diversifiable and non-diversifiable risk.
• Risk Management: An introduction to the basic strategies for managing financial risk, including diversification, hedging, and insurance.
• Summary: A review of the core concepts of risk and its relationship to expected return.

Chapter 7: Corporate Finance

• Weighted Average Cost of Capital (WACC): Calculating the blended cost of a company's capital, including both debt and equity.
• Beta and its Uses: Defining beta as a measure of a stock's systematic risk and explaining its role in the Capital Asset Pricing Model (CAPM).
• Return on Equity (ROE): A key profitability metric measuring how effectively a company generates profit from its shareholders' equity.
• Modigliani & Miller: Introducing the M&M theorem on capital structure irrelevance and its implications for corporate finance.
• Project Valuation: Applying WACC and discounted cash flow analysis to evaluate corporate investment projects.
• Growth Opportunity: How to value a company's opportunities for future growth separately from its existing assets.
• Computation or Table Lookup: A practical guide to using financial calculators or tables for common financial computations.

Section 3: Market Theory

This final section synthesizes all the previous material into a coherent theory of how financial markets work. It explores how assets are priced, how portfolios should be constructed, and the theories that attempt to explain market behavior.

Chapter 8: Portfolio Theory

• · Efficient-Market Hypothesis (EMH): The theory that asset prices fully reflect all available information, making it impossible to consistently "beat the market."
• · Modern Portfolio Theory (MPT): The framework for constructing portfolios that maximize expected return for a given level of risk, based on diversification and the benefits of combining assets with low correlations.
• · Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return for assets, used to calculate a project's cost of equity.
• · Arbitrage Pricing Theory (APT): A multi-factor alternative to the CAPM, which explains asset returns through their exposure to various macroeconomic risk factors.
• · Correlation Among Securities: The critical importance of correlation in determining the overall risk of a portfolio.
• · Optimal Market Portfolio: The theoretical portfolio consisting of all assets in the market, weighted by their market value, which forms the foundation of the CAPM.
• · Summary: A final review of the key theories that explain how financial markets operate and how rational investors should behave.

Conclusion

A final reflection on the journey through the principles of finance, encouraging readers to apply their new understanding to make better financial decisions.

Principles of Finance /E-cyclopedia Resources by Kateule Sydney is licensed under CC BY-SA 4.0