Finance examines how individuals and companies raise and spend money, as well as how they should raise and spend money, so as to produce the highest expected value from investments in assets.
An asset is an object into which an investment is made with the expectation of uncertain future cash flows. Assets can be ‘real’ (such as equipment, new products and markets, or companies) or ‘financial’ (for example, stocks and bonds). The study of investments in real assets falls under the rubric of Corporate Finance, while that of financial assets falls under Capital Markets (sometimes called ‘Investments’).
Corporate Finance and Capital Markets
Corporate Finance addresses how managers of companies make real investments, raise capital, control risks, and return money to investors. On MBA programs, topics of study can include cash flows, capital budgeting, capital structure and cost of capital, business valuation, mergers and acquisitions, risk management, as well as payout policies.
Capital Markets examines how financial securities are priced by markets, and how to make decisions concerning investments in portfolios of different types of financial assets. MBA courses that cover Capital Markets should include the relation between risk and return, pricing of bonds, stocks and derivatives, term structure of interest rates, allocation of wealth among different types of securities, and institutional frictions that prevent attainment of optimal prices.
A few simple assumptions about investor behavior underlie much of Finance. For example, that, all else equal, investors prefer more wealth to less; less risk to more; and want their cash flows sooner rather than later. The latter assumptions lead to the idea of a discount rate, the notion that future cash flows are discounted in value to equate to the present, using a factor that reflects a risk-adjusted cost of capital relevant to the asset.
These ideas combine to establish a key rule: We should invest in an asset only if it is expected to generate a return greater than its cost of capital, or equivalently, if it currently has a positive expected value (‘positive net present value’). Since that judgment requires assessing an asset’s intrinsic value, tools and methods to assess such value are central to Finance on MBA programs, and indeed otherwise. Intrinsic value, in turn, is determined by the sum of all expected future cash flows from the asset, discounted back to the present at its cost of capital.
Finance in business schools
In both its theories and in practice, the core ideas in Finance are founded on a set of logically cogent ideas. There are few disciplines taught in business schools where academic research and the real world come together as remarkably well as in Finance. The ideas that underpin the field not only win Nobel prizes regularly, but they also form the basis upon which billions of dollars change hands every day.
That said, there are many questions that Finance still continues to grapple with. For example:
- What causes recurrent financial crises?
- What is the role of ‘long tail’ risks, and how can they be better understood and analyzed?
- Why do we witness apparently predictable irrational investment decision-making by investors and managers?
- Why do markets and companies seem prone to herd behaviors?
- How can corporate governance practices and incentives be structured so as to produce value-creating outcomes for the long-run as opposed to the short-run?
- What is the right balance between free markets and regulation in enabling the best outcomes for society-at-large?