Basics of Finance

In: Business and Management

Submitted By sanjanasanju
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Ch 1: BASIC CONCEPTS IN FINANCE

• Finance is the study of how resources are valued and allocated in time.

• Outcomes of financial decisions are spread out over time and not known with certainty in advance

• Three key concepts in finance are : Time value of money Asset Valuation (stocks, bonds, derivatives,...) Risk management

1.1: Interest and return

• Income almost never matches consumption desires exactly. Either one will need to borrow to purchase more than one can afford or save excess income.

• Costs / benefits of financial decisions are spread over time. So one needs to compare values of cashflows which mature at different times.

Time value of money: 1ZAR in the hand today is worth more than the expectation of 1ZAR in the future. Why? • Opportunity cost: To give up consumption of your 1ZAR today, you would expect to be rewarded with a greater amount in the future; the promise of consumption at a higher level in the future motivates one to save. The desire to receive surplus on savings leads to an interest rate called the pure time value of money. • Inflation: Prices of goods rarely stay the same over time. The purchasing power of 1ZAR now is (usually) greater than 1ZAR later. Investors expect a higher rate of return to compensate for inflation. • Uncertainty: One may not receive the expected sum - this is referred to as investment or credit risk.

• Opportunity cost: Pure time value of money give rise to pure rate of interest.

• Inflation: The rate of interest on top of the rate of inflation is the nominal riskfree rate.

• Uncertainty: The excess amt added to the nominal risk-free interest rate is the risk premium.

1.1.1: Interest Borrowing is not free: borrower pays premium for sum of money from lender. The cost of borrowing is interest. • Interest rates are not necessarily fixed - they vary at different times - different rates may be…...

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