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Lecture 1: Introduction to Finance

What is Finance?​

Finance is about business activity patterns - every business acquires and discloses assets.

Core Question​

What do we study in finance?

Decision making regarding:

  • How to finance ourselves
  • Which investments to make

Types of Finance​

Personal Finance​

  • Life goal management
  • Risk management
  • Budgeting and cash flow
  • Credit management
  • Insurance and retirement planning

Corporate Finance (95% of course)​

  • Investment decisions
  • Financing decisions
  • Capital structure
  • Dividend policy

Public Finance​

  • Government financial decisions

Real vs Financial Assets​

Real Assets​

Definition: Assets that produce other assets or income

Examples:

  • Manufacturing equipment
  • Real estate
  • Land
  • Machinery
  • Buildings

Key: Can be used to create products and generate income

Simple Example: A pizza oven in a restaurant - it directly produces pizzas (goods) that generate income

Financial Assets​

Definition: Claims on real assets or other financial assets

Examples:

  • Bonds and stocks
  • Cash (claim against central bank)
  • Certificates of ownership

Key: Represent ownership/claims, don't directly produce goods

Simple Example: A stock certificate of Apple - it doesn't produce iPhones directly, but gives you ownership claim to Apple's real assets (factories, equipment, etc.)

Corporate Decisions​

Every corporation has two main decision types:

1. Investment Decisions​

Question: What should we do with our money?

Examples:

  • Invest $100B in S&P 500 index
  • Build new facilities
  • Acquire companies

Goal: Maximize return given risk

Simple Example: Apple deciding whether to build a new iPhone factory in China or invest the money in R&D

2. Financing Decisions​

Question: Where does the money come from?

Options:

  • Debt: Borrowing (bonds, loans)
  • Equity: Selling ownership (stocks)

Goal: Minimize financing cost

Simple Example: Tesla needs $1B for new factory - should they borrow from banks (debt) or sell more Tesla stock (equity)?

Time Value of Money​

Core Principle​

$100 today ≠ $100 in one year

Even with:

  • No inflation
  • No credit risk
  • Perfect certainty

Why?​

  1. Opportunity Cost: Money can be invested today
  2. Consumption Preference: People prefer current consumption
  3. Real Interest Rate: Compensation for deferring consumption

Example​

  • Invest $100 at 10% for 1 year
  • Year 1: 100×1.10=110100 \times 1.10 = 110
  • Year 2: 110×1.10=121110 \times 1.10 = 121 (not $120!)

Compound Interest: Interest on interest

Simple Analogy: Like a snowball rolling down a hill - it gets bigger as it rolls because it picks up more snow (interest) on top of the snow it already has

NPV and Decision Making​

Net Present Value​

NPV=Present Value of Future Cash Flows−Initial Investment\text{NPV} = \text{Present Value of Future Cash Flows} - \text{Initial Investment}

Present Value​

PV=Future Value(1+r)t\text{PV} = \frac{\text{Future Value}}{(1 + r)^t}

Where:

  • r = Discount rate (required return)
  • t = Time period

Decision Rules​

  • NPV > 0: Accept project
  • NPV < 0: Reject project
  • NPV = 0: Indifferent

Simple Example: If you can invest $100 and get $110 back (NPV = +$10), you should do it. If you only get $90 back (NPV = -$10), don't do it.

Mutually Exclusive Projects​

Rule: Choose project with highest NPV

Examples:

  • Bridge vs Tunnel
  • University A vs University B
  • War vs Peace

Simple Example: You can only attend one university. Choose the one that gives you the highest NPV (best return on your investment in education).

MBA Investment Example​

Scenario​

Vasily considering MBA degree investment

Investment Analysis​

Initial Costs (Time 0)​

  • Transportation: 50×60=3,00050 \times 60 = 3,000 shekels
  • Tuition: 30,00030,000 shekels
  • Opportunity Cost: 12×52×100=62,40012 \times 52 \times 100 = 62,400 shekels
  • Total: 97,00097,000 shekels

Future Benefits​

  • Current Salary: 150,000 shekels/year
  • Salary Increase: 10% for 10 years, then 2%
  • Additional Income: 15,000 shekels/year

NPV Calculation​

Assumptions:

  • 10-year horizon
  • Discount rate: 10%
  • Present Value of Benefits: 92,000 shekels
  • NPV: 92,000−97,000=−5,00092,000 - 97,000 = -5,000 shekels

Decision: Reject MBA

Sensitivity Analysis​

If discount rate = 3%:

  • Present Value increases
  • NPV becomes positive
  • Decision: Accept MBA

Key Concepts​

Finance Fundamentals​

  • Finance = Investment + Financing decisions
  • Real assets produce goods/services
  • Financial assets represent claims
  • Time value of money is fundamental

Decision Framework​

  • NPV Rule: Accept positive NPV projects
  • Mutually Exclusive: Choose highest NPV
  • Discount Rate: Reflects opportunity cost
  • Sensitivity Analysis: Test scenarios

Market Structure​

  • Primary Market: New securities issuance
  • Secondary Market: Trading existing securities
  • Intermediaries: Connect suppliers and demanders
  • Market Makers: Provide liquidity

Practical Applications​

  • Personal: Life goal planning
  • Corporate: Value maximization
  • Investment: Risk-return analysis
  • Markets: Efficient allocation