Fundamentals of Finance
Finance is, broadly, about two things: one is what happens to decisions within firms in terms of how much value they create – decisions regarding corporate governance, capital budgeting, and investment; the other is how the capital market reacts to these decisions and how risk gets priced in the market.
In terms of what happens within the firm, the basic principles to remember are that if you want to use finance to create value, the first thing you need is a good strategy. The second thing you need is a good internal resource allocation system so that capital is flowing to the highest-value project. The third thing you need is the right performance metrics with which to judge people so that you maximize shareholder value on a day-to-day basis. Finally, you need the right corporate culture within the organization to make sure the implicit rules by which people are being judged and rewarded make sense.
From the external perspective, capital will flow to the highest- value user. The firms that will be valued more highly are the ones that are making positive net present value investments. The market will demand a higher risk premium for investing in firms that are riskier. If you are an investor and you hold a diversified portfolio, you don’t really have to care so much about what is happening in the firm because the capital market at an aggregate level is taking care of allocating resources to the best users. You have to make sure you hold a diversified portfolio so that if one out of the 200 firms in your portfolio disappoints, the whole portfolio doesn’t go down.
