The role of financial institutions
Probably the easiest way to understand how corporate finance acts as a critical intermediary process between groups of people is to look at the role of financial institutions in the greater economy. Financial institutions, such as banks and credit unions, have a role that involves redistributing money between those who want money and those who have excess money, all in a manner that the general population believes is based on reasonable terms.
Now, whether financial institutions as a whole are fully successful in their role is no longer a matter of debate: They are not. The cyclical role being played out time and again prior to the Great Depression, prior to the 1970s economic troubles, and prior to the 2007 collapse are symptomatic of a systematic operational failure yet to be resolved. For the most part, the role they play is necessary, however. These institutions facilitate the movement of resources across the entire world. They accept money from those who have more than they’re using and offer interest rate payments in return. Then they turn around and give that money to those seeking loans, charging interest for this service. In this role, financial institutions are intermediaries that allow people on either side of these sorts of transactions to find each other by way of the bank itself. Without this role, investments and loans would very nearly come to a total halt compared to the extremely high volume and value of the current financial system.
Corporate finance plays a similar role as an intermediary for the exchange of value of goods and services between individuals and organizations. Corporate finance, as the representation of the value developed by groups of people working together toward a single cause, studies how money is used as an intermediary of exchange between and within these groups to reallocate value as is deemed necessary.
Defining investing
It may be helpful to backtrack a bit. What the heck is an investment, anyway? An investment is anything that you buy for the purpose of deriving greater value than you spent to acquire it. Yes, yes, stocks and bonds are good examples; you buy them, they go up in value, and you sell them. But you can think of some other examples that aren’t so … already in this book. A house that you buy for the purpose of generating income is a good example of an investment: You buy it, you generate revenue as its renters pay their rent, and after the house goes up in value, you sell it. (Your own home usually isn’t considered an investment.)
Because money places an absolute value on transactions that take place, you can very easily measure not only these transactions but also all of several potential options in a given decision. In other words, you can measure the outcome of a decision before it’s made, thanks to corporate finance. That’s the second thing that makes corporate finance a very unique study: It analyzes the value of interactions between people, the value of the actions taken, and the value of the decisions made and then compiles that information into a single agglomerate based on professional interconnectedness in a single corporation.
This analysis allows you to measure how effectively you’re making decisions and optimize the outcome of future decisions you’ll have to make. The decisions that corporations make tend to have very far-reaching consequences, influencing the lives of employees, customers, suppliers, partners, and the greater national economy, so ensuring that a corporation is making the correct decisions is of the utmost importance. Corporate finance allows you to do this, so if you have a favorite corporation, hug the financial analysts next time you see them (or maybe just send a cookie bouquet; you might freak someone out if you just randomly starting hugging people).
Setting the Stage
Unless you’re in a rare minority who live “off the grid” (secluded and self-sufficient), nearly every aspect of your life is strongly influenced, directly or otherwise, by corporate finances. The price and availability of the things you buy are decided using financial data. Chances are high that your job relies on decisions made using financial data. Your savings and investments all rely quite heavily on financial information. Your house, car, where you live, and even the laws in your area are all determined using financial information about corporations.
From the very beginning, a corporation needs to decide how it will fund its start-up, the time when it first begins purchasing supplies to start operating. This single decision decides a significant amount about the corporation’s costs, which, in turn, decide a lot about the prices it will charge. Where it sells its goods depends greatly on whether the corporation can sell its goods at a price high enough to generate a profit after the costs of production and distribution, assuming that competitors can’t drive down prices in that area. The number of units that the corporation produces depends entirely on how productive its equipment is, and the corporation will only purchase more equipment if doing so doesn’t cost more than the corporation will be able to make in profits.
You’re probably thinking to yourself, “But that’s only my work life. Surely corporate finance has no influence on my personal life.” Well, besides controlling how much you make, what you can afford, what your job is, and where you work, corporations have this habit of also financially assessing government policy.
When a proposed law (called a bill) is introduced, corporations determine what its financial impact will be on them. They also assess whether a law that exists (or doesn’t exist) has a financial impact on corporations. If the impact is greater than the cost of hiring a lobbyist in Washington, D.C., they’ll hire a lobbyist to pressure politicians into doing what they want. This effort includes campaign contributions, marketing on behalf of the politician, and more. Going even as big as international relations between nations, a single large corporation can bring an entire global industry to a stop by convincing the right people that one nation is selling goods at a price lower than cost, which causes political conflict between nations. This scenario has happened multiple times in the past, with the majority of claims being made by U.S. companies, and it can easily happen again.
Every aspect of your life is influenced in some way by the information derived from corporate finance. Money is a measure of value, and you are valuable, so nearly everything that makes you who you are can be measured in terms of money. If it can be measured in terms of money, decisions will be made in terms of money. If you’re not the one making those decisions, you should probably be asking yourself who is.
Chapter 2
Introducing Finance Land
IN THIS CHAPTER
