Chapter 1

The Tale of Corporate Finance

IN THIS CHAPTER

Understanding the meaning of money

Looking at the study of corporate finance

Seeing the role corporate finance plays in your life

Making corporate finance work for you

Corporate finance is more than just a measure of money. As you see in this chapter, money is incidental to finance. When discussing corporate finance, we are actually looking at the entire world in a new way - a way that measures the entire universe and the things within it in a way that makes it useful to us. We can calculate things in terms of corporate finance that simply can't be accurately measured in any other way. Throughout this chapter we talk about the nature of money and how it applies to corporate finance.

Telling a Story with Numbers

Corporate finance is the study of relationships between groups of people that quantifies the otherwise immeasurable. To understand how this definition makes any sense at all, first you have to take a quick look at the role of money in the world.

According to Adam Smith, an 18th century economist, the use of money was preceded by a barter system. In a barter system, people exchange goods and services of relatively equivalent value without using money. Perhaps if you worked growing hemp and making rope out of it, you could give that rope to people in exchange for food, clothes, or whatever else you needed that the people around you might be offering. What happens, though, when someone wants rope, but that person has nothing you want? What about those times when you need food, but no one needs rope? Because of these times, people started to use a rudimentary form of money. So, say that you sell your rope to someone, but they have nothing you want. Instead, they give you a credit for their services that you are free to give to anyone else. You decide to go and buy a bunch of beer, giving the brewer the note of credit, ensuring that the person who bought your rope will provide the brewer a service in exchange for giving you beer. Thus, the invention of money was born, though in a very primitive form.

Looking at money in this way, you come to realize that money is actually debt. When you hold money, it means that you've provided goods or services of value to someone else and that you are now owed value in return. The development of a standardized, commonly used currency among large numbers of people simply increases the number of people willing to accept your paper or coin I.O.U.s, making that currency easier to exchange among a wider number of people, across greater distances, and for a more diverse variety of potential goods and services.

According to 21st century anthropologist David Graebner, this story was probably something closer to bartering with the government as a taxation, which meant providing goods and services to the government (for example, the emperor) and then being provided units of "currency" worth production rations. So, you can say that money was invented for the first government contractors as a method for the government to acquire resources in return for units of early currency worth specific amounts of resources rather than a true barter.

Simply put, money is debt for the promise of goods and services that have an inherent usefulness, but money itself is not useful except as a measure of debt. People use money to measure the value that they place on things. How much value did a goat have in ancient Egypt? You could say that one goat was worth five chickens, but that wouldn't be very helpful. You could say that a brick maker's labor was worth half that of a beer maker, but you couldn't exactly measure that mathematically, either. Using these methods, people had no real way to establish a singular, definitive measurement for the value that they placed on different things. How can you measure value, then? You measure value by determining the amount of money that people are willing to exchange for different things. This method allows you to very accurately determine how people interact, the things they value, and the relative differences in value between certain things or certain people's efforts. Much about the nature of people, the things they value, and even how they interact together begin to become very clear when you develop an understanding of what they're spending money on and how much they're spending.

Fast-forward more than eight millennia - well after the establishment of using weighted coins to measure an equivalent weight of grain, well after the standardized minting of currency, and well past the point where the origins of money became forgotten by the vast majority of the world's population (welcome to the minority) - all the way into the modern era of finance. Money begins to take on a more abstract role. People use it as a way to measure resource allocations between groups and within groups. They even begin to measure how well a group of people are interacting by looking at their ability to produce more using less. Success is measured by their ability to hoard greater amounts of this interpersonal debt. The ability to hoard debt in this manner defines whether the efforts of one group of people are more or less successful than the efforts of another group. People use money to place a value on everything, and, because of this, it's possible to compare "apples and oranges." Which one is better, apples or oranges? The one that people place more value on based on the total amount of revenues. Higher revenues tell you that people place greater value on one of those two fruits because they are willing to pay for the higher costs plus any additional profits.

So, when I say that corporate finance is the study of the relationships between groups of people, I'm referring to measuring how groups of people are allocating resources among themselves, putting value on goods and services, and interacting with each other in the exchange of these goods and services. Corporate finance picks apart the financial exchanges of groups of people, all interconnected in professional relationships, by determining how effectively and efficiently they work together to build value and manage that value once it's been acquired. Those organizations that are more effective at developing a cohesive team of people who work together to build value in the marketplace will be more successful than their competitors.

In corporate finance, you measure all this mathematically in order to assess the success of the corporate organization, evaluate the outcome of potential decisions, and optimize the efforts of those people who form economic relationships, even if for just a moment, as they exchange goods, services, and value in a never-ending series of financial transactions. The financial decisions made collectively form a trend of behaviors that can be analyzed using any of several types of indicators:

• Leading indicators: Leading indicators include any measures of macroeconomic data that indicate what the health of the economy will look like in the immediate future, including new unemployment claims, for example.
• Coincident indicators: Coincident indicators are measures of macroeconomic data that indicate the health of the economy now. One example is new industrial production.
• Lagging indicators: Lagging indicators are indicators that tend to confirm what the economy has already begun to do, such as duration of unemployment.
• Sentiment indices: These are measures of how people feel about the economy. They aren't entirely accurate nor always helpful, but they do help give us an idea about how people feel about the economy, which does tend to be tied to other hard data. Consumer sentiment, for example, tends to be down when employment is down or when people don't feel confident in their own employment. These factors tend to influence stocks nearly as significantly as other, more solid, indicators.

Characterizing Motivations

Corporate finance plays a very interesting role in all societies. Finance is the study of relationships between people: how they distribute themselves and their resources, place value on things, and exchange that value among each other. Because that's the case, finance (all finance) is the science of decision-making. This is the process of studying human behavior and determining how people make decisions regarding what they do with their lives and the things they own. Corporate finance, as a result, studies decision-making in terms of what is done by groups of people working together in a professional manner.

This definition guides you in two primary directions regarding what makes corporate finance unique:

• It tells you that corporate finance is a critical aspect of human life as an intermediary that allows people to transfer value among themselves.
• It tells you how groups of people interact as a single unit, a corporation, and how decisions are made on behalf of the corporation by people called managers.

Corporate finance is far more than a study about money. Money is just the unit of measure people use to calculate everything and make sense of it numerically, to compare things in absolute terms rather than relative ones. Corporate finance is a unique study that measures value. Once you accept that, it becomes apparent that everything in the world has value. Therefore, you can use corporate finance to measure everything around you that relates to a corporation, directly or...