These are all very practical decisions, and the methods of analyzing them make use of Principle 1:A dollar today is not worth the same as a dollar tomorrow. Economists have considered the management of personal financial resources over a lifetime to be a central issue worthy of serious study, and several Nobel Prizes in economics have been awarded for contributions in this area. And, as Box 3.1 shows, financial literacy for a nation’s people is a goal being pursued by countries all over the world.

Most financial decisions boil down to figuring out how much an asset is worth. For example, in deciding whether to invest in a security such as a stock or a bond or in a business opportunity, you have to determine whether the price being asked is high or low relative to other investment opportunities available to you. In addition to investment decisions, there are many other situations in which one needs to determine the value of an asset. For example, suppose that the tax assessor in your town has assessed your house at $500,000 for property tax purposes. Is this value too high or too low? Or suppose you and your siblings inherit some property, and you decide to sell it and share the proceeds equally among yourselves. How do you decide how much it is worth?

In the previous chapters we introduced the concept of valuation, which involved converting cash flows that are expected to happen in the future into today’s terms, and we learned about the returns on various assets and how to analyze the past performance of financial instruments to inform investment decisions. However, the future is not known for sure. The cash flows that occur may be different from what we initially expect, and the value (and rates of return) of financial instruments change over time. In this chapter, we introduce a fundamental concept in finance: Uncertainty about the future can affect valuation and decision making.

We begin by defining what risk is in finance, and how it affects financial decisions. We then dive into how risk can be managed, which includes identifying relevant risks, assessing how they can affect one’s financial situation, and then determining appropriate techniques that can be used to reduce these risks.

Before proceeding with our first steps in valuation, we need to introduce some tools and define some notation that will be used here and throughout the book when valuing assets.

At a fundamental level, the value of an asset comes from the cash flows that are associated with it—that is, from the amounts of money that the owner either receives or pays at various points in time. An essential tool in analyzing cash flows from any financial decision is a diagram known as a timeline, a linear representation of cash outflows and inflows over a period of time. A negative sign in front of a cash flow means that you are paying that amount of money (it’s a cash outflow from you). No sign means that you are receiving an amount of money (it’s a cash inflow to you).

In the last few chapters we have considered financial and strategic decisions made within companies, and whether they improve the value of the company. In this chapter we continue examining company decisions, and focus on a particular financial decision—the payout decision, which considers whether a company keeps the cash it holds or gives it back to investors. As we will show, this decision is important because firms can potentially increase their value—and benefit their investors—through their choice of whether to pay out cash to investors. Furthermore, as we discussed in the previous chapter, agency problems may arise when companies hold onto large amounts of cash due to managerial conflicts of interest. Thus, payout can serve an important role in corporate governance.

In previous chapters we explored how to calculate the value of a company, given decisions that it had already made. In subsequent chapters we then focused on decisions that a manager within a company could make, and how they affect company value, such as project investment decisions. In this chapter we continue to examine decisions made by companies, and focus on a particularly important decision—the financing decision. Capital structure is the mix of financing sources that a firm uses to fund its operations, growth, and investment projects. A firm may choose to use internal funding from operations, or use external funding from issuing debt (bonds) or equity (stock), or other financing instruments.

In the previous chapter we discussed what risk is and how managing risk is an essential element of every financial decision. Risk stems from uncertainty about the future. In this chapter, we introduce and explain financial contracts—options—that help resolve uncertainty by allowing an asset to be traded at a fixed price in the future after observing outcomes. More specifically, put options allow the choice to sell or not sell an underlying asset in the future, while call options allow the choice to buy or not buy an underlying asset in the future. The owner does not have to sell (in the case of a put) or buy (in the case of a call) in the future if it is not beneficial to them. Thus, the value of option contracts is that they embed flexibility—the owner makes the decision after the market price of the underlying asset is observed.

In the previous chapter we went over the process by which investors form portfolios, how to measure the risk and return of a given portfolio, and how an optimal portfolio can be chosen from a riskless asset and a set of risky assets. We saw that the optimal portfolio consists of holding some portion of one’s money in the riskless asset and some portion in the tangency portfolio consisting of the optimal combination of risky assets (OCRA). In this chapter we introduce the capital asset pricing model (CAPM), which specifies exactly what the OCRA should be. The CAPM predicts, under a set of assumptions, that the OCRA consists of holding all assets in the market in proportion to their value. Thus, all investors should hold some combination of the market portfolio and the riskless asset because it is most efficient.