Finance

Finance, branch of economics concerned with providing funds to individuals, businesses, and governments. Finance allows these entities to use credit instead of cash to purchase goods and invest in projects. For example, an individual can borrow money from a bank to buy a home. An industrial firm can raise money through investors to build a new factory. Governments can issue bonds to raise money for projects.
Finance plays an important role in the economy. As banks, credit unions, and other financial institutions provide credit, they help expand the economy by directing funds from savers to borrowers. For example, a bank acquires large amounts of money from the deposits of individual savers. The bank does not let this money sit idle but instead provides loans to borrowers who might then build a house or expand a business. The savings of millions of people percolate through many financial institutions, spurring economic growth.
A wide variety of financial institutions have different roles in finance and the economy. Some institutions, such as banks, link lenders and borrowers. These institutions act as an intermediary among consumers, businesses, and governments by lending out deposits. Other institutions, such as stock exchanges, provide a market for existing securities, which include stocks and bonds. Stock exchanges encourage investment because they enable investors to sell their securities when the need arises.
Many aspects of finance are studied individually. Corporate finance centers on how businesses can best raise and spend their funds. Public finance focuses on the financial role of federal, state, and local governments.

Source : Microsoft ® Encarta ® 2006.

Diversification

Diversification, financial strategy of holding different kinds of investments to reduce the risk of financial loss. An investor who holds stock in only one company risks losing his or her entire investment if the company fails. Investing in a number of different kinds of companies lessens the risk because it is unlikely that all of these companies will fail or lose value. Diversification also increases the opportunity for success. Placing money in different investments increases the odds that one or more of these investments will succeed.
To achieve diversification, many investment advisers in the United States recommend holding a number of different stocks and bonds from both American and international companies. Mutual funds are excellent investments for diversification because such funds may hold stocks in a variety of companies as well as various types of bonds. Owning other investments, such as precious metals and real estate, also helps to achieve diversification.

Contributed By:Samuel Case
Source : Microsoft ® Encarta ® 2006.

MANAGING RISK

Events outside the control of a corporation can affect the firm and its financing decisions. For example, a change in the interest rate can suddenly make borrowing money very inexpensive or very costly. From 1975 to 1995, interest rates in the United States were as high as 15 percent and as low as 3 percent. Many economic factors, such as changes in the price of oil or the price of foreign currency, can affect businesses as well.
Corporate financial managers need to make sure that potential economic fluctuations do not threaten the firm. A variety of tools, known as derivatives, help manage the risk of such events occurring. Four important kinds of derivatives include (1) futures, (2) forwards, (3) options, and (4) swaps. Futures are promises to buy or sell something in the future at a price that is agreed upon today. For example, a candy manufacturer might commit to purchasing a specified quantity of cocoa at a specified price from the producer in six months. Futures are traded on organized futures exchanges, such as the Chicago Mercantile Exchange or the Chicago Board of Trade. Forwards are similar to futures, but they are arranged directly between a firm and a bank. Options give a firm the right to buy or sell something in the future at a price that is agreed upon today. For example, if the candy-manufacturer does not know how much cocoa will be needed in six months, it could take out an option to buy cocoa at a certain price. Swaps involve firms swapping one set of payments for another. For example, an American firm may agree to make a series of dollar payments to a Japanese bank, while the bank in return promises to make a series of yen payments.
Derivatives are very popular. For example, worldwide trading of futures amounts to about $35 trillion a year. Most firms use derivatives to reduce risk, but some use them to speculate by buying and selling derivatives in hopes of earning a profit. When these speculations don't work out, losses can be substantial. For example, the United Kingdom's Barings', one of the world's oldest banks, collapsed in 1995 when futures speculation by one of its traders in Singapore resulted in losses of over $1 billion.
Methods of corporate finance continually evolve as financial managers invent new ways to raise money and avoid risk. Smart investment and financing decisions are crucial to a firm's success.

Source : Microsoft ® Encarta ® 2006.

RAISING MONEY FOR INVESTMENTS

Investments require cash. There are three common ways a corporation may be able to raise this cash: (1) by paying smaller dividends, (2) by borrowing, or (3) by selling more stock. Each method has advantages and disadvantages.
A firm can finance projects by paying smaller dividends. By paying out less of its profits in dividends, the company can keep more of its profits as retained earnings and use them to fund its investments. Using retained earnings to finance projects appeals to managers because they can avoid paying interest. However, the shareholders may not like it if their dividend becomes smaller. Also, sometimes the firm needs more money for a particular project than it has available in retained earnings.
A company can also choose to borrow money to fund its projects. A firm can either borrow from a bank or directly from investors by issuing bonds. Although a firm must pay interest if it borrows money, it can deduct the interest from its profits and therefore pay less in taxes. However, there are limits to how much a firm can borrow, and too much borrowing could lead to bankruptcy.
Selling stock is a third way companies can raise funds. Unlike a loan, the funds received from the sale of stock belong to the company and do not have to be repaid. As a consequence, the firm does not have the expense of paying interest. However, the firm must still earn a certain return on its investment to obtain the cash to pay dividends or devote to retained earnings. Businesses also may not want to issue stock because the costs of issuing stock, such as fees for legal and banking services, are usually higher than for issuing bonds.
A financial manager must consider factors other than cost when deciding how to raise money. For example, if a firm tries to raise new funds, the public will speculate about the company's plans. If investors think the plans are a bad idea the company's stock price could fall.
International financial markets have become increasingly important sources of funds. United States firms frequently raise money in overseas financial centers such as London or Tokyo. Loans from abroad often have a lower interest cost to domestic U.S. corporations because foreign banks are not subject to the restrictions of the U.S. Federal Reserve System. For example, instead of borrowing dollars from a bank in the United States, American firms may borrow dollars that have been deposited in London or Tokyo banks. These are known as Eurodollars. Eurodollars are U.S. dollars held in banks outside of the United States. Similarly, instead of issuing bonds in the United States, U.S. firms may issue bonds in a foreign country to a group of international investors. These are called Eurobonds. Eurobonds are bonds sold outside the country whose currency is used to write the bond. For example, a bond denominated in U.S. dollars issued by a Japanese bank is a Eurobond.

Source : Microsoft ® Encarta ® 2006.

INVESTMENT DECISIONS

Corporate investment decisions often involve substantial amounts of money. Many investment decisions are also difficult to reverse and can affect the company's business far into the future. For example, in 1966 Boeing Company, an airplane manufacturer, decided to invest about $1 billion to develop the 747 jumbo jet. This investment delivered long-term benefits as the company was still selling the jets 30 years later. It was also able to take advantage of its experience with the 747 to develop new kinds of aircraft.
A business regards an investment as successful if it increases the wealth of the shareholders who own the company. This is accomplished when the firm earns profits and passes them back to the shareholders either in the form of dividends or as increases in the value or price of the stock. Dividends are a share of profits paid to shareholders as cash or as additional shares of stock. Profits or earnings that are not distributed to shareholders stay with the firm and are called retained earnings. These earnings influence the value of the stock because they increase the total asset value, or total amount of assets, of the firm. Because the value of their company's possessions has increased, the shareholders own stock that is worth more. If the firm realizes retained earnings of $1 per common share, it will add $1 to the value of each share. However, since many forces influence stock prices, the actual price of the stock will probably fluctuate and be more or less than the additional $1 per share.
Investment decisions—that is, deciding what projects to invest in—are based on two criteria: the expected rate of return and the risk or uncertainty of achieving the expected rate of return. The project's rate of return, or simply its return, is a measurement of its profit. A financial manager estimates the return based on forecasts of potential sales, expenses, and profits that might occur from an investment. For example, a company might have an opportunity to invest in a project that costs $100 million. If the project is expected to produce a profit of $10 million, this equals a rate of return of 10 percent on the investment of $100 million.
Before evaluating the rate of return, a financial manager must also consider the return's risk. The manager must consider the chances of earning or losing money on the project and how great the profits or losses could be. For example, if the company has a 90 percent chance of earning the $10 million return, the risk is rather small. On the other hand, if the company has only a 5 percent chance of earning the $10 million return, the project is very risky. Expected rates of return are higher with risky projects because they must compensate for the project's uncertainty to attract investors. Although their returns are not guaranteed, higher risk projects have a potential for greater profit.
Whether or not the company should go ahead with the project depends on what the $100 million could earn if invested differently. The company should accept any project that is expected to earn a higher return than shareholders can earn with another investment. For example, the shareholders could invest their $100 million by buying real estate. If the shareholders could earn a 20 percent return on their real estate investment, they are giving up that opportunity to invest in the company. In other words, 20 percent is the cost of investing their capital in the project, or the cost of capital. The firm should only accept projects whose expected return exceeds the shareholder's cost of capital.
In addition to investing in projects, firms also buy and sell entire businesses. Sometimes this takes place with a mutual agreement to merge or combine two companies into one. In other cases one firm, the buying firm, goes against the wishes of another firm's management, the target firm, and attempts a takeover. For example, a company can appeal directly to the target firm's shareholders by offering to buy their stock. If the buying firm acquires enough of the target firm's stock, it can control the target firm's activities.

Source : Microsoft ® Encarta ® 2006.

CORPORATE OWNERSHIP

Small businesses may be owned by a single individual, but major corporations are far too large to be owned in this way. Instead corporations are owned by many people, called shareholders, who own shares of stock. Investors purchase stock because it allows them to share in the company's profits, although there are no guarantees that the company will be successful. Each share of stock represents ownership of a portion of the firm and its possessions, or assets. For example, Exxon Corporation has about 600,000 shareholders, who together own a total of about 1.2 billion shares of stock.
Shareholders who possess a large number of shares own a larger portion of the company than those who possess only a few shares. For example, an individual who owns one share of Exxon stock owns just under one-billionth of the company. At the other extreme, a large financial institution, such as an insurance company or a company that manages investments, may own several million shares of Exxon stock. About half the shares of large corporations are owned directly by individuals. The other half are owned by financial institutions.
Shares of stock are bought and sold on a number of stock exchanges. For example, Exxon's shares are regularly bought and sold on the New York Stock Exchange. At the end of 1995 Exxon's shares were priced at $80 each. At that price it would have cost about $100 billion to buy all of Exxon's stock.
Although a corporation's shareholders own the company, they do not manage it. Instead they elect a board of directors who hire key company executives and review their job performance.
Source : Microsoft ® Encarta ® 2006.

Corporate Finance

Corporate Finance branch of economics concerned with how businesses raise and spend their money. Companies spend or invest funds in projects that might make the firm more profitable, such as a new factory or an improved product. Corporate finance involves selecting projects that maximize profits and make the best use of a company's funds. Sometimes businesses can fund these projects on their own. Other times businesses must raise funds from outside the company. Corporate finance also involves finding the best way for businesses to pay for their projects.

Source : Microsoft ® Encarta ® 2006.

International Finance

International Finance, systems for moving money and credit across national boundaries.
For information on: • making credit available to promote trade, reconstruction, or development, see Credit: International Credit;International Monetary Fund; Letter of Credit • converting payments and debts in different currencies, see Foreign Exchange • measure of the state of a nation's international finances, see Balance of Payments • banks that operate internationally, see Banking: International Banking • raising money internationally, see Corporate Finance: Raising Money for Investments

Source : Microsoft ® Encarta ® 2006.

HOW PUBLIC FINANCE AFFECTS THE ECONOMY

Government spending and taxation directly affect the overall performance of the economy. For example, if the government increases spending to build a new highway, construction of the highway will create jobs. Jobs create income that people spend on purchases, and the economy tends to grow. The opposite happens when the government increases taxes. Households and businesses have less of their income to spend, they purchase fewer goods, and the economy tends to shrink. A government's fiscal policy is the way the government spends and taxes to influence the performance of the economy.
When the government spends more than it receives, it runs a deficit. Governments finance deficits by borrowing money. Deficit spending—that is, spending funds obtained by borrowing instead of taxation—can be helpful for the economy. For example, when unemployment is high, the government can undertake projects that use workers who would otherwise be idle. The economy will then expand because more money is being pumped into it. However, deficit spending also can harm the economy. When unemployment is low, a deficit may result in rising prices, or inflation. The additional government spending creates more competition for scarce workers and resources and this inflates wages and prices.
The total of all federal government deficits forms the national debt. The size of the U.S. national debt has grown during the 20th century. The debt equaled about $25 billion in 1919 after World War I and about $260 billion in 1945 after World War II. In 1970 the debt stood at about $380 billion. Ten years later, the national debt had soared to nearly $1 trillion. In 2000 the national debt totaled $5.7 trillion.
Many people are concerned about the size of the U.S. national debt. They fear that a large amount of debt harms the economy and feel that the money used to pay interest on the debt could be better spent on other uses. Some people are also concerned about the ability of future generations to pay back the debt. However, many economists argue that the size of the debt is misleading. They point out that an important measure of the severity of a nation's debt is its size as a percentage of the nation's gross domestic product. Based on this measurement, the national debt of the United States during the mid-1990s was about half the size of the U.S. debt at the end of World War II in 1945. Other economists contend that when the balance of the debt is compared between years it does not account for the effects of inflation, which makes balances from later years appear larger.

Contributed By:Robert H. Haveman

Source : Microsoft ® Encarta ® 2006.

PUBLIC REVENUE

Governments must have funds, or revenue, to pay for their activities. Governments generate some revenue by charging fees for the services they provide, such as entrance fees at national parks or tolls for using a highway. However, most government revenue comes from taxes, such as income taxes, capital taxes, and sales and excise taxes.
An important source of tax revenue in most industrialized countries is the income or payroll tax, also known as the personal income tax. Income taxes are imposed on labor or activities that generate income, such as wages or salaries. In the United States, income taxes account for about half of the total revenue of local, state, and federal governments combined. The federal government, many state governments, and some local governments levy personal income taxes.
Another important source of government revenue is the capital tax. Capital includes items or facilities that generate profits, such as factories, business machinery, and real estate. Some types of capital taxes are known as “profits” taxes. One kind of capital tax used by the federal government in the United States is the corporate income tax. A property tax is a capital tax used by state and local governments. Property taxes are levied on items such as houses or boats.
Sales and excise taxes are also a major source of government tax revenue. Many state and local governments levy a sales tax on the purchase of certain items. Consumers usually pay a percentage of the sales price as the tax. Excise taxes are used by all levels of government. An excise tax is levied on a specific product, such as alcohol, cigarettes, or gasoline. The tax is usually included in the purchase price.
In Canada and many European, South American, and Asian countries, a value-added tax (VAT) provides significant revenue. The VAT is levied on the value added to a product during production as its components are assembled into final goods. For example, a clothing manufacturer might spend $500 on fabric, thread, zippers, and other goods required to make dresses. The manufacturer then adds $1,000 to cover the costs of labor and the use of machines and equipment and sells the dresses for a total of $1,500. The value-added tax is paid on this $1,000.

Contributed By:Robert H. Haveman
Source : Microsoft ® Encarta ® 2006.

PUBLIC SPENDING

Each year national, state, and local governments create a budget to determine how much money they will spend during the upcoming year. The budget determines which public goods to produce, which spillovers to correct, and how much assistance to provide to financially disadvantaged people. The chief administrator of the government—such as the president, prime minister, governor, or mayor—proposes the budget. However, the legislature—such as the congress, parliament, state legislature, or city council—ultimately must pass the budget. The legislature often changes the size and composition of the budget, but it must not make changes that the chief administrator will reject and veto.
Government spending takes two forms: exhaustive spending and transfer spending. Exhaustive spending refers to purchases made by a government for the production of public goods. For example, to construct a new harbor the government buys and uses resources from the economy, such as labor and raw materials. In transfer spending the government transfers income to people to help them support themselves. Transfers can be one of two kinds: cash or in-kind. Cash transfers are cash payments, such as social security checks and welfare payments. In-kind transfers involve no cash payments but instead transfer goods or services to recipients. Examples of in-kind transfers include food stamp coupons and Medicare. Recipients of food stamp coupons exchange the coupons for groceries.
As recently as the 1960s most spending by the U.S. government was exhaustive spending for items such as national defense, roads, airports, schools, and parks. In the mid-1960s transfer spending began to grow rapidly. In the United States today, over 50 percent of federal government spending is for cash and in-kind transfers. About 20 percent of state and local government spending is transfer spending.

Contributed By:Robert H. Haveman
Source : Microsoft ® Encarta ® 2006.

WHY PUBLIC FINANCE IS NEEDED

Governments provide public goods—government-financed items and services such as roads, military forces, lighthouses, and street lights. Private citizens would not voluntarily pay for these services, and therefore businesses have no incentive to produce them.
Public finance also enables governments to correct or offset undesirable side effects of a market economy. These side effects are called spillovers or externalities. For example, households and industries may generate pollution and release it into the environment without considering the adverse effect pollution has on others. If it costs less to pollute than not to, people and businesses have a financial incentive to continue polluting. Pollution is a spillover because it affects people who are not responsible for it. To correct a spillover, governments can encourage or restrict certain activities. For example, governments can sponsor recycling programs to encourage less pollution, pass laws that restrict pollution, or impose charges or taxes on activities that cause pollution.
Public finance provides government programs that moderate the incomes of the wealthy and the poor. These programs include social security, welfare, and other social programs. For example, some elderly people or people with disabilities require financial assistance because they cannot work. Governments redistribute income by collecting taxes from their wealthier citizens to provide resources for their needy ones. The taxes fund programs that help support people with low incomes.

Contributed By:Robert H. Haveman
Source : Microsoft ® Encarta ® 2006.

Public Finance

Public Finance, field of economics concerned with how governments raise money, how that money is spent, and the effects of these activities on the economy and on society. Public finance studies how governments at all levels—national, state, and local—provide the public with desired services and how they secure the financial resources to pay for these services.
In many industrialized countries, spending and taxation by the government form a large portion of the nation's total economic activity. For example, total government spending in the United States equals about 40 percent of the nation's gross domestic product—that is, the value of all the goods and services produced within the United States in one year (see Gross National Product).

Contributed By:Robert H. Haveman
Source : Microsoft ® Encarta ® 2006.