Top Ten Finance Concepts
Top Ten Finance concepts that bogged you down during your MBA.
By Adhisma Das
Written by Adhisma Das, a student in my Risk management classes at the MBA program at SP Jain. Adhisma looks at the top ten finance concepts that stump business school students during their MBA degree.
Finance Fobia! No, that is not a typo; the word ‘phobia’ was intended to be spelt that way.
Why ‘F’ you ask? Well, it’s not for the sake of sweet alliteration. And if you are thinking on the lines of the mundane – ‘F’ for Finance, ‘F’ for Fobia; you are absolutely wrong! Well, yes, the ‘F’ bit is correct, but it stands for the numerous F grades that students in my MBA course earn in the subject. Not a surprise actually. How many graduate high school students do you know are able to reconcile their bank accounts, including interest allocations or are able to compare two different loans that might be on offer to them? Aren’t these concepts basic requirements for managing ones personal finances? Fact is they are simple mathematical concepts, bordering on common sense. Yet, students easily get bogged down by them. In this article we pick 10 such finance concepts that were all-time pet peeves for the students.
- Time Value of Money: According to this concept the worth of, say a dollar invested today, is more than the same one dollar invested tomorrow. This is the basic concept out of which concepts like Present Value, Future Value, Compounding and Discounting stem. It is obvious that failing to understand or rather remember this concept leads to a lot of heart burn for students!
- Statistical distributions and their role in Finance: Market returns are uncertain and known to be risky. Therefore, probability distributions are used to depict asset return sensitivity, assuming that the asset return is a random variable. Uniform, Poisson, Binomial and the omnipresent Normal distributions and parameters like mean and standard deviation that describe them need to be understood at a basic and applied level. Understanding these concepts and subsequently applying them to finance using tools such as Monte Carlo Simulation is an area where many students fail.
- Probability: Probability describes the odds of an event happening as a percentage and is heavily used in concepts like credit worthiness and risk. In order to make any informed, consistent investment decision that manages expectations in an unpredictable environment, tools of probability theory are used.
- Risk and Reward: Statistics and probability lead us to the intriguing concept of the risk – reward relationship. Risk and reward are found to be correlated. A high probability of losing money implies that you will earn more money through a higher rate of return, i.e. the riskier the investment the greater the potential reward. This leads us to further concepts like the trade off between risk and reward and how to maximize reward while at the same time minimize the risk of loss.
- Opportunity Cost: When one invests and gets the same amount back, you understand that it is neither a loss nor a gain. When one invests and in return gets an amount less than the amount invested, that is a loss; greater than amount invested, a profit. But most of my classmates were puzzled when asked whether there is a cost if one does not invest in a venture or an asset? Shouldn’t the un selected option be ignored? Why does that option concern us and more importantly, how can we measure our loss and gain on the option when we have not invested in it? This is the concept of Opportunity Cost; i.e. the notional loss that we bear by foregoing gains from an option that we have not invested in. This was something which was pretty hard to digest for students from non-finance backgrounds.
- Sunk Cost: These are costs that have already been incurred and cannot be recovered. According to traditional finance these should not be considered while taking a decision to continue with a particular investment or not. That is, one must not waste more money on a bad investment, i.e. “don’t throw good money after bad”. The initial invested amount should be considered as “sunk”. The confusion for students was: When are these costs to be considered? Should they never be considered at all? How does one decide whether these costs are irrecoverable or not, i.e. truly defined as sunk costs?
- Mental Accounting and Fungibility: Mental accounting is closely related to human behavior, where what one does with his money is largely governed by the source of that money and vice verse. Humans tend to compartmentalize their money, say while taking an investment decision and at first glance this seems logical. But, while studying finance, we came across the fungible property of money and that there is no point in segmenting funds and saving up money for an investment when you are neck-deep in debt on the other hand.
- Risk and its management: Risk is a word which is so freely used in our day- to-day lives that its importance in finance, i.e. the process of quantifying it and thereby effectively managing it, boggles the minds of most students trying to study finance. This probably stems from the mentality that considers all investments as gambles, where the greed of huge unexpected gains makes one choose to ignore risk and its management.
- Asset Valuations: Valuing a portfolio, firm, investment; the various methods available; when to use what and why, causes a great deal of anguish amongst students of finance. And when the portfolio being valued includes complicated derivative assets like options and swaps or intangibles, this anguish is multiplied a few times more.
- Optimum Capital Structure: Capital structure comprises of equity (our own money) and debt (other people’s money). A combination of the two gives the firm a value, and a firm always aspires to achieve that optimal ratio which maximizes its value. On the face on it, debt may significantly reduce the cost of capital due to tax deductibility. So, should a firm employ debt alone and no equity? This may not be feasible, because, debt also increases the risk of the firm because of an increase in fixed costs, i.e. interest expenses. So how does one achieve this optimal structure?
These were some of the concepts in finance that students found confusing. Of course this is not an exhaustive list and is greatly dependent on other factors like a student’s prior academic and professional background. There may be students who only partly agree with this list and some who do not agree at all!