A new Short Introduction to Corporate Finance book by Cambridge Judge Professor Raghavendra Rau simplifies an often intimidating subject into six basic ideas – all revolving around the principle of ‘no free lunch’.
Corporate finance is a topic many people find intimidating and impenetrable, a thicket of jargon that’s given rise to an army of deciphering accountants and other finance professionals.
A new book authored at Cambridge Judge Business School aims to cut through that fog of jargon by presenting corporate finance as six basic, easily understood ideas – all revolving around one “homespun” truth: “there is no free lunch in a competitive market”.
(Or, in jargon: “arbitrage is not possible in a perfectly competitive market”.)
“Most of finance is really not complex at all,” says Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge, whose Short Introduction to Corporate Finance has just been published by Cambridge University Press. “Everything in corporate finance can be explained by one or more of these six basic ideas.”
The six ideas are Net Present Value; Portfolio Theory and the Capital Asset Pricing Model; Capital Structure Theory; Option Pricing Theory; Asymmetric Information; and Market Efficiency. The latter five of the six were the subject of Nobel Prize-winning work. The book discusses why these ideas were so important, why they won Nobel Prizes, and how they all fit together.
A better understanding of these six ideas, says Professor Rau, can help individuals and businesses feel more confident in handling many elements of finance without resorting to costly financial advisors.
“If I want to get my car repaired, the more obscure the terms that the mechanic throws around, the happier I feel that I did not try to fix the car myself (and the more willing I would be to pay that big bill),” the book says. “In finance terms the more incomprehensible the jargon is, the less willing you are to handle your financial activities yourself.”
The six basic ideas of corporate finance:
- Net Present Value (NPV): Involves how, in making investment decisions, managers seek to maximise the NPV of the investment’s payoffs based on cash flows, value of the payoffs at a given point in time, and how to finance the investment.
- Portfolio Theory and the Capital Asset Pricing Model: Revolves around how an investment as part of a portfolio of investments compares to alternative possible investments a firm can make.
- Capital Structure Theory: Involves the forms of capital a firm chooses to raise, typically debt or equity, often influenced by the returns demanded by different types of investors.
- Option Pricing Theory: Concerns the range of investment decisions a firm makes, involving options to buy or sell an asset at a price fixed today.
- Asymmetric Information: Much like a used car salesman who knows the true service record of a vehicle better than a potential buyer, buyers and sellers of financial products don’t have identical information. This doesn’t always work in the seller’s favour, as a buyer can adjust an offered price to offset the disadvantage.
- Market efficiency: While efficient markets should fully reflect all available information, this is perhaps the most controversial idea in corporate finance – because market prices don’t always reflect cash flows and other factors that went into computing net present value.
A jargon-free example in the book on how the “no free lunch” principle affects Option Pricing Theory discusses the way some Michelin-starred restaurants charge a non-refundable booking fee if a diner fails to cancel with three days’ notice. The restaurant has the diner’s credit card details, so the diner has in effect bought an option to keep a reservation at the restaurant open. Similarly, the difference in price between a refundable and non-refundable hotel room is the value of the option to cancel.
So, if you’re confused about the difference between “the yield to maturity for bonds” and “the internal rate of return for investments”, rest assured that you’re not alone – as those phrases are examples of what the book calls the “sheer number of different terms for exactly the same thing” that help “completely baffle laypersons”.