This chapter summarizes the basic concepts and techniques that are used throughout the other chapters. We first look at the time value of money and common interest rate calculations. We then recapitulate how a firm’s accounting system records and reports financial data about the firm. An example illustrates how these techniques and data can be used for investment decisions. Subsequently, we introduce the economic concepts of utility and risk aversion, and their use in financial decision making. The chapter concludes with a brief look at the role of financial markets, both from a theoretical and practical perspective.

The time value of money

Sources of time value

The time value of money can be summarized in the simple statement that €1 now has a higher value than €1 later. The time value of money springs from two sources: time preference and productive investment opportunities. Time preference, or ‘human impatience’ as the economist Fisher (1930) calls it, is the preference for present rather than future consumption. This is more than just impatience. Some consumption cannot be postponed for very long, for example the necessities of life. For other goods, the time pattern of people’s consumptive needs is almost inversely related to the time pattern of their incomes. People want to buy houses when they are young and starting families, but if they had to accumulate the necessary money by saving, only a few could afford to buy a house before retirement age. Moreover, postponing consumption involves risk. Even if the future money is certain, the beneficiary, or the consumptive opportunity, may no longer be around. As a result, people require a compensation for postponing consumption and are willing to pay a premium to advance it.