In the previous chapter we explored how to determine the interest rates (rates of return) for risk-fee assets (i.e., investments with no default risk); however, individuals and investment professionals invest their wealth in not only risk-free assets, but also risky assets. There are a great number of risky assets, such as individual stocks, that individuals can potentially invest in, and thus individuals can form a portfolio of different assets. In addition to choosing which assets to invest in, individuals must also choose how much to invest in each asset. The process through which people choose assets to invest their wealth in is called portfolio selection.

In previous chapters, we introduced the fundamental principles behind understanding the value of financial investments, such as stocks, bonds, and options. However, many of these investments (such as shares of stock or bonds issued by a company or call options that allow the holder to purchase shares of a company’s stock) are based on specific companies. To fully understand such investments, it is necessary to better understand the companies that they are based on. In Chapter 8 we examined company financial statements as a first step toward analyzing companies in more detail. We now expand upon this and explore how the information from financial statements can be used to estimate the economic value of a company.

In this chapter we focus on further developing and applying our valuation tools to better understand company value. We begin by taking the perspective of an observer examining a company from the “outside,” that is, someone who cannot influence the way a company is run. In other words, given how a company is being managed by its current managers, what should its value be? Starting in the next chapter, we will consider the perspective of a manager from within a company, and determine how the actions of those running a company can affect its value.

This chapter reviews research on social cognition and age. This covers self-focused processes, including self-referencing and memory as well as own-age bias and stereotype threat and stigma. Processes focused on other people are also reviewed, including moral judgment, empathy, theory of mind, social interactions and impression formation, memory for impressions, and trust.

In this chapter we review an important source of information about companies: financial statements. Financial statements are reports published by businesses and other organizations that provide investors and other stakeholders with information about a firm’s assets, liabilities, existing and potential cash flows, and so on. The core financial statements, which are usually published quarterly and annually, are the balance sheet, the income statement, and the statement of cash flows. Financial statements provide information about a firm’s current and past financial state, information that is key in figuring out a firm’s current economic value and the outlook on how the firm may perform in the future.

In the previous chapter we focused on decisions within companies, and discussed decision rules that managers can follow to choose investment projects. A key takeaway is that managers should make project decisions that increase the value of the company. In this chapter, we explore how organization structure can support decision making that increases value. We also consider how in some circumstances it can cause poor decisions to be made that disadvantage the firm.

Many firms separate ownership and control—the people who run companies and make decisions (referred to as agents) are not always the same people who own the companies (known as principals). This separation offers many benefits, helping to guide companies toward optimal investment and operating decisions. However, it can also result in bad decisions being made. For example, managers and other stakeholders may have their own interests and take actions that benefit themselves but not the company.

In this chapter we explore the global financial system, which encompasses the institutions that carry out the financial decisions of households, firms, and governments. Up to this point in the book, we have presented principles, concepts, models, and analytical tools that are valid no matter what the institutional structure. In most cases the exact details of the institutions did not matter—for example, whether a company borrowed money from a small regional bank or a large international bank. However, in practice, the institutional structure does matter and you need to understand why and how in order to know what tools are best for financial decision making. There is a wide variety of different financial institutions across the globe that make up the financial system, and the nature and details of these institutions vary across different countries and also change over time. How can we understand why there are so many different financial institutions and the roles they play, when they are constantly changing?

This chapter opens with a list of scenarios that are all examples of financial decisions. It introduces a scientific approach to analyzing and making such decisions. We first look at what finance is and at the various contributions a study of finance can make to individuals, firms, and societies. Next, we look at a general overview of the financial system and the roles that various actors play within it. We then explore ten unifying principles from which all the tools and techniques of modern finance can be derived.

In Chapter 5 we introduced derivatives, which are financial instruments whose price is based on (i.e., derived from) the value of one or more other assets called underlying assets. These underlying assets may be equity securities, fixed-income securities, foreign currencies, or commodities such as gold and silver. The value of a derivative is reliant on the movement of the value of the underlying asset; for example, a derivative might promise to pay you a specified amount of money if the price of another asset, such as a stock, goes above a certain level.

Throughout Part II we have focused on determining and understanding the value within firms on both sides of the balance sheet. Chapters 9 and 10 focus on valuing the assets of the firm—understanding how to value the entire firm (its total assets) as well as individual projects undertaken within the firm. Chapter 13 focuses on understanding the value of the liabilities and equity of the firm, and how this side of the balance sheet can be structured through a firm’s capital structure. Our workhorse tool set for analyzing these issues was discounted cash flow (DCF) analysis. In this chapter, we introduce a different valuation tool, option pricing analysis, as an improved valuation framework that allows us to explore these topics.

This chapter reviews findings about the structural changes to the brain, considering effects on both gray matter and white matter and relationships between these measures and behavior. It also reviews research on changes with age to the connectivity of the brain and the default mode network. Findings related to effects of aging on perception and sensation as well as neurotransmitters are presented. The chapter ends with extensive coverage of individual difference factors, including genetic influences, intelligence, cognitive reserve, bilingualism, personality, and stress.

In the previous chapters we introduced some of the conceptual underpinnings of finance. To engage in any financial transaction, however, requires interacting with some part of the financial system. For example, if you want to deposit cash into a savings account, you will have to do so at a bank.

The financial system refers to the markets and institutions used to carry out the decisions that households, business firms, and governments make about managing their money and other financial assets.