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The Rules of Finance

The goal of finance is to find the optimal enterprise solutions that balance expected return and expected risk. We can find and implement the optimal solutions by using financial information, tools, and models. In finance we want to reduce expected risk and increase expected return, but since getting rid of risk entirely is impossible we look for the best combination of the two. Even though a riskless venture is not possible, Harry Markowitz, a talented economist, brought forth (to our delight) the efficient frontier theory. The purpose of Markowitz theory is simply to find the obtainable enterprises that have the highest expected return for any given risk. This set of enterprises creates an optimal portfolio.

What does return mean? It is the expected future cash flow from an investment. Why? Because the sole reason we invest is because we want that cash! If we really want cash, then why can’t we just focus on that? You might ask. Well, that is when risk comes into the equation. Risk, is the always present deviation that we expect from those good-looking future cash flows.

The Tools of Finance In order to determine the appropriate amount of expected return, given any level of risk, we must use the most important and widely used tool of finance: Discounted Cash Flows. The projected cash flows are our measure of value, and the discount rate that we use on these cash flows takes care of the expected risk. The result is a number that tells us everything

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