Corporate Finance: Investment Decisions

• Companies produce goods and services bought by economic agents.
• Companies need assets, both tangible (machinery, buildings) and intangible (patents, brand names, customer satisfaction).
• Funds used to buy assets are the company's financing.
• Financial managers make investment and financing decisions.
• Investment decisions determine what to invest in.
• Financing decisions determine how to raise money for investments.
• Corporate finance studies corporate financial decisions and analytical tools.
• Investment decisions involve buying assets for business operations.
• These are also called capital budgeting or capital expenditure (CAPEX) decisions.
• Investment decisions can have long-term (building a power plant) or short-term consequences (advertising).
• Companies thrive by launching new products/services, but these require costly investments.
• Facebook (Meta) invested $60 million to acquire Pebbles.
• Ford plans to invest $1 billion to build an assembly plant in Mexico.
• A financial manager raises money for investments.
• Companies can offer investors shares of future profits or promise repayment with interest.
• Shares are equity and promises of repayment are liabilities.
• Investment involves acquiring real assets.
• Financing involves issuing financial assets to investors.
• John Deere has maintained credit lines with banks allowing it to borrow up to $7.2 Billion.
• LVMH repaid €750 million in debt issued in 2009 and 2011.
• Walmart raised its annual dividend to $2.00 a share.

Investment or Financing Decisions

• Intel spends $7 billion to develop a new microprocessor factory (investment).
• BMW borrows 350 million euros from Deutsche Bank (financing).
• Royal Dutch Shell builds a pipeline to bring natural gas onshore (investment).
• Avon spends €200 million to launch a new cosmetics line (investment).
• Pfizer issues new shares to buy a biotech company (both financing and investment).

Corporations and Goals

• A corporation is a legal entity formed under law with articles of incorporation which set out the purpose of the business and how it is to be governed and operated.
• A corporation is owned by shareholders but is legally distinct.
• Shareholders have limited liability, meaning they are not personally responsible for the corporation's debt.
• Corporations have separation of ownership and control.
• Shareholders have voting rights and elect a board of directors.
• The board appoints and advises top managers (CEOs) and monitors performance.
• Smaller businesses are usually sole proprietorships. In Spain, they are called "autónomos".
• Some businesses voluntarily decide to hold unlimited liability. They are called partnerships. In Spain, they are called Sociedades Colectivas or Comunidades de Bienes.
• Other companies may have unlimited liability but only contribute to funding having limited liability. These hybrid forms of businesses are limited partnerships. In Spain, they are called Sociedades Comanditarias.
• There are also other legal forms.

Measuring a Corporation's Activity

• To measure a corporation's activities, look at:
• Market capitalization
• Assets
• Sales or revenue
• Earnings, profit, or net income
• Number of employees
• A large market cap does not necessarily mean a large value of sales

Financial Manager Roles

• CEO: Chief executive officer
• CFO: Chief financial officer or financial manager
• COO: Chief operating officer
• Most corporations have a CFO who oversees all financial staff.
• Below the CFO are a treasurer and a controller.
• The treasurer manages cash, raises capital, and maintains bank relationships
• The controller prepares financial statements, manages budgets/accounting, and handles taxes.
• A treasurer manages capital, a controller ensures efficient money use.
• Investment projects tie into product development, production, and marketing.
• Financial managers stand between the firm and outside investors.
• Financial managers engage in the firm's operations and deals with financial institutions, investors, and markets.
• For small corporations, shareholders and management may overlap.
• Delegation works if shareholders have a common goal.
• Shareholders can agree to maximize the market value of their investment.
• This goal works if shareholders can access well-functioning financial markets.

Profit Maximization

• Profit maximization is not the main goal of a corporation.
• A company can increase current profits by cutting wasteful costs.
• Shareholders don't want higher short-term profits if long-term profits will be damaged.
• A company may increase future profits by cutting this year's dividend and investing the freed-up cash in the firm.
• Instead, maximizing, or at least maintaining, value is necessary for long-run survival.
• Consider if an airline corporation should purchase new planes:
• If the planes provide 20% rate of return, then shareholders benefit from the company keeping cash and investing in new planes
• If those planes offer only 5% return, then stockholders benefit more from the cash and without the project.
• The minimum acceptable rate of return is the hurdle rate or opportunity cost of capital. It depends on alternative investment opportunities.
• Corporations increase value by accepting projects that earn more than the opportunity cost of capital.
• The opportunity cost of capital is based on the risk of the investment project needing to trade off higher returns.
• Financial markets share the investors’ opportunity cost of capital to managers.
• Managers can observe the opportunity cost of capital for safe investments and must estimate risky investments.

Agency Problems

• Managers may act in their own interests rather than maximize shareholder value.
• Control is delegated to the board of directors, which delegates further control to managers.
• Separation of ownership/control leads to agency problems.
• Losses from agency problems are called agency costs.
• Corporations can mitigate agency problems through:
• Internal controls
• Executive compensation (usually in stocks)
• Corporate governance (laws, regulations, institutions)
• Shareholders want managers to maximize share value.
• Value maximization may conflict with the interests of other stakeholders.
• Successful firms have satisfied customers and loyal employees.
• Sometimes corporate decisions ignore society, causing concerns about climate change and justice with scandals.

Socially Responsible Investment (SRI)

• Socially responsible investment (SRI) is becoming widespread.
• SRI prioritizes decisions that benefit shareholders and society
• SRI focuses on Environmental, Social, and Governance (ESG) criteria.
• SRI enables evaluating companies that care for the environment, consumer protection, and human rights.
• Financial returns are secondary to moral values.
• Investors reduce the cost of capital for businesses with positive social side effects.
• Investors increases the cost of capital to firms that harm society, needing a higher return.
• SRI investment criteria:
• Exclude unacceptable activities
• Select firms meeting an ESG benchmark
• Assess compliance of ESG norms
• Incorporate ESG info
• Invest in firms with sustainable behavior
• Generate social or environmental effects
• Actively engage for best ESG practices
• The market for sustainable bonds is similar to loans.
• Sustainable bonds rely on meeting sustainability criteria and using proceeds for sustainable investments.
  • Green bonds finance climate or environmental projects.
  • Blue bonds finance marine and ocean projects
  • Social bonds finance projects with positive social outcome.

Financial Markets

• Financial managers need to understand current investment needs satisfied by the situation of financial markets and preferences.
• Corporations obtain financing through financial markets and institutions.
• A financial market is a system of individuals, institutions, and instruments bringing together agents with investment needs and agents with excess funds.
• It facilitates the flow of funds between individuals, businesses, and governments.
• A financial market is where securities are issued and traded.
• A security is a traded financial asset.
  • The stock market is the most crucial financial market for corporations.

Types of Financial Markets

• Primary vs. Secondary:
  • Issuers create securities and obtain cash in primary markets.
  • Securities trade between investors without the issuer in secondary markets.
• Equity vs. Fixed-income:
  • Equity markets trade company shares.
  • Fixed-income markets issue/exchange debt securities (bonds).
• Organized vs. Over-the-Counter (OTC):
• Organized markets offer centralized, safe trading.
• OTC markets lack a central exchange system and regulator.
• Other markets:
• Foreign exchange (currencies)
• Commodities (corn, oil)
• Derivatives (securities based on other assets such as oil) Financial institutions raise money from investors to finance individuals, companies, and organizations.
• They raise money through deposits or insurance and invest in stocks, bonds, or loans.
• Traditional companies invest in plant and equipment.

Financial Intermediaries and Institutions

• Mutual funds
• Pension funds
• Hedge funds
• Insurance companies
• Commercial banks
• Investment banks
• Public institutions (central banks, regulators)

Functions of Financial Markets

1. Transfer of resources across time: enable agents that require funds and agents with funds - If you don’t have money today, say to buy a car, you can borrow money from the bank and pay off the loan later.
2. Risk transfer and diversification: investors reduce risk through a variety of securities. - If you buy these funds, you are insulated from the company-specific risks of companies that are part of a given stock-market index. - When you buy car insurance, you reduce the risk of a material loss from an accident by paying a premium. - Consider also a wheat farmer and a bakery that are exposed to fluctuations in the price of wheat when the bakery can agree with the farmer to buy wheat in the future at a fixed price. This is essentially how commodities markets work
3. Liquidity: investments can be easily converted to cash. - Liquid financial markets guarantee that if you hold a security, you can, at almost no cost, sell it in the market when you have a sudden need for funds, either for some unexpected expenditure or for an investment opportunity.
4. Payment mechanism: agents can transfer funds without physical proximity. Examples include transfer systems, checking accounts, credit cards, payment systems with smartphones
5. Information provision: inform investors' cost of capital and value creation of the investment - Stock prices summarizes the investors’ collective assessment of how well a company is doing, both its current performance and its prospects. - An increase in stock price sends a positive signal from investors to managers and is stronger when managers have compensation tied to stock price

Instruments for Corporate Financing

• Corporations issue claims on future cash flows through equity-like and debt-like securities.

Equity vs. Debt

• Equity: financial contract that is entitled to ownership with voting rights and entitled to dividends
• Debt: financial contract that is entitled to a fixed cash flow payment for a set period

Difference Between Debt and Equity

• Cash flow rights
  • Debt holders have priority in repayment
  • Shareholders have a residual claim on the corporations cash flow
• Control Rights
  • Debt holders have no control rights unless if the company liquidates and the board of directors are responsible for control
• Value on equity or debt must reflect on subjective evaluations for cash flow claims underlying values
• Instruments determine a value of debt and equity to determine the total value of a firm
• Financial systems in the economy have markets and financial intermediaries.
• Markets and institutions have different operations.
• A financial market trades financial assets.
• Physical location is irrelevant.

Types of Assets

• Assets are expected economic resources. Real assets (tangible and intangible) generate wealth.
• Tangible assets: buildings, equipment, inventory.
• Intangible assets: patents, copyrights, software. Financial assets are contracts that give the right to receive a future payment in the present.
• Every contract is an asset for somebody and liability for somebody else.

Types of Contracts

• Debt contracts offer a future stream of payments.
• Equity contracts (shares/stocks) offer profit sharing and corporate control via voting rights.
• Derivative contracts exchange financial assets at a fixed price.
• Securities are traded financial assets (e.g., stocks, bonds).

Main Operations

• Buy: to transfer wealth into the future while increasing value.
• Sell: to transform investment to cash and expect that asset to drop.

Types of Markets

• Fixed-income markets exchange debt securities (bonds).
• Equity markets trade shares. Ex. Bolsa de Madrid.
• Derivatives markets trade derivatives. Ex. Futures, Forwards, Options.
• Commodities markets involve trading tangible items.
• Foreign exchange markets exchange currencies.

Regulations

• Regulated markets have standardized operations. Ex. Stock exchanges, Futures, Public bond markets etc.
• OTC markets are unregulated.

Functions

• Primary markets issue assets and obtain funds.
• Secondary markets exchange assets and provide liquidity.
• Financial institutions provide services between finance and surplus of funds.
• They exchange assets, and then inter-mediate for individuals and companies.
• The funding is through selling insurance or equity with funds investing into, loans, stocks and bonds

Financial Institutions vs. Financial Markets

• In contrast to the financial markets where agents exchange assets among themselves in a direct manner. The intermediation service basis on raising money from individuals and companies and then provide financing to other individuals and companies using those funds.

Financial Institutions vs. Traditional Companies

• Traditional companies' funding is through equity (selling ownership) or debt (borrowing).

• Financial institutions invest their funds in financial assets: loans to businesses or individuals, stocks and bonds.

• A traditional company makes its main investments, in plant, property, equipment or other real assets.

• Commercial banks accept deposits and to provide financing to individuals and businesses by giving loans. Ex. Banco de Santander, LaCaixa, BBVA.

• Investment banks provide financing to companies by running the corporate financing processes: IPO , issuance of corporate bonds, mergers & acquisitions.

• Insurance companies provide services in reducing the risk of a material or monetary loss by charging premiums. For instance, the car insurance is a financial instrument.

• Mutual funds, pension funds and hedge funds collect funds from individuals and business and then, invest in a pool of financial assets

• Public institutions: Central banks, financial markets supervisor