Investment and Financing Decisions

Investment and Financing Decisions

• Companies produce goods and services
• Economic agents purchase these goods and services
• Companies invest in tangible (machinery, buildings) and intangible (patents, brand names, customer satisfaction) assets.
• Funds used to acquire assets represent a company's financing.
• Financial managers address investment ("What should we invest in?") and financing ("How do we raise funds?") questions.
• Corporate finance studies corporate financial decisions and analytical tools for decision-making.
• Investment decisions concern asset purchases for business operations, termed capital budgeting or CAPEX decisions.
• Decisions include long-term investments (e.g., power plant) and short-term (e.g., advertising).
• Companies thrive by launching new products/services, requiring substantial, risky investments.
• Meta invested $60 million in Pebbles which is an Israeli VR software developer.
• Ford plans a $1 billion investment for a Mexico assembly plant.
• Financing involves raising capital for investments and operations.
• Companies attract investors by offering future profit shares or repaying cash with interest.
• These claims represent either equity or liabilities.
• Investment involves acquiring real assets, while financing involves issuing financial assets.
• John Deere holds up to $7.2 billion in credit lines with banks.
• LVMH repaid a €750 million debt.
• Walmart increased annual dividends to $2.00 per share.
• Intel invests $7 billion in a new microprocessor factory.
• BMW borrows €350 million from Deutsche Bank.
• Royal Dutch Shell constructs an Australian natural gas pipeline.
• Avon spends €200 million on a new European cosmetics line.
• Pfizer issues shares to acquire a biotech company.

Corporations and Their Goals

• Corporations are legal entities formed under law, outlined by articles of incorporation.
• Corporations are owned by shareholders, they have limited liability, and are not personally liable for debts.
• Corporations separate ownership (shareholders) from control, shareholders have voting rights.
• A board of directors is elected to appoint managers (CEOs) and monitor their performance.
• Smaller companies are usually sole proprietorships and in Spain are called autónomos.
• Proprietors can voluntarily hold unlimited liability, known as partnerships (Sociedades Colectivas or Comunidades de Bienes in Spain).
• Limited partnerships include some partners with unlimited liability and others with limited liability (Sociedades Comanditarias in Spain).
• Key metrics of corporation size include market capitalization, assets, sales/revenue, earnings/profit, and employee count.
• Market capitalization is not directly linked to the value of sales.
• CEO stands for Chief Executive Officer.
• CFO stands for Chief Financial Officer/Manager.
• COO stands for Chief Operating Officer.
• Large corporations typically have a CFO who oversees financial staff.
• A treasurer and controller report to the CFO.
• The treasurer manages cash, raises capital, and maintains bank relations.
• The controller prepares financial statements, manages budgets/accounting, and handles taxes.
• The treasurer manages capital, and the controller ensures efficient money use.
• Financial managers are responsible for investment or financing decisions.
• They stand between the firm and outside investors, involve internal operations, and deal with financial institutions/markets.
• Maximize the market value of shareholders' investment in the firm.
• Risk-averse shareholders can adjust their portfolio if managers make investments that are deemed as "too risky."
• Profit maximization alone is not a well-defined corporate objective.
• Shareholder value is not increased by cutting costs unless the outlays were wasteful in the first place.
• Cutting dividends to increase future profits is not in the shareholders' best interest if the company earns only a very low rate of return on the new investment
• Value maximization is necessary for long-run survival.
• The stock market offers a 10% expected return, then the shareholders would be happy if the planes offer a rate of return of, say 20%, then shareholders would be happy to let the company keep the cash and invest it in the new planes
• A project should be rejected if its return is less than the hurdle rate/opportunity cost of capital, based on available investment opportunities.
• Corporations increase value by undertaking projects that earn more than the opportunity cost of capital.
• The opportunity cost of capital relies on the risk of the investment project.
• Financial markets inform managers of investors' opportunity cost of capital.
• Opportunity cost can be gauged from interest rates on safe debt for safe investments, or estimated for risky ones.
• Agency problems arise when managers act in their own interests rather than maximizing shareholder value.
• Control is delegated to a board of directors and further to managers.
• Agency costs are losses incurred due to these conflicts.
• Corporations mitigate risks by internal controls, executive compensation (stock), and corporate governance.
• Value maximization can conflict with the interests of other stakeholders.
• Valuable firms have satisfied customers and loyal employees.
• A firm's reputation is important to society
• Socially Responsible Investment (SRI) focuses on benefiting shareholders and stakeholders in society.
• SRI aims to meet goals within Environmental, Social, and Governance (ESG) criteria.
• SRI allows market participants to conduct evaluations to invest in companies that promote taking care of the environment, consumer protection or human rights
• Non-socially responsible firms need to generate a higher return.
• SRI is implemented by excluding unacceptable activities, selecting ESG-compliant firms, assessing compliance, incorporating information, targeting sustainable firms, aiming for impact, and engaging in ESG practices.
• Sustainable bonds are similar to loans and have payoffs based on meeting issuer sustainability criteria.
• Green bonds finance climate/environmental projects.
• Blue bonds finance positive marine/ocean projects.
• Social bonds finance positive social outcome projects.

Financial Markets and Financial Intermediaries

• Financial decisions require understanding investment needs, market conditions, and investor preferences.
• Corporations need financial markets/institutions for financing investments.
• Excess cash can be invested through these markets/institutions.
• A financial market brings together agents with investment needs and excess funds, regardless of their physical location.
• Financial markets facilitate the flow of funds between individuals, businesses, and governments.
• A security (e.g., stock) is a traded financial asset.
• The stock market is the most important market for corporations.
• Primary markets create securities and obtain cash from investors.
• Secondary markets exchange them between investors, without the issuer's participation.
• Equity markets trade company shares ( e.g. Bolsa de Madrid).
• Fixed-income markets issue/exchange debt securities (bonds).
• Organized markets offer centralized, safe trading.
• OTC markets operate without a central system/regulator.
• Foreign exchange markets handle currencies.
• Commodities markets trade raw materials (corn, oil, etc.).
• Derivatives markets trade securities based on other assets (e.g., oil).
• Financial institutions raise money to then provide financing.
• They raise money in different ways, for example, by taking deposits or selling insurance policies.
• They invest their funds in financial assets, for example, in stocks, bonds, or loans to businesses or individuals.
• Traditional companies have main investments in plant, equipment, or other real assets.
• Financial intermediaries include mutual funds, pension funds, hedge funds, insurance companies, commercial/investment banks, and public institutions.
• Financial markets transfer resources across time.
• Agents getting funds today from agents with excess funds, in exchange for a transaction the other way in the future
• Financial markets enable risk transfer and diversification through various securities.
• Risk is associated with holding a single security through the function of financial markets.
• Financial markets offer liquidity, that is to recover investments in exchange for cash when needed.
• Financial institutions offer payment mechanisms for easy fund transfers.
• Well-functioning financial markets provide information that can allow estimation of rates of return that can be expected on savings
• Financial markets can allow managers to infer investors' cost of capital and determine value creation.
• Stock prices showing the investors' collective assessment can increase with good management, incentivizing them to align with shareholders.

Instruments for Corporate Financing

• Corporations issue claims on future cash flows for financing through debt or equity-like securities.
• Equity is a financial contract that entitles the stockholder to have perpetual ownership of a corporation, i.e., it provides voting rights in the shareholder meeting and the right to receive the corporation's dividends, or the share of proceeds from its liquidation
• Debt is a financial contract that entitles the lender to receive a fixed set of cash payoffs from the corporation for a certain period
• Debt prioritizes repayment and are predertermined.
• Shareholders obtain residual claims and payoffs are not determined.
• Debt holders have no control rights over the corporation, unless it is liquidated
• Shareholders have complete control, where the board of directors are the ones who manage.

Extra notes

• Financial system in the economy is composed of financial markets and financial intermediaries. Each of these two financial structures allows different financial and investment operations.

• Can buy and sell financial assets in financial markets

• A financial market is a system of individuals, institutions, and instruments that brings together agents with financing needs and agents with excess funds, regardless of their physical location.

• Is to facilitate the exchange of funds between agents that have need for funds and agents that have surplus of funds

• Definition of assets: Assets are economic resources of a business that are expected to provide future benefits.

• We distinguish two general asset types:

  • Real Assets: tangible and intangible goods that, if put to productive use, generate future wealth. Ex: Tangible assets = buildings, equipment, machinery, computers, inventory etc. Intangible assets = patents, copyrights, software etc.
  • Financial Assets: contracts that give the right to receive a future payment in an exchange for a payment today. Every financial contract is an asset for somebody and a liability for somebody else!
    • Debt contract: Contract that entitles the purchasing side the right to receive a future stream of predetermined periodical payments. --> Buyer of debt vs. issuer of debt
      • Ex. Loans, bonds. Bonds: government and corporate bonds. Government bonds: Treasury bills, Treasury notes, Government bonds
    • Equity contract (shares/stocks): Contract that entitles the purchasing side the right to:
      • A share of the company profits (when applicable).
      • Control corporate decisions via voting rights.
      • Derivative contracts (futures, forwards, options, etc): Derivatives are financial contracts that allow exchange of financial assets or commodities in the future at a fixed price.

• A security is a traded financial asset. Ex. stocks and bonds are securities, loans are financial assets, but not securities Main operations in the financial markets: Buy: When do we buy an asset?

  • When we wish to transfer current wealth into the future. Financial assets allow us to do this without increasing today’s consumption or investment in real assets any further.
  • We expect the value of an asset to increase in the future.

Sell: When do we sell an asset?

- We wish to transform our investment into cash and use it to finance today’s consumption, investment in real assets or investment in other financial assets.
- We expect the value of an asset we own to drop in the future.

• Types of financial markets according to the financial asset:

• Fixed-income markets: Public or private debt markets allow issuance and exchange of debt securities (bonds).

• Equity markets: Financial market where investors can trade shares. Stock exchanges are the common known equity markets. Ex. Bolsa de Madrid.

• Derivatives markets: Financial markets that allow trading derivatives Futures, Forwards, Options and Swaps

• Commodities markets: involve trading, corn, wheat, cotton, fuel oil, natural gas, copper, silver, etc. As such, commodities markets are exception of financial markets because the trades actually involve real assets. We consider them as a type of financial market because we can transfer them from present to the future using the derivatives contracts

• Foreign exchange markets: Involve the exchange of different currencies

Types of financial markets according to level of regulation:

- Regulated (Organized markets): markets where operations are standardized. Trading takes place in a centralized, safe, and transparent manner. Ex: Stock exchanges, Futures, Public bond markets etc.

• Unregulated markets and OTC (over the counter): each operation is unique. In an OTC market, trades are made without a central exchange system (no regulator).

Types of financial markets according to its function:

• Primary markets: markets where financial assets are issued, and sellers obtain funds. Secondary markets: already issued assets are exchanged, providing liquidity to their owners.

Financial institutions: