Investment and Financing Decisions

Investment and Financing Decisions

• Companies invest in tangible (machinery, buildings) or intangible (patents, brand names) assets to produce goods/services.
• Financing of companies refers to the funds that are used to purchase assets.
• Financial managers make decisions about investments and raising capital.
• Corporate finance studies corporate financial decisions and related analytical tools.
• Investment decisions, also known as capital budgeting (CAPEX), involve purchasing assets that contribute to business operations.
• Investment decisions can have long-term or short-term effects.
• Companies prosper by launching new products/services but investments have costs and risks.
• Facebook (Meta) invested $60 million to acquire Pebbles, an Israeli virtual reality software company.
• Ford invested $1 billion to build an assembly plant in Mexico.
• A financial manager’s role is to raise money for investments and operations.
• Companies may offer investors a share of future profits or promise repayment with interest to secure cash investments.
• Equity and Liabilities are represented by these claims.
• Investment involves acquiring real assets, while financing entails issuing financial assets to investors.
• John Deere has credit lines with banks allowing borrowing up to $7.2 billion.
• LVMH repaid €750 million in debt issued in 2009 and 2011.
• Walmart increased its annual dividend to $2.00 a share.

Investment vs Financing Decisions

• Intel's $7 billion investment in a microprocessor factory is an investment decision.
• BMW borrowing 350 million euros is a financing decision.
• Royal Dutch Shell constructing a natural gas pipeline is an investment decision.
• Avon spending €200 million on a new cosmetics line is an investment decision.
• Pfizer issuing new shares to acquire a biotech company is both a financing and investment decision.

Corporations and Their Goals

• Corporations are legal entities formed with articles defining their purpose, governance, and operation.
• Corporations are owned by shareholders and have limited liability.
• Limited liability shields shareholders from personal responsibility for repaying corporate debt.
• Corporations have separate ownership and control structures.
• Shareholders have voting rights in shareholder meetings.
• A board of directors is elected to appoint/ advise top managers (CEOs) and monitor performance.

Other Forms of Business Administration

• Smaller businesses are commonly organized as sole proprietorships.
• Partnerships involve proprietors voluntarily holding unlimited liability.
• Limited partnerships have partners with both limited and unlimited liability.
• There are other types of legal forms.

Measuring Corporate Activity

• Five main variables measure the dimension of a business:
  • Market capitalization
  • Assets
  • Sales or revenue
  • Earnings, profit or net income
  • Number of employees
• A company's size based on market cap may not correlate with its sales value.
• The CEO is the Chief Executive Officer.
• The CFO is the Chief Financial Officer or Financial Manager
• The COO is the Chief Operating Officer.

The Financial Manager

• Most large corporations have a CFO who oversees all financial staff.
• A treasurer and a controller are usually below the CFO.
• The treasurer manages the firm’s cash, raises capital, and handles bank/ investor relations.
• The controller prepares financial statements, manages budgets/accounting, and manages tax affairs.
• Investment projects involve managers from various areas for planning and analysis.
• A financial manager is responsible for an investment or financing decision.
• The financial manager bridges the firm and outside investors, involved in operations, financial institutions, and financial markets.
• Separation of ownership and management occurs in large corporations.
• Maximizing the market value of shareholders’ investment is a common financial goal.
• This goal is sensible with access to well-functioning financial markets.

Profit Maximization

• Profit maximization is not a well-defined corporate goal.
• Cutting costs may not necessarily add value.
• Increasing future profits by cutting dividends isn't ideal if the return is low.
• Maximization, or at least maintaining value, is vital for long-run survival.

Value Maximization

• Investments can increase or decrease market value.
• Airline Corporation Example:
  • Stock market investments offer 10% return for similar risk.
  • 20% return from new planes benefits shareholders.
  • 5% return leads to stockholder loss, manager should decline.
• A minimum acceptable rate of return is the hurdle rate or opportunity cost of capital.
• Corporations raise value by green-lighting investment projects exceeding the opportunity cost of capital.
• Opportunity cost of capital depends on the risk of investment.
• Opportunity cost of capital must be estimated for risky investments.

Agency Problems

• Managers may prioritize their interests over shareholder value in large corporations.
• Control is delegated to the board of directors, which delegates further control to managers.
• Separation of ownership and control can cause agency problems
• Agency costs include value losses or expenses to reduce agency problems.

Mitigating Agency Problems

• Internal controls, executive compensation (stock), and corporate governance are methods.
• Corporate governance is regulations/institutions protecting investor rights and limiting managerial power.

The Ethics of Maximizing Value

• Shareholders want to maximize share value.
• Value maximization may conflict with stakeholder interests.
• Valuable firms are those with satisfied customers and loyal employees.
• Reputation is important for corporations.
• Society is an important stakeholder.
• Corporate "sharks" create scandals.
• There are concerns about corporate climate change efforts and social justice.

Socially Responsible Investment (SRI)

• Socially responsible investment (SRI) is a strategy increasingly used by investors and corporations.
• SRI prioritizes actions benefitting shareholders and stakeholders, including society.
• SRI focuses are Environmental, Social, and Governance (ESG) criteria.
• SRI participants evaluate companies based on environmental care, consumer protection, and human rights.
• Financial returns receive secondary consideration after moral values.
• Investors lower capital cost for socially beneficial firms and raise it for harmful ones, hence the need for higher returns.

SRI Investment Criteria

• SRI investors can discriminate investment opportunities;
  • Excluding unacceptable activities
  • Selecting firms meeting an ESG benchmark
  • Assessing compliance of ESG norms
  • Incorporating ESG information to assess returns.
  • Investing in sustainable behavior focused funds
  • Ambitiously create social/environmental outcomes
  • By actively engaging for best ESG practices

Sustainable Bonds

• Sustainable Bonds share likeness to loans
• Sustainable bonds payoffs rely on the issuer meeting sustainability criteria, with proceeds going to green/social investments.
  • Green bonds finance climate/environmental projects.
  • Blue bonds finance marine/ocean projects.
  • Social bonds finance projects with social outcome.

Financial Markets and Financial Intermediaries

• Financial decision-makers need awareness about financial markets and investor preferences.
• Corporations needing cash must engage with financial markets/institutions.
• Corporations with extra cash invest it through these avenues.
• Financial markets are systems that connect individuals, institutions, and instruments.
• A financial market involves the issuance/trading of securities (financial assets).
• The stock market is the most important market for corporations.

Types of Financial Markets

• Primary vs. Secondary: Issuers create securities and obtain cash in primary markets. Secondary markets involve investors trading securities without the issuer's participation.
• Equity versus Fixed-Income: Equity markets trade company shares, while fixed-income markets trade debt securities.
• Organized vs. Over-the-Counter (OTC): Organized markets have standardized trading. OTC markets lack a central exchange system.
• Foreign Exchange: Currency exchange
• Commodities: Corn, wheat, or Oil
• Derivatives: Its securities depend on other securities prices.
• Financial institutions/intermediaries provide financing by raising money from investors.

Financial Institutions vs Traditional Companies

• Financial institutions collect deposits or sell insurance to gather funds. Traditional companies gain capital through selling equity or borrowing.
• They invest in financial assets. Traditional companies mainly invest in physical assets.

Types of Financial Intermediaries/Institutions

• Mutual funds, pension funds, and hedge funds.
• Insurance companies.
• Commercial Banks
• Investment banks
• Public institutions.

Functions of Financial Markets

1. They allow agents that need funds today to obtain resources from agents that now have excess funds, in exchange for a transaction the other way in the future.
2. Risk transfer and diversification: Financial markets allow investors to access a wide array of securities that allow agents to reduce the risk associated with holding a single security and allows the transfer of risk.
3. Liquidity: Ability to turn investment back into cash when needed
4. Payment Mechanism: Financial Institutions allow transfer of funds without the physical presence of cash.
5. Provision of information: The ability to see what securities and commodities are worth, and estimate the rates of return that investors can expect on their savings.

Instruments for Corporate Financing

• Corporations distribute claims on cash flows to get current financing.
• Companies choose from equity-like and debt-like options.
  • Equity: a right of ownership with voting rights.
  • Debt: contract to receive a set of cash payoffs over time

Differences Between Debt and Equity

• Cash flow rights:
  • Debtholders have priority in repayment with predetermined payments and maturity.
  • Shareholders have residual claim and limited liability.
• Control rights:
  • Debtholders lack control unless liquidation begins.
  • Shareholders control the firm via the board of directors.

Extra Notes

• The Financial system is comprised of financial markets and intermediaries allowing operations to occur.
• Financial system: markets where we can buy and sell financial assets.
• Markets enable agents to exchange of funds.

Assets

• Assets are economic resources a business uses that, when used correctly, generate future wealth.
  • Real Assets are tangible and intangible goods that generate future wealth
    • Tangible examples include: buildings and machinery
    • Intangible examples include: copyrights and patents
  • Financial Assets are contracts the give the right to receive a future payment in an exchange for the payment today
    • Debt contracts: Purchasing the right the receiving a future stream of periodical payments
    • Equity contracts: Purchasing 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.

Main Operations in Financial Markets

• Buying: We buy when we which to transfer wealth into the future because we accept the value of an asset to increase.
• Selling: We sell when we which to cash out to finance consumption, investment, or believe the asset will drop in value.

Types of Financial Markets According to the Financial Asset

• Fixed Income Markets: Allows exchange of debt.
• Equity Markets: A market where shares can be traded.
• Derivative Markets: Allows the trading of derivatives.
• Commodity Markets: Allow the trading of real assets.
• Foreign Exchange Markets: Exchange of different currencies.

Types of Financial Markets According to Their Level of Regulation

• Regulated Markets: Operations are standardized, safe, and transparent.
• Unregulated Markets: Operations are unique and lack a central system.

Types of Financial Markets According to Function

• Primary: Assets are issued and sellers obtain finds
• Secondary: Assets are exchanged already and liquidity is provided.

Financial Institutions vs Financial Markets

• Financial Institutions allow intermediation to bring together lenders and those who are looking to be financed; -In financial markets, agents trade directly.
• Finacial insitutions take deposits/ sell insurance so provide funding as traditional companies go through equity/debt