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Print this chapterIntroducing Finance
Read this introductory article, which will help you understand what the field of finance encompasses. What do you learn in a course in finance that you do not learn in financial accounting? How does finance build on what you learned? What does a financial manager do?
Types of Financial Decisions: Investment and Financing
Investment and financing decisions boil down to how to spend money and how to borrow money.
Learning Objective
Identify the criteria a corporation must use when making a financial decision
Key Points
- The primary goal of bothinvestmentandfinancingdecisions is to maximizeshareholdervalue.
- Investment decisions revolve around how to bestallocatecapitalto maximize their value.
- Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sellequity.
Terms
- equity
Ownership, especially in terms of net monetary value, of a business.
- expected return
Considering the magnitude and likelihood of exogenous events, the yield that an investor predicts s/he will earn on average.
- financing
A transaction that provides funds for a business.
There are two fundamental types of financial decisions that thefinanceteam needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.
Investment
An investment decision revolves around spending capital onassetsthat willyieldthe highestreturnfor the company over a desired timeperiod. In other words, the decision is about what to buy so that the company will gain the most value.
To do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.
The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine anexpected return.This return is not guaranteed, but is the average return on an investment if it were to be made many times.
The investments must meet three main criteria:
- It must maximize the value of the firm, after considering the amount ofriskthe company is comfortable with (risk aversion).
- It must be financed appropriately (we will talk more about this shortly).
- If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.
Financing
All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.
There are two ways to finance an investment: using a company's own money or by raising money from external funders. Each has its advantages and disadvantages.
There are two ways to raise money from external funders: by taking ondebtor selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back withinterest, which is the cost of borrowing. Selling equity is essentially selling part of your company. When a company goes public, for example, they decide to sell their company to the public instead of toprivateinvestors. Going public entails sellingstockswhich represent owning a small part of the company. The company is selling itself to the public in return for money.
Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.
