CHAPTER 15-FINANCE

LEARNING OBJECTIVES
1. Appreciate the crucial relationship between risk and return and the way this
affects all business decisions.
2. Understand the issues involved in short-term capital management and methods that
managers can use to increase the rate of return on capital.
3. Understand the issues involved in long-term capital management and financial tools
like net present value and breakeven analysis that help managers decide where to invest
capital in the future to increase return on capital.
4. Describe four different methods companies can use to finance capital investments.
5. Differentiate between the roles debt and equity securities play in financial decision
making.

I. WHAT IS FINANCE?
Finance is the set of activities required to decide how to invest a company’s
capital so it generates additional cash, profit, and capital in the future to increase
profitability. The goal is to put assets to their most highly-valued use so they generate the
highest rate of return possible, maximizing profitability.

A. The Relationship Between Risk and Return

The rate of return on an asset is a financial ratio similar to those in Chapter 14. It
tells investors how much they have gained or lost by investing their capital in a specific
way during a certain time period.
Value of the asset now-Value at Time of Purchase X 100
Value of the asset at time of purchase

1. The Role of Risk is that the greater the uncertainty of return on an investment, the
greater the risk. When people or companies possess assets, they have two main financial
goals which requires a trade-off that determines the amount of return they will receive:
a. First, they want to preserve or protect the value of their capital so it won’t lose
its value or purchasing power over time.
b. Second, they want it to appreciate as rapidly as possible, increasing its
purchasing power.
2. The longer the period of time of the investment, the greater will be the uncertainty over
the return and the less opportunity an investor has to use the money elsewhere. For
example, interest rates on longer term Certificates of Deposit are higher than shorter term
Certificates of Deposit.
3. The riskier the type of investment, the greater the uncertainty over the return. For
example, investing in a new company carries a higher risk than investing in a known and
stable one and putting money in a money market fund carries less risk than investing in
stocks.
4. Investors want a risk premium because the higher the risk of investing in a certain
asset, the higher the rate of return required to compensate investors for bearing those
risks.
5. In finance, all kinds of capital investments must be compared in terms of their relative
risks and returns.
B. The Role of Business Finance
Capital is at the heart of finance and financial analysis because it provides the
funds used to purchase the means of production. The goal of business finance is to
increase the return on a company’s capital because it is the best way to maximize the
market value of stockholders’ equity. Investors recognize that a high ROIC indicates a
high potential for future cash flow and profitability.
1. Companies “use money to make money”. They depend on stockholders’ equity to buy
the assets it needs to pursue its business model.
2. The role of business finance is to ensure that the methods a company uses to borrow,
invest, spend, and lend its capital lead to a rate of return that maximizes the present
market value of its stock.
3. The two main kinds of financial activity used to manage these four uses of capital are
capital investment and budgeting and capital financing.

II. CAPITAL INVESTMENT AND BUDGETING

Capital investment and budgeting involves the development of a
financial plan and budget to manage and invest capital to purchase assets that will lead to
the highest ROIC. The nature of capital investment decisions differ according to whether
a company is dealing with current, short-term assets or fixed, long-term assets because
each is associated with different kinds of risks and returns.

A. Short-term Capital Management Decisions

Short-term capital management decisions are those that involve less than a one
year time frame. Examples are those decisions about ordering raw materials and
components, managing inventory, prepaid expenses, and accounts receivable.
1. The most important issue facing a company is how to invest its working capital to
increase the speed with which cash is converted to products, and, through sales, to
generate more cash.
2. Working capital is the “free cash” or funds available to feed a business’s operating
activities. The equation is
Current Assets- Current Liabilities= Working Capital
3. Working capital has a time value attached to it. The longer it is locked up in unsold
inventory or accounts receivable, the slower the cash flow back into the company,
decreasing its return on working capital.
4. Looking at the operating cycle will help understand that there are some steps financial
managers can take to improve the cash flow. The longer a business’s operating cycle, the
longer its money is tied up in inventory.
5. Decisions about cash outflows for inputs are related to but separate from decisions
about cash inflows from customers.
6. Cash outflow cycles can be reduced by obtaining the best possible terms from
creditors and by reducing inventory holding costs through just-in-time methods.
7. Cash inflows can be improved by shortening the receivables period.
B. Long-term Capital Budgeting Decisions
Long-term capital budgeting decisions involve choices about how to invest
capital for extended periods of time and are always made in the context of risk and
uncertainty. The goal is to invest in opportunities that will create a high rate of return.
1. Financial managers forecast the different rates of return that could be obtained from a
variety of investments such as new equipment to improve existing products, development
of new products, or acquisition of another producer.
2. Net present value (NPV) reduces a future stream of revenues to their current or
present value in order to compare them to the current or present cost of the capital that
would need to be invested for that particular project.
3. To discount the future stream of revenues to their present value, a company has to
consider its total value, or the cost of capital, that would be generating revenue if
invested in another way. The cost of capital is worked out by calculating the average of
the costs of money borrowed from banks or paid in bond interest, or considering how
much it could earn from its retained earnings.
4. Breakeven analysis is used to estimate the potential sales and costs associated with a
product, then discounted by the NPV to determine if it is positive. The break-even point
is the sales level that just covers all costs and expenses, where net profit or loss is zero.
5. Reducing the amount of time needed to reach break-even and receive rapidly
increasing profits can improve profitability.
6. A capital budget is a set of rules for allocating funds to the different functions to
achieve a predetermined rate of return on an investment. If costs go above budget, the
return will be lower or take more units sold to pay back the investment, lowering profits.

C. A Company as a Portfolio of Investments

Each of a company’s different products can be looked at as a separate investment.
The goal is for each to achieve or exceed its estimated return on capital, with a positive
NPV.
1. Brand managers are responsible for managing a particular type of branded product to
maximize its profitability over time. They can do so by reducing costs, improving
revenues, investing in research and development to improve the product’s competitive
advantage, or using promotions to add customers.
2. Many large companies have divisions that are treated as profit centers, in other words,
each is responsible for making a return that achieves its objectives.

III. CAPITAL FINANCING

Capital financing involves the development of a financial plan to allow a
company to obtain the capital necessary to fund its investments in assets at the lowest
possible cost. The goal is to maximize the return on capital invested.

A. Methods of Short-Term Financing

The goal of short term financing is to minimize the costs of financing a
company’s operating cycle and to invest its excess cash as profitably as possible.
1. The make-up of the company’s working capital determines the way managers fund
short term needs. It may be tied up in inventory, accounts receivable, final products, or
cash on hand.
2. Cash reserves are available to some companies, but those in a rapid growth mode
seldom have enough and need to borrow. Lenders must differentiate companies growing
rapidly and with profitable business models from those who are inefficient.
3. Unsecured loans are not backed by collateral. Many companies secure a line of credit
against which they can “draw” funds to finance accounts payable. A revolving line of
credit extends over two or more years.
4. Secured loans are backed by a company’s assets, or collateral. It may be fixed assets
such as land, a building, or equipment, or it may be current assets such as accounts
receivable.
5. Factoring involves a company selling the rights to its future accounts receivable to a
broker at a discount to generate cash immediately.
6. The role of risk is that people or companies that are perceived as high risk must pay a
higher risk premium, such as a higher interest rate, to borrow money. Companies with
lower perceived risk, such as Blue Chips, may choose to issue their own commercial
paper, which is unsecured debt due in less than 90 days. Commercial paper requires a
lower interest rate than would be paid a bank.

B. Methods of Long-Term Financing

Long-term financing involves funding the purchase of fixed assets such as land,
buildings, machinery, and IT systems that will be used for several years to produce a
particular kind of product. Four methods used to fund long-term investments are
spending retained earnings, issuing debt securities, selling equity securities, or more
recently, outsourcing production to another company. Several factors determine a
company’s choice.
1. Securities are legal documents that provide evidence of a claim against a company’s
assets.
2. The relative cost of financing through each method must be assessed. Lenders and
investors will assess a company’s profitability before deciding on rates of interest or
stock price.
3. Leverage is the ability to use borrowed capital in ways that have the potential to lead
to high rates of return.
4. Wealthy investors use hedge funds, a kind of mutual fund that uses investors’ capital
purely for the purpose of leverage.
5. Equity securities, primarily capital stock, give their owners a claim on a share of the
assets and profits of a company.
6. Debt securities have first claim on a company’s assets if it fails and debt holders
receive interest payments and their invested money back at the end of the term.
7. A company’s capital structure is the balance of a company’s debt to its equity.
C. Debt Securities: Bonds
Debt securities are legally enforceable promises by a company, the debtor, to
repay the money it has borrowed at a future date known as the principal, to pay interest
in the meantime at stated intervals to the creditor. Debt securities are listed as liabilities
on the balance sheet.
1. Bonds are debt securities issued by a company using a deed of trust or bond indenture
through a commercial bank which acts as a trustee.
2. Bonds have a face or par value, which is paid at maturity and an interest rate.
3. Bonds are ranked according to the creditworthiness of the issuer. The rating of a
particular bond can change over time as the company’s financial condition changes. The
riskier the company, the higher rate of interest the company will have to pay when they
are issued and investors will suffer as they will have difficulty selling them unless they
sell at a discounted rate.
4. The value of bonds change as interest rates change over time. Generally, as interest
rates rise, the value of the bond will fall because the rate of return relative to other
investments has fallen.
5. The company issuing the bond benefits when interest rates rise because it has the
money at a lower rate.
6. Information on bonds and their prices are available online and in the Wall Street
Journal. Current yield tells an investor the current rate of return on a bond.

D. Equity Securities: Stocks

Equity securities are the capital stock certificates a company issues that give
their owners legal rights to a company’s assets, and the rights to receive dividends from
any profits the company earns. The capital that stockholders give for the stock is used to
pay for a company’s resources and assets used to pursue its business model.
1. The initial public offering (IPO) is the first time the owners of a company who
currently own all of its stock, offer their stock to the general public. This sale is usually
handled by an investment bank that advertises and promotes it. The higher the price of
the stock, the more capital it will generate for the company, providing an incentive for the
company to look profitable.
2. Companies may issue more stock over time to raise more money, but when they do
there are such disadvantages as diluting the equity of existing stockholders. Diluting
control, and reducing the market value, at least in the short term.
3. Four main types of stock are Blue Chip, Growth stocks, income stocks, and speculative
stocks.
4. Selling and buying stocks is done primarily on either the New York Stock Exchange or
the NASDAQ. The NYSE is home to large, profitable, blue chip companies and the
NASDAQ to young, high-tech, or information technology companies.
5. Information about stocks is available through many online sources such as
Morningstar, Yahoo, and MSNBC or through the Wall Street Journal and other
periodicals. Stock information is usually presented showing 52 week high and low,
volume traded, net change, price-to-earnings ratio, and current price.
E. Non-operations Investing and Financing
Although the most important cash flows are those from current operations,
companies also generate cash from other investments.
1. Other sources of funds may be money markets, the stock of other companies such as its
suppliers, government and corporate bonds, commercial paper, or negotiable securities.
2. Companies may choose to buy back their own stock on the open market to increase the
value of its stock. The result for current stockholders is the opposite of diluting it by
selling more. Stock that has been bought back is known as Treasury Stock.
3. Companies may also choose to get a better return on its capital by acquiring another
company.

REVIEW OF LEARNING OBJECTIVES

1. Explain the crucial relationship between risk and return and the way this affects
all business decisions.
A basic principle of finance is that the higher the risks involved in investing in a
particular asset, the higher the rate of return people require to compensate them for
bearing those risks. In finance, all kinds of capital investments must be compared in
terms of their relative risks and returns.

2. Discuss the issues involved in short-term capital management and methods that
managers can use to increase the rate of return on capital.
The main issue in short-term capital management is to increase the efficiency of
working capital to purchase more materials for production by speeding the flow of cash
into a company and reducing the gap between the time resources are paid for and when
revenues come in.

3. Discuss the issues involved in long-term capital management and financial tools
like net present value and breakeven analysis that help managers decide where to
invest capital in the future to increase return on capital.
Long-term capital management involves choices about how to invest a company’s
capital for extended periods of time. NPV discounts the stream of revenue from a future
investment by the cost of capital and compares it to the current cost of capital to decide
the value of an investment option. Breakeven analysis forecasts the revenues and costs
associated with a project to locate the breakeven point, when revenues cover all costs.

4. Describe four different methods companies can use to finance capital investments.
Four methods used to fund long-term investments are spending retained earnings,
issuing debt securities, selling equity securities, or more recently, outsourcing production
to another company. Several factors determine a company’s choice.
5. Differentiate between the roles debt and equity securities play in financial
decision making.
Debt financing requires that interest be paid on a regular basis and that the
principal be repaid on time or a company’s assets can be claimed by the creditor. It
leverages a company’s assets and provides tax benefits as interest is an expense. Equity
securities can raise money that is not a debt, but dilutes the benefits of current owners
such as share of the profits and control. The share price will affect the potential benefits
of selling stock.