Finance:
Corporate or Business Finance is basically the methodology
of allocating financial resources, with a financial value,
in an optimal manner to maximize the wealth of a business
enterprise. There are three major decisions to be made in
this allocation process: capital budgeting, financing, and
dividend policy. Capital budgeting is the decision regarding
the choice of which investments are to be made with the resources
that have been brought into the business or earned and retained
by the business. The choice depends on the returns to be made
from the investment exceeding the cost of capital. The method
used to do this is the discounted time-value of money of the
cash flow from the investment. This value is the internal
rate of return (IRR), a measure of return on investment. When
the IRR exceeds the required return, which is equal to the
cost of the funds invested—see weighted average cost
of capital, below—then the investment should be made.
If such a required return is used as the discount rate, then
that is the same as saying the investment will yield a positive
net present value (NPV). If there are two or more investments
that can be made, but they are mutually exclusive, then they
must be ranked; and the one with the highest NPV should be
chosen. If there is a limited amount of funds to be invested,
then some bankers or advisers who obtain additional funds
for a business may require that the business choose among
the investments so as not to exceed the limited level of funds
available. This selection process, which is called capital
rationing, should be done in a similar manner to rank the
projects by selecting the combination of investments that
do not exceed the total funds available and that yield the
maximum total net present value.
Financing is the decision of
which resources or funds are to be brought into the business
from external investors and creditors in order to be invested
in profitable projects. The first external source of finance
is debt, which includes loans from banks and bonds purchased
by bondholders. The debt creditors take less risk of nonrepayment
because the business must repay them if there are funds available
to do so when the debt becomes due. The second external source
of finance is equity, which includes common stock and preferred
stock. The equity investors in the business take more business
risk and may not receive payment until the creditors are repaid
and the management of the business decides to distribute funds
back to the investors. The goal of the financing decision
is to obtain all the resources necessary, to make all the
investments that yield a return in excess of the cost of the
funds invested or the required rate of return, and to obtain
these funds at the lowest average cost, so as to reduce the
required rate of return and increase the net present value
of the projects selected.
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