Page 323 - Encyclopedia of Business and Finance

eobf_F 7/5/06 3:02 PM Page 300

Finance

be done in a similar manner to rank the projects by select- maximize wealth by maximizing the rates of return on
ing the combination of investments that do not exceed the investments of capital and thus maximizing the total net
total funds available and that yield the maximum total net present value of the business. This can be done by mini-
present value. mizing the amount of capital used for given business
Financing is the decision of which resources or funds investments with given business returns.
are to be brought into the business from external investors Weighted average cost of capital is the weighted aver-
and creditors in order to be invested in profitable projects. age of the returns on investment or future dividends for
The first external source of finance is debt, which includes the stockholders and interest rates on debt for the credi-
loans from banks and bonds purchased by bondholders. tors. This average return should be used as the required
The debt creditors take less risk of nonrepayment because return for investments, as mentioned earlier, because it
the business must repay them if there are funds available represents the weighted average of the required returns of
to do so when the debt becomes due. The second external all the different debt creditors and equity investors. It also
source of finance is equity, which includes common stock represents the weighted average of the costs that can be
and preferred stock. The equity investors in the business saved by the business if the resources or financial funds are
take more business risk and may not receive payment until returned to the creditors and investors instead of being
the creditors are repaid and the management of the busi- used for investments within the business.
ness decides to distribute funds back to the investors. The Capital structure is represented by the types of
goal of the financing decision is to obtain all the resources sources of capital funds invested in the business. A com-
necessary, to make all the investments that yield a return mon measure of sources is the percentage of debt relative
in excess of the cost of the funds invested or the required to equity that appears on a company’s balance sheet. Usu-
rate of return, and to obtain these funds at the lowest aver- ally, the cost or required returns for the debt is much less
age cost, so as to reduce the required rate of return and than the equity, especially on an after-tax basis. Thus, the
increase the net present value of the projects selected. total cost of capital declines when some debt funds from
Dividend policy is the decision regarding funds to be creditors are substituted for equity funds from investors.
distributed or returned to the equity investors. This can be Yet as more debt is added, the business becomes riskier
done with common stock dividends, preferred stock divi- because of the higher amount of fixed payments that must
dends, or stock repurchase by the business of its own be made to creditors, whether or not the business is gen-
stock. The aim of this decision is to retain the resources in erating adequate funds from earnings; and then the costs
the business that are required to run the business or make of both the debt and equity funds are increased to the
additional investments in the business, as long as the point where the weighted-average cost increases.
returns earned exceed the required return. In theory, man- Acquisitions, which are purchases of other businesses,
agement should return or distribute all resources that can- are merely another type of capital budgeting investment
not be invested in the business at levels in excess of the for a business. Such purchases should be evaluated in the
required return. In practice, however, dividends are often same manner as any other capital investment, as outlined
maintained at or changed to certain levels in order to con- earlier, to obtain the maximum positive net present value,
vey the proper signals to the investors and the financial though the issues and data are often more complex to ana-
markets. For example, dividends can be maintained at lyze.
moderate levels to demonstrate stability, maintained at or Price/earnings ratio is often used in making acquisi-
reduced to low levels to demonstrate the growth opportu- tions as an abbreviated measure of valuation. This ratio is
nities for the business, or increased to higher levels to of the value or price of a business or its stock to its earn-
demonstrate the restoration of a strong financial (capital) ings. Yet the actual decision to make an acquisition is a
structure (debt and equity capital) for the business. capital budgeting decision; the resultant determination of
Capital is the total of financial resources invested in price or net present value can then be described in relative
the business. In terms of the sources, there are two types terms to the earnings in the price/earnings ratio.
of capital: interest-bearing debt funds, such as loans, Returns for any business or particular debt or invest-
bonds, short-term notes, and interest-bearing payables to ment made in the business are merely the cash flows that
trade suppliers; and equity, such as common and preferred will ultimately be earned by the business or particular
stock and the earnings retained in the business that add to creditors and stockholders. These can be expressed in dol-
stockholders’ share of the entities. In terms of uses, there lar terms or as percentages, with the latter being the aver-
are also two types of capital: net working capital, such as age annual percentage of the cash flows relative to the
operating cash, inventory, and receivables, less interest- overall investment in the business or the particular
free payables to trade suppliers; and fixed capital, such as amounts of debt or stock involved. For debt instruments,
property, plant, and equipment. Capital is managed to these percentage rates are called interest rates. For specific

300 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION