corporate finance needed in 3hours!!

Group Members

Lina Al Ali 1510693

Salha Alhumood 1620078

Tuleen

Ruba

Lara

Research Project Topic

Corporate Finance and Investment Decisions

Course

BNFN430- Corporate Finance

Submission Date

24th April 2018

(Get info from research papers from ebsco and do APA style in text citation and referencing)

Corporate Finance and Investment Decision

Corporate finance is a branch of finance that focuses on the sources funding a company’s operations and investment decision, the type of capitalization structure used by corporations as well as the role of managers in the maximization of the shareholders’ equity (Fracassi, 2016). Corporate finance also has tools and analysis that are used to calculate the appropriate allocation of resources for each project of the corporation. The main goal behind corporate finance is to help the managers maximize the company’s value which in turn increases the shareholders’ wealth through profitable investment projects.

Corporate finance originated from modern-day Republic of Netherlands in the 17th century. The Dutch Republic is where the first formally listed public company was formed, the first stock exchange and market (Ehrhardt & Brigham, 2016). Corporate finance has come to be an integral part of the business world as it entails the general operation of a company. It involves capital structure, investment projects, company valuation, dividend policy and working capital management. Corporate finance is also applied in investment banking to when financing joint investment ventures and infrastructure finance. Risk management is another tool of corporate finance and is important to managers when analyzing an investment venture to measure the level of risk as well as determining the appropriate strategies to implement for hedging that risk.

Corporate financing primarily refers to the capitalization structure opted for by a company to either sustain its business operations or fund new investment projects. The source of financial funding of a company defines the capital structure of a company. There are three sources of capital that a company can chose from namely; debt capital, equity capital and preferred stock. Debt capital refers to funds that have been borrowed from financial institutions such as banks or bonds issued to the public. Debt financing attracts annual interest that the company must pay upon the maturity of the deb (Vernimmenet al., 2014).

Equity capital refers to the decision by a company to sell its shares to investors and pay dividends from its profits for each share held. Investor’s value is increased when the company invests in projects that have a positive rate of return. Preferred stock refers to shares that are superior to common shares in that they have a priority during liquidation process where they are paid out first.

Corporate finance involves financial analysis that are relied upon by managers when making their decisions. These decisions include investment decision, financial decision, dividend decision and liquidity decision. Investment decisions is the most important function of managers as it involves the allocation and utilization of capital resources to acquire long term assets. The process involves identifying and evaluating new investment ventures and comparing its profit margin to that of prevailing investment. Due to the uncertain nature of the future, investment ventures come with a risk factor that must be taken into consideration when calculating the expected returns.

Investment decision can be categorized into two categories namely; long-term investment decision and the short-term investment decision. Long-term investment decision is the capital budgeting that involves investment projects that have a long maturity date of more than one year. Consequently, short-term investment decision simply put is the management of working capital. This involves allocating funds to inventories and receivables and is mostly controlled by the trade-off between liquidity of the company and profitability (Levy, 2015).

Moreover, investment decision also entails deciding on which funds to use to fund the investment venture proposed. It can involve selling assets that are less profitable and using those funds to invest in other more profitable projects. Projects that are not adding value with time should be cut off and these funds be utilized in other projects. Conclusively, investment decision is an important function of managers and therefore accurate information and statistics should be presented for reference. This is the role of corporate finance tools and analysis procedures to provide this information to the managers.

Corporate Financing

Corporate financing essentially deals with the sources of short-term and long-term

funding of a corporation’s activities and its capital structure. Corporate financing is mainly concerned with the financial decision making as to what is the best way to finance a corporation’s projects or operations that in return will increase or maximize shareholders value. According to Tsai, Yang, Leu, Lee & Yang (2013), “The essential goal of corporate finance is to maximize corporate value while reducing a firm’s financial risks” (p. 1104). Financial managers should focus on achieving these two goals while engaging in financing decisions.

I. Corporate financing decisions

Corporate financing decision making is not an easy task; it requires careful studies and

evaluation in order to make the best decision that will increase the firm’s value. Corporate financing decision in fact involves a “multi criteria based group decision making (MCDM)”. A multi criteria decision making is traditionally implemented or used on complex decisions with certain environmental limitations and financial requirements (Tsai, Yang, Leu, Lee & Yang, 2013). It is useful when corporations are presented with a decision making problem that entails a choice among alternatives. An assessment criteria is established to evaluate the alternatives on the basis of the criteria. The criteria and alternatives are usually interdependent. Multi criteria-decision making generally entails a combination of different analytical approaches including “Decision Making Trial and Evaluation Laboratory (DEMATEL), Analytic Network Process (ANP) approach and the Goal Programming (GP) model to form an integrated Group Decision Making Support (GDMS) model for corporate financing decisions” (Tsai, Yang, Leu, Lee & Yang, 2013, p. 1110). The main financial decision areas that are covered in the finance decision making are corporate financial planning, capital budgeting, financial investment, financial risk assessment and other financial areas. In addition, there a number of underlying factors that affect a corporation’s financing decisions making. These factors include profit, tax rate, debt capacity, control right, capital cost and the financial covenant of an organization (Tsai, Yang, Leu, Lee & Yang, 2013). There are number of proposed theories by researchers to aid financial personnels in the financial decision making process. However, there are often conflicting judgments and ideas accompanying such process as it is a group decision making. Conducting group decision making is often a difficult task as different individuals have different preferences among the alternatives presented or different set of criteria which might result in varying judgements and opinions. That being said, it is important for corporations to determine the way of evaluating the financial criteria hence the selection of the best financial alternative that not only will maximize shareholders value but also reduce the firm’s financial risks and maintain the financial flexibility of the corporation (Tsai, Yang, Leu, Lee & Yang, 2013).

I. Capital structure and Sources of funds

A capital structure consists of the different sources of funds that firms use in order to

finance their business activities. Firms can either finance their business using only equity or a combination of debt and equity. Luiza (2017) states,

The optimal capital structure for a company is represented by the combination of its

equity and the borrowed capital which leads to maximizing the market price of shares of that enterprise. At the same time, the optimal financial structure represents the mixture of financing sources that determines a minimization of the weighted average cost of the

company’s equity.

Hence, When deciding on a capital structure, corporation’s main goal is to maximize market share price and minimize weighted average cost of capital (WACC), which is the cost of debt plus cost of equity. Corporations often try to balance between equity and debt financing to get the maximum advantage and the minimum amount of costs. According to Luiza (2017), “The capital structure can be interpreted in terms of target structure meant to balance the level of risk and the rate of return” (p. 177) The debt portion of the capital structure or the borrowed amount represents the level of risk on a company’s earnings. An increased borrowing usually entails a higher leverage ratio and a higher level of risk. A higher leverage ratio corresponds to higher estimation of the rate of return as demanded by equity and debt holders. The high leverage will decrease the firm’s share price in the market but the estimated higher rate of return represents an increase in share price which creates a balance between the two. Hence, an optimal capital structure represents a structure that provides a balance between risk and return while maximizing the share’s market price (Luiza, 2017).

There are two main sources of funds for any corporation; equity and debt. Equity usually

represents ownership in the firm to the equity holder. Debt, on the other hand, does not represent ownership. Thus, firms might be less inclined to finance their capital structure using only equity because they do not want to share ownership rights and additional profits with many shareholders. In addition, financing using only equity increases the cost of capital for the firm and increases the rate of return as demanded by equity holders. On the contrary, Borrowing provides firms with major advantages. First, interest expenses are tax deductible meaning leverage provide firms with a tax shield or tax savings advantage. Second, shareholders do not have to share any additional profits generated by the business with debt holders as debt holders are only paid a fixed amount. Debt also has a lower cost than equity and require a lower rate of return because it is less risky. There are a number of models that rationalize the capital structure of firms such as Modigliani-Miller theory which encourage borrowing to gain the tax savings advantage and the trade off theory which justify moderate leverage ratios. However, the capital structure of firms vary from company to company according to many factors such a size and type of industry. For instance, “Companies that have safe tangible assets and high taxable incomes that generate significant tax savings should have a high leverage. Small profitable enterprises that have a high share of risky intangible assets should be financed entirely from equity” (Luiza, 2017, p. 178). Hence the capital structure of the firm with small profits is different from one with large income. Similarly, firms in different industries usually have different capital structure. Thus, capital structure decisions vary from firm to firm and usually have different rationales behind them.

· Risks of investment decisions (Salha)

Corporations often face several risks associated with investment decisions. One risk they face is the variability of the expected returns. An investor will expect to achieve certain returns from the investment, if the actual return received from an investment fails to fulfill the expected return, the investor will be facing the risk of investment decision (Virlics, 2013). The return on investment may not be sufficient to cover the cost of investment which will represent a loss to the corporation. Another risk associated with investment decisions is Non-controlling external factors. These external factors, such as political and economic factors, are beyond the control of investors and may cause many investment failures (Virlics, 2013) For instance, when Saudi Arabia and Qatar had political issues, many Saudi and Qatari investors were harmed and lost their investments. Moreover, business between the two countries is no longer allowed. As a result, Saudi investors can not invest in Qatar and vice versa. Likewise, investment decisions are also affected by economic conditions. For instance, in 2008, many investors faced losses due to the unexpected financial crisis that resulted from subprime mortgages. External factors can not be expected or controlled and can change suddenly; hence, they represent a risk on the investment. Investment decisions are also sensitive to new information. An investment decision will change according to the new information available about market. Eeckhoudt (2005) states,

New information may be useful for better decisions. Good information affects the decision maker’s welfare and the optimal risk management.Information may arrive during the investment period and this can make the investor make some additional decisions regarding his investment. Information at some point of the period may be useful, but referring to the horizon of the investment, it may be negative information (as cited in Virlics, 2013).

Therefore, the investor should be up to date and seek new information about the market, politics, economy to make wise investment decisions at the right time. Furthermore, most of investment risks are irreversible. Once an investor makes an investment, in most cases he/she can not reverse the action. Hence, in some investments such as a investing in a new factory, the investment can’t be reversed. Even if the investor obtained new information that might’ve influenced his/her decision, the investor can not change his/her decision no matter what is the outcome of the investment. In such irreversible investments, new information will only cause the investor to regret his/her decision (Virlics, 2013). Another risk associated with investment decisions is the unpredictability of future events. The investor can not accurately predict or forecast future events. The investment decision may turn out risky if the investor’s predictions about the future failed to capture the reality of future events. As a result, the investor might incur losses because the investment decision was made based on a false forecasts (Disatnik and Steinhart, 2015). Investment decisions under uncertainty present investors with major investment risks as the outcome of an investment will be unpredictable. Another risk related to investment decisions is misleading market signals. The market may affect investment decisions in a negative way when its signals give misleading entails to investors that affect their decisions. For instance, when large wealthy investors bought large amount of stocks, they influenced the market and stock price movement. As a result, small investors were inclined to purchase stocks. They invested heavily in some industries, then they realized that it was a misleading signal from big investors who distorted the market by buying large number of shares only to sell them which caused share prices to go down. Consequently, small investors lost due to the decrease in their share prices. This situation have faced Saudi investors previously in 2006. The below figure shows the highest peak in Saudi stock market where many investor purchased shares as a result of misleading market signals, followed by a huge drop in 2007 due to the sale of shares and fall

in prices.

Figure 1

Moreover, having too many investment possibilities and multi directions of investing capital may present a risk to the investor. When an investor is faced with many good investments and directions, the investor might get distracted and might not be able to make a good investment decision. Hence, the investor fails to grasp the best investment opportunity. Consequently, the investor makes a decision in an investment that generates the lowest return or the highest cost, but he/she will not realize it until the investment is done (Disatnik and Steinhart, 2015).

CONCLUSION

References :

References

Ehrhardt, M. C., & Brigham, E. F. (2016).  Corporate finance: A focused approach. Cengage learning.

Fracassi, C. (2016). Corporate finance policies and social networks.  Management Science,  63(8), 2420-2438.

Levy, H. (2015).  Stochastic dominance: Investment decision making under uncertainty. Springer.

Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y., & Salvi, A. (2014).  Corporate finance: theory and practice. John Wiley & Sons.

DISATNIK, D., & STEINHART, Y. (2015). Need for Cognitive Closure, Risk Aversion,