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Some words about acquisitions.

UNIT I

What is 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 retainedby 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 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.

What is financing?

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 non repayment 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.

What is a dividend policy?

Dividend policy is the decision regarding funds to be distributed or returned to the equity investors. This can be done with common stock dividends, preferred stock dividends, or stock repurchase by the business of its own stock. The aim of this decision is to retain the resources in the business that are required to run the business or make additional investments in the business, as long as the returns earned exceed the required return.

In theory, management should return or distribute all resources that cannot be invested in the business at levels in excess of the required return. In practice, however, dividends are often maintained at or changed to certain levels in order to convey the proper signals to the investors and the financial markets. For example, dividends can be maintained at moderate levels to demonstrate stability, maintained at or reduced to low levels to demonstrate the growth opportunities for the business, or increased to higher levels to demonstrate the restoration of a strong financial (capital) structure (debt and equity capital) for the business.

What is a capital?

Capital is the total of financial resources invested in the business. In terms of the sources, there are two types of capital: interest-bearing debt funds, such as loans, bonds, short-term notes, and interest-bearing payables to trade suppliers; and equity, such as common and preferred stock and the earnings retained in the business that add to stockholders’ share of the entities.

In terms of uses, there are also two types of capital: net working capital, such as operating cash, inventory, and receivables, less interest-free payables to trade suppliers; and fixed capital, such as property, plant and equipment. Capital is managed to maximize wealth by maximizing the rates of return on investments of capital and thus maximizing the total net present value of the business.

Weighted average cost of capital is the weighted average of the returns on investment or future dividends for the stockholders and interest rates on debt for the creditors. This average return should be used as the required return for investments, as mentioned earlier, because it represents the weighted average of the required returns of all the different debt creditors and equity investors. It also represents the weighted average of the costs that can be saved by the business if the resources or financial funds are returned to the creditors and investors instead of being used for investments within the business.

Capital structure is represented by the types of sources of capital funds invested in the business. A common measure of sources is the percentage of debt relative to equity that appears on a company’s balance sheet. Usually, the cost or required returns for the debt is much less than the equity, especially on an after-tax basis.

Thus, the total cost of capital declines when some debt funds from creditors are substituted for equity funds from investors. Yet as more debt is added, the business becomes riskier because of the higher amount of fixed payments that must be made to creditors, whether or not the business is generating adequate funds from earnings; and then the costs of both the debt and equity funds are increased to the point where the weighted average cost increases.

Some words about acquisitions.

Acquisitions, which are purchases of other businesses, are merely another type of capital budgeting investment for a business. Such purchases should be evaluated in the same manner as any other capital investment, as outlined earlier, to obtain the maximum positive net present value.

Price/earnings ratio is often used in making acquisitions as an abbreviated measure of valuation. This ratio is of the value or price of a business or its stock to its earnings. Yet the actual decision to make an acquisition is a capital budgeting decision; the resultant determination of price or net present value can then be described in relative terms to the earnings in the price/earnings ratio.