Now that we have examined the main concepts and tools in finance, we are ready to discuss how managers analyze and carry out key financial decisions at their respective enterprises. Decisions are either long term or short term. In this presentation we focus on the main long term decisions facing companies; capital budgeting decisions, valuation issues and capital structure choices.
Capital Budgeting
Capital Budgeting (CB) decisions are probably among the most important tasks faced by the management of any type of business. New product launches, new marketing campaigns, plant modernization, business expansions or contraction, are examples of CB tasks. Basically, the whole subject of CB could be collapsed into a single question: “Should a project under consideration be accepted or rejected?” To answer this vital question effectively, we need to be familiar with CB techniques such as payback, net present value (NPV), and internal rate of return (IRR) methods. In addition to being able to apply these methods to any CB situation, we also need to be able to determine the relevant cash flows (CFs) for all projects under consideration.
Briefly then, each project has three types of cash flows: initial CFs; operating CFs; and terminal CFs. Generally speaking, initial CFs are negative in nature -they are the costs of getting the project off the ground (cash outflows). The other two, operating and terminal CFs are positive (cash inflows). Although finding operating CFs is can be complex, we can define an operating (or periodic) cash flow as the sum of periodic net income after taxes plus periodic depreciations.
Valuation
It is almost impossible to think of any financial decision that does not depend on valuation. In fact, valuation lies at the heart of any CB decision.
Consider NPV for example. NPV is essentially about valuation - valuing cash flows. Furthermore, valuation techniques are used to “price” all sorts of decisions - from recruitment decisions (stock options and compensation plans) to buying, selling, and expanding businesses; and from launching new units to shutting down plants and operations. Generally, we may value the right-hand side of the balance sheet - stocks and bonds- or the left-hand side - the assets. Additionally, valuation could be based on current market dynamics -market-value-based, or past and historical figures - book-value-based. Normatively, finance requires always looking to the future for making present day decisions. As a result, market-based valuations that are built upon projected future cash flows are the norm.
Capital Structure
“Bottom lines”, and consequently market values, are also affected by the extent to which companies use debt to finance their assets. The structure of debt and equity within a business - in effect, the right hand side of the balance sheet - is known as capital structure(CS). CS becomes a key decision issue for management because as companies start using more and more debt, they become more and more risky. Such risk is referred to as financial risk. Management should move toward an “optimum” CS.
Another risk that affects the “bottom line” has to do with the extent to which a business utilizes fixed assets in its operations. This latter phenomenon gives rise to operating risk - also known as operating leverage. The higher the proportion of fixed assets in a balance sheet, the higher the risk the company faces. How do we explain this phenomenon? In times of economic downturn, companies will find it difficult to recover large fixed expenses.
