There are two fundamental types of financial decisions that the finance team needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.
An investment decision revolves around spending capital on assets that will yield the highest return for the company over a desired time period. In other words, the decision is about what to buy so that the company will gain the most value.
To do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.
The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine an expected return. This return is not guaranteed, but is the average return on an investment if it were to be made many times.
The investments must meet three main criteria:
- It must maximize the value of the firm, after considering the amount of risk the company is comfortable with (risk aversion).
- It must be financed appropriately (we will talk more about this shortly).
- If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.
All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.
There are two ways to finance an investment: using a company's own money or by raising money from external funders. Each has its advantages and disadvantages.
There are two ways to raise money from external funders: by taking on debt or selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing. Selling equity is essentially selling part of your company (Figure 1). When a company goes public, for example, they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.
Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.