The topics in brief
Financial markets
Suppliers of financial capital and demanders of financial capital come together on the financial markets. Suppliers are private investors, funds, companies (e.g. insurance companies) and buyers are companies, states, ... Among other things, securities are traded, i.e. contracts that define the financial claims of buyers and sellers. Securities can take many forms, such as shares, bonds, options, swaps, forwards, futures, fund units, but can be traded in various ways. Trading is possible via regulated markets, such as stock exchanges, as well as through informal agreements (OTC = over-the-counter).
Financing and companies
Companies can be organized in various legal forms.
1. sole proprietorship
2. partnership (GbR, OHG, KG)
3. corporation (AG, GmbH)
In the following, we mostly consider corporations whose shares are traded on the market. It should be noted that corporations are independent legal entities and the company owners (= equity providers, shareholders) are not personally liable for the company's liabilities. In corporations, the Chief Financial Officer (CFO) makes most of the financial decisions. The following explanations thus mostly apply to his problems. The CFO is responsible for investment and financing, among other things. Investments are the purchase of real assets, as well as capital budgeting or capital expenditures and influence the asset side of the balance sheet. Financing, which affects the liabilities side, includes the sale of securities and the management of equity and debt capital. Examples of investments include the acquisition of WhatsApp for $META for 22 billion US dollars. Examples of financing include issuing shares to banks or other institutional investors or taking out loans and issuing bonds. The order of the funding target management looks like this, for example:
1. raising capital from investors
2. investing in the company's business
3. cash generation through the company's business
4. repayment of principal and interest by lenders
5. reinvestment in the operating business or
6. payment of investor dividends (to equity providers)
The CFO's biggest task is to decide whether reinvestment in the company's own business or payment of dividends to equity providers is the better option. In theory, the following assumptions are therefore made: Dividends are done when the company has no better use than shareholders, and reinvestment is done when a better opportunity is found. The benchmark here is the return of the best comparable alternative investment of the shareholders = opportunity cost (represents a lost profit or a lost benefit that arises either completely or only partially when choosing one of several options compared to the best option). Therefore, the financial manager makes decisions in all three areas: Investment, financing and distribution (dividend).
As CFO of the company, he therefore makes decisions "on behalf of the shareholders".
What goals do shareholders have?
1) Maximizing consumption: consuming as much as possible
2) Protection against consumption risks: they should be able to realize the desired consumption at any time.
The financial manager should therefore increase the shareholders' wealth by maximizing the value of the company and thus the share price. This is, of course, the shareholders' point of view.
Forms of financing
There are three aspects of financing.
The source of fundswith the question of external financing or internal financing,
the maturity according to the classification of short-term (up to 1 year), medium-term (1 to 5 years) and long-term (>5 years), and the legal status of the capital providers and liability with the question of equity financing Or debt financing
The most important points of the introduction
Financial managers work in the interests of the owners and work to increase the market value of the company. Investment decisions relate to the assets side of the balance sheet and financing decisions to the liabilities side.
The opportunity costs (= return on a comparable alternative investment) are relevant benchmarks for investment decisions The capital market provides information on these returns.
Sneak
peak of the next topic: DCF model and investment decision
SourceBrealey, R., S. Myers, F. Allen, A. Edmans (2022): Principles of Corporate Finance, 14th edition, McGraw Hill, ISBN 1260013901 and lecture slides