Chapter 26 Value and corporate finance

No, Sire, it’s a revolution!

This section presents the concepts and theories that underpin all important financial decisions. In particular, we will examine their impact on value, keeping in mind that basically to maximise a value, we must minimise a cost. The chapters in this section will introduce you to the investment decision processes within a firm and their impact on the overall value of the company.

Section 26.1 The purpose of finance is to create value

1. Investment and value

The accounting rules we looked at in Chapter 4 showed us that an investment is a use of funds, but not a reduction in the value of assets. We will now go one step further and adopt the viewpoint of the financial manager for whom a profitable investment is one that increases the value of capital employed.

We shall see that a key element in the theory of markets in equilibrium is the market value of capital employed. This theory underscores the direct link between the return on a company’s investments and that required by investors buying the financial securities issued by the company.

The true measure of an investment policy is the effect it has on the value of capital employed. This concept is sometimes called “enterprise value”, a term our reader should not confuse with the value of equity (capital employed less net debt). The two are far from the same!

Hence the importance of every investment decision, as it can lead to three different outcomes:

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