There are three main decisions that any business entity must make. These apply whether we are talking about a single enterpreneur or the largest corporations on the planet. Most other business considerations usually fall under one of the three main ones. The purpose of a business entity is to create value for their shareholders and these three decisions determine whether value is created or destroyed. The situation is a little different for non-profit organizations, but not much. Just like for-profit business entities, they face the same optimization problem of how to use their resources as efficiently as possible.
The investment decision determines how the resources of the entity should be allocated in order to generate the highest return on investment. Hiring a new person, expanding to a new location or creating a new product are all examples of investment decisions. A business entity has a hurdle rate which represents the minimum return on investment that it must earn for the investment to make sense. This hurdle rate is often same as the cost of capital for the business. This makes a lot of sense, because if the cost of funding the investment is higher than the return it generates, the investment will not be profitable.
Shareholder value is created when a business entity makes investments that generate higher return than their cost of capital. Conversely value is destroyed if the business makes investments that generate lower return than their cost of capital. It is important to realize that investments should not be made just because they have a positive return, but only when that return exceeds the hurdle rate.
The financing decision determines how the operations of the business should be financed. There are basically only two ways to finance a business: the shareholders can use their own money (equity) or the business can borrow money (debt). The decision whether to use equity or debt, and to what proportion, is based largely on the cost of each type of capital. These are known as cost of equity and cost of debt which together make up the cost of capital for the business.
Shareholder value is maximized when the business has optimal capital structure which minimizes the cost of capital for the business. Value is destroyed when the business is not financed efficiently. This could happen for example if inexpensive debt is available but it is not utilized.
The dividend decision determines how much of the profits that the business earns should be distributed back to its shareholders. Many companies also buy back their own shares, but that is just another way to return capital back to the shareholders. The decision to pay dividends should be based on what kind of investment opportunities the company has compared to what kind of other investment opportunities the shareholders would have if the dividends were paid out. Generally new companies should not pay dividends when they are in a phase of strong growth, while mature companies that are not growing much anymore should begin to return capital to shareholders.
If a business has investments available that generate high return, paying dividends would likely destroy shareholder value because they are unable to use that capital as efficiently elsewhere. However, if the business cannot find investments with adequate return, it is in the interests of the shareholders that the profits are paid out so that they can be invested in other companies where that capital can be employed more efficiently. Yes, there is such a thing as having too much money and when that occurs it is said the business is overcapitalized.
Some of this information may seem obvious, but I find it is still helpful to put it into words with proper definitions and really think about it. I suspect this is something many small business owners understand subconciously, but do not necessarily think about conciously. Every business owner should have at least some figures for their cost of equity, cost of debt and hurdle rate, even if they are rough estimates. I would suggest that the investment decision is by far the most important for small business owners and that is where they should spend most of their time. That is what makes or breaks a business.
To sum things up, a successful business is one that:
- Makes investments that exceed its cost of capital by a good margin.
- Has access to financing and uses debt and equity in correct proportion.
- Pays dividends only when no suitable investments are available, but does not hoard cash either.
To close this post, I have to acknowledge Aswath Damodaran as a big contributor to my understanding of corporate finance. He has a lot of free content available on his website and YouTube, so if you wish to learn more, check him out.