Source of Capital

How does a company manage to generate cash flow? To answer this question, the study of investment decision and financial decision is crucial. Both of the decisions are discuss as follow:

1. Investment decision

The company needs to acquire asset such as building, plant and equipment, etc to run business to earn profits. If it sees the opportunity that can increase the shareholder wealth, it may want to expand the business. Hence, which asset to acquire and which project to select, all of these considerations are included in the investment decision. In other words, the company will assess the project or assets weather worth to invest or not. If the project yields a financial return, the shareholder wealth increased. There are many type of project assessment (called investment appraisal) can be use by the company. The major methods are accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR). The NPV is the method that consistent with the financial objective of shareholder wealth maximization.

2. Financial Decision

In order for the company to make an investment effectively, the financial decisions are related. It concern on the issues such as how much capital to raise, what are the best mixes of the source of capital. The sources of capital can be distinct into equity and debt. Both of the sources have its pros and cons. The main consideration for the company to raise capital is to construct a capital structure that gives the lower cost of capital and lower risk. In the NPV methods, the lower cost of capital will generates higher present value, which maximizes the shareholder's wealth. The higher the risk, the expected return by the investor will be increase. The expected return of the investor is the cost of the company for raising the funds. As the result, cost of capital will increase.

There are many theories