Business finance : theory and practice

Chapter 2 • A framework for financial decision making
all of the other shareholders. Project X and Project Y suggest what is obviously true:
that where the business undertakes projects whose rates of return are greater than the
interest rate at which shareholders can borrow or lend, their wealth will be increased.
Projects that yield a lower rate than the shareholders’ interest rate will have the effect
of reducing the wealth of the shareholders. Project X produces a return of 20 per cent
p.a., that is, (£120,000 − £100,000)/£100,000, Project Y makes a 9 per cent return; the
interest rate is 10 per cent. It is obvious that a project yielding 10 per cent would not
alter the wealth of shareholders.
Opportunity cost of finance
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The borrowing/lending interest rate represents the opportunity cost to the shareholder
of making investments in the projects. The existence of the facility to borrow or
to lend means that those who have the cash but do not want to spend have the opportunity
to lend at the interest rate as an alternative to investing. Any investments in projects
must therefore compete with that opportunity and, to be desirable, produce
returns in excess of the interest rate.
Borrowing by the business
Suppose that Industries Ltd’s management decided to undertake Project X, but for
some reason or another, it also decided to pay an immediate dividend of £50,000,
making up the shortfall of the cash needed for the investment by borrowing at 10 per
cent p.a. for the duration of the project. This would mean that the £50,000 borrowed
with interest, a total of £55,000, would have to be repaid from the £120,000 proceeds
from the investment, leaving £65,000 of the £120,000 proceeds from Project X to be
paid as a dividend next year.
For Eager this would mean a dividend of £5,000 now and another one of £6,500 next
year. What effect will this have on her present wealth? She can borrow the amount that
will, with interest, grow to £6,500; this will be £5,909 [that is, £6,500 × 100/(100 + 10)],
which together with the £5,000 dividend will give her £10,909, an increase in wealth of
£909. Note that this is identical to the increase in her current wealth that we found
when we assessed Project X assuming that it was to be financed entirely by the shareholders.
Not surprisingly, it could equally well be shown that this would also be true
for the other shareholders, and no matter what proportion of the £100,000 the business
borrows, Project X will remain equally attractive.
Therefore, it seems not to matter where the cash comes from: if the investment will
increase shareholders’ wealth under one financing scheme, it will increase it by the
same amount under some other scheme.
The theoretical implications of Projects X and Y
Our example illustrates three important propositions of business finance:
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1 Businesses should invest in projects that make them wealthier. By doing this the wealth
of the shareholders will be increased. By investing in as many such projects as are
available, shareholders’ wealth will be maximised.
2 Personal consumption/investment preferences of individual shareholders are irrelevant in
making corporate investment decisions. Irrespective of when and how much individuals
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