Three Theories Used When Making Finance Decisions
Before a project can be financed, accurate valuation must be determined. Project valuation is determined using the discounted rate to determine the net present value. It can be tricky calculating all projected cash flows as a result of the project and more importantly, the total cost of the project once complete (some take into account future upkeep or maintenance). Once the valuation is predicted, though, it is the finance decision that will determine if the project is a go or a no-go at that moment in time. How do firms decide which projects to finance today and which to save for the future? How do they decide which to finance at all?
There are three types of theories commonly referred to when deciding which strategic moves will be followed through with in the immediate future. The first is the Pecking-Order Theory. This theory suggests that firms will only finance what they are able to do so using an internal source for funds. In other words, they use their own capital or finance only when a reasonable low interest rate exists. This method is seen as the most efficient method of choosing a project to finance, because the firm doesn’t have to turn to outside investors or banks.
The Trade-Off Theory is where firms opt for the trade-off that exists when financing a new project will result in tax benefits from incurring debt. This theory can become tricky when the marginal benefit of incurring debt (tax benefits of debt) are outweighed by the marginal cost of incurring debt (bankruptcy costs of debt). A firm is challenged with finding an optimal level of financing, i.e. moving forward with a project.
Finally, a Market Timing Hypothesis simply implies a firm will finance the least-expensive project firm conducive to the market. This theory disregards the firm’s current level of private capital and debt. Unlike the first two theories mentioned, this assumes the project is going to happen. The question is whether or not to finance from within or external to the organization. In addition, a decision made using this logic leads more to what the trend is in the financial community is. Whether or not the economy is operating under a debt or equity notion can be viewed by the company as the way to finance.
Of course there exists other ways of financing. Outlined above are three common theories used by corporations – whether they are aware they are following a pattern or not. There are also dividend programs, private investors, investment banking and so on. Understanding how your firm makes finance decisions can help determine which projects to pursue and can better facilitate communication between levels of management.
