Corporate finance

Corporate finance is the area of finance dealing with the sources of funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.[1] Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Investment analysis (or capital budgeting) is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with equity or debt capital. Working capital management is the management of the company's monetary funds that deal with the short-term operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).

The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms "corporate finance" and "corporate financier" may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses. Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions.[2]

Financial management overlaps with the financial function of the Accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders.

Outline of corporate finance

The primary goal of financial management is to maximize or to continually increase shareholder value.[3] Maximizing shareholder value requires managers to be able to balance capital funding between investments in projects that increase the firm's long term profitability and sustainability, along with paying excess cash in the form of dividends to shareholders. Managers of growth companies (i.e. firms that earn high rates of return on invested capital) will use most of the firm's capital resources and surplus cash on investments and projects so the company can continue to expand its business operations into the future. When companies reach maturity levels within their industry (i.e. companies that earn approximately average or lower returns on invested capital), managers of these companies will use surplus cash to payout dividends to shareholders. Managers must do an analysis to determine the appropriate allocation of the firm's capital resources and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt.[3][4]

Choosing between investment projects will be based upon several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk. (2) These projects must also be financed appropriately. (3) If no growth is possible by the company and excess cash surplus is not needed to the firm, then financial theory suggests that management should return some or all of the excess cash to shareholders (i.e., distribution via dividends).[5]

This "capital budgeting" is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm's capital structure. Management must allocate the firm's limited resources between competing opportunities (projects).[6]

Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital.[7] Investments should be made on the basis of value-added to the future of the corporation. Projects that increase a firm's value may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no growth or expansion is possible by a corporation and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.[8][9]

Capital structure

Capitalization structure

Domestic credit to private sector in 2005.
Main article: Capital structure
Further information: Security (finance)

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately.[10] The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt and equity (and hybrid- or convertible securities). As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm. There are two interrelated considerations here:

Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how to allocate the company's resources. However economists have developed a set of alternative theories about how managers allocate a corporation's finances. One of the main alternative theories of how firms manage their capital funds is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One of the more recent innovations in this area from a theoretical point of view is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

Sources of capital

Further information: Security (finance)

Debt capital

Further information: Bankruptcy and Financial distress

Corporations may rely on borrowed funds (debt capital or credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public. Bonds require the corporations to make regular interest payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full. Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges. Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use collateral assets as a form of repaying their debt obligations (or through the process of liquidation).

Equity capital

Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in value of the company (or appreciate in value) over time to make their investment a profitable purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects (or investments) that earn a positive rate of return for the owners. Investors prefer to buy shares of stock in companies that will consistently earn a positive rate of return on capital in the future, thus increasing the market value of the stock of that corporation. Shareholder value may also be increased when corporations payout excess cash surplus (funds from retained earnings that are not needed for business) in the form of dividends.

Preferred stock

Preferred stock is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company).[13]

Preferred stock usually carries no voting rights,[14] but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation".

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.[15]

Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:[16]

Investment and project valuation

In general,[17] each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate"[18] – is critical to choosing good projects and investments for the firm. The hurdle rate is the minimum acceptable return on an investment – i.e., the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix.[19] Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include Residual Income Valuation, MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

Valuing flexibility

In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach.[20] Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers).[21][22] Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.[23] Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the "flexible and staged nature" of the investment is modelled, and hence "all" potential payoffs are considered. See further under Real options valuation. The difference between the two valuations is the "value of flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA)[24] and Real options valuation (ROV);[25] they may often be used interchangeably:

Quantifying uncertainty

Given the uncertainty inherent in project forecasting and valuation,[24][26] analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface",[27] (or even a "value-space",) where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average of the various scenarios; see First Chicago Method. (See also rNPV, where cash flows, as opposed to scenarios, are probability-weighted.)

A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of variables and their realizations" [28] is to construct stochastic[29] or probabilistic financial models – as opposed to the traditional static and deterministic models as above.[26] For this purpose, the most common method is to use Monte Carlo simulation to analyze the project's NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or trials, "covering all conceivable real world contingencies in proportion to their likelihood;" [30] see Monte Carlo Simulation versus "What If" Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.

Dividend policy

Main article: Dividend policy

Dividend policy is concerned with financial policies regarding the payment of a cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends,[31] and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess cash surplus so as to fund future projects internally to help increase the value of the firm.

Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth companies would prefer managers to retain earnings and pay no dividends (use excess cash to reinvest into the company's operations), whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends when a positive return cannot be earned through the reinvestment of undistributed earnings. A share buyback program may be accepted when the value of the stock is greater than the returns to be realized from the reinvestment of undistributed profits. In all instances, the appropriate dividend policy is usually directed by that which maximizes long-term shareholder value.

Working capital management

Main article: Working capital

Managing the corporation's working capital position to sustain ongoing business operations is referred to as working capital management.[32][33] These involve managing the relationship between a firm's short-term assets and its short-term liabilities. In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital budgeting, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long-term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.

Working capital

Working capital is the amount of funds which are necessary to an organization to continue its ongoing business operations, until the firm is reimbursed through payments for the goods or services it has delivered to its customers.[34] Working capital is measured through the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, capital resource allocations relating to working capital are always current, i.e. short-term. In addition to time horizon, working capital management differs from capital budgeting in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants – may be more relevant here).

The (short term) goals of working capital are therefore not approached on the same basis as (long term) profitability, and working capital management applies different criteria in allocating resources: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.[35] These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.[33]

Relationship with other areas in finance

Investment banking

Use of the term "corporate finance" varies considerably across the world. In the United States it is used, as above, to describe activities, analytical methods and techniques that deal with many aspects of a company's finances and capital. In the United Kingdom and Commonwealth countries, the terms "corporate finance" and "corporate financier" tend to be associated with investment banking – i.e. with transactions in which capital is raised for the corporation.[37] These may include

Financial risk management

Risk management [29][38] is the process of measuring risk and then developing and implementing strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk). It will also play an important role in short term cash- and treasury management; see above. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for small firms to have a formal risk management function, many still apply risk management informally. See also Enterprise risk management.

The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives; see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because company specific, "over the counter" (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or exchanges are often preferred. These standard derivative instruments include options, futures contracts, forward contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB 133, IAS 39.

This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous capital financial investments. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. There is a fundamental debate [39] relating to "Risk Management" and shareholder value. Per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress. A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of bankruptcy in that market.

See also

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Lists:

References

  1. ↑ See Corporate Finance: First Principles, Aswath Damodaran, New York University's Stern School of Business
  2. ↑ Katz, Jeffrey; Zimmerman, Scott. "Recent Developments in Acquisition Finance". Transaction Advisors. ISSN 2329-9134.
  3. 1 2 Jim McMenamin (11 September 2002). Financial Management: An Introduction. Routledge. pp. 23–. ISBN 978-1-134-67624-8.
  4. ↑ Carlos Correia; David K. Flynn; Enrico Uliana; Michael Wormald (15 January 2007). Financial Management. Juta and Company Ltd. pp. 5–. ISBN 978-0-7021-7157-4.
  5. ↑ Financial Management; Principles and Practice. Freeload Press, Inc. 1968. pp. 265–. ISBN 978-1-930789-02-9.
  6. ↑ See: Investment Decisions and Capital Budgeting, Prof. Campbell R. Harvey; The Investment Decision of the Corporation, Prof. Don M. Chance
  7. ↑ Myers, Stewart C. "Interactions of corporate financing and investment decisions—implications for capital budgeting." The Journal of finance 29.1 (1974): 1-25.
  8. ↑ Pamela P. Peterson; Frank J. Fabozzi (4 February 2004). Capital Budgeting: Theory and Practice. John Wiley & Sons. ISBN 978-0-471-44642-2.
  9. ↑ Lawrence J. Gitman; Michael D. Joehnk; George E. Pinches (1985). Managerial finance. Harper & Row.
  10. ↑ See: The Financing Decision of the Corporation, Prof. Don M. Chance; Capital Structure, Prof. Aswath Damodaran
  11. ↑ Capital Structure: Implications, Prof. John C. Groth, Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure, Ruben D. Cohen, Citigroup
  12. ↑ See:Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes, Nishant Choudhary, LL.M. 2011 (Business & finance), George Washington University Law School
  13. ↑ Drinkard, T., A Primer On Preferred Stocks., Investopedia
  14. ↑ "Preferred Stock ... generally carries no voting rights unless scheduled dividends have been omitted." – Quantum Online
  15. ↑ Drinkard, T.
  16. ↑ Kieso, Donald E.; Weygandt, Jerry J. & Warfield, Terry D. (2007). Intermediate Accounting (12th ed.). New York: John Wiley & Sons. p. 738. ISBN 0-471-74955-9.
  17. ↑ See: Valuation, Prof. Aswath Damodaran; Equity Valuation, Prof. Campbell R. Harvey
  18. ↑ See for example Campbell R. Harvey's Hypertextual Finance Glossary or investopedia.com
  19. ↑ Prof. Aswath Damodaran: Estimating Hurdle Rates
  20. ↑ See: Real Options Analysis and the Assumptions of the NPV Rule, Tom Arnold & Richard Shockley
  21. ↑ Aswath Damodaran: Risk Adjusted Value; Ch 5 in Strategic Risk Taking: A Framework for Risk Management. Wharton School Publishing, 2007. ISBN 0-13-199048-9
  22. ↑ See: §32 "Certainty Equivalent Approach" & §165 "Risk Adjusted Discount Rate" in: Joel G. Siegel; Jae K. Shim; Stephen Hartman (1 November 1997). Schaum's quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students. McGraw-Hill Professional. ISBN 978-0-07-058031-2. Retrieved 12 November 2011.
  23. ↑ Dan Latimore: Calculating value during uncertainty. IBM Institute for Business Value
  24. 1 2 See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and problems of financial management, Jae K. Shim and Joel G. Siegel.
  25. ↑ See:Identifying real options, Prof. Campbell R. Harvey; Applications of option pricing theory to equity valuation, Prof. Aswath Damodaran; How Do You Assess The Value of A Company's "Real Options"?, Prof. Alfred Rappaport Columbia University & Michael Mauboussin
  26. 1 2 See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations, Prof. Aswath Damodaran
  27. ↑ For example, mining companies sometimes employ the "Hill of Value" methodology in their planning; see, e.g., B. E. Hall (2003). "How Mining Companies Improve Share Price by Destroying Shareholder Value" and I. Ballington, E. Bondi, J. Hudson, G. Lane and J. Symanowitz (2004). "A Practical Application of an Economic Optimisation Model in an Underground Mining Environment".
  28. ↑ Virginia Clark, Margaret Reed, Jens Stephan (2010). Using Monte Carlo simulation for a capital budgeting project, Management Accounting Quarterly, Fall, 2010
  29. 1 2 See: Quantifying Corporate Financial Risk, David Shimko.
  30. ↑ The Flaw of Averages, Prof. Sam Savage, Stanford University.
  31. ↑ See Dividend Policy, Prof. Aswath Damodaran
  32. ↑ See Working Capital Management, Studyfinance.com; Working Capital Management, treasury.govt.nz
  33. 1 2 Best-Practice Working Capital Management: Techniques for Optimizing Inventories, Receivables, and Payables, Patrick Buchmann and Udo Jung
  34. ↑ Security Analysis, Benjamin Graham and David Dodd
  35. ↑ See The 20 Principles of Financial Management, Prof. Don M. Chance, Louisiana State University
  36. ↑ William Lasher (2010). Practical Financial Management. South-Western College Pub; 6 ed. ISBN 1-4390-8050-X
  37. ↑ Beaney, Shaun, "Defining corporate finance in the UK", Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011)
  38. ↑ See: Global Association of Risk Professionals (GARP); Professional Risk Managers' International Association (PRMIA)
  39. ↑ See for example: Prof. Jonathan Lewellen, MIT: Financial Management Notes: Risk Management

Further reading

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