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Corporate Finance
Corporate Finance is a specific area of finance dealing with the
financial decisions corporations make and the tools as well as analyses
used to make these decisions. The discipline as a whole may be divided
among long-term and short-term decisions and techniques with the
primary goal being the enhancing of corporate value by ensuring
that return on capital exceeds cost of capital, without taking excessive
financial risks.
Capital investment decisions comprise the long-term choices about
which projects receive investment, whether to finance that investment
with equity or debt, and when or whether to pay dividends to shareholders.
Short-term corporate finance decisions are called working capital
management and deal with balance of current assets and current liabilities
by managing cash, inventories, and short-term borrowing and lending
(e.g., the credit terms extended to customers).
Corporate finance is closely related to managerial finance, which
is slightly broader in scope, describing the financial techniques
available to all forms of business enterprise, corporate or not.
Contents of Article
1 Capital investment decisions
1.1 The investment decision
1.1.1 Project valuation
1.1.2 Valuing flexibility
1.2 The financing decision
1.3 The dividend decision
2 Working capital management
2.1 Decision criteria
2.2 Management of working capital
3 Financial risk management
4 Relationship with other areas in finance
5 Related articles
6 External links and references
Capital investment decisions
The framework for this section is based on Prof. Aswath Damodaran
of NYU’s Stern School of Business.
Longer term decisions - generally relating to fixed assets and capital
structure - are referred to as Capital investment decisions. The
decision here will be based on several inter-related criteria. In
general, management must "maximize the value of the firm"
by investing in projects which are NPV positive, when valued using
an appropriate discount rate; these projects must also be financed
appropriately. If no such opportunites exist, management should
return excess cash to shareholders. Capital investment decisions
thus comprise an investment decision, a financing decision, and
a dividend decision.
The investment decision
Management must allocate limited resources between competing opportunities.
Doing so requires estimating the value of each opportunity or project:
a function of the size, timing and predictability of future cash
flows.
Project valuation
In general, each project's value will be estimated using a discounted
cash flow (DCF) valuation, and the opportunity with the highest
value, as measured by net present value (NPV) will be selected (see
Fisher separation theorem). This requires estimating the size and
timing of all of the incremental cash flows resulting from the project.
These future cash flows are then discounted to determine their present
value. These present values are then summed, and this sum is the
NPV. See also Time value of money.
The NPV is greatly influenced by the discount rate. Thus selecting
the proper discount rate - the project hurdle rate - is critical
to making the right decision. 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 financing mix, the weighted average cost of capital,
or WACC. Managers use models such as the CAPM or the APT to estimate
the right rate for the project.
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 payback, IRR, Modified IRR, equivalent
annuity, capital efficiency, and ROI.
See also: list of valuation topics, stock valuation, fundamental
analysis
Valuing flexibility
In many cases, for example R&D projects, a project may open
(or close) paths of action to the company, but this reality will
not typically be captured in a strict NPV approach. Management will
therefore (sometimes) employ tools which place an explicit value
on these options. So, whereas in an a DCF valuation, the average,
or scenario specific, cash flows are discounted, here the “flexibile
and staged nature” of the investment is modelled, and hence
"all" potential payoffs are considered. The difference
between the two valuations is the "option value" inherent
in the project.
The two most common tools are Decision Tree Analysis (DTA) and
Real options.
The DTA approach attempts to capture flexibility by incorporating
likely events and consequent management decisions into the valuation.
In the decision tree, each management decision in response to an
"event" generates a "branch" or "path"
which the company could follow. (For example, management will only
proceed with stage 2 of the project given that stage 1 was succesful.
In a DCF model, on the other hand, there is no branching - each
scenario must be modelled separately.) The highest value path (probability
weighted) is regarded as representative of project value.
The real options approach is used when the value of a project is
contingent on the value of some other asset or underlying variable.
(For example, the viability of a mining project is contingent on
the price of gold; if the price is too low management will abandon
the mining rights, if sufficiently high management will develop
the Ore-body. Again, a DCF valuation would capture only one of these
outcomes.) Here, using financial option theory as a framework, the
decision to be taken is identified as corresponding to either a
call option or a put option - valuation is then via the Binomial
model or, less often for this purpose, via Black Scholes; see Contingent
claim valuation. The "true" value of the project is then
the NPV of the "most likely" scenario plus the option
value.
The financing decision
Any corporate investment must be financed appropriately. As above,
the financing mix can impact the valuation; both hurdle rate and
cash flows (and hence the riskiness of the firm) will be affected.
Management must therefore identify the "optimal mix" of
financing – the capital structure that results in maximum
value. (See Balance sheet, WACC, Fisher separation theorem; but,
see also the Modigliani-Miller theorem.)
The sources of financing will, generically, comprise some combination
of debt and equity. Financing a project through debt results in
a liability that must be serviced - and hence there are cash flow
implications regardless of the project's success. Equity financing
is less risky in the sense of cash flow commitments, but results
in a dilution of ownership and earnings. The cost of equity is also
typically higher than the cost of debt (see CAPM and WACC), and
so equity financing may result in an increased hurdle rate which
may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the
asset being financed as closely as possible, in terms of both timing
and cash flows.
The dividend decision
In general, management must decide whether to invest in additional
projects, reinvest in existing operations, or return free cash as
dividends to shareholders. The dividend is calculated mainly on
the basis of the company's unappropriated profit and its business
prospects for the coming year. If there are no NPV positive opportunities,
i.e. where returns exceed the hurdle rate, then management must
return excess cash to investors - these free cash flows comprise
cash remaining after all business expenses have been met. (In the
case of a "Growth stock", investors expect that the company
will, almost by definition, retain earnings so as to fund growth
internally. In other cases, even though an opportunity is currently
NPV negative, management may consider “investment flexibility”
and potential payoff and decide to retain cash flows ; see above
and Real options.)
Management must also decide on the form of the distribution, generally
as cash dividends or via a share buyback. There are various considerations:
where shareholders pay tax on dividends, companies may elect to
retain earnings, or to perform a stock buyback, in both cases increasing
the value of shares outstanding; some companies will pay "dividends"
from stock rather than in cash. (See Corporate action.) Today it
is generally accepted that dividend policy is value neutral (see
Modigliani-Miller theorem).
Working capital management
Decisions relating to working capital and short term financing are
referred to as working capital management. These involve managing
the relationship between a firm's short-term assets and its short-term
liabilities. The goal of Working capital management is to ensure
that the firm is able to continue its operations and that it has
sufficient cash flow to satisfy both maturing short-term debt and
upcoming operational expenses.
Decision criteria
By definition, Working capital management entails short term decisions
- generally, relating to the next one year period - which are "reversible".
These decisions are therefore not taken on the same basis as Capital
Investment Decisions (NPV or related, as above) rather they will
be based on cash flows and / or profitability.
One measure of cash flow is provided by the cash conversion cycle
- the net number of days from the outlay of cash for raw material
to receiving payment from the customer. As a management tool, this
metric makes explicit the inter-relatedness of decisions relating
to inventories, accounts receivable and payable, and cash. Because
this number effectively corresponds to the time that the firm's
cash is tied up in operations and unavailable for other activities,
management generally aims at a low net count.
In this context, the most useful measure of profitability is Return
on capital (ROC). The result is shown as a percentage, determined
by dividing relevant income for the 12 months by capital employed;
Return on equity (ROE) shows this result for the firm's shareholders.
Firm value is enhanced when, and if, the return on capital, which
results from working capital management, exceeds the cost of capital,
which results from capital investment decisions as above. ROC measures
are therefore useful as a management tool, in that they link short-term
policy with long-term decision making. See Economic value added
(EVA).
Management of working capital
Guided by the above criteria, management will use a combination
of policies and techniques for the management of working capital.
These require managing the current assets - generally cash balances,
inventories and debtors. There are also a variety of short term
financing options which are considered.
cash management – identify the cash balance
which allows for the business to meet day to day expenses, but reduces
cash holding costs
inventory management - identify the level of inventory which allows
for uninterrupted production but reduces the investment in raw materials
and hence increases cash flow; see Just In Time (JIT) and Economic
order quantity (EOQ).
debtors management - identify the appropriate credit
policy, i.e. credit terms which will attract customers, such that
any impact on cash flows and the cash conversion cycle will be offset
by increased revenue and hence Return on Capital (or vice versa);
see Discounts and allowances.
short term financing - inventory is ideally financed by credit granted
by the supplier; dependent on the cash conversion cycle, it may
be necessary to utilize a bank loan (or overdraft), or to "convert
debtors to cash" through "factoring".
Main article: Financial risk management
Risk management is the process of measuring risk and then developing
and implementing strategies to manage that risk. Financial risk
management focuses on risks that can be managed ("hedged")
using traded financial instruments (typically changes in commodity
prices , interest rates, foreign exchange rates and stock prices).
Financial risk management will also play an important role in cash
management.
This area is related to corporate finance in two ways. Firstly,
firm exposure to business risk is a direct result of previous Investment
and Financing decisions. Secondly, both disciplines share the goal
of creating, or enhancing, firm value. All large corporations have
risk management teams, and small firms practice informal, if not
formal, risk management.
Derivatives are the instruments most commonly used in Financial
risk management. Because unique derivative contracts tend to be
costly to create and monitor, the most cost-effective financial
risk management methods usually involve derivatives that trade on
well-established financial markets. These standard derivative instruments
include options, futures, forwards, and swaps.
See: Default (finance); Credit risk; Interest rate risk; Liquidity
risk; Market risk; Operational risk; Volatility risk; Settlement
risk.
[edit]Relationship with other areas in finance
Corporate finance utilizes tools from almost all areas of finance.
Some of the tools developed by and for corporations have broad application
to entities other than corporations, for example, to partnerships,
sole proprietorships, not-for-profit organizations, governments,
mutual funds, and personal wealth management. But in other cases
their application is very limited outside of the corporate finance
arena. Because corporations deal in quantities of money much greater
than individuals, the analysis has developed into a discipline of
its own. It can be differentiated from personal finance and public
finance.
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From Wikipedia, the public domain free encyclopedia.
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