Corporate finance

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Corporate finance

Working capital management
Cash conversion cycle
Return on capital
Economic value added
Just In Time (business)
Economic order quantity
Discounts and allowances
Factoring (finance)

Capital budgeting
Capital investment decisions
The investment decision
The financing decision
Capital investment decisions

Sections
Managerial finance
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action

Finance series
Financial market
Financial market participants
Corporate finance
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v d e

In the United States, corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to enhance corporate value without taking excessive financial risks.

The discipline is divided among long-term and short-term decisions and techniques. Capital investment decisions are 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. Working capital management deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the credit terms extended to customers).

Corporate value is enhanced when return on capital, a function of working capital management, exceeds cost of capital, a function of capital investment.

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.

In the United Kingdom and Commonwealth countries, corporate finance and corporate financier are associated with investment banking, which raises capital for the corporation.

Contents

[edit] Capital investment decisions[1]

Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. 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. These projects must also be financed appropriately. If no such opportunities exist, maximizing shareholder value dictates that management return excess cash to shareholders. Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

[edit] The investment decision

Main article: Capital budgeting

Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.

[edit] 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 the resultant 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 (see Time value of money). These present values are then summed, and this sum is the NPV.

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. 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 payback, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.

See also: list of valuation topics, stock valuation, fundamental analysis

[edit] 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 a DCF valuation the most likely or 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 option

  • 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 successful; stage 3, in turn, depends on stage 2. 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 following example shows a portfolio of 7 investment options (projects), but the organization has only $10,000,000 available for the total investment. The calculation uses discounted payoffs (PV: Present values) in a 4 years projection. Bold lines mark the best selection 1, 3, 6 and ,7 which will cost $7,740,000 and create a payoff of 2,710,000. All other combinations would either exceed the budget or yield a lower payoff: Image:Project Investment Portfolio Occam s Tree.gif

[edit] The financing decision

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. 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.

[edit] The dividend decision

Main article: 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. (This is the general case, however there are exceptions. For example, investors in a "Growth stock", 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” / potential payoffs 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).

[edit] 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.

[edit] 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).

[edit] 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 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.

  • Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
  • 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. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

[edit] Financial risk management

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 contracts, forward contracts, and swaps.

See: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk.

[edit] Relationship with other areas in finance

[edit] 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, decisions 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.[2]

[edit] Personal and public 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.

[edit] Related Professional Qualifications

The new internationally recognised Corporate Finance Qualification (CF) is the only directly related professional qualification, although many others traditionally can lead to the field:

[edit] References

  1. ^ The framework for this section is based on Notes by Aswath Damodaran at New York University's Stern School of Business
  2. ^ Beaney, Shean, "Defining corporate finance in the UK", The Institute of Chartered Accountants, April 2005

[edit] See also

[edit] External links

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General

Valuation and Capital Budgeting

Capital Structure and Dividend Policy

Working Capital Management

Real options

Decision Tree Analysis

Financial risk management

Related Professional Qualification

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