Domestic credit to private sector in 2005
'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 while reducing the firm's financial
risks. Equivalently, the goal is to
maximize the corporations'
return on capital. Although it is in principle different from
managerial finance which studies the financial decisions 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.
The discipline can be divided into 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. On the other hand, the short term decisions can be grouped under the heading "
Working capital management". This subject 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 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 banker is to evaluate investment projects for a bank to make investment decisions.
==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.
The investment decision
Main articles: 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.
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 net of the initial investment outlay 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
Valuing flexibility
Main articles: Real options analysis,
decision tree
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 options analysis:
★ 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
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
Main articles: Capital structure
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.
One of the main theories of how firms make their financing decisions is the
Pecking Order Theory, 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. Another major theory is the
Trade-Off Theory in which firms are assumed to trade-off the
Tax Benefits of debt with the
Bankruptcy Costs of debt when making their decisions. One last theory about this decision is the
Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.
The dividend decision
Main articles: 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).
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 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.
★ 'Inventory management'. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see
Supply chain management;
Just In Time (JIT);
Economic order quantity (EOQ);
Economic production quantity (EPQ).
★ '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".
Financial risk management
Main articles: 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.
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, 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]
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.
Related Professional Qualifications
Qualifications related to the field include:
★ Finance qualifications:
Masters degree in Finance (MSF),
Chartered Financial Analyst (CFA),
Corporate Finance Qualification (CF),
Certified International Investment Analyst(CIIA),
Association of Corporate Treasurers (ACT),
Certified Market Analyst (CMA/FAD) Dual Designation,
Master Financial Manager (MFM),
Master of Finance & Control (
MFC), .
★ Business qualifications:
Master of Business Administration (
MBA),
Master of Commerce (M Comm),
Doctor of Business Administration (
DBA)
★
Accountancy qualifications:
★
★
Qualified accountant:
Certified Public Accountant (
CPA),
Chartered Certified Accountant(
ACCA),
Chartered Management Accountant (CIMA),
Chartered Accountant (
ACA)
★
★ Non-statutory qualifications:
Chartered Cost Accountant (CCA Designation from
AAFM),
Certified Management Accountant (CMA),
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
See also
★
Financial modeling
★
Business organizations
★
Financial planning
★
Investment bank and
Investment Banking
★
Managerial economics
★
Private equity
★
Real option
★
Venture capital
★ ''Related topics by category:''
★
★
List of accounting topics
★
★
List of corporate finance topics
★
★
List of valuation topics
★
★
List of finance topics
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