Corporate finance
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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.
Capital investment decisions
- [The framework] for this section is based on [Prof. Aswath Damodaran] of NYU’s Stern School of Business.
The investment decision
Main article: Capital budgeting
Management must allocate limited resources between competing opportunities 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. 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. 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
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.
- 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
Any corporate investment must 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.
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. (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 and cash equivalents, 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".
Financial risk management
Main article: Financial risk managementRisk 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
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.See also
- Management accounting
- Investment bank and Investment Banking
- Real option
- Mergers and acquisitions
- * leveraged buyout
- * takeover
- * corporate raid
- * reverse merger
- Managerial economics
- Venture capital
- Private equity
- See also:
- *List of corporate finance topics
- *List of valuation topics
- *List of finance topics, alphabetical list
External links and references
General
- [Corporate Finance page], Prof. Aswath Damodaran, Stern School of Business, New York University
- [Global Financial Management page], Prof. Campbell R. Harvey, Fuqua School of Business, Duke University
- [Finance Lectures] (.exe format), Peter Ekman, CEU Business School
- [Studyfinance.com], University of Arizona
- [Web Sites for Discerning Finance Students], Prof. John Wachowicz at the University of Tennessee.
- [FM Worksheets] excel in Financial Management By Matt Evans
- [Valuation], Prof. Aswath Damodaran
- [Equity Valuation], Prof. Campbell R. Harvey
- [Investment Decisions and Capital Budgeting], Prof. Campbell R. Harvey
- [Capital Budgeting], Studyfinance.com
- [Common challenges in capital budgeting], Investment Analysts Society of South Africa
- [Capital Structure], Prof. Aswath Damodaran
- [Dividend Policy], Prof. Aswath Damodaran
- [Capital Structure and Payout Policies], Prof. Campbell R. Harvey
- [Dividend Policy], Studyfinance.com
- [Working Capital Management], Studyfinance.com
- [Working Capital Works], investopedia.com
- [Counting the Benefits of Working Capital Management], businessfinancemag.com
- [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
- [Real Options Tutorial], Prof. Marco Dias, PUC-Rio
- [A Real Options Resource], MoneyScience.org
- [An introduction to real options], Investment Analysts Society of South Africa
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