Corporate Finance

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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 valuation (finance) while reducing the firm's financial risks. Equivalently, the goal is to maximization 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 ownership 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 assets and liabilities; the focus here is on managing cash, inventory, 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 decisionsThe framework for this section is based on Notes by Aswath Damodaran at New York University's Stern School of Business 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===

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 Net present value.

The Net present value 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 investment on an investment—i.e. the Capital asset pricing model#Asset-specific required return. 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 capital asset pricing model or the arbitrage pricing theory 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 Net present value, there are several other measures used as (secondary) Decision making#Decision making in business in corporate finance. These are visible from the DCF and include payback, internal rate of return, Modified Internal Rate of Return, Equivalent Annual Cost, capital efficiency, and Return on investment.

See also: list of finance topics#valuation, 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 expected value or average or scenario planning cash flows are discounted, here the “flexibile and staged nature” of the investment is Mathematical model, and hence "all" potential Moneyness are considered. The difference between the two valuations is the "option value" inherent in the project.

The two most common tools are decision tree (DTA) and Real options analysis:

The DTA approach attempts to capture flexibility by incorporating Event (probability theory) and consequent Decision making#Decision making in business and management 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) is regarded as representative of project value

The real options approach is used when the value of a project is List of finance topics#Contingent claim valuation on the Value (economics) of some other asset or underlying. (For example, the Economic geology of a mining project is contingent on the price of gold; if the price is too low, management will abandon the Mineral rights, if sufficiently high, management will Underground mining (hard rock)#Development Mining vs. Production Mining the ore. Again, a DCF valuation would capture only one of these outcomes.) Here, using Option (finance) 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 options model or, less often for this purpose, via Black-Scholes formula; see List of finance topics#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===

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, Weighted average cost of capital, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of Bond (finance) and Equity investment. 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 Capital asset pricing model and Weighted average cost of capital), 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 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 Return on investment exceed the hurdle rate, then management must return excess cash to Equity investment - these Cash flow 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 Treasury stock. There are various considerations: where shareholders pay Dividend tax, 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 Treasury 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 Asset#Current assets and its Current liability. The goal of Working capital management is to ensure that the firm is able to continue its Operations management 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 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 Asset#Current assets (generally cash and cash and cash equivalents, Inventory 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 (finance), 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 List of Latin phrases#V); 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 (trade)".

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 ("Hedge (finance)") using traded financial instruments (typically changes in commodity, interest rates, exchange rates and stock). 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 (economics). All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

Derivative (finance) 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 option (finance)s, futures contracts, forward contracts, and swap (finance).

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 of Nations 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.Beaney, Shean, "Defining corporate finance in the UK", The Institute of Chartered Accountants, April 2005

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: Master of Science 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)

Accountant:

Accountant#Accountancy_qualifications_and_regulation: Certified Public Accountant (CPA), Chartered Certified Accountant(Chartered Certified Accountant), Chartered Institute of Management Accountants (CIMA), Chartered Accountant (Chartered accountant)
Non-statutory qualifications: Chartered Cost Accountant (CCA Designation from AAFM), Certified Management Accountant (CMA),

References

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 finance topics#Corporate finance
List of finance topics#Valuation
List of finance topics

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