Corporate finance

Corporate finance
Working capital
Cash conversion cycle Return on capital Economic Value Added Just-in-time Economic order quantity Discounts and allowances Factoring
Capital budgeting
Capital investment decisions The investment decision The financing decision
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Domestic credit to private sector in 2005.

Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value^[1] while managing the firm's financial risks. 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, short term decisions deal 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).^{[citation needed]}

The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.

Capital investment decisions

Capital investment decisions^[2] are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. (1) 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 in consideration of risk. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

The investment decision

Main article: Capital budgeting

Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting.^[3] Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

Project valuation

Further information: Business valuation, stock valuation, and fundamental analysis

In general,^[4] 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 (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such 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. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate"^[5] – is critical to making an appropriate 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 project-relevant 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 discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

Valuing flexibility

Main articles: Real options analysis and decision tree

In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach.^[6] 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 “flexible and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA)^[7][8] and Real options analysis (ROA);^[9] they may often be used interchangeably:

• DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modelled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
• ROA is usually 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: (1) 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; (2) an appropriate valuation technique is then employed – usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.)

Quantifying uncertainty

Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance

Given the uncertainty inherent in project forecasting and valuation,^[8][10] analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface",^[11] (or even a "value-space"), where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average of the various scenarios.

A further advancement is to construct stochastic^[12] or probabilistic financial models – as opposed to the traditional static and deterministic models as above.^[10] For this purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using an add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or "trials"; see Monte Carlo Simulation versus “What If” Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.

The financing decision

Main article: Capital structure

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately.^[13] The sources of financing are, generically, capital self-generated by the firm as well as debt and equity financing sourced form outside investors. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term financial management decisions). There are two interrelated decisions here:

• Management must 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.) Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control 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.^[14]
• Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap entails matching the assets and liabilities according to maturity pattern ("Cashflow matching") or duration ("immunization"); managing this relationship in the short-term is a major function of working capital management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate risk.

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. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. 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 article: The Dividend Decision

Whether to issue dividends,^[15] and what amount, is calculated mainly on the basis of the company's unappropriated profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows i.e. cash remaining after all business expenses, and capital investment needs have been met.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then – finance theory suggests – management must return excess cash to investors as dividends. This is the general case, however there are exceptions. For example, shareholders of 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 dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, 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 – i.e. the value of the firm would be the same, whether it issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).

Working capital management

Main article: Working capital

Decisions relating to working capital and short term financing are referred to as working capital management.^[16] These involve managing the relationship between a firm's short-term assets and its short-term liabilities. In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA).

Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term, decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants – may be more relevant here).

Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).

• The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into 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. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)
• 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. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.^[17] 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".

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.^[18] These may include

• Raising seed, start-up, development or expansion capital
• Mergers, demergers, acquisitions or the sale of private companies
• Mergers, demergers and takeovers of public companies, including public-to-private deals
• Management buy-out, buy-in or similar of companies, divisions or subsidiaries – typically backed by private equity
• Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership
• Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses
• Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
• Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above.
• Raising debt and restructuring debt, especially when linked to the types of transactions listed above

Financial risk management

Main article: Financial risk management

Risk management ^[19] 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 and market risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value.

It is common for large corporations to have risk management teams. While it is impractical for many small firms to have formal risk management teams, many still practice risk management principles through informal teams. There is a fundamental debate on the value of "Risk Management" and shareholder value that questions a shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links value of risk management in a market to the cost of bankruptcy in that market.

Derivatives are the instruments most^{[citation needed]} 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 or exchanges. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. More customized and second generation derivatives known as exotics trade over the counter aka OTC.

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

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.

Alternate Approaches

A standard assumption in Corporate finance is that shareholders are the residual claimants and that the primary goal of executives should be to maximize shareholder value. Recently, however, legal scholars (e.g. Lynn Stout ^[20]) have questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous assumption.

See also

• Financial modeling
• Business organizations
• Financial planning
• Investment bank
• Venture capital
• Right-financing
• Factoring (finance)

Lists:

• List of accounting topics
• List of finance topics
  • List of corporate finance topics
  • List of valuation topics

References

1. ^ See Corporate Finance: First Principles, Aswath Damodaran, New York University's Stern School of Business
2. ^ The framework for this section is based on Notes by Aswath Damodaran at New York University's Stern School of Business
3. ^ See: Investment Decisions and Capital Budgeting, Prof. Campbell R. Harvey; The Investment Decision of the Corporation, Prof. Don M. Chance
4. ^ See: Valuation, Prof. Aswath Damodaran; Equity Valuation, Prof. Campbell R. Harvey
5. ^ See for example Campbell R. Harvey's Hypertextual Finance Glossary or investopedia.com
6. ^ See: Real Options Analysis and the Assumptions of the NPV Rule, Tom Arnold & Richard Shockley
7. ^ See: Decision Tree Analysis, mindtools.com; Decision Tree Primer, Prof. Craig W. Kirkwood Arizona State University
8. ^ ^{a b} See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and problems of financial management, Jae K. Shim and Joel G. Siegel.
9. ^ See: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
10. ^ ^{a b} See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations, Prof. Aswath Damodaran
11. ^ For example, mining companies sometimes employ the “Hill of Value” methodology in their planning; see, e.g., B. E. Hall, "How Mining Companies Improve Share Price by Destroying Shareholder Value"
12. ^ See: Quantifying Corporate Financial Risk, David Shimko.
13. ^ See: The Financing Decision of the Corporation, Prof. Don M. Chance; Capital Structure, Prof. Aswath Damodaran
14. ^ See:Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes, Nishant Choudhary, LL.M. 2011 (Business & finance), George Washington University Law School
15. ^ See Dividend Policy, Prof. Aswath Damodaran
16. ^ See Working Capital Management, Studyfinance.com; Working Capital Management, treasury.govt.nz
17. ^ See The 20 Principles of Financial Management, Prof. Don M. Chance, Louisiana State University
18. ^ Beaney, Shaun, "Defining corporate finance in the UK", Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011)
19. ^ See: Global Association of Risk Professionals (GARP); Professional Risk Managers' International Association (PRMIA)
20. ^ Lynn A. Stout (2002). Bad and Not-So-Bad Arguments for Shareholder Primacy, University of California, Los Angeles School of Law Research Paper No. 25; Lynn A. Stout (2007). The Mythical Benefits of Shareholder Control, REGULATION Spring 2007.