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Corporate finance

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Working capital management

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


Capital budgeting

Capital investment decisions
The investment decision
The financing decision


Sections

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


Finance series

Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation


Domestic credit to private sector in 2005

Corporate finance is an area of finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate 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, 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 bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs.

Contents

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. (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.

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The investment decision

Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting [3]. Making this 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

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.

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 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 (see list of valuation topics).

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.[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 “flexibile 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] and Real options analysis (ROA) [8]; 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, management chooses the actions corresponding to the highest value path probability weighted; (3) then, assuming rational decision making, this path is taken as representative of project value. See Decision theory: Choice under uncertainty.

Quantifying uncertainty

Given the uncertainty inherent in project forecasting and valuation [9], 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" (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 specific 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, 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 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 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 Crystal Ball. Using simulation, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". Here, 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 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.

The financing decision

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately [11] . 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. 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 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.

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. 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

Whether to issue dividends,[12] and what amount, is calculated mainly on the basis of the company's unappropriated profit and its earning prospects for the coming year. If there are no NPV positive opportunities, i.e. projects 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 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 (see Modigliani-Miller theorem).

Working capital management

Decisions relating to working capital and short term financing are referred to as working capital management[13]. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

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 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 [14]. 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".

Financial risk management

Risk management [15] 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 enhancing, or preserving, firm value. All[citation needed] large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

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. 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.[16]

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:

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 and 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 and Decision Tree Primer, Prof. Craig W. Kirkwood Arizona State University
  8. ^ 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
  9. ^ See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations, Prof. Aswath Damodaran
  10. ^ See Quantifying Corporate Financial Risk David Shimko, Kellogg Graduate School of Management, Northwestern University
  11. ^ See The Financing Decision of the Corporation, Prof. Don M. Chance, Capital Structure, Prof. Aswath Damodaran
  12. ^ See Dividend Policy, Prof. Aswath Damodaran
  13. ^ See Working Capital Management, Studyfinance.com; Working Capital Management, treasury.govt.nz
  14. ^ See The 20 Principles of Financial Management, Prof. Don M. Chance, Louisiana State University
  15. ^ See Professional Risk Managers' International Association and Global Association of Risk Professionals
  16. ^ Beaney, Shaun, "Defining corporate finance in the UK", The Institute of Chartered Accountants, April 2005

See also


Study guide

Up to date as of January 14, 2010

From Wikiversity

Finance is among the most stereotypically MBA things an MBA will learn.

Aim of 'Corporate Finance' is to help financial managers value assets and take informed decisions.

If you want to understand corporate finance, learn thoroughly:

Putting it all together, you'd get something called a model. That model will tell you how much any asset that generates cash flows (such as a stock) is worth. People in business think that this might be useful to know.

More specifically, these tools are useful for evaluating the potential returns of various courses of action, including but not limited to capital investments.

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