Corporate finance
Corporate Finance is the specific area of finance dealing with the financial decisions corporations make, and the tools and analysis used to make the decisions. The discipline as a whole may be divided between long term, capital investment decisions , and short term, working capital management. The two are related in that firm value is enhanced when return on capital, a function of working capital management, exceeds cost of capital, which results from the longer term, capital decisions. 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 below is based on of NYU?s Stern School of Business.
Longer term decisions - generally relating to fixed assets and capital structure - are referred to as Capital investment decisions. The decision here will be based on several inter-related criteria. In general, management must "maximize the value of the firm" by investing in projects which are NPV positive, when valued using an appropriate discount rate; these projects must also be financed appropriately. If no such opportunites exist, management should return excess cash to shareholders.
The investment decision
Management must allocate limited resources between competing opportunities. In general, each will be asessed via a DCF valuation, and the opportunity with the highest value, as measured by Net present value, NPV, will be selected (see Fisher separation theorem). In this approach, project returns are discounted, i.e. "present valued" at the project's hurdle rate. The returns valued must be the incremental cash flows generated by the investment and must include all costs and benefits. 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, the weighted average cost of capital, or WACC. Other selection criteria visible from the DCF include: payback, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
In many cases, for example R&D projects, management may depart from a strict NPV approach. Whereas in an a DCF valuation, the 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. Decision Tree Analysis (DTA) incorporates likely events and consequent management decisions into the valuation. In the decision tree each decision generates a "branch" or path, and each event, with its various outcomes has a probability weighted result. The highest value path (probability weighted) is selected and is regarded as representative of project value. The Real options approach is used when the payoff of a project is contingent on the value of some other asset. (For example, the viability of a mining project is contingent on the price of gold. In an NPV valuation, the gold price is a given, whereas in the real options framework, the volatility of the gold price is an input.) Here, using financial options as a framework, the decision to be taken is identified as corresponding to either a call or a put; valuation is then via the Binomial model or, less often, via List of valuation topics, Stock valuation , Fundamental analysis, Business valuation , Capital Asset Pricing Model CAPM
The financing decision
Any corporate investment must be financed appropriately. As above, the financing mix can impact the valuation; both hurdle rate and cash flows (and hence the riskiness of the firm) will be effected. Management must therefore identify the "optimal mix" of financing ? the capital structure that results in maximum value. (See Balance sheet and WACC; 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
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 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.
Working capital management
Decisions relating to working capital and short term financing are referred to as working capital management. These, generally, relate to the next one year period and are "reversible"; as such they are typically assessed on the basis of cash flows and profitability, as opposed to NPV. Nevertheless, it is important that in each period, the return on capital, resulting from working capital management, exceeds the cost of capital, resulting from capital investment decisions; see EVA.
Cash flows are managed via a combination of policies and techniques for managing the current assets - generally cash balances, inventories and debtors. There are also a variety of short term financing options which are considered. These decisions are inter-related, most directly through the cash conversion cycle i.e. the net number of days from the outlay of cash for raw material, to receiving payment from the customer.
- 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 JIT and 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 (or visa-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".
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
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