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Corporate finance

From Academic Kids

Corporate Finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analyses used to make these decisions. 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.

Contents

Capital investment decisions

The framework for this section is based on Prof. Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar) 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. 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. Doing so requires estimating the value of each opportunity or project. This, in turn, requires the decisionmaker to place a value on cash flows that occur in the future, that are subject to risk, that may depend upon risky inputs, and that may open or close options down the road.

Estimating the present value of future cash flows

In general, each project will be assessed via a discounted cash flow valuation. This requires estimating the size and timing of all of the incremental cash flows in and out of the project. Future cash flows are then discounted to calculate the present value of the future cash flows. The opportunity with the highest value, as measured by net present value, NPV, will be selected (see Fisher separation theorem). The present value is greatly influenced by the degree of the discount rate. Thus selecting the proper discount rate is critical to making the right decision. The discount rate is also one ways the decisionmaker can take into account the risk of the project. If the future cash flows of a project are certain, the decisionmaker would discount them at the market rate for certain, or near-certain returns, such as the rate for a government bond with the same payoff date. Discounting future cash flows with this simple rate accounts for the fact that a dollar today is (usually) worth more than a dollar tomorrow. (Or, put another way, that you have to pay interest to borrow money today and pay it back tomorrow.)

Estimating the value of risky cash flows

However, few projects offer certain returns. In reality, the decisionmaker must contend with the riskiness of the project. Thus, the decisionmaker needs to determine the discount rate for a future cash flow with a similar degree of risk. In this approach, project returns are discounted at the project's hurdle rate. The hurdle rate is the minimum acceptable return on an investment - i.e. the project appropriate discount rate. Managers can use models such as the capital asset pricing model to estimate the right rate for the riskiness of the project. 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.

Estimating the value of options

See also list of finance topics#valuation, stock valuation, fundamental analysis, business valuation , capital asset pricing model

In many cases, for example R&D projects, the project may open or close paths of action for the company. In these cases, 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.

Using real option valuation

A more complex approach to valuing options and handling risky inputs is the real options approach. This technique can be used when the payoff of a project is contingent on the value of some other asset or to more precisely quantify the value of options that the company may excercise in the future. For example, the viability of a mining project is contingent on the price of gold. In a simple NPV valuation, the gold price is given as a simple estimate, whereas in the real options framework, the volatility of the gold price is used as an input to estimate the variance of the project's payoff. 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 Black Scholes.

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 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.

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

Related articles

External links

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Real options

Decision Tree Analysis

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