Business, Legal & Accounting Glossary
Corporate finance is an important sub-division of finance. It deals with various financial decisions made by corporations. It also looks at various resources that are used to make financial decisions. The basic aim of corporate finance is to generate the maximum possible value and reduce the financial risks taken by a firm.
Corporate finance is normally categorized into three broad categories – long term decisions, techniques, and short term decisions. Capital investment decisions are mainly concerned with various financial aspects of projects undertaken by companies.
Short term corporate finance decisions are classified as working capital management. Working capital management deals with areas like current liabilities and current assets. Other areas of importance in short term corporate finance decisions are management of inventories and cash resources. Lending and borrowing of money for shorter spans of time are also important in this regard.
Corporate finance deals with the monetary decisions that businesses make and the analytic tools required for making such decisions. At its best, the goal of corporate finance is to try to maximize shareholder value. Although technically corporate finance is slightly different from managerial finance in-as-much as it concerns the type of firms it relates to – managerial finance studies the financial decisions of all firms including proprietorships and partnerships – the concepts of both are almost the same.
Financial decisions that corporations require to make and the techniques required for putting them to practice may be short term or long term. Short term decisions relate to balancing current assets and current liabilities, a process that requires managing micro issues such as cash and inventory management and short term borrowing and lending as in the credit period to be allowed to customers.
Long term decision making, on the other hand, relates to choosing the projects that will receive investment, raising finance through equity or debt and declaration (if at all) of dividends to be paid to shareholders.
Corporate finance is often associated with investment banking. Typically, an investment bank plays a role in the evaluation of a corporation’s financial needs and suggest the best possible method of raising capital to meet corporate goals including growth, development and acquisitions.
These are primary choices between reinvesting available funds and increasing shareholder value or paying surplus cash to shareholders by way of dividends. This thus involves making decisions regarding investing in fixed assets and capital structure. The management may decide to invest in projects that give a positive net present value after taking into account an appropriate discount rate. Whatever decision is taken has to be with the end goal of increasing the value of the firm. Decisions also need to be taken to finance such projects appropriately. When no opportunities exist, the management must declare a dividend.
Capital budgeting is a process that involves the allocation of resources. There may be more than one project worthy of investment at a given point in time. Allocating resources to these projects thus involves estimation of the value of each project, which basically depends upon the size, the timing of the project and the implications on future cash flows.
Typically, the discounted cash flow method of valuation is used to estimate the value of a project. According to the corporate finance theory as propounded by Joel Dean, whichever opportunity has the highest value as calculated by the resultant NPV (net present value) will be selected. In the process, the timing of increase in cash flows as a result of the project and the estimated size of the project will be taken into account. Cash flows, in turn, are discounted to arrive at their present value considering the time value of money, which is basically the calculation of interest earned over a given point in time. The sum of these present values net of the initial outlay required for investing in the project is the NPV.
The rate used for discounting future cash flows to the present value greatly affects the NPV. It is crucial that a proper discount rate is identified. Also critical to making the right decision is the project ‘hurdle rate’, which is simply the minimum acceptable rate of return on capital invested in the project. At the same time, the hurdle rate should also reflect the risk involved, generally assessed on the basis of the volatility of cash flows, and consider the type of financing required for undertaking the project.
There are different models to choose for estimating an appropriate discount rate for a particular project. Most managers often rely upon CAPM (Capital Asset Pricing Model) and APT (Arbitrage Pricing Theory). For arriving at the cost of the type of financing chosen for the project, usually, the weighted average cost of capital (WACC) is used. However, using the WACC applicable to the entire business for choosing the appropriate discounted rate is not advisable particularly when the risk involved in the project is different from the firm’s existing asset portfolio.
Besides NPV, there are also other criteria for selection in corporate finance. These include the internal rate of return or IRR, modified IRR, discounted payback period, equivalent annuity, the efficiency of capital involved in the project and return on investment. On the other hand, Residual Income Valuation, market value and economic value added (Joel Stern, Stern Stewart & Co) and adjusted present value (Stewart Myers) are alternatives to NPV.
Many times, for example in research and development projects, a project may open multiple courses of action, a reality that may not be captured by the NPV approach. In such cases, the management generally uses tools that put an expressed value to these options. In a discounted cash flow valuation, the scenario-specific cash flows or average cash flows are discounted; these tools model the flexible and staged nature of the investment, which means that the entire potential payoff is weighed. The ‘value of flexibility’ that is inherent in the project is reflected by the difference in the two valuations.
Decisions Tree Analysis (DTA) and Real options valuation (ROV) are the two most common decision support tools that are often used by management.
Stewart Myers was the first to discuss real options in corporate finance in 1977.
There is always an element of uncertainty in forecasting valuation of projects, which is why analysts would want to evaluate the sensitivity of a project’s NPV to various assumptions to the discounted cash flow model. A typical sensitivity analysis involves varying one key factor while holding all other assumptions as constant. The analyst, for example, will first establish NPV across various growth rates in annual revenue at set increments and then calculate the sensitivity as a slope using the formula ΔNPV / Δ factor. More than one variable may be of interest and the several combinations produce a ‘value surface’ where NPV is a function of several variables.
Analysts also run scenario-based forecasts of NPV using a related technique. The scenario here constitutes a specific outcome for global factors across the economy such as product demand, commodity prices, exchange rates etc as well as for factors specific to the company such as unit cost etc. for example, the analyst may give a value to several revenue growth scenarios; 20% for a best-case scenario, 10% for likely case and 0% for the worst case. In this case, the NPV is calculated for each with all fundamental inputs adjusted so as to be consistent with growth assumptions. The thing to be noted here is that all combinations of assumptions must be internally consistent for a scenario-based analysis but it need not be the case for the sensitivity based analysis. This methodology is used to determine the NPV that is devoid of the bias of the estimator. The management determines the probability (subjective) for each scenario as the NPV for the various scenarios of the project is then the probability-weighted average.
A further advancement is to construct probabilistic or stochastic (having a random variable) instead of the conventional static and deterministic models as discussed above. This “overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of variables and their realizations”. Monte Carlo simulation is the most commonly method used for analyzing the project NPV. Although this method was introduced by David B. Hertz in 1964, it has become popular only recently. Nowadays, analysts are able to run simulations on spreadsheet-based DCF models. Typically, a risk analysis add-in like @Risk or Crystal Ball is used. In this method, the cash flow impacted by uncertainty are simulated to reflect their ‘random characteristics’ mathematically. Being a mathematical representation, the simulation throws up several thousand random but possible outcomes that cover all “conceivable real-world contingencies in proportion to their likelihood. The output here is a statistical bar chart that depicts NPV of the project and the average NPV of the likely investment along with its volatility and other sensitivities. The bar chart provides information that is not available in static DCF. For example, it makes possible estimation of the probability that a project has a NPV greater than any value including zero.
The analyst, in this case, will give an appropriate probability distribution to each variable and wherever possible point out the observed correlation between each variable instead of simply giving three discrete values to revenue growth. These distributions can then be sampled used to produce thousands of random but possible scenarios. The result provides statistics such as average NPV and standard deviation of NPV, which reflect the project’s ‘randomness’ more precisely than the variance seen in the scenario-based analysis. These statistics are frequently used for estimation of the underlying ‘spot price’ and real option valuation’s volatility. An advanced Monte Carlo model would incorporate the possible occurrence of events like a credit crunch that cause variations in one or more of the DCF models.
If the goals of corporate finance are to be achieved, it is crucial that any investment is appropriately financed. Financing options applicable across all types of businesses are:
The type of capital raised affects the riskiness of the company as both the hurdle rate and cash flows are impacted. As a consequence, the financing mix will have a dual affect; it will impact the company’s valuation, which in turn will affect other long-term decisions of the management. There are two things that need to be considered here:
The major part of the theory here is covered under the Trade-Off Theory, which says that firms often trade-off the tax benefits of debt with the bankruptcy cost of debt while taking decisions. However, there are many alternative theories developed by economists to explain financing decisions. Stewart Myers Pecking Order Theory suggests that when internal financing is available, companies would avoid external financing and avoid raising capital through fresh equity if low-interest debt financing is available. The capital structure substitution theory, on the other hand, suggests that managements tend to manipulate the capital structure with the end goal of maximizing earnings per share.
However, an emerging finance theory is right financing. The theory states that company value and return on investment can be enhanced over time by establishing the right investment goals, policy framework, capital structure and source of financing (equity or debt) under given market conditions and within a given economy. A recent introduction in this theory is the market timing hypothesis, which is inspired by literature on behavioural finance. The hypothesis tries to explain that companies look for cheaper financing no matter the level of their internal resources, debt and equity.
The decision on whether or not to pay a dividend and the amount of dividend is primarily the subject matter of the company’s profits that have not been appropriated otherwise and earning prospects for the next year. The amount to be paid is usually calculated on the basis of expected free cash flow that is cash leftover after paying all business expenses and meeting investment needs.
The corporate finance theory states that the management must return excess cash to shareholders if there are no opportunities of starting new project/s where the return on investment is more than the hurdle rate or NPV positive projects. While this is the generally accepted principle, there are a few exceptions to the rule. A common example is that of a growth stock where shareholders by definition expect the company to retain and invest profits for funding growth. In cases where opportunities with current negative NPV exist; the management may decide to retain earnings and take a considered call on the basis of potential of future payoffs.
Another decision regarding dividend that management must take is the mode in which dividend is to be paid. Generally, cash dividends are paid but there is another option by way of share buyback. The decision on mode of dividend payout must be on the basis of the following considerations;
It is generally accepted that regardless of the dividend policy, cash payout or share buyback, the value of the company is not affected and remains the same.
Working capital management relates to decisions regarding working capital and short term financing. Working capital is the operating liquidity available to the company. Net Working Capital is current assets minus current liabilities. Managing the relationship between these two is the subject matter of working capital management.
Now, as explained above, the primary goal of corporate finance is to enhance company value. For this purpose, the management takes long term investment decisions by selecting and investing in NPV positive projects. Such investments eventually impact working capital in terms of cash flow and cost of capital. Working capital management is thus about ensuring that the company has adequate funds to be able to operate as well as has adequate cash flows to service long term debt and pay short term debt as and when it falls due for payment. Eventually, if the cost of capital is less than the return on investment it will amount to enhancing the value of the company.
As mentioned above, working capital is the amount of money readily available to the company. It is the difference between current assets (funds that are available in cash or can be convertible into cash) and current liabilities (cash requirements). Decisions relating to working capital management are always short term decisions. Working capital decisions differ from capital investment decisions not only in the matter of time horizon but also on considerations regarding discounting and profitability. Moreover, to some extent, working capital decisions are also reversible. While return targets and tolerance for risk remain the same, there are some considerations such as those imposed by loan covenants that may be more relevant in the case of working capital management.
Decisions regarding the management of working capital are thus quite different from capital management as different criteria are applied in the decision-making process. In working capital decisions the main criteria are cash flow and return on capital. Of the two, cash flow is probably more important.
Not operating cycle or cash conversion cycle is the more commonly used measure of cash flow. This is represented by the difference in time between cash payment for purchases (raw material) and cash collection of sale proceeds. It is basically the company’s ability to convert sales into cash. The management must aim at a lower number because it effectively represents the time for which the firm’s cash is tied up and not available for other activities. Another measure, though widely used is the gross operating cycle, which is similar to the net operating cycle except for the fact that it does not consider the deferral period allowed by creditors (suppliers).
Profitability or return on capital (ROC) is reflected as a percentage arrived at by dividing relevant annual income by the capital employed and multiplying by 100. The same method is used to show return on equity (ROE) to shareholders. Here also, the firm’s value is enhanced when the return on capital is more than the cost of capital. ROC is useful to the management in-as-much that it is a short term policy that influences the long term decision-making process.
The management is guided by the above criteria. In the process of managing working capital requirements, the management will use a combination of policies and techniques aimed at managing current assets, cash and cash equivalents such as inventories and receivables. Included in the process is taking recourse to short term financing provided cash flows and returns are acceptable.
Corporate Finance and Other Areas in Finance
The term corporate finance is used to mean different things in different countries. In the United States it is used for describing decisions, activities and techniques that deal with a company’s finances and financial and capital management; in fact, everything that has to do with money in a corporation. However, in the United Kingdom and Commonwealth countries, corporate finance and corporate financier are interchangeable terms used to denote activities associated with investment banking. An investment bank assists corporations to raise capital through various means. Investment banking is associated with the following:
Risk management in corporate finance is the process that involves the measurement of risk and the consequent development and implementation of strategies to manage that risk. The primary focus of financial risk management is on the impact on company value due to unfavourable changes in commodity prices, foreign exchange rates and interest rates. A large corporation typically has a risk management team, which is usually a part of or associated with the internal audit team. It is uncommon for small firms to have a formal risk management team as it is not practical. However, those who need to hedge their risks do so by applying risk management strategies informally.
Financial risk management lays special emphasis on risks that can be minimized by using financial instruments traded over the counter or on recognized stock exchanges. These are typically derivative products such as futures contracts, options, forwards contracts and swaps. Since, over the counter trading is costly and also difficult to monitor, corporations generally prefer financial instruments traded on recognized and well-established exchanges. However, the second-generation derivatives or what is commonly known as exotic derivatives are traded over the counter. Accounting treatment of hedging related transactions is however different from general accounting.
Financial risk management is related to fiancé in two different ways. First, the firm’s exposure to risk is a direct consequence of previous decisions related to finance and investment. Secondly, the focus of both risk management and corporate finance is to enhance company value. However, risk management and shareholder value may at times be at loggerheads with each other. The point of debate here is the shareholder’s desire to optimize risk against taking exposure to pure risk, events that have only a negative outcome.
Corporate finance incorporates tools from nearly every area of finance. Most of the tools developed for and by corporations can be easily used by all types of business entities including sole proprietorships, partnerships, non-profit organizations, governments, asset management companies and personal wealth management. But in other aspects of finance, the application of corporate finance is limited to corporate entities. Since the amount of money that corporations use is much larger, corporate finance has developed into a separate discipline that is different from public and personal finance.
Corporate finance assumes that the shareholder is the residual claimant and the primary goal of management should be to maximize shareholder value. However, some legal luminaries have out put a question mark on that assumption. The implication is that the assumed goal of maximizing shareholder value is inappropriate. The criticism also brings into focus the suggestion of corporate finance that share buybacks purport to be return of company value to shareholders. Legal scholars claim that this is logically an erroneous assumption.
Real options analysis is used for employing put and call option rating processes. It is also used to determine whether money should be pumped into current projects for purposes like research and development. Real options analysis is also used for making decisions related to the growth of a company.
Financial analysis is primarily used for purposes related to assessing various business functions that are important for the overall improvement of the business prospects of a company. A very important area of financial analysis is the amount of profit potentiality offered by business activity.
With the help of technical analysis, corporations are able to opt for instruments of investment. This makes it an extremely important part of the corporate finance processes. Technical analysis is normally applied by technical business analysts working in different corporations.
DuPont analysis deals primarily with return on equity. It divides return on equity into three parts – financial leverage, operating efficiency, and asset use efficiency. Du Pont analysis is widely used in a number of industries including the banking sector.
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This glossary post was last updated: 16th April, 2020 | 14 Views.