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Corporate
finance
is an area of finance dealing with the financial decisions corporations
make and the tools and analysis used to make these decisions. The
primary goal of corporate finance is to maximize corporate value
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 banker is
to evaluate company's financial needs and raise the appropriate
type of capital that best fits those needs.
Capital
investment decisions
Capital investment
decisions are long-term corporate finance decisions relating to
fixed assets and capital structure. Decisions are based on several
inter-related criteria. 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.
These projects must also be financed appropriately. If no such opportunities
exist, maximizing shareholder value dictates that management 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 ("projects")
in a process known as capital budgeting. Making this capital allocation
decision requires estimating the value of each opportunity or project:
a function of the size, timing and predictability of future cash
flows.
Project
valuation
In general,
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. These future cash flows are then discounted to
determine their present value. These present values are then
summed, and this sum net of the initial investment outlay is the
NPV.
The NPV is greatly
influenced by the discount rate. Thus selecting the proper discount
rate—the project "hurdle rate"—is critical to making the right 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 payback period, IRR, Modified IRR, equivalent annuity, capital
efficiency, and ROI.
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. 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) and Real options analysis
(ROA):
DTA values
flexibility by incorporating possible events (or states)
and consequent management decisions. 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) (assuming
rational decision making) this path is then taken as representative
of project value. See Decision theory: Choice under uncertainty.
(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.)
ROA is used
when the value of a project is contingent on the value
of some other asset or underlying variable. Here, 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 - valuation
is then via the Binomial model or, less often for this purpose,
via Black Scholes. The "true" value of the project is then the
NPV of the "most likely" scenario plus the option value. (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.)
Quantifying
uncertainty
Given
the uncertainty inherent in project forecasting and valuation, 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 (calculated as
? NPV / ? factor). For example, the analyst will set annual revenue
growth rates at 5% for "Worst Case", 10% for "Likely Case" and 25%
for "Best Case" - and produce three corresponding NPVs.
Using a related
technique, analysts may also run scenario based forecasts so as
to observe the value of the project under various outcomes. Under
this technique, a scenario comprises a particular outcome for economy-wide,
"global" factors (exchange rates, commodity prices, etc...) as
well as for company-specific factors (revenue growth rates,
unit costs, etc...). Here, extending the example above, key inputs
in addition to growth are also adjusted, and NPV is calculated for
the various scenarios. Analysts then plot these results to produce
a "value-surface" (or even a "value-space"), where NPV is a function
of several variables. Another 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. 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.
A further advancement
is to construct stochastic or probabilistic financial models - as
opposed to the traditional static and deterministic models as above.
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".
The simulation produces several thousand trials (in contrast
to the scenario approach above) and outputs a histogram of project
NPV. 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).
Here, continuing
the above example, instead of assigning three discrete values to
revenue growth, the analyst would assign an appropriate probability
distribution (commonly triangular or beta). This distribution -
and that of the other sources of uncertainty - would then be "sampled"
repeatedly so as to generate the several thousand realistic (but
random) scenarios, and the output is a realistic, representative
set of valuations. 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 traditional scenario
based approach.
The
financing decision
Achieving the
goals of corporate finance requires that any corporate investment
be financed appropriately. 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.
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, 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
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.
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 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. 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 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.
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 different criteria are applied here: the
main considerations are cash flow and liquidity - cashflow is probably
the more important of the two.
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. 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;
ex: 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).
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
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 creating,
or enhancing, firm value. All large corporations have risk management
teams, and small firms practice informal, if not formal, risk management.
Derivatives
are the instruments most 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.
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.
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:
Finance qualifications:
Masters degree in Finance (MSF), Chartered Financial Analyst (CFA),
Corporate Finance Qualification (CF), Certified International
Investment Analyst(CIIA), Association of Corporate Treasurers
(ACT), Certified Market Analyst (CMA/FAD) Dual Designation, Master
Financial Manager (MFM), Master of Finance & Control (MFC),
Certified Treasury Professional(CTP)Association for Financial
Professionals.
Business
qualifications: Master of Business Administration (MBA), Master
of Commerce (M Comm), Doctor of Business Administration (DBA),
Certified Business Manager (CBM)
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