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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 cr 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.
Capital investment decisions
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 decisionManagement must allocate limited resources between competing opportunities. Doing so requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows. Project valuationIn 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 (see Fisher separation theorem). 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 is the NPV. See also Time value of money. 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, the weighted average cost of capital, or WACC. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project. 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, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Valuing flexibilityIn 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 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. The difference between the two valuations is the "option value" inherent in the project. The two most common tools are Decision Tree Analysis (DTA) and Real options.
The financing decisionAny 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 affected. 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 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 decisionMain article: 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 (see Modigliani-Miller theorem). Working capital managementDecisions 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. The goal of Working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Decision criteriaBy definition, Working capital management entails short term decisions - generally, relating to the next one year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability.
Management of working capitalGuided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These require managing the current assets - generally cash balances, inventories and debtors. There are also a variety of short term financing options which are considered.
Financial risk managementMain article: 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 financeCorporate 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 articles
External links and referencesGeneral
Valuation and Capital Budgeting
Capital Structure and Dividend Policy
Working Capital Management
Real options
Decision Tree Analysis Financial risk management What does Corporate finance mean ? Search with Google !Article on Corporate finance, category, different spelling or sense |
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