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Corporate finance

2007 Schools Wikipedia Selection. Related subjects: Business

   Corporate finance

   Working capital management
   Cash conversion cycle
   Return on capital
   Economic value added
   Just In Time (business)
   Economic order quantity
   Discounts and allowances
   Factoring (finance)

   Capital budgeting
   Capital investment decisions
   The investment decision
   The financing decision
   Capital investment decisions

   Sections
   Managerial finance
   Management accounting
   Mergers and acquisitions
   Balance sheet analysis
   Business plan
   Corporate action
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   Finance series
   Financial market
   Financial market participants
   Corporate finance
   Personal finance
   Public finance
   Banks and Banking
   Financial regulation
   v d e

   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 enhance
   corporate value while reducing the firm's financial risks.
   Equivalently, the goal is to maximize the corporations' return to
   capital. 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 investment projects for a bank to make investment decisions.

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
   (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 (see Time value of money). These present values are then summed,
   and this sum 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, IRR, Modified IRR, equivalent
   annuity, capital efficiency, and ROI.

          See also: list of valuation topics, stock valuation, fundamental
          analysis

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 "option value" inherent in the project.

   The two most common tools are Decision Tree Analysis (DTA) and Real
   option
     * The DTA approach attempts to capture flexibility by incorporating
       likely events and consequent management decisions into the
       valuation. In the decision tree, each management decision in
       response to an "event" generates a "branch" or "path" which the
       company could follow. (For example, management will only proceed
       with stage 2 of the project given that stage 1 was successful;
       stage 3, in turn, depends on stage 2. In a DCF model, on the other
       hand, there is no "branching" - each scenario must be modelled
       separately.) The highest value path ( probability weighted) is
       regarded as representative of project value

     The following example shows a portfolio of 7 investment options
     (projects), but the organization has only $10,000,000 available for
     the total investment. The calculation uses discounted payoffs (PV:
     Present values) in a 4 years projection. Bold lines mark the best
     selection 1, 3, 6 and ,7 which will cost $7,740,000 and create a
     payoff of 2,710,000. All other combinations would either exceed the
     budget or yield a lower payoff: Image:Project Investment Portfolio
     Occam s Tree.gif

     * The real options approach is used when the value of a project is
       contingent on the value of some other asset or underlying variable.
       (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.) 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;
       see Contingent claim valuation. The "true" value of the project is
       then the NPV of the "most likely" scenario plus the option value.

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. (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.

   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. 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

   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. (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. (See Corporate action.)
   Today it is generally accepted that dividend policy is value neutral
   (see Modigliani-Miller theorem).

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. 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 criteria

   By 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.
     * One measure of cash flow is provided by the cash conversion cycle -
       the net number of days from the outlay of cash for raw material to
       receiving payment from the customer. As a management tool, this
       metric makes explicit the inter-relatedness of decisions relating
       to inventories, accounts receivable and payable, and 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.

     * 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. Firm value is enhanced when, and if, the return on
       capital, which results from working capital management, exceeds the
       cost of capital, which results from capital investment decisions as
       above. ROC measures are therefore useful as a management tool, in
       that they link short-term policy with long-term decision making.
       See Economic value added (EVA).

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; see 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); see
       Discounts and allowances.

     * 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.

          See: Financial engineering; Financial risk; Default (finance);
          Credit risk; Interest rate risk; Liquidity risk; Market risk;
          Operational risk; Volatility risk; Settlement risk.

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

   The new internationally recognised Corporate Finance Qualification (CF)
   is the only directly related professional qualification, although many
   others traditionally can lead to the field:
     * Qualified accountant qualifications: Chartered Accountant ( ACA),
       Certified Public Accountant ( CPA)

     * Other non-statutory accountancy qualifications: Chartered Cost
       Accountant (CCA Designation from AAFM), Certified Management
       Accountant (CMA), Chartered Management Accountant (ACMA)

     * Business qualifications: Master of Business Administration ( MBA),
       Master of Finance & Control ( MFC), Doctor of Business
       Administration ( DBA)

     * Finance qualifications: Masters degree in Finance (MSF), Corporate
       Finance Qualification (CF), Chartered Financial Analyst (CFA),
       Certified International Investment Analyst(CIIA) , Association of
       Corporate Treasurers (ACT), Certified Market Analyst (CMA/FAD) Dual
       Designation, Master Financial Manager (MFM).

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