Corporate finance
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{{Corporate finance}}
[[Image:2005private sector credit.PNG|thumb|right|Domestic credit to private sector in 2005]]
'''Corporate finance''' is an area of [[finance]] dealing with the financial decisions [[corporation]]s make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to [[maximization|maximize]] [[valuation (finance)|corporate value]] while reducing 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 [[ownership equity|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 [[assets|current assets]] and [[liabilities|current liabilities]]; the focus here is on managing cash, [[inventory|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<ref>The framework for this section is based on [http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/other/Image2.gif Notes by Aswath Damodaran at New York University's Stern School of Business]</ref> 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===<!-- This section is linked from [[List of finance topics]] -->
{{main|Capital budgeting}}
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====
{{see|stock valuation|fundamental analysis}}
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 (economist)|Joel Dean]] in 1951; see also [[Fisher separation theorem]], [[John_Burr_Williams#Theory|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 [[discount]]ed to determine their ''[[present value]]'' (see [[Time value of money]]). These present values are then summed, and this sum net of the initial investment outlay is the [[Net present value|NPV]].
The [[Net present value|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 investment|return]] on an investment—i.e. the [[Capital asset pricing model#Asset-specific required return|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 [[capital asset pricing model|CAPM]] or the [[arbitrage pricing theory|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 [[Net present value|NPV]], there are several other measures used as (secondary) [[Decision making#Decision making in business|selection criteria]] in corporate finance. These are visible from the DCF and include [[payback period]], [[internal rate of return|IRR]], [[Modified Internal Rate of Return|Modified IRR]], [[Equivalent Annual Cost|equivalent annuity]], capital efficiency, and [[Return on investment|ROI]]; see [[list of finance topics#valuation|list of valuation topics]].
====Valuing flexibility====
{{main|Real options analysis|decision tree}}
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 [[expected value|most likely]] or average or [[scenario planning|scenario specific]] cash flows are discounted, here the “flexibile and staged nature” of the investment is [[Mathematical model|modelled]], and hence "all" potential [[Moneyness|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|Decision Tree Analysis]] (DTA) and [[Real options analysis]]:
*The DTA approach attempts to capture flexibility by incorporating ''[[Event (probability theory)|likely events]]'' and consequent ''[[Decision making#Decision making in business and management|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|probability weighted]]) is regarded as representative of project value
*The [[real option]]s approach is used when the value of a project is ''[[List of finance topics#Contingent claim valuation|contingent]]'' on the ''[[Value (economics)|value]]'' of some other asset or [[underlying|underlying variable]]. (For example, the [[Economic geology|viability]] of a [[mining]] project is contingent on the price of [[gold]]; if the price is too low, management will abandon the [[Mineral rights|mining rights]], if sufficiently high, management will [[Underground mining (hard rock)#Development Mining vs. Production Mining|develop]] the [[ore|ore body]]. Again, a DCF valuation would capture only one of these outcomes.) Here, using [[Option (finance)|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 options model|Binomial model]] or, less often for this purpose, via [[Black-Scholes formula|Black Scholes]]; see [[List of finance topics#Contingent claim valuation|Contingent claim valuation]]. The "true" value of the project is then the NPV of the "most likely" scenario plus the option value.
====Quantifying uncertainty====
{{see|Monte Carlo methods in finance}}
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. [[assumption]]s) to the DCF [[Mathematical model|model]]. In a typical [[sensitivity analysis]] the analyst will vary one key factor, while ''[[ceteris paribus]]'' holding constant all other inputs. The sensitivity of NPV to a change in that factor is then observed (calculated as Δ NPV / Δ factor). For example, the analyst will set annual [[Revenue#Financial_analysis|revenue]] [[growth rate]]s 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 planning|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 rate]]s, [[commodity|commodity prices]]) ''as well as'' for company-specific factors (revenue growth rates, [[unit cost]]s). 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-[[Euclidean space|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 [[Weighted mean|probability-weighted average]] of the various scenarios. Note that for scenario based analysis, the various combinations of inputs must be ''[[Consistency|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 system (mathematics)|deterministic]] models as above. For this purpose, the most common method is to use [[Monte Carlo methods|Monte Carlo simulation]] to analyze the project’s NPV (introduced to finance by [[David B. Hertz]] in 1964). Here, 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. (Typically, an [[add-in]] such as [[Crystal Ball Software|Crystal Ball]] is used to run simulations in [[spreadsheet]] based DCF models.)
Here, continuing the above example, instead of assigning three discrete values to revenue growth, the analyst would assign an appropriate [[probability distribution]] (commonly [[triangular distribution|triangular]] or [[beta distribution|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===<!-- This section is linked from [[List of finance topics]] -->
{{main|Capital structure}}
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]], [[Weighted average cost of capital|WACC]], [[Fisher separation theorem]]; but, see also the [[Modigliani-Miller theorem]].)
The sources of financing will, generically, comprise some combination of [[Bond (finance)|debt]] and [[Equity investment|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 [[Capital asset pricing model|CAPM]] and [[Weighted average cost of capital|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. 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===
{{main|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 [[Return on investment|returns]] exceed the hurdle rate, then management must return excess cash to [[Equity investment|investors]]. These [[Cash flow|''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 [[Corporate_finance#Valuing_flexibility|above]] and [[Real option]]s.
Management must also decide on the form of the distribution, generally as cash [[dividend]]s or via a [[Treasury stock|share buyback]]. There are various considerations: where shareholders pay [[Dividend tax|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 [[Treasury stock|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==<!-- This section is linked from [[List of finance topics]] -->
{{main|Working capital}}
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 [[Asset#Current assets|short-term assets]] and its [[Current liability|short-term liabilities]]. The goal of Working capital management is to ensure that the firm is able to continue its [[Operations management|operations]] and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
===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). So the decisions relating to working capital are always current decisions, i.e., short term decisions.
The short term decisions of the firm are similar to those of long term in terms of risk and return, but they differ in many other ways like time factor, discounting consideration, liquidity etc. So these decisions are not taken on the same basis as long term decisions. These decisions have different criteria like cash flow and profitability.
*The most important criterion for making short term decisions is cash flows. And the best measure of cash flow is net operating cycle or cash conversion cycle. It represents the time difference between cash payment for raw materials and cash collection for sales. Another aspect of cash conversion cycle is gross operating cycle which is same as net operating cycle except the fact that it does not take into account the creditors deferral period. 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.
*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 [[Asset#Current assets|''current assets'']] (generally [[cash]] and [[cash and cash equivalents|cash equivalents]], [[Inventory|inventories]] and [[debtor]]s) 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 (business)|Just In Time]] (JIT); [[Economic order quantity]] (EOQ); [[Economic production quantity]] (EPQ).
*'''Debtors management'''. Identify the appropriate [[Credit (finance)|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 (trade)|factoring]]".
==Financial risk management==
{{main|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 ("[[Hedge (finance)|hedged]]") using traded [[financial instruments]] (typically changes in [[commodity|commodity prices]], [[interest rate]]s, [[exchange rate|foreign exchange rate]]s and [[stock|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 (economics)|value]]. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.
[[Derivative (finance)|Derivatives]] are the instruments most commonly used in Financial risk management. Because unique derivative [[contract]]s 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 [[option (finance)|option]]s, [[futures contract]]s, [[forward contract]]s, and [[swap (finance)|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 of Nations|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.<ref>Beaney, Shaun, [http://www.icaew.co.uk/index.cfm?route=122299 "Defining corporate finance in the UK"], The Institute of Chartered Accountants, April 2005</ref>
===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: [[Master of Science in Finance|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]]), .
* Business qualifications: [[Master of Business Administration]] ([[MBA]]), [[Master of Commerce]] (M Comm), [[Doctor of Business Administration]] ([[DBA]]), [[Certified Business Manager]] ([[CBM]])
* [[Accountant|Accountancy qualifications]]:
**[[Accountant#Accountancy_qualifications_and_regulation|Qualified accountant]]: [[Certified Public Accountant]] ([[CPA]]), [[Chartered Certified Accountant]]([[Chartered Certified Accountant|ACCA]]), [[Chartered Institute of Management Accountants|Chartered Management Accountant]] (CIMA), [[Chartered Accountant]] ([[Chartered accountant|ACA]])
** Non-statutory qualifications: [[Chartered Cost Accountant]] (CCA Designation from [[AAFM]]), [[Certified Management Accountant]] (CMA),
==References==
<references/>
==See also==
* [[Financial modeling]]
* [[Business organizations]]
* [[Financial planning]]
* [[Investment bank]]
* [[Managerial economics]]
* [[Private equity]]
* [[Real option]]
* [[Venture capital]]
* [[Right-financing]]
* [[Factoring (finance)]]
*''Related topics by category:''
** [[List of accounting topics]]
**[[List of finance topics#Corporate finance|List of corporate finance topics]]
**[[List of finance topics#Valuation|List of valuation topics]]
**[[List of finance topics]]
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