corporate finance

corporate finance

Corporate Finance

1. Introduction to Corporate Finance

Many general readers intrigued by the financial news fail to realize that most of corporate finance consists of a set of integrated subjects. They “group together” the topics commonly covered in corporate finance texts. This is appropriate; most questions asked by practitioners are framed in general terms, which our subjects cover. The separation of any subject into its basic forms does lead to a pricing of risks only at the margin because portfolio effects are not taken into account. Corporate ownership structures are complex. A given firm may have a majority shareholder, while another has no dominant owner at all. To understand how each form emerges, we need to go beyond simple illustrations and define precisely each of these forms. This should help us understand “What corporate structure will a new company choose”.

The discipline of corporate finance has become a language of business as essential to its functioning as accounting or marketing. After considering questions such as “What is corporate finance?” and “Why is it important for students to learn about it?”, we look at the relationships between the subjects that form the core of corporate finance and review the main issues for each. The growth of the firm introduces a separation between the ownership and control of the firm. The separation is at the heart of the key characteristic of public companies: their share capital is publicly traded. What implications does this separation have for the way companies should be run?

2. Financial Analysis and Planning

However, when they decide to issue securities to the public, they are required to file a prospectus or registration statement with the Securities and Exchange Commission (SEC) – an agency of the US government. They also need to make periodic filings to the SEC, in which the financial well-being of the firm would be published. That is why reporting requirements are publicized to protect the investors. If financial information is the lifeblood of a firm, much like the blood running through the human body, those who keep the business areas alive – the cash, credit demand, capital expenditures, the quality of the product sales – have examined the financial health of many firms.

Refers to analyzing a firm’s financial statements and relationships as well as planning and forecasting future financial performance. It also includes the development of pro forma financial statements; that is, projected financial statements. Financial analysis, financial planning, and pro forma research are important for financial management because they directly involve the firm’s well-being. All three are also necessary for any firm that is to run effectively for any length of time because they provide important feedback for all management functions. If the firm is privately held, then quite often the principals have little more to go on than their business breed. In order to effectively manage the firm, they need financial information.

3. Capital Budgeting and Investment Decisions

Investment in shares and debentures is the direct claims of the investors on the assets and income of the firm. The finance manager is not concerned with the claims of the investors on the income of the form. But in the case of investment in fixed assets, the finance manager has to be more concerned. He is concerned in the sense whether the earnings before interest and tax (EBIT) will be adequate enough to cover the cost of the fixed assets plus a return on investments. Typically, in a large firm where there are numerous firms or where shareholders are indifferent, the payment of interest does not become critical as it would have been in a small firm or where shareholders’ trend takes a more active interest. Therefore, the acceptance or rejection of a capital project faces the problem of balancing the expected return on investment and the ability to service the firm’s debt without further financial risk. The management, therefore, has to frame a dividend policy that will satisfy both the debt providers as well as the shareholders. So, essentially, whenever a proposal comes up for acceptance or evaluation, it has to be first seen that there is adequate finance – both debt and equity – to finance the asset. Only then will the earnings be sufficient enough to service the debt and meet the equity holders’ expectations and also generate a surplus.

Most of the studies relating to investments have been associated with the large-scale capital projects undertaken in the sphere of large firms. The expenditure in fixed assets as a percentage of the gross national product is usually of the order of 12 to 14 percent in underdeveloped countries and has been around 10 percent in the past in the developed countries. Fixed capital investment is considered to be essential for the process of economic development. The economic base can be broadened, the employment opportunities can be increased, income distribution can be brought about, and price stability can be maintained by a suitable policy of investment. Therefore, investment is said to be the accelerator to investment in the national income of the country. Investors are interested in wealth maximization which is to be achieved by making an optimal choice of investments. In this concept of wealth maximization, attention is focused only on the long-run financial problems of the firm.

4. Financing and Capital Structure

Assuming that debt has already been issued to finance the firm and no further new financing is possible, the Dividend Decision of our firm must be consistent with its investment decision proceeds, or even part of the company itself, must be issued. Just as the firm cannot issue negative investment, it cannot issue negative dividends’ payouts. The fewer dividends the firm issues, the more cash it accumulates. Conversely, the more dividends it pays out, the smaller the cash cushion becomes, and the higher the default risk. And just as the company decides to issue debt, the company may at some other time repurchase equity, thus decreasing the stock of debt it must roll over on its next round of refinancing.

This module will introduce financing and capital structure. The financing issue is then how to pay for the investment. If the company raises funds by selling assets, it is the same as giving up some of the project to someone else. Today in the US, the majority of new financing occurs by issuing stock both in direct or indirect forms. Despite this, much of the theory of financing is focused on the corporate bond market. Why is this the case? In part, it is because there are rumors of the pending death of the corporate bond market. Competing products such as PIK (Payment-In-Kind) bonds and leveraged loans and advanced securitization technology have created stiff competition for the corporate bond market. And bankruptcy costs are no longer just about legal costs but about reputation costs that are borne by the physical capital owned by the corporation. If bondholders do not have absolute priority, their refusal to renegotiate with the firm’s owners would result in idle physical assets with zero productivity and therefore value. To sum up, publicly traded debt is often used in corporate finance models as a stand-in for all relevant financing markets.

5. Risk Management and Corporate Governance

Corporate Governance. More recently, finance has cast its attention toward corporate governance. We define corporate governance as the set of mechanisms used to maintain an alignment between outside investors who provide capital for corporate projects and inside managers who are responsible for companies’ operations. It is relevant to the exercise of power at the firm level, the personal accountability of the managers in decision-making in the process of strategic thinking and policy making. Corporate governance clarifies the dubious public perception about how a company is managed and controlled. Corporate governance is concerned with an issue that is central to the global economy, the development of capital markets, and their essential role in accelerating economic growth, mobilizing resources, and increasing productivity, creating new employment, and thereby ensuring sustainable overall development. Corporate governance is the set of rules, procedures, and institutions that enable a society to ensure the rights of its citizens and groups to have obtained individual and collective goals.

Risk management is one of the most important and perhaps least understood aspects of corporate finance. Professionals in finance work with the uncertainty that results: the poor often incontrovertible cash flow forecasts and stated objectives, the apparent limitations of capital markets, and dictated financial policies. Academic research and practice in corporate finance have focused on the value-creation problem to the neglect of the value-preserving function. Financial engineering, creative accounting, and of late behavioral finance are more in vogue than risk management, which these days is relegated to the backwaters of finance, usually in the footnotes to textbooks and as the prerequisite slides to more “important” topics. Really, the outsized salaries of financial services professionals, financial crises, scandals, and personal trauma from losing one’s life savings can all be traced to the failure of risk management. Yet, with the notable exceptions of options and reserves, there is no systematic approach in financial theory that is useful for managing risk. This has to be balanced against the breathtaking simplicity and elegance of the relative value-maximizing CAP-M that is within the grasp of many students by the time they have taken an undergraduate class in finance!