Corporate finance
Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.
Correspondingly, corporate finance comprises two main sub-disciplines. Capital budgeting is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with equity or debt capital. Working capital management is the management of the company's monetary funds that deal with the short-term operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending.
The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms "corporate finance" and "corporate financier" may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.
Although it is in principle different from managerial finance which studies the financial management 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. Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the deployment of capital resources to increase a firm's value to the shareholders.
History
Corporate finance for the pre-industrial world began to emerge in the Italian city-states and the low countries of Europe from the 15th century.The Dutch East India Company was the first publicly listed company ever to pay regular dividends.
The VOC was also the first recorded joint-stock company to get a fixed capital stock. Public markets for investment securities developed in the Dutch Republic during the 17th century.
By the early 1800s, London acted as a center of corporate finance for companies around the world, which innovated new forms of lending and investment; see.
The twentieth century brought the rise of managerial capitalism and common stock finance, with share capital raised through listings, in preference to other sources of capital.
Modern corporate finance, alongside investment management, developed in the second half of the 20th century, particularly driven by innovations in theory and practice in the United States and Britain.
Here, see the later sections of History of banking in the United States and of History of private equity and venture capital.
Outline
The primary goal of Corporate Financeis to maximize or to continually increase shareholder value.
Here, the three main questions that financial managers addresses are: what long-term investments should we make? ''What methods should we employ to finance the investment? How do we manage our day-to-day financial activities?'' These three questions lead to the primary areas of concern in corporate finance: capital budgeting, capital structure, and [|working capital management].
This then requires that managers find an appropriate balance between: investments in "projects" that increase the firm's long term profitability; and paying excess cash in the form of dividends to shareholders; short term considerations, such as paying back creditor-related debt, will also feature.
Choosing between investment projects will thus be based upon 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 - "hurdle rate" - in consideration of risk. These projects must also be financed appropriately. If no growth is possible by the company and excess cash surplus is not needed to the firm, then financial theory suggests that management should return some or all of the excess cash to shareholders.
The first two criteria concern "capital budgeting", the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm's capital structure, and where management must allocate the firm's limited resources between competing opportunities.
Capital budgeting is thus also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Projects that increase a firm's value may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions.
The third criterion relates to dividend policy.
In general, managers of growth companies will use most of the firm's capital resources and surplus cash on investments and projects so the company can continue to expand its business operations into the future. When companies reach maturity levels within their industry, managers of these companies will use surplus cash to payout dividends to shareholders.
Thus, when no growth or expansion is likely, and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
Capital structure
Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt and equity. However, as above, since both hurdle rate and cash flows will be affected, the financing mix will impact the valuation of the firm, and a considered decisionis required here.
See Balance sheet, WACC.
Finally, there is much theoretical discussion as to other considerations that management might weigh.
Capitalization structure
As outlined, the financing "mix" will impact the valuation of the firm, and must therefore be structured appropriately:there are then two interrelated considerations here:
- Management must identify the "optimal mix" of financing – the capital structure that results in maximum firm value - but must also take other factors into account. Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity is also typically higher than the cost of debt - which is, additionally, a deductible expense – and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
- Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap entails matching the assets and liabilities respectively according to maturity pattern or duration ; managing this relationship in the short-term is a major function of working capital management, as discussed [|below]. Other techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also common. See: Asset liability management; Treasury management; Credit risk; Interest rate risk.
Related considerations
The starting point for discussion here is the Modigliani–Miller theorem.
This states, through two connected Propositions, that in a "perfect market" how a firm is financed is irrelevant to its value:
the value of a company is independent of its capital structure; the cost of equity will be the same for a leveraged firm and an unleveraged firm.
"Modigliani and Miller", however, is generally viewed as a theoretical result, and in practice, management will here too focus on enhacing firm value and / or reducing the cost of funding.
Re value, much of the discussion falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how to allocate the company's resources, finding an optimum re firm value.
The capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share are maximized.
Re cost of funds, the Pecking Order Theory 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.
One of the more recent innovations in this area from a theoretical point of view is the market timing hypothesis. This hypothesis, inspired by the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.
Capital budgeting
The process of allocating financial resources to major investment- or capital expenditure is known as capital budgeting.Consistent with the overall goal of increasing firm value, the decisioning here focuses on whether the investment in question is worthy of funding through the firm's capitalization structures.
To be considered acceptable, the investment must be value additive re: improved operating profit and cash flows; as combined with any new funding commitments and capital implications.
Re the latter: if the investment is large in the context of the firm as a whole, so the discount rate applied by outside investors to the firm's equity may be adjusted upwards to reflect the new level of risk, thus impacting future financing activities and overall valuation.
More sophisticated treatments will thus produce accompanying sensitivity- and risk metrics, and will incorporate any inherent contingencies.
The focus of capital budgeting is on major "projects" - often investments in other firms, or expansion into new markets or geographies - but may extend also to new plants, new / replacement machinery, new products, and research and development programs;
day to day operational expenditure is the realm of financial management as below.