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Corporate finance is the area of
finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available which could ...

finance
that deals with sources of funding, the
capital structure Capital structure in corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and manag ...

capital structure
of corporations, the actions that managers take to increase the
value Value or values may refer to: * Value (ethics) it may be described as treating actions themselves as abstract objects, putting value to them ** Values (Western philosophy) expands the notion of value beyond that of ethics, but limited to Western s ...
of the firm to the
shareholder A shareholder (in the United States often referred to as stockholder) of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal en ...
s, and the tools and
analysis Analysis is the process of breaking a complexity, complex topic or Substance theory, substance into smaller parts in order to gain a better understanding of it. The technique has been applied in the study of mathematics and logic since before Ari ...

analysis
used to allocate financial resources. The primary goal of corporate finance is to
maximize In mathematical analysis, the maxima and minima (the respective plurals of maximum and minimum) of a function (mathematics), function, known collectively as extrema (the plural of extremum), are the largest and smallest value of the function, ei ...
or increase
shareholder value Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders. It became pr ...
. Correspondingly, corporate finance comprises two main sub-disciplines.
Capital budgeting Capital most commonly refers to: * Capital letter Letter case (or just case) is the distinction between the letters that are in larger uppercase or capitals (or more formally ''majuscule'') and smaller lowercase (or more formally ''minusc ...
is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with
equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the differe ...
or
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
capital.
Working capital Working capital (abbreviated WC) is a financial metric which represents Accounting liquidity, operating liquidity available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plant and equ ...
management is the management of the company's monetary funds that deal with the short-term operating balance of
current asset In accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compar ...
s and
current liabilities In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been calle ...
; the focus here is on managing cash,
inventories Inventory (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of varieties of the English language native to the United States. Currently, American English i ...
, 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 An investment bank is a financial services Financial services are the economic services provided by the finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concer ...
. 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. Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions. Although it is in principle different from
managerial finance Management (or managing) is the administration of an organization An organization, or organisation (English in the Commonwealth of Nations, Commonwealth English; American and British English spelling differences#-ise, -ize (-isation, -iz ...
which studies the financial management of all firms, rather than
corporations A corporation is an organization—usually a group of people or a company A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal personality, legal ...

corporations
alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Financial management Financial management may be defined as the area or function in an organization which is concerned with profitability, expenses, cash and credit, so that the "organization may have the means to carry out its objective as satisfactorily as possible ...
overlaps with the financial function of the
accounting profession Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other obj ...
. However,
financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporatio ...
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 The Italian city-states were numerous political and independent territorial entities that existed in the Italian Peninsula The Italian Peninsula (Italian Italian may refer to: * Anything of, from, or related to the country and nation of ...
and the
low countries The term Low Countries, also known as the Low Lands ( nl, de Lage Landen, french: les Pays-Bas) and historically called the Netherlands ( nl, de Nederlanden), Flanders, or Belgica, refers to a coastal lowland region in Northwestern Europe forming ...
of Europe from the 15th century. The Dutch East India Company (also known by the abbreviation “
VOC VOC, VoC or voc may refer to: Science and technology * Open-circuit voltage (VOC), the voltage between two terminals when there is no external load connected * Variant of concern, a category used during the assessment of a new variant of a virus * ...
” in Dutch) was the first
publicly listed company A public company, publicly traded company, publicly held company, publicly listed company, or public limited company is a company whose ownership is organized via shares of stock which are intended to be freely traded on a stock exchange or in O ...
ever to pay regular
dividend A dividend is a distribution of profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
s. The VOC was also the first recorded
joint-stock company A joint-stock company is a business entity in which shares of the company's stock can be bought & sold by shareholders. Each shareholder owns company stock in proportion, evidenced by their share (finance), shares (certificates of ownership). Sh ...
to get a fixed
capital stock__NOTOC__ A corporation's share capitalGlossary on Trade Financing Terms - S
or capital ...
. Public markets for investment securities developed in the
Dutch Republic The United Provinces of the Netherlands, or United Provinces (officially the Republic of the Seven United Netherlands), commonly referred to in historiography Historiography is the study of the methods of historian ( 484– 425 BC) was ...
during the 17th century. By the early 1800s,
London London is the and of and the . It stands on the in south-east England at the head of a down to the , and has been a major settlement for two millennia. The , its ancient core and financial centre, was founded by the as ' and retains b ...

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
managerial capitalism
and common stock finance, with
share capital __NOTOC__ A corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; ...
raised through listings, in preference to other
sources of capital
sources of capital
. Modern corporate finance, alongside
investment management Investment management is the professional asset management Asset management refers to a systematic approach to the governance and realization of value from the things that a group or entity is responsible for, over their whole life cycles. It ...
, 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 financial management is to maximize or to continually increase shareholder value. Maximizing shareholder value requires managers to be able to balance capital funding between investments in
"projects"
that increase the firm's long term profitability and sustainability, along with paying excess cash in the form of dividends to shareholders. Managers of growth companies (i.e. firms that earn high rates of return on invested capital) 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 (i.e. companies that earn approximately average or lower returns on invested capital), managers of these companies will use surplus cash to payout dividends to shareholders. Managers must do an analysis to determine the appropriate allocation of the firm's capital resources and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt. Choosing between investment projects will thus be based upon several inter-related criteria. (1) 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 in consideration of risk. (2) These projects must also be financed appropriately. (3) 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 (i.e., distribution via dividends). This "
capital budgeting Capital most commonly refers to: * Capital letter Letter case (or just case) is the distinction between the letters that are in larger uppercase or capitals (or more formally ''majuscule'') and smaller lowercase (or more formally ''minusc ...
" is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm's
capital structure Capital structure in corporate finance Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and manag ...

capital structure
. Management must allocate the firm's limited resources between competing opportunities (projects). Capital budgeting is 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 In , mergers and acquisitions (M&A) are transactions in which the ownership of , other business organizations, or their operating units are transferred or with other entities. As an aspect of , M&A can allow enterprises to grow or , and change ...
. When no growth or expansion is possible by a corporation 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 Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...
and
equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the differe ...
(and hybrid- or convertible securities). However, as above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm, and a considered decision is required here. See
Balance sheet In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...

Balance sheet
, WACC. Finally, there is much theoretical discussion as to other considerations that management might weigh here.


Sources of capital


Debt capital

Corporations may rely on borrowed funds (debt capital or
credit px, Domestic credit to private sector in 2005 Credit (from Latin Latin (, or , ) is a classical language belonging to the Italic languages, Italic branch of the Indo-European languages. Latin was originally spoken in the area around Rome, k ...
) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public. Bonds require the corporations to make regular
interest In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is distinct from a which the borrower may pay the len ...

interest
payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full. Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges. Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use
collateral Collateral may refer to: Business and finance * Collateral (finance) In loan agreement, lending agreements, collateral is a Borrower, borrower's pledge (law), pledge of specific property to a lender, to Secured loan, secure repayment of a loan. ...
assets as a form of repaying their debt obligations (or through the process of
liquidation Liquidation is the process in accounting by which a company A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal personality, legal or a mixture o ...
).


Equity capital

Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in value of the company (or appreciate in value) over time to make their investment a profitable purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects (or investments) that earn a positive rate of return for the owners. Investors prefer to buy shares of stock in companies that will consistently earn a positive rate of return on capital in the future, thus increasing the market value of the stock of that corporation. Shareholder value may also be increased when corporations payout excess cash surplus (funds from retained earnings that are not needed for business) in the form of dividends.


Preferred stock

Preferred stock is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to
common stock Common stock is a form of corporate equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other va ...
, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Preferred stock usually carries no voting rights, but may carry a
dividend A dividend is a distribution of profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
and may have priority over common stock in the payment of dividends and upon
liquidation Liquidation is the process in accounting by which a company A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal personality, legal or a mixture o ...
. Terms of the preferred stock are stated in a "Certificate of Designation". Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:. * Preference in dividends * Preference in assets, in the event of liquidation * Convertibility to common stock. * Callability, at the option of the corporation * Nonvoting


Capitalization structure

As mentioned, the financing mix will impact the valuation of the firm: 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 (see trade-off theory below). Financing a project through debt results in a
liability Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, retai ...
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 equityIn finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire c ...
'' (see CAPM and APT) is also typically higher than the ''
cost of debt In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods an ...
'' - which is, additionally, a
deductible expense Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and credits. The dif ...
– 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
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s 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 Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, re ...
respectively according to maturity pattern (" cashflow matching") or
duration Duration may refer to: * The amount of Time#Terminology, time elapsed between two events * Duration (music) – an amount of time or a particular time interval, often cited as one of the fundamental aspects of music * Duration (philosophy) – a th ...
("
immunization Immunization, or immunisation, is the process by which an individual's immune system becomes fortified against an infectious agent (known as the antigen, immunogen). When this system is exposed to molecules that are foreign to the body, called ' ...
"); managing this relationship in the ''short-term'' is a major function of
working capital management Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analysis u ...
, as discussed below. Other techniques, such as
securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling ...
, or hedging using interest rate- or
credit derivativeIn finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available w ...
s, are also common. See
Asset liability management Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liability (financial accounting), liabilities as part of an investment strategy in financial acco ...
;
Treasury management Treasury management (or treasury operations) includes management Management (or managing) is the administration of an organization, whether it is a business, a not-for-profit organization, or government body. Management includes the activit ...
;
Credit risk A credit risk is risk of default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
;
Interest rate risk Interest rate risk is the risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty Uncertainty refers to Epistemology, epistemic situations involving imperfect or unknown information. It applies to ...
.


Related considerations

Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the
tax benefits of debt A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law, a legal person is any person A person (plural people or persons) is a being that has certain capacities or attr ...
with the bankruptcy costs of debt when choosing how to allocate the company's resources. However economists have developed a set of alternative theories about how managers allocate a corporation's finances. One of the main alternative theories of how firms manage their capital funds is the Pecking Order Theory ( Stewart Myers), which suggests that firms avoid external financing while they have
internal financingIn the theory of capital structure, internal financing is the process of a firm using its profits or asset In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is any ...
available and avoid new equity financing while they can engage in new debt financing at reasonably low
interest rates An interest rate is the amount of interest In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and inves ...
. Also, the
capital structure substitution theory In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital stru ...
hypothesizes that management manipulates the capital structure such that
earnings per share Earnings per share (EPS) is the monetary value of earningsEarnings are the net benefits of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single ...

earnings per share
(EPS) are maximized. 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 of the more recent innovations in this area from a theoretical point of view is the market timing hypothesis. This hypothesis, inspired in 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.


Investment and project valuation

In general, each "
project A project (or program) is any undertaking, carried out individually or collaboratively and possibly involving research or design, that is carefully plan A plan is typically any diagram or list of steps with details of timing and resources, us ...

project
's" value will be estimated using a
discounted cash flow In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available ...
(DCF) valuation, and the opportunity with the highest value, as measured by the resultant
net present value The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ra ...
(NPV) will be selected (first applied in a corporate finance setting by Joel Dean in 1951). This requires estimating the size and timing of all of the ''incremental''
cash flow A cash flow is a real or virtual movement of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
s resulting from the project. Such future cash flows are then
discounted Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. ...
to determine their ''
present value In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavi ...
'' (see
Time value of money The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, ...
). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See for general discussion, and
Valuation using discounted cash flows Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money The time value of money is the widely accepted conjecture ...
for the mechanics, with discussion re modifications for corporate finance. The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate" – is critical to choosing appropriate projects and investments for the firm. 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 project-relevant 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 The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by t ...
(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; see . These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV, which more directly consider
economic profit An economic profit is the difference between the revenue a commercial entity has received from its outputs and the opportunity cost In Microeconomics, microeconomic theory, opportunity cost is the loss of the benefit that ''could'' have been en ...
, include residual income valuation, MVA /
EVA Eva or EVA may refer to: * Eva (name) Eva is a female given name, the Latinate counterpart of English Eve (name), Eve, derived from a Hebrew (language), Hebrew name meaning "life" or "living one". It can also mean full of life or mother of l ...
(
Joel SternJoel M. Stern was chairman and chief executive officer of Stern Value Management, formerly Stern Stewart & Co, and the creator and developer of economic value added. He was a recognised authority on financial economics Financial economics is the br ...
, Stern Stewart & Co) and APV ( Stewart Myers). With the cost of capital correctly and correspondingly adjusted, these valuations should yield the same result as the DCF. See also '' list of valuation topics''.


Valuing flexibility

In many cases, for example projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach. Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the
cost of capital In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant l ...
) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers; see Penalized present value).Aswath Damodaran
Risk Adjusted Value
Ch 5 in ''Strategic Risk Taking: A Framework for Risk Management''. Wharton School Publishing, 2007.
See: §32 "Certainty Equivalent Approach" & §165 "Risk Adjusted Discount Rate" in: Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.Dan Latimore
''Calculating value during uncertainty''
Institute for Business Value, IBM Institute for Business Value
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 "flexible and staged nature" of the investment is Mathematical model, modelled, and hence "all" potential Moneyness, payoffs are considered. See Real options valuation#Applicability of standard techniques, further under Real options valuation. The difference between the two valuations is the "value of flexibility" inherent in the project. The two most common tools are decision tree, Decision Tree Analysis (DTA) and real options valuation (ROV); they may often be used interchangeably: * DTA values flexibility by incorporating ''Event (probability theory), possible events'' (or State prices, states) and consequent ''Decision making#Decision making in business and management, management decisions''. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modelled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this "knowledge" of the events that could follow, and assuming Optimal decision, rational decision making, management chooses the branches (i.e. actions) corresponding to the highest value path probability, probability weighted; (3) this path is then taken as representative of project value. See . * ROV is usually used when the value of a project is ''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: (1) 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; (2) an appropriate valuation technique is then employed – usually a variant on the binomial options model or a bespoke Monte Carlo methods in finance, simulation model, while Black–Scholes model, Black–Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) See also Business valuation#Option pricing approaches, § Option pricing approaches under Business valuation.


Quantifying uncertainty

Given the uncertainty inherent in project forecasting and valuation,See: "Capital Budgeting Under Risk". Ch.9 i
Schaum's outline of theory and problems of financial management
Jae K. Shim and Joel G. Siegel.
Se
Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations
Prof. Aswath Damodaran
analysts will wish to assess the ''sensitivity'' of project NPV to the various inputs (i.e. assumptions) to the DCF Mathematical model, model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ''ceteris paribus''. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at various Compound annual growth rate, growth rates in Revenue#Financial analysis, annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%...), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface (mathematics), surface" (or even a "value-Euclidean space, space"), where NPV is then a Function (mathematics)#Functions with multiple inputs and outputs, function of several variables. See also Stress testing#Financial sector, Stress testing. Using a related technique, analysts also run scenario planning, scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand, demand for the product, exchange rates, commodity, commodity prices, etc.) ''as well as'' for company-specific factors (unit costs, etc.). As an example, the analyst may specify various revenue growth scenarios (e.g. -5% for "Worst Case", +5% for "Likely Case" and +15% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be ''internally consistent'' (see Financial modeling#Accounting, discussion at Financial modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "Bias of an estimator, 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; see First Chicago Method. (See also rNPV, where cash flows, as opposed to scenarios, are probability-weighted.) A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of variables and their realizations"Virginia Clark, Margaret Reed, Jens Stephan (2010)
Using Monte Carlo simulation for a capital budgeting project
Management Accounting Quarterly, Fall, 2010
is to construct stochasticSee
Quantifying Corporate Financial Risk
, David Shimko.
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. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using a Comparison of risk analysis Microsoft Excel add-ins, risk-analysis add-in, such as ''@Risk'' or ''Crystal Ball''. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several ''thousand'' random but possible outcomes, or trials, "covering all conceivable real world contingencies in proportion to their likelihood;"The Flaw of Averages
, Prof. Sam Savage, Stanford University.
see Monte Carlo method#Monte Carlo simulation versus "what if" scenarios, Monte Carlo Simulation versus "What If" Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value). Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular distribution, triangular or beta distribution, beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly – Cholesky decomposition#Monte Carlo simulation, incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. 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 scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see . A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.


Dividend policy

Dividend policy is concerned with financial policies regarding the payment of a cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated Profit (accounting), profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, 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. If there are no NPV positive opportunities, i.e. projects where Return on investment, returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess cash surplus so as to fund future projects internally to help increase the value of the firm. Management must also choose the ''form'' of the dividend distribution, as stated, generally as cash
dividend A dividend is a distribution of profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
s or via a Treasury stock, share buyback. Various factors may be taken into consideration: where shareholders must pay Dividend tax, tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from Treasury stock, stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, then, shareholders of growth stock, growth companies would prefer managers to retain earnings and pay no dividends (use excess cash to reinvest into the company's operations), whereas shareholders of value stock, value- or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends when a positive return cannot be earned through the reinvestment of undistributed earnings. A share buyback program may be accepted when the value of the stock is greater than the returns to be realized from the reinvestment of undistributed profits. In all instances, the appropriate dividend policy is usually directed by that which maximizes long-term shareholder value.


Working capital management

Managing the corporation's working capital position to sustain ongoing business operations is 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. In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital budgeting, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and
cost of capital In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant l ...
. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to Operations management, operate, and that it has sufficient cash flow to service long-term debt, and to satisfy both maturing money market, short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.


Working capital

Working capital is the amount of funds that are necessary for an organization to continue its ongoing business operations, until the firm is reimbursed through payments for the goods or services it has delivered to its customers. Working capital is measured through the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, capital resource allocations relating to working capital are always current, i.e. short-term. In addition to time horizon, working capital management differs from capital budgeting in terms of time value of money, discounting and profitability considerations; decisions here are also "reversible" to a much larger extent. (Considerations as to risk appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants – may be more relevant here). The (short term) goals of working capital are therefore not approached on the same basis as (long term) profitability, and working capital management applies different criteria in allocating resources: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the most important). * The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The 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. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.) * 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. As above, firm value is enhanced when, and if, the return on capital exceeds the
cost of capital In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant l ...
.


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 debtors) and the short term financing, such that cash flows and returns are acceptable.Best-Practice Working Capital Management: Techniques for Optimizing Inventories, Receivables, and Payables
, Patrick Buchmann and Udo Jung
* Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. * Inventory theory, 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 discussion under Inventory optimization and Supply chain management. Note that "inventory" is usually the realm of operations management: given the potential impact on cash flow, and on the balance sheet in general, finance typically "gets involved in an oversight or policing way".William Lasher (2010). Practical Financial Management. South-Western College Pub; 6 ed. * Debtors management. There are two inter-related roles here: (1) 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. (2) Implement appropriate credit scoring policies and techniques such that the Default risk, risk of default on any new business is acceptable given these criteria. * 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"; see generally, trade finance.


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, analytical methods 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 An investment bank is a financial services Financial services are the economic services provided by the finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concer ...
– i.e. with transactions in which capital is raised for the corporation. See under for a listing of the various transactions here, and for a description of the role.


Financial risk management

Risk management is the process of measuring risk and then developing and implementing strategies to manage ("Hedge (finance), hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse changes in commodity, commodity prices, interest rates, exchange rate, foreign exchange rates and stock, stock prices (market risk). It will also play an important role in short term cash management, cash- and treasury management; see #Capitalization_structure, above. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for small firms to have a formal risk management function, many still apply risk management informally. See also and Enterprise risk management. The discipline typically focuses on risks that can be hedged using traded financial instruments, typically Derivative (finance), derivatives; see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because company specific, "Over-the-counter (finance), over-the-counter" (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or Exchange (organized market), exchanges are often preferred. These standard derivative instruments include option (finance), options, futures contracts, forward contracts, and swap (finance), swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB 133, IAS 39. This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous capital financial investments. Secondly, both disciplines share the goal of enhancing, or preserving, firm Value (economics), value. There is a fundamental debateSee for example: Prof. Jonathan Lewellen, MIT
Financial Management Notes: Risk Management
/ref> relating to "Risk Management" and shareholder value. Per the Modigliani–Miller theorem, Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress. A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of bankruptcy in that market.


See also

* * *
Financial management Financial management may be defined as the area or function in an organization which is concerned with profitability, expenses, cash and credit, so that the "organization may have the means to carry out its objective as satisfactorily as possible ...
* Strategic financial management * Financial accounting ** Financial statement analysis ** Financial ratio * Stock market * Security (finance) * Growth stock * Financial planning * Investment bank * Venture capital * Private equity * Corporate tax * Corporate governance * Lists: * List of accounting topics * List of finance topics ** List of finance topics#Corporate finance, List of corporate finance topics ** List of finance topics#Valuation, List of valuation topics


References


Further reading

* In ''The Modern Theory of Corporate Finance'', edited by Michael C. Jensen and Clifford H. Smith Jr., pp. 2–20. McGraw-Hill, 1990. *


Bibliography

* * * * * * * * * * * {{Authority control Corporate finance,