Corporate finance is one of the most challenging topics to master in any business course. However, understanding finance is one of the most important aspects of managing a business. This post contains inputs from Frank Gong and course material by Aswath Damodaran.
What is Corporate Finance?
In any corporate or business we make decisions on a daily basis that have financial implications. Any decision which affects the finances of the business or corporate is a finance decision.
The broad view of corporate finance includes everything from determining the prices of your products, to employee wage increases, and even decisions related to the payment terms of your customers.
In a more practical sense, we can define the financial view of a firm as below
- Assets in place (existing investments that generate cash flows today)
- Growth assets (expected value that will be created by future investments)
- Debt (fixed claim on cash flows, not so important for management)
- Equity (residual claim on cash flows, important for management)
Principles of Corporate Finance
The fundamental principle of business is the shareholder paradigm which states that it is the goal of a firm, business, or corporate to maximize the value of the shareholder. From that fundamental principle flow the three major decisions related to corporate finance: (1) the investment decision, (2) the financing decision, and (3) the dividend decision.
The investment decision
To maximize the value of the firm, we must invest in assets that earn a return greater than the minimum acceptable hurdle rate. The hurdle rate reflects the riskiness of the investment and the mix of debt and equity to fund it. The return reflects the magnitude and timing of the cash flows resulting from the investment, as well as all its side effects.
The financing decision
To maximize the value of the firm, we must find and choose the right kind of debt and the right mix of debt and equity to fund our operations.
The dividend decision
In case you cannot find investments that will further grow the value of the firm, return the cash to the shareholders of the firm. The quantity of the return depends on the current and potential future investment opportunities. The method of returning cash depends on the shareholder preference. Some shareholders prefer dividend payout, others prefer stock buyback programs.
Consequences of the Principles
The purpose of maximizing the value of the firm gives corporate finance its focus.
It is because this single goal that corporate finance can focus on the “right” investment, the “right” mix of debt and equity, and the “right” amount of cash that should be returned to the shareholder. Among a wide range of choices, corporate finance aims to choose that exact option which will maximize the firm’s value.
The focus of the corporate finance will change across the life cycle of the firm. The available sources of capital will be more diverse for a mature business compared to a start-up business. A firm in young growth phase will most likely reinvest all of its earnings into fueling future growth.
In the next sections we give you a taste of what’s involved with each of the three major decisions.
The Investment Decision
The investment decision can be summarized with two key terms: hurdle rate and returns.
As the financial resources of any firm are finite, the hurdle rate can be considered the internal benchmark for investment evaluation. If a project does not pass the benchmark it should not be accepted.
Additionally, some projects will be more riskier than others. The risk of a project is represented in its hurdle rate. The hurdle rate for a very risky investment will be much higher than the hurdle rate of a very safe investment. The difference between a safe investment and a risky investment is captured in the risk premium. Thus, we can describe the hurdle rate as follows:
Hurdle Rate = Riskless Rate + Risk Premium
This description outlines three major questions.
- What is risk and riskless?
- How do we measure risk?
- How to quantify risk into a risk premium?
There are several models available that help find answers to these questions. We will discuss the models and dive deeper in the Capital Asset Pricing Model (CAPM) in another post.
The most obvious aspect of evaluating an investment is its future returns. There are two aspects to this problem.
First, we must decide how we will measure the returns. There are many ways to account for and measure returns. We could consider the accrual basis, where revenue is recorded when it is earned regardless of when the invoices are paid. However, a downside is that until the buyer pays the outstanding invoice the return from the sale cannot be reinvested.
Second, we must consider the timing of the returns. Early returns can be quickly reinvested by the firm, whereas late returns may hamper the firm to undertake other projects. Also, we must consider the time value of money.
Return mantra: “Time-weighted, Incremental, Cash Flow Return”
- Cash flows, because you cannot “spend” earnings
- Incremental, because you want to evaluate returns related to the investment
- Time-weighted, because early returns are more convenient than later returns
In another post we will dive deeper in the topic and discuss terms such as Net Present Value (NPV), Internal Rate of Return (IRR), terminal value, sensitivity analysis and more
The Finance Decision
The finance decision can be summarized with one word: debt.
Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.
Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.
When repaying a loan, you pay back the principal and interest on the principal, so the total amount repaid is higher than the amount lent. So you could say that taking on debt destroys value for the shareholder but that’s not necessarily true.
Apart from increasing the capital available to the firm which can be used to invest in profitable projects, there are other reasons why a firm would take on debt.
First and foremost, interest expenses on debt are tax deductible which means a firm can reduce its effective tax rate.
Also, since debt repayment is a directly taken from the firm’s earnings it reduces the available free cash flow. That could inspire the management team to be more disciplined about investments.
There are also some disadvantages: expected bankruptcy cost, agency costs and loss of flexibility.
As there are both advantages and disadvantages, to maximize the value of the firm we can determine what is the optimal debt ratio.
To determine the optimal debt ratio, we must take into account not only the cost of the debt but also the cost of the equity. This is closely linked to the cost of capital calculation and hurdle rate for the Investment Decision.
The Dividend Decision
The dividend decision can be summarized by a single question: to reinvest or to return?
The main purpose of a firm is to maximize the valued created for the shareholder. If the management can no longer grow the value of the firm, it should return the capital to the shareholders. The shareholders are then able to reinvest the capital in other ventures or firms that may increase their wealth.
There are two ways to return value to the shareholder: dividends and buyback programs.
A dividend is a periodic return of cash to the shareholders. The dividend payout is the percentage of earnings the firm pays in dividend. The dividend yield is the return an investor can make from the dividends.
It is not always in the best interest of the shareholder to pay dividends as shareholders are taxed on income from capital gains.
Furthermore, firms that pay out dividends are expected to continue to do so in the future at the same rate and yield. Therefore, the payout becomes a measure of success for the management team. Paying dividends now makes it more challenging for the management to stop paying dividends in the future. This is annoying as it directly impacts the cash flow of the firm.
In a buyback program the firm uses its cash to repurchase outstanding shares from shareholders.
A buyback program has many advantages.
Most importantly, it is not expected to be a periodic event. That means the management can choose to initiate a buyback when it believes to be the right choice rather than based on the expectation of the market.
Additionally, it allows the management to send a signal to the market. If the management believes the firm is currently undervalued, it will buy back outstanding shares at a much higher price than its currently traded at. This shows confidence as well as indicates what the management believes is a more accurate value of the firm.
The main difference between corporate finance and valuation is that the former deals with decisions related to your firm, whereas the latter deals with the evaluation of other firms.
There are many reasons to perform a valuation of a firm. Maybe you are looking to invest in the company by buying shares. Using a proper valuation will help you find those companies that are currently undervalued and are most likely to earn you a good return. Perhaps you are interested in acquiring the firm. Then a proper valuation will help you to determine the correct price for the firm and prevent you from overpaying. Or maybe you are a consultant and want to help the firm improve. In that case a detailed valuation will help you identify problems related to finance you can help alleviate.
There are several methods to do valuation.
The intrinsic valuation will value an asset as function of its fundamentals. The fundamentals are (1) cash flows, (2) growth, and (3) risk. In general, discounted cash flows models are used for intrinsic valuation. In practical terms, it is very similar to the job of corporate finance but for a different company.
The relative valuation values an asset as function of what investors are paying for similar assets. You can use multiples and ratios of all kinds of numbers related to the firm’s financial statements.
The contingent claim valuation values an asset using option pricing models.
We will talk more about valuation and Discounted Cash Flow (DCF) models in a different post.