Corporate Finance Theory – Introduction
Very general meaning of CORPORATE FINANCE is “Financial activities associated with running a business” and I am sure everybody is well versed in this definition of Corporate Finance. But do you know which are the actual Corporate finance theory and practices that are involved in real life Corporate Finance?
Here is the article which will give you a glimpse of real-world Corporate Finance theory and practice.
The questions which are answered by Corporate Finance are decision making about capital, finding the sources of capital, decisions regarding payment of dividend, Finance involved in Mergers and Acquisitions processes of the corporate finance companies.
Transactions involved in Corporate Finance theory
- Raising seed, startup, expansion or development capital.
- Mergers, demergers, acquisitions or the sale of private companies
- Mergers, demergers, takeovers of public companies
- Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses
- Financing joint ventures, project finance, infrastructure finance, public-private partnerships
- Raising debt and restructuring debt, especially when linked to the types of transactions listed above
Skeleton of Corporate Finance Theory and practice
Capital budgeting (Investment analysis)
- The “capital” refers to long-term assets.
- The “budget” is a plan which details projected cash inflows and outflows during the future period
When a firm is in a plan of doing long-term investments, for different purposes like, replacing the old machinery, buying of new machinery, investing in new plants, developing new products, research and developments, it needs to do analysis of whether these projects are worth funding of cash through the firm’s capital structure. Hence this entire process of analysis is called as capital budgeting. The capitalization structure may include debt, equity and retained earnings.
Maximizing shareholder value
Financial management has the major goal of increasing the shareholder value. For this corporate finance managers must balance between the investments in projects which will increase the firm’s profitability as well as sustainability and paying of the excess cash in the form of dividends to shareholders.
With the resources and surplus cash, managers can invest these for the purpose of company expansion. So managers must do a proper analysis to determine the appropriate allocation of the firm’s capital resources and cash surplus between projects and payment of dividends to the shareholders.
Return on investment
Whenever we do any investment in the projector in terms of cash the purpose behind it is to earn on that investment. In corporate finance theory, the same concept is applied to investing in some asset such that it will yield an appreciation of value to the organization. Return on investment is the term which is used to measure the return earned in comparison with the capital invested.
In terms of Mergers and Acquisitions, LBO is the very commonly used concept. LBO’s can have many different forms such as Management Buy-Out(MBO), Management Buy-In (MBI), Secondary Buyout and tertiary buyout.
A growth stock as the name suggests is a stock of a company which generates significant positive cash flow and its revenues are expected to increase more rapidly than the companies from the same industry.
The general meaning of this Efficient Market Hypothesis is,” the financial markets are efficient in terms of information”. The three major forms of this hypothesis are: “weak”, “semi-strong”, and “strong”.
The weak form titles that prices on traded assets reflect all past publicly available information. The semi-strong form reflects all publicly available information and that prices instantly change to reflect the new public information. Strong form claims that the prices instantly reflect even hidden information.
The firm can use the self-generated fund as a capital or can go for external funding which is obtained by issue of debt and equity. Debt financing, of course, comes with an obligation which is to be made through cash flows regardless of project’s level of success. Whereas equity financing is less risky with respect to cash flow payments but has a consideration in the ownership, control, and earnings of the organization. Management should use optimal mix in terms of capital structure with due consideration to the timing and cash flow.
In order to sustain ongoing business operations, corporate needs to manage its working capital. Working capital is the subtraction of current liabilities from current assets. Working capital is measured through the difference between cash or readily convertible into cash (Current Assets) and cash requirements (Current Liabilities).
Assets on a Balance sheet are classified as Current assets and long terms assets. The duration for which certain assets and liabilities a firm has in hand is very useful.
Depending on the duration for which the loan is availed the bank loan is classified as short-term(one year or less) loans and long-term(known as a term) loans.
Which are the sources of capital?
Debt can be obtained through bank loans, notes payable or bonds issued to the public. For debt through Bonds requires an organization to make regular interest payments on the borrowed capital until it reaches its maturity date after which it must be paid back in full. In some cases, if the interest expenses cannot be made by corporations through cash payments then the firm may also use collateral assets as a form of repaying their debt obligations.
A company can raise the capital through selling the shares in the stock market. Thus investors which are also called as shareholders buy the shares with a hope of getting an appropriate return (dividends and increased shareholders value) from the company. Thus investors invest only in those corporate finance companies which have positive earnings.
It’s a combination of properties which are not possessed by equity and a debt instruments. These stocks do not carry voting rights but have a priority over common stock in terms of dividend payments, assets allocation at the time of liquidation.
Cost of Capital
It is the rate of return which must be realized in order to satisfy investors. Cost of debt is the return required by the investors who invest in the firm’s debt. Cost of debt is largely related to the interest the firm pays on its debt. Whereas the cost of equity is calculated as:
Cost of Equity = Risk Free Rate+Beta*Equity Risk Premium
The return from the project must be greater than the cost of the project in order for it to be acceptable.
The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock, and common stock or equity. It is also referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital.
WACC = E/V*Re+D/V*Rd(1-Tc)
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Investment and project valuation
Project’s value is estimated using a Discounted Cash Flow (DCF) valuation and the highest Net Present Value (NPV) project will be selected. For finding out this, cash flows from the project are measured and then they are discounted to find their present value. The summation of these present values is NPV.
There are some other measures as well, including discounted payback period, IRR, ROI, Residual Income Valuation, MVA / EVA.
Revenue, Expenses, and Inventory
An organization’s income is calculated by subtracting expenses from its revenue.
Not all the costs are considered as expenses, hence accounting standards have made certain specifications regarding which costs to be allocated to the income statement as expenses and which costs to be allocated to inventory account and appear as an asset on balance sheet.
Certain financial ratios are very helpful in evaluating firms performance. These a ratios are used to measure:
- Turnover rates
- Return on Investments
The time between the date the inventory (or raw materials) is paid for ant the date the cash is collected from the sale of the inventory is termed as Cash cycle.
The corporate finance formula for calculating the cash cycle is:
Days in inventory + days in receivables – days in payables.
As cash cycle affects the need for financing it is very important from a corporate point of view.
Payment of the dividend is mainly related to the dividend policy which is determined on the basis of a financial policy of the company. All the matters regarding the issue of dividends, amount of dividends to be issued is determined by the company’s excess cash after payment of all the dues. If the company has surplus cash and if it is not required by the business, in that case, a company can think about payment of some or all of the surplus earnings in the form of dividends.
Company’s Sustainable growth rate is calculated by multiplying the ROE by the earnings retention rate.
As we know the risk that a firm can face is Business Risk, Financial Risk, and Total corporate risk.
Business Risk: This risk associated with a firms operations. A measure of the business risk is the asset beta, which is also known as unlevered beta.
Financial Risk: This risk is associated with the firm’s capital structure. It is affected by the firms financing decision.
Total Corporate Risk: This is the sum of Business and Financial risks and it is measured by the equity beta which is also called as levered beta.
Sometimes, a firm has extra cash on hand, so it may choose to buy back some of its outstanding shares. This eventually has an added advantage, as a firm has its own information which market doesn’t have. Therefore, a share buyback could serve as a signal that the share price has potential to rise at above-average rates.
Corporate finance theory and practice – Mergers and Acquisitions
Based on some financial or nonfinancial (expansion) reasons companies may merge. The target firm is acquired with the purpose that synergies from the merger will exceed the price premium.
How Is Corporate Finance associated with other areas of finance?
Though the word Corporate Finance theory sounds very limited, it has an association with the activities, and methodical aspects of a company’s finances and capital.
In the area of Investment banking, the transactions in which capital is raised for the organization include:
- Seed capital, startup.
- Mergers and Demergers of the companies.
- Management Buyout (MBO’s), Leveraged Buyout (LBO’s)
- Capital raising through equity, debt
- Restructuring of the business
Financial Risk Management
Risk management has a very important role in every aspect of a business. Financial risk management is related to management of corporate value in the event of adversarial changes in stock prices, commodity prices, exchange rates, interest rates.
This has been a guide to Corporate Finance Theory and practice. here we have discussed the planning, Transactions, Skeleton, Source of capital and how it is associated with the other finance company etc. you may also learn more about corporate finance theory and practice from the following articles-
- Important Skill Of Project Finance Jobs
- Types Of Cost Of Equity
- What is WACC (Resourceful)
- Important Steps To Calculate Beta (Powerful)
- Discounted Cash Flow (Benefits)
- All you wanted to know about Corporate Finance
- Finance vs Economics: Features
Corporate Finance Theory Infographics
Learn the juice of this Corporate Finance Theory in just a single minute, Corporate Finance Theory Infographics.