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{{Short description|Framework for corporate funding, capital structure, and investments}}{{Corporate finance}}{{Banking |related}}Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, 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.See Corporate Finance: First Principles, Aswath Damodaran, New York University’s Stern School of BusinessCorrespondingly, corporate finance comprises two main sub-disciplines. {{Citation needed|date=April 2011}} 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 (such as the terms on credit extended to customers).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

{{See also|History of banking|Financial centre#History|Mergers and acquisitions#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 (also known by the abbreviation “VOC” in Dutch) was the first publicly listed company ever to pay regular dividends.Freedman, Roy S.: Introduction to Financial Technology. (Academic Press, 2006, {{ISBN|0123704782}})DK Publishing (Dorling Kindersley): The Business Book (Big Ideas Simply Explained). (DK Publishing, 2014, {{ISBN|1465415858}})Huston, Jeffrey L.: The Declaration of Dependence: Dividends in the Twenty-First Century. (Archway Publishing, 2015, {{ISBN|1480825042}}) 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.Ferguson, Niall (2002). Empire: The Rise and Demise of the British World Order and the Lessons for Global Power, p. 15. “Moreover, their company [the Dutch East India Company] was a permanent joint-stock company, unlike the English company, which did not become permanent until 1650.“Smith, B. Mark: A History of the Global Stock Market: From Ancient Rome to Silicon Valley. (University of Chicago Press, 2003, {{ISBN|9780226764047}}), p. 17. As Mark Smith (2003) notes, “the first joint-stock companies had actually been created in England in the sixteenth century. These early joint-stock firms, however, possessed only temporary charters from the government, in some cases for one voyage only. (One example was the Muscovy Company, chartered in England in 1533 for trade with Russia; another, chartered the same year, was a company with the intriguing title Guinea Adventurers.) The Dutch East India Company was the first joint-stock company to have a permanent charter.“Clarke, Thomas; Branson, Douglas: The SAGE Handbook of Corporate Governance. (SAGE Publications Ltd., 2012 {{ISBN|9781412929806}}), p. 431. “The EIC first issued permanent shares in 1657 (Harris, 2005: 45).“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 {{slink|City of London#Economy}}. 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.BOOK,books.google.com/books?id=qgAnuSzVHKkC&pg=PP1, A History of Corporate Finance, Baskin, Jonathan, Baskin, Jonathan Barron, Miranti, Paul J. Jr., 1999-12-28, Cambridge University Press, 9780521655361, en, JOURNAL, Smith, Clifford W., Jensen, Michael C., 2000-09-29, The Theory of Corporate Finance: A Historical Overview, en, Rochester, NY, 244161, BOOK,books.google.com/books?id=geEzo9s9QbUC&pg=PA75, Capitals of Capital: A History of International Financial Centres, 1780–2005, Cassis, Youssef, Cambridge University Press, 2006, 978-0-511-33522-8, Cambridge, UK, 1; 74–5, BOOK,books.google.com/books?id=fPugmGG-ircC&pg=PT149, The Global Securities Market: A History, Michie, Ranald, 2006, OUP Oxford, 0191608599, 149, BOOK,books.google.com/books?id=ItqhNQusviAC&pg=PA13, International Banking: 1870–1914, Oxford University Press, 1991, 978-0-19-506271-7, Cameron, Rondo, New York, NY, 13, Bovykin, V.I., BOOK,books.google.com/books?id=J0vl6CltQjEC&q=the%20city%20richard%20roberts&pg=PA2, The City: A Guide to London’s Global Financial Centre, Roberts, Richard, Economist, 2008, 9781861978585, 6; 12–13; 88–89, 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.BOOK, Jim McMenamin, Financial Management: An Introduction,books.google.com/books?id=stnjJx-sPjUC&pg=PA23, 11 September 2002, Routledge, 978-1-134-67624-8, 23–, 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.BOOK, Carlos Correia, David K. Flynn, Enrico Uliana, Michael Wormald, Financial Management,books.google.com/books?id=yClNbKM7hScC&pg=SA5-PA6, 15 January 2007, Juta and Company Ltd, 978-0-7021-7157-4, 5–, 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).BOOK, Financial Management; Principles and Practice,books.google.com/books?id=sSzpPWDSapoC&pg=PA265, 1968, Freeload Press, Inc., 978-1-930789-02-9, 265–, This “capital budgeting” is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm’s capital structure. Management must allocate the firm’s limited resources between competing opportunities (projects).See: Investment Decisions and Capital Budgeting, Prof. Campbell R. Harvey; The Investment Decision of the Corporation {{Webarchive|url=https://web.archive.org/web/20121012234632www.duke.edu/~charvey/Classes/ba350_1997/vcf2/vcf2.htm#257,2,Slide |date=2012-10-12 }}, Prof. Don M. ChanceCapital 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.Myers, Stewart C. “Interactions of corporate financing and investment decisions—implications for capital budgeting.” The Journal of finance 29.1 (1974): 1-25. 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. 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.BOOK, Pamela P. Peterson, Frank J. Fabozzi, Capital Budgeting: Theory and Practice,books.google.com/books?id=eW_rmXkRDg0C, 4 February 2004, John Wiley & Sons, 978-0-471-44642-2, BOOK, Lawrence J. Gitman, Michael D. Joehnk, George E. Pinches, Managerial finance,archive.org/details/managerialfinanc00gitm, registration, 1985, Harper & Row, 9780060423360, A long-standing debate in corporate finance has focused on whether maximizing shareholder value or stakeholder value should be the primary focus of corporate managers, with stakeholders widely interpreted to refer to shareholders, employees, suppliers and the local community.JOURNAL, Smith, H. Jeff, 2003-07-15, The Shareholders vs. Stakeholders Debate,sloanreview.mit.edu/article/the-shareholders-vs-stakeholders-debate/, MIT Sloan Management Review, en-US, In 2019, the Business Roundtable released a statement, signed by 181 prominent U.S. CEOs, which committed to lead their companies for “the benefit of all stakeholders”.WEB, Business Roundtable Redefines the Purpose of a Corporation to Promote ‘An Economy That Serves All Americans’,www.businessroundtable.org/business-roundtable-redefines-the-purpose-of-a-corporation-to-promote-an-economy-that-serves-all-americans, 2023-04-17, www.businessroundtable.org, en, Despite intense debate and recent momentum for the stakeholder theory, shareholder theory still dominates corporate world strategy.JOURNAL, Chuma, Casius, Qutieshat, Abubaker, 2023-03-30, Where Does the Value of A Corporation Lie? A Literature Review,193.204.40.129/index.php/ea/article/view/2168, Economia Aziendale Online, en, 14, 1, 15–32, 10.13132/2038-5498/14.1.15-32, 2038-5498,

Capital structure

{{Further| Security (finance)}}Achieving the goals of corporate finance requires that any corporate investment be financed appropriately.See: The Financing Decision of the Corporation {{Webarchive|url=https://web.archive.org/web/20121012234632www.duke.edu/~charvey/Classes/ba350_1997/vcf2/vcf2.htm#256,1,Slide |date=2012-10-12 }}, Prof. Don M. Chance; Capital Structure, Prof. Aswath Damodaran The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt and equity (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, WACC.Finally, there is much theoretical discussion as to other considerations that management might weigh here.

Sources of capital

Debt capital

{{Further| Bankruptcy|Financial distress}}Corporations may rely on borrowed funds (debt capital or credit) 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 corporation to make regular 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. One exception is zero-coupon bonds (or “zeros“). 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 assets as a form of repaying their debt obligations (or through the process of liquidation).

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 a specialized form of financing which combines properties of common stock and debt instruments, and is generally considered a hybrid security. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company).Drinkard, T., A Primer On Preferred Stocks., InvestopediaPreferred stock usually carries no voting rights,“Preferred Stock ... generally carries no voting rights unless scheduled dividends have been omitted.” – Quantum Online {{Webarchive|url=https://web.archive.org/web/20120623022006www.quantumonline.com/glossary.cfm |date=2012-06-23 }} but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. 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.Drinkard, T.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:BOOK, Kieso, Donald E., Weygandt, Jerry J., amp, Warfield, Terry D., 2007, Intermediate Accounting, 12th, John Wiley & Sons, New York, 978-0-471-74955-4, 738, .

• 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

(File:2005private sector credit.PNG|thumb|350px|right|Domestic credit to private sector in 2005)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,Capital Structure: Implications {{Webarchive|url=https://web.archive.org/web/20120121165857www.qfinance.com/mergers-and-acquisitions-best-practice/capital-structure-implications?full |date=2012-01-21 }}, Prof. John C. Groth, Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure, Ruben D. Cohen, Citigroup - but must also take other factors into account (see trade-off theory below). 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 (see CAPM and APT) 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.See:Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes, Nishant Choudhary, LL.M. 2011 (Business & finance), George Washington University Law SchoolJOURNAL, New issues in corporate finance, European Economic Review, 1988, Colin, Mayer, 32, 5, 1167-1183, 10.1016/0014-2921(88)90077-3,www.academia.edu/3384676/New_issues_in_corporate_finance,
• 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 (“cashflow matching“) or duration (“immunization“); 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

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 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 financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates.Also, the capital structure substitution theory hypothesizes that management manipulates the capital structure such that 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 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.

Investment and project valuation

{{Further|Business valuation|Mergers and acquisitions#Business valuation|fundamental analysis}}In general,See: Valuation, Prof. Aswath Damodaran; Equity Valuation, Prof. Campbell R. Harvey each “project’s” value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (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 flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See {{slink|Financial modeling#Accounting}} for general discussion, and Valuation using discounted cash flows 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“See for example Campbell R. Harvey’s Hypertextual Finance Glossary or investopedia.com – 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.Prof. Aswath Damodaran: Estimating Hurdle Rates 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 (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 {{slink|Capital budgeting#Ranked projects}}. 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, include residual income valuation, MVA / EVA (Joel Stern, 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 R&D 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.See: Real Options Analysis and the Assumptions of the NPV Rule, Tom Arnold & Richard Shockley Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) 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. {{ISBN|0-13-199048-9}}See: §32 “Certainty Equivalent Approach” & §165 “Risk Adjusted Discount Rate” in: BOOK, Joel G. Siegel, Jae K. Shim, Stephen Hartman, Schaum’s quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students,archive.org/details/schaumsquickguid00sieg, registration, 12 November 2011, 1 November 1997, McGraw-Hill Professional, 978-0-07-058031-2, 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.Michael C. Ehrhardt and John M. Wachowicz, Jr (2006). Capital Budgeting and Initial Cash Outlay (ICO) Uncertainty. Financial Decisions, Summer 2006, Article 2Dan Latimore: Calculating value during uncertainty. 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 most likely or average or scenario specific cash flows are discounted, here the “flexible and staged nature” of the investment is modelled, and hence “all” potential payoffs are considered. See 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 Analysis (DTA) and real options valuation (ROV);See:Identifying real options, Prof. Campbell R. Harvey; Applications of option pricing theory to equity valuation, Prof. Aswath Damodaran; How Do You Assess The Value of A Company’s “Real Options“? {{Webarchive|url=https://web.archive.org/web/20191020222316www.expectationsinvesting.com/tutorial11.shtml |date=2019-10-20 }}, Prof. Alfred Rappaport Columbia University & Michael Mauboussin they may often be used interchangeably:

• DTA values flexibility by incorporating possible events (or states) and consequent 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 rational decision making, management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See {{slink|Decision theoryChoice under uncertainty}}.
• ROV is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using 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 simulation model, while 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 § Option pricing approaches under Business valuation.

Quantifying uncertainty

{{Further|Sensitivity analysis|Scenario planning|Monte Carlo methods in finance|Valuation using discounted cash flows #Determine equity value|Discrete-event simulation#Evaluating capital investment decisions}}Given the uncertainty inherent in project forecasting and valuation,“Capital Budgeting Under Risk”. Ch.9 in Schaum’s outline of theory and problems of financial management, Jae K. Shim and Joel G. Siegel.Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations, Prof. Aswath DamodaranThe Role of Risk in Capital Budgeting - Scenario and Simulation Assessments, Boundless Financeanalysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF 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 growth rates in 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“For example, (:Category:Mining companies|mining companies) sometimes employ the “Hill of Value” methodology in their planning; see, e.g., B. E. Hall (2003). “How Mining Companies Improve Share Price by Destroying Shareholder Value” and I. Ballington, E. Bondi, J. Hudson, G. Lane and J. Symanowitz (2004). “A Practical Application of an Economic Optimisation Model in an Underground Mining Environment” {{webarchive|url=https://web.archive.org/web/20130702162353downloads.cyestcorp.com/Technical%20Papers/Practical%20Application%20of%20an%20Economic%20Optimisation%20Model%20in%20an%20Underground%20Mining%20Environment.pdf |date=2013-07-02 }}. (or even a “value-space“), where NPV is then a function of several variables. See also Stress testing.Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, “global” factors (demand for the product, exchange rates, 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 discussion at Financial modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an “unbiased” NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the 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 David Shimko (2009). www.qfinance.com/financial-risk-management-best-practice/quantifying-corporate-financial-risk?full" title="web.archive.org/web/20100717072252www.qfinance.com/financial-risk-management-best-practice/quantifying-corporate-financial-risk?full">Quantifying Corporate Financial Risk. archived 2010-07-17. or probabilistic financial models – as opposed to the traditional static and deterministic models as above. For this purpose, the most common method is to use 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 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 {{webarchive|url=https://web.archive.org/web/20111207025740www.analycorp.com/uncertainty/flawarticle.htm |date=2011-12-07 }}, Prof. Sam Savage, Stanford University. see 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 or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be “sampled” repeatedly – 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 {{slink|Real options valuation#Valuation inputs}}. 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 Claire Boyte-White (2023). 4 Reasons a Company Might Suspend Its Dividend, Investopedia to issue dividends,See Dividend Policy, Prof. Aswath Damodaran and what amount, is determined mainly on the basis of the company’s unappropriated 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 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 dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay 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 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 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- 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

{{See also|Cash flow forecasting#Corporate finance}}Managing the corporation’s working capital position to sustain ongoing business operations is referred to as working capital management.See Working Capital Management {{Webarchive|url=https://web.archive.org/web/20041107091859www.studyfinance.com/lessons/workcap/index.mv |date=2004-11-07 }}, Studyfinance.com; Working Capital Management {{webarchive|url=https://web.archive.org/web/20071017004224treasury.govt.nz/publicsector/workingcapital/chap2.asp |date=2007-10-17 }}, treasury.govt.nz These involve managing the relationship between a firm’s short-term assets and its 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.The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long-term debt, and to satisfy both maturing 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.Security Analysis, Benjamin Graham and David Dodd 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 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.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital.See The 20 Principles of Financial Management {{Webarchive|url=https://archive.today/20120731063449www.bus.lsu.edu/academics/finance/faculty/dchance/Instructional/PrinciplesofFinancialManagement.htm |date=2012-07-31 }}, Prof. Don M. Chance, Louisiana State University These policies aim at managing the current assets (generally cash and cash equivalents, 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 {{Webarchive|url=https://web.archive.org/web/20140201174839www.qfinance.com/contentFiles/QF02/hbmpf5qp/12/0/best-practice-working-capital-management-techniques-for-optimizing-inventories-receivables-and-payables.pdf |date=2014-02-01 }}, 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 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. {{ISBN|1-4390-8050-X}}{{rp|714}}
• Debtors management. There are two inter-related roles here: (1) Identify the appropriate 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 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”; see generally, trade finance.

Relationship with other areas in finance

Investment banking

{{see|Investment banking #Corporate finance}}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 countries, the terms “corporate finance” and “corporate financier” tend to be associated with investment banking – i.e. with transactions in which capital is raised for the corporation or shareholders; the services themselves are often referred to as advisory, financial advisory, deal advisory and transaction advisory services.Shaun Beaney, Katerina Joannou and David Petrie What is Corporate Finance?, Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011 and September 2020) See under {{slink|Investment banking#Corporate finance}} for a listing of the various transaction-types here, and {{slink|Financial analyst#Investment Banking}} for a description of the role.“>

Financial risk management{| class“wikitable floatright” | width“250”

style="text-align:center;“| Concerns|

• Credit risk
• Default (finance)
• Financial risk
• Interest rate risk
• Insurance
• Liquidity risk
• Operational risk
• Settlement risk
• Value at Risk
• Volatility risk

Financial risk management, generically, is focused on measuring and managing market risk, credit risk and operational risk.Within corporates, John Hampton (2011). The AMA Handbook of Financial Risk Management. American Management Association. {{ISBN|978-0814417447}} the scope is broadened to overlap enterprise risk management, and then addresses risks to the firm’s overall strategic objectives,focusing on the financial exposures and opportunities arising from business decisions, and their link to the firm’s appetite for risk, as well as their impact on share price.The discipline is thus related to corporate finance, both re operations and funding, as below; and in large firms, the risk management function then overlaps “Corporate Finance”, with the CRO consulted on capital-investment and other strategic decisions.

1. Both areas share the goal of enhancing, and preserving, the firm’s economic value. Risk Management and the Financial Manager. Ch. 20 in BOOK, Principles of Finance, 2022, 9781951693541, Julie Dahlquist, Rainford Knight, Alan S. Adams,open.umn.edu/opentextbooks/textbooks/principles-of-finance, Here, businesses actively manage any impact on profitability, cash flow, and hence firm value, due to credit and operational factors - this, overlapping “working capital management” to a large extent. Firms then devote much time and effort to forecasting, analytics and performance monitoring. (See also FP&A, “ALM” and treasury management.)
2. Firm exposure to market (and business) risk is a direct result of previous capital investments and funding decisions: where applicable here,See “III.A.1.7 Market Risk Management in Non-financial Firms”, in Carol Alexander, Elizabeth Sheedy eds. “The Professional Risk Managers’ Handbook” 2015 Edition. PRMIA. {{ISBN|978-0976609704}}David Shimko (2009). Dangers of Corporate Derivative Transactions typically in large corporates and under guidance from their investment bankers, firms actively manage and hedge these exposures using traded financial instruments, usually standard derivatives, creating interest rate-, commodity- and foreign exchange hedges; see Cash flow hedge.

See also

{{Wikiversity}}{{cols}}

• Outline of corporate finance
• {{slink|Financial economicsCertainty}}
• {{slink|Financial economicsCorporate finance theory}}
• {{slink|Outline of financeCorporate finance theory}}
• Capital management
• Corporate budget
• Corporate governance
• Corporate tax
• FP&A
• Financial accounting
• Financial analysis
• Financial management
• Financial planning
  • Financial ratio
  • Financial statement analysis
• Growth stock
• Investment bank
• Private equity
• Security (finance)
• Stock market
• Strategic financial management
• Venture capital
• {{sectionlink|Professional certification in financial servicesCorporate finance}}

{{colend}}Lists:

• List of accounting topics
• (:Category:Corporate finance theorists|List of Corporate finance theorists)
• List of finance topics
  • List of corporate finance topics
  • List of valuation topics

References

{{Reflist|35em}}

Bibliography

• BOOK, Jonathan Berk, Peter DeMarzo, Corporate Finance, Pearson Education, Pearson, 2013, 978-0132992473, Jonathan Berk (finance), 3rd,
• BOOK, Peter Bossaerts, Bernt Arne Ødegaard, Lectures on Corporate Finance, World Scientific, 2006, 978-981-256-899-1, Second,
• BOOK, Richard Brealey, Stewart Myers, Franklin Allen, Franklin Allen, Principles of Corporate Finance, Mcgraw-Hill, 2013, 978-0078034763, Richard Brealey, Stewart Myers, Principles of Corporate Finance,
• BOOK, CFA Institute, Corporate Finance: Economic Foundations and Financial Modeling, Wiley, 2022, 978-1119743767, CFA Institute, 3rd,
• BOOK, Thomas E. Copeland, J. Fred Weston, Kuldeep Shastri, Financial Theory and Corporate Policy, Pearson, 2004, 978-0321127211, 4th,
• BOOK, Principles of Finance, 2022, 9781951693541, Julie Dahlquist, Rainford Knight, Alan S. Adams,open.umn.edu/opentextbooks/textbooks/principles-of-finance,
• BOOK, Aswath Damodaran, Corporate Finance: Theory and Practice, Wiley, 1996, 978-0471076803,archive.org/details/corporatefinance0000damo, Aswath Damodaran,
• BOOK, João Amaro de Matos, Theoretical Foundations of Corporate Finance, Princeton University Press, 2001, 9780691087948,
• BOOK, Joseph Ogden, Frank C. Jen, Philip F. O’Connor, Advanced Corporate Finance, Prentice Hall, 2002, 978-0130915689,
• BOOK, C. Krishnamurti, S. R. Vishwanath, Advanced Corporate Finance, MediaMatics, 2010, 978-8120336117,www.phindia.com/Books/BookDetail/9788120336117/advanced-corporate-finance-vishwanath-krishnamurti,
• BOOK, Pascal Quiry, Yann Le Fur, Antonio Salvi, Maurizio Dallochio, Pierre Vernimmen, Corporate Finance: Theory and Practice, Wiley, 2011, 978-1119975588, 3rd,
• BOOK, Stephen Ross (economist), Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Corporate Finance, Mcgraw-Hill, 2012, 978-0078034770, 10th,
• BOOK, Joel Stern, Joel M. Stern, The Revolution in Corporate Finance, Wiley-Blackwell, 2003, 9781405107815, 4th,
• BOOK, Jean Tirole, The Theory of Corporate Finance, Princeton University Press, 2006, 0691125562, Jean Tirole,
• BOOK, Ivo Welch, Corporate Finance, 2017, 9780984004928, Ivo Welch, 4th,book.ivo-welch.info/home/,

Further reading

• BOOK, The Theory of Corporate Finance: A Historical Overview, 244161, Jensen, Michael C., Smith. Clifford W., 29 September 2000, Michael C. Jensen, In The Modern Theory of Corporate Finance, edited by Michael C. Jensen and Clifford H. Smith Jr., pp. 2–20. McGraw-Hill, 1990. {{ISBN|0070591091}}
• JOURNAL, The Theory and Practice of Corporate Finance: Evidence from the Field, Graham, John R., Harvey, Campbell R., AFA 2001 New Orleans; Duke University Working Paper, 1999, 220251,

External links

{{Library resources box |by=no |onlinebooks=no |others=no |about=yes |label=Corporate Finance}}

• Corporate Finance Overview - Corporate Finance Institute

{{Corporate finance and investment banking}}{{Authority control}}