Corporate or Business Finance is basically the methodology of allocating financial resources, with a financial value, in an optimal manner to maximize the wealth of a business enterprise. There are three major decisions to be made in this allocation process: capital budgeting, financing, and dividend policy.
Capital budgeting is the decision regarding the choice of which investments are to be made with the resources that have been brought into the business or earned and retained by the business. The choice depends on the returns to be made from the investment exceeding the cost of capital. The method used to do this is the discounted time-value of money of the cash flow from the investment. This value is the internal rate of return (IRR), a measure of return on investment. When the IRR exceeds the required return, which is equal to the cost of the funds invested—see weighted average cost of capital, below—then the investment should be made. If such a required return is used as the discount rate, then that is the same as saying the investment will yield a positive net present value (NPV). If there are two or more investments that can be made, but they are mutually exclusive, then they must be ranked; and the one with the highest NPV should be chosen. If there is a limited amount of funds to be invested, then some bankers or advisers who obtain additional funds for a business may require that the business choose among the investments so as not to exceed the limited level of funds available. This selection process, which is called capital rationing, should be done in a similar manner to rank the projects by selecting the combination of investments that do not exceed the total funds available and that yield the maximum total net present value.
Financing is the decision of which resources or funds are to be brought into the business from external investors and creditors in order to be invested in profitable projects. The first external source of finance is debt, which includes loans from banks and bonds purchased by bondholders. The debt creditors take less risk of nonrepayment because the business must repay them if there are funds available to do so when the debt becomes due. The second external source of finance is equity, which includes common stock and preferred stock. The equity investors in the business take more business risk and may not receive payment until the creditors are repaid and the management of the business decides to distribute funds back to the investors. The goal of the financing decision is to obtain all the resources necessary, to make all the investments that yield a return in excess of the cost of the funds invested or the required rate of return, and to obtain these funds at the lowest average cost, so as to reduce the required rate of return and increase the net present value of the projects selected.
Dividend policy is the decision regarding funds to be distributed or returned to the equity investors. This can be done with common stock dividends, preferred stock dividends, or stock repurchase by the business of its own stock. The aim of this decision is to retain the resources in the business that are required to run the business or make additional investments in the business, as long as the returns earned exceed the required return. In theory, management should return or distribute all resources that cannot be invested in the business at levels in excess of the required return. In practice, however, dividends are often maintained at or changed to certain levels in order to convey the proper signals to the investors and the financial markets. For example, dividends can be maintained at moderate levels to demonstrate stability, maintained at or reduced to low levels to demonstrate the growth opportunities for the business, or increased to higher levels to demonstrate the restoration of a strong financial (capital) structure (debt and equity capital) for the business.
Weighted average cost of capital
Weighted average cost of capital is the weighted average of the returns on investment or future dividends for the stockholders and interest rates on debt for the creditors. This average return should be used as the required return for investments, as mentioned earlier, because it represents the weighted average of the required returns of all the different debt creditors and equity investors. It also represents the weighted average of the costs that can be saved by the business if the resources or financial funds are returned to the creditors and investors instead of being used for investments within the business.
Capital structure is represented by the types of sources of capital funds invested in the business. A common measure of sources is the percentage of debt relative to equity that appears on a company’s balance sheet. Usually, the cost or required returns for the debt is much less than the equity, especially on an after-tax basis. Thus, the total cost of capital declines when some debt funds from creditors are substituted for equity funds from investors. Yet as more debt is added, the business becomes riskier because of the higher amount of fixed payments that must be made to creditors, whether or not the business is generating adequate funds from earnings; and then the costs of both the debt and equity funds are increased to the point where the weighted-average cost increases.
Acquisitions, which are purchases of other businesses, are merely another type of capital budgeting investment for a business. Such purchases should be evaluated in the same manner as any other capital investment, as outlined earlier, to obtain the maximum positive net present value, though the issues and data are often more complex to analyze.
Price/earnings ratio is often used in making acquisitions as an abbreviated measure of valuation. This ratio is of the value or price of a business or its stock to its earnings. Yet the actual decision to make an acquisition is a capital budgeting decision; the resultant determination of price or net present value can then be described in relative terms to the earnings in the price/earnings ratio.
Returns for any business or particular debt or investment made in the business are merely the cash flows that will ultimately be earned by the business or particular creditors and stockholders. These can be expressed in dollar terms or as percentages, with the latter being the average annual percentage of the cash flows relative to the overall investment in the business or the particular amounts of debt or stock involved. For debt instruments, these percentage rates are called interest rates. For specific investment decisions, the returns used should be those that are incremental of the specific investment.
Return/interest rates are based on three components: pure return for the investor or creditor providing funds; coverage of inflation rates, so that the purchasing power of the proceeds is maintained apart from the true return; and additional return for additional risk, such as an equity investment in a risky business as opposed to a bond from the U.S. government. These components are then compounded with each other, rather than merely added together, to obtain the overall interest rate or required return on equity investment. When calculating return or interest rates, any additional up-front money, such as closing costs, must also be added to the investment; this amount increases or reduces the return, depending on who pays for it.
Residual values are a portion of the returns to be earned in an investment that is returned to the business when the investment is sold or the project is terminated. This can be most important in the liquidation of inventory and receivables when operations of a portion of a business are terminated or when real estate ceases to be required and thus can be sold, for example, when a factory is closed or when a lease term is complete.
Maturities of debt instruments, such as bonds, loans, or notes payable, are the amounts of time outstanding before the debt becomes due. The financial management rule with respect to maturities is to match the duration of the funds being borrowed by the debtor, or invested by the creditor, with the timing of his or her own business needs for funds in the future. Thus, the financing of a new business—with the likely future expansions of property, plant, equipment, inventory, and receivables—can be done with longer-term debt funds. Yet the financing of a specific shorter-term need, such as the outlays on a construction project before completion payments are made, should be comparably shorter in maturity. Similarly, the investment of temporary excess cash should be in shorter-term instruments, such as short-term CDs or Treasury bills. If maturities are not matched, then the additional time before the debt becomes due from or to you becomes a period of speculation on the rise or fall of future interest rates.
International finance is concerned with the same methodology of allocating financial resources, but with modifications or areas of emphasis required by the restrictions of currency and capital movements among countries and the differences in the currencies used in different countries. The following paragraphs represent some of the major changes to the basic financial decisions:
- Foreign capital budgeting requires the use of foreign cash flows and local tax rates, but U.S. inflation rates and U.S. dollars at the current exchange rates can be used. The required return or cost of capital then need only be adjusted, as with any investment, for the greater or lesser risk of the project in which the investment is made, which includes the greater or lesser risk of the country in which the investment is being made.
- Foreign capital markets are a source for both debt and equity funds, for both foreign subsidiary operations and the general needs of the overall business. Foreign subsidiary capital structures often utilize more local debt when legally and practically available in order to reduce the risk of blockages of earned funds from repatriation to the parent company in another country. In addition, local-currency debt reduces the risk for the parent company if the exchange rates for the local currency change adversely.
- Foreign-exchange rates can change dramatically and therefore pose a significant risk for the value of assets held in or future payments from foreign countries. These exposures may be in dealings with third parties or within a company’s own foreign subsidiaries. Forward currency contracts or currency options, instruments used to purchase one currency for another currency in the future at guaranteed exchange rates, can be used to protect against such risk. While these contracts are often also used to make profits by managers who believe the exchange rates will change in a manner different from the expectations implicit in the overall currency market, such use should be viewed as risky speculation.
- Personal finance is concerned with the same methodology of allocating resources, but with a greater emphasis on allocating some of them to obtain the maximum consumption satisfaction at the lowest cost, as opposed to earning income and cash flow returns on the investments.
- Budgeting and financial planning are the processes used by financial managers to forecast future financial results for a business, a person, or a particular investment. Usually, the major components of earnings, cash flow, and capital are projected in the form of forecasted income statements, cash-flow statements, and balance sheets. The latter show where the capital funds are invested in the components of fixed and working capital, as well as the sources of these capital funds in terms of the debt, stock, and retained earnings.