Corporate Finance

The term corporate finance refers to a special area of ​​finance that deals with issues about optimal capital structure, dividend policy of the company and the evaluation of investment decisions and the determination of enterprise value. This native of the English literature and teaching term covers roughly the German-speaking traditional subjects taught investment analysis, corporate finance and valuation and capital market theory. In the German literature, the term corporate financing is used as a synonym.

The discipline is divided into a long-term and short-term decision horizon and techniques with the primary goal to enhance shareholder value by increasing the return on capital or the capital costs can be reduced, without taking risks that exceed their own risk tolerance.

  • Capital investment decisions comprise the long-term selection of the projects in which to invest, with the question of whether these projects will be financed with equity and / or debt and whether and when a dividend to shareholders to be paid.
  • The short-term decisions of corporate finance are as working capital management refers to and deal with the management of current assets (current asset ) and short-term liabilities (current liabilities ), where liquidity management, the optimization of the capital tied up in inventory and current liabilities and investments special attention.

Corporate Finance is a part of financial management, which has a slightly broader scope and applies to all other forms of organizations in addition to private sector entities.

  • 5.1 Decision Criteria
  • 5.2 Cash Management
  • 5.3 Financial Risk Management

Capital investment decisions

The long-term financing decisions relating to fixed assets and the capital structure and are called capital investment decisions. These decisions are based on various interdependent criteria. In general, the management needs to maximize shareholder value by investing in projects with a positive net present value. If the expected capital returns from these projects are valued at an appropriate discount rate, these projects must also be financed with the same interest rate.

If there are no such opportunities, management should distribute the excess cash to the shareholders. Capital investment decisions thus comprise investment decisions that financing decisions and dividend policy.

Investment decisions

The decision process in which the distributed management of limited resources among competing business fields is referred to as Capital Budgeting ( Capital Budgeting ). In order to make these decisions on capital allocation, the value of each investment option or each project depending on the volume of capital, time and distribution of predictability and uncertainty of future cash flows must be estimated.

Project review

The current value of a project is usually determined that all project-relevant cash flows are discounted to their present values ​​. The project with the highest NPV ( Net Present Value, NPV ) is realized first. For this purpose, the amount and timing of all future cash flows must be estimated. These are then discounted using the discount rate and added to the present value. The present value concept is today the most widely used method for determining the capital value of an investment.

The present value is influenced by the choice of the discount rate. The choice of the correct interest rate largely determines the correctness of the decision to be taken. The discount rate represents a lower limit for the project rate of return dar. It corresponds to the risk-free rate plus a project- specific risk premium. The project risks are typically determined by the expected volatility of cash flows. In order to estimate a discount rate for a specific project, using models such as CAPM Manager or APT. For the evaluation of the selected mode of financing the weighted average cost of capital ( weighted average cost of capital, WACC ) is used.

There are, in Corporate Finance, various other metrics that are used in conjunction with the present value as secondary selection criteria. These are related to the present value method and include the break-even analysis, the IRR (internal rate of return, IRR ), the Equivalent Annual Cost Method (EAC ) and the return on investment (ROI).

Flexible pricing models

In many scenarios, such as research and development projects, a project for a company open up completely new paths of action, these opportunities are not taken into account in a net present value analysis. Therefore, instruments are sometimes used here, which assign these options, an explicit value. While in the present value method, the most probable, average or scenario specific cash flows are discounted, several stateful scenario developments and their potential, different cash returns weighted by their probability and calculated in the flexible evaluation. The difference with the simple present value method is the modeling and evaluation of different possible paths of development. In these different option values ​​can be contained, to be assessed.

The two most commonly used instruments are here, the decision tree and the real options.

  • The decision tree analysis reaches the evaluation of various development scenarios by exogenous events with probabilities, upon which management decisions can be estimated. Each management decision in response to an event generates an edge or a branch in the decision tree, which a company can follow. (Eg:. 's Management will only go into phase 2 of a project when the Phase 1 was successfully completed Phase 3, however, depends on phase 2 from the sequence of events and subsequent decisions lead to different final results and each form. . a development path in the decision tree in the net present value method, there is no conditional branches - each phase must be modeled as stand-alone scenario). The path with the highest probability-weighted present value gives the representative project value.
  • The approach of real options is used when the value of a project is dependent on another value variables. (Eg:. The feasibility of a mining project for gold mining is dependent on the price of gold on the market, if the price of gold is too deep, the mining project will not be realized if it is sufficiently large, the mining project will be carried out ). Here, the option pricing theory is used as a framework, the decision to be made is either a call option or a put option. The assessment is then carried out using the binomial model or - less frequently for this purpose - via Black- Scholes option pricing see. The ' true ' value of the project is then the present value of the most probable scenario plus the option value.

Financing decisions

Every business investment must be adequately funded. As mentioned above, by the choice of financing both the discount as well as the future cash flows affected. The composition of the financing of equity and debt thus will affect the value of an investment. Management must therefore determine the optimal financing mix, ie is to find the capital structure, which leads to the maximum value (see: Asset and Liability Management, Fisher separation theorem, but also Modigliani -Miller theorem).

In the choice of corporate financing, many factors play into the decision with a. In the capital structure policy, the ratio of equity to debt or its objectives for change is set. Depending on additional financing requirements on foreign or self-financing are developed, ie the necessary additional capital is raised as debt with a longer or shorter term or as equity. As measures such as the IPO, the capital or the reallocation of debt may be mentioned. The project debt financing ( debt ) represents a debt, their interest payments must be served. This resulted in interest outflows with corresponding influence on the project net present value. Equity financing is less risky in terms of cash flow liabilities, but it leads to a reduction in the return on equity if the result of the project objectives are not achieved. The cost of equity is also typically higher than the cost of foreign debt ( see CAPM and WACC ), and so equity financing may lead to an increased discount rate exceeds the interest rate risk of a debt financing by far in the end. Management must also ensure the further that the capital raising to coincide as closely as possible to the amounts and timing of cash flows on the investment expenses.

Dividend decision - Dividend policy

Generally speaking, the management has to decide whether free capital to be distributed in other projects in the ongoing operation or as a dividend to shareholders. The dividend is calculated mainly on the basis of the undistributed net income and the prospects of the business during the coming year. If there are no opportunities with positive net present value, a return in excess of the risk -adjusted discount rate, management must distribute the excess funds to the investors. These free cash equivalents include the money that is available after deduction of all operating expenses and required operational provisions.

If the company is classified by the shareholder as a growth value (growth stock ), so he expects by definition that these free agents remain in the company and lead to self-financed growth in which he participates by increasing the share value. In other cases, management may argue that the free funds to remain in business, even if no investment opportunities with a cash surplus in sight. You like this point ( possible future acquisitions, for example ) for possible future investment opportunities. However, there is cash in hand with increasing the risk that the company itself, possibly unintentionally, target of a takeover attempt is.

The case of redemption of free funds, the management has to decide whether this means dividend (see special dividend ) or to be made by means of share buy-back. Various factors are taken into account: While shareholders pay taxes on dividends, restraining the free agent or a share repurchase can increase shareholder value. Some companies will pay out the "dividends" as bonus shares to the shareholders. According to the Modigliani -Miller theorem today agree many investors that the dividend policy has no effect on the company's value.

Management of net working capital

The decisions to finance the working capital and short term financing are referred to as management of net working capital, and short-term financial planning. It 's all about the monitoring and influencing the ratio of current assets to current liabilities. The aim is to ensure the continuation of the business (going concern) and to ensure that sufficient liquid funds are available to pay off both all maturing liabilities and to cover the ongoing business expenses.

Decision criteria

By definition, the management of net working capital is concerned with short-term decisions with a time horizon to the next twelve months. These decisions therefore not based on a present value perspective, but optimize cash flows and returns oriented period, without discounting.

  • A measure of the turnover of money is the cash conversion cycle. This metric measures the number of days between the payment of the inputs until payment is received because of their own customer invoices. This figure makes the interdependence visible between the procurement decision and inventory turnover, accounts payable and receivable, as well as the respective terms of payment. The index characterizes the time at which the capital is tied up in current assets and is not available for other use. It is therefore tried to make the cycle time as short as possible.
  • The best measure of the profitability in this context is the ROI (return on capital; ROC). The key figure is shown as a percentage value by the yield of the last 12 months, divided by the capital employed. The return on equity (return on equity, ROE) shows the result for the shareholders. The enterprise value increases if and only if the return on equity is higher than the cost of capital.
  • ROC is a useful management measure because it sets the short-term operational decisions based on the net current assets with long-term decisions to invest capital in the relationship. See also Economic value added (EVA).

Cash Management

Based on the above criteria, management will use a combination of methodological principles and techniques to optimize the bound in net working capital capital so that, although any time all liabilities can be operated with enough cash, but that also minimize capital is tied up in current assets. Cash, stock and outstanding receivables (debtors ) should therefore be kept as small as possible, but be buffered with sufficient reserves to ensure that the solvency and availability of its products is guaranteed.

  • Cash management - identifying the exact day the cash balance, which must be available for each of the reporting date due invoices, as well as the expected cash receipts. Any excess liquidity may be more long term in the capital market and thus gives a contribution to the financial result.
  • In order to optimize inventory turns, the minimum holdings are determined, which are necessary for uninterrupted production, then, stocks of raw materials and intermediate products will be reduced to the minimum stocks. This requires a well-organized requirements planning, procurement and management of the stock, see just-in -time production (JIT ).
  • Accounts receivable management is concerned with the determination of appropriate credit policy, such as payment terms, which are so attractive for new customers, that the negative effects of the increased capital tied up in working capital by the income from the increased sales will more than offset (or vice versa).
  • Short-term assets: the assets in the camp bound is ideally financed by trade credit, with a notice that is based on the cash conversion cycle. It may also be necessary to accounts receivable for sale (known as factoring) to provide short-term cash.

Financial Risk Management

Perceives risk management is to manage the identification and measurement of risks and the development and implementation of strategies to these risks. Financial risk management focuses on financial risks, such as commodity price, interest rate, exchange rate and equity price changes, which compensates with appropriate financial instruments ( hedged ) can be. Financial risks also play an important role in cash management. This area is in two closely related to corporate finance. On one hand, the risk exposure of a company is the direct consequence of antecedent investment and financing decisions. Secondly, both disciplines share the same goal of creating and enhancing the company's value. All the big companies have a risk management team and small and medium enterprises practice an informal, if not formal risk management. The use of derivative instruments is a very common means in financial risk management. Because derivative OTC transactions are very costly to produce and monitor the most cost effective method is the use of exchange-traded derivatives that are traded on well-functioning financial markets. The standard instruments include options, futures, forwards and swaps. See: Financial Engineering; Financial risk; Default risk; Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk.

Respect to other financial subjects

Corporate Finance uses instruments from almost all areas of financial management. Some of the instruments that have been developed for use in corporate finance, have also been widely used elsewhere, eg in partnerships and collaborations in NGO organizations in government and administration, investment funds and asset management. In other cases, certain instruments are very limited in other applications or was not installed. Because large corporations deal with amounts of money that are much larger than those of high net worth individuals, the corporate- finance- based analysis has developed into an independent discipline. It can be differentiated from personal finance and public finance.