Corporate Finance FundamentalEvery  decision made  in  a  business  has  financial  implications,  and  any  decision  that  involves  the  use  of  money  is  a  corporate  financial  decision. Defined broadly, everything that a business does fits under the rubric of corporate finance.  It  is,  in  fact, unfortunate  that I  even  call  this post  corporate  finance,  since  it  suggests  to many observers  a  focus  on  how  large  corporations  make  financial  decisions,  and  seems  to exclude small and private businesses  from  its purview. A more appropriate  title  for  this post would be Business Finance, since the basic principles remain the same, whether one looks  at  large,  publicly  traded  firms  or  small  privately  run  businesses. All  businesses have  to  invest  their  resources wisely,  find  the  right  kind  and mix  of  financing  to  fund these investments and return cash to the owners if there are not enough good investments

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In  this post, I will  discuss the  fundamental of the corporate finance by  listing  the three  fundamental principles  that underlie corporate  finance –  the  investment,  financing and dividend principles – and the objective of firm value maximization that is at the heart of corporate financial theory.  This post establishes the first principles that govern corporate finance.  The investment  principle,  that  specifies  that  businesses  invest  only  in  projects  that  yield  a return  that  exceeds  the  hurdle  rate,  the  financing  principle,  that  suggests  that  the  right financing mix for a firm is one that maximizes the value of the investments made and the dividend principle, which requires that cash generated in excess of “good project” needs be returned to the owners, are the core for what follows. Enjoy!

 

 

Some Fundamental Propositions about Corporate Finance

There are several fundamental arguments are made in the topic of corporate finance:

  • Corporate finance matters to everybody. There is a corporate financial aspect to almost every  decision  made  by  a  business;  while  not  everyone  will  find  a  use  for  all  the components  of  corporate  finance,  everyone will  find  a  use  for  at  least  some  part  of  it.  Marketing  managers,  corporate  strategists  human  resource  managers  and  information technology managers  all make  corporate  finance  decisions  every  day  and  often  don’t realize it. An understanding of corporate finance may help them make better decisions.
  • Corporate finance has an internal consistency that flows from its choice of maximizing firm  value  as  the  only  objective  function  and  its  dependence  upon  a  few  bedrock principles:  risk  has  to  be  rewarded;  cash  flows  matter more  than  accounting  income; markets are not easily fooled; every decision a firm makes has an effect on its value.
  • Corporate finance must be viewed as an integrated whole, rather than as a collection of decisions. Investment decisions generally affect financing decisions, and vice versa; financing decisions generally affect dividend decisions, and vice versa. While there are circumstances  under  which  these  decisions may  be  independent  of  each  other,  this  is seldom  the  case  in  practice. Accordingly, it is unlikely  that  firms  that  deal with  their problems on a piecemeal basis will ever resolve these problems. For instance, a firm that takes poor  investments may soon  find  itself   with a dividend problem  (with  insufficient funds  to  pay  dividends)  and  a  financing  problem    (because  the  drop  in  earnings may make it difficult for them to meet interest expenses).
  • Corporate finance is fun. This may seem  to be  the  tallest claim of all. After all, most people associate corporate finance with numbers, accounting statements and hardheaded analyses.  While  corporate  finance  is  quantitative  in  its  focus,  there  is  a  significant component  of  creative  thinking  involved  in  coming  up with  solutions  to  the  financial problems businesses do encounter. It is no coincidence that financial markets remain the breeding grounds for innovation and change.
  • The best way to learn corporate finance is by applying its models and theories to real world problems. While  the  theory  that has been developed over  the  last  few decades  is impressive,  the ultimate  test of any  theory  is  in applications. As we  show  in  this post, much,  if not all, of  the  theory can be applied  to  real companies and not  just  to abstract examples, though I have to compromise and make assumptions in the process. 

 

 

Structural Set-up of Firms

In this post, I will use “firm” generically to refer to “any business“, large or small, manufacturing or service, private or public. Thus, a corner grocery store and Microsoft are both firms. The firm’s investments are generically termed “assets“.  While  assets  are  often categorized  by  accountants  into  fixed  assets, which  are  long-lived,  and  current  assets, which  are  short-term, we  prefer  a  different  categorization. The  assets  that  the  firm  has already  invested  in  are  called  “assets-in-place“,  whereas  those  assets  that  the  firm  is expected to invest in the future are called “growth assets“. While it may seem strange that a firm can get value from investments it has not made yet, high-growth firms get the bulk of their value from these yet-to-be-made investments. 
To finance these assets,  the  firm can  raise money  from  two sources.  It can  raise funds  from  investors  or  financial  institutions  by  promising  investors  a  fixed  claim (interest payments) on the cash flows generated by the assets, with a limited or no role in the day-to-day running of  the business. We categorize this type of financing to be “debt“.

Alternatively, it can offer a residual claim on the cash flows (i.e., investors can get what is left over after the interest payments have been made) and a much greater role  in  the operation  of  the  business. I term this “equity“. Note  that  these  definitions  are  general enough  to  cover  both  private  firms, where  debt may  take  the  form  of  bank  loans,  and equity  is  the owner’s own money, as well as publicly  traded companies, where  the firm may issue bonds (to raise debt) and stock (to raise equity). 
 

 

The Objective of Firms

No discipline can develop cohesively over time without a unifying objective. The growth of corporate financial theory can be traced to its choice of a single objective and the  development  of models  built  around  this  objective.  The  objective  in  conventional corporate  financial  theory  when  making  decisions  is  to  maximize  the  value  of  your business  or  firm.  Consequently,  any  decision  (investment,  financial,  or  dividend)  that increases  the  value  of  a  business  is  considered  a  ‘good’  one, whereas  one  that  reduces firm  value  is  considered  a  ‘poor’  one. While  the  choice  of  a  singular  objective  has provided corporate finance with a unifying theme and internal consistency, it has come at a cost. To the degree  that one buys  into  this objective, much of what corporate financial theory suggests makes sense. To the degree that this objective is flawed, however, it can be argued that the theory built on it is flawed as well.

Many of the disagreements between corporate financial theorists and others (academics as well as practitioners) can be traced to fundamentally different views about the correct objective for a business. For instance, there  are  some  critics  of  corporate  finance who  argue  that  firms  should  have multiple objectives where  a  variety  of  interests  (stockholders,  labor,  customers)  are met, while there  are  others who would  have  firms  focus  on what  they  view  as  simpler  and more direct objectives such as market share or profitability.

Given  the  significance  of  this  objective  for  both  the  development  and  the applicability of corporate financial  theory,  it  is  important  that we examine  it much more carefully  and  address  some  of  the  very  real  concerns  and  criticisms  it  has  garnered:  it assumes that what stockholders do in their own self-interest is also in the best interests of the firm;  it  is sometimes dependent on  the existence of efficient markets; and  it  is often blind to the social costs associated with value maximization. 

 

Basic Principles of Corporate Finance 

Every discipline has its basic [others may say it as “first”] principles that govern and guide everything that gets done within that discipline. All of corporate finance is built on three principles, which we will title, rather unimaginatively, as: (1) the investment Principle; (2) the financing Principle; and (3) the dividend Principle. The investment principle determines where businesses invest their resources,  the  financing  principle  governs  the  mix  of  funding  used  to  fund  these investments  and  the  dividend  principle  answers  the  question  of  how  much  earnings should be reinvested back into the business and how much returned to the owners of the business.

  • The Investment Principle: Invest in assets and projects that yield a return greater than the minimum  acceptable  hurdle  rate.  The  hurdle  rate  should  be  higher  for  riskier projects  and  should  reflect  the  financing  mix  used  –  owners’  funds  (equity)  or borrowed money (debt). Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
  • The Financing Principle: Choose a financing mix (debt and equity)  that maximizes the  value  of  the  investments made  and match  the  financing  to  nature  of  the  assets being financed.
  • The Dividend Principle: If there are not enough investments that earn the hurdle rate, return the cash to the owners of the business. In the case of a publicly traded firm, the form  of  the  return  –  dividends  or  stock  buybacks  –  will  depend  upon  what stockholders prefer.

 

While  making  these  decisions,  corporate  finance  is  single  minded  about  the ultimate objective, which  is assumed  to be maximizing  the value of  the business. These first  principles  provide  the  basis  from which we will  extract  the  numerous models  and theories  that  comprise  modern  corporate  finance,  but  they  are  also  common  sense principles. It  is  incredible conceit on our part to assume  that until corporate finance was developed  as  a  coherent  discipline  starting  a  few  decades  ago,  that  people  who  ran businesses  ran  them  randomly  with  no  principles  to  govern  their  thinking. 

Good businessmen  through  the  ages  have  always  recognized  the  importance  of  these  first principles  and  adhered  to  them,  albeit  in  intuitive ways.  In  fact,  one  of  the  ironies  of recent  times  is  that many managers  at  large  and  presumably  sophisticated  firms  with access to the latest corporate finance technology have lost sight of these basic principles.

Next, let’s discuss these three basic principles in greater details. Read on…

 

 

The Investment Principle

Firms have scarce resources  that must be allocated among competing needs. The first  and  foremost  function  of  corporate  financial  theory  is  to  provide  a  framework  for firms  to  make  this  decision  wisely.  Accordingly,  we  define  investment  decisions  to include not only those that create revenues and profits (such as introducing a new product line or expanding into a new market), but also those that save money (such as building a new and more efficient distribution system).

Further, I argue  that decisions about how much  and  what  inventory  to  maintain  and  whether  and  how  much  credit  to  grant  to customers  that are  traditionally categorized as working capital decisions, are ultimately investment  decisions,  as well. At  the  other  end  of the  spectrum,  broad  strategic  decisions  regarding which markets to enter and the acquisitions of other companies  can  also  be  considered  investment decisions.

Corporate  finance  attempts  to  measure  the  return  on  a  proposed  investment decision and compare  it  to a minimum acceptable hurdle rate  in order to decide whether or not  the project  is  acceptable or not.   The hurdle  rate has  to be  set higher  for  riskier projects  and  has  to  reflect  the  financing mix  used,  i.e.,  the  owner’s  funds  (equity)  or borrowed  money  (debt). 

Hurdle Rate:  A  hurdle  rate  is  a minimum  acceptable  rate  of  return  for investing resources in a project.

 

Having established the hurdle rate, we turn our attention to measuring the returns on an investment:

  • Evaluate three alternative ways of measuring returns – conventional accounting earnings, cash  flows and  time-weighted cash  flows  (where we consider both how large the cash flows are and when they are anticipated to come in):
  • Consider  some of  the potential  side-costs which might not be captured  in any of  these measures,  including  costs  that may  be created  for existing  investments by taking a new  investment, and side-benefits, such as options  to enter new markets and  to expand  product  lines  that  may  be  embedded  in  new  investments,  and  synergies, especially when the new investment is the acquisition of another firm. 

 

 

The Financing Principle

Every business, no matter how large and complex it is, is ultimately funded with a mix of borrowed money  (debt) and owner’s  funds  (equity). With a publicly  trade  firm, debt  may  take  the  form  of  bonds  and  equity  is  usually  common  stock.  In  a  private business, debt  is more  likely  to be bank  loans and an owner’s  savings  represent equity.

While  I  consider  the  existing  mix  of  debt  and  equity  and  its  implications  for  the minimum acceptable hurdle  rate as part of  the  investment principle, I  throw open  the question of whether  the existing mix  is  the  right one  in  the  financing principle  section.

While  there might  be  regulatory  and  other  real world  constraints  on  the  financing mix that a business can use,  there  is ample  room  for  flexibility within  these constraints. We then turn to the question of whether the existing mix of financing used by a business is the “optimal” one, given our objective  function of maximizing firm value,. While  the  tradeoff between the benefits and costs of borrowing are established in qualitative terms first, we also look at two quantitative approaches to arriving at the optimal mix. In the first approach, we examine the specific conditions under which the optimal financing mix is  the one  that minimizes  the minimum acceptable hurdle  rate.  In  the  second approach, we look at the effects on firm value of changing the financing mix. 

When  the optimal  financing mix  is different  from  the existing one, we map out the best ways of getting from where we are (the current mix)  to where we would  like  to be  (the optimal), keeping in mind the investment opportunities that the firm has  and  the  need  for  urgent  responses,  either  because  the  firm  is  a  takeover  target  or under  threat  of  bankruptcy.  Having  outlined  the  optimal  financing  mix,  we  turn  our attention  to  the  type of  financing a business  should use,  i.e., whether  it  should be  long term or  short  term, whether  the payments on  the  financing  should be  fixed or variable, and if variable, what it should be a function of. Using a basic proposition that a firm will minimize  its  risk  from  financing and maximize  its capacity  to use borrowed  funds  if  it can match up  the cash flows on  the debt  to  the cash flows on  the assets being financed, we  design  the  perfect  financing  instrument  for  a  firm.  We  then  add  on  additional considerations  relating  to  taxes  and  external  monitors  (equity  research  analysts  and ratings agencies) and arrive at fairly strong conclusions about the design of the financing.

 

The Dividend Principle

Most  businesses  would  undoubtedly  like  to  have  unlimited  investment opportunities  that yield returns exceeding  their hurdle rates, but all businesses grow and mature. As a consequence, every business that thrives reaches a stage in its life when the cash flows generated by existing investments is greater than the funds needed to take on good investments. At that point, this business has  to figure out ways to return the excess cash  to  owners.  In  private  businesses,  this may  just  involve  the  owner withdrawing  a portion of his or her  funds  from  the business.  In a publicly  traded corporation,  this will involve  either  dividends  or  the  buying  back  of  stock. 

For stockholders in publicly traded firms, we will note that this decision is fundamentally one of whether they trust the managers of the firms with their cash, and much of this trust is based upon how well these managers have invested funds in the past.

 

Corporate Financial Decisions, Firm Value and Equity Value

If the objective function in corporate finance is to maximize firm value, it follows that  firm value must be  linked  to  the  three corporate  finance decisions outlined above investment, financing, and dividend decisions. The link between these decisions and firm value  can  be made  by  recognizing  that  the  value  of  a  firm  is  the  present  value  of  its expected  cash  flows,  discounted  back  at  a  rate  that  reflects  both  the  riskiness  of  the projects  of  the  firm  and  the  financing  mix  used  to  finance  them

Investors  form expectations  about  future  cash  flows  based  upon  observed  current  cash  flows  and expected  future growth, which,  in  turn, depends upon  the quality of  the  firm’s projects (its investment decisions) and the amount reinvested back into the business (its dividend decisions). The  financing decisions affect  the value of a  firm  through both  the discount rate and, potentially, through the expected cash flows.

This  neat  formulation  of  value  is  put  to  the  test  by  the  interactions  among  the investment,  financing,  and  dividend  decisions,  and  the  conflicts  of  interest  that  arise between  stockholders  and  lenders  to  the  firm,  on  the  one  hand,  and  stockholders  and managers, on  the other.