Finance (Encyclopedia of Business and Finance)
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 investedee weighted average cost of capital, belowhen 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 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 businessith the likely future expansions of property, plant, equipment, inventory, and receivablesan 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.
ISSUES IN APPLIED CORPORATE FINANCE AND VALUATION
Estimation of the Cost of Capital. In recent decades, theoretical breakthroughs in such areas as portfolio diversification, market efficiency, and asset pricing have converged into compelling recommendations about the cost of capital to a corporation. The cost of capital is central to modern finance, touching on investment and divestment decisions, measure of economic profit, performance appraisal, and incentive systems. Each year in the United States, corporations undertake more than $500 billion in expenditures, so how firms estimate the cost is not a trivial matter. A key insight from finance theory is that any use of capital imposes an opportunity cost on investors; namely, funds are diverted from earning a return on the next-best equal risk investment. Since investors have access to a host of financial market opportunities, corporate use of capital must be benchmarked against these capital market alternatives. The cost of capital provides this benchmark. Unless a firm can earn in excess of its cost of capital, it will not create economic profit or value for investors. A recent survey of leading practitioners reported the following best practices:
- Discounted cash flow (DCF) is the dominant investment-evaluation technique.
- Weighted average cost of capital (WACC) is the dominant discount rate used in DCF analyses.
- Weights are based on market, not book, value mixes of debt and equity.
- The after-tax cost of debt is predominantly based on marginal pretax costs, as well as marginal or statutory tax rates.
- The capital asset pricing model (CAPM) is the dominant model for estimating the cost of equity.
Discounted cash flow valuation models. The parameters that make up the DCF model are related to risk (the required rate of return) and the return itself. These models use three alternative cash-flow measures: dividends, accounting earnings, and free cash flows. Just as DCF and asset-based valuation models are equivalent under the assumption of perfect markets, dividends, earnings, and free cash-flow measures can be shown to yield equivalent results. Their implementation, however, is not straightforward. First, there is inherent difficulty in defining the cash flows used in these models. Which cash flows and to whom do they flow? Conceptually, cash flows are defined differently depending on whether the valuation objective is the firm's equity or the value of the firm's debt plus equity. Assuming that we can define cash flows, we are left with another issue. The models need future cash flows as inputs. How is the cash-flow stream estimated from present data? More important, are current and past dividends, earnings, or cash flows the best indicators of that stream? These pragmatic issues determine which model should be used. Although the dividend model is easy to use, it presents a conceptual dilemma. Finance theory says that dividend policy is irrelevant. The model, however, requires forecasting dividends to infinity or making terminal value assumptions. Firms that presently do not pay dividends are a case in point. Such firms are not valueless. In fact, high-growth firms often pay no dividends, since they reinvest all funds available to them. When firm value is estimated using a dividend discount model, it depends on the dividend level of the firm after its growth stabilizes. Future dividends depend on the earnings stream the firm will be able to generate. Thus, the firm's expected future earnings are fundamental to such a valuation. Similarly, for a firm paying dividends, the level of dividends may be a discretionary choice of management that is restricted by available earnings. When dividends are not paid out, value accumulates within the firm in the form of reinvested earnings. Alternatively, firms sometimes pay dividends right up to bankruptcy. Thus, dividends may say more about the allocation of earnings to different claimants than valuation. All three DCF approaches rely on a measure of cash flows to the suppliers of capital (debt and equity) to the firm. They differ only in the choice of measurement, with the dividend approach measuring the cash flows directly and the others arriving at them in an indirect manner. The free cash-flow approach arrives at the cash-flow measure (if the firm is all-equity) by subtracting investment from operating cash flows, whereas the earnings approach expresses dividends indirectly as a fraction of earnings.
The capital asset pricing model. This is a set of predictions concerning equilibrium expected returns on risky assets. Harry Markowitz established the foundation of modern portfolio theory in 1952. The CAPM was developed twelve years later in articles by William Sharpe, John Lintner, and Jan Mossin. Almost always referred to as CAPM, it is a centerpiece of modern financial economics. The model gives us a precise prediction of the relationship that we should observe between the risk of an asset and its expected return. This relationship serves two vital functions. First, it provides a benchmark rate of return for evaluating possible investments. For example, if we are analyzing securities, we might be interested in whether the expected return we forecast for a stock is more or less than its "fair" return given its risk. Second, the model helps us to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace. For example, how do we price an initial public offering of stock? How will a new investment project affect the return investors require on a company's stock? Although the CAPM does not fully withstand empirical tests, it is widely used because of the insight it offers and because its accuracy suffices for many important applications. Although the CAPM is a quite complex model, it can be reduced to five simple ideas:
- Investors can eliminate some risk (unsystematic risk) by diversifying across many regions and sectors.
- Some risk (systematic risk), such as that of global recession, cannot be eliminated through diversification. So even a basket with all of the stocks in the stock market will still be risky.
- People must be rewarded for investing in such a risky basket by earning returns above those that they can get on safer assets.
- The rewards on a specific investment depend only on the extent to which it affects the market basket's risk.
- Conveniently, that contribution to the market basket's risk can be captured by a single measurebeta"hat expresses the relationship between the investment's risk and the market's risk.
Finance theory is evolving in response to innovative products and strategies devised in the financial market-place and in academic research centers.
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Finance (Encyclopedia of Business)
The field of finance encompasses numerous corporate and governmental activities. In the most basic sense, the term "finance" can be used to describe the activities of a firm attempting to raise capital through the sale of stocks, bonds, or other promissory notes. Similarly," public finance" is a term used to describe government capital-raising activities through the issuance of bonds or the imposition of taxes. The theory of finance, in the broadest sense, can be defined as an integrated body of knowledge constructed around the goal of maximizing shareholder wealth and the principles of the time value of money, leverage, diversification, and an investment's expected rate of return versus its risk.
Within the discipline of finance, there are three basic components. First, there are financial instruments. These instrumentstocks and bondsre recorded evidence of obligations on which exchanges of resources are founded. Effective investment management of these financial instruments is a vital part of any organization's financing activities. Second, there are financial markets, which are the mechanisms used to trade the financial instruments. Finally, there are banking and financial institutions which facilitate the transfer of resources among those buying and selling the financial instruments.
In today's business environment, corporate finance addresses issues relating to individual firms. Specifically, the field of corporate finance seeks to determine a firm's best sources of capital, the optimal investments that a firm should make, the best methods of financing those investments, and the method by which to manage daily financial activities to ensure that firms have adequate cash flow. Finance influences all segments of corporate activity, both for profit oriented firms and nonprofit firms. Through the acquisition of funds, the allocation of resources, and the tracking of financial performance, finance provides a vital function for any organization's activities. Furthermore, finance provides stockholders and other interested parties with a tool with which to assess management activities and measure a firm's performance.
Like other business disciplines, the study of finance was originally part of the field of economics. By the end of the 19th century, however, the Industrial Revolution had changed the existing business environment so drastically that there was a growing need for the detailed study of business problems and processes. Thus, corporate finance was born with the purpose of describing and documenting the quickly evolving financial instruments, markets, and institutions in the newly industrialized age.
During the 1930s and the Great Depression, the field of finance underwent a series of meaningful changes. Due to the circumstances of the time, individuals involved in the field became increasingly focused on activities surrounding bankruptcy, liquidation, reorganization, and government regulation. During the 1940s and early 1950s, finance continued to exist as a descriptive field that focused on raising capital and on activities concerning stockholders' equity and liabilities.
In the mid-1950s, finance underwent further changes. The field of finance evolved from a purely descriptive discipline to a proactive field that provided managers with financial information useful in making decisions regarding their firm's operations. Many of these changes can be attributed to the work of Joel Dean (1906-1979), who furthered the understanding of the area of capital budgeting and sought to make it a major discipline within the field of finance. Capital budgeting resulted in an increased understanding of the cost of capital and the valuation of financial assets. Furthermore, these changes led to more interest in the theory of capital structure, security analysis, and portfolio management.
The field of finance continued to evolve in the 1980s and 1990s, constantly reacting to activities in the economy and to new theoretical ideas. During periods of economic volatility, finance provides managers with tools to react swiftly to economic downturns. In an era of global competition and international business, finance is used to better understand and value the operations of firms abroad. As government deregulation of various industries results in industry-wide consolidations, financial managers turn their attention to the valuation of existing firms and the pricing of mergers and acquisitions. Stock buybacks and new sources of financing represent other areas of interest to financial managers in a rapidly changing business climate.
updated by David P. Bianco]
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