What is Corporate Finance?
ItÕs all corporate finance.
Myunbiased view of the world
Everydecision made in a business has financial implications, and any decision thatinvolves the use of money is a corporate financial decision. Defined broadly,everything that a business does fits under the rubric of corporate finance. Itis, in fact, unfortunate that we even call the subject corporate finance,because it suggests to many observers a focus on how large corporations makefinancial decisions and seems to exclude small and private businesses from itspurview. A more appropriate title for this discipline would be BusinessFinance, because the basic principlesremain 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 returncash to the owners if there are not enough good investments.
Inthis introduction, we will lay the foundation for this discussion by listingthe three fundamental principles that underlie corporate finance—theinvestment, financing, and dividend principles—and the objective of firmvalue maximization that is at the heart of corporate financial theory.
Incorporate finance, we will use firmgenerically to refer to any business, large or small, manufacturing or service,private or public. Thus, a corner grocery store and Microsoft are both firms. ThefirmÕs investments are generically termed assets.Although assets are often categorized by accountants into fixed assets, whichare long-lived, and current assets, which are short-term, we prefer a differentcategorization. The assets that the firm has already invested in are called assetsin place, whereas those assets that thefirm is expected to invest in the future are called growth assets. Though it may seem strange that a firm can getvalue from investments it has not made yet, high-growth firms get the bulk oftheir value from these yet-to-be-made investments. To finance these assets, thefirm can raise money from two sources. It can raise funds from investors orfinancial institutions by promising investors a fixed claim (interest payments)on the cash flows generated by the assets, with a limited or no role in theday-to-day running of the business. We categorize this type of financing to be debt. Alternatively, it can offer a residual claim onthe cash flows (i.e., investors can get what is left over after the interestpayments have been made) and a much greater role in the operation of thebusiness. We call 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 ownerÕs own money,as well as publicly traded companies, where the firm may issue bonds (to raisedebt) and common stock (to raise equity).
Thus,at this stage, we can lay out the financial balance sheet of a firm as follows:
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Note the contrast between this balance sheet and a conventional accountingbalance sheet.
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An accounting balance sheet isprimarily a listing of assets in place, though there are some circ*mstanceswhere growth assets may find their place in it; in an acquisition, what getsrecorded as goodwill is a conglomeration of growth assets in the target firm,synergies and overpayment.
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Every disciplinehas first principles that govern and guide everything that gets done within it.All of corporate finance is built on three principles, which we will call,rather unimaginatively, the investment principle, the financing principle, andthe dividend principle. The investment principle determines where businessesinvest their resources, the financing principle governs the mix of funding usedto fund these investments, and the dividend principle answers the question ofhow much earnings should be reinvested back into the business and how muchreturned to the owners of the business. These core corporate finance principlescan be stated as follows:
<![if !supportLists]>á<![endif]>The Investment Principle: Invest in assets and projectsthat yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher forriskier projects and should reflect the financingmix used—ownersÕ funds (equity) orborrowed money (debt). Returns on projects should be measured based on cashflows generated and the timing of these cash flows; they should also consider both positiveand negative side effects of these projects.
<![if !supportLists]>áThe Financing Principle: Choose a financing mix(debt and equity) that maximizes the valueof the investments made and match the financing to nature of theassets being financed.
<![if !supportLists]>á<![endif]>The Dividend Principle: If there are not enough investmentsthat earn the hurdle rate, return the cash to the owners of the business. In the case of apublicly traded firm, the form of the return—dividends or stock buybacks—will dependon what stockholders prefer.
Whenmaking investment, financing and dividend decisions, corporate finance issingle-minded about the ultimate objective, which is assumed to be maximizingthe value of the business. These first principles provide the basis from whichwe will extract the numerous models and theories that comprise modern corporatefinance, but they are also commonsense principles. It is incredible conceit onour part to assume that until corporate finance was developed as a coherentdiscipline starting just a few decades ago, people who ran businesses made decisionsrandomly with no principles to govern their thinking. Good businesspeoplethrough the ages have always recognized the importance of these firstprinciples and adhered to them, albeit in intuitive ways. In fact, one of theironies of recent times is that many managers at large and presumablysophisticated firms with access to the latest corporate finance technology havelost sight of these basic principles.
The Objective of the Firm
Nodiscipline can develop cohesively over time without a unifying objective. Thegrowth of corporate financial theory can be traced to its choice of a singleobjective and the development of models built around this objective. Theobjective in conventional corporate financial theory when making decisions isto maximize the value of the business or firm. Consequently, any decision(investment, financial, or dividend) that increases the value of a business isconsidered a good one, whereas one that reduces firm value is considered a poorone. Although the choice of a singular objective has provided corporate financewith a unifying theme and internal consistency, it comes at a cost. To thedegree that one buys into this objective, much of what corporate financialtheory 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. Manyof the disagreements between corporate financial theorists and others(academics as well as practitioners) can be traced to fundamentally differentviews about the correct objective for a business. For instance, there are somecritics of corporate finance who argue that firms should have multipleobjectives where a variety of interests (stockholders, labor, customers) aremet, and there are others who would have firms focus on what they view assimpler and more direct objectives, such as market share or profitability.
Giventhe significance of this objective for both the development and theapplicability of corporate financial theory, it is important that we examine itmuch more carefully and address some of the very real concerns and criticismsit has garnered: It assumes that what stockholders do in their ownself-interest is also in the best interests of the firm, it is sometimesdependent on the existence of efficient markets, and it is often blind to thesocial costs associated with value maximization.
The Investment Principle
Firmshave scarce resources that must be allocated among competing needs. The firstand foremost function of corporate financial theory is to provide a frameworkfor firms to make this decision wisely. Accordingly, we define investmentdecisions to include not only those thatcreate revenues and profits (such as introducing a new product line orexpanding into a new market) but also those that save money (such as building anew and more efficient distribution system). Furthermore, we argue thatdecisions about how much and what inventory to maintain and whether and howmuch credit to grant to customers that are traditionally categorized as workingcapital decisions, are ultimately investment decisions as well. At the otherend of the spectrum, broad strategic decisions regarding which markets to enterand the acquisitions of other companies can also be considered investmentdecisions. Corporatefinance attempts to measure the return on a proposed investment decision andcompare it to a minimum acceptable hurdle rate to decide whether the project isacceptable. The hurdle rate has tobe set higher for riskier projects and has to reflect the financing mix used,i.e., the ownerÕs funds (equity) or borrowed money (debt). In the discussion ofrisk and return, we begin this process by defining risk and developing aprocedure for measuring risk. In risk and return models, we go about convertingthis risk measure into a hurdle rate, i.e., a minimum acceptable rate ofreturn, both for entire businesses and for individual investments.
Havingestablished the hurdle rate, we turn our attention to measuring the returns onan investment. In analyzing projects, we evaluate three alternative ways ofmeasuring returns—conventional accounting earnings, cash flows, andtime-weighted cash flows (where we consider both how large the cash flows areand when they are anticipated to come in). In extensions of this analysis, weconsider some of the potential side costs that might not be captured in any ofthese measures, including costs that may be created for existing investments bytaking a new investment, and side benefits, such as options to enter newmarkets and to expand product lines that may be embedded in new investments,and synergies, especially when the new investment is the acquisition of anotherfirm.
The Financing Principle
Everybusiness, no matter how large and complex, is ultimately funded with a mix of borrowedmoney (debt) and ownerÕs funds (equity). With a publicly trade firm, debt maytake the form of bonds and equity is usually common stock. In a privatebusiness, debt is more likely to be bank loans and an ownerÕs savings representequity. Though we consider the existing mix of debt and equity and itsimplications for the minimum acceptable hurdle rate as part of the investmentprinciple, we throw open the question of whether the existing mix is the rightone in the financing principle section. There might be regulatory and otherreal-world constraints on the financing mix that a business can use, but thereis ample room for flexibility within these constraints. We begin the discussionof financing methods, by looking at the range of choices that exist for bothprivate businesses and publicly traded firms between debt and equity. We thenturn to the question of whether the existing mix of financing used by abusiness is optimal, given the objective function of maximizing firm value.Although the trade-off between the benefits and costs of borrowing areestablished in qualitative terms first, we also look at two quantitativeapproaches to arriving at the optimal mix. In the first approach, we examinethe specific conditions under which the optimal financing mix is the one thatminimizes the minimum acceptable hurdle rate. In the second approach, we lookat the effects on firm value of changing the financing mix.
When the optimalfinancing mix is different from the existing one, we map out the best ways ofgetting from where we are (the current mix) to where we would like to be (the optimal), keeping in mind theinvestment opportunities that the firm has and the need for timely responses, eitherbecause the firm is a takeover target or under threat of bankruptcy. Havingoutlined the optimal financing mix, we turn our attention to the type offinancing a business should use, such as whether it should be long-term orshort-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 propositionthat a firm will minimize its risk from financing and maximize its capacity touse borrowed funds if it can match up the cash flows on the debt to the cashflows on the assets being financed, we design the perfect financing instrumentfor a firm. We then add additional considerations relating to taxes andexternal monitors (equity research analysts and ratings agencies) and arrive atstrong conclusions about the design of the financing.
The Dividend Principle
Mostbusinesses would undoubtedly like to have unlimited investment opportunitiesthat yield returns exceeding their hurdle rates, but all businesses grow andmature. As a consequence, every business that thrives reaches a stage in itslife when the cash flows generated by existing investments is greater than thefunds needed to take on good investments. At that point, this business has tofigure 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 fromthe business. In a publicly traded corporation, this will involve either payingdividends or buying back stock. the discussion of dividend policy, we introducethe basic trade-off that determines whether cash should be left in a businessor taken out of it. For stockholders in publicly traded firms, we note thatthis decision is fundamentally one of whether they trust the managers of the firmswith their cash, and much of this trust is based on how well these managershave invested funds in the past. Finally, we consider the options available toa firm to return assets to its owners—dividends, stock buybacks andspin-offs—and investigate how to pick between these options.
Ifthe objective function in corporate finance is to maximize firm value, itfollows that firm value must be linked to the three corporate finance decisionsoutlined—investment, financing, and dividend decisions. The link betweenthese decisions and firm value can be made by recognizing that the value ofa firm is the present value of its expected cash flows, discounted back at arate that reflects both the riskiness of the projects of the firm and thefinancing mix used to finance them.Investors form expectations about future cash flows based on observed currentcash flows and expected future growth, which in turn depend on the quality ofthe firmÕs projects (its investment decisions) and the amount reinvested backinto the business (its dividend decisions). The financing decisions affect thevalue of a firm through both the discount rate and potentially through theexpected cash flows.
Thisneat formulation of value is put to the test by the interactions among theinvestment, financing, and dividend decisions and the conflicts of interestthat arise between stockholders and lenders to the firm, on one hand, andstockholders and managers, on the other. We introduce the basic modelsavailable to value a firm and its equity, and relate them back to managementdecisions on investment, financial, and dividend policy. In the process, weexamine the determinants of value and how firms can increase their value.
There are severalfundamental arguments we will make repeatedly in this discussion:
<![if !supportEmptyParas]>1. Corporate finance has aninternal consistency that flows from itschoice of maximizing firm value as the only objective function and itsdependence on a few bedrock principles: Risk has to be rewarded, cash flowsmatter more than accounting income, markets are not easily fooled, and everydecision a firm makes has an effect on its value.2. Corporate financemust be viewed as an integrated whole,rather than a collection of decisions. Investment decisions generally affectfinancing decisions and vice versa; financing decisions often influencedividend decisions and vice versa. Although there are circ*mstances under whichthese decisions may be independent of each other, this is seldom the case inpractice. Accordingly, it is unlikely that firms that deal with their problemson a piecemeal basis will ever resolve these problems. For instance, a firmthat takes poor investments may soon find itself with a dividend problem (withinsufficient funds to pay dividends) and a financing problem (because the drop in earnings may makeit difficult for them to meet interest expenses).
3. Corporate finance matters toeverybody. There is a corporate financialaspect to almost every decision made by a business; though not everyone willfind a use for all the components of corporate finance, everyone will find ause for at least some part ofit. Marketing managers, corporatestrategists, human resource managers, and information technology managers allmake corporate finance decisions every day and often donÕt realize it. Anunderstanding of corporate finance will help them make better decisions.
4. Corporate finance is fun. This may seem to be the tallest claim of all. Afterall, most people associate corporate finance with numbers, accountingstatements, and hardheaded analyses. Although corporate finance is quantitativein its focus, there is a significant component of creative thinking involved incoming up with solutions to the financial problems businesses do encounter. Itis no coincidence that financial markets remain breeding grounds for innovationand change.
5. The best way to learncorporate finance is by applying its models and theories to real-world problems. Although the theory that has been developed overthe past few decades is impressive, the ultimate test of any theory isapplication. As we will argue, much (if not all) of the theory can be appliedto real companies and not just to abstract examples, though we have tocompromise and make assumptions in the process.
Thisintroduction establishes the first principles that govern corporate finance.The investment principle specifies that businesses invest only in projects thatyield a return that exceeds the hurdle rate. The financing principle suggeststhat the right financing mix for a firm is one that maximizes the value of theinvestments made. The dividend principle requires that cash generated in excessof good project needs be returned to the owners. These principles are the corefor corporate finance.
