Corporate finance is the field of finance dealing with financial decisions that business

enterprises make and the tools and analysis used to make these decisions. The primary
goal of corporate finance is to maximize corporate value while managing the firm's
financial risks. Although it is in principle different from managerial finance which studies
the financial decisions of all firms, rather than corporations alone, the main concepts in
the study of corporate finance are applicable to the financial problems of all kinds of
firms.

The discipline can be divided into long-term and short-term decisions and techniques.
Capital investment decisions are long-term choices about which projects receive
investment, whether to finance that investment with equity or debt, and when or whether
to pay dividends to shareholders. On the other hand, short term decisions deal with the
short-term balance of current assets and current liabilities; the focus here is on managing
cash, inventories, and short-term borrowing and lending (such as the terms on credit
extended to customers).

The terms corporate finance and corporate financier are also associated with investment
banking. The typical role of an investment bank is to evaluate the company's financial
needs and raise the appropriate type of capital that best fits those needs. Thus, the terms
“corporate finance” and “corporate financier” may be associated with transactions in
which capital is raised in order to create, develop, grow or acquire businesses.

Capital investment decisions

Capital investment decisions are long-term corporate finance decisions relating to fixed
assets and capital structure. Decisions are based on several inter-related criteria. (1)
Corporate management seeks to maximize the value of the firm by investing in projects
which yield a positive net present value when valued using an appropriate discount rate in
consideration of risk. (2) These projects must also be financed appropriately. (3) If no
such opportunities exist, maximizing shareholder value dictates that management must
return excess cash to shareholders (i.e., distribution via dividends). Capital investment
decisions thus comprise an investment decision, a financing decision, and a dividend
decision.

The investment decision

Management must allocate limited resources between competing opportunities (projects)

in a process known as capital budgeting.[4] Making this investment, or capital allocation,
decision requires estimating the value of each opportunity or project, which is a function
of the size, timing and predictability of future cash flows.
Project valuation

In general, each project's value will be estimated using a discounted cash flow (DCF)
valuation, and the opportunity with the highest value, as measured by the resultant net
present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951;
see also Fisher separation theorem, John Burr Williams: theory). This requires estimating
the size and timing of all of the incremental cash flows resulting from the project. Such
future cash flows are then discounted to determine their present value (see Time value of
money). These present values are then summed, and this sum net of the initial investment
outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount
rate - often termed, the project "hurdle rate" - is critical to making an appropriate
decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the
project appropriate discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and must take into account the
financing mix. Managers use models such as the CAPM or the APT to estimate a
discount rate appropriate for a particular project, and use the weighted average cost of
capital (WACC) to reflect the financing mix selected. (A common error in choosing a
discount rate for a project is to apply a WACC that applies to the entire firm. Such an
approach may not be appropriate where the risk of a particular project differs markedly
from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection
criteria in corporate finance. These are visible from the DCF and include discounted
payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart &
Co) and APV (Stewart Myers). See list of valuation topics.

Valuing flexibility

In many cases, for example R&D projects, a project may open (or close) the paths of
action to the company, but this reality will not typically be captured in a strict NPV
approach Management will therefore (sometimes) employ tools which place an explicit
value on these options. So, whereas in a DCF valuation the most likely or average or
scenario specific cash flows are discounted, here the “flexibile and staged nature” of the
investment is modelled, and hence "all" potential payoffs are considered. The difference
between the two valuations is the "value of flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA)[8][9] and Real options
analysis (ROA); they may often be used interchangeably:

 DTA values flexibility by incorporating possible events (or states) and consequent
management decisions. (For example, a company would build a factory given that
demand for its product exceeded a certain level during the pilot-phase, and
outsource production otherwise. In turn, given further demand, it would similarly
 expand the factory, and maintain it otherwise. In a DCF model, by contrast, there
is no "branching" - each scenario must be modelled separately.) In the decision
tree, each management decision in response to an "event" generates a "branch" or
"path" which the company could follow; the probabilities of each event are
determined or specified by management. Once the tree is constructed: (1) "all"
possible events and their resultant paths are visible to management; (2) given this
“knowledge” of the events that could follow, and assuming rational decision
making, management chooses the actions corresponding to the highest value path
probability weighted; (3) this path is then taken as representative of project value.
See Decision theory: Choice under uncertainty.

 ROA is usually used when the value of a project is contingent on the value of
some other asset or underlying variable. (For example, the viability of a mining
project is contingent on the price of gold; if the price is too low, management will
abandon the mining rights, if sufficiently high, management will develop the ore
body. Again, a DCF valuation would capture only one of these outcomes.) Here:
(1) using financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option; (2) an
appropriate valuation technique is then employed - usually a variant on the
Binomial options model or a bespoke simulation model, while Black Scholes type
formulae are used less often; see Contingent claim valuation. (3) The "true" value
of the project is then the NPV of the "most likely" scenario plus the option value.
(Real options in corporate finance were first discussed by Stewart Myers in 1977;
viewing corporate strategy as a series of options was originally per Timothy
Luehrman, in the late 1990s.)

Quantifying uncertainty

Given the uncertainty inherent in project forecasting and valuation,[11][9] analysts will wish
to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF
model. In a typical sensitivity analysis the analyst will vary one key factor while holding
all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor
is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst
will determine NPV at various growth rates in annual revenue as specified (usually at set
increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this
formula. Often, several variables may be of interest, and their various combinations
produce a "value-surface" (or even a "value-space"), where NPV is then a function of
several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a
scenario comprises a particular outcome for economy-wide, "global" factors (demand for
the product, exchange rates, commodity prices, etc...) as well as for company-specific
factors (unit costs, etc...). As an example, the analyst may specify various revenue growth
scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"),
where all key inputs are adjusted so as to be consistent with the growth assumptions, and
calculate the NPV for each. Note that for scenario based analysis, the various
combinations of inputs must be internally consistent, whereas for the sensitivity approach
these need not be so. An application of this methodology is to determine an "unbiased"
NPV, where management determines a (subjective) probability for each scenario – the
NPV for the project is then the probability-weighted average of the various scenarios.

A further advancement is to construct stochastic or probabilistic financial models – as

opposed to the traditional static and deterministic models as above For this purpose, the
most common method is to use Monte Carlo simulation to analyze the project’s NPV.
This method was introduced to finance by David B. Hertz in 1964, although has only
recently become common: today analysts are even able to run simulations in spreadsheet
based DCF models, typically using an add-in, such as Crystal Ball. Here, the cash flow
components that are (heavily) impacted by uncertainty are simulated, mathematically
reflecting their "random characteristics". In contrast to the scenario approach above, the
simulation produces several thousand random but possible outcomes, or "trials"; see
Monte Carlo Simulation versus “What If” Scenarios. The output is then a histogram of
project NPV, and the average NPV of the potential investment – as well as its volatility
and other sensitivities – is then observed. This histogram provides information not visible
from the static DCF: for example, it allows for an estimate of the probability that a
project has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue
growth, and to the other relevant variables, the analyst would assign an appropriate
probability distribution to each variable (commonly triangular or beta), and, where
possible, specify the observed or supposed correlation between the variables. These
distributions would then be "sampled" repeatedly - incorporating this correlation - so as
to generate several thousand random but possible scenarios, with corresponding
valuations, which are then used to generate the NPV histogram. The resultant statistics
(average NPV and standard deviation of NPV) will be a more accurate mirror of the
project's "randomness" than the variance observed under the scenario based approach.
These are often used as estimates of the underlying "spot price" and volatility for the real
option valuation as above; see Real options valuation: Valuation inputs. A more robust
Monte Carlo model would include the possible occurrence of risk events (e.g., a credit
crunch) that drive variations in one or more of the DCF model inputs.

The financing decision

Achieving the goals of corporate finance requires that any corporate investment be
financed appropriately.[13] As above, since both hurdle rate and cash flows (and hence the
riskiness of the firm) will be affected, the financing mix can impact the valuation.
Management must therefore identify the "optimal mix" of financing—the capital
structure that results in maximum value. (See Balance sheet, WACC, Fisher separation
theorem; but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity
financing. Financing a project through debt results in a liability or obligation that must be
serviced, thus entailing cash flow implications independent of the project's degree of
success. Equity financing is less risky with respect to cash flow commitments, but results
in a dilution of share ownership, control and earnings. The cost of equity is also typically
higher than the cost of debt (see CAPM and WACC), and so equity financing may result
in an increased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as
closely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking
Order Theory, which suggests that firms avoid external financing while they have
internal financing available and avoid new equity financing while they can engage in new
debt financing at reasonably low interest rates. Another major theory is the Trade-Off
Theory in which firms are assumed to trade-off the tax benefits of debt with the
bankruptcy costs of debt when making their decisions. An emerging area in finance
theory is right-financing whereby investment banks and corporations can enhance
investment return and company value over time by determining the right investment
objectives, policy framework, institutional structure, source of financing (debt or equity)
and expenditure framework within a given economy and under given market conditions.
One last theory about this decision is the Market timing hypothesis which states that
firms look for the cheaper type of financing regardless of their current levels of internal
resources, debt and equity.

The dividend decision

Whether to issue dividends, and what amount, is calculated mainly on the basis of the
company's unappropriated profit and its earning prospects for the coming year. If there
are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then
finance theory suggests that management should pay the amount dividends. These free
cash flows comprise cash remaining after all business expenses have been met.

This is the general case, however there are exceptions. For example, shareholders of a
"Growth stock", expect that the company will, almost by definition, retain earnings so as
to fund growth internally. In other cases, even though an opportunity is currently NPV
negative, management may consider “investment flexibility” / potential payoffs and
decide to retain cash flows; see above and Real options.

Management must also decide on the form of the dividend distribution, generally as cash
dividends or via a share buyback. Various factors may be taken into consideration: where
shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a
stock buyback, in both cases increasing the value of shares outstanding. Alternatively,
some companies will pay "dividends" from stock rather than in cash; see Corporate
action. Today, it is generally accepted that dividend policy is value neutral (see
Modigliani-Miller theorem).

Working capital management

Decisions relating to working capital and short term financing are referred to as working
capital management These involve managing the relationship between a firm's short-term
assets and its short-term liabilities.

As above, the goal of Corporate Finance is the maximization of firm value. In the context
of long term, capital investment decisions, firm value is enhanced through appropriately
selecting and funding NPV positive investments. These investments, in turn, have
implications in terms of cash flow and cost of capital.

The goal of Working capital management is therefore to ensure that the firm is able to
operate, and that it has sufficient cash flow to service long term debt, and to satisfy both
maturing short-term debt and upcoming operational expenses. In so doing, firm value is
enhanced when, and if, the return on capital exceeds the cost of capital; See Economic
value added (EVA).

Decision criteria

Working capital is the amount of capital which is readily available to an organization.

That is, working capital is the difference between resources in cash or readily convertible
into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the
decisions relating to working capital are always current, i.e. short term, decisions.

In addition to time horizon, working capital decisions differ from capital investment
decisions in terms of discounting and profitability considerations; they are also
"reversible" to some extent. (Considerations as to Risk appetite and return targets remain
identical, although some constraints - such as those imposed by loan covenants - may be
more relevant here).

Working capital management decisions are therefore not taken on the same basis as long
term decisions, and working capital management applies different criteria in decision
making: the main considerations are (1) cash flow / liquidity and (2) profitability / return
on capital (of which cash flow is probably the more important).

 The most widely used measure of cash flow is the net operating cycle, or cash
conversion cycle. This represents the time difference between cash payment for
raw materials and cash collection for sales. The cash conversion cycle indicates
the firm's ability to convert its resources into cash. Because this number
effectively corresponds to the time that the firm's cash is tied up in operations and
unavailable for other activities, management generally aims at a low net count.
(Another measure is gross operating cycle which is the same as net operating
cycle except that it does not take into account the creditors deferral period.)

 In this context, the most useful measure of profitability is Return on capital

(ROC). The result is shown as a percentage, determined by dividing relevant
income for the 12 months by capital employed; Return on equity (ROE) shows
this result for the firm's shareholders. As above, firm value is enhanced when, and
 if, the return on capital, exceeds the cost of capital. ROC measures are therefore
useful as a management tool, in that they link short-term policy with long-term
decision mak

Management of working capital

Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital[16]. These policies aim at managing the
current assets (generally cash and cash equivalents, inventories and debtors) and the
short term financing, such that cash flows and returns are acceptable.

 Cash management. Identify the cash balance which allows for the business to
meet day to day expenses, but reduces cash holding costs.

 Inventory management. Identify the level of inventory which allows for

uninterrupted production but reduces the investment in raw materials - and
minimizes reordering costs - and hence increases cash flow; see Supply chain
management; Just In Time (JIT); Economic order quantity (EOQ); Economic
production quantity (EPQ).

 Debtors management. Identify the appropriate credit policy, i.e. credit terms
which will attract customers, such that any impact on cash flows and the cash
conversion cycle will be offset by increased revenue and hence Return on Capital
(or vice versa); see Discounts and allowances.

 Short term financing. Identify the appropriate source of financing, given the
cash conversion cycle: the inventory is ideally financed by credit granted by the
supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to
"convert debtors to cash" through "factoring".

Relationship with other areas in finance

] Investment banking

Use of the term “corporate finance” varies considerably across the world. In the United
States it is used, as above, to describe activities, decisions and techniques that deal with
many aspects of a company’s finances and capital. In the United Kingdom and
Commonwealth countries, the terms “corporate finance” and “corporate financier” tend
to be associated with investment banking - i.e. with transactions in which capital is raised
for the corporation. These may include

 Raising seed, start-up, development or expansion capital

 Mergers, demergers, acquisitions or the sale of private companies
  Mergers, demergers and takeovers of public companies, including public-to-
private deals
 Management buy-out, buy-in or similar of companies, divisions or subsidiaries -
typically backed by private equity
 Equity issues by companies, including the flotation of companies on a recognised
stock exchange in order to raise capital for development and/or to restructure
ownership
 Raising capital via the issue of other forms of equity, debt and related securities
for the refinancing and restructuring of businesses
 Financing joint ventures, project finance, infrastructure finance, public-private
partnerships and privatisations
 Secondary equity issues, whether by means of private placing or further issues on
a stock market, especially where linked to one of the transactions listed above.
 Raising debt and restructuring debt, especially when linked to the types of
transactions listed above

Financial risk management

Risk management is the process of measuring risk and then developing and implementing
strategies to manage that risk. Financial risk management focuses on risks that can be
managed ("hedged") using traded financial instruments (typically changes in commodity
prices, interest rates, foreign exchange rates and stock prices). Financial risk management
will also play an important role in cash management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business
and market risk is a direct result of previous Investment and Financing decisions.
Secondly, both disciplines share the goal of enhancing, or preserving, firm value.

All large corporations have risk management teams, and small firms practice informal, if
not formal, risk management. There is a fundamental debate on the value of "Risk
Management" and shareholder value that questions a shareholder's desire to optimize risk
versus taking exposure to pure risk (a risk event that only has a negative side, such as loss
of life or limb). The debate links value of risk management in a market to the cost of
bankruptcy in that market.

Derivatives are the instruments most commonly used in financial risk management.
Because unique derivative contracts tend to be costly to create and monitor, the most
cost-effective financial risk management methods usually involve derivatives that trade
on well-established financial markets or exchanges. These standard derivative
instruments include options, futures contracts, forward contracts, and swaps. More
customized and second generation derivatives known as exotics trade over the counter
aka OTC.

Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools
developed by and for corporations have broad application to entities other than
corporations, for example, to partnerships, sole proprietorships, not-for-profit
organizations, governments, mutual funds, and personal wealth management. But in other
cases their application is very limited outside of the corporate finance arena. Because
corporations deal in quantities of money much greater than individuals, the analysis has
developed into a discipline of its own. It can be differentiated from personal finance and
public finance.

What Does Cost Of Capital Mean?

The required return necessary to make a capital budgeting project, such as building a new
factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.

Investopedia explains Cost Of Capital

The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a
different vehicle with similar risk.
Definition:

Equity financing is money acquired from the small business owners themselves or from
other investors.

Stockholders purchasing shares in a corporation, for instance, create equity financing, as do

angel investors who provide funding. Small business owners may invest their own funds into
their businesses, funds gleaned from inheritance, savings, or even the sale of personal assets
which then serves as equity financing for the business.

Besides contributing to a healthy balance sheet, making a personal investment that serves as
equity financing in a business is often necessary to attract other investors and/or lenders. If
you, as the small business owner, are not prepared to put any of your personal funds into the
business, what does that say to anyone else who might be thinking of investing in the
business - or that you're asking for a business loan? Investors and lenders like to see an
equity financing contribution of 25 to 50 percent.

Generally, investors and lenders take your equity financing contribution as a sign of your
commitment to the business. They want to see that you are willing to share the risks, as well
as the rewards.

While there is a great deal of talk about angel investors as sources of equity financing, the
main sources of equity financing for small businesses continue to be family and friends.