Principles of Corporate Finance - Coursework Example

PRINCIPLES OF CORPORATE FINANCE 1. Principles of Corporate Finance a. The Investment Principle Generally and in broad sense, investment signifies the use or employment of capital for purposes of gain. However, from a strictly financial standpoint, modern investment is the surrendering of purchasing power to another with a view to obtaining a profit in addition to the return of the amount surrendered. There are two fundamental considerations entering into the making of an investment. The security of principal and the security of income. Accordingly, nothing constitutes investment which does not imply the recovery of both the principal sum and also an additional amount or amounts representing income or profit (Sakolski 2009, p.7) b. The Financing Principle One of the principles of financing, whether to start a company, maintains its operations, or advances its growth, is to make a proper match between the assets and their associated forms of financing. The general principle is to finance current (short-term) assets with short-term financing and long-term assets with long-term or permanent financing. For instance, a shoe-store owner matched sixty-day financing against an asset expected to be sold within that period. Similarly, companies finance their infrastructure of office space, systems, and equipment with either long-term debt or capital supplied by shareholders, more permanent form of financing. This principle is important because for instance, if one tried to finance the purchase of a new home (a long-term asset) with an 8 percent, nonamortizing $200,000 loan that came due in only three years. Under the terms of the loan, one should pay $16,000 in annual interest and then would be obligated to repay the $ 200,000 at the end of the third year. This would be feasible if one could negotiate another loan at the end of the three years to replace that one that’s due and if interests’ rate were still affordable. However, money might become so tight that one could not locate a new lender or the lender one found might want 10 or 12 percent. In either case, foreclosure would be likely. One could not operate with such situation, and neither can a business enterprise (Luecke 2004, p.107) c. The Dividend Principle As a principle, a firm should return cash to the owners if there are not enough investments that earn the hurdle rate (Baker & Power 2005, p.458). “Dividends are share of profits paid to shareholders” (Yalden et al. 2008, p.367). It is a portion of company’s earnings or profits distributed pro rata to its shareholders. A corporation can distribute its profits to shareholders by paying a dividend. Cash dividends are usually paid in cash while dividends in specie can be paid by distributing property other than cash to shareholders. A stock dividend is sometimes used to pay a shareholder. Instead of cash, shareholders are being paid by issuing more of the corporation’s share. 2. Capital Investment decisions 2.1 The Investment Decision a. Project Valuation Generally, the valuation process takes place to determine the current worth of an asset or project. The key to successfully investing in and managing assets lies in understanding not only what the value is, but the sources of value. The value obtained from any valuation model is affected by firm-specific as well as marketwide information. Therefore, the value will change as new information is revealed (Damodaran p.3). b. Valuing Flexibility Managers react to changes in the economic environment by adjusting their plans and strategies. For instance, if a company develops a new product, it may invest to expand their business line. Then if prices of critical inputs rise, it may scale back production or even terminate the effort. This ‘flexibility’ represents a certain value. Flexibility mostly occurs at the individual business or project level, and concerns decisions related to production, capacity investments, marketing, research and development, and so on. In valuing an entire company, flexibility is relevant only in special cases, such as in the case of companies with a single product, companies in commodity-based industry, or companies in or near distress (Kolle et al. 2005, p.543). 2.2 The Financing Decision a. Capital Structure The capital structure of an enterprise consists of debt and equity funds (Woelfel 1993, p.99). The sources and composition of the two type of capital determine to a considerable extent the financial stability and long-term solvency of the firm. Equity capital is risk capital, and the return of investment to an investor is subject to many uncertainties. Debt capital must be paid on a specified data, usually with interest, if the firm is to survive. There is no ideal capital structure common to all firms. In general, a firm should not have a heavy amount of long-term debt and preferred stock in relation to common stock and retained earnings (Woelfel 1993, p.99). 2.3 The Dividend Decision When a company makes a ‘dividend decision’ its management determine whether the company should a dividend and if it does, what proportion of earnings to pay out and how much to retain within the firm for further investment (Viljoen 2007, p.244). In other words, dividend decisions relate to the determination of how much and how frequently cash can be paid out of the profits of an entity as income for its proprietors. The dividend decision thus has two elements. The first is the amount to be paid out and the second is the amount to be retained to support the growth of the entity (Ogilvie, Graham, & Parkinson 2005, p.13). 3 Working Capital Management 3.1 Decision Criteria Decision criteria are defining the criteria used by businesses to make decisions (Turk & Scherer 2002, p. 141). According to Thomas (2002, p.93), decisions often require the consideration of more than one objective. For instance, in selecting a manager for an overseas operation, one may want to maximize the manager’s ability to adapt to the new culture, maximize the level of technical skill brought to the situation, and also minimize the cost of the assignment. The be rational, a decision maker must identify all of the criteria that should be considered in the decision-making process. 3.2 Management of Working Capital a. Cash Management Cash management in simple terms is management of the company’s cash resources. Cash management is one aspect of the treasury functions and it is as important as the management of any other company resources. Companies must have enough cash to purchase inventory for resale to customers, and to pay debts and operating expenses. In managing cash to meet these needs, cash management can accelerate cash receipt, delay disbursement, forecast cash inflows and outflow, and invest idle cash. Effective cash management involves speeding up the billing and collection process in order to move cash into the company’s account so it can be used effectively (Plewa & Friedlob 1995, p.3). Cash management is a prime example of the purpose of investing in general, to husband and grow assets in order to cover liabilities. Cash, as opposed to more rewarding but riskier assets such as stocks or bonds, is preferable for meeting large, short-term liabilities that are well defined and predictable. Holding cash is also the only sensible investment choices for meeting uncertain liabilities that arise in an emergency. The range of cash management alternatives is sufficiently large and complicated to warrant careful planning when deciding on which specific cash vehicles to hold (Fabozzi 2000, p.1). b. Inventory Management All organizations keep inventory and these include raw materials, work in process, supplies used in operations, and finished goods. Consequently, the inventory brings with it a number of costs which include money, space, deterioration, damage, and theft (Muller 2003, p.2). Inventory management involves a trade-off between the costs associated with keeping inventory versus the benefits of holding inventory. Higher inventory levels result in increased cost from storage, insurance, spoilage, and interest on borrowed funds needed to finance inventory acquisition (Shim & Siegel 1997, p.111). In manufacturing, inventory is considered waste but in environments where an organization suffers from poor cash flow or lacks of strong control over electronic information transfer among all departments and all significant suppliers, lead times, and quality of materials received, inventory plays important roles. Some of the more important reasons for obtaining and holding inventory are predictability. In order to engage in capacity planning and production scheduling, one needs to control how much raw material parts and subassemblies to process at a given time. A supply inventory on hand is protection since you need to satisfy customer or production demand on time. Inventory protects a company form unreliable suppliers or when an item is scarce and it is difficult to ensure a steady supply. Buying quantities of inventory at appropriate time helps avoid the impact of cost inflation. If one company by a larger quantity of an item less frequently, the ordering cost are less than buying smaller quantities over and over again. For this reason inventory management is very essential to the company. c. Debtor’s Management Many business bankruptcies are initiated by management and seek reorganization rather than liquidation. The debtor’s management has the exclusive right to propose a plan of reorganization, which usually includes restructuring of debt and equity and may also include sales of one or more of the businesses of the debtor. The initial strategies of the debtor’s management are usually to restructure the outstanding debt, obtain new financing, divest some businesses, and retain others and continue on as directors and officers of the reorganized entity (Shea 1999, p.19). d. Short term financing Firms need both a long-term investment in working capital and a short-term or cyclical one. Cyclical working capital is best financed by short-term debt since the seasonal build-up of assets to address seasonal demand will be reduced and converted to cash to repay borrowed funds within a short predictable period. By matching the term of liabilities to the term of the underlying assets, short-term financing helps a firm manage inflation and other financial risks. Short-term financing is also preferable since it is usually easier to obtain and priced lower that long-term debt (Seidman 2004, p.94). 4 Financial Risk Management 4.1 Objectives and Policies Objectives and policies are critical to effective risk management. Risk management policies are divided into three major areas- objective, authority/ responsibility, and implementation. Objectives stated in risk management policies are usually to minimize the costs of risk management activities. This translates to intelligent and appropriate use of risk avoidance, risk reduction, risk transfer, and risk retention strategies (Kavanugh & William 2004, p.146). 4.2 Risk Exposures a. Market Risk Markets are volatile in nature, they go up and down, and investment need time to grow (Mladjenovic 2006, p.51). Investing requires diligent work and research before putting hard earned money in quality investments with a long-term perspective. Understanding market risk is especially important for people who are tempted to put their money or emergency funds into volatile investments such as growth stocks. Every business involves risk and one of the risk facing companies include market risk. This is were the market will not respond to company’s products or services, either because there is no real market need or the market is not yet ready. Market risks are very difficult to overcome (Abrams & Kleiner p.126). b. Interest Rate Risk When a company rely heavily on borrowed funds for capital, the need to monitor and manage their interest rate risk is high. Interest rate risk increases with a loan’s term, the amortization schedule and maturity for fixed interest loans is central to managing interest rate risks (Seidman 2004, p.414). Interest-rate risk refers to the danger that future movements in the market interest rates will induce a net adverse revaluation of the asset and liability positions an institution holds (Kaufman & Litan 1993, p.71). c. Foreign Exchange Risk Foreign exchange risk does not confront the lender or investor directly if the obligation is denominated in non-local currency. Yet exchange-rate movements can influence the creditworthiness of borrowers and issuers, and factors affecting exchange rates are often closely allied to those that affect country conditions in general (Smith & Walter p.294). Firms that engage in cross-border business generally bear some amount of exchange risk, the risk comes from the variability of exchange rates, and therefore the uncertain value of future cash slows (Bruner et al. 2003, p.305). d. Other Price Risk Unless the consumption of a product is simultaneous with production there is a risk to the owner of the product. This risk can be in two forms. Risk of price changes or risk of loss in quality and quantity. The price risk depends on the degree of price variability over time. This risk is often shifted among participants in the marker by means of various market devices and institutions (Hill & Bender 1995, p.40). e. Credit Risk Unlike market risk, where traders can move in or out of liquid markets in relatively homogenous products, credit derivative are long-term illiquid investments. Each borrower is different, and present unique credit risk issues. There are two main types of credit risk that a portfolio of assets or a position in a single asset, is exposed to. A credit default risk is the risk that an issuer of debt is unable to meet its financial obligations. A credit spread risk is the excess premium, over and above government or risk-free risk, required by the market for taking on certain assumed credit exposure (Choudry 2004, p.3). f. Liquidity Risk Liquidity risk can be grouped into asset liquidity and funding liquidity risk. The former relates to the risk that the liquidation value of assets differs significantly from the current mark-to-market value. The latter refers to the risk that an institution could run out of cash and is unable to raise new funds to meet is payment obligations, which could lead to formal default. Asset liquidity risk can be evaluated by the price impact of the liquidation. In contrast, funding liquidity risk deals with cash resources as well as potential cash requirements. (Jorion 2000, p.399) 5 Finance Relationship with Investment Banking a. Raising Capital Capital is critical to the success of a company and the need to be able to raise capital effectively is one of the reasons that limited liability was introduced into corporate law (Yalden et al. 2008, p.303). b. Mergers and Acquisitions Mergers and acquisitions occur when two or more organizations join together all or part of their operations. The difference between merges and acquisitions relate mainly to the relative size of the individual companies in the business combination, ownership of the combined business, and management control of the combined business (Gingerich & Ondeck 1996, p.37). c. General Advisory Services Corporate finance activities of investment banks predominantly relate to advisory work on mergers, acquisitions, divestitures, recapitalizations, leveraged buyouts, and a variety of other generic and specialized corporate transactions (Walter 2004, p.24). d. Sales and Trading Sales and trading is much more than an opportunistic business driven by individual traders’ skills at outguessing the market. It is a business in which profits are largely driven by fundamental competitive advantage (Sten & Chew 2003, p.50). 6. Bibliography Baker H. K. & Powell G. E. 2005. 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Global banking. Oxford University Press, US Stern J, & Chew D. 2003. The revolution in corporate finance. Wiley-Blackwell, US Stoltz A. & Viljoen M. 2007. Financial Management: Fresh Perspectives. Pearson South Africa, Cape Thomas D. C. 2002. Essentials of international management: a cross-cultural perspective. SAGE, US Turk Ž. & Scherer R. 2002. EWork and EBusiness in Architecture, Engineering and Construction: Proceedings of the Fourth European Conference on Product and Process Modelling in the Building and Related Industries, Portorož, Slovenia, 9-11 September 2002. Taylor & Francis, Netherlands Yalden R. et. al., 2008. Business Organizations: Principles, Policies, and Practice. Emond Montgomery Publication,Canada Walter I. 2004. Mergers and acquisitions in banking and finance: what works, what fails, and why. Oxford University Press, US Woelfel C. J. 1993. Financial statement analysis: the investor's self-study guide to interpreting & analyzing financial statements. 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