Corporate Finance Research Paper

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Corporate ﬁnance is concerned with ﬁnancial decisions made by corporations. These decisions can be grouped easily into two major categories: investment decisions and ﬁnancing decisions.

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Regarding the ﬁrst major decisions a ﬁrm must take, each company needs real assets (tangible and in-tangible) to carry on its business and keep its operations going. How much a ﬁrm should invest and what speciﬁc assets a ﬁrm should invest in are the typical questions related to investment decisions. Investment decisions, then, determine the total amount of assets held by a company and the composition of these assets. The economic evaluation of investment projects aims at orienting corporations’ choices connected to their asset allocation process. This process that leads a company to allocate its capital to investment proposals whose beneﬁts are to be realized in the future is generally referred to as capital budgeting.

All the assets we mentioned above are to be paid for. To raise the money necessary to their investments policy, corporations issue securities on ﬁnancial markets. These ﬁnancial assets have value since they represent claims on companies’ real assets. Securities issued by corporations include not only shares of stock but also bonds, bank loans, lease obligations, and any other form of ﬁnancing. How the cash required for investments should be obtained is the answer that ﬁnancing decisions must give. Financing decision, in fact, are concerned with determining the best mix of ﬁnancial sources in the form of equity and debts. In other words, ﬁnancing decisions deﬁne the total amount and the composition of a company’s capital structure. The deﬁnition of capital structure referred to is that which takes into account the explicitly costly forms of ﬁnancing raised from the company’s investors. For sake of simplicity, they are divided into ﬁnancial debts and equity without dwelling on the diﬀerent form of ﬁnancing.

According to what has been highlighted about corporate ﬁnance decisions, ﬁnancial management attempts to ﬁnd speciﬁc answers to needs arising from both investment and ﬁnancing areas.

After deﬁning what corporate ﬁnance decisions are concerned with, the next step in this analysis will be to reread investment policies and capital structure decisions in the light of the theory of shareholders’ value. Since the principle of maximizing shareholders’ wealth largely is accepted as the rational guide for running a business and for the eﬃcient allocation in an economy, it is assumed to be the objective in considering how ﬁnancial decisions should be made.

Investment decisions and ﬁnancing decisions must contribute together to create value for the company’s shareholders. From one hand, a ﬁnancial manager that acts in its shareholders’ interest should invest in those projects that increase the overall ﬁrm’s value and, then, its shares’ value. From the other hand, the mix of ﬁnancial resources that maximizes the company’s value should be adopted. From this point of view, it becomes crucial to understand how corporate borrowing aﬀects its shareholders’ wealth according to Modigliani and Miller proposition II. In their article, Modigliani and Miller (1963) state that, in a world with taxes, the value of a levered ﬁrm increases in proportion to the debt–equity ratio (Debt Equity). As we will show in Sect. 6 this is due to the fact that ﬁnancial charges are tax deductible whereas dividends and retained earnings are not; an increase in debts will reduce the company’s cost of capital and raise the ﬁrms’ value.

In addition to that, it must be kept in mind that investment decisions and ﬁnancing decisions interact, sometimes producing diﬀerent consequences on the company’s value. In fact, any change in the ﬁrm’s capital structure inﬂuences the cost of capital that a company applies to discount investments cash ﬂows. Consequently, any rise in the cost of capital could make any investment less proﬁtable, reducing its contribution to the overall company’s value.

From what has been said, it can be concluded that both investment and ﬁnancial decisions have to be analyzed in relation to their impact on the ﬁrm’s major objective: to make the ﬁrm’s shareholders as well oﬀ as possible. As a result, an optimal combination of the two areas of decision will maximize the value of the ﬁrm for its shareholders.

Consistent with that, the ﬁnancial manager must act as an intermediary between the ﬁrm’s operations and capital markets where the ﬁrm’s securities are traded. The purpose of capital markets is allocating savings eﬃciently in an economy, from ultimate savers to ultimate users of funds who invest in real assets (companies). In fact, companies issue securities and raise cash by selling those ﬁnancial assets to investors. Then the cash is invested in the ﬁrm’s operations and used to purchase real assets. Later, if the ﬁrm does well, the real assets generate cash inﬂows that more than repay the initial investment. Finally, once the ﬁrm’s operations generate new cash, this is either re-invested in the company or returned to investors who hold the securities originally issued. The last decision is not completely free for the ﬁnancial manager, but it depends on several factors such as the characteristics of the speciﬁc ﬁnancing, the dividend policy, the ﬁnancial needs of the company.

1. Corporate Finance Decisions And Financial Control

In order to make optimal ﬁnancial decisions in keeping with the major objective of the ﬁrm (i.e., maximizing its shareholders’ wealth), the ﬁnancial manager must implement inside the ﬁrm an eﬀective process of analysis, planning, and control and make use of some analytical tools. In fact, ﬁnancial analyses are a necessary condition for making appropriate ﬁnancial decisions in the meaning as stated before. From a very simplistic point of view, in order to create value for all the company’s investors (debtholders and stake-holders), the asset allocation process must yield more than the company’s cost of capital.

Since the ﬁnancial manager has to grant that the cash ﬂow ability of the ﬁrm will properly remunerate its ﬁnancial sources over the long run, they must evaluate the size and timing of cash ﬂows and monitor the company’s capital structure, its major sources and uses of funds, and its proﬁtability over time. As a measure of the company’s proﬁtability ROI (return on investments operating income capital invested) is taken into consideration. According to that, the ﬁnancial manager is concerned on one hand with the proﬁtability of the company’s investments and with the eﬃciency of the implemented asset management decisions. It means that they have to make use of rational tools to evaluate capital budgeting decisions. On the other hand, the ﬁnancial manager is interested in keeping constantly under control the changes in the company’s capital structure that can aﬀect both the ﬁrm’s cost of capital and the yield required by capital suppliers. If the company’s cost of capital is deﬁned as the weighted average cost of capital (WACC) and represents the net cost of debts and equity weighted by their percentage on the total capital structure, an increase in the percentage of debts, for instance, can reduce the WACC since they are less costly than equity, due to their ﬁscal deductibility; at the same time, an excessive rise in debts can make the company be perceived as a riskier investment and thus induce investors to require higher yields on debt and equity. Both these eﬀects have to be taken into account once the ﬁnancial manager is approaching any ﬁnancing decision.

In the light of what ﬁnancial managers must do to maximize shareholders’ value, ﬁnancial control can be deﬁned as the whole of the activities and tools that enable ﬁnancial managers to carry out ﬁnancial analyses for the purposes of internal and external control. By internal control, we mean evaluating the investments proﬁtability and the eﬃciency eﬀective-ness of the capital budgeting process. In addition to that, a form of internal control is considered as any analysis turned to keep under observation the com-position of the company’s capital structure. External control is any aspect of ﬁnancial analysis that outside suppliers of capital take into consideration in evaluating the ﬁrm and that the ﬁnancial manager should be interested in the endeavor of bargaining more eﬀectively for outside funds.

So far it has been stated that the main corporate goal is to increase the shareholders’ wealth. According to that, a company creates value if its shareholders’ wealth rises. It is worth mentioning that, recently, ﬁnancial markets and investors have taken into ac-count new parameters in the evaluation of ﬁnancial investments. These parameters add a social and ethical appraisal of ﬁnancial investments to a pure ﬁnancial valuation. Such parameters aim at reminding companies of their social responsibilities and spur them to give constructive contributions to society and bring positive energy to the solutions of its problems.

As a consequence of the new approach to interpreting the corporate role within the society, investors choose to invest their money only in those companies that behave ethically. On the other hand, ﬁnancial products suppliers are tailoring new ﬁnancial products which are labeled as ethical, and that respond to the new evaluation requirements.

The Dow Jones Sustainability Index (DJSGI) can be seen as an example of this new trend inside ﬁnancial markets. That index, in fact, consists of more than 200 companies that represent the top 10 percent of leading sustainability companies in 64 industry groups in the 33 countries covered by the DJSGI.

The companies included in the DJSGI have shown over time a strong commitment on the achievement of the ﬁve corporate sustainability performance principles: innovation, high standard corporate governance, shareholders’ requirements, best practices, and social behaviors.

From what has just been highlighted, managers must be aware that new principles beyond those suggested by ﬁnancial theories have to be pursued in running their business.

2. An Integrated System Of Financial Analyses

An eﬀective ﬁnancial analysis, planning, and control process is critical to enhance enterprise value and, then, shareholders’ wealth. To make rational decisions in the shareholders’ interest, ﬁnancial managers need to be supported by an integrated system of ﬁnancial analyses and reports. These tools enable ﬁnancial managers constantly to control both the proﬁtability of the company (in the meaning of the ﬁrm’s ability to generate cash ﬂows from its operating activities) and the cost of resources applied to undertake operating investments that determine the company’s cost of capital.

Since they need to keep under control both the proﬁtability of capital invested and the cost of re-sources raised from investors, ﬁnancial managers make use of an integrated system of analyses that includes ﬁnancial statements, ratios, ﬁnancial planning, investment valuation, and capital structure analysis. Each of these tools plays a key role with reference to the ﬁnancial control activity, providing the ﬁnancial manager with a wide range of information that helps in orienting the company’s investment and ﬁnancing decisions. Even if ﬁnancial analysis, planning, and control activities are often considered as diﬀerent tools, they have to be viewed as a whole since they together aim at accomplishing the maximization of shareholders’ value.

In large companies it often happens that diﬀerent managers carry out the above-mentioned analyses in diﬀerent departments. It becomes important, then, to construct an integrated system of data exchange that allows the diﬀerent tools to work jointly. To assess an investment’s proﬁtability, for instance, it is necessary to forecast the company’s market share in order to determine its potential incremental revenues and cash ﬂows. In addition to that, the composition of the expected capital structure will be also needed to calculate the new cost of capital and discount future cash ﬂows at that rate.

3. Financial Accounting

Financial accounting (ﬁnancial statements, ratios, and cash ﬂow statements) gives the ﬁnancial manager a picture of the ﬁrm’s past performance and its current standing. These analyses help the ﬁnancial manager to understand the company’s current economic and ﬁnancial situation and make forecasts for the future. It also allows the manager to represent the ﬁrm’s position according to its competitors and its evolution over time.

The reorganization of ﬁnancial statements (assets and liabilities statement and income statement) ac-cording to some predeﬁned schemes is the ﬁrst step of a process that, starting from accounting information, ends up with the appraisal of a company’s performance from both income and cash ﬂow perspective.

One of the criteria applied to reorganize the company’s ﬁnancial statements is, for instance, the activity-related method. With relation to this approach, we group the balance sheet entries in current and noncurrent assets and liabilities according to their pertinence or otherwise to the operating cycle of the company. The same criterion applied to the items contained in the income statement allows us to separate revenues and costs in relation with the four activity areas that can be identiﬁed in an ongoing business: current, ﬁnancial, subsidiary, and extra-ordinary activities.

Once ﬁnancial statements have been reorganized, it is possible for the ﬁnancial manager to combine income statement and balance sheet entries in order to obtain signiﬁcative ratios. Second, from reorganized ﬁnancial statements, a cash ﬂow statement can be drawn up as well.

In particular, a complete system of ratios describes the current state of health of the company according to diﬀerent points of view: liquidity, proﬁtability, lever-age. This analysis oﬀers a static diagnosis of the ﬁrm that can be helpful for managerial control and for a better understanding of what outside suppliers of capital may expect in terms of a company’s ﬁnancial condition and performance. In fact, both the ﬁnancial manager and the company’s investors are interested in measuring the return on investments of the company, its capability of repaying debts in the short run and in the long run, and the relation between debt and equity. Consistent to that aim, ratios are mostly employed for ex-post analysis, to verify the eﬀect of investment and ﬁnancing decisions on the company’s proﬁtability, and for the composition of its assets and liabilities.

The ﬁnal step in the above-mentioned process of ﬁnancial analysis is represented by the construction of the cash ﬂow statement. Cash ﬂow analysis can be seen as a dynamic analysis that highlights the company’s ability of generating cash ﬂow. Using cash ﬂow, the ﬁnancial manager identiﬁes the sources and uses of monetary resources during a given period. The cash ﬂow statement groups all the inﬂows and outﬂows according to their pertinence to the current activity, the ﬁnancing and reimbursement activity, the investment activity (operating and nonoperating), and to the remuneration of debt holders and stakeholders. In other words, this tool leads to the quantiﬁcation of the cash inﬂows that the company is currently able to generate from its operating activity, and the comparison of them to the ﬂows absorbed by the investment policy, the debt repayment, and the dividend policy. In fact, it is one thing if a company can provide the monetary resources autonomously to undertake investments and adequately remunerate the capital invested, while it is quite another if the same company regularly needs to ﬁnd outside sources of capital in order to avoid ﬁnancial distress caused by an insufﬁcient production of cash inﬂow.

Consistent with that, the cash ﬂow analysis can be interpreted as an ex-post analysis that helps the ﬁnancial manager to appraise the impact of investment and ﬁnancing decisions in terms of ﬁnancial ﬂows.

4. Financial Planning

Financial planning enables ﬁnancial managers to assess the eﬀects of ﬁnancing and investment decisions ex-ante. Financial planning is a necessary analysis as investment and ﬁnancing decisions interact and they should not be made independently. Financial planning is concerned with analyzing ﬁnancial ﬂows of the ﬁrm as a whole, forecasting the consequences of investment and ﬁnancing decisions, and weighing the eﬀects of diﬀerent alternatives. In fact, any ﬁnancial decision that aﬀects the investment policy of the ﬁrm or its mix of ﬁnancial sources raised from investors inﬂuences the company’s future proﬁtability as well as its capital structure (and its cost of capital). The ﬁnancial manager has to deﬁne both a target ﬁnancing mix and a target return on investments and undertake only the investments ﬁnancings consistent with those targets. In order to keep under control any unexpected change that can modify the company’s return on investments or its cost of capital, the ﬁnancial manager has to analyze any ﬁnancial strategy very carefully and to take into consideration any economic and ﬁnancial impact that it may have. Moreover, ﬁnancial planning makes possible the comparison of diﬀerent investment and ﬁnancing strategies in order to evaluate which one maximizes shareholders’ wealth.

The tangible tool applied in the planning process is the ﬁnancial plan describing the ﬁrm’s ﬁnancial strategy and projecting its future consequences in a proforma balance sheet, income statement, and cash ﬂow statement. In particular, the forecasted cash ﬂow statement provides an eﬀective method for the ﬁnancial manager to assess the growth of the company and its resulting ﬁnancial needs as well as to determine the best alternative to ﬁnance those needs.

In fact, the plan sets ﬁnancial goals and it represents a benchmark itself for evaluating subsequent performance. Helping the company to achieve these goals is one of the chief responsibilities of ﬁnancial planning.

Finally, the planning horizon depends on the company and its business. High-tech companies, for instance, produce much shorter ﬁnancial plans than most companies do as a consequence of technologies life cycle, whereas public utilities and energy companies make longer ﬁnancial plans due to the long lead time of their capital projects.

5. Investments Valuation

Capital budgeting involves the entire process of planning capital expenditures whose returns are normally expected to extend beyond one year. Since we stated that investment decisions must be made so that they maximize shareholders’ value, capital budgeting decisions forcedly must be related to the ﬁrm’s overall strategic planning. Capital budgeting must be integrated with strategic planning as excessive investments or inadequate investments could cause serious con-sequences for the future of the ﬁrm. If the company invested too much in ﬁxed assets overestimating its potential growth, it would incur unnecessarily heavy expenses that would reduce its return on investments. On the other hand, if a company has not invested enough in new production capacity it may lose a portion of its customers to rival ﬁrms. A related problem is how to properly phase the availability of capital assets in order to have them ‘working’ at the correct time. An eﬀective process of capital budgeting aims at improving the timing of asset acquisitions and the quality of assets purchased. Another reason that highlights the relevance of the capital budgeting process is that asset expansion typically involves substantial expenditures. Before a company under-takes an expensive investment such as the purchase of a new plant, the launch of a new product, or the signature of a commercial agreement, it needs to plan how to raise funds required for that speciﬁc project. A number of factors make capital budgeting one of the major ﬁnancial management decisions. In fact, not only does any investment decision contribute to deter-mine the company’s proﬁtability (and its ROI) and, then, the shareholders’ value, but also the capital budgeting process vitally aﬀects all departments of a ﬁrm (such as production, marketing, ﬁnance, to mention a few). Since ﬁnancial managers need to keep under control the asset allocation process so as to grant the maximum value to their shareholders, it can be said conﬁdently that one of the most important corporate ﬁnance functions is the economic valuation of investment projects. In fact, the ﬁrst step in undertaking any allocation project is the analysis of its economic and ﬁnancial proﬁle. The latter aspect is taken into account in drawing up the ﬁnancial plan, where the ﬁnancial manager veriﬁes the compatibility of the cash ﬂows related to the project under consideration with those that happen at the overall company’s level.

The ﬁnancial manager must carry out those projects that maximize the incremental value for the company’s shareholders. In order to increase shareholders’ wealth, a project must yield more than the cost of funds used to undertake the capital expenditure. It is, then, possible to conclude that the ﬁnancial manager must judge a certain investment project according to its expected return. If this is higher than the company’s cost of capital, the speciﬁc investment will create value for the company’s shareholders.

As the asset allocation process is led on a continual basis, the ﬁnancial manager must measure constantly the proﬁtability of the ﬁrm’s investment activity. Such a form of control makes use of appropriate methods of analysis like the NPV and the IRR. The NPV (net present value) is the present value of the cash lows stemming from the investment project; the IRR (internal rate of return) is that rate that makes the NPV equal to zero and it can be seen as the gross return of an investment project.

The implementation of the above-mentioned tools of ﬁnancial control on investments prevents the funds being misallocated. In fact, when many alternatives of investment are evaluated, the most proﬁtable will be chosen ﬁrst, then the others one by one according to their expected rate of return. This modus operandi becomes a necessary approach if the company has a limited amount of funds available to ﬁnance investment projects (capital rationing).

6. Capital Structure Analysis

Capital structure refers to how the ﬁrm’s assets are ﬁnanced. If the monetary resources that the current activity is able to produce are not enough to oﬀset the cash-outs due to the company’s investment activity, the ﬁrm needs to raise new funds from investors. Accordingly, capital structure is concerned with explicitly costly forms of ﬁnancing just as ﬁnancial debts (bonds, loans, overdrafts) and equity are. In fact, both debt holders and shareholders want to be remunerated for the money they invested into the company. It is then possible to determine the cost of capital as the average of the net cost of debt and equity (WACC). To calculate the average, the impact of debts and equity on the total capital structure has to be taken into account.

The composition of capital structure inﬂuences the company’s cost of capital from two diﬀerent points of view. First, any change in the amount of debts and equity will make their weights vary so that we come up with a new WACC, other things being equal. Second, the cost of capital will diﬀerently change according to which form of ﬁnancing is chosen. Since ﬁnancial charges are tax deductible whereas dividends and retained earnings are not, an increase in debts will reduce the WACC. However, it must not be concluded that a company should be 100 percent debt-ﬁnanced. In fact, the more debts rise the higher the risk of ﬁnancial distress will be. This higher risk perceived by investors leads debt holders and stakeholder to ask for being granted a higher rate of return.

The composition of capital structure impacts on the shareholders’ value since it inﬂuences the cost of capital invested in the company. If the return on investments remains equal, a rise in the cost of capital will cause a decrease in the company’s proﬁtability and in shareholders’ wealth. The ﬁnancial manager has to take into consideration the eﬀect on the capital structure when any ﬁnancing decision is evaluated. Once a ﬁnancial need arises from the planning activity, the ﬁnancial manager should simulate what impact a debt or equity issue may have on the overall company. This activity enables the ﬁnancial manager to quantify the eﬀects of ﬁnancing alternatives in terms of the ﬁrm’s cost of capital and ﬁnancial riskiness.

We are assuming that there are no capital constraints that aﬀect the company so that the ﬁrm can count on an unlimited access to both the equity market and the debt market. According to this hypothesis, the ﬁnancial manager can choose the ﬁnancing alternative that maximizes the shareholders’ value and minimizes the cost of capital. Sometimes, however, the ﬁrm has to face with a limited availability of ﬁnancing alternatives to raise money from investors. In fact, many factors such as capital markets features or aspects related to companies’ ownership and control could make some ﬁnancing decisions unfeasible. At the same time, other aspects such as corporate taxation can make some sources of ﬁnancing prefer-able in comparison to others.

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