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The big picture of corporate finance

In this paper, we wanted to draw the big picture of corporate finance, underline the main decisions that finance managers make, and the goal and target of any specific firm. We do this by evaluating the primary purpose of financial managers and his or her actions. In this paper, we will not go deep into detailed calculations and mathematics but focus on the big picture of corporate finance. Because if we have the big picture, we can connect the reasons and logic, and the calculations will make more sense. Throughout this paper, we will talk about the definition of corporate finance, the goals of a financial manager, and the three main decisions to achieve the goals. Going through the paper, we would look at the firm financial status through financial managers to understand what and why they make these financial decisions. We would like to thank Dr. Kim for showing us the essential big picture throughout the class and case study. 

  1. The main goal of financial managers

The primary objective of the financial manager should be maximizing shareholder wealth by maximizing the firm's intrinsic value, which converts to increasing the fundamental stock price. Specifically, the financial manager's primary goal is maximizing the total of the future expected free cash flow, which is discounted to today's money at the firm's weighted average cost of capital (WACC).

Before going deeper into the manager's decisions and activities, we need to know why we need to maximize the stock price today by increasing the free cash flows in the future. The reason here is stock price today does not reflect the firm's historical performance nor today's performance. The stock price of today reflects the expectation of investors toward firm performance in the future. Here we assume that the firm will last forever, as the manager will do his job well enough to keep the firm growing forever. If the firm does not last forever, for example, it lasts only three years, then there is no reason for anyone to buy the firm's stocks since they become worthless after three years. Another assumption is that there are no agency problems, or the managers will behave ethically and always act in the shareholders' best interest.

In short, the formula is shown below.


-      Free cash flows (FCF) are the cash flows available (or free) for distributing to all of the firm's investors, including debtholders and shareholders.

-      The weighted average cost of capital (WACC) is the average required rate of return from all of the company's investors.

  1. Maximizing the firm's intrinsic value


By looking at the formula, we can see that there are two ways to maximize the firm's intrinsic value: by increasing the amount of expected free cash flows or decreasing the weighted average cost of capital. This resulted from three main decisions from the manager: 

-      Capital budgeting decision: evaluating the size, timing, and risk of future cash flow of long-term investments. This decision mainly aims to increase future FCF.

-      Working capital management decision: managing the firm's short-term assets and liabilities, including everyday financial activities, optimizing their productivities. This decision mainly aims to keep the firm staying financially healthy, and partly increase the potential future free cash flows.

-      Capital structure decision: maintaining the proportion of debt and equity in the firm while financing the money needed to fund investments. This decision mainly aims to decrease the WACC. The lower of the WACC means a higher amount of money when we discount future cash flows.

Before going deeper into each decision, it's essential to know some aspects affecting a financial manager's decision. Why we have to discount the money back to today's worth? That's because of one of three aspects when we consider the value of any investment in finance: the size of the expected cash flow, in which the bigger is, the better; the timing of the expected cash flow, in which the sooner the money, the better; and the risk of the expected, in which the less risk is, the better. We can easily understand that at any time, a more significant amount of money is always more desirable than a smaller amount of money. But what role does time or risk play in investors' decisions? We will answer this question separately.

Firstly, why timing is an important aspect when we evaluate the cash flows? That is because money has a time value.

  1. Time value of money

In life, we usually face a situation when we need to save money for future purposes or borrow money for present use. We then have to calculate the extra payment we receive or the interest we have to pay to the lender. This individual personal situation also applies to the corporate situation. In real life, the firm may face situations when it needs money and has to borrow it or when it has extra cash and invests money. Money has time value in which we prefer, the sooner the money received is, the better. Therefore, the small amount of money today may be equivalent to a more significant amount of money in the future. This also reflects one of three essential aspects of cash flow: the sooner the cash flow is, the better. 

The time value of money principle is one of the fundamental rules in finance. Only by doing that will we see if the projects generate more money than the amount we invest today. To evaluate different projects in a different time, we have to compare the money them in the same time frame. To assess the firm value today, we have to discount all of the future cash flow back to today's number; and to evaluate the firm value in a specific time in the future, we have to compound all of the firm's cash flows from now to that time. For any firm, their WACC represents their required return of money, and we use that as the discounted rate for the future cash flows of the firm. This concept is essential since most of the cash flows that drive the firm value are from the future. So, the time value of money helps us to consider, evaluate, optimize all of the firm's decisions. There are various kinds of cash flow from the future, for example, single cash flow, annuity, annuity due, perpetuity. For now, we would not go deep into calculations but understand the importance of time when evaluating money, since it is frequently used when evaluating the future cash flows or future projects.

  1. Risk and return

The second important aspect of evaluating investments is the risk of the cash flows. The risk is defined in finance as the chance that an outcome or investment's actual return will differ (bigger or smaller) from an expected outcome. The risk includes the possibility of losing some or all of the original investment. The higher the chance of a return deviate far (below or above) from the expected return, the higher the risk. In finance, we calculate the risk by using the standard deviation. The bigger standard deviation represents a bigger risk. The higher the risk, the higher the potential return, and the lower the risk, the lower the potential return. This does not mean that we should reject the high-risk investment, but we should understand the risk before investing and expect a higher return to compensate for the bigger risk. In general, when the financial manager evaluates investments, he or she should go for the lowest risk for the same amount of money return. 

The cost of capital, including the cost of debt and the cost of equity, is the money that the outside investors, including debtholders and shareholders, require when investing capital in the firm. Because they have different risks to face, they need different returns to their risks. We would go into risk and return when we calculate the WACC of the company. But for now, it is crucial that we grasp this concept to understand more about the capital structure decision of the firm financial managers.

In the corporate finance world, when calculating the risk of investment, all the formulae are based on the accumulated risk, with the base of the risk-free rate. The risk-free rate is the interest rate treasury bonds of the United States government. It is because we assume that the US government has no risk of going bankrupt. Basically, when investors do not invest their money, they face the risk of inflation, which means the money would worthless over time as the price of goods increases every year. As the US government controls the inflation rate using fiscal and monetary policy, investing in government treasuries will keep the money up with the inflation rate.

  1. Financial managers' main tools.

As we mentioned before, the financial manager has three main decisions to make: capital budgeting decision, capital structure management, and working capital management. We will go through all of the decisions in this paper from a short-term perspective to a long-term view. The working capital management decision is dealing more with the company's present state, or short-term resolution, while capital budgeting and capital structure management decisions deal with long term objectives of the firm. But first, we will talk about the main tools that a financial manager uses to do his job.

To analyze the company performance, to evaluate its progress, to compare the firm with the industry, and to navigate the company in the right direction in the future, financial managers have to use the firm's financial statements. The three primary financial statements reports are the income statement, balance sheet, and statement of cash flows. The financial statements are the historical records of the company over time, reflect the firm's activities and financial performance. These financial statements are the snapshots of the company at any particular time.

The first core financial statement of any firm is the income statement (exhibit 1), which shows us all of the company revenues, expenses, and ultimately profit or loss over a period of time. The first thing showed in the income statement is sales, which usually is the main income for any company. After deducting all the operating expenses, including the cost of goods sold, selling and administrative expenses, wages, and fixed assets depreciation, what we have left is Operating income. This figure measures the amount of profit realized by the firm's operations. After we include any non-operating income (such as gain or loss on a short-term investment, dividends from other firms), this figure becomes earnings before interest and taxes (EBIT). Since EBIT does not include interest expenses and taxes, we can see the first picture of how well the company is doing. A firm that generates increasing EBIT over time is an indicator of good operating. 

Next, the firm has to pay interest expense to debtholders, regardless they have profit or loss EBIT. As we mentioned before, debtholders also require a return on their lending money. They need interest expense paid back to them to compensate for the risk they have when lending the firm money. Since the loan is a contract between lender and borrower, the lender would be protected under law, and the interest expense incurred is required to pay back to the lender before the firm pays taxes. The amount of interest is fixed and written in the contract. 

After paying all the interest expenses, the firm will be left with taxable income. The amount of taxes is required by the government and different from industries to locations. Unlike interest expense, this tax amount is not fixed and subject to change as the government's tax policies change. Another difference from interest expense is that if the firm has negative taxable income, they will have tax refunds from the government. 

Finally, after paying taxes, the firm is left with net income. It indicates how much money the firm's revenue exceeds all of the expenses. Net income, or net earnings, will then be split into Dividends and Retained earnings. Dividends are the money that paid out to the equity holders. Retained earnings are they money reinvested back into the firm to fund its growth. 

The second financial statement is the balance sheet. Unlike the income statement, which shows the company operating performance over a period of time, the balance sheet is a snapshot of the firm at one specific moment. It displays the company's total assets, and how these assets are financed, through either debt or equity. The balance sheet is based on the fundamental equation that the total amount of assets is equal to the total amount of liabilities and the shareholders' equity. Furthermore, the items on the balance sheet are generally put in liquidity order, with the most liquid items on top and the least liquid items on the bottom. Based on those principles, the balance sheet is divided into two sections. The first section shows all of the company's assets, from current assets (cash, account receivables, inventories) to long-term assets such as property, plant, and equipment (PP&E). The second section shows the firm's liabilities, from current liabilities to long-term liabilities. It also shows shareholders' equity, which represents the amount of money invested in the firm from the owners; and retained earnings, which come from the net income. When compare the balance sheet from the beginning and the end of a period of time, we can see the decisions that a financial manager made. Working capital management decision is related to the current assets and current liabilities of the firm. Capital budgeting decisions can be seen from the firm's changes in fixed assets (PP&E). Capital structure decision is dealing with a mixture of long-term liabilities and shareholders' equity.

Statement of cash flows reports the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how money moved in and out of business. Cash flows during the time fall into three specific sections, which are operation activities, financing activities, and investing activities. These sections again represent three main decisions of the financial manager, which are working capital management, capital structure decision, and capital budgeting decision, respectively.

These financial statements are records for historical data of the company. By looking at these statements, the financial manager can find the information needed to calculate and evaluate all of his decisions. Using balance sheet, a financial manager can see the how well the firm operating over the period of time by using ratio analysis to calculate and make a working capital decision; he can also use the proportion of long-term debt and shareholder's equity to calculate the WACC for capital structure decision; and finally, he can calculate the free cash flows the firm has generated to make capital budgeting decision.

  1. Three main decisions of a financial manager 
  2. Working capital management decision

The first main decision of a financial manager is working capital management decisions. This decision deal with the firm's present and short-term perspective to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to the best effect. The result of good working capital management is that the firm will have sufficient cash flow to meet its current operating costs and current debt commitments. What is the networking capital? It is the difference between its short-term operating assets and short-term operating liabilities. Operating current assets are those short-term assets used to support the operations of a business. In most organizations, the key operating current assets are cash, accounts receivable, and inventory. Short-term liabilities are resulting from the primary business operations of a firm. They are non-interest bearing and comprise of accounts payable, accrued expenses, and income tax payable. The financial manager makes financial analysis of cash flows and operating working capital by applying ratio analysis through financial statements.

Ratio analysis

Ratio analysis is the quantitative analysis of financial information from the firm's financial statements. Ratios are important as they provide input for evaluating or comparing a firm to its past performance, its competitors, or the industry benchmark. They are useful not only for a financial manager to identify areas of weakness and strength but also for investors to determine creditworthiness and estimate future cash flows and risks. They also enable the financial manager and investors to drill down into specific aspects of the firm's operating standards. For example, the firm may have profit, but it has issues with cash or holds too much in account receivables or inventories. Financial ratios fall into five main categories depending on their parameters and the questions they answer.

- Liquidity ratios: these ratios answer if the firm can meet its short-term obligations using the resources it currently has on hand. They show the liquidity position of the firm. For example, the quick ratio tells how much cash they have to pay the current debt without changing in receivables and inventories, while the current ratio tells how much the total current assets compared to the current liabilities.

- Assets management ratios: these are measures of how efficiently a company day-to-day operations managing inventories, selling, and producing products or using assets to generate sales. For example, inventory turnover tells how long the firm produces its products since it has raw materials, while days sales outstanding (DSO) tells how long the firm collects its receivables. Fixed assets turnover measures how well the company turns assets into sales. 

- Debt management ratios: these ratios measure the flexibility of the firm to pay the long-term obligations and whether its earnings meet its debts servicing requirements. For example, debt ratio reflects the ability to use all assets to pay the debts; time interest earned ratio calculates how the firm's earning can pay its interest expense.

- Profitability ratios: these ratios convey how well a company can generate profits from its operations. For example, the net profit margin measures how much of the firm sales turns into profit, return on equity tells how much profit the firm generates from the money that shareholders gave them.

- Market value ratios: These are the most commonly used ratios in the fundamental analysis since they give investors prediction and valuation of future earnings and performance. Since these ratios involve market value, analysts often use them to compare the firm with its competitors and the industry in which it competes. For example, the price-to-earnings ratio indicates the relative value of a company's shares in an apples-to-apples comparison.

When we study the financial ratios, we should know that in order to evaluate them to gain insights, we need a benchmark. Usually, the benchmark is the industry averages or other competitors. Ratios are typically only comparable across firms within the same sector and the same industry. For example, a debt-equity ratio that might be normal for a financial services firm might be deemed unsustainably high for a technology company. While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.

Dupont analysis

The Dupont model is a framework for analyzing the fundamental performance of the firm by analyzing the main factors driving the profit. The model analyzes the profitability ratio return on equity (ROE) by decomposing it into three main metrics: operating efficiency, assets-use efficiency, and leverage efficiency. The Dupont analysis is expanded ROE by multiplying net profit margin by assets turnover by equity multiplier. As we said before, the paper would not go into detailed calculations, but we would go for the valuable applications of this equation. It enables managers to identify the main drivers of the firm profit; therefore, identify the strengths and weaknesses in operation. Investors also can use this model to compare the operating efficiency with other firms within the industry.

Calculating free cash flows

One of the important uses of these financial statements for managers is to calculate the free cash flows (FCF). The firm's free cash flow is the cash available for investors (debtholders and shareholders) after the firm making necessary investments in operating capital. In other words, FCF is the net operating profit after taxes (NOPAT) deducting from the required investments in operating capital (RIOC). From the income statement, NOPAT is calculated as a measure of profit that excludes the costs and tax benefits of debt financing or, in short, the earnings before interest and taxes but adjusted for the impact of taxes. During its operations, the firm needs to pay its operating expenses, and also invest in some assets. From the balance sheet, the required investments in operating capital (RIOC) are calculated as the difference between the current operating assets and current operating liabilities plus the changes in the company capital expenditures. By subtracting the RIOC from the NOPAT, we get the FCF during the period of operating (usually one year). The ultimate objective of working capital management decisions is to maximize the free cash flows for the current year and in the future by optimizing the operating efficiency.

  1. Capital structure decision

The capital structure is a particular combination of debt and equity used by a company to finance its overall operations and growth. Financial managers make capital structure decisions based on a mixture of debt and equity. Each way of financing money has its own advantages and disadvantages, especially in risk and return, so financial managers have to make sure that the company has the right amount of debt and equity to lower the financial risk while increasing the return of the company. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, and retained earnings.

How a company finances money

There are two main ways for a firm to finance its money: liabilities or equities. These are reflected in the balance sheet. The money is used to buy company assets, which are also listed in the balance sheet. These assets are needed for any company to generate sales and, eventually, profit. However, how the company uses debt or equity to fund its operations and growth will pose distinct kinds of risk to investors. Therefore, investors require different payback as compensation. These paybacks are in the form of interest expense for debtholders or dividends for shareholders. However, since debtholders and shareholders face different risks than each other's, they have different returns and privileges.

  1. Debt financing

Debt is the first way that a company can raise money in the capital markets. A debt arrangement gives the firm permission to borrow money under the condition that it is to be paid back at a later date with interest. Debt allows a firm to purchase high-value assets without having the entire amount of cash on hand to make the purchase. As we see before, in the income statement, the firm is required to pay interest expenses to debtholders first before it pays taxes. Debtholders are also the first ones to claim the company assets if the company goes bankrupt. Therefore, in the debtholders' perspective, investing by lending money is less risky than investing by buying the firm's equity. Also, when the firm issues bonds or takes loans, this process is faster and easier; this makes the cost of debt is usually less than the cost of equity. Company benefits from debt because not only debt helps lower the cost of capital but also allows a company to retain ownership, unlike equity. The cost of debt is driven by the default risk of the firm, and the risk-free rate of the market. When the firm holds the higher debt, it faces a higher chance of bankruptcy since the operating income it generates maybe not enough to pay its interest rate. There are two main ways company finances by debt: bonds or loans.

-      Bonds

Bond is a fixed income security contract between individual investors and the firm. It is called fixed income because the borrower (the firm) has to pay the investors fixed interest payments (known as coupon payments) and principle, on specific dates, until maturity, to the holders of the bond. Bond has a face value, usually at $1000, coupon interest rate, coupon dates payment usually as semiannual, and maturity when the firm has to pay the face value. The price of the bond is driven by the law of supply and demand. The attractive bond gets more demand from the investors and therefore has a higher price and vice versa. The bond's coupon rate is driven by the firm's credit quality and time to maturity. Bonds issued by firms with less credit quality or more default risks are less attractive to investors, and so bond with longer time to maturity because of interest change risk and inflation risk. Therefore, these bonds have a higher coupon interest rate. After investors buy bonds from companies, they can trade them with others. Changes in market interest rates make bonds more or less attractive to other investors. Applying the law of demand and supply, if the bond's coupon rate is higher than the market rates, then it becomes more attractive to investors, then its price goes up. These bonds will then be sold higher than its par value and called premium bonds. Oppositely, bonds with coupon rates lower market rates will be sold at a lower price and called a discount bond.

-      Loans

A loan is also a debt contract between borrower and lender. It also enables the borrower to finance the money by payback the interest and principal in the future. However, loans are typically issued by a bank, financial institutions, and governments. These debtholders also consider the firm's financial risk when they lend money. The higher default risk of the firm needs a higher interest rate to compensate. Banks usually use leverage ratios and liquidity ratios to determine the risk of the company.

  1. Equity financing

Equity financing is the process of raising capital through the sale of shares. Equity allows outside investors to take partial ownership of the company through buying preferred stocks or common stocks. When the firm issue new shares, it incurs flotation such as underwriting fees, legal fees, and registration fees. Issuing equity is more expensive than issuing debt due to its flotation cost. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings or interest rates is high. When a company goes bankrupt, shareholders are the last ones to claim the company's assets. They are also the last ones to receive their return through dividends. As a result, they are exposed to higher risk than debtholders and require the higher return of the company. In other words, shareholders have a claim on future earnings as well as the management of the company. There are two types of equity in the company that represents different privileges and, therefore, risk.

Preferred stocks

Preferred stockholders are the owners of the firm, just like common stockholders. However, preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. However, preferred stockholders usually have no or limited right to vote the board of directors in corporate firms. If the firm goes bankrupt, then the preferred stockholders have a better claim of the firm's assets than common stockholders but less claim than debtholders. Also, in the situation that firm temporarily suspends its dividends, preferred stockholders would have the right to receive dividends payout first before common stockholders when the firm resumes distributing dividends. Because of this uniqueness of privileges, preferred stockholders have a higher risk than debtholders but less risk than common stockholders. Therefore, their required returns are more than debtholders but less than common stockholders. 

Common stocks

When we mention stocks or equity, common stocks are the most "common" stocks issued by firms. Common stock represents ownership in the firm. The owners of common stock have the right to elect their board of directors and vote on company policies. Thus, common stock owners indirectly manage the company. If the firm goes bankrupt, common stockholders are the last ones to claim the company's assets after debtholders and equity holders. This makes it riskier to hold common stocks than preferred stocks and bonds. Their risks and privileges make their required return on common stocks the highest. However, common stockholders will have the highest yield of return when the company performs well.

CAPM

The Capital Asset Pricing Model (CAPM) is the model used to calculate the required rate of return from equity holders or the cost of equity. The idea is that when investors consider investing in the stock, they have to know the risk and, therefore, the return based on the specific risk of the firm and the industry in which it competes. The risk-free rate is the rate of government treasuries in which investors find the return every year without having the risk of default (the government has no risk of bankruptcy). CAPM is an evolving model that uses the risk-free rate as the base and the multiplication of market-rate premium and Beta. Market rate premium is the difference in the return between market and risk-free assets, while Beta is the measurement of the risk of the stock compared to the market. A higher beta means a risker company to invest. Using the CAPM model, we can estimate the cost of equity of a specific firm.

WACC

The weighted average cost of capital (WACC) is the ultimate estimation of the firm cost of capital. The cost of capital, as explained before, is the required return on investment of investors in the company. However, since different investors have different risk, their rates of return are different. Thus, to calculate the firm's overall rate of return, we have to take into account the proportion of each category of capital. The WACC is calculated from all sources of capital, including the cost of debt (bonds' coupon rate, loans' interest rate…) and cost of equity (preferred stocks' rate and common stocks' rate). The WACC tells us about the overall risk of the firm. An increase firm's risk from investors' perspective would result in an increase in WACC. 

Modigliani-Miller Theorem and tax shield

The M&M theory suggests that in the presence of corporate taxes, the use of debt is useful because the firm can lower the WACC. To answer why we have to see the difference between debt finance and equity finance.

Firstly, the cost of debt is usually lower than the cost of equity. Therefore, when an unleveraged firm uses debt to finance its operating capital, the WACC would initially decrease. However, as the debt level in the firm increases, the default risk of the firm increases. When the shareholders see a higher risk from the firm, they increase their required rate of return to match their risk. Ultimately, the cost of equity goes up and balances out the decrease from the low cost of debt. Thus, the WACC stays the same. 

However, since the interest expenses are deductible from taxes, this makes a tax shield that the cost of debt is adjusted and actually lower than the cost of debt before taxes. Consequently, the WACC would decrease when a firm issues debt. This doesn't mean the firm could go for a high proportion of debt because firms that have high proportion debt are exposed to high default risk, and debt investors would see more risk and increase their required return.

The M&M theorem suggests that there would be a proper debt and equity proportion that will bring the WACC down since the increase in the cost of debt will not offset the tax shield effect. Ultimately, the objective of capital structure decisions from financial managers is to find this level of debt and equity to minimize the WACC and consequently maximize the firm's value.

  1. Capital budgeting decision

As many CEOs said, most of their time is spent to make capital budgeting decisions. In fact, this is the most difficult and time-consuming decision of financial managers. Capital budgeting is the process where financial managers undertake various methods to evaluate potential major projects or investments. As mentioned before, the stock price of the firm today reflects the expectation of the firm's future performance. Therefore, the capital budgeting decision plays a significant role in driving the stock price today, thus, driving the shareholders' wealth.

This decision is challenging because, in order to evaluate investments and projects in the future, financial managers have to make various assumptions about the firm and the projects in the future. As part of the decision, they have to estimate projects' lifetime cash inflows and outflows to determine if the potential returns that would be generated meet a sufficient target benchmark. All of the figures have to be forecasted with multiple assumptions, which include the firm's future WACC. The ultimate estimation is forecasting the project's incremental cash flows.

The project's incremental cash flows are the additional free cash flows (FCF) that the firm will be received from taking on the investments. Positive incremental cash flow is a good indicator that the firm should invest in the project as it increases the free cash flow. Incremental cash flow is calculated by subtracting the cash outflows from the cash inflows of the project. To find the precise incremental cash flow, financial managers have to take into account of assets purchases and depreciation, changes in working capital, sunk costs, opportunity costs, externalities, and revenue.

Theoretically, the firm should invest in any project that has positive incremental cash flows. However, since the firm has limited resources such as capital, labors, and risk tolerance, it cannot take just pursue any or all projects that increase the firm's value. Additionally, projects may be independent, if the cash flows of one are not affected by the acceptance of others, or projects may be mutually exclusive if the cash flows of one can be adversely affected by the acceptance of others. The firm can take multiple independent projects but only one mutually exclusive one at a time. Because of that, the firm needs several methods to evaluate the best investments.


  1. Conclusion

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