An Overview of Corporate Finance
Take a quick overview of Corporate Finance subject, and get familiar to basic financial terms. It is very useful to study Mathematical Finance.the value of the firm to the owner.
To start a firm you need to make an investment in assets such as inventory, machinery, land and labor. This is called investment decision. And, you can finance your investment by borrowing and selling some shares of the firm. This is called financing decision. And, when your firm begins operation, it will generate cash. This is the basis of value creation. The purpose of the firm is to create value for the owner.
Corporate Finance is the study of investment and financing decision making, and how should a firm manage its short-term operating cash flows in order to increase the value of the firm to the owner.
Business can take many forms. But, the three basic forms are:
- The Sole Proprietorship
- The Partnership
- The Corporation
The Sole Proprietorship
A sole proprietorship is a business owned by one person. The person, owner, is liable for all business debts and obligations. And, the profits of the business are taxed as individual income.
When two or more people get together to carry out business, they form a partnership. The partners (except limited partners who have limited liability) are liable for all business debts and obligations. The profits of the business are taxed as personal income to the partners.
The two main advantages of the sole proprietorship and the partnership are that it is easy to start with limited budget and have to pay taxes only on personal incomes. But, it is difficult for large business to exist as a sole proprietorships or partnerships, because of:
- Unlimited liabilities to the sole proprietors and the partners
- Limited life of the business, as it depends on the life, mood and the circumstances of the sole proprietors or the partners
- Difficulty of transferring ownership, and
- Limited budget and difficulty in raising cash
So, to carry out large businesses, usually corporations are formed.
How corporations are formed?
Suppose you decide to start a firm to make some goods. To do this you hire managers to buy raw material, and you assemble a work force that will produce and sell finished goods. You can finance your investment by borrowing and selling some shares of the firm. A large corporation may have hundreds of thousands of shareholders, who become owners of the fraction of the firm by their fraction of investment. And your business set-up is called a "corporation".
What is a corporation?
A corporation is a legal entity owned by its shareholders and run by its managers. According to the law, it is a legal person that is owned by its shareholders. As a legal person, a corporation can have a name and enjoy many of the legal powers of natural persons. The corporation can make contracts, carry on a business, borrow or lend money, and sue or be sued. One corporation can make a takeover bid for another and then merge the two businesses. Corporations pay taxes but cannot vote!
Functions of a corporation
Corporations invest in real assets, which generate cash inflows and income. The shareholders, who own the corporation, want its managers, who run the corporation, to maximize its overall value and the current price of its shares.
To maximize the value for the owners, corporations face two principal decisions:
- Investment decision: what investments should the corporation make?
- Financing decision: how should it pay for the investments?
The investment decision is one of the two principal decisions a corporation has to take. The investment decisions of a corporation are of two types:
1. Smaller Investment Decisions
Corporations make thousands of smaller and simpler investment decisions every year. These investments decisions are for example purchase of a vehicle, machine tools or any other regular running equipment. Usually managers themselves take these decisions.
2. Larger Investment Decisions
Larger investment decisions are also called capital budgeting or capital expenditure (CAPEX) because usually these investments list in a company's annual budget. Managers do not take these decisions by themselves only. These decisions are taken after intensive research, in consultation with engineering, manufacturing and marketing department, and with the approval of board of governance.
The investment decision is the first principal decision a corporation has to take. The second is financing decision which means how to raise money for this investment. A corporation can raise money from:
- Lenders, and
A. Borrowing Money from Lenders
A corporation can borrow money from:
- Issuing Bonds
A corporation can borrow money from a bank, where the corporation has to repay the cash back plus a fixed rate of interest for the use of capital.
A corporation can also borrow by issuing bonds. In this case, the corporation also has to repay the cash back plus a fixed rate of interest for the use of capital.
The corporations often pay interest rate to bond holders less than the interest rate they have to pay to the banks. However, it is very difficult for young corporations to sell their bonds. So, usually they have to rely on bank loans.
Corporations can raise money either by:
Reinvesting the cash flow in the shape profits. In this case the corporation is investing on behalf of existing shareholders.
Issuing new shares. The investors who buy new shares contribute cash in exchange for a fraction of the corporation's future cash flow and profits.
In both the cases the shareholders are equity investors, who contribute equity financing.
Shareholders who own the company are called principals and management who runs the company on behalf of the shareholders are called shareholder's agents.
Conflicts between shareholders and management's objectives create agency problem. Because, shareholders' main priority involves seeking new investments to raise share value, while management may pursue job security, corporate luxury, and high compensation at the expense of shareholders.
Conflicts of interests between principal and agent results in agency cost which include:
Corporate expenditure that benefits management, but costs stockholders. For example, a company buying an unneeded corporate jet.
The expense that arises from the need to monitor management actions. For example, an outside auditor hired to review financial statements.
Lost opportunities. For example, a company not taking a merger which could benefit the shareholders but not the management.
How to Mitigate Agency Problem?
Agency problems are mitigated by good systems of corporate governance. The most important measure is managerial compensation which could gather the interests of shareholders and management. For example, managers are spurred on by incentive schemes that produce big return if shareholders gain but are valueless if they do not. Besides, managers who pursue shareholders' goals are in greater demand.
Basic Financial terms in Corporate and Mathematical Finance
Selection of assets, risk and return, and portfolio analysis
View the online notes for Financial Mathematics (CT1)
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