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Joshua Vernazza May 14

,
2014
Everything we do for one goal
In today’s capitalist economy, most economic growth is heavily accomplished by
businesses. Businesses impact the economy by adding value to the economy. These gains arise
from a series of investments made by a wider range of beings and entity’s. Businesses in all
their various stages rely greatly on corporate finance to play and finance their investments and
projects. As businesses start to grow, the importance becomes more significant and
pronounced. A firm’s primary objective is to increase the wealth of its shareholders, corporate
finance plays a vital role in achieving this goal.
The primary goal of corporate finance is to maximize shareholder value. What we mean
when we want to maximize shareholder value is what management’s objective is to maximize
the fundamental price of the firm’s common stock, not just the current market price. Even
though firms do have other objectives “in particular, the managers who make the actual
decisions are interested in their own personal satisfaction, in their employees’ welfare, and in
the good of their communities and of society at large,” management focus primarily on
maximizing shareholder value. (10) There is no one way to maximize shareholder value, it can
be done over the long-term or the short-term and through other methods, so the job of the
finance is to determine how best to do both. There are times that these goals may appear to be
in competition with one another.
In a company corporate financers are devoted to the task of figuring out how to allocate
assets for the overarching goal of maximizing shareholder value. They must ensure that the
right assets are in the right place at the right time. They must also manage the company's
liabilities so that all projects are financed in an optimal way without taking on too much risk.
Corporate financers must determine when a company should take on a liability. This is relevant
when a firm has multiple projects with the likelihood they will be successful and must decide
whether they should finance multiple projects by taking on debt, equity or a combination of
both. Finally, they must make sure an organization is to make sure that money is at the right
place at the right time. A company wants to have enough money to pay its bills, but also wants
to invest so that it can grow in the future. Corporate finance assists in the formation of new
businesses, and allows businesses to take advantage of opportunities to grow. The strategic
use of financial instruments, such as loans and investments, is key to the success of every
business. They must overall be dedicated to figuring out how to allocate assets to do so, for the
overarching goal of maximizing shareholder value. To achieve these goals corporate financers
rely on corporate finance theory to help them make these decisions.
The link between these decisions and firm value can be made by recognizing a
company’s ability to generate cash flows now and in the future. This brings about an important
topic about corporate finance: the time value of money. One of the underlying theory of
finance is the concept that the value of a dollar today is higher than one in the future. That is
that the value of a firm is the present value of its expected cash flows, discounted back at a rate
that reflects both the riskiness of the projects of the firm and the financing mix used to finance
them. (Cite) Shareholders form expectations about future cash flows based on observed
current cash flows and expected future growth, which in turn depend on the quality of the
firm’s projects and the amount reinvested back into the business. The financing judgments
affect the value of a firm through both the discount rate and potentially through the expected
cash flows. This means that management’s way affect shareholder wealth is to alter the free
cash flows of a business project and to alter the discount rate.
In particular, corporate finance is the area of finance dealing with the sources of funding
and the capital structure of corporations and the actions that managers take to increase the
value of the firm to the shareholders, as well as the tools and analysis used to allocate financial
resources. (Book) This various aspects of corporate finance work together to overall maximize
the shareholder wealth. We will focus on mainly four aspects of corporate finance: capital
budgeting, capital structure, and working capital management and dividend policy. Earlier we
noted that a firm’s value is determined by present value of its expected cash flows, discounted
back at a rate that reflects both the riskiness of the projects of the firm and the financing mix
used to finance them. Capital budgeting deals with a firms planning process in determining the
value of project, capital structure deals with the cost incurred by a firm to finance these
projects, working capital deals with a firm ability to stay on top of its liabilities and dividend
policy deals with the payment of a cash dividend in the present or paying an increased dividend
at a later stage. These four aspects affect the valuation of a firm directly and indirectly by
affecting each other.
To understand the complex relation between one another we must first go over some
basic principles that corporate finance builds on. We must first understand the time value of
money, the relationship between risk and return and stock valuation. The time value of money
is a very important concept that allows us factor in the act that the value of money fluctuates
over time. We can use this relation to allow to discount money to compare cash flows at
different points in time. The time value of money is very useful, but it’s limited in how it helps
us take on risk. The time value of money is very useful as a comparison tool. Around the 1950’s
a few economists came up with what we now know as the Capital asset pricing model. The
capital asset pricing model is a model that describes the relationship between risk and expected
return. This model is very important because it allows us to use it as a measure to which we can
justify the risk we take. It allows us to determine if the reward we get from taking on extra risk
is worth it. This model is not only relevant for businesses in its search for more capital, but it’s
also useful for investors. The introduction of these concepts became very controversial when
they were introduced but now define how we think of corporate finance. The discovery of the
Capital Asset Pricing Model (CAMP) was awarded with the 1990 Noble Prize. Now that we have
the tools that facilitate the analysis of decisions in a business we can proceed.
We will start of talking about capital budgeting as a firms planning methodology of
investments and projects relating to a company’s funding through and affecting the firm's
capital structure. Company managers must use the firm's limited resources between a set of
projects, this makes up the main focus of capital budgeting. Capital budgeting is based on the
same procedures that are used in security valuation, but with two major differences. (381)
However, firms actually create capital budgeting projects, so capital budgeting involves project
creation. Second, most investors have no influence over the cash flows produced by their
investments, whereas corporations do have a major influence on their projects’ results. This
influence is what brings about the creating d capital budgeting.
Capital budgeting is also concerned with the setting of criteria about which projects
should receive investment funding to increase the value of the firm, and whether to finance
that investment with equity or debt capital. Investments should be made on the basis of value-
added to the future of the corporation. If companies execute their plans well, then capital
budgeting projects will be successful, but poor execution will lead to project failures. Poorly
executed projects, as we will see, affect business in multiple ways, such as through loss in the
cost of capital needed to raise the funds in the first place but as well the uncaptured cash
outflows. Still, in both security analysis and capital budgeting, we forecast a set of cash flows,
find the present value of those flows, and then make the investment if and only if the PV of the
future expected cash flows exceeds the investment’s cost.
A firm’s growth, and even its ability to remain competitive and to survive, depends on a
constant flow of ideas for new products, improvements in existing products, and ways to
operate more efficiently. Accordingly, well-managed firms go to great lengths to develop good
capital budgeting proposals. Firm use capital budgeting to analyze need for the following needs:
replacement needed to continue profitable operations, replacement to reduce costs, expansion
of existing products or markets, expansion into new products or markets, contraction decisions,
safety and/or environmental projects and mergers. (601)
Choosing between capital budgeting projects may be based upon several inter-related
criteria. 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. Therefore, the following procedures have been established for screening
projects and deciding which to accept or reject: Net Present Value, Internal Rate of Return,
Modified Internal Rate of Return, Profitability Index, Regular Payback and Discounted Payback.
We will note that net present value is the single best criterion because it provides a direct
measure of the value a projects add to shareholders wealth (book). Although these models are
useful it is important that financers don’t solely reply on the models. It is important not to use
them as the sole criterion but at the same time it is foolish to ignore their results.
The next aspect of corporate finance that is very important to maximizing the value of
the firm is capital structure. The capital structure decision affects financial risk and, hence, the
value of the company. The capital structure theory helps us understand the factors most
important in the relationship between capital structure and the value of the company. The
theory of capital structure is heavily tied with the weighted average cost of capital. The
weighted average cost of capital is the cost we pay for financing our projects. We can break up
our cost of capital into the weighted average of cost of debt, the cost of common equity raised,
and the cost of external equity.
Managers choose the capital structure so that it maximizes shareholders’ wealth. The
basic approach taken is done by considering a trial capital structure, based on the market
values of the debt and equity, and then estimate the wealth of the shareholders under that
capital structure. That approach is repeated until an optimal capital structure is identified.
There are several steps in the analysis of each potential capital structure: estimating the
interest rate the firm will pay, estimating the cost of equity, estimating the weighted average
cost of capital, estimating the value of operations, which is the present value of free cash flows
discounted by the new WACC. (610) The objective is to find the amount of debt financing that
maximizes the value of operations. As we will show, this is also the capital structure that
maximizes shareholder wealth and the intrinsic stock price.
A very important aspect to understanding the important of capital structure is the
inverse relation between risk and interest. If we think of our weighed average cost of capital,
we see that our cost of capital relies on both debt and equity. It becomes important to consider
risk, such a business risk and financial risk when one goes about choosing a capital structure.
Business risk deals in particular with the successfulness of a business and thus is related to
equity, while financial risk takes the risk to a new level by injecting leverage into the equation.
We will now focus on those aspects of corporate finance that deal with decisions that
affect the short term. We want to make sure we are financially sound in the present so we can
work on the future. Working capital management deals with what is the appropriate amount of
working capital, both in total and for each specific account, and how the working capital should
be financed. Note that sound working capital management goes beyond corporate finance.
Indeed, improving the firm’s working capital position generally comes from improvements in
the operating divisions, but in reality improvements in working capital management are limited
to the technology of the time. Corporate finance comes into play in evaluating how effective
the firm’s operating departments are relative to other firms in its industry and also in
evaluating the profitability of alternative proposals for improving working capital management.
In addition, financial managers decide how much cash their companies should keep on hand
and how much short-term financing should be used to finance their working capital.
A very important concept in corporate finance is net operating working capital. Net
operating working capital is defined as current operating assets minus current operating
liabilities. The net operating cost of working capital is equal to cash required in operations,
accounts receivable, and inventories, less accounts payable and accruals. A traditional measure
of a company’s liquidity and potential for growth. It helps a company see how stable and liquid
it is to meet it demands for cash due to operations. (642)
Similarly to working capital management dividend policy has an impact on the short
term value of firm. The firm itself determines how much to give their shareholders and most
businesses would undoubtedly like to have unlimited investment opportunities that yield
returns exceeding their hurdle rates, but all businesses grow and mature. As a consequence,
every business that thrives reaches a stage in its life when the cash flows generated by existing
investments is greater than the funds needed to take on good investments. At that point, this
business has to figure out ways to return the excess cash to owners.
The discussion of dividend policy, we introduce the basic trade-off that determines
whether cash should be left in a business or taken out of it. For stockholders in publicly traded
firms, we note that this decision is fundamentally one of whether they trust the managers of
the firms with their cash, and much of this trust is based on how well these managers have
invested funds in the past. Finally we must consider how management must also choose the
form of the dividend distribution, generally as cash dividends or via a share buyback. (Book)
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.
We have gone through the different aspects of corporate finance. We can also see how
each different aspect deals with a different aspect of the company overall, that is to say
particular braches of corporate finance are responsible for maintaining a particular role of the
company in check. We see how each aspect is very important at keeping the company in a
healthy status. They all work together and are important as a whole.
Now we can go back to maximizing the shareholder’s wealth and we can show how each
different aspect work sat maximizing shareholder wealth. Two aspect which are very closely
tied are capital budgeting and capital structure. If we consider the fact that firm’s value is
determined by present value of its expected cash flows, discounted back at a rate that reflects
both the riskiness of the projects of the firm and the financing mix used to finance then we
quickly see that capital budgeting and capital structure strongly affect the price. We see that
making capital budgeting decisions that increase the free cash flows a firm receives in the long
term and I the short term. This shows us that capital budgeting can maximize shareholder
wealth by making investment and projects that give a positive value.
We now switch to capital structure and the weighted average cost of capital. We see
that lowering the average cost of a capital of a firm has a direct impact on the value of them
form. A company’s weighed average cost of capital is a weighted average of its cost of equity
and its cost of debt. A firm must made smart decision to find the point at which it can take
advantage of debt as a form of financing, but not to the point that the leverage makes it too
risky. As to maximizing shareholder wealth, management can’t research and take on projects
that make the company generate more cash flow. Financial management can work on a capital
structure that lowers its weighted average cost of capital so that the present value of the firm
increases.
Overall corporate fiancé encompasses a large set of principles that businesses must look
over and follow so that a company is in a healthy status. We have gone over four main types:
capital budgeting, capital structure, and working capital management and dividend policy. They
each have a role in helping the organization We should also note that much of these governing
divisions in a company’s financial groups couldn’t not have been attained thank to a few
theoretical financial concepts: time value of money and the capital asset pricing model. All
these pieces come together and allow us to accomplish the one object we want: maximizes
shareholder wealth.














Works Cited
Brigham, Eugene F., and Michael C. Ehrhardt. Financial Management: Theory and Practice.
Mason, OH: South-Western Cengage Learning, 2011. Print.