Corporate Finance
By Finance Club, IIT Roorkee on The Capital
Bankers are just like anybody else, except richer. — Odgen Nash
Disclaimer: This blog can in no way be treated as a complete and exhaustive introduction to Corporate Finance. The purpose of this blog is to give you a head start in this direction. Rest depends on how much you are willing to learn and explore. Regularly follow news updates and market events and cultivate a habit of reading A LOT.
Corporate Finance is defined as an area of finance that deals with the methodology of managing a corporation so as to increase its value. It majorly outlines and portrays the analysis underpinning 3 major company decisions-
1.) Investing in projects which could offer the best return on investment (ROI) or those projects which could generate synergies with existing investments or could pave the way for the growth of the company.
2.) Financing these investments in company projects by raising capital through the best possible routes (debt/equity)
3.) Distributing the profits to shareholders of the company in forms of dividend or reinvesting in the company again if deemed best providing greater capital appreciation to investors
However, principles of corporate finance can be applied to any decision which involves the use of money, even in small, privately run businesses (for ex. a stationery shop in your locality or an independent bookstore).
The primary objective of corporate finance is to maximize or increase shareholder value. For publicly traded firms, the objective narrows down to maximizing stock price!
Since the subject of this blog is vast and complicated, we will give a brief introduction to corporate governance and the first principles of corporate finance. Then, we will discuss one of the first principles in detail. Rest, we will carry on in upcoming blogs on corporate finance.
BASICS OF CORPORATE STRUCTURE
The shareholders are the investors in a corporation. In true sense, they are the owners of the corporate business. Thus the purpose of corporate governance is to increase the shareholders’ value.
In an attempt to create a corporation in which stockholders’ interests are looked after, firms follow either one-tier or two-tier corporate hierarchical structures.
The one-tier structure is the Anglo-American model, while the two-tier structure is the German model. Generally, firms in India, the US, and the UK follow the one-tier structure, while the two-tier model has been adopted by Germany, China, Indonesia, etc.
Let us look a bit closely at the two-tier corporate hierarchy followed by the one-tier system:
TWO TIER STRUCTURE
A two-tier structure consists of two separate boards: (1) a supervisory board, which is primarily composed of non-executive directors, and (2) a management (executive) board, which is composed of executive directors. The supervisory board oversees the management board.
Board of Directors
Are elected by the shareholders, to represent their interests in the functioning of the corporation. The role of the board is to monitor a corporation’s management team, represent the interests of the shareholders and employees, review business decisions, and nominate the Executive and decide their compensation.
Board members can be divided into three categories:
Chairman: The Chairman is responsible for running the board smoothly, and effectively. The Chairman is elected from the board of directors. In a two-tier system, the role of the Chairman is to preside over and moderate the board meetings and ensure the smooth communication between the Board and the Executive Managers.
Inside Directors: Inside directors are either shareholders or high-level managers from within the company. They are mainly responsible for reviewing high-level business decisions and generally participate directly in the decision-making process since they are employees of the firm.
Outside Directors: Outside directors are not related to the firm ie. they are neither investors nor employees of the firm. They should ideally outnumber the Inside Directors. They share the responsibilities of the directors (although they generally do not have the capacity to intimately participate in the decision-making process) but are additionally tasked to present one unbiased view that is independent of the management.
Management Team
The top tier management team is nominated by the board of directors. It consists of highly valued employees in the company who are responsible for implementing board decisions in a seamless manner. The management team may be voted out if the board or the shareholders are not satisfied with the results.
The Top Management conventionally consists of the following main positions:
Chief Executive Officer (CEO): As the top manager, the CEO is typically responsible for the corporation’s entire functioning ranging from the operations to revenues to financing and reports directly to the board of directors.
Chief Operations Officer (COO): Responsible for the corporation’s operations, the COO looks after issues related to marketing, sales, production, and personnel. Reports directly to the CEO.
Chief Financial Officer (CFO): Also reports directly to the CEO, the CFO is responsible for managing the financials of the firm. He/She is responsible for maintaining daily cash cycles, long term liabilities, etc.
ONE TIER STRUCTURE
This structure generally lends more flexibility and independence to the Top Management. The main advantage of this setup over the former is that it relatively speeds up the decision-making process and thus improves the efficiency of the firms. However, in years following the 2008 Financial crises, the one-tier structure has been subject to manifold regulations so that management can be kept under check and thus preventing them from resorting to making overzealous decisions. Even in India, this structure received a lot of flak following the Satyam Scandal, and several lawyers and accountants are calling for the implementation of the two-tier system.
The one-tier system only consists of one board, which consists of the executive members as well as the outside directors. The CEO is the chairman of the board, and every decision is subject to the approval of the board.
The one-tier system generally is not very accommodative of the shareholders, thus reflective of the free-market capitalism of the US and other western countries. While the two-tier system is more inclusive for the workers and the shareholders, thus reflective of the worker-centric ethics of Eastern Europe.
THE FIRST PRINCIPLES OF CORPORATE FINANCE
Suppose you are a manager at a corporation, and you have a proposed investment opportunity. So the first decision you need to make is whether or not to pursue this opportunity. Also, if you have more than one proposed opportunity, then you need to rank those opportunities and choose the optimal one. The investing principle helps you to make these decisions. Once you choose the right opportunity, you need to make a decision regarding financing the opportunity. You might use the shareholders’ money (Equity) or borrowed money (debt) or both. Now, The financing principle comes into the picture. It helps you to choose the optimal mix of equity and debt for your project. You invest in the project and the company earns a profit. Now, you need to decide how much of the earnings you want to reinvest into the business and how much money you want to return to owners (shareholders). The dividend principle helps you in making this decision. The above-mentioned principles are the foundation of corporate finance. Let’s discuss the investing principle in detail.
The Investing Principle
While we introduced the investing principle, you might have figured out that to choose the right project, we must price each of these investment projects and come up with a descriptive number known as the Rate of Return. We implement a project only if its estimated Rate of Return is greater than a benchmark rate or hurdle rate.
What is the Hurdle Rate and how do we price a decision?
Hurdle rate can be defined as the lowest rate of return that the project must earn in order to offset the costs of the investment. The hurdle rate is established keeping in mind the risk associated and how leveraged the company is (measured through the leverage ratio, which demonstrates the fraction of capital financed through debt). Once the hurdle rate is established, we need to value the projects and rank them.
Sadly for finance enthusiasts, there is no magic recipe to do that. There are various available techniques which are weighed accordingly as per the requirements. However, the most widely used strategies are Net present value (NPV) and Internal rate of return (IRR).
Net present value(NPV): As the name suggests, NPV is the present value of the future cash flows on the project(negative as well as positive), net of the initial investment. The present value of future cash flows is obtained using the DCF formula. If you are not familiar with the DCF formula click here. The general formulation of NPV is as follows:
Where
CFt = Cash flow in period t
r = required rate of return for the investment or hurdle rate
N = life of the project
Let’s take an example:
Consider a project with an initial investment of ₹1000 crores, and expected cash flows of ₹200 crores in year 1, ₹300 crores in year 2,₹500 crores in year 3, and ₹600 crores in year 4. Assuming the required rate of return to be 10%, we can calculate the present value of the future cash flows and NPV.
For year 1, the present value of cash flow = 200/(1 + 0.1)¹= ₹181.8 crores. Similarly, the present value of cash flow in year 2, year 3, and year 4 is ₹247.9 crores, ₹375.6 crores, and ₹409.8 crores respectively.
NPV of project = 181.8 + 247.9 + 375.6 + 409.8–1000 = ₹215.1 crores. This implies that if we invest in this project we will acquire an investment with the present value of ₹1215.1 crores at the cost of ₹1000 crores. You might have noticed that NPV is actually the amount by which the investor’s wealth increases as a result of the investment. Thus, NPV suggests a very simple rule:
Invest in a project if NPV is positive and don’t invest if NPV is negative.
If there are many proposed projects, we can rank them according to their NPV. Now, let’s discuss another very popular technique to evaluate a project. It is actually linked with NPV and is also a DCF based technique.
Internal rate of return(IRR): In general terms, the IRR of a project is the discounting rate that makes the NPV of a project equal to zero. Thus, the NPV equation can be expressed as :
We can solve the above-mentioned equation to calculate IRR. Try to find the IRR of the proposed project in the previous example using the trial and error method or a financial calculator. The IRR comes out to be 17.94%. It is greater than the hurdle rate of 10%.
Making decisions or ranking projects based on IRR is also very simple. Invest in a project if IRR is greater than the hurdle rate and don’t if it is less than the hurdle rate. In case we have more than one proposed project we can rank them based on their IRR. It might have noticed that IRR is a root of the NPV equation. So, the equation may have more than one root or no root at all. In those cases, we stick to the NPV technique. If there is no root then you can easily evaluate the project by just looking for the sign of NPV.
We also need to investigate a crucial case. Suppose you have two projects with different cash flow patterns. Is it possible that NPV rule and IRR rule rank them differently? Yes, it is. Let’s revisit the example we discussed earlier. Suppose there is another project (let’s call them Project A and Project B respectively).
NPV(Project B) > NPV(Project A)
IRR(Project A) > IRR(Project B)
While NPV of Project B is greater than Project A, The IRR of Project A is greater than Project B. In these cases, we should choose the project having greater NPV. The reason for this decision is quite simple. Mathematically, whenever we discount a cash flow at a particular discount rate, we implicitly assume that we can reinvest a cash flow at that same discount rate. In NPV calculation, we discount cash flows at the hurdle rate (in our example at 10%) while in IRR calculation we discount cash flows at IRR (in our example at 17.94% and 17.39%). Can we reinvest the cash inflows from the projects at 10%, or 17.94%, or 17.39%? When we assume the required rate of return is 10%, we are assuming an opportunity cost of 10% — that we can either find other projects that pay a 10 % return or payback our sources of capital that cost us 10%.
The fact that we earned 17.94% in Project A or 17.39% in Project B does not mean that we can reinvest future cash flows at those rates. (In fact, if we can reinvest future cash flows at 17.94% or 17.39%, these should have been used as our required rate of return instead of 10 percent.) Because the NPV criterion uses the most realistic discount rate — the opportunity cost of funds — the NPV criterion should be preferred if NPV and IRR criterion rank projects differently. There are few other techniques like payback period or decision rules based on accounting income and cash flows. The payback period is sometimes used as a secondary criterion for ranking projects.
Apart from the rate of return, other side costs and side benefits are also considered while evaluating a project. For ex., if an online streaming services providing company enters a new market, it provides a new market for the existing content and new content for its existing markets. The opportunity cost of using existing resources in a new project can be considered as a side cost.
In our next blog on this subject, we will drive into the details of the financing and dividend principles and finally present a primer as to how exactly decisions are implemented in the corporate world.
We hope this brief and gentle introduction will be enough to get you started in this direction. We really would recommend you to go through the given links and try to come in terms with how decisions are really weighed and made. Since these are turbulent and unprecedented times, we think in the immediate future there will be a surge in demand for core-finance specialists to help companies out of recession. So go on reading and exploring until we come up with the next blog.
Important Links
Suggested reading: Introduction to Corporate Finance
Capital Structure: Capital Structure Definition
Capital Budgeting: Capital Budgeting Definition
Net Working Capital: Working Capital (NWC) Definition
