Introduction
The understanding with clarity the term, “Corporate Finance” is necessary to put the topic in its correct perspective by knowing the meaning of the word “Corporate” defined in all dictionaries as the “formation, belonging or pertaining to a body of individuals with or without a purpose”. Combining this with the word finance and “eureka”, it means money, money and more money, and strikes all without doubt as the collective management of money and making of money! In a crude manner of saying it, that is what all financial corporations are for and how all financial corporations are measured.
The world of international corporate finance is a unique and specific place where all financial dealings are based on corporate decision making with the usage of all the tools and analytical decision making powers at their disposal.
The purpose and aims of all corporations are to ensure that without taking excessive financial risks, their corporate value is enhanced. To achieve these goals, corporate finance institutions use all resources available to them to help them with their financial business dealing and undertakings with specialised expertise. Among the various tools used by financial corporations is also the one to develop relationships in other areas from where capital can be availed, such as from partnerships, proprietorships, not-for-profit institutions, governments, mutual funds and personal wealth management entities. As corporations deal in vast quantities of monies based on corporate decisions in comparison to investments by individuals, we can analytically differentiate with ease between the public financing and private financing systems.
For the success and efficient running of any markets, its participants within the corporate finance sectors and outside must have the knowledge to correctly price the commodities they deal in. Their expertise and innovation to timely make decisions to their advantage based on the information they gather, research on and assess as viable financial investments makes them the very forces around which the economy and market is based upon and revolves around.
Background to Global Financial Markets
While the history of corporate finance in historical terms has been neglected and research texts are difficult to find on them with regard to the development of enterprises. What little historical literature on corporate finance is available has been surprising and shockingly undervalued. As a consequence major events in the setting up of big businesses have never been fully revealed. One reason for this may be because most of the initiators of such businesses may never have realised how large their businesses would eventually grow. Besides these facts, even scholars have not fully realised the importance of corporate finance and not put use their “investigative grey cells” into overdrive for drawing proper conclusions over the financial revolutions of past times.
Businesses have flourished and capitals have flowed between countries through out the world since centuries. With the passage of time, money centres all around the world were invented and innovative practices adopted for the practically managing capital along corporate lines. The demands of the changing times encouraged the creation and further development of national monetary units being controlled by central banks, together with privately owned commercial banks, institutions and insurance companies.
Working Methodologies
Corporate finance managers enjoy a broader base from where they use many different techniques available to them to manage capital in all kinds of businesses including the private and public sectors. They also have the option of doing these businesses in their local market or in the international markets.
The strategic planning of all financial corporations are goals-oriented and based on short-term, medium-term and long-term targets. These plans are implemented into decisive choice actions for investments into projects, equity, lending and borrowing and other viable ventures and the profits made through the investments are paid out as dividends to their shareholders. While the long term investments are allocated as “capital investments” and short-term investments are considered as “working capital”, the focus of all financial corporations has also to be on their current levels of assets, liabilities and inventories.
Some of the tools that financial corporation use are briefly defined as the following:
Capital Investment Decisions
Fixed assets and capital structuring are generally associated with long-term investments and decisions taken by financial corporations in these matters are considered as “Capital Investment Decisions” based on the various inter-related criteria of the corporation. Investments in financially appropriate projects therefore, are with the intention of maximizing the “net present value” of the investments made. If investments incur losses, they reflect negatively on the management of the financial corporation as the stakes of their shareholders loose value, thus capital investment decisions comprise of a strategic investment decision, financing decision and a dividend based decision.
Investment Decisions
The investment decisions are based upon the limitation bound allocated resources at the disposal of the management of financial corporations. The capital budgeting process identifies viable opportune projects based on the estimating of the value of expected returns in relation to its size, time frame and predicted cash flows.
All project values are estimated as at discounted cash flow rates and its expected highest value is taken as the “net present value”, while the likely minimum acceptable rates are considered as the “hurdle rates”. The “option value”, thus is the difference between the opposing extremes between the “net present value” and the “hurdle value”. Thus the deciding of the appropriate discounted rates are of critical important for the success or failure of the financial corporations.
In easy words, the “net present values” reflect the amount of investment put in with profits and the “hurdle rate” reflects the amount of investment minus the incurred losses. Two of the most commonly used models to work out the “option values” inherent to projects are the “Decision Tree Analysis” and the “Real Option” analytic tools. With the decision tree method of analysis, all possible stimulated mocked up scenarios generate branches or paths and with the later analysis are made on stimulated mock event scenarios without the generation of branches and paths. These models indicate in differing manners the generation of all values for evaluations of the projects. Finance corporations to make similar value evaluations depending upon their preference and choice also use other models.
The Financing Decision
All financial corporations base their financing decisions on the cardinal law that their investments are correctly managed. As such, the cash flow based on the hurdle rate is calculated as the maximum risks that corporations can take. Therefore, an optimal mix for investment has to be estimated for financing of projects structured to result in maximizing profits or in other words maximizing the net present value. In general financing sources are combined with equities and debts resulting in projects financing being weighted with liabilities. The servicing costs of these liabilities have also to be taken into consideration regardless of the projects making profits or incurring losses.
While equity financing is considered comparatively less risky, it dilutes ownership and earnings. The main disadvantage of equity financing is that during negative periods the dilution in ownership and earnings result in exaggerated increased hurdle rates which may offset the cash flow and an all possibility end up costing more than the liability servicing costs. In the financing decision making process, the corporate management must also try to align the financing mix to the asset in which investments are being made as closely as possible.
The Dividend Decision
While dividends are calculated on the basis of a company’s inappropriate profits and business prospect forecasts for the whole of the next coming year, finance corporations have to decide to invest in additional projects or reinvest in their existing operations or return the free cash as dividends to their shareholders. In case of there being negative net present values, managements have to return remaining excess cash after all business expenses have been met to their investors. However, in such cases managements may also consider investment flexibility or potential payoffs or even buy-back shares from the investors. Uninterrupted cash flows of finance corporations are a must at all times.
Working Capital Management
The working capital management decisions on short term financing are dependent on a company’s short-term assets and short-term liabilities. The aim of the working capital management is to make certain that a company has sufficient cash flow and can smoothly continue its operations and have the ability to meet the requirements of its maturing short-term debts and upcoming expected operational expenses. The decisive criteria of working capital management are based on a company’s short-term reversible decision policy in relation to the coming one year period dependence on cash flows and profitability. The managers of working capital consider the managing cash with them, convertibles, inventories and debtors as its current assets with short term financing like cash flows and returns also taken into account.
The development of strategic plans to measures and manage financial risks like the fluctuations in the prices of commodities, interest rates, exchange rates, stock prices and unforeseen scenarios can have an important impact on cash management. Therefore all risk factors are also taken into consideration when working out the estimates for projects.
Approaches and Effects
The enhancement and successes of corporate finance sectors reflect the health and soundness of the economies of countries and their sustainable development levels. Therefore the strengthening of the corporate governance is essential for creating environments conducive for attraction of investments and industrialization. Invigorating economic health in a chain-reaction motivates good governance practices leading to easier and better capital from investors confident of earning better results even at premium investment costs in emerging markets. Success breeds confidence and the flow of easy capital ensures that businesses run well managed with transparency and fair practices for all stakeholders in booming times.
In such exciting environments, reputed international companies and multi-national companies also join the band-wagon and diversify their portfolios by establishing businesses leading to national and international economies being integrated more favorably. Economic development successes also encourage changes in regulation and legislative in stock exchanges, banking systems and government to be more favourable and advantageous to the interests of all members holding stakes in such markets.
Examples
Some success stories of the international finance corporation (IFC), a group of the world bank serving in the global financial markets utilises the following methods for issuance and implementation of financial instruments:
In Eastern Europe and Central Asia
IFC in private enterprise partnerships in Eastern Europe and Central Asia, is promoting the advancement of better corporate governance systems and practices by providing advisory services in Armenia, Azerbaijan, Georgia, Kazakhstan, Russia, and Ukraine”. These services are for the training and advise on governance issues like the improvement of corporate structures, issuance of shares and the conducting of regular shareholders meetings between managers, directors and shareholders.
Services are also provided for selecting companies and banks that are committed to improving their standards and in their pilot projects involved with more in-depth work. Assistance and guidance for the development of model documents is further provided to local companies and banks for their charters and bylaws. IFC also provides education in the corporate market to shareholders about their rights and trains university professors to develop corporate governance course materials. Furthermore, assistance is provided for conducting surveys of corporate governance practices and facilitates linkages with potential investors in these countries.
In Russia and Ukraine
In Russia and Ukraine more than 75 percents of the banks with which IFC worked opted to appoint independent directors on their boards. This enabled the banks to draw further investments through the vast experiences they had drawn from IFC training in the fields of financial management and corporate governance. It also helped these particular banks to be more competitive in the international markets through improved practices.
450 Million dollars investments were raised by Azerbaijan, Georgia, Russia and Ukraine through the participation of IFC corporate governance based projects due to the training and eventual improvements in their work practices. Because of the increasing awareness in the corporate finance world to achieve competitive edges for success, IFC conducted seminars to over 4000 companies and banks in Eastern Europe and Central Asia on corporate governance. These seminars achieved the purpose of ensuring that the skills of good governance by future managers and lawyers come into play.
University professors in more than 75 universities have been introduced to corporate governance subjects for inclusion in their curricula as subjects for students, thus educational institutions and the general public also have benefited from these training. Furthermore, journalists have been trained by IFC for accurate reporting on corporate governance matters. With the experiences gained from Eastern Europe and Central Asia, corporate governance works is further being expanded by IFC beyond these areas with renewed enthusiasm.
For instance, in Romania major shareholders in collaboration with IFC improved the operational efficiency and corporate governance of the Banca Commercials Roman’s through innovative steps of drafting a revised charter for the establishment of that banks new board of committee for auditing, compliance and compensation. Among the other changes made were the separation of the roles of the chief executive officer and the Chairman, and the introduction of two-tiered board structures plus the nomination of independent board members.
All this IFC technical assistance helped in the strengthening of the Banca Commercials Roman Bank’s governance systems and its framework of risk management. In December 2005, the acquisition of 61 percent of the Erste Bank of Austria worth 4.4 billion dollars was the largest banking privatization in Central and Eastern Europe and served as the beneficial evidences achieved through these steps.
Latin America
In Latin American countries of Brazil, Chile and Colombia, corporate governance reforms were recommended by IFC for developing healthy capital markets. Working together with big firms like CPFL energia and oderbrecht of Brazil and Suramericana group of Colombia, IFC collaborations helped in the improvement of governance for due recognition in their capital markets. The OECD Latin American Corporate Governance Roundtable as co-sponsors of IFC coordinates cooperation between business leaders, investors, government representatives, professionals and corporate governance members for developing reforming agendas for public and private sectors. In 2005, thirteen leading companies have adopted the recommended corporate governance norms principles of OECS and IFC in Latin America and gained impressively significant capital market and operational benefits.
In Other Regions
In the African and Asian countries of Egypt, China and Vietnam, IFC introduced itself through project models designed and developed in Russia and other places, which were launched as successful corporate governance programs.
With IFC focus now on more complex topics such as internal control in risk management etc., its work with government institutions and the private sectors for further developing specialized areas will help the developing markets continued progress towards reaching required levels of international practices.
Conclusion
Corporate finance covers every decision a corporate makes that can change the status of its finances and can therefore be based on the following points: The objective function defines what exactly the objective should be in the investment decision. The investment decision defines how a business can allocate required resources, keeping in view the prevalent competitions in the market. In the financial decision we examine sources for optimal mixing of finance to evaluate the taking up of a project or not. The dividend decision relates to whether a business should reinvest into its operations or return the excess cash it has to share-holders as dividends. And finally we have the valuation factor where all of the decisions made by a firm are based on the target achievement of the net present value.
We come to the final conclusion in its “nut-shell form” that to be successful leader in the corporate finance world, sound financial strength with precise knowledge about the working of the corporate structure is a pre-requisite. The capabilities to logically evaluate market opportunities and to make timely decisions and act upon them are a must to have an edge. Besides these qualities, the natural ability of feeling the market pulse with a forward looking view on the national and international chain of events that could change the environment scenarios for better or worse in the corporate finance world.
References
- An introduction to real options, Investment Analysts Society of South Africa Corporate finance – Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Corporate_finance Accessed February, 21 2007
- International Corporate Finance Training Course http://www.nyif.com/courses/crpf_5001.html Accessed February, 21 2007
- International Finance Corporation – Promoting Corporate Governance for Sustainable Development http://www.gcgf.org/ Accessed February, 21 2007
- IFC News – Press Releases & Features Promotes Stronger Corporate Governance http://www.ifc.org/ifcext/media.nsf/Content/Corp_Governance Accessed February, 21 2007
- IFC News – Press Releases & Features IFC News http://www.ifc.org/ifcext/media.nsf Accessed February, 21 2007
- Organization for Economic Co-operation and Development http://www.oecd.org/ Accessed February, 21 2007
- Principals of Corporate Finance 6th Edition – Brealey and Myers http://www.mhhe.com/business/finance/bm/toc.mhtml Accessed February, 21 2007
- The World Bank http://www.worldbank.org/ Accessed February, 21 2007
