Corporate Finance concerns the financial decisions managers of firms have to make. It can be split in two basic questions:
- What real assets should the firm invest in? Capital budgeting (investment decisions) is a process a business undertakes to evaluate potential investment projects which require investment in real assets such as land, plant, machinery and new product development.
- How should the real assets be financed? The financing decisions (capital structure decisions) considers both, debt and equity (share capital) that are going to be used to finance the investments required in a project.
FORMS OF BUSINESS ORGANISATIONS
Most large businesses are organised in the form of limited liability companies or corporations. The form of organising a business affects first of all, the source of the finances available and secondly, the conflicts of interests that might arise within an organisation between the partners.
Proprietorship is the simplest form. It is owned and run by one single person which is called the proprietor. The limitations from the financial perspective is that the funding of the firm only can be provided by the sole proprietor. Also, the firm is legally not separated from the proprietor which means that the owner is unlimited liable with personal assets if the proprietorship firm is unable to pay. Therefore, the proprietorship firm is also not limited, and the liability of the firm is no restricted to the capital that has been invested. Nevertheless, proprietorships are simple to start with, there is very limited regulations and the income is taxed together with that of the proprietor’s income.
A partnership firm can have several partners who contribute to the capital of the firm. This enables the firm to raise more capital than one single person in a proprietorship. As well as in the proprietorship, in a partnership firm the personal assets of the partners are unlimited liable to repay debts. However, there are venture capital funds where the general partners (venture capital manager) who actively manage have unlimited liability and the investors (limited partner) have limited liability.
A corporation is a legal entity separated from its owner which makes it possible to enter into contracts. The corporation is liable for itself and cannot be transferred to the shareholders. Therefore, the owners or shareholders are limited liable and are taxed separately from the corporation. However, this might lead to a double taxation – the profit earned by the company will be taxed and the dividends paid to the shareholders too. Corporations make it possible that people can invest in the company even if they are not directly involved in managing the company. This enables the corporation to raise large numbers of money which then supports investments in the company’s expansion.
History of corporations
In the 1600s the spice trade between East Asia and other countries was very profitable but required large numbers of money to finance the business. Additionally, it was very risky to ship the goods. In that time only the ones who were involved in running the business and knew about what was going on within the company, invested because the risk of losing money due to the unlimited liability was very high. The first step into the direction of limited liabilities made the British-owned company “United East Indian Company” in 1623. This enabled the company to raise a large amount of money to finance their fleet of ships, trade with East Asia and to overtake other firms. This was the first step into the direction of having the opportunity to raise finances beyond what has been possible so far and to undertake large and risky ventures. Nowadays, most large companies are organised as corporations. However, the large number of investors brings challenges with it.
ABOUT THE ROLE OF A FINANCE MANAGER
The finance manager plays an important role in helping the firm to raise finances and invest these funds in projects that create value for the firm and its shareholders. There are different goals the finance manager has to perform.
- Management between firm and investors (providers of capital): Either through financial markets such as equity and bond markets or through financial institutions as debts funds in the form of a loan from commercial banks or other financial institutions. The finance manager helps the firm to understand and meet expectations of the investors.
- Management of the firm’s funds. Internally is what has been generated from the operations. Externally concerns the funds raised from investors. The finance manager helps to invest the funds in different projects within the firms so that it is ensured that the projects generate adequate value to meet the expectations of the firm’s investors.
- Advising top management on what to do with the cash flows: The finance managers helps to decide whether the firm should reinvest the funds in the business or return the funds to the investors. The decision to reinvest depends on the availability of attractive investment opportunities for the firm.
In the case of funds raised from investors in the form of debt, there is a mandated repayment that has to be paid in the from of interest and principal. In the case of funds raised from investors in the form of equity, there are no minimum dividends required however investors might expect dividends.
ASSETS AND SOURCES OF FUNDS
The balance sheet provides information about the assets a firm owns on a specific date and how they have been funded. In order to finance the assets, the firm needs the same amount in total liabilities and equity -> Total assets = Equity + Total Liabilities
EQUITY AND LIABILITIES
Shareholders’ funds include
- initial capital that shareholders have invested
- retained earnings (capital that has been reinvested)
Tangible and intangibles assets: Tangible (land, plant, machinery, warehouses, office buildings, transport equipment) and intangible (technical expertise, know-how, brands, patents). Particularly for technological firms’ intangible assets can provide a competitive advantage. Current assets are short term assets which exist one year or less. Examples would be receivables, cash and balance. The two major sources of funds in a firm are debt and equity. Debt is the money borrowed from investors and there have to be paid interest and principal. Debt can be borrowed in the form of a loan or bonds. The investors have priorities of being paid by the firm and if the company is not able to pay the investors can force it into bankruptcy. On the other hand, equity is provided by shareholders and there is no minimum re-payment required. Equity investors get a share of profits, can elect members of board directors, benefit from dividends if there are any, profit from share price increases, however bear the risk of losing their investment.
Separation of Ownership and Management
While being able to raise a significant amount of resources from large group of investors, it causes separation between the owners of the firm that is the shareholders and the management. This separation has advantages and disadvantages. A benefit is that the firm is being managed by professional managers who are selected for their ability. On the other hand, there is the principal-agent problem or also called agency-costs. That problem arises where an agent (manager) has to make decisions on behalf of the principal (shareholders) and the incentives of the agent and principal to do not align with each other. Also, the shareholders do not have the same information that mangers have resulting in information asymmetry between the principal and the agent. In such a situation, mangers may not work in the best interest of the shareholders. One of the challenges for large corporations is to align the interest of the mangers with that of the shareholders. There is actually a mechanism used by firms to help satisfying both interests. This is made by issuing stock options to managers. These stocks options provide the mangers the possibility to purchase share of the company at a pre-determined price. If stock prices then increase, the managers gain from it. This provides incentives for the mangers to put in more effort and manage the firm to create value which will result in an increase in the share price.
The corporation and the stock market
The first issue of share to the general public is called Initial Public Offering (IPO). On the stock market the investors can buy and sell shares and therefore supports firms to raise equity capital and provide liquidity to shares issued by the firm. Market capitalisation… .. of a firm is the market value of the equity share issued by the firm .. of a stock market is the sum of market capitalisations of all the firms listed on the exchange. Average daily turnover is the total turnover of share bought and sold on an exchange in a year divided by the number of days of trading in a year. The average daily turnover is a measure of the liquidity in an exchange because it measures the average value of shares transacted on a typical day on an exchange.
In my opinion corporate finance is one of the most important division of a business because matters such as financing, capital structuring and investment decisions are indispensable for a successful firm. As it focuses on maximising shareholder value through long and short-term financial planning and the implementation of various strategies while balancing risk and profitability – it helps to stand out from the competition. Additionally, I believe all of the different business forms do have their advantages and disadvantages. It depends on the size of the business, number of partners, liability, taxation, fund raising abilities and organisational and management structure. Considering all of these points the decision has to be made. For example, the liability – how much risk am I willing to take? The liability includes different aspects such as the relation between the partners, the riskiness of the market itself, the number of employees and the personal situation (house, family, children). It helps to make a decision by taking all of the mentioned points into account and weigh which form makes sense the most.
Provided PDF’s and videos: Introduction (1), Forms of business organisation (2), Role of the finance manager (3), Assets and sources of funds (4), Separation of ownership and management (5), The corporation and the stock market (6).