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The Fundamentals of Corporate Finance

2019-05-20 来源: 51due教员组 类别: Essay范文

下面为大家整理一篇优秀的essay代写范文- The Fundamentals of Corporate Finance,供大家参考学习,这篇论文讨论了公司财务。公司财务是研究公司中与货币相关的决策,包括资本投资、资本融资、资本结构、短期流动性等。公司财务关注的是对公司资本管理的研究,随着时间的推移,它会有新的研究和发现。公司财务中的某些问题,如资本结构问题,仍然缺乏精确的公式和严谨的理论。虽然遵循公司财务的基本原则和公认的做法是有益的,但比较不同的方法和参考各种资源也很重要。

Corporate Finance,公司财务,essay代写,作业代写,代写

Corporate finance is the study of money-related decisions in corporations, which encompass capital investments, capital financing, capital structure, short-term liquidity, and so on. The primary goal of corporate finance is to maximize the value of the company to its shareholders through multiple channels, such as maximizing profits, minimizing costs, maximizing market share and establishing sustainable competitive advantage in the industry (Lecture 1 page 5). The subject of corporate finance also consists of a series of analytical tools that enable managers and other stakeholders to take measures to allocate a company’s financial resources in an optimal way so as to achieve this ultimate objective (Giddy 2008). This paper is to describe and discuss the principles of corporate finance and major concepts and theories. As such, this paper is to be divided into three sections, each section focusing on each of the three principles of corporate finance. Under each section are descriptions and practical examples of the concepts and theories following the principle. To go into more depth, this paper will also compare and contrast related theories and practices and analyze the pros and cons. The objective of the paper is to give an overview of the important components of corporate finance and elaborate on a few of those wherever appropriate.

1. The Investment Principle

The first principle of corporate finance is to invest in assets and projects that would yield a return greater than the minimum acceptable hurdle rate (Lecture 1 page 3). In layperson’s term, the cost of investment must exceed the return of investment or otherwise the action would not make economic sense. The return of capital is most commonly and widely measured by cash flow, with time factored into the equation. The value of money does not stand still, but rather it changes with time. The time value of money denotes that money at the present is worth more than the exact amount of money in the future, because the money in the now holds the potential to earn more money over time. The earning capacity of money derives from interest, which is the amount a lender charges a borrower for the use of his or her assets. The rate of interest is typically expressed as a percentage of principal, noted on an annual basis, which is known as the annual percentage rate or APR. In financial equations, interest rate is expressed as “r” and it explains the differences between cash flows along the spectrum of the timeline; in another frame of thought, interest rate discounts cash amounts in points of the future back to the present baseline and the discounted value represents the opportunity cost of time. For instance, if you have 3000 dollars in the bank and the current bank rate is 2%, you have the choice of spending the money on a trip to the Caribbean or keeping it in your savings account. If you keep the money in the bank, in a year you would have 3060 dollars, earning 60 dollars of interest. If you decide to blow it on a winter vacation, you would have nothing in the bank in a year. The 60 dollars is the opportunity cost of your choice. Now, a friend wants to borrow the 3000 dollars and promises to pay you back 3100 dollars in a year. Should you lend it to her? Purely from the perspective of the investment principle, you should because if you discount 3100 dollars, which is the future value of your investment, with the bank rate 2%, the present value would be 3039.21 dollars, which is more than the 3000 dollars you have. Therefore, the net present value is 39.21 dollars, which is a positive return. As illustrated by the example, net present value is simply the present value of the expected cash flow minus the the principal or the cost of investment. When the NPV is positive, the investment is worthwhile; and to pick the most profitable investment assets or project, the investor should choose the one with the highest NPV.

Slightly different from the example, corporations mostly have multiple cash flows over many periods of time, one period usually being one financial year. In addition, interested rate compounds over time, with some compound annually and some semi-annually. To calculate the present value of all expected future cash flows of a company, corporate finance introduces the method called discounted cash flow analysis (Appendix 1). The DCF analysis is also commonly used for stock valuation as it discounts the profits that the stock will bring to the shareholders in the foreseeable future (Sharpe 1978). The DCF can be used with a broad range of firms, and for firms with a stable and predictable dividend payouts, there is another major stock valuation method called discounted discount model, which we will discuss in the third section. The period of time “n” goes on to infinity and the discount rate r often uses WACC, an important concept soon to follow in the paper. Furthermore, there exists another criterion for the return of investment called the internal rate of return or IRR. Instead of applying “r” as a given, the IRR method sets the NPV to zero to arrive at “r”. In this case, “r” is the internal rate of return and used as a benchmark to the discount prevailing in the market. When the IRR is bigger than the discount rate, the investment is a yes; otherwise it is a no.

On the other end of the investment principle lies the hurdle rate or the cost of investment. One way to understand the cost of capital is that it is the opportunity cost of funds for the lenders of the capital (Lecture 2 page 3). As company’s capital typically consists of shareholders’ equity and debt and they each come at a cost for the company. To compute the cost, a company can calculate the cost of equity and the cost of debt separately and get the weighted average of these costs. This method is called the weighted average cost of capital, or WACC, and the formula looks like this: WACC = wdrd (1-t) + wprp +were. Wd is the weight of debt, wp is the weight of preferred stock and we is the weight of equity, t is company tax rate. For example, if a company has 40% of its capital in debt, which has an interest of 7%, and the remaining in equity which pays a dividend of 10%, no preferred stock, the tax rate is 20%, by simple arithmetics we can calculate WACC to be 0.182. WACC is a significant concept for it has many hats in corporate finance. In addition to signify the opportunity cost of capital, it also indicates the risk of a firm’s future cash flow. Moreover, the weightings of debt and equity reflects the composition of a firm’s capital structure, which we will discuss shortly.

2. The Financing Principle

One of the most fundamental rules of investment is the higher the risk, the higher the yield and vice versa. Although in theory risk and yield go hand in hand, in practice, managers at corporations should control risks and maximize the value of capital by choosing the appropriate mix of debt and equity. In order to control for risks and increase capital value, we must first measure the risk and return of a firm’s capital.

A company’s capital is a portfolio of different assets which primarily consists of debt and equity. There exist a few probable rates of return such as recession, normal and boom. To solve for the expected return of the portfolio, we must first solve for the expected return of each asset followed by calculating the weighted average of all the possible scenarios. Using expected rate of return of each asset, we can further calculate the squared deviation of the rates of return in each scenario and arrive at the variance and standard deviation of each asset by getting the square root of variance (Lecture 3 page 6). The standard deviation is the measurement for risk; the higher the standard deviation, the riskier the asset. To arrive at the expected return of the portfolio, we compute the weighted average of the expected return of each individual asset using the formula rp=wBrB + wSrS,  in which rp stands for the return of the portfolio, rB that of bonds or debt, rS that of stocks or equity. The formula for calculating the risk of the portfolio is a little more complex and requires the covariance of the two assets:

Dividing the covariance of the two assets by the products of the two standard deviation, we get correlation of the two assets. In the equation above, pBS is the correlation coefficient. If the two assets are uncorrelated, for instance, the correlation coefficient would be zero; if they are positively correlated, the coefficient would range from zero to one; and if they are negatively correlated, the coefficient would range from minus one to zero. Therefore, it is obvious that negative correlation gives the lowest risk, and no correlation stands in the middle, while positive correlation results in the highest risk. Conventional wisdom tells us that the more diversified a portfolio, the less risky it is; in other words, by enhancing the diversification of the asset pool, a company can meaningfully reduce the standard deviation of the portfolio without affecting adversely its expected return, as shown in the graph (Appendix 2).

To delve deeper into the risk of a portfolio, the study of corporate finance breaks it down into two types, namely systematic risk and unsystematic risk. In the graph we see that as the number of assets increases, the risk curve takes on a downward sloping concave shape but it never goes to zero. Rather, the curve flattens out as the number of assets approaches infinity. The space between the flattened curve and the bottom of risk axis is systematic risk, which cannot be diversified away because it is embedded in the economy and affects almost all assets, such as GDP growth rate and the overnight rate (Lecture 1 page 23). In contrast, unsystematic risk affects a specific individual asset or a group of assets and can be reduced by diversification. For instance, stocks of a luxury consumer product company are exposed to risk of the company’s performance and this risk may be offset by stocks of a telecommunication company or bonds. Corporations can utilize this knowledge to allocate capital to obtain the most efficient portfolio of assets (Appendix 3).

To achieve the optimal portfolio, a company may also add risk-free assets into the mix, such as T-bills in the US. The financial officer of the company can select a point on the efficiency curve, as shown in Appendix 4, and connect this point with the risk-free point on the return axis, the consequent line represents the possibilities of the risk-free security and the selected risky asset combination. By moving along the line, the financial officer adjusts the percentage of the risk-free and risky assets in the portfolio. However, there exists one line, the capital market line, that gives superior returns at a fixed amount of risk to all the other lines and it is the tangent of the risky asset curve. The intersection between the CML and the efficiency curve is the market portfolio (Appendix 5). An informed financial officer creates a company’s capital portfolio along this line, given the company’s risk tolerance. For instance, if a company wants to shoot for higher returns at the expense of higher exposure to market risk, the portfolio would be higher along the line, and vice versa.

Despite that unsystematic risk could be minimized by a sufficiently diversified portfolio, as represented by the market portfolio, to compose the optimal capital portfolio, a company must understand and control the systematic risk of every security. The best measurement of systematic risk concurred by researchers is the Beta (Appendix 6). It quantifies the movement of an individual security to that of the market. With the Beta, we can calculate the expected return of an individual security from the known expected return of the market (Appendix 7). A Beta of zero means that the security does not respond to market movement, and therefore its expected return is equal to the risk-free rate. A Beta of one signifies that it mirror the movement of the market and would yield the market rate of return. A beta higher than 1 magnifies the movement of the market and would result in higher than market returns but also bigger than market losses.

The capital structure of a firm aims to minimize cost and risk exposure, maximize value and its debt to equity ratio should reflect the type of business it operates. The previous section has explained the role of WACC, so the changes in capital structure should strive to achieve the lowest WACC. Furthermore, it should also aim to obtain the highest value, which in the subject of corporate finance has a few parameters to choose from. The first one is return on equity, or ROE, which is net income divided by shareholder’s equity; the second one is return on assets, or ROA, which is net income divided by total assets; the third one is earnings per share, which is net income divided by outstanding common shares. A company should use a mixture of these parameters in accordance with company’s financial characteristics to get a comprehensive view of the company’s capital returns.

There’s no hard and fast rule when it comes to arriving at the best capital structure, nor is there a golden ratio between debt and equity. Rather, decisions about capital structure are determined by corporate taxes and specific financial distress. Modigliani and Miller devised a theory that significantly simplifies capital structure theory. Centering on leverage, which means the amount of debt a company uses to finance its capital, they proposed two propositions to evaluate how financial leverage affects a company’s market value. Proposition one assumes there are no taxes, in which case the capital structure of a company is irrelevant to its market value. Proposition two assumes taxes exist, where higher financial leverage brings up the cost of equity on a linear function (Lecture 3 page 11). Moreover, the tax advantage of debt can be offset by the costs of financial distress resulting from taking on debt. These could be a mix of monitoring cost, bonding costs, residual loss, agency cost, asymmetric information cost and so forth (Lecture 3 page 31 - 33). All in all, when determining and adjusting a company’s capital structure, one must consider a set of factors, which include the company’s business, taxes, governance, financial transparency and the tangibility of its assets (Lecture 3 page 38).

The Dividend Principle

The last major principle of corporate finance is the dividend principle. It states that if the residual income is not enough to make investment that can make more than the hurdle rate, distribute the cash to shareholders through either dividends or stock buybacks. Dividend is the cash amount a company gives to shareholders on a specific date and is usually expressed as dollars per share or as a percentage of EPS (Lecture 5 page 6). Dividend payouts may affect stock price and the effects would depend on the market’s attitude toward the payouts.

Three theories exist to explain the relationships between dividend payouts and stock prices. The first one refers back to Modigliani and Miller’s theory which states that investors are indifferent to dividend payouts and retention-based capital gains, rendering dividend irrelevant to the stock price. However, it must be pointed out the assumptions of this theory, that there are no taxes and no other agency costs, are unlikely to happen in reality. The next one states that investors welcome payout and like higher payout better than lower payout. This group investors are usually averse to risk and considers dividends more secure than future capital gains. In this instance, dividends are not only relevant to stock prices but higher dividends bring forth higher stock prices. The last one considers taxes to be a high factor and that investors prefer a lower dividend payout. For this group of investors, who have higher degrees of risk tolerance, dividend differed equates to long-term capital gains. In this case, higher dividends can lead to lower stock prices.

From the position of the corporation, how much cash to give out as dividend has to match the specific profile of the firm’s capital budget. A company should have both a capital budget and a target equity ratio, the product of which results in earnings needed to be retained. Subtracting retained earnings from net income yields the amount that should be distributed as dividends. This is the essence of the residual dividend model. The economic rational for the cash distribution is so that the company can avoid incurring cost to issue new equity, which is called floatation cost. The very action of dividend payouts sends signals to the market about the company management’s view of the business and the future. For example, if a company increases its dividend, it shows the market that it is confident that its earnings will keep strong in the foreseeable future. Using next year’s dividend, the discounted dividend model sheds light on the stock value of the company, following the equation: stock value = dividend per share/ cost of equity - dividend growth rate. However, it is important to keep in mind that this model is only suitable for company that has a stable and regular dividend payout as it requires the input of a dividend growth rate.

Final Thoughts

Corporate finance focuses on the study of capital management of firms and it evolves over time with new research and findings. Certain questions in corporate finance still lack precise formulas and rigorous theories, such as those of capital structure. While it is useful to follow the fundamental principles and recognized practices in corporate finance, it is also important to compare different approaches and refer to various resources.

References

Course Lectures 1-5

Giddy, Ian, Briefing onThe Five Principles of Corporate Finance, New York University, 2008. Retrieved from http://pages.stern.nyu.edu/~igiddy/articles/five_principles.htm on December 6, 2017.

Sharpe, William F, Investments, Prentice-Hall, 1978, pp. 300

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