A PRIMER ON CORPORATE FINANCE DECISIONS
KIRAN KUMAR K V
In the remarkably transformed global business and financial environment, the opportunities and challenges for the corporate finance practitioners has elevated to a newer and more complex state. In response, shareholder value has become the central corporate agenda and corporates are becoming more focused on value creation (Chandra, Strategic Financial Management: Managing for Value Creation, 2014).
Corporate Finance Decisions are few of the important areas of executive decision making that have not just a bearing on the value creation, but, also has the power to erode the value (or value erosion). Few such decisions are accountably taken by the finance heads of the companies, who may be designated Chief Financial Officer (CFO), Finance Controller, Treasury Manager, and Finance Director and so on. These decisions include decisions on project acceptance, financing structure, cost tracing and control, enterprise risk management, financials of mergers and acquisitions, dividend pay-out policies, leasing financials, working capital control and other major financially implicating decisions.
Through this article I am attempting to summarise the different corporate finance decisions that have such value creating potential for corporates. I have also tried to gather some information of how these corporate finance decisions are being practised in the real world, through a selective literature review.
Value Creating corporate finance decisions
Discussed below are few decisions that pose a certain alternates to the decision maker, especially when she is a corporate finance manager:
Objective setting in terms of performance parameter:
Even though the shareholder value maximisation becomes the ultimate objective of the executive decision makers of the company, it still is a broader term when it comes to setting periodic performance target. For instance, there are few decisions, the results of which in terms of value creation occurs after few years or many a times the value created may not be direct. Given that the vision of the organisation needs to be achieved through a series of shorter term objective setting, there requires a measurable, numeric and concrete measure of performance, that is also time bound. Various such measures are proposed by researchers, consultants and industry practitioners:
i). Total Shareholder Return (TSR)
iii). Economic Value Added
iv). Enterprise Discounted Cash Flow
viii). Earnings before Interest, Tax, Depreciation and Amortisation
x). Cash Earnings per Share
The corporate objective approach has moved from a mere revenue maximising or profit maximising goal to a broader perspective. Corporates are better off targeting maximisation shareholder wealth. Extension of this is the stakeholder theory, which argues that managers should make decisions taking into consideration of the interest of all stakeholders of the firm. Triple Bottom Line approach suggested by John Elkington seeks to measure organisational performance in terms of three criteria viz., economic (Profit), ecological (Planet) and social (Profit).
Capital Budgeting Decisions:
Generally referring to the decisions pertaining to the capital expenditure requiring project evaluation, capital budgeting begins the financial process of determining the viability of the pursuance of a given project choice. Capital budgeting decisions are an all-important area of corporate finance because it creates accountability and measurability on the decision makers. Any business that seeks to invest its resources in a project, without an understanding of the risks and returns involved would be held as irresponsible by its owners and other stakeholders. A generic process of capital budgeting starts with developing and formulating long-term strategic goals, then seeking out new investment projects, estimating the future cash flows, evaluating the viability of projects and creating the decision. Few questions that need to be answered in the process are regarding the project cost, time horizon of the project, exclusivity of the project with other alternatives and the cost of financing the project. There are multiple techniques of project appraisal suggested by researchers and academicians and also being practiced by the corporate finance practitioners. The three common and basic techniques are (1) Break-Even Analysis (2) Payback Period (3) Net Present Value or NPV (4) Internal Rate of Return or IRR. Most other methods are modified versions of the above three methods. For instance, Modified Internal rate of Return or MIRR is a technique similar to IRR, but with a relaxation an assumption of IRR, i.e., with regards to the reinvestment rate being constant throughout the project time period.
Frameworks based on discounted cash flow techniques like net present value, internal rate of return, discounted payback period with modifications around the same are highly discussed in addition to non-discounted cash flow techniques like payback period, accounting rate of return, return on investment, financial breakeven point and incremental cash flow analysis.
Estimating of Cost of Equity:
The cost of capital is the rate of return that the suppliers of capital – bondholders and owners – require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted average of these costs.
The various sources of financing include equity, preference and debt. Computing the cost of preference and debt are less ambiguous as the expectation of suppliers of such capital is quite clearly reflected in the rate of dividend or interest in the contract. The issue is with computing the cost of equity, as the investors’ required rate is not clearly expressed as each investor has his own risk-return utility function and each of their expectations differ. Therefore, certain models like Dividend Yield Model, Earnings Yield Model, Capital Asset Pricing Model, Dividend Discount Model, Bond Yield plus Risk Premium Model, Three Factor Model, Five Factor Model etc., are proposed by researchers.
Another challenge of estimating cost of capital is with respect to the weights to be considered. Ideally, one must use the proportion of each source of capital that the company would use in the project or company. Few approaches to compute such weights can be numerated as below: (1) Target Capital Structure Weights (2) Current Book Value Weights (3) Current Market Value Weights (4) Average of Comparable Companies Target Capital Structure Weights
Capital Assets Pricing Model (CAPM) is a highly advocated model for estimating cost of equity, whereas models like dividend discount model, five factor model, three-factor model, arbitrage pricing theory, earnings yield approach and bond yield plus risk premium approach are also discussed in academic platforms.
Choice of Sources of Long-term Financing:
Specifically addressing the issue of financing the funding requirement of long-term capital expenditures of the companies, despite differences in company size and structure, we can identify the below three broad sources of financing: (1) Retaining the Earnings (2) Borrowing from Outsiders (3) Sharing of ownership. There are individual types of securities within each of these categories and many innovative products like mezzanine financing are also making their ways into this arena.
With the basic concept of optimum capital structure as a canon, firms use ROI-ROE analysis, Leverage Analysis, Ratio Analysis and other comparative analysis frameworks.
A dividend is a distribution paid to shareholders based on the number of shares owned. Dividends are declared by a corporation’s board of directors, whose actions may require approval by shareholders or may not require such approval. In contrast to the payment of interest and principal on a bond by its issuer, the payment of dividend is discretionary rather than a legal obligation and may be limited to by legal statutes and by debt contract p[provisions. Taken together, cash dividends and the shares repurchased in any given year constitute a company’s payout for the year. Payout policy of a company is the set of principles guiding payouts. Companies can pay dividends in a number of ways. Cash dividends can be distributed to shareholders through regular, extra, or liquidating dividends. There are also other forms like stock dividends and stock splits. Companies generally follow one of the below policy in framing their dividend policy – (1) A Long-term Payout ratio (2) A Long-term Dividend Change Ratio
Dividend payments can be made by way of paying a regular cash dividend regularly. This can be based on a target dividend payout ratio (either stable or step-up) or a target dividend value.
Paying extra or special dividend is also a practice followed by in some cases. Of course, there will be a liquidating dividend in case the company is being liquidated, stock dividends (also called bonus issue of shares) in case company has shortage of cash.
Corporate Restructuring Decisions:
Theoretically similar to a capital budgeting decision, decisions on corporate restructuring is not solely the exercise of corporate finance department, instead a committee comprising of representations from different functionalities are given such responsibility. Finance department representation may have to provide inputs to the broader decision so as to the – purchase consideration, financial viability, mode of settlement, source of financing for the M&A etc.
Another corporate finance professional’s function is to be part of overall business strategy formulation at the firm level. This functionality includes contribution of inputs regarding the capital expenditure decisions pertaining to production, operation, human resources and marketing activities, M&As as discussed above, cost control strategies, performance oriented organisational structure building and enterprise risk management.
Corporate Finance Practices – Review of Select Literature
The best manner to know what is being practised on field is through directly asking the practitioners. As the context in which this study is being taken up is in the area of corporate finance practices, the practitioners of corporate finance are those who are working as executives in corporates and involved in decision making relating to finance areas. One such study was done by Graham & Harvey (Graham & Harvey, 2001) in USA, where they surveyed 392 CFOs about the cost of capital, capital budgeting and capital structure. They claim that their survey results were both reassuring and surprising. On one hand they found that firm size significantly affects the corporate finance decisions. For instance, using of project-specific cost of capital rate versus firm-wide rates, or use of NPV by large firms versus use of payback criterion by smaller firms were few highlights of their study. One of the traditional study in this area was that of John Lintner (Lintner, 1956), where the Lintner field studied corporate dividend policies of 28 (selected out of 600 listed companies) companies and found that no dividend decisions was taken without considering the existing rate of dividend payout (target dividend payout ratio) and in their word “existing dividend rate continued to be a central benchmark for the problem in managements’ eyes”. Bruner et. al. (Bruner, Eades, Harris, & Higgins, 1998) conducted a similar survey with a limited scope of studying the cost of capital practices of 27 corporations, 10 financial advisers and 7 bestselling texts. They found that there existed close alignment among these groups on the use of theoretical frameworks and on many aspects of estimation.
Similar work in India was carried out by Manoj Anand (Anand, 2002). Eighty-one CFOs from a cross-section of Indian firms were surveyed on their practices relating to capital budgeting, cost of capital, capital structure and dividend policy decisions along with examining the relationship of these responses as conditional on firm characteristics like firms size, profitability, risk, growth, CFO’s education, and the sector. They found that most firms chose Cash Value Added (CVA) as their primary objective, companies use more than one technique to assess project risk, most of the firms use a single rate of cost of capital firm-wide, large firms give higher importance to Capital Assets Pricing Model (CAPM) than small firms, retained earnings were the most favoured source of long term financing among CFOs, most CFOs’ believe that management should be responsive to the shareholders’ preferences regarding dividends and many other characteristics were recorded. Overall this study concluded that practices of corporate finance are consistent with theory. Especially: (a) shareholder value maximisation objective is widely used; (b) Net Present Value (NPV) approach is widely used; (c) Industry-wide beta lead CAPM approach is widely used; (d) Project risk estimate is considered to be an important process in capital budgeting decisions; (e) Retained earnings are most favoured source of long term financing; (f) Management believes that dividend decisions are important in acting as signalling mechanism. In summary, in the words of the Manoj Anand– “the practitioners do use the basic corporate finance tools that the professional institutes business schools have taught for years like NPV, CAPM, and pecking-order theory for capital budgeting, cost of capital, and capital structure decisions to a great extent. However, the corporate finance practices vary with the firm size”. Verma et. al. (Verma, Gupta, & Batra, 2009) carried out a comprehensive primary survey of 30 CEOs/CFOs of Indian manufacturing companies to find out which capital budgeting technique was most preferred, especially in the given full-fledged globalised business environment. One of the basic conclusion they drew was that as the environment was becoming competent, companies were tending to giving higher importance of making the right investment decisions. This was evident in firms adopting formal capital budgeting analysis irrespective of the size of the investment outlay. They also found that firms follow multiple techniques for each project decision rather than a single technique. The survey also revealed that discounted capital budgeting techniques like NPV, IRR etc, were preferred over traditional non-discounting techniques like payback period, whereas, Weighted Average Cost of Capital (WACC) was used as discounting factor. In a nutshell, in the authors’ words – “whenever the budget is large or the nature of industry demands, more sophisticated discounted techniques should be used”.
In summary, we can say that corporate finance decisions are not some managerial functions discussed only in text books, instead they are real world practices. The list discussed in this paper is not exhaustive, but covers majority of the decisions. A need for rigorous research to bring the industry practices into corporate finance text books to be taught in B-Schools, as well as in-depth research to bring out newer frameworks to approach these decision making challenges by the industry.
Anand, M. (2002, October-December). Corporate Finance Practices in India: A Survey. Vikalpa: The Journal for Decision Makers, 27(4), 29-56.
Bruner, R. F., Eades, K. M., Harris, R. S., & Higgins, R. C. (1998, Sprin-Summer). Best Practices in Estimating the Cost of Capital: Survey and Synthesis. Financial Practice and Education, 8(1), 13-28.
Chandra, P. (2014). Strategic Financial Management: Managing for Value Creation (First ed.). McGraw Hill Education (India) Private Limited.
Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics.
Lintner, J. (1956, May). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97-113. Retrieved from http://links.jstor.org/sici?sici=0002-8282%28195605%2946%3A2%3C97%3ADOIOCA%3E2.0.CO%3B2-D
McClure, B. (n.d.). All About EVA. Retrieved from INVESTOPEDIA: http://www.investopedia.com/articles/fundamental/03/031203.asp
Verma, S., Gupta, S., & Batra, R. (2009, July-September). A Survey of Capital Budgeting Practices in Corporate India. VISION – The Journal of Business Perspective, 13(3).
Author is Faculty in Finance at
International School of Management
Excellence (ISME), Bangalore.
He can be reached at firstname.lastname@example.org