What is corporate finance

HOW TO DEFINE A CORPORATION

A corporation is a defined as a legal entity and therefore consider as a legal person. Because of that, a corporation has to pay taxes, can enter contracts, conduct its ordinary business activities, lend or borrow money and can sue or be sued by others. Corporations do not have a defined life and therefore could live forever. In order to create a corporation in the U.S. it is necessary to follow the procedure laid down by the article of incorporation which for example regulate the composition and the roles of the board of directors who are elected by the shareholders. The main roles of the board of directors is to help the top management and to approve important decisions such as the payment of dividends to shareholders. A corporation is owned by its shareholders but it is important to stress that legally it is separated from them. Shareholders in fact enjoy the right of limited liability meaning that they can not be sued for the actions of the corporation and cannot be asked for money to pay back the corporation’s debts. If the shares of a company are held by a small group of investors, and therefore privately, the corporation is said to be closely held; while companies having shares publicly traded on the market are known as public companies. Obviously, when companies are owned by a large number of shareholders, when talking about managerial decisions, single shareholders have no power. This principle is defined as separation of ownership. But, because managers are not the owners of the company, there is the possibility that they act for their interests and not for the shareholders’ ones.

AN INTRODUCTION OF CORPORATE FINANCE

When talking about how a firm gets and uses its money we have to distinguish among investment decisions and financing decisions. Investment decisions are decisions involving the acquisition of tangible or intangible assets, their management and when or how to shut down. Investment decisions are also called capital budgeting or capital expenditure (CAPEX) decisions. When a company is evaluating a capital budgeting decision, it has to consider, not only the cost of the asset it wants to acquire and the revenues it will generate, but also the time necessary for the asset to start earning money. For example, if a firm has the permission to build a nuclear reactor, it is true that it will provide a cash-in for a long period of time but, it is also true that the cost necessary to build it is very high and the time necessary to do so and to make it work properly is very long. Financing decisions involve the sale of financial assets in order to obtain cash and the ones related on how to pay back debts to banks, bondholders and stockholders who bought those financial assets in the past. When a corporation asks money on the market it promises to the people who lend the money to pay it back with a fixed rate of interest. If instead, the corporation is selling its own stocks on the market the people who buy them, thus becoming shareholders of the company, do not receive a fixed return but a fraction of the profits the corporation will make in the future. Shareholders are also called equity investors, and when the firm decides to finance its activity thanks to them it is equity financing. The choice of the company to finance its activity with debt or equity is called a capital structure decision where as “capital” we mean the firm’s sources of long term financing. Issuing stocks is only one of the ways thanks to which a company can equity financing: when a company reinvests the gains generated by its existing assets into new assets, we are again referring to equity financing. If the firm instead, decides not to invest its profits it can:

• Hold the cash in order to invest it in the future

• Give the money to shareholders via dividends

• Repurchase its own stocks

Giving the money back to shareholders or repurchasing the stocks are for the firm forms of payout decisions. When talking about firms selling shares on the market, their market capitalization or market cap is defined as:

Number of shares available in the market x price of each share

FINANCIAL MANAGERS

A financial manager has multiple roles inside a corporations: he can help managers conducting the firm’s operations in those areas in which they need to decide whether an investment is good or bad, he is the one responsible for the relationships between the firm, the shareholders and financial institutions when the firm need to raise money or when it has to pay back the capital received in the past.

THE GOAL OF A CORPORATION

Because the corporation is owned by its shareholders, its main goal is to maximize their satisfaction. The best way to do so is to increase the value of the company’s shares. It is important to stress that not always maximizing the stock price is the coincides with maximizing the firm’s profits: a firm can for example maximize the profits of the current year by using a lot of debt that will damage future profits, the price of the company’s stocks and therefore make investors unhappy in the end.

WHEN A FIRM SHOULD INVEST

As said, a corporation can decide either to give the money back to shareholders via dividends or it can invest it. But, if it decides to do so, will shareholders be happy? To answer this question we need two important data:

• What is the market average return on investments

• What is the return the investment will provide to the company

If, for example, the market offers a return of 5% while the company’s investment offers a return of 7%, investors will be happy if the company invests that money. If the investment would produce a return lower than the one offered by the market, investors would be happier if they received the money via dividends to invest it in the market. The minimum return that the investment must have to make investors indifferent on whether receiving the money themselves or let the company reinvest it is called the hurdle rate or cost of capital and it represents the opportunity cost of capital because it depends on the opportunities shareholders have on the market to invest their money.

CONFLICTS BETWEEN MANAGEMENT AND OWNERS

Because managers are the ones controlling the corporations they could decide to act for their own interests by increasing bonuses, pay checks and other benefits. When this happens there is a conflict between them and the shareholders. These conflicts are called agency problems and they could lead to agency costs. Agency costs could arise for example when managers do not act to maximize the firm’s value or if the firm spends too much money in order to make shareholders control their activity.