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Tuesday, April 15, 2014

What matters in corporate finance

Corporate finance encompasses a wide range of approaches to financial management. It includes securities underwriting, asset management, financial reporting, strategic investing and more. The following presentation is essentially a textbook in a slide show since it has multiple chapters and is 816 slides long. This post attempts to summarize key points and navigate through the slides to highlight particularly useful concepts.

Present value

Of the thirty-five chapters in the slide show, six are devoted to the concepts of present value and net present value. That is a substantial weighting toward one particular way of thinking. So what is it about present value that is so important?  Present value measures the current value of future cash flows. In this sense, knowing what a project or investment is worth in advance of implementing it makes sense from a financial management perspective. According to Investopedia and the presentation, the formula for NPV is as follows:

Net Present Value (NPV) 

When expanded out, the net present value can also be expressed as the follows per Finance Formula:

Net Present Value Formula

So what do all these numbers mean? Basically, NPV is what a future cash flow would be worth if it were to be purchased in the present. For example, what is the value of a $100 face value bond that pays a periodic interest rate of 5% for 10 years? According to Money Chimp's PV calculator, it is worth $61.39. Since total interest includes the sum of all cash payments to be received in the future, the present value will be lower because the interest has not been applied yet. Without the present value calculations, a bond purchase or project management cost might be overestimated or underestimated leaving room for overpayment and underpayment.

Principles of-corporate-finance from Abdul Memon

Risk management

Another subject the slide show emphasizes is risk management. There are five chapters dedicated to this topic. Moreover, of those chapters, the issues of opportunity cost, international risk and capital budgeting risk are discussed. Opportunity cost is a type of investment risk that occurs when potential investments are forgone for other investments that may yield less return on investment. Since investment capital itself often has costs, knowing the price of risk is relevant to corporate financial planning so that risk can be priced in to expected ROI. To illustrate, Chapter 8 talks about how standard deviation around expected returns differs between corporations.

Debt management

How much debt and debt financing are also discussed in about five chapters worth of slides. This is because debt is important for businesses seeking to expand, grow and develop. Moreover, staying competitive is an ongoing endeavor for corporations and oftentimes, debt helps facilitate that. However, how well debt is managed also impacts the effectiveness of that debt. For example, Chapter 18 covers how much debt a firm should borrow and details tax benefits of interest payments when compared against capital investment.

The bottom line of corporate finance is profit maximization. How that profit is used is also relevant to financial management as distribution of profit via dividends lowers available cash for investing and operational activities. For a company with a strong growth trajectory and objective, too much dividend distribution negatively effects competitive positioning and market expansion. For larger, more established companies, dividends make more sense as they help ensure longer-term capital investment. Overall however, all facets of corporate financial management impact how monetarily efficient and optimal an organization is.