Corporate Finance Questions & Answers
What Is Corporate Finance?
Corporate finance is a broad term that refers to financial decisions and conditions that every company, big and small, face. Questions that corporate finance help to answer include:
What type of investments should you take on?
Where will be receive our long term and short term financing? Will we take on other owners or finance the loan?
How will we manage everyday financial activities, such as collecting from customers and paying bills?
These questions and more are addressed by every company that is a going concern. Many small business owners are not specialized in finance, but all must make financial decisions in order to succeed.
In large corporations, the “owners”, or “shareholders” are often not involved in the day to day operations of the business. For this, the company hires professionals to handle all aspects of running a successful business. One of the most important roles in all companies is the Chief Financial Officer, or the CFO. This individual oversees all financial decisions for the company, and is accountable for all money spent and borrowed on behalf of the company.
The financial manager is responsible for a number of financial management decisions that affect all stakeholders in the company. Issues that the financial management must face include:
Capital Budgeting: In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Generally, the goal is to create a situation in which the value of the cash flow generated by an asset exceeds the cost of the asset. The type of business will determine variations int eh type of investment opportunities that are sought. No matter what the specific nature of the an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the “size”, “timing” and “Risk” of future cash flows is the essence of capital budgeting.
Capital Structure: The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to supports its long-term investments. A firm’s “capital structure” is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. For, how much should the firm borrow? Second, what are the least expensive sources of funds?
Working Capital Management: The term “working capital” refers to a firm’s short term assets, such as the inventory, and its short-term liabilities, such as money owed to suppliers (or Accounts Payable).
Forms of Business Organization:
There are three primary types of legal business organization in the U.S., sole proprietorship, partnership and corporation. Each of the three have distinct advantages and disadvantages for the life of the business. All three have different tax structures and legal obligations. As the firm grows, the tax advantages of the corporate legal structure generally outweighs the disadvantages to incorporating.
A “Sole Proprietorship” is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Generally, you simply need to obtain a business license based on your social security number and you are ready to open for business. The owner of the sole proprietorship keeps all the profits. However, the owner also has unlimited liability for business debts. This means that creditors can go beyond the assets of the business in the event of a default, and can move on to the owner’s personal assets in the event of a default.
A “partnership” is similar to a proprietorship, that that there are two or more owners, or partners. In a general partnership, all partners share equally in both the profits and the losses, or liabilities. In a Limited Partnership, one or more “general partners” will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership.
The advantages and disadvantages of a partnership are basically the same as a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wants to sell or dies.
The “corporation” is the most important form of business entity in the United States. A corporation is a legal “person”, which is separate and distinct from its owners. This creates separate rights, duties and privileges of an actual person. Starting a corporation is more complicated than either a sole proprietor or a partnership.
The goal of every business is ultimately to generate profit. This allows for growth of the company, increased development, and long term financial security. In a corporate setting, there are financial managers that make decisions for the stockholders of the firm. The individuals who buy a share, or stock, in a corporation, are investing with the intention of making a profit on their investment. The decisions of the corporation are constantly assessed in the context of what is best for the shareholders, and how profitable the decisions will be for the shareholders.
In a corporate environment, the relationship between stockholders and management is called the “agency relationship”. This type of relationship exists whenever someone hires someone else to represent his/her interests. In all such relationships, there is the possibility for conflict between the principal and the agent. Such a conflict is called the “agency problem”.
Management and stockholder goals might differ in various situations. The stockholders may want the management to make decisions purely for the goal of higher profits, while management might be inclined to make decisions based on the long term welfare of the company employees. There are many different ways to provide incentives for management to work in shareholders best interest, and ultimately both the shareholders and the management should be driven by ethical values.
Financial Markets and the Corporation:
The primary advantage of the corporate form is that the ownership of the organization can be easily transferred more quickly than other forms of money, and money can be raised more readily. Financial markets enhance these advantages.
Cash flows to and from the firm in the relationship between the firm and the financial markets. The firm sells shares of stock and borrows money to raise cash. Cash flows to the firm from the financial markets. The financial markets function both as primary and secondary markets for debt and equity securities. The term “primary market” refers to the original sale of securities by governments and corporations. The “secondary markets” are those in which these securities are bought and sold after the original sale. Equities are sold solely by the corporation.
In a primary market transaction, the corporation is the seller and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions; public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public. However, a private placement is a negotiated sale involving a specific buyer. The SEC (Securities and Exchange Commission) oversee all public offerings of debt and equity. This agency requires the firm to disclose a great deal of information before selling any securities.
Secondary market transactions involve one owner or creditor selling to another. It is the secondary markets that provide the means for transferring ownership of corporate securities. Within the secondary market, there are two types of markets, the dealers versus the auction. Dealers buy and sell for themselves at their own risk. Auction markets have a physical location (like Wall Street).