What are the key concepts required for a basic understanding of corporate finance?What do we need to know if we are to understand the CFO? In this post I intend to explain the fundamentals.
To understand corporate finance we need to rely on a reference scheme, start from an initial finding and then use some guidelines to develop our analysis. It is these guidelines that follow in the next section.
How can a company make investors want to invest their money in it?
A company is a business linked to some financing with invested capital (the business assets) for the purpose of creating value as a reward for its investors. It’s assets are financed by equity and/or debt and result in fixed assets and working capital requirements (WCR). Without financing the business would not exist.
Corporate finance attracts investors to provide capital to a company by connecting the financial decisions inside the business, maximizing company value for the shareholders and keeping risks under control.
Money is not free of charge because investors can invest their money elsewhere and get some revenue. They must therefore be attracted to invest in a business by a reward (profit) and rewarded for accepting some risks. As different investment opportunities have different risk levels investors must be rewarded for their risk taking.
However, some sort of financing is always necessary to create business and to attract this financing a business needs to create value and the reward the sources of finance. Therefore, investors require a minimum return from any investment they make (the risk free investment hurdle) plus an additional reward for any additional risk beyond the risk free hurdle.
For the business equity has no visible cost, while for debt the cost is visible in the form of interest payments, though in most jurisdictions there is a benefit in the form of tax deductions.
There are two main types of finance; debt and equity.
Debt (credit) is essentially borrowed funds. It comes in several forms including bank loans, bonds and notes payable. It is typically tax deductable and repayable on a predetermined schedule with interest.
Equity is a second way for businesses to raise funds. This is done by selling a share in the company to investors who expect that the business will grow and/or pay dividends from excess funds so that they can earn a positive return on capital.
Together the sum of the cost of debt financing and equity financing equals the cost of capital. This is the minimum amount any business must raise through its activities to satisfy its shareholders and debtholders.
Investors come in two broad types; shareholders and debtholders.
Shareholders (stockholders) have the possibility to receive the highest are rewarded with profits from the enterprise. However, they face uncertain returns on their investment (for example the risk of bankruptcy) , little room for legal action against the management team, and only get their investment back if they are able to liquidate their holdings (if intrinsic value remains).
Debtholders on the other hand are always rewarded first with interest on the capital they lend to the enterprise, before the shareholder. They receive a predetermined return (the interest rate) and have direct recourse to legal action if they are not reimbursed.
To summarize debtholders have the lower risk investment, but shareholders have a greater opportunity to realise above expectation rewards.
We refer to ‘value creation’ when a company creates more than was expected or more precisely when ROCE > WACC.
Some key terms used in this post…
The cost of financial resources is described through the ‘Weighted Average Cost of Capital’ or ‘WACC’. This is calculated using the following formula;
Shareholder capital invested x net profit expectation + debtholder capital invested x interest rate required = ‘Weighted Average Cost of Capital’ (WACC)
Return on Capital Employed (ROCE) is a profitability ratio that measures how efficiently a business generates profits. by comparing capital employed and the net operating profit. It is useful as a long term metric as it ignores the effectsof interest and taxes and depreciation and focuses solely on the efficiency of capital utilisation. The formula for ROCE is;
ROCE = Net Operating Profit (EBIT) / Capital Employed
ROCE = Net Operating Profit / (Total Assets – Current Liabilities)
NOPAT or ‘Net Operating Profit After Tax’ describes the potential cash revenue available for distribution to shareholders, if it had no debt. The formula for NOPAT is;
NOPAT = Operating Income (1 – Tax Rate)
It is considered a more accurate measure of operating efficency than most other metrics, especially for leveraged companies, as it does not include the tax savings many companies get from debt.