Corporate finance - AbsoluteAstronomy.com

Corporate finance is the area of finance

Finance

"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

dealing with monetary decisions that business enterprises

Business

A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...

make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize

Shareholder value

Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders...

shareholder value

Valuation (finance)

In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...

while managing the firm's financial risks. Although it is in principle different from managerial finance

Managerial finance

Managerial finance is the branch of finance that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique....

which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques.
Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity

Ownership equity

In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...

or debt

Debt

A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories

Inventory

Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...

, and short-term borrowing and lending (such as the terms on credit extended to customers).

The terms corporate finance and corporate financier are also associated with investment banking

Investment banking

An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...

. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.

Capital investment decisions

Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capital structure

Capital structure

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...

. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the value of the firm by investing in project

Project

A project in business and science is typically defined as a collaborative enterprise, frequently involving research or design, that is carefully planned to achieve a particular aim. Projects can be further defined as temporary rather than permanent social systems that are constituted by teams...

s which yield a positive net present value

Net present value

In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

when valued

Valuation

-Economics:*Valuation , the determination of the economic value of an asset or liability**Real estate appraisal, sometimes called property valuation , the appraisal of land or buildings...

using an appropriate discount rate

Discount rate

The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

in consideration of risk

Risk

Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

. (2) These projects must also be financed appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

The investment decision

Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting

Capital budgeting

Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing...

. Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

Project valuation

In general, each project's value will be estimated using a discounted cash flow

Discounted cash flow

In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...

(DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value

Net present value

(NPV) will be selected (applied to Corporate Finance by Joel Dean

Joel Dean (economist)

Joel Dean is best known for his contributions to Corporate Finance theory in general, and particularly to the area of Capital budgeting. He is regarded as one of the founders of business economics...

in 1951; see also Fisher separation theorem

Fisher separation theorem

In economics, the Fisher separation theorem asserts that the objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. The theorem therefore separates management's "productive opportunities" from the entrepreneur's "market...

, John Burr Williams#Theory). This requires estimating the size and timing of all of the incremental cash flow

Cash flow

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...

s resulting from the project. Such future cash flows are then discounted

Discounts and allowances

Discounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...

to determine their present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...

(see Time value of money

Time value of money

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

). These present values are then summed, and this sum net of the initial investment outlay is the NPV

Net present value

. See Financial modeling.

The NPV is greatly affected by the discount rate

Discount rate

The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

. Thus, identifying the proper discount rate – often termed, the project "hurdle rate" – is critical to making an appropriate decision. The hurdle rate is the minimum acceptable return

Return on investment

Return on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...

on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

of cash flows, and must take into account the project-relevant financing mix. Managers use models such as the CAPM

Capital asset pricing model

In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...

or the APT

Arbitrage pricing theory

In finance, arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a...

to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital

Weighted average cost of capital

The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....

(WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period

Discounted payback period

The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project....

, IRR

Internal rate of return

The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...

, Modified IRR

Modified Internal Rate of Return

The modified internal rate of return is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size...

, equivalent annuity

Equivalent Annual Cost

In finance the equivalent annual cost is the cost per year of owning and operating an asset over its entire lifespan.EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans...

, capital efficiency, and ROI

Return on investment

. Alternatives (complements) to NPV include MVA

Market value added

Market Value Added is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value...

/ EVA

Economic value added

In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...

(Joel Stern

Joel Stern

Joel M. Stern is Chairman and Chief Executive Officer of Stern Stewart & Co., and the creator and developer of Economic Value Added . He is a recognized authority on financial economics, corporate performance measurement, corporate valuation and incentive compensation and is a pioneer and leading...

, Stern Stewart & Co

Stern Stewart & Co

Stern Stewart & Co is a worldwide management consulting firm founded in New York in 1982. The company developed the Economic value added concept and currently owns the trademark. The current CEO and chairman of Stern Stewart & Co., New York is Joel M. Stern...

) and APV

Adjusted present value

Adjusted Present Value is a business valuation method. APV is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing...

(Stewart Myers

Stewart Myers

Stewart Clay Myers is the Robert C. Merton Professor of Financial Economics at the MIT Sloan School of Management. He is notable for his work on capital structure and innovations in capital budgeting and valuation, and has had a "remarkable influence" on both the theory and practice of corporate...

). See list of valuation topics.

Valuing flexibility

In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach. Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely

Expected value

In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...

or average or scenario specific

Scenario planning

Scenario planning, also called scenario thinking or scenario analysis, is a strategic planning method that some organizations use to make flexible long-term plans. It is in large part an adaptation and generalization of classic methods used by military intelligence.The original method was that a...

cash flows are discounted, here the “flexible and staged nature” of the investment is modelled

Mathematical model

A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used not only in the natural sciences and engineering disciplines A mathematical model is a...

, and hence "all" potential payoffs

Moneyness

In finance, moneyness is a measure of the degree to which a derivative is likely to have positive monetary value at its expiration, in the risk-neutral measure. It can be measured in percentage probability, or in standard deviations....

are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.

The two most common tools are Decision Tree Analysis

Decision tree

A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. It is one way to display an algorithm. Decision trees are commonly used in operations research, specifically...

(DTA) and Real options analysis

Real options analysis

Real options valuation, also often termed Real options analysis, applies option valuation techniques to capital budgeting decisions. A real option itself, is the right — but not the obligation — to undertake some business decision; typically the option to make, abandon, expand, or contract a...

(ROA); they may often be used interchangeably:

DTA values flexibility by incorporating possible events
Event (probability theory)
In probability theory, an event is a set of outcomes to which a probability is assigned. Typically, when the sample space is finite, any subset of the sample space is an event...

(or states
State prices
In financial economics, a state-price security, also called an Arrow-Debreu security , is a contract that agrees to pay one unit of a numeraire if a particular state occurs at a particular time in the future and pay zero numeraire in all other states...

) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modelled separately.) In the decision tree
Decision tree
A decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. It is one way to display an algorithm. Decision trees are commonly used in operations research, specifically...

, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making
Optimal decision
An optimal decision is a decision such that no other available decision options will lead to a better outcome. It is an important concept in decision theory. In order to compare the different decision outcomes, one commonly assigns a relative utility to each of them...

, management chooses the actions corresponding to the highest value path probability weighted
Probability
Probability is ordinarily used to describe an attitude of mind towards some proposition of whose truth we arenot certain. The proposition of interest is usually of the form "Will a specific event occur?" The attitude of mind is of the form "How certain are we that the event will occur?" The...

; (3) this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
ROA is usually used when the value of a project is contingent on the value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...

of some other asset or underlying variable
Underlying
In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...

. (For example, the viability
Economic geology
Economic geology is concerned with earth materials that can be used for economic and/or industrial purposes. These materials include precious and base metals, nonmetallic minerals, construction-grade stone, petroleum minerals, coal, and water. The term commonly refers to metallic mineral deposits...

of a mining
Mining
Mining is the extraction of valuable minerals or other geological materials from the earth, from an ore body, vein or seam. The term also includes the removal of soil. Materials recovered by mining include base metals, precious metals, iron, uranium, coal, diamonds, limestone, oil shale, rock...

project is contingent on the price of gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

; if the price is too low, management will abandon the mining rights
Mineral rights
- Mineral estate :Ownership of mineral rights is an estate in real property. Technically it is known as a mineral estate and often referred to as mineral rights...

, if sufficiently high, management will develop the ore body
Ore
An ore is a type of rock that contains minerals with important elements including metals. The ores are extracted through mining; these are then refined to extract the valuable element....

. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

as a framework, the decision to be taken is identified as corresponding to either a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...

or a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...

; (2) an appropriate valuation technique is then employed – usually a variant on the Binomial options model or a bespoke simulation model
Monte Carlo methods in finance
Monte Carlo methods are used in finance and mathematical finance to value and analyze instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value, and then determining their average value over the range of resultant outcomes. This is usually done...

, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers
Stewart Myers
Stewart Clay Myers is the Robert C. Merton Professor of Financial Economics at the MIT Sloan School of Management. He is notable for his work on capital structure and innovations in capital budgeting and valuation, and has had a "remarkable influence" on both the theory and practice of corporate...

in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman
Timothy Luehrman
Timothy A. Luehrman is a Finance academic at Harvard Business School. He is best known for his work on valuation and real options; specifically, he conceived the idea of treating business strategy as a series of options, and his papers here are widely quoted....

, in the late 1990s.)

Quantifying uncertainty

Given the uncertainty

Uncertainty

Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...

inherent in project forecasting and valuation, analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model

Mathematical model

. In a typical sensitivity analysis

Sensitivity analysis

Sensitivity analysis is the study of how the variation in the output of a statistical model can be attributed to different variations in the inputs of the model. Put another way, it is a technique for systematically changing variables in a model to determine the effects of such changes.In any...

the analyst will vary one key factor while holding all other inputs constant, ceteris paribus
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...

. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at various growth rates

Compound annual growth rate

Compound annual growth rate is a business and investing specific term for the smoothed annualized gain of an investment over a given time period...

in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface

Surface

In mathematics, specifically in topology, a surface is a two-dimensional topological manifold. The most familiar examples are those that arise as the boundaries of solid objects in ordinary three-dimensional Euclidean space R3 — for example, the surface of a ball...

", (or even a "value-space

Euclidean space

In mathematics, Euclidean space is the Euclidean plane and three-dimensional space of Euclidean geometry, as well as the generalizations of these notions to higher dimensions...

"), where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based

Scenario planning

forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product

Demand

- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...

, exchange rate

Exchange rate

In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s, commodity prices

Commodity

In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

, etc...) as well as for company-specific factors (unit cost

Unit cost

The unit cost of a product is the cost per standard unit supplied, which may be a single sample or a container of a given number. When purchasing more than a single unit, the total cost will increase with the number of units, but it is common for the unit cost to decrease as quantity is increased...

s, etc...). As an example, the analyst may specify various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling

Financial modeling

Financial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other investment...

), whereas for the sensitivity approach these need not be so. An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average

Weighted mean

The weighted mean is similar to an arithmetic mean , where instead of each of the data points contributing equally to the final average, some data points contribute more than others...

of the various scenarios.

A further advancement is to construct stochastic

Stochastic

Stochastic refers to systems whose behaviour is intrinsically non-deterministic. A stochastic process is one whose behavior is non-deterministic, in that a system's subsequent state is determined both by the process's predictable actions and by a random element. However, according to M. Kac and E...

or probabilistic financial models – as opposed to the traditional static and deterministic

Deterministic system (mathematics)

In mathematics, a deterministic system is a system in which no randomness is involved in the development of future states of the system. A deterministic model will thus always produce the same output from a given starting condition or initial state.-Examples:...

models as above. For this purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV. This method was introduced to finance by David B. Hertz

David B. Hertz

David Bendel Hertz is known for his contributions to operations research in general, and specifically for pioneering the use of Monte Carlo methods in finance. He was a director at McKinsey & Company and at Arthur Andersen ....

in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet

Spreadsheet

A spreadsheet is a computer application that simulates a paper accounting worksheet. It displays multiple cells usually in a two-dimensional matrix or grid consisting of rows and columns. Each cell contains alphanumeric text, numeric values or formulas...

based DCF models, typically using an add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or "trials"; see Monte Carlo Simulation versus “What If” Scenarios. The output is then a histogram

Histogram

In statistics, a histogram is a graphical representation showing a visual impression of the distribution of data. It is an estimate of the probability distribution of a continuous variable and was first introduced by Karl Pearson...

of project NPV, and the average NPV of the potential investment – as well as its volatility

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution

Probability distribution

In probability theory, a probability mass, probability density, or probability distribution is a function that describes the probability of a random variable taking certain values....

to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation

Correlation

In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....

between the variables. These distributions would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant statistics (average

Average

In mathematics, an average, or central tendency of a data set is a measure of the "middle" value of the data set. Average is one form of central tendency. Not all central tendencies should be considered definitions of average....

NPV and standard deviation

Standard deviation

Standard deviation is a widely used measure of variability or diversity used in statistics and probability theory. It shows how much variation or "dispersion" there is from the average...

of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying

Underlying

In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the derivative depend on the value of this underlying...

"spot price

Spot price

The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...

" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch

Credit crunch

A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...

) that drive variations in one or more of the DCF model inputs.

The financing decision

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are, generically, capital self-generated by the firm

Internal financing

In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm's owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which...

as well as debt

Bond (finance)

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

and equity financing sourced form outside investor

Investor

An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...

s. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term financial management decisions). There are two interrelated decisions here:

Management must identify the "optimal mix" of financing—the capital structure that results in maximum value. (See Balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

, WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....

, Fisher separation theorem
Fisher separation theorem
In economics, the Fisher separation theorem asserts that the objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. The theorem therefore separates management's "productive opportunities" from the entrepreneur's "market...

; but, see also the Modigliani-Miller theorem
Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...

.) Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution
Dilution
Dilution may refer to:* Reducing the concentration of a chemical* Serial dilution, a common way of going about this reduction of concentration* Homeopathic dilution* Dilution , an equation to calculate the rate a gas dilutes...

of share ownership, control and earnings. The cost of equity
Cost of equity
In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow...

is also typically higher than the cost of debt (see CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...

and WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....

), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
Management must attempt to match the long-term financing mix to the asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

s being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch
Asset liability mismatch
In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible....

or duration gap
Duration gap
-Definition:The difference between the duration of assets and liabilities held by a financial entity.-Overview:The duration gap is a financial and accounting term and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate...

entails matching the assets and liabilities according to maturity pattern ("Cashflow matching
Cashflow matching
Cashflow matching is a process of hedging in which a company or other entity matches its cash outflows with its cash inflows.-See also:*Cash-flow hedging*Duration gap*Dedicated Portfolio Theory*Fannie Mae-External links:**...

") or duration ("immunization
Immunization (finance)
In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...

"); managing this relationship in the short-term is a major function of working capital management, as discussed below. Other techniques, such as securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...

, or hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

using interest rate-
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...

or credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...

s, are also common. See Asset liability management
Asset liability management
In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....

; Treasury management
Treasury management
Treasury management includes management of an enterprise's holdings, with the ultimate goal of maximizing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding...

; Credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

; Interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...

.

One of the main theories of how firms make their financing decisions is the Pecking Order Theory

Pecking Order Theory

In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984...

, which suggests that firms avoid external financing

External financing

In the theory of capital structure, External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. There are many kinds of external financing...

while they have internal financing

Internal financing

available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt

Tax benefits of debt

In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems around the world, and until recently under the U.S...

with the bankruptcy costs of debt

Bankruptcy Costs of debt

Within the theory of corporate finance, bankruptcy costs of debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy. The fact that bankruptcy is generally a costly process in itself and not only a transfer of ownership implies that...

when making their decisions. An emerging area in finance theory is right-financing

Right-financing

The concept of right-financing was coined by English political economist Dr. Peter Middlebrook to highlight the importance of adopting the appropriate policy, institutional and financial support mechanisms to maximize sustainable returns on both public and private investments over time...

whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One last theory about this decision is the Market timing hypothesis

Market timing hypothesis

The market timing hypothesis is a theory of how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. It is one of many such corporate finance theories, and is often contrasted with the pecking order theory and the trade-off theory,...

which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

The dividend decision

Whether to issue dividends, and what amount, is calculated mainly on the basis of the company's unappropriated profit

Profit (accounting)

In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...

and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows

Cash flow

i.e. cash remaining after all business expenses, and capital investment needs have been met.

If there are no NPV positive opportunities, i.e. projects where returns

Return on investment

exceed the hurdle rate, then – finance theory suggests – management must return excess cash to investors as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock

Growth stock

In finance, a growth stock is a stockof a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry...

", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and Real option

Real option

s.

Management must also decide on the form of the dividend distribution, generally as cash dividend

Dividend

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

s or via a share buyback

Treasury stock

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ....

. Various factors may be taken into consideration: where shareholders must pay tax on dividends

Dividend tax

A dividend tax is an income tax on dividend payments to the stockholders of a company.-Collection:In many jurisdictions, the government requires the company to withhold at least the standard tax, paying this to the national revenue authorities and paying out only the balance to the...

, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock

Treasury stock

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ....

rather than in cash; see Corporate action

Corporate action

A corporate action is an event initiated by a public company that affects the securities issued by the company. Some corporate actions such as a dividend or coupon payment may have a direct financial impact on the shareholders or bondholders; another example is a call of a debt security...

. Today, it is generally accepted that dividend policy

Dividend policy

Dividend policy is concerned with taking a decision regarding paying cash dividend in the present or paying an increased dividend at a later stage. The firm could also pay in the form of stock dividends which unlike cash dividends do not provide liquidity to the investors, however, it ensures...

is value neutral – i.e. the value of the firm would be the same, whether it issued cash dividends or repurchased its stock (see Modigliani-Miller theorem

Modigliani-Miller theorem

The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...

Working capital management

Decisions relating to working capital

Working capital

Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...

and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities

Current liability

In accounting, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer...

. In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital

Cost of capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...

. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate

Operations management

Operations management is an area of management concerned with overseeing, designing, and redesigning business operations in the production of goods and/or services. It involves the responsibility of ensuring that business operations are efficient in terms of using as little resources as needed, and...

, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt

Money market

The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...

and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added

Economic value added

(EVA).

Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term, decisions. In addition to time horizon

Time horizon

A time horizon, also known as a planning horizon, is a fixed point of time in the future at which point certain processes will be evaluated or assumed to end. It is necessary in an accounting, finance or risk management regime to assign such a fixed horizon time so that alternatives can be...

, working capital decisions differ from capital investment decisions in terms of discounting

Time value of money

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite

Risk appetite

Risk Appetite is a method to help guide an organisation’s approach to risk and risk management.-Definition:The level of risk that an organisation is prepared to accept, before action is deemed necessary to reduce it...

and return targets remain identical, although some constraints – such as those imposed by loan covenant

Loan covenant

A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.Typically,...

s – may be more relevant here).

Working capital management decisions are therefore not taken on the same basis as long term decisions, and working capital management applies different criteria in decision making

Decision making

Decision making can be regarded as the mental processes resulting in the selection of a course of action among several alternative scenarios. Every decision making process produces a final choice. The output can be an action or an opinion of choice.- Overview :Human performance in decision terms...

: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the more important).

The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle
Cash conversion cycle
In management accounting, the Cash Conversion Cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth...

. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)
In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity
Return on equity
Return on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...

(ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on capital, exceeds the cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...

. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash

Cash

In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...

and cash equivalents

Cash and cash equivalents

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities and commercial...

, inventories

Inventory

and debtor

Debtor

A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...

s) and the short term financing, such that cash flows and returns are acceptable.

Cash management
Cash management
In United States banking, cash management, or treasury management, is a marketing term for certain services offered primarily to larger business customers...

. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence increases cash flow; see Supply chain management
Supply chain management
Supply chain management is the management of a network of interconnected businesses involved in the ultimate provision of product and service packages required by end customers...

; Just In Time (JIT); Economic order quantity
Economic order quantity
Economic order quantity is the level of inventory that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was...

(EOQ); Economic production quantity
Economic production quantity
Economic Production Quantity model determines the quantity a company or retailer should order to minimize the total inventory costs by balancing the inventory holding cost and average fixed ordering cost. The EPQ model was developed by E.W. Taft in 1918.This method is an extension of the Economic...

(EPQ).
Debtors management. Identify the appropriate credit policy
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...

, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances
Discounts and allowances
Discounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...

.
Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....

(or overdraft), or to "convert debtors to cash" through "factoring".

Investment banking

Use of the term “corporate finance” varies considerably across the world. In the United States

United States

The United States of America is a federal constitutional republic comprising fifty states and a federal district...

it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a company’s finances and capital. In the United Kingdom

United Kingdom

The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...

and Commonwealth

Commonwealth of Nations

The Commonwealth of Nations, normally referred to as the Commonwealth and formerly known as the British Commonwealth, is an intergovernmental organisation of fifty-four independent member states...

countries, the terms “corporate finance” and “corporate financier” tend to be associated with investment banking

Investment banking

– i.e. with transactions in which capital is raised for the corporation. These may include

Raising seed, start-up, development or expansion capital
Mergers, demergers, acquisitions or the sale of private companies
Mergers, demergers and takeovers of public companies, including public-to-private deals
Management buy-out, buy-in or similar of companies, divisions or subsidiaries – typically backed by private equity
Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership
Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses
Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above.
Raising debt and restructuring debt, especially when linked to the types of transactions listed above

Financial risk management

Risk management

Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...

is the process of measuring risk

Risk

and then developing and implementing strategies to manage that risk. Financial risk management

Financial risk management

Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...

focuses on risks that can be managed ("hedged

Hedge (finance)

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

") using traded financial instruments

Financial instruments

A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....

(typically changes in commodity prices

Commodity

In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

, interest rate

Interest rate

An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s, foreign exchange rates

Exchange rate

and stock prices

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

). Financial risk management will also play an important role in cash

Cash

management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk

Market risk

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...

is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value

Value (economics)

An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...

.

It is common for large corporations to have risk management teams. While it is impractical for many small firms to have formal risk management teams, many still practice risk management principles through informal teams. There is a fundamental debate on the value of "Risk Management" and shareholder value that questions a shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links value of risk management in a market to the cost of bankruptcy in that market.

Derivatives

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

are the instruments most commonly used in financial risk management. Because unique derivative contract

Contract

A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...

s tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets or exchanges

Exchange (organized market)

An exchange is a highly organized market where tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.-Description:...

. These standard derivative instruments include options

Option (finance)

In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

, futures contract

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

s, forward contract

Forward contract

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...

s, and swaps

Swap (finance)

In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...

. More customized and second generation derivatives known as exotics trade over the counter aka OTC

OTC

OTC may refer to:* Oakwood Technology College* Owatonna Tool Company* Oklahoma Tax Commission* Odenton Town Center* Officer in Tactical Command* Officer Training Corps* Offshore Technology Conference* Ohio Turnpike Commission...

See: Financial engineering; Financial risk

Financial risk

Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...

; Default (finance)

Default (finance)

In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

; Credit risk

Credit risk

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

; Interest rate risk

Interest rate risk

Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...

; Liquidity risk

Liquidity risk

In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...

; Market risk

Market risk

; Operational risk

Operational risk

An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...

; Volatility risk

Volatility risk

Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlyings is a major influencer of prices....

; Settlement risk

Settlement risk

Settlement risk is the risk that a counterparty does not deliver a security or its value in cash per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value per the trade agreement....

; Value at Risk

Value at risk

In financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...

Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations have broad application to entities other than corporations, for example, to partnerships, sole proprietorships, not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from personal finance

Personal finance

Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over time, taking into account various financial risks and future...

and public finance

Public finance

Public finance is the revenue and expenditure of public authoritiesThe purview of public finance is considered to be threefold: governmental effects on efficient allocation of resources, distribution of income, and macroeconomic stabilization.-Overview:The proper role of government provides a...

Alternate Approaches

A standard assumption in Corporate finance is that shareholders are the residual claimants and that the primary goal of executives should be to maximize

Shareholder value

shareholder value

Valuation (finance)

In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...

. Recently, however, legal scholars (e.g. Lynn Stout

Lynn Stout

Lynn A. Stout is the Paul Hastings Professor of Corporate and Securities Law at the University of California, Los Angeles School of Law. She specializes in researching, writing on, and teaching about corporate law, securities and derivatives regulation, law and economics, and prosocial behavior and...

) have questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous assumption.