Corporate Finance

I

INTRODUCTION
Corporate Finance branch of economics concerned with how businesses raise and spend their money. Companies spend or invest funds in projects that might make the firm more profitable, such as a new factory or an improved product. Corporate finance involves selecting projects that maximize profits and make the best use of a company's funds. Sometimes businesses can fund these projects on their own. Other times businesses must raise funds from outside the company. Corporate finance also involves finding the best way for businesses to pay for their projects.
II

CORPORATE OWNERSHIP
Small businesses may be owned by a single individual, but major corporations are far too large to be owned in this way. Instead corporations are owned by many people, called shareholders, who own shares of stock. Investors purchase stock because it allows them to share in the company's profits, although there are no guarantees that the company will be successful. Each share of stock represents ownership of a portion of the firm and its possessions, or assets. For example, Exxon Corporation has about 600,000 shareholders, who together own a total of about 1.2 billion shares of stock.
Shareholders who possess a large number of shares own a larger portion of the company than those who possess only a few shares. For example, an individual who owns one share of Exxon stock owns just under one-billionth of the company. At the other extreme, a large financial institution, such as an insurance company or a company that manages investments, may own several million shares of Exxon stock. About half the shares of large corporations are owned directly by individuals. The other half are owned by financial institutions.
Shares of stock are bought and sold on a number of stock exchanges. For example, Exxon's shares are regularly bought and sold on the New York Stock Exchange. At the end of 1995 Exxon's shares were priced at $80 each. At that price it would have cost about $100 billion to buy all of Exxon's stock.
Although a corporation's shareholders own the company, they do not manage it. Instead they elect a board of directors who hire key company executives and review their job performance.
III

INVESTMENT DECISIONS
Corporate investment decisions often involve substantial amounts of money. Many investment decisions are also difficult to reverse and can affect the company's business far into the future. For example, in 1966 Boeing Company, an airplane manufacturer, decided to invest about $1 billion to develop the 747 jumbo jet. This investment delivered long-term benefits as the company was still selling the jets 30 years later. It was also able to take advantage of its experience with the 747 to develop new kinds of aircraft.
A business regards an investment as successful if it increases the wealth of the shareholders who own the company. This is accomplished when the firm earns profits and passes them back to the shareholders either in the form of dividends or as increases in the value or price of the stock. Dividends are a share of profits paid to shareholders as cash or as additional shares of stock. Profits or earnings that are not distributed to shareholders stay with the firm and are called retained earnings. These earnings influence the value of the stock because they increase the total asset value, or total amount of assets, of the firm. Because the value of their company's possessions has increased, the shareholders own stock that is worth more. If the firm realizes retained earnings of $1 per common share, it will add $1 to the value of each share. However, since many forces influence stock prices, the actual price of the stock will probably fluctuate and be more or less than the additional $1 per share.
Investment decisions—that is, deciding what projects to invest in—are based on two criteria: the expected rate of return and the risk or uncertainty of achieving the expected rate of return. The project's rate of return, or simply its return, is a measurement of its profit. A financial manager estimates the return based on forecasts of potential sales, expenses, and profits that might occur from an investment. For example, a company might have an opportunity to invest in a project that costs $100 million. If the project is expected to produce a profit of $10 million, this equals a rate of return of 10 percent on the investment of $100 million.
Before evaluating the rate of return, a financial manager must also consider the return's risk. The manager must consider the chances of earning or losing money on the project and how great the profits or losses could be. For example, if the company has a 90 percent chance of earning the $10 million return, the risk is rather small. On the other hand, if the company has only a 5 percent chance of earning the $10 million return, the project is very risky. Expected rates of return are higher with risky projects because they must compensate for the project's uncertainty to attract investors. Although their returns are not guaranteed, higher risk projects have a potential for greater profit.
Whether or not the company should go ahead with the project depends on what the $100 million could earn if invested differently. The company should accept any project that is expected to earn a higher return than shareholders can earn with another investment. For example, the shareholders could invest their $100 million by buying real estate. If the shareholders could earn a 20 percent return on their real estate investment, they are giving up that opportunity to invest in the company. In other words, 20 percent is the cost of investing their capital in the project, or the cost of capital. The firm should only accept projects whose expected return exceeds the shareholder's cost of capital.
In addition to investing in projects, firms also buy and sell entire businesses. Sometimes this takes place with a mutual agreement to merge or combine two companies into one. In other cases one firm, the buying firm, goes against the wishes of another firm's management, the target firm, and attempts a takeover. For example, a company can appeal directly to the target firm's shareholders by offering to buy their stock. If the buying firm acquires enough of the target firm's stock, it can control the target firm's activities.
IV

RAISING MONEY FOR INVESTMENTS
Investments require cash. There are three common ways a corporation may be able to raise this cash: (1) by paying smaller dividends, (2) by borrowing, or (3) by selling more stock. Each method has advantages and disadvantages.
A firm can finance projects by paying smaller dividends. By paying out less of its profits in dividends, the company can keep more of its profits as retained earnings and use them to fund its investments. Using retained earnings to finance projects appeals to managers because they can avoid paying interest. However, the shareholders may not like it if their dividend becomes smaller. Also, sometimes the firm needs more money for a particular project than it has available in retained earnings.
A company can also choose to borrow money to fund its projects. A firm can either borrow from a bank or directly from investors by issuing bonds. Although a firm must pay interest if it borrows money, it can deduct the interest from its profits and therefore pay less in taxes. However, there are limits to how much a firm can borrow, and too much borrowing could lead to bankruptcy.
Selling stock is a third way companies can raise funds. Unlike a loan, the funds received from the sale of stock belong to the company and do not have to be repaid. As a consequence, the firm does not have the expense of paying interest. However, the firm must still earn a certain return on its investment to obtain the cash to pay dividends or devote to retained earnings. Businesses also may not want to issue stock because the costs of issuing stock, such as fees for legal and banking services, are usually higher than for issuing bonds.
A financial manager must consider factors other than cost when deciding how to raise money. For example, if a firm tries to raise new funds, the public will speculate about the company's plans. If investors think the plans are a bad idea the company's stock price could fall.
International financial markets have become increasingly important sources of funds. United States firms frequently raise money in overseas financial centers such as London or Tokyo. Loans from abroad often have a lower interest cost to domestic U.S. corporations because foreign banks are not subject to the restrictions of the U.S. Federal Reserve System. For example, instead of borrowing dollars from a bank in the United States, American firms may borrow dollars that have been deposited in London or Tokyo banks. These are known as Eurodollars. Eurodollars are U.S. dollars held in banks outside of the United States. Similarly, instead of issuing bonds in the United States, U.S. firms may issue bonds in a foreign country to a group of international investors. These are called Eurobonds. Eurobonds are bonds sold outside the country whose currency is used to write the bond. For example, a bond denominated in U.S. dollars issued by a Japanese bank is a Eurobond.
V

MANAGING RISK
Events outside the control of a corporation can affect the firm and its financing decisions. For example, a change in the interest rate can suddenly make borrowing money very inexpensive or very costly. From 1975 to 1995, interest rates in the United States were as high as 15 percent and as low as 3 percent. Many economic factors, such as changes in the price of oil or the price of foreign currency, can affect businesses as well.
Corporate financial managers need to make sure that potential economic fluctuations do not threaten the firm. A variety of tools, known as derivatives, help manage the risk of such events occurring. Four important kinds of derivatives include (1) futures, (2) forwards, (3) options, and (4) swaps. Futures are promises to buy or sell something in the future at a price that is agreed upon today. For example, a candy manufacturer might commit to purchasing a specified quantity of cocoa at a specified price from the producer in six months. Futures are traded on organized futures exchanges, such as the Chicago Mercantile Exchange or the Chicago Board of Trade. Forwards are similar to futures, but they are arranged directly between a firm and a bank. Options give a firm the right to buy or sell something in the future at a price that is agreed upon today. For example, if the candy-manufacturer does not know how much cocoa will be needed in six months, it could take out an option to buy cocoa at a certain price. Swaps involve firms swapping one set of payments for another. For example, an American firm may agree to make a series of dollar payments to a Japanese bank, while the bank in return promises to make a series of yen payments.
Derivatives are very popular. For example, worldwide trading of futures amounts to about $35 trillion a year. Most firms use derivatives to reduce risk, but some use them to speculate by buying and selling derivatives in hopes of earning a profit. When these speculations don't work out, losses can be substantial. For example, the United Kingdom's Barings', one of the world's oldest banks, collapsed in 1995 when futures speculation by one of its traders in Singapore resulted in losses of over $1 billion.
Methods of corporate finance continually evolve as financial managers invent new ways to raise money and avoid risk. Smart investment and financing decisions are crucial to a firm's success.
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