Defining the Principles of Corporate Finance
- Define planning and control.
- Know the primary goals of corporate financial planning and control.
- Define and know the benefits, breakeven, and drawbacks of profit maximization.
- How profit, value, risk and return affect a firm's overall performance.
- Introduction to capital budgeting methods used to select proposed projects.
Planning involves the development of future objectives and the preparation of a number of budgets to achieve those objectives. It requires investment and activity decisions to be determined, based on the firm's financial situation and structure.
Short-term planning includes investment decisions that are less risky or uncertain. Short-term market trends are more predictable, and it is easier to use short range solutions to adjust to changing market trends and fulfill immediate operations needs. Short-term plans typically conclude within months, or within the calendar year. Time-sensitive items are prioritized, and goals are realized more quickly.
Long-term planning is strategic. Planned new products, services, goals, and objectives are anticipated, scheduled, and funded, over a longer period (typically four to five years). Revenue milestones are also projected. Action plans are proposed for each year of the long-term plan, so progress may be monitored and funds allocated as necessary.
Control involves the steps taken by management to ensure that objectives established in the planning stage are attained. Control also ensures all parts of the organization function consistently with established organizational policies.
Good planning, without effective control, is time wasted. Moreover, unless plans are established in advance, there will be no objectives to control.
Performance is a subjective measure of a firm's general financial condition over a given period, in comparison to similar firms within the same industry or aggregate sector. It is an indicator of the efficient use of assets generated from the primary business operation and revenues. Financial analysis compares solvency, profitability, growth, and other ratios to gain a clear picture of the firm's past and present performance, and to forecast, more accurately, the future performance of the company.
- Past Performance historically tracks the firm over a period (typically three to five years).
- Future Performance uses historical figures, calculations, and statistics, including present and future values. (Caution: Extrapolation can result in errors, since past statistics can be poor predictors of future prospects.)
- Comparative Performance gauges the firm's performance, compared to similar firms within the industry.
Financial statements can indicate declining debt or margin growth rate. The following financial statement line items may be used to determine performance.
- Operations revenue
- Operating income, or cash flow
- Total unit sales
A company's bottom line is its net income, or profit. Maximized profit is the surplus base profit after all production costs, including management's wages, have been paid. This applies to firms that are under competition, as well as to monopolies. To maximize profit, firms under competition may have to lower their product price to increase sales, while monopolies are better able to keep their product price consistent. Profit maximization may be expressed as:
Maximized Profit = Total Revenues – Total Costs
P = TR – TC
Where, P = Profit.
TR = Total Revenue.
TC = Total Costs.
THE PROFIT MAXIMIZATION RULE (MAXIMIZING PROFIT)
Product supply and demand must be understood to maximize profit. The firm's demand curve indicates the point (of demand) where the product is purchased at a certain price.
Competition influences the product price. The quality of the product also influences product price. High value or high quality products can be sold at higher prices. Higher prices translate into bigger profits. As a result, larger quantities of these high value types of products are produced with the intent to maximize profit. Therefore, when demand is high, the supply decreases, due to product sales.
Conversely, when demand is low, supply is high, and the firm lowers the price to move the product.
When product supply decreases and the demand remains the same, the firm will raise the product price with the intent of maximizing their profit.
The targeted goal is when maximum profits are achieved, while costs have been kept to a minimum. Volume economics make this possible. It enables the firm to produce more products, with less capital investment.
The profit maximization rule states that the firm must choose the level of output where,
The Marginal Cost (MC) = The Marginal Revenue (MR)
The Marginal Cost (MC) Curve is
If MR > MC, profit is increasing and marginal profit is positive.
If MR < MC, profit is decreasing and marginal profit is negative.
While profit maximization is an important goal, financial managers should not be tempted to use it solely as their primary objective for the firm. To make it the sole objective would result in each decision being evaluated based on its degree of contribution to the firm's earnings. Other drawbacks of using a profit maximization approach exclusively include the facts that,
1. Profit is difficult to measure accurately. It is constantly changing, due to internal and external circumstances.
2. The relationship between profit change and risk varies.
3. Profit maximization fails to consider the timing of benefits.
4. The term "profit" varies according to economic or accounting interpretations.
5. Inflation and international currency transactions add ambiguity.
- How risky are the company's operations
- Patterned earnings increases or decreases over time
- The value and reliability of reported earnings
REAL RATE OF RETURN
The real rate of return is the rate of return that the investor requires in exchange for relinquishing their current use of the funds on a non-inflation adjusted basis. Essentially:
Real Rate of Return = Rate of Return – Inflation Rate
RISK-FREE RATE OF RETURN
The risk-free rate of return is compensation to the investor for the current use of the investor's funds, plus loss in purchasing power due to inflation. It does not compensate for associated risk.
EXAMPLE. The risk-free rate of return is the combined real rate of return (5 percent) plus the inflation premium (3 percent):
The Risk-Free Rate of Return = Real Rate of Return + Inflation Premium
8 percent = 5 percent + 3 percent
Firms continually monitor and re-evaluate decisions in an effort to mitigate risks. There are basic kinds of risk that the company watches.
- Business risk.
- Financial risk.
- Risk premium.
Business risk involves the firm's ability or inability to maintain its competitive position and advantage, and to retain its stability and earnings growth.
The risk premium is a special kind of risk associated with an investment. The risk premium will be greater or less, depending on the type of investment (That is common stock, bonds, and so forth.). The risk premium can range from 0 percent (very short-term U.S. government-backed security) to 10 to 15 percent (gold mining exploration).
Bonds are considered less risky than common stock, for example, because the firm has a contractual obligation to pay interest to bondholders, whereas they do not with common stock.
ESTIMATING NEW PROJECT CAPITAL COST
The capital cost of operations is the funds committed because of an investment decision. Prior to financing a new project, the firm must assess the overall degree of risk the new project carries, relative to current business operations.
Future profits for a new operation are generally calculated using one or all of the following methods.
- The Net Present Value (NPV) method
- The Time Adjusted or, Internal Rate of Return method
- The Payback Period
The NPV is the most commonly used decision-making tool. Using the Payback Period method is more beneficial when liquidity is unclear.
NET PRESENT VALUE (NPV)
The net present value (NPV) is the difference between the present value of the cash inflows and cash outflows associated with the investment project. The NPV is the simplest method to use, and the easiest to adjust for risk. In the NPV formula, the cost of capital becomes the actual discount rate, which is used to compute the net present value of the proposed project. The discount rate in the NPV formula recognizes that the money earned today will be less valuable in the future. Projects that generate negative net present values are rejected.
INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) may also be referred to as the economic rate of return (ERR), or time adjusted rate of return. Definitively, the IRR is the interest yield an investment project promises over its useful lifespan, or essentially, it is the proposed project's expected growth rate.
It may be deduced that the higher the IRR is, the stronger the potential growth of the project. The actual rate of return (ROR) generated by the proposed project will differ from its estimated IRR rate. It may be deduced that the higher the IRR is, the stronger the potential growth of the project. The IRR may be compared against the cost of capital that the firm needs for the investment project. When the IRR is equal to, or greater than, the cost of capital, the project should be acceptable for investment. When the IRR is less than the cost of capital, the project should be rejected, since it is anticipated that the project will not return at least the cost of the funds invested in it.
The IRR method advantageously considers certain assumptions:
- The time value of money, discounting future returns and costs back to the present
- All cash flows over the entire economic life of a capital good
- Comparing investments with unequal first costs and unequal lives
Drawbacks of using the IRR method include the following:
- Its compound complex interest calculations
- Its assumption capital goods generate revenue, which is generally not true for individual capital assets, and
- It is a difficult method to understand
PAYBACK METHOD and PAYBACK PERIOD
The payback method focuses on the payback period, defined as the length of time it takes for an investment to recoup its initial cost from its generated cash receipts. Theoretically, the sooner the cost of the investment can be recovered, the more desirable the initial investment appears to be. The payback period is the investment required, or initial cost of the project, divided by the net annual cash inflow. The payback method does not account for the time value of money or profitability. For these reasons, the net present value (NPV) or internal rate of return (IRR) capital budgeting methods are preferred.
The discounted net present value (NPV) should exceed the expected cost of financing to approve of investing in the particular project. High risk projects have a discount rate that is larger than the firm's apparent historic weighted average cost of capital (WACC). The firm's WACC includes stocks, bonds, other debt, and capital sources. The firm must add sufficient value to compensate for risk.