An Overview of the Corporate Finance Essay Example Pdf - Free Essay Example

One of the most critical decisions that every organizations needs to make in order to test its feasibility in the market, is the financial decisions. Corporate finance is that area of finance which gives the business enterprises the means to analyse and make financial decisions. It has a major goal to maximize the value of the corporate and at the same time manage the risks that are associated with the same. This discipline of corporate finance has majorly two different categories. They are long-term and short term categories. Decisions that are pertaining to capital investment include the choices of financing in equity or debt or to make payments in form of dividends to shareholders. The other form is the short-term decision making which is mainly concerned with balancing the working capital that includes current assets and current liabilities. In the present scenario, corporate finance has vast associations with investment banking. Today, an investment bank is used to make an evaluation of the financial needs of a firm and make means to provide for these needs. Corporate finance also varies from company to company. In US it talks about the techniques that are related to managing a companys finances where as in UK, it is more associated with investment banking. Nevertheless, the idea that the term carries includes all long and short term management of finance. (Corporate Finance, 2010) This paper deals with studying seven most significant areas of corporate finance, which help in a better understanding of investment decisions that a firm is required to make. They have been mentioned in the subsequent section. Basic Forms of Business Organizations There are basically four forms of business organizations. They have been mentioned as follows: Sole Proprietorship A business that is entirely managed by a single individual is termed as a sole proprietorship. It is not considered to be a legal entity. All the debts that are associated with the business is the sole responsibility of the individual who owns the business. The owner here has to file a personal income tax in course of running the business. Also, as the owner dies, the business terminated. It is also possible that the user sells his business and no longer remains the proprietor. General Partnership This is a form of business organization that is formed when two or individuals start a business for making profit. The percentage contribution of each of the partners corresponds to the profit share. All partners are equally responsible for the debts of the business and have to take responsibility of the actions of all involved in the partnership. The partnership incomes are also shown on the personal income tax returns of the partners. (Vernimmen, 2009) Limited Liability Company This is a more flexible for of a business organization where there are advantages of liability protection. Here the partners are not liable for the business debts. It is not appropriate for raising capital or for becoming public. It is associated with many periodic filings with the sate hence is more difficult to function as compared to a general partnership. Corporations This is the best form of business organization for raising capital through the same of equities. Here, a board of directors is appointed by the shareholders of the corporation and these board members decide the managing body. It does not diminish at the end of its members. Here, each of the members have to pay their respective taxes on dividends collected while the corporation its own taxes. It is more expensive to form as compared to partnerships. (COMMON FORMS OF BUSINESS ORGANIZATION, 2010) Determinants of k Interest Rates There are basically five determinants of interest rates. The first one is the real interest rate (k*). This interest rate is free of inflation, risks. In US, it is calculated as the rates on Treasury bills subtracted by the expected inflation rate. The second determinant is inflation risk premium (IRP). This defines the average rate of inflation in course of the time that a security lasts. It generally constitutes of the largest part of the nominal rate. The third determinant is default-risk premium (DRP). This interest rate compensates for the chances the borrower would default for taking money. In US it is calculated as the difference between T-bonds rate and that of a corporate bond which has equal maturity and marketability. The next determinant is maturity premium (MP). This is a premium that is an additional over the real rate of interest which acts as a compensation for the exposure of security to the interest rate risk. With increasing maturity, risk increases. The final of these determinants is the liquidity premium. This compensates for the lack of ability of a security to get converted into cash at a value close to market value. On the basis of these determinants, k interest rate can be calculated as: k= k* + IRP + DRP + MP + LP Business Cycles and Yield Curves Yield curves are profoundly used as analysis tool of the financial markets. The Fed policy makers would soon be using it as one of the key indicators. It is more closely associated with the changes in inflation expectations. It can also be used in prediction of the real economic activity. As we have seen the determinants of interest rates where the expected inflation had been taken into account, yield curves help in forming interest rates that takes into account the future growth and interest rates as well. Yield curves also have long associations with business cycles. The reason for the same is that it gives the most suitable predictions for the business cycle turning points. Even though it is a complex terminology, it has a number of characteristics that are common with business cycles. Research says that whenever there is an expansion in the business cycle, there is a rise of both short and long rates and vice versa for the downturns. It has also been found that all occasions wh en the yield curves that have negative slopes, where the short rates exceed the long rates, the business cycle has been at its peak. Other than those times of unusual behaviour that the Government has shown, almost every expansion has seen short rates rising more than long rates and every recession has seen long rates rising more than short rates. This is the relation between business cycle and yield curves. On a further description of business cycles with yield curves, if one considers an expansion in the business cycle initially, with an improvement from the times of recession, there is an increase in the relative demand for liquidity which increases the short rates. As liquidity begins to tighten; the probability of short rates to continue climbing decreases. As a result, the liquidity premiums begin to shift. Now the rise in short rates does not pass on to long rates and the yield curve gets flatter. Now, the probability of future weakness takes height and therefore yields sprea ds hence increasing the gap between short and long rates. (Keen, 1989) Financial Markets and Institutions In course of its functioning over decades, financial markets have changed their definitions. Today, there are recognized as mechanisms that allow trade of financial securities, commodities and other items that carry value. The transaction costs associated are relatively low and the lower it is the more efficient the market is. Financial markets are basically associated with raisin capital, transferring risks, and also international trade. Securities here can be termed s receipts which the borrower issues to the lender who promises to pay back the capital taken. In return, some form of interests or dividends is expected by the borrowers. Financial markets could either be capital markets composed of stock and bond markets, commodity markets, money markets, derivatives, futures markets, insurance markets and foreign exchange markets. Also, there are primary markets which sell or buy newly formed securities and secondary markets which sell held securities or buy the existing ones. Talk ing about a financial institution, it provides financial services to its clients. They most significantly work as financial intermediaries. There are basically three types of financial institutions. There are deposit-taking institutions which are related to managing loans and deposits. They would be in the form of banks, credit unions, building societies, trust companies and also mortgage loan companies. The other types are the insurance companies and pension funds and the third type are in the form of brokers, underwriters and investment funds. Working as intermediaries, financial institutions are responsible for transfer of funds from investors to companies who require those funds. In other words, they are the ones who facilitate the flow of money. In most countries, financial institutions work under prudential regulations with due regard to consumer protection and stability of the market. (Vernimmen, 2009) Risk and Required Return In most general terms, a risky situation is that which has a certain probability of loss. As the probability of this loss increases, the chances of risk also increase. This can be described by virtue of probability distribution of the possible returns out of it. As far as the return is concerned, the most likely outcome of the same is measured in the form of expected value. If the distribution has been considered normal, the expected value if the arithmetic mean. The more is the expected value of return, the better is the investment. Variance and standard deviation are two important measures that check for risk measurement. In this context dispersion means a higher value of uncertainty that accounts for a higher value of risks. In order to calculate the required rate of return, there are two major factors that have to be taken into account. They are perceived riskiness of the investment and the required rate on making investments other than the ones chosen. So a required rate of re turn can be calculated as the sum of risk free return and the premium that is associated with the risks. Risk-free rate of return signifies the pure-time value of money. It is just the interest paid over the delay of consumption. As far as the risk premium is concerned, it can be classified as follows: Business Risk Financial Leverage Liquidity Risk Exchange Rate Risk Risk and return can be graphically understood by the following graph: Profit versus Wealth Maximization In the traditional times, profit maximization was of major concern and wealth maximization was hardly given any thought. But on further understanding the market, it was found that profit maximization was only about increasing profits not taking into account the need to larger market share, high value of sales, more amount of stability etc. Also, profit maximization did not take into account the difference between shirt-term, mid-term and long-term profits. Also, it did not include profits over time. Today, many organizations are running on the pillars of social responsibility. Profit maximization does not give any heed to the society which is certainly not agreeable in the present context. As far as present scenario is concerned, one can take it for granted that a company would flourish just on the ideas of profit maximization, Hence, came the concept of wealth maximization. As far as wealth maximization is concerned, it is majorly involved in increasing the Earnings per Share (EPS ) of a firm and also to maximize the present value of net worth of the system. One can define wealth here as the difference between the value of gross present worth and the investment which is required to achieve the benefits. Here, gross present worth is actually the capitalised value of the benefits that are expected. There is a discount on this value depending on the uncertainty factor of the benefits associated with the same. So, one can define wealth maximization here is the total cash flow at a particular time as compared to the profits at that time based on a certain activity. All those actions taken by a company where the net present worth is found to be above zero value, there are chances of creating wealth out of them. They should always be considered for wealth maximization rather than on the limited-scope profit maximization. (Profit Maximization vs Wealth maximization, 2007) Types of Financial Instruments Financial instruments are the trading entities in the financial market explained in the previous sections. These financial instruments are mentioned as follows: Equities It is a representation of ownership in a company. Stock markets are the places where the trade of equities can be done. There are chances of purchasing equities directly from a company by virtue of Initial Public Offer (IPO). It is generally considered to be a good investment in the long run but also has a large amount of risks associated with it. Ownership of equities makes a person, a shareholder of a company. (Vishwanath, 2007) Mutual Funds Here, a group of people are given the opportunity to put their money together as an investment and rely on professional organization to manage the same. It has a pre-determined financial objective. The major characteristics associated with the same are diversification in risks, efficiency of costs, management by professionals and sound regulation. Every company has different schemes under this context depending on the type of market requirements. Bonds These financial instruments are of fixed-income nature which has the sole purpose of raising capital from the market. Almost every institution whether private, financial, state or even central and other Government institutions use it to generate funds. Of these Government bonds have least risks associated but that comes with a low level of return as well. Deposits Surplus funds can be secured using investment in banks or through the deposits in post offices. As far as lying on the spectrum is concerned, they generally lie at a lower end but is effective for older people. Cash Equivalents These are of the safest forms of investment options. Hey are also highly liquid in nature. In modern terms treasury bills and also market funds are equivalents of cash. (Financial Instruments, 2011)