Corporate Finance

Corporate Finance is the area of finance that deals with the financial decisions of firms; the main goal of corporate finance is to maximize corporate value. The term corporate finance applies to the financial decisions taken inside the firm in terms of investments, financing and corporate governance. It also applies to the activities of investment banking that deal with firm transactions such as mergers, acquisitions, initial public offerings or leveraged buy outs among others.

Within the firm, corporate finance deals mostly with capital budgeting decisions and financing decisions. Capital budgeting decisions refer to the selection of which investment projects should be undertaken. These decisions should take into account the expected cash flows of the projects, but also their risk and the amount of flexibility and embedded strategic options that they entail. Corporate Finance provides with the tools to analyze such elements in the context of an investment decision. Financing decisions are related to the liability structure of the firm. Firms´ capital structure can affect taxation, bankruptcy risk, the perception of the market and the incentives within the firm. In this sense capital structure can be optimized to maximize shareholders´ value. Corporate Finance also deals with the payout policy of the firm.

Corporate Finance also deals with the transactions that are traditionally in the sphere of investment banking. Among them the area of mergers and acquisitions deals with transactions that involve changes in the nature and control of the firm. Leveraged buy outs and private equity in general are also areas of interest within corporate finance. Although Banking in general is often considered an area on its own it is closely related to corporate finance.

Finally corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, management, and the board of directors. While the study of corporate governance involves several areas of law and economics it has been traditionally considered associated with corporate finance given its association with the agency problems that are the core of many corporate finance problems. The study of executive compensation and the provision of incentives inside the firm are also often analyzed as a subset of corporate governance.

Bibliography

  • Brealey, Richard A., Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance, Irwin McGraw-Hill – 2006.
  • Copeland, Tom, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, Wiley – 2000.
  • Damodaran, Aswath, Corporate Finance: Theory and Practice, Wiley – 2001.
  • Grinblatt, Mark, and Sheridan Titman, Financial Markets and Corporate Strategy, Wiley – 2001.
  • Stephen A. Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance, Irwin McGraw-Hill – 2005.

Articles in specialised publications

  • Fazzari, Steven M., R. Glenn Hubbard, and Bruce C. Petersen, 1988, “Financing Constraints and Corporate Investment.” Brookings Papers on Economic Activity, Vol. 1, pp. 141-195.

    In basic economic theory, financial and investement decisions should be made seperately. Fazzari et al. are the first to argue that, when companies have financing restrictions, investment policy becomes seriously affected. Over the last few years, a considerable number of articles have analysed the influence of financing restrictions – such as having an insufficiently developed capital market, in investment policy.

  • Harvey, Campbell, and John Graham, 2001, “The theory and practice of corporate finance: Evidence from the field,” Journal of Financial Economics 60, 187-243.

    A fundamental paper to understanding how financial theory has contributed to real policies of companies. It is based on a survey of financial directors of American companies, and shows that in the majority of cases directors act in accordance with academic principles.

  • Jensen, Michael C., and William H. Meckling, “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure,” Journal of Financial Economics, 1976, 305-360.

    The most quoted article in Corporate Finance. It introduces the concepts of agency costs referring to the problem suffered by companies owned by shareholders and controlled by directors. As the shareholdres and directors have different objectives, the managers tend to carry out actions which do not maximise the value of the share. Agency problems is one of the areas most analysed in Corporate Finance literature. It is also one of the first applications of game theory in Finance.

  • La Porta, Rafael, Florencio López de Silanes, Andrei Shleifer and Robert Vishny, 1998, “Law and Finance,”, Journal of Political Economy, Vol. 106, No. 6, 1113-1155.

    These four authors, known in the academic world by their initials, LLSV, are pioneers in the field of Corporate Governance. Their work shows that there are legal conditions which determine how companies are governed. They also demonstrate that those countries with corporate governance systems which leave the investor unprotected against company management are less profitable and property is much more concentrated.

  • Mehra, Rajnish, and Edward C. Prescott. 1985. “The Equity Premium: A Puzzle.” Journal of Monetary Economics vol. 15, no. 2 (March):145–161.

    Mehra y Prescott showed that in the 90 years before 1978 investment in shares had generated an annual profitability of 6 percentage points more than State bonds. The magnitude of such a difference could not be explained reasonably with the existing theoretical models. In fact, investors should have an excessive risk aversion coefficient in order to justify this performance. A satisfactory solution to this paradox has still not been found. (Prescott received the Nobel prize in 2004).

  • Modigliani Franco, and Merton Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, Vol. 48, No. 3 (Jun., 1958) , pp. 261-297.

    These two economists, awarded with the Nobel prize, began their research in the field of Corporate Finance fifty years ago in order to show that under strict conditions, financing decisions are irrelevant. From here, Corporate Finance research has focused on the factors which make financing decisions relevant.

  • Myers, S., 1977, Determinants of corporate borrowing, Journal of Financial Economics 5, 147-175.

    The first important contribution which attempts to explain the theorem of irrelevance of Modigliani y Miller, using the arguments of information asymmetry. Myers theoretically shows that when shareholders have incomplete information about shares from the directors, debt is a mechanism which, by limiting their discretion, prevents directors from making inefficient decisions.

  • Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press

    A good book for understanding Behavioural Finance, which contributes to explaining financial phenomena with the basic idea that investors are not rational. Behavioural Finance applies Psychology concepts and constructions such as the excess of confidence, the aversion to loss or prospect theory to markets.

  • Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press.

    Andrei Shleifer’s book is essential for understanding how irrational investors have an effect on markets. The principal idea is that in markets with investors who respond to unpredictable feelings, a sophisticated investor can make money by correcting the errors made by the irrational investors. However, when sophisticated investors (eg. risk funds) do not have unlimited funds, hedging does not prevent prices from reflecting the fundamental value of assets.

Interesting links