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Corporate Finance: Financial Control
Corporate Finance: Financial Control Marta Renzetti, SDA Bocconi-Corporate Finance, Milan, Italy Ó 2001 Elsevier Ltd. All rights reserved. This article is reproduced from the previous edition, volume 4, pp. 2792–2797, Ó 2001, Elsevier Ltd.
Abstract Corporate finance is concerned with financial decisions made by corporations. These decisions can be grouped easily into two major categories: investment decisions and financing decisions. Investment decisions and financing decisions must contribute together to create value for the company’s shareholders. In order to make optimal financial decisions in keeping with the major objective of the firm (i.e., maximizing its shareholders’ wealth), the financial manager adopts some analytical tools in the analysis, planning, and control activities of the firm. In fact, financial analysis is a necessary condition for making appropriate financial decisions. Accordingly, financial control can be defined as the whole of activities and tools that enable financial managers to carry out financial analyses for purposes of internal and external control. Since they need to keep under control both the profitability of capital invested and the cost of resources raised from investors, financial managers make use of an integrated system of analyses that includes financial statements, ratios, financial planning, investment valuation, and capital structure analysis. Each of these tools plays a key role with reference to the financial control activity, providing the financial manager with a wide range of information that helps the company’s investment and financing decisions.
Corporate finance is concerned with financial decisions made by corporations. These decisions can be grouped easily into two major categories: investment decisions and financing decisions. Regarding the first major decisions a firm must take, each company needs real assets (tangible and intangible) to carry on its business and keep its operations going. How much a firm should invest and what specific assets a firm should invest in are the typical questions related to investment decisions. Investment decisions, then, determine the total amount of assets held by a company and the composition of these assets. The economic evaluation of investment projects aims at orienting corporations’ choices connected to their asset allocation process. This process that leads a company to allocate its capital to investment proposals whose benefits are to be realized in the future is generally referred to as capital budgeting. All the assets we mentioned above are to be paid for. To raise the money necessary to their investments policy, corporations issue securities on financial markets. These financial assets have value since they represent claims on companies’ real assets. Securities issued by corporations include not only shares of stock but also bonds, bank loans, lease obligations, and any other form of financing. How the cash required for investments should be obtained is the answer that financing decisions must give. Financing decision, in fact, are concerned with determining the best mix of financial sources in the form of equity and debts. In other words, financing decisions define the total amount and the composition of a company’s capital structure. The definition of capital structure referred to is that which takes into account the explicitly costly forms of financing raised from the company’s investors. For sake of simplicity, they are divided into financial debts and equity without dwelling on the different form of financing. According to what has been highlighted about corporate finance decisions, financial management attempts to find specific answers to needs arising from both investment and financing areas.
International Encyclopedia of the Social & Behavioral Sciences, 2nd edition, Volume 4
After defining what corporate finance decisions are concerned with, the next step in this analysis will be to reread investment policies and capital structure decisions in the light of the theory of shareholders’ value. Since the principle of maximizing shareholders’ wealth largely is accepted as the rational guide for running a business and for the efficient allocation in an economy, it is assumed to be the objective in considering how financial decisions should be made. Investment decisions and financing decisions must contribute together to create value for the company’s shareholders. From one hand, a financial manager that acts in its shareholders’ interest should invest in those projects that increase the overall firm’s value and, then, its shares’ value. From the other hand, the mix of financial resources that maximizes the company’s value should be adopted. From this point of view, it becomes crucial to understand how corporate borrowing affects its shareholders’ wealth according to Modigliani and Miller proposition II. In their article, Modigliani and Miller (1963) state that, in a world with taxes, the value of a levered firm increases in proportion to the debt–equity ratio (Debt/Equity). As we will show in Section Capital Structure Analysis this is due to the fact that financial charges are tax deductible whereas dividends and retained earnings are not; an increase in debts will reduce the company’s cost of capital and raise the firms’ value. In addition to that, it must be kept in mind that investment decisions and financing decisions interact, sometimes producing different consequences on the company’s value. In fact, any change in the firm’s capital structure influences the cost of capital that a company applies to discount investments cash flows. Consequently, any rise in the cost of capital could make any investment less profitable, reducing its contribution to the overall company’s value. From what has been said, it can be concluded that both investment and financial decisions have to be analyzed in relation to their impact on the firm’s major objective: to make the firm’s shareholders as well off as possible. As a result, an
http://dx.doi.org/10.1016/B978-0-08-097086-8.73030-3
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optimal combination of the two areas of decision will maximize the value of the firm for its shareholders. Consistent with that, the financial manager must act as an intermediary between the firm’s operations and capital markets where the firm’s securities are traded. The purpose of capital markets is allocating savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets (companies). In fact, companies issue securities and raise cash by selling those financial assets to investors. Then the cash is invested in the firm’s operations and used to purchase real assets. Later, if the firm does well, the real assets generate cash inflows that more than repay the initial investment. Finally, once the firm’s operations generate new cash, this is either reinvested in the company or returned to investors who hold the securities originally issued. The last decision is not completely free for the financial manager, but it depends on several factors such as the characteristics of the specific financing, the dividend policy, the financial needs of the company.
Corporate Finance Decisions and Financial Control In order to make optimal financial decisions in keeping with the major objective of the firm (i.e., maximizing its shareholders’ wealth), the financial manager must implement inside the firm an effective process of analysis, planning, and control and make use of some analytical tools. In fact, financial analyses are a necessary condition for making appropriate financial decisions in the meaning as stated before. From a very simplistic point of view, in order to create value for all the company’s investors (debtholders and stakeholders), the asset allocation process must yield more than the company’s cost of capital. Since the financial manager has to grant that the cash flow ability of the firm will properly remunerate its financial sources over the long run, they must evaluate the size and timing of cash flows and monitor the company’s capital structure, its major sources and uses of funds, and its profitability over time. As a measure of the company’s profitability ROI (return on investments ¼ operating income/capital invested) is taken into consideration. According to that, the financial manager is concerned on one hand with the profitability of the company’s investments and with the efficiency of the implemented asset management decisions. It means that they have to make use of rational tools to evaluate capital budgeting decisions. On the other hand, the financial manager is interested in keeping constantly under control the changes in the company’s capital structure that can affect both the firm’s cost of capital and the yield required by capital suppliers. If the company’s cost of capital is defined as the weighted average cost of capital (WACC) and represents the net cost of debts and equity weighted by their percentage on the total capital structure, an increase in the percentage of debts, for instance, can reduce the WACC since they are less costly than equity, due to their fiscal deductibility; at the same time, an excessive rise in debts can make the company be perceived as a riskier investment and thus induce investors to require higher yields on debt and equity. Both these effects have to be taken into account once the financial manager is approaching any financing decision.
In the light of what financial managers must do to maximize shareholders’ value, financial control can be defined as the whole of the activities and tools that enable financial managers to carry out financial analyses for the purposes of internal and external control. By internal control, we mean evaluating the investments profitability and the efficiency/effectiveness of the capital budgeting process. In addition to that, a form of internal control is considered as any analysis turned to keep under observation the composition of the company’s capital structure. External control is any aspect of financial analysis that outside suppliers of capital take into consideration in evaluating the firm and that the financial manager should be interested in the endeavor of bargaining more effectively for outside funds. So far it has been stated that the main corporate goal is to increase the shareholders’ wealth. According to that, a company creates value if its shareholders’ wealth rises. It is worth mentioning that, recently, financial markets and investors have taken into account new parameters in the evaluation of financial investments. These parameters add a social and ethical appraisal of financial investments to a pure financial valuation. Such parameters aim at reminding companies of their social responsibilities and spur them to give constructive contributions to society and bring positive energy to the solutions of its problems. As a consequence of the new approach to interpreting the corporate role within the society, investors choose to invest their money only in those companies that behave ethically. On the other hand, financial products suppliers are tailoring new financial products which are labeled as ethical, and that respond to the new evaluation requirements. The Dow Jones Sustainability Index (DJSGI) can be seen as an example of this new trend inside financial markets. That index, in fact, consists of more than 200 companies that represent the top 10% of leading sustainability companies in 64 industry groups in the 33 countries covered by the DJSGI. The companies included in the DJSGI have shown over time a strong commitment on the achievement of the five corporate sustainability performance principles: innovation, high standard corporate governance, shareholders’ requirements, best practices, and social behaviors. From what has just been highlighted, managers must be aware that new principles beyond those suggested by financial theories have to be pursued in running their business.
An Integrated System of Financial Analyses An effective financial analysis, planning, and control process is critical to enhance enterprise value and, then, shareholders’ wealth. To make rational decisions in the shareholders’ interest, financial managers need to be supported by an integrated system of financial analyses and reports. These tools enable financial managers constantly to control both the profitability of the company (in the meaning of the firm’s ability to generate cash flows from its operating activities) and the cost of resources applied to undertake operating investments that determine the company’s cost of capital. Since they need to keep under control both the profitability of capital invested and the cost of resources raised from
Corporate Finance: Financial Control investors, financial managers make use of an integrated system of analyses that includes financial statements, ratios, financial planning, investment valuation, and capital structure analysis. Each of these tools plays a key role with reference to the financial control activity, providing the financial manager with a wide range of information that helps in orienting the company’s investment and financing decisions. Even if financial analysis, planning, and control activities are often considered as different tools, they have to be viewed as a whole since they together aim at accomplishing the maximization of shareholders’ value. In large companies it often happens that different managers carry out the above mentioned analyses in different departments. It becomes important, then, to construct an integrated system of data exchange that allows the different tools to work jointly. To assess an investment’s profitability, for instance, it is necessary to forecast the company’s market share in order to determine its potential incremental revenues and cash flows. In addition to that, the composition of the expected capital structure will be also needed to calculate the new cost of capital and discount future cash flows at that rate.
Financial Accounting Financial accounting (financial statements, ratios, and cash flow statements) gives the financial manager a picture of the firm’s past performance and its current standing. These analyses help the financial manager to understand the company’s current economic and financial situation and make forecasts for the future. It also allows the manager to represent the firm’s position according to its competitors and its evolution over time. The reorganization of financial statements (assets and liabilities statement and income statement) according to some predefined schemes is the first step of a process that, starting from accounting information, ends up with the appraisal of a company’s performance from both income and cash flow perspective. One of the criteria applied to reorganize the company’s financial statements is, for instance, the activity-related method. With relation to this approach, we group the balance sheet entries in current and noncurrent assets and liabilities according to their pertinence or otherwise to the operating cycle of the company. The same criterion applied to the items contained in the income statement allows us to separate revenues and costs in relation with the four activity areas that can be identified in an ongoing business: current, financial, subsidiary, and extraordinary activities. Once financial statements have been reorganized, it is possible for the financial manager to combine income statement and balance sheet entries in order to obtain significative ratios. Second, from reorganized financial statements, a cash flow statement can be drawn up as well. In particular, a complete system of ratios describes the current state of health of the company according to different points of view: liquidity, profitability, leverage. This analysis offers a static diagnosis of the firm that can be helpful formanagerial control and for a better understanding of what outside suppliers of capital may expect in terms of
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a company’s financial condition and performance. In fact, both the financial manager and the company’s investors are interested in measuring the return on investments of the company, its capability of repaying debts in the short run and in the long run, and the relation between debt and equity. Consistent to that aim, ratios are mostly employed for ex-post analysis, to verify the effect of investment and financing decisions on the company’s profitability, and for the composition of its assets and liabilities. The final step in the above mentioned process of financial analysis is represented by the construction of the cash flow statement. Cash flow analysis can be seen as a dynamic analysis that highlights the company’s ability of generating cash flow. Using cash flow, the financial manager identifies the sources and uses of monetary resources during a given period. The cash flow statement groups all the inflows and outflows according to their pertinence to the current activity, the financing and reimbursement activity, the investment activity (operating and nonoperating), and to the remuneration of debt holders and stakeholders. In other words, this tool leads to the quantification of the cash inflows that the company is currently able to generate from its operating activity, and the comparison of them to the flows absorbed by the investment policy, the debt repayment, and the dividend policy. In fact, it is one thing if a company can provide the monetary resources autonomously to undertake investments and adequately remunerate the capital invested, while it is quite another if the same company regularly needs to find outside sources of capital in order to avoid financial distress caused by an insufficient production of cash inflow. Consistent with that, the cash flow analysis can be interpreted as an ex-post analysis that helps the financial manager to appraise the impact of investment and financing decisions in terms of financial flows.
Financial Planning Financial planning enables financial managers to assess the effects of financing and investment decisions ex-ante. Financial planning is a necessary analysis as investment and financing decisions interact and they should not be made independently. Financial planning is concerned with analyzing financial flows of the firm as a whole, forecasting the consequences of investment and financing decisions, and weighing the effects of different alternatives. In fact, any financial decision that affects the investment policy of the firm or its mix of financial sources raised from investors influences the company’s future profitability as well as its capital structure (and its cost of capital). The financial manager has to define both a target financing mix and a target return on investments and undertake only the investments/financings consistent with those targets. In order to keep under control any unexpected change that can modify the company’s return on investments or its cost of capital, the financial manager has to analyze any financial strategy very carefully and to take into consideration any economic and financial impact that it may have. Moreover, financial planning makes possible the comparison of different investment and financing strategies in order to evaluate which one maximizes shareholders’ wealth.
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The tangible tool applied in the planning process is the financial plan describing the firm’s financial strategy and projecting its future consequences in a proforma balance sheet, income statement, and cash flow statement. In particular, the forecasted cash flow statement provides an effective method for the financial manager to assess the growth of the company and its resulting financial needs as well as to determine the best alternative to finance those needs. In fact, the plan sets financial goals and it represents a benchmark itself for evaluating subsequent performance. Helping the company to achieve these goals is one of the chief responsibilities of financial planning. Finally, the planning horizon depends on the company and its business. High-tech companies, for instance, produce much shorter financial plans than most companies do as a consequence of technologies life cycle, whereas public utilities and energy companies make longer financial plans due to the long lead time of their capital projects.
Investments Valuation Capital budgeting involves the entire process of planning capital expenditures whose returns are normally expected to extend beyond 1 year. Since we stated that investment decisions must be made so that they maximize shareholders’ value, capital budgeting decisions forcedly must be related to the firm’s overall strategic planning. Capital budgeting must be integrated with strategic planning as excessive investments or inadequate investments could cause serious consequences for the future of the firm. If the company invested too much in fixed assets overestimating its potential growth, it would incur unnecessarily heavy expenses that would reduce its return on investments. On the other hand, if a company has not invested enough in new production capacity it may lose a portion of its customers to rival firms. A related problem is how to properly phase the availability of capital assets in order to have them ‘working’ at the correct time. An effective process of capital budgeting aims at improving the timing of asset acquisitions and the quality of assets purchased. Another reason that highlights the relevance of the capital budgeting process is that asset expansion typically involves substantial expenditures. Before a company undertakes an expensive investment such as the purchase of a new plant, the launch of a new product, or the signature of a commercial agreement, it needs to plan how to raise funds required for that specific project. A number of factors make capital budgeting one of the major financial management decisions. In fact, not only does any investment decision contribute to determine the company’s profitability (and its ROI) and, then, the shareholders’ value, but also the capital budgeting process vitally affects all departments of a firm (such as production, marketing, finance, to mention a few). Since financial managers need to keep under control the asset allocation process so as to grant the maximum value to their shareholders, it can be said confidently that one of the most important corporate finance functions is the economic valuation of investment projects. In fact, the first step in undertaking any allocation project is the analysis of its economic and financial profile. The latter aspect is taken into account in drawing up the financial plan, where the financial
manager verifies the compatibility of the cash flows related to the project under consideration with those that happen at the overall company’s level. The financial manager must carry out those projects that maximize the incremental value for the company’s shareholders. In order to increase shareholders’ wealth, a project must yield more than the cost of funds used to undertake the capital expenditure. It is, then, possible to conclude that the financial manager must judge a certain investment project according to its expected return. If this is higher than the company’s cost of capital, the specific investment will create value for the company’s shareholders. As the asset allocation process is led on a continual basis, the financial manager must measure constantly the profitability of the firm’s investment activity. Such a form of control makes use of appropriate methods of analysis like the NPV and the IRR. The NPV (net present value) is the present value of the cash lows stemming from the investment project; the IRR (internal rate of return) is that rate that makes the NPV equal to zero and it can be seen as the gross return of an investment project. The implementation of the above mentioned tools of financial control on investments prevents the funds being misallocated. In fact, when many alternatives of investment are evaluated, the most profitable will be chosen first, then the others one by one according to their expected rate of return. This modus operandi becomes a necessary approach if the company has a limited amount of funds available to finance investment projects (capital rationing).
Capital Structure Analysis Capital structure refers to how the firm’s assets are financed. If the monetary resources that the current activity is able to produce are not enough to offset the cash-outs due to the company’s investment activity, the firm needs to raise new funds from investors. Accordingly, capital structure is concerned with explicitly costly forms of financing just as financial debts (bonds, loans, overdrafts) and equity are. In fact, both debt holders and shareholders want to be remunerated for the money they invested into the company. It is then possible to determine the cost of capital as the average of the net cost of debt and equity (WACC). To calculate the average, the impact of debts and equity on the total capital structure has to be taken into account. The composition of capital structure influences the company’s cost of capital from two different points of view. First, any change in the amount of debts and equity will make their weights vary so that we come up with a new WACC, other things being equal. Second, the cost of capital will differently change according to which form of financing is chosen. Since financial charges are tax deductible whereas dividends and retained earnings are not, an increase in debts will reduce the WACC. However, it must not be concluded that a company should be 100% debt financed. In fact, the more debts rise the higher the risk of financial distress will be. This higher risk perceived by investors leads debt holders and stakeholder to ask for being granted a higher rate of return. The composition of capital structure impacts on the shareholders’ value since it influences the cost of capital invested in
Corporate Finance: Financial Control
the company. If the return on investments remains equal, a rise in the cost of capital will cause a decrease in the company’s profitability and in shareholders’ wealth. The financial manager has to take into consideration the effect on the capital structure when any financing decision is evaluated. Once a financial need arises from the planning activity, the financial manager should simulate what impact a debt or equity issue may have on the overall company. This activity enables the financial manager to quantify the effects of financing alternatives in terms of the firm’s cost of capital and financial riskiness. We are assuming that there are no capital constraints that affect the company so that the firm can count on an unlimited access to both the equity market and the debt market. According to this hypothesis, the financial manager can choose the financing alternative that maximizes the shareholders’ value and minimizes the cost of capital. Sometimes, however, the firm has to face with a limited availability of financing alternatives to raise money from investors. In fact, many factors such as capital markets features or aspects related to companies’ ownership and control could make some financing decisions unfeasible. At the same time, other aspects such as corporate taxation can make some sources of financing preferable in comparison to others.
See also: Corporate Governance; Finance, Geography of; Organizational Decision Making.
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Bibliography Bernstein, L.A., 1978. The Analysis of Financial Statements. Dow Jones-Irwin, Homewood, IL. Brealey, R., Myers, S. Principles of Corporate Finance, fifth ed. McGraw-Hill Irwin, New York. Broke, M.Z., 1990. Handbook of International Financial Management. Macmillan. Cheng, F.L., 1985. Financial Analysis and Planning. Addison-Wesley, Reading, MA. Dallocchio, M., 1996. Corporate Finance. Managing Corporate Decisions. Egea, Milan, Italy. Modigliani, F., Miller, M.H., 1958. The cost of capital, corporate finance and the theory of investment. American Economic Review 48 (3), 261–297. Modigliani, F., Miller, M.H., 1963. Corporate income taxes and the cost of capital: a correction. American Economic Review 53 (3), 433–443. Ross, S.A., Westerfield, R.W., Jaffe, J., 1996. Corporate Finance. Irwin. Solomon, E., 1963. The Theory of Financial Management. Columbia University Press, New York. Van Horne, J.C., 1989. Financial Management and Policy. Prentice Hall, Englewood Cliffs, NJ. Weston, J.F., Thomas, T.E. Managerial Finance, ninth ed. Dryden Publisher, Orlando, FL. Weston, J.F., Thomas, T.E., 1992. Financial Theory and Corporate Policy. AddisonWesley, Reading, MA.
Abstract Corporate finance is concerned with financial decisions made by corporations. These decisions can be grouped easily into two major categories: investment decisions and financing decisions. Investment decisions and financing decisions must contribute together to create value for the company’s shareholders. In order to make optimal financial decisions in keeping with the major objective of the firm (i.e., maximizing its shareholders’ wealth), the financial manager adopts some analytical tools in the analysis, planning, and control activities of the firm. In fact, financial analysis is a necessary condition for making appropriate financial decisions. Accordingly, financial control can be defined as the whole of activities and tools that enable financial managers to carry out financial analyses for purposes of internal and external control. Since they need to keep under control both the profitability of capital invested and the cost of resources raised from investors, financial managers make use of an integrated system of analyses that includes financial statements, ratios, financial planning, investment valuation, and capital structure analysis. Each of these tools plays a key role with reference to the financial control activity, providing the financial manager with a wide range of information that helps the company’s investment and financing decisions.
Corporate finance is concerned with financial decisions made by corporations. These decisions can be grouped easily into two major categories: investment decisions and financing decisions. Regarding the first major decisions a firm must take, each company needs real assets (tangible and intangible) to carry on its business and keep its operations going. How much a firm should invest and what specific assets a firm should invest in are the typical questions related to investment decisions. Investment decisions, then, determine the total amount of assets held by a company and the composition of these assets. The economic evaluation of investment projects aims at orienting corporations’ choices connected to their asset allocation process. This process that leads a company to allocate its capital to investment proposals whose benefits are to be realized in the future is generally referred to as capital budgeting. All the assets we mentioned above are to be paid for. To raise the money necessary to their investments policy, corporations issue securities on financial markets. These financial assets have value since they represent claims on companies’ real assets. Securities issued by corporations include not only shares of stock but also bonds, bank loans, lease obligations, and any other form of financing. How the cash required for investments should be obtained is the answer that financing decisions must give. Financing decision, in fact, are concerned with determining the best mix of financial sources in the form of equity and debts. In other words, financing decisions define the total amount and the composition of a company’s capital structure. The definition of capital structure referred to is that which takes into account the explicitly costly forms of financing raised from the company’s investors. For sake of simplicity, they are divided into financial debts and equity without dwelling on the different form of financing. According to what has been highlighted about corporate finance decisions, financial management attempts to find specific answers to needs arising from both investment and financing areas.
International Encyclopedia of the Social & Behavioral Sciences, 2nd edition, Volume 4
After defining what corporate finance decisions are concerned with, the next step in this analysis will be to reread investment policies and capital structure decisions in the light of the theory of shareholders’ value. Since the principle of maximizing shareholders’ wealth largely is accepted as the rational guide for running a business and for the efficient allocation in an economy, it is assumed to be the objective in considering how financial decisions should be made. Investment decisions and financing decisions must contribute together to create value for the company’s shareholders. From one hand, a financial manager that acts in its shareholders’ interest should invest in those projects that increase the overall firm’s value and, then, its shares’ value. From the other hand, the mix of financial resources that maximizes the company’s value should be adopted. From this point of view, it becomes crucial to understand how corporate borrowing affects its shareholders’ wealth according to Modigliani and Miller proposition II. In their article, Modigliani and Miller (1963) state that, in a world with taxes, the value of a levered firm increases in proportion to the debt–equity ratio (Debt/Equity). As we will show in Section Capital Structure Analysis this is due to the fact that financial charges are tax deductible whereas dividends and retained earnings are not; an increase in debts will reduce the company’s cost of capital and raise the firms’ value. In addition to that, it must be kept in mind that investment decisions and financing decisions interact, sometimes producing different consequences on the company’s value. In fact, any change in the firm’s capital structure influences the cost of capital that a company applies to discount investments cash flows. Consequently, any rise in the cost of capital could make any investment less profitable, reducing its contribution to the overall company’s value. From what has been said, it can be concluded that both investment and financial decisions have to be analyzed in relation to their impact on the firm’s major objective: to make the firm’s shareholders as well off as possible. As a result, an
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optimal combination of the two areas of decision will maximize the value of the firm for its shareholders. Consistent with that, the financial manager must act as an intermediary between the firm’s operations and capital markets where the firm’s securities are traded. The purpose of capital markets is allocating savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets (companies). In fact, companies issue securities and raise cash by selling those financial assets to investors. Then the cash is invested in the firm’s operations and used to purchase real assets. Later, if the firm does well, the real assets generate cash inflows that more than repay the initial investment. Finally, once the firm’s operations generate new cash, this is either reinvested in the company or returned to investors who hold the securities originally issued. The last decision is not completely free for the financial manager, but it depends on several factors such as the characteristics of the specific financing, the dividend policy, the financial needs of the company.
Corporate Finance Decisions and Financial Control In order to make optimal financial decisions in keeping with the major objective of the firm (i.e., maximizing its shareholders’ wealth), the financial manager must implement inside the firm an effective process of analysis, planning, and control and make use of some analytical tools. In fact, financial analyses are a necessary condition for making appropriate financial decisions in the meaning as stated before. From a very simplistic point of view, in order to create value for all the company’s investors (debtholders and stakeholders), the asset allocation process must yield more than the company’s cost of capital. Since the financial manager has to grant that the cash flow ability of the firm will properly remunerate its financial sources over the long run, they must evaluate the size and timing of cash flows and monitor the company’s capital structure, its major sources and uses of funds, and its profitability over time. As a measure of the company’s profitability ROI (return on investments ¼ operating income/capital invested) is taken into consideration. According to that, the financial manager is concerned on one hand with the profitability of the company’s investments and with the efficiency of the implemented asset management decisions. It means that they have to make use of rational tools to evaluate capital budgeting decisions. On the other hand, the financial manager is interested in keeping constantly under control the changes in the company’s capital structure that can affect both the firm’s cost of capital and the yield required by capital suppliers. If the company’s cost of capital is defined as the weighted average cost of capital (WACC) and represents the net cost of debts and equity weighted by their percentage on the total capital structure, an increase in the percentage of debts, for instance, can reduce the WACC since they are less costly than equity, due to their fiscal deductibility; at the same time, an excessive rise in debts can make the company be perceived as a riskier investment and thus induce investors to require higher yields on debt and equity. Both these effects have to be taken into account once the financial manager is approaching any financing decision.
In the light of what financial managers must do to maximize shareholders’ value, financial control can be defined as the whole of the activities and tools that enable financial managers to carry out financial analyses for the purposes of internal and external control. By internal control, we mean evaluating the investments profitability and the efficiency/effectiveness of the capital budgeting process. In addition to that, a form of internal control is considered as any analysis turned to keep under observation the composition of the company’s capital structure. External control is any aspect of financial analysis that outside suppliers of capital take into consideration in evaluating the firm and that the financial manager should be interested in the endeavor of bargaining more effectively for outside funds. So far it has been stated that the main corporate goal is to increase the shareholders’ wealth. According to that, a company creates value if its shareholders’ wealth rises. It is worth mentioning that, recently, financial markets and investors have taken into account new parameters in the evaluation of financial investments. These parameters add a social and ethical appraisal of financial investments to a pure financial valuation. Such parameters aim at reminding companies of their social responsibilities and spur them to give constructive contributions to society and bring positive energy to the solutions of its problems. As a consequence of the new approach to interpreting the corporate role within the society, investors choose to invest their money only in those companies that behave ethically. On the other hand, financial products suppliers are tailoring new financial products which are labeled as ethical, and that respond to the new evaluation requirements. The Dow Jones Sustainability Index (DJSGI) can be seen as an example of this new trend inside financial markets. That index, in fact, consists of more than 200 companies that represent the top 10% of leading sustainability companies in 64 industry groups in the 33 countries covered by the DJSGI. The companies included in the DJSGI have shown over time a strong commitment on the achievement of the five corporate sustainability performance principles: innovation, high standard corporate governance, shareholders’ requirements, best practices, and social behaviors. From what has just been highlighted, managers must be aware that new principles beyond those suggested by financial theories have to be pursued in running their business.
An Integrated System of Financial Analyses An effective financial analysis, planning, and control process is critical to enhance enterprise value and, then, shareholders’ wealth. To make rational decisions in the shareholders’ interest, financial managers need to be supported by an integrated system of financial analyses and reports. These tools enable financial managers constantly to control both the profitability of the company (in the meaning of the firm’s ability to generate cash flows from its operating activities) and the cost of resources applied to undertake operating investments that determine the company’s cost of capital. Since they need to keep under control both the profitability of capital invested and the cost of resources raised from
Corporate Finance: Financial Control investors, financial managers make use of an integrated system of analyses that includes financial statements, ratios, financial planning, investment valuation, and capital structure analysis. Each of these tools plays a key role with reference to the financial control activity, providing the financial manager with a wide range of information that helps in orienting the company’s investment and financing decisions. Even if financial analysis, planning, and control activities are often considered as different tools, they have to be viewed as a whole since they together aim at accomplishing the maximization of shareholders’ value. In large companies it often happens that different managers carry out the above mentioned analyses in different departments. It becomes important, then, to construct an integrated system of data exchange that allows the different tools to work jointly. To assess an investment’s profitability, for instance, it is necessary to forecast the company’s market share in order to determine its potential incremental revenues and cash flows. In addition to that, the composition of the expected capital structure will be also needed to calculate the new cost of capital and discount future cash flows at that rate.
Financial Accounting Financial accounting (financial statements, ratios, and cash flow statements) gives the financial manager a picture of the firm’s past performance and its current standing. These analyses help the financial manager to understand the company’s current economic and financial situation and make forecasts for the future. It also allows the manager to represent the firm’s position according to its competitors and its evolution over time. The reorganization of financial statements (assets and liabilities statement and income statement) according to some predefined schemes is the first step of a process that, starting from accounting information, ends up with the appraisal of a company’s performance from both income and cash flow perspective. One of the criteria applied to reorganize the company’s financial statements is, for instance, the activity-related method. With relation to this approach, we group the balance sheet entries in current and noncurrent assets and liabilities according to their pertinence or otherwise to the operating cycle of the company. The same criterion applied to the items contained in the income statement allows us to separate revenues and costs in relation with the four activity areas that can be identified in an ongoing business: current, financial, subsidiary, and extraordinary activities. Once financial statements have been reorganized, it is possible for the financial manager to combine income statement and balance sheet entries in order to obtain significative ratios. Second, from reorganized financial statements, a cash flow statement can be drawn up as well. In particular, a complete system of ratios describes the current state of health of the company according to different points of view: liquidity, profitability, leverage. This analysis offers a static diagnosis of the firm that can be helpful formanagerial control and for a better understanding of what outside suppliers of capital may expect in terms of
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a company’s financial condition and performance. In fact, both the financial manager and the company’s investors are interested in measuring the return on investments of the company, its capability of repaying debts in the short run and in the long run, and the relation between debt and equity. Consistent to that aim, ratios are mostly employed for ex-post analysis, to verify the effect of investment and financing decisions on the company’s profitability, and for the composition of its assets and liabilities. The final step in the above mentioned process of financial analysis is represented by the construction of the cash flow statement. Cash flow analysis can be seen as a dynamic analysis that highlights the company’s ability of generating cash flow. Using cash flow, the financial manager identifies the sources and uses of monetary resources during a given period. The cash flow statement groups all the inflows and outflows according to their pertinence to the current activity, the financing and reimbursement activity, the investment activity (operating and nonoperating), and to the remuneration of debt holders and stakeholders. In other words, this tool leads to the quantification of the cash inflows that the company is currently able to generate from its operating activity, and the comparison of them to the flows absorbed by the investment policy, the debt repayment, and the dividend policy. In fact, it is one thing if a company can provide the monetary resources autonomously to undertake investments and adequately remunerate the capital invested, while it is quite another if the same company regularly needs to find outside sources of capital in order to avoid financial distress caused by an insufficient production of cash inflow. Consistent with that, the cash flow analysis can be interpreted as an ex-post analysis that helps the financial manager to appraise the impact of investment and financing decisions in terms of financial flows.
Financial Planning Financial planning enables financial managers to assess the effects of financing and investment decisions ex-ante. Financial planning is a necessary analysis as investment and financing decisions interact and they should not be made independently. Financial planning is concerned with analyzing financial flows of the firm as a whole, forecasting the consequences of investment and financing decisions, and weighing the effects of different alternatives. In fact, any financial decision that affects the investment policy of the firm or its mix of financial sources raised from investors influences the company’s future profitability as well as its capital structure (and its cost of capital). The financial manager has to define both a target financing mix and a target return on investments and undertake only the investments/financings consistent with those targets. In order to keep under control any unexpected change that can modify the company’s return on investments or its cost of capital, the financial manager has to analyze any financial strategy very carefully and to take into consideration any economic and financial impact that it may have. Moreover, financial planning makes possible the comparison of different investment and financing strategies in order to evaluate which one maximizes shareholders’ wealth.
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The tangible tool applied in the planning process is the financial plan describing the firm’s financial strategy and projecting its future consequences in a proforma balance sheet, income statement, and cash flow statement. In particular, the forecasted cash flow statement provides an effective method for the financial manager to assess the growth of the company and its resulting financial needs as well as to determine the best alternative to finance those needs. In fact, the plan sets financial goals and it represents a benchmark itself for evaluating subsequent performance. Helping the company to achieve these goals is one of the chief responsibilities of financial planning. Finally, the planning horizon depends on the company and its business. High-tech companies, for instance, produce much shorter financial plans than most companies do as a consequence of technologies life cycle, whereas public utilities and energy companies make longer financial plans due to the long lead time of their capital projects.
Investments Valuation Capital budgeting involves the entire process of planning capital expenditures whose returns are normally expected to extend beyond 1 year. Since we stated that investment decisions must be made so that they maximize shareholders’ value, capital budgeting decisions forcedly must be related to the firm’s overall strategic planning. Capital budgeting must be integrated with strategic planning as excessive investments or inadequate investments could cause serious consequences for the future of the firm. If the company invested too much in fixed assets overestimating its potential growth, it would incur unnecessarily heavy expenses that would reduce its return on investments. On the other hand, if a company has not invested enough in new production capacity it may lose a portion of its customers to rival firms. A related problem is how to properly phase the availability of capital assets in order to have them ‘working’ at the correct time. An effective process of capital budgeting aims at improving the timing of asset acquisitions and the quality of assets purchased. Another reason that highlights the relevance of the capital budgeting process is that asset expansion typically involves substantial expenditures. Before a company undertakes an expensive investment such as the purchase of a new plant, the launch of a new product, or the signature of a commercial agreement, it needs to plan how to raise funds required for that specific project. A number of factors make capital budgeting one of the major financial management decisions. In fact, not only does any investment decision contribute to determine the company’s profitability (and its ROI) and, then, the shareholders’ value, but also the capital budgeting process vitally affects all departments of a firm (such as production, marketing, finance, to mention a few). Since financial managers need to keep under control the asset allocation process so as to grant the maximum value to their shareholders, it can be said confidently that one of the most important corporate finance functions is the economic valuation of investment projects. In fact, the first step in undertaking any allocation project is the analysis of its economic and financial profile. The latter aspect is taken into account in drawing up the financial plan, where the financial
manager verifies the compatibility of the cash flows related to the project under consideration with those that happen at the overall company’s level. The financial manager must carry out those projects that maximize the incremental value for the company’s shareholders. In order to increase shareholders’ wealth, a project must yield more than the cost of funds used to undertake the capital expenditure. It is, then, possible to conclude that the financial manager must judge a certain investment project according to its expected return. If this is higher than the company’s cost of capital, the specific investment will create value for the company’s shareholders. As the asset allocation process is led on a continual basis, the financial manager must measure constantly the profitability of the firm’s investment activity. Such a form of control makes use of appropriate methods of analysis like the NPV and the IRR. The NPV (net present value) is the present value of the cash lows stemming from the investment project; the IRR (internal rate of return) is that rate that makes the NPV equal to zero and it can be seen as the gross return of an investment project. The implementation of the above mentioned tools of financial control on investments prevents the funds being misallocated. In fact, when many alternatives of investment are evaluated, the most profitable will be chosen first, then the others one by one according to their expected rate of return. This modus operandi becomes a necessary approach if the company has a limited amount of funds available to finance investment projects (capital rationing).
Capital Structure Analysis Capital structure refers to how the firm’s assets are financed. If the monetary resources that the current activity is able to produce are not enough to offset the cash-outs due to the company’s investment activity, the firm needs to raise new funds from investors. Accordingly, capital structure is concerned with explicitly costly forms of financing just as financial debts (bonds, loans, overdrafts) and equity are. In fact, both debt holders and shareholders want to be remunerated for the money they invested into the company. It is then possible to determine the cost of capital as the average of the net cost of debt and equity (WACC). To calculate the average, the impact of debts and equity on the total capital structure has to be taken into account. The composition of capital structure influences the company’s cost of capital from two different points of view. First, any change in the amount of debts and equity will make their weights vary so that we come up with a new WACC, other things being equal. Second, the cost of capital will differently change according to which form of financing is chosen. Since financial charges are tax deductible whereas dividends and retained earnings are not, an increase in debts will reduce the WACC. However, it must not be concluded that a company should be 100% debt financed. In fact, the more debts rise the higher the risk of financial distress will be. This higher risk perceived by investors leads debt holders and stakeholder to ask for being granted a higher rate of return. The composition of capital structure impacts on the shareholders’ value since it influences the cost of capital invested in
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the company. If the return on investments remains equal, a rise in the cost of capital will cause a decrease in the company’s profitability and in shareholders’ wealth. The financial manager has to take into consideration the effect on the capital structure when any financing decision is evaluated. Once a financial need arises from the planning activity, the financial manager should simulate what impact a debt or equity issue may have on the overall company. This activity enables the financial manager to quantify the effects of financing alternatives in terms of the firm’s cost of capital and financial riskiness. We are assuming that there are no capital constraints that affect the company so that the firm can count on an unlimited access to both the equity market and the debt market. According to this hypothesis, the financial manager can choose the financing alternative that maximizes the shareholders’ value and minimizes the cost of capital. Sometimes, however, the firm has to face with a limited availability of financing alternatives to raise money from investors. In fact, many factors such as capital markets features or aspects related to companies’ ownership and control could make some financing decisions unfeasible. At the same time, other aspects such as corporate taxation can make some sources of financing preferable in comparison to others.
See also: Corporate Governance; Finance, Geography of; Organizational Decision Making.
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Bibliography Bernstein, L.A., 1978. The Analysis of Financial Statements. Dow Jones-Irwin, Homewood, IL. Brealey, R., Myers, S. Principles of Corporate Finance, fifth ed. McGraw-Hill Irwin, New York. Broke, M.Z., 1990. Handbook of International Financial Management. Macmillan. Cheng, F.L., 1985. Financial Analysis and Planning. Addison-Wesley, Reading, MA. Dallocchio, M., 1996. Corporate Finance. Managing Corporate Decisions. Egea, Milan, Italy. Modigliani, F., Miller, M.H., 1958. The cost of capital, corporate finance and the theory of investment. American Economic Review 48 (3), 261–297. Modigliani, F., Miller, M.H., 1963. Corporate income taxes and the cost of capital: a correction. American Economic Review 53 (3), 433–443. Ross, S.A., Westerfield, R.W., Jaffe, J., 1996. Corporate Finance. Irwin. Solomon, E., 1963. The Theory of Financial Management. Columbia University Press, New York. Van Horne, J.C., 1989. Financial Management and Policy. Prentice Hall, Englewood Cliffs, NJ. Weston, J.F., Thomas, T.E. Managerial Finance, ninth ed. Dryden Publisher, Orlando, FL. Weston, J.F., Thomas, T.E., 1992. Financial Theory and Corporate Policy. AddisonWesley, Reading, MA.